Overview

Shanghai Pharmaceuticals Holding Co., Ltd. (Shanghai Pharmaceuticals) is a state owned national pharmaceutical group headquartered in Shanghai. Currently Shanghai Pharmaceuticals is the only integrated pharmaceutical company in the PRC that is both a leading pharmaceutical manufacturer and distributor.

Shanghai Pharmaceuticals primarily operates in the following three business segments in the PRC:

- Pharmaceutical business. Shanghai Pharmaceuticals is engaged in the research and development, manufacture and sales of a broad range of pharmaceutical and healthcare products.

- Pharmaceutical distribution and supply chain solutions. Shanghai Pharmaceuticals provides distribution, warehousing, logistics and other value-added pharmaceutical supply chain solutions and related services to pharmaceutical manufacturers and dispensers, such as hospitals, distributors and pharmacies.

- Pharmaceutical retail. Shanghai Pharmaceuticals operates and franchise a network of retail pharmacies across nine provinces, municipalities and autonomous regions.

Shanghai Pharmaceuticals was formed in the 2009 restructuring with the acquisition of the Pharmaceuticals Business from the Controlling Shareholders Shanghai Pharmaceutical (Group).

The following map illustrates the geographic location or coverage of Shanghai Pharmaceuticals manufacturing facilities, distribution network and pharmaceutical retail networks.

Pharmaceutical Business

- 3rd largest pharmaceutical company in the PRC (In terms of revenue of pharmaceutical business in 2009, according to the NFS Report.)

- 53 major products,

a. Covering eight of the top ten therapeutic areas in terms of sales in the PRC

b. Aggregate accounted for 52.4% of the segment revenue of its pharmaceutical business

- Products cover approximately 70.0% of the drugs on the National List of Essential Drugs

- Majority of pharmaceutical products are prescription drugs

- Obtained and maintained

a. PRC GMP certifications for all of its active production lines

b. cGMP standards of the United States or the GMP standards of the European Union for parts of the lines

- Valid manufacturing permits for all pharmaceutical products (Under applicable PRC law, each drug manufacturing permit is valid for a term of five years upon issuance and may be renewed within six months prior to its expiration.)

Product Portfolio

- Manufactured and marketed 950 pharmaceutical products, including

a. 492 chemical drugs

b. 313 modern Chinese medicines

c. 24 biopharmaceutical products

d. Active pharmaceutical ingredients

e. Chinese herbal medicines and other healthcare products And which,

f. 01 wre eprescription drugs

g. 505 were included in the National Medical Insurance Drugs Catalog

h. 215 were included in the National List of Essential Drugs

- Expand to include six additional products upon the completion of pending acquisitions

- Pharmaceutical products coverage and brands

Research & Development

Shanghai Pharmaceuticals` research activities are conducted both in-house and through collaborations with external research partners, such as research institutes, universities and other pharmaceutical companies.

Shanghai Pharmaceuticals` research and development efforts focus on the following:

- Innovative drug research. Shanghai Pharmaceuticals seek to discover innovative drugs that address major unmet medical needs through independent research efforts and collaboration with external research partners, such as research institutes, universities and other pharmaceutical companies;

- Generic drug development. Shanghai Pharmaceuticals seek to develop first-to-market generic drugs in major therapeutic areas, such as cardiovascular system, alimentary tract and metabolism, central nervous system, antiinfectives for systemic use and antineoplastic and immunomodulating agents;

- Product improvement. Shanghai Pharmaceuticals seek to improve quality standard, discover new uses and refine production processes for its existing products; and

- International registration. Shanghai Pharmaceuticals seek to increase the value of its products by ensuring that its product quality meets the required international standards and by conducting required clinical trials and testing.

Pharmaceutical Distribution and Supply Chain Solutions

- 2nd largest distributor of pharmaceutical products (In terms of revenue in 2009, according to the NFS Report)

- The largest distributor of pharmaceutical products (11.0% market share) in the Eastern China Region (In terms of revenue in 2009, according to the NFS Report)

- 3,354 distributors as of December 31,2010 (3,623 distributors in 2008 and 3,550 distributors in 2009)

- Operates a national distribution network comprising 41 subsidiaries and branches and 32 logistics centers and warehouses

- Covered Eastern China Region, the Northern China Region and the Southern China Region

- Acquisition of CITIC Pharma, a leading pharmaceutical distributor in Beijing

- 58.8% of the external revenue from sales of imported medicines and those manufactured by subsidiaries of international pharmaceutical companies in the PRC

- Direct sell of products to over 7,600 hospitals and other medical institutions in the PRC

Shanghai Pharmaceuticals usually enter into annual distribution agreements with its distributors. These distribution agreements set the quantity and price of products as well as monthly, quarterly and/or yearly sales volume targets. Normally, no long-term contract was used. Shanghai Pharmaceuticals actively monitors the performance of its distributors, whose are required to provide Shanghai Pharmaceuticals with market information such as market activities, inventory levels and sales volumes. Shanghai Pharmaceuticals generally collect payment from its distributors before delivering goods to them. However, for the distributors with long-term relationships, Shanghai Pharmaceuticals typically allow short-term credit ranging between 30 and 120 days. In 2008, 2009 and 2010, sales of Shanghai Pharmaceuticals` product by it`s own pharmaceutical distribution and supply chain solutions business accounted for 12.2%, 13.0% and 13.2%, respectively, of Shanghai Pharmaceuticals pharmaceutical business segment revenue.

Cooperation with international and domestic pharmaceutical companies

As of December 31, 2010, Shanghai Pharmaceuticals` suppliers included 33 of the top 50 international pharmaceutical companies and 92 of the top 100 domestic pharmaceutical companies in terms of revenue in 2009. Shanghai Pharmaceuticals also formed a number of pharmaceutical joint ventures with international pharmaceutical companies such as Shanghai Roche. In 2008, 2009 and 2010, 23.9%, 14.5% and 13.0% of Shanghai Pharmaceuticals` profit before income tax was derived from these jointly controlled entities and associates respectively. Recently, Shanghai Pharmaceuticals entered into a non-binding memorandum of understanding with Pfizer, Inc. in April 2011 for potential collaborations in the PRC in a number of areas.

Pharmaceutical Retail

- A retail pharmacy network in nine provinces in the PRC

- Consisted of 1,682 retail pharmacies, which

1,187 were directly operated retail pharmacies

495 were franchise pharmacies

Operational Integration synergies

Upon the 2009 restructuring process and recent acquisitions, Shanghai Pharmaceuticals created four unified management platforms to manage common resources across its subsidiaries. The possible synergies that may create are:

- Pharmaceutical distribution and supply chain solutions: Set up a platform to directly manage and coordinate the distribution businesses currently operated by its manufacturing subsidiaries

- Raw material procurement: Centralize the purchasing of raw material to gain additional bargaining power

- Pharmaceutical sales and marketing: Centralize and coordinate the sales and marketing efforts for pharmaceutical products, aimed to lower sales and marketing costs

- Government affairs: Establish a designated team to coordinate the efforts in submitting and securing bids in the statutory hospital tender process.

Internal Price Driver

Strong R&D capabilities

Shanghai Pharmaceuticals` research activities are conducted both in-house and through collaborations with external research partners, such as research institutes, universities and other pharmaceutical companies. As of December 31, 2010, Shanghai Pharmaceuticals had 319 patents and

Shanghai Pharmaceuticals have developed 54 new products for which Shanghai Pharmaceuticals have obtained Certificates of New Medicine, including 4 innovative drugs, 3 first-to-market generic drugs and 8 first-three-to-market generic drugs, of which eight were developed since 2008. In PRC, innovative drugs and first-to-market generic drugs generally enjoy administrative protection in the form of “monitoring period” of up to three to five years, depending on the types of drugs, beginning from the earliest approval on the commencement of production of the same drug.

In 2008, 2009 and 2010, Shanghai Pharmaceuticals had research and development-related expenses of RMB228.8 million, RMB259.2 million and RMB285.7 million, respectively. Besides, various levels of the PRC government have awarded Shanghai Pharmaceuticals with grants to fund R&D programs. In 2008, 2009 and 2010, Shanghai Pharmaceuticals had been awarded grants the aggregate amount of RMB4.1 million, RMB26.8 million and RMB76.1 million (including RMB34.5 million of grants that had been awarded but not yet received by Shanghai Pharmaceuticals as of December 31, 2010)

The following table compares Shanghai Pharmaceuticals` R&D expenses with some listed pharmaceuticals firms in HK.

Outstanding M&A capabilities and industry consolidation

The pharmaceutical market in PRC is highly fragmented. According to the NFS Report, in 2009, PRC has

- Over 5,300 pharmaceutical companies, which

a. Over 3,500 were drug companies

b. Over 1,100 were active pharmaceutical ingredients manufacturers

c. No one commanding a market share of more than 2%

d. 3 largest distributors, namely Sinopharm (1099 HK) , Shanghai Pharmaceuticals (2607 HK) and Jointown Pharmaceutical (600998 CH); accounted only for 20.9% of the total pharmaceutical distribution market (In terms of aggregate revenue in pharmaceutical products)

In U.S., the three largest U.S. distributors accounted for 97.0% of the U.S. distribution market in 2009. With ongoing healthcare reform taking place in PRC, regulatory standard in PRC is expected to increase, such as GMP standard, environmental protection and R&D capabilities. With a considerable investment of capital expected in modifications, enterprises that record low profits or at loss will not be able to survive. As a result, the industry will be more centralized and develop under a standardized framework.

