Healthy Profits Ahead: Katherine Lu of Oppenheimer on Picking Winners in China’s Healthcare Sector

Crocker: Can you describe your background and how you came to cover the healthcare sector in China?

Katherine:  My background is very health-care related. I began my career as a scientist at Roche and Johnson & Johnson. Before I came to Wall Street, I worked as a healthcare management consultant. I started in equity research following large-cap medical device companies at Cowen & Co., and then joined CIBC in 2006, working in U.S. specialty pharmaceuticals. In 2007 we had the opportunity to initiate coverage on China healthcare.

Crocker: Is the healthcare sector in China one that investors should be exposed to right now? What do you see as the key factors driving the growth and demand there?

Katherine: I think healthcare definitely is a sector that investors should have incremental exposure to on the China side. While there are various estimates out there, we believe China’s healthcare spending totaled $170 billion in 2008, with $40 billion of spending in the pharmaceutical sector, making it the 5th largest in the world. The growth is being driven by increased government spending. Earlier this month, the Chinese government announced its healthcare reform plan, which will increase government spending by RMB 850 billion in the next three years. Theoretically, if all this spending is incremental, then government spending on healthcare could double in the next three years. That will definitely drive sector growth in the next three to five years, and we expect the overall healthcare sector to grow over 20 percent on a compounded annual basis.

Crocker: I know that in the United States, most people who invest in healthcare – whether in biotech, specialty pharmaceuticals, or medical devices – place a lot of emphasis on intellectual property to drive stock values. I think many people have the impression that enforcing IP rights in China is very problematic. Do you think that’s an accurate view?

Katherine: I would agree with that view. But the government is definitely taking steps to improve the intellectual property environment. China’s pharmaceutical market is essentially a generic market. On that side, I think the importance of IP is low and will remain low. China must eventually improve its intellectual property environment in order to attract multinational players to introduce innovative therapeutics into the Chinese market, and I think that will happen at least in the next five to ten years.

Crocker: With that said, if you view intellectual property enforcement in China as relatively immature, does that translate to a different way that investors should be analyzing companies than perhaps they’ve been trained to by looking at U.S. healthcare?

Katherine: Absolutely. On the pharmaceuticals side, we use the U.S. specialty pharma model to look at the Chinese pharmaceutical market. China’s pharmaceutical market is a generic market, but it is a branded generic market. So it’s different from the United States. In China, a generic drug can actually have quite a long lifetime after its launch. Even three years after the patent expired on NORVASC, it remains Pfizer’s top-selling drug in China.

Crocker: Can you give us a little bit of background on the role of the Chinese State Food and Drug Administration (SFDA)? How does their approval process parallel or differ from that of the U.S. FDA? How can investors judge if a drug is likely to make it through the approval process?

Katherine: The SFDA runs a process very similar to the FDA on the drug approval side. Companies need to conduct clinical trials in order to submit an application and get approval. The clinical research development is also divided into four phrases. But the requirement on the clinical trial is on a much smaller scale as compared to the FDA approval process. I think the chance for a drug to get approved by the SFDA is higher, for two reasons. First, the Chinese market is largely a generic market, and generic drugs have less approval risk than new, proprietary products. Second, the domestic regulatory approval standard is less stringent than the FDA approval standard.

Crocker: In July 2007, SFDA Chief Zheng Xiaoyu was executed after a major scandal involving the approval of drugs that proved to be toxic. How much has the approval process changed in the last two years? In your experience, has the SFDA been able to get drugs moving through the pipeline again?

Katherine: The SFDA experienced a drastic change following Zheng Ziaoyu’s execution. They significantly stepped up their approval criteria. In the 12 months following his execution, there were very few products approved – almost none. But beginning in early 2008, things started to speed up. The SFDA cleared the significant backlog of pending approvals by the end of the year. By our estimate, right now, the generic review and approval cycle is about 23 months – with some first-to-market generics, it’s about 15 months.

This year I think the government is going to place an emphasis on innovation, so it will speed up the approval process on innovative products and first-to-market generics. In China, first-to-market generics are also regarded as innovative products. But for those high-risk products, such as injectable traditional Chinese medicine or narcotic drugs, the government has made the approval criteria more stringent. They will try to conduct reinspection even for some approved products.

Crocker: You mentioned that in China, generics play a much bigger role in the pharmaceuticals market. What kind of share do generics have? What do you see is the future of developing proprietary or new drugs in China, and what role do their universities play in that process?

Katherine: I think the generic market probably accounts for 80 to 90 percent of China’s total pharmaceuticals market. The government definitely tries to push for innovation. On the one hand, China needs to improve the intellectual property environment in order to attract larger international players, to encourage them to introduce their innovative products in China. These days we’re seeing global pharmaceutical companies increase spending in China’s research and development. They either set up their own proprietary R&D lab in China, or they use the Chinese CRO to play into their global R&D strategy to lower the cost. Of course, local colleges also generate some R&D projects, but at this point I think that’s more for the domestic pharmaceutical players.

Crocker: Increased government spending is a major theme, and I know there has been a lot of talk about China expanding their healthcare insurance schemes. How does healthcare insurance work in China, and what’s the coverage like today?

Katherine: The government is trying to use healthcare reform to significantly expand the coverage nationