China Healthcare Sector:2017Outlook

The sector underperformed the market YTD 2016, which was mainly attributable to: 1) on-going provincial tenders squeezing margins for manufacturers; 2) on-going drug validation campaign weighing in on drug makers’ quality and efficacy; and 3) two-invoice system to phase out small and local distributors.

    Key sentiment changes in 2017 vs. 2016. 1) Majority of the provincial tenders to be concluded soon; 2) initial impact from the validation campaign has somewhat priced-in and reflected in most of the drug makers’ books in 2016; and 3) on-going drug validation campaign to favor large drug manufacturers with strong R&D capabilities in FY17E. Thus, we expect a revitalized FY17E, driven by market leaders among different sub-sectors, given the whole industry consolidation is on the rise.

    HK-listed healthcare names are currently trading at 16x FY17E P/E and 0.9x PEG, which we believe is attractive. The reasonable valuation range for the sector should be 17x-22x FY17E P/E, in our view, as we expect the sector growth rate to revitalize from single digit growth while most companies to deliver c.15/20% top/bottom-line growth in FY17E vs. c.15% bottom-line growth in FY16E.

    HK-listed healthcare names are among the lowest valuation compared with regional counterparts. To put things into perspective, A-share counterparts are currently averaging 26x FY17E P/E and 1.2x PEG (FY18E EPS over FY16E EPS); while other countries within the region - Japan and Korea, are currently trading at 35x/24x and 1.9x/2.1x PEG, respectively. The divergence is mainly due to the different development phase as well as different growth story among different countries as well as different investment mentality.

    We expect that healthy/visible earnings growth should result in better returns in 2017. We believe: 1) leading drug manufacturers with strong R&D capabilities or potential M&A opportunities; 2) distributors with nation-wide footprints; and 3) companies with visible earnings growth in the upcoming years, will have a better chance to outperform the market in FY17E. Our top picks for 2017: 1) China Medical System (867 HK) on visible growth momentum; 2) China Biologic Products (CBPO US) on strong pipeline products and inorganic growth; and 3) HEC Pharm (1558 HK) on solid growth in FY16E-18E and strong R&D capabilities.