In 2011, Shanghai Pharmaceuticals has 2 major acquisitions. In April 2011, Shanghai Pharmaceuticals acquired the entire equity interest of CHS for an aggregate consideration in cash of approximately RMB3,569.0 million. CHS is a holding company, whose main asset is its wholly owned subsidiary CITIC Pharma, a leading pharmaceutical distributor in Beijing in terms of revenue in 2009. In December 2010, Shanghai Pharmaceuticals entered into an agreement to acquire from Shanghai Pharmaceutical (Group) the Antibiotics Business, for an aggregate consideration in cash of approximately RMB1,487.8 million. The number of its major products will expand from 53 to 59 upon completion of the Antibiotics Business acquisition.

Being one of the market leaders, Shanghai Pharmaceuticals maintains a strong cash reserve and operational cash flow, which will be ready for potential M&A activities. Hence, Shanghai Pharmaceuticals would benefit from the industry consolidation with its outstanding M&A capabilities. The following table exhibits the cash balance of major listed Pharmaceuticals firms in HK.

Well-developed distribution network with direct sales focus

Shanghai Pharmaceuticals operates a national distribution network, which specialize in distributing products directly to hospitals and other medical institutions, including community healthcare centers and clinics, which generally has higher margin than sales to other distributors. Shanghai Pharmaceuticals directly sell its products to

- Over 7,600 hospitals and other medical institutions in the PRC, including

a. 229, or 63.8% of, Class III hospitals

b. 79, or 55.7% of, Class II hospitals in the Eastern China Region

In 2010, Shanghai Pharmaceuticals direct sales accounted for 61.9% of the external revenue of the pharmaceutical distribution and supply chain solutions business. Shanghai Pharmaceuticals also plans to expand its sales channels through partnerships or alliances with local distributors and other logistics service providers, such as China Post Logistics Co.,Ltd.

Songjiang Model

Under current regulations, hospitals are no longer allowed to profit from their sale of drugs on the National List of Essential Drugs. Shanghai Pharmaceuticals will enter into an agreement with District Health Department in PRC. The agreement allows Shanghai Pharmaceuticals to become the sole distributor for drugs on the National List of Essential Drugs to be purchased by community hospitals in these districts, while Shanghai Pharmaceuticals offers discounts on these drugs sold or sponsors healthcare-related programs.

The direct sales focus and Songjiang Model of the pharmaceutical distribution business will boost its revenue and ease the adverse effect from the product pricing constraint.

External Price Driver

Rapid development of China`s pharmaceutical industry

According to the China Health Statistics Yearbook 2010, the total healthcare spending in the PRC grew from RMB866.0 billion in 2005 to RMB1,720.5 billion in 2009, representing a CAGR of 18.7%. The increase in the PRC`s total healthcare spending has been reflected in the significant growth in both the PRC pharmaceutical product and distribution markets. Between 2005 and 2009, the PRC pharmaceutical product market grew at a CAGR of 18.6% and the distribution market grew at a CAGR of 17.3%. The market is driven by a number of favorable socioeconomic factors, which included:

- Fast Growing GDP and Disposable Income

Nominal GDP of the PRC increased from RMB18.4 trillion in 2005 to RMB34.1 trillion in 2009, representing a CAGR of 16.7%.

The average per capita annual disposable income of the urban population in the PRC increased from RMB10,493 in 2005 to RMB17,175 in 2009, representing a CAGR of 13.1%,

- Growth, Aging and Increased Life Expectancy of the Population

- Increasing Urbanization

From 2005 to 2009, the percentage of urban population grew from 43.0% to 46.6%

- Rising Health Awareness and Healthcare Spending

From 2005 to 2009, per capita healthcare spending in PRC increased from US$89 to US$167, representing a CAGR of 17%,

12th five-year plan of the PRC

n the coming Twelfth Five-Year Plan, the PRC government devotes to make more healthcare resources available to the rural population and the suburban communities. The PRC government will step up its support to the development and modernization of Chinese medicines and pharmaceutical industries. The PRC government introduced a series of programs, included

- PRC government announced an CNY850.0 billion investment programs between 2009 and 2011

- Expansion of the Social Medical Insurance in the PRC

The social medical insurance programs collectively covered 94% of the PRC population; by. 2011, these programs are expected to collectively cover 100% of the PRC population.

Expansion both the coverage and the benefits under the reformed social medical insurance

- Adoption of the National List of Essential Drugs

a. Derived from the National Medical Insurance Drugs Catalog program

b. Sets a maximum retail price or fixed retail price for the listed drugs

c. Essential drugs become more affordable to patients

d. Increase in the usage and demand for essential drugs

- Expansion of the Community Healthcare Centers and Clinics

From 2005 to 2009, the number of community healthcare centers and clinics increased from 17,128 to 27,308, representing a CAGR of 12.4%.

We expected that the rapid growth of the PRC`s pharmaceutical industry and the 12th five-year plan would provide a major boost in the total revenue of the pharmaceutical sector.

Risk

Products pricing control

Substantial portions of Shanghai Pharmaceuticals` pharmaceutical products are included in the National Medical Insurance Drugs Catalog and are subject to retail price controls imposed by the PRC government in the form of fixed retail prices or maximum retail prices.

In July 2010, the NDRC announced a survey of the wholesale prices of approximately 900 pharmaceutical products and the operations of the relevant pharmaceutical product manufacturers. The purpose of this survey is to exanimate the cost structure of the selected pharmaceutical products. The result of this survey, which has not been released publicly, may lead to further downward adjustments in the maximum retail prices of these pharmaceutical products.

Twenty-two of Shanghai Pharmaceuticals` products were included in the scope of this survey, which collectively accounted for 10.8% of the segment revenue of the pharmaceutical business in 2010. Furthermore, in March 2011, the NDRC lowered the maximum retail prices of certain pharmaceutical products, affecting 35 of its products, including two major products, which collectively accounted for 2.1%, 2.4% and 2.6% of the segment revenue of the pharmaceutical business in 2008, 2009 and 2010, respectively.

Healthcare Reform

The PRC government dedicates to boost the development and modernization of the pharmaceutical industries. Regulatory standard in PRC is expected to increase, such as GMP standard. In 2011, SFDA announced the new GMP standards, with effective from 1 March 2011. The new GMP standards draw reference from the GMP standards of European Union, U.S. Food and Drug Administration and GMP standards of World Health Organization, and represent significant upgrade over the old GMP standards. Both hardware standard and software requirements will be significantly increased and hence the cost of operation for Shanghai Pharmaceuticals and other pharmaceutical firm would increase substantially in result. We expected more measures and regulations would come in future.

Lower than industrial average growth rate

The following table shows the growth rate of listed pharmaceutical firms in HK.

Despite of the 2009 restructuring, the growth rate of Shanghai Pharmaceuticals is below the industrial average. Hence, the organic growth rate of Shanghai Pharmaceuticals would below further. In future, we expect a higher organic growth for Shanghai Pharmaceuticals otherwise a devaluation of the stock may be resulted.

Financial Information

Profit Margin Trend

The following tables exhibit Shanghai Pharmaceuticals` profit margin trends.

From 2008 – 2010, the gross profit margins for all three segments business of Shanghai Pharmaceuticals were stable. However, Shanghai Pharmaceuticals recorded a decline in the overall net profit margin. The reason for the decline is the increase of revenue of lower net margin business (Pharmaceutical distribution and supply chain solutions) in proportion. For short term, we expect Shanghai Pharmaceuticals will experience further pressure on its profit margin due to the acquisition of new business with lower profit margin. In the long run, Shanghai Pharmaceuticals may reverse the trend by capturing the operational Integration synergies.

Peers Comparison

Shanghai Pharmaceuticals Versus Sinopharm and Industrial average

Being the first two biggest pharmaceutical distributors in PRC, Shanghai Pharmaceuticals and Sinopharm show some common characteristic and differences. They maintained higher than industrial average P/E, market capitalization, and sales turnover. In contrast, due to the differences in business model, they recorded lower than industrial average ROE, gross and net profit margin. For their differences, Sinopharm`s sales turnover is significantly over Shanghai Pharmaceuticals due to its market share advantage. In contrast, Shanghai Pharmaceuticals records higher gross and net profit margin, which is benefited from its pharmaceutical manufacturing business.

We believe the above industrial average valuation and P/E of Shanghai Pharmaceuticals and Sinopharm is accounted for their superior sales turnover and M&A capabilities.

Valuation

For the valuation of Shanghai Pharmaceuticals, we adopted the financial multiplier valuation model with focus on P/E ratio.

In our valuation of Shanghai Pharmaceuticals, we take the following factors into consideration:

- A modest organic growth in sales turnover with great discount to industrial average

- Sales turnover boost by the acquisitions of Antibiotics Business and CHS

- A minor increase in sales turnover by further M&A action in 2011

- A minor decrease in gross and net profit margin reflecting M&A effects

- A discounted P/E ratio of Sinopharm as reference. The discount is used to reflect the slower growth rate of Shanghai Pharmaceuticals

- A minor increase in tax rate

We forecast the leading P/E for Shanghai Pharmaceuticals to be 28x and EPS of CNY0.84. With the IPO price of HK$21.8 – HK$26, the implied leading P/E would be 22.0x – 26.2x, representing a 6.8% - 27.4% upside potential. We give Shanghai Pharmaceuticals a 12 month target price of HK$27.8 and “Long-term investment subscription” rating.

Financial Information

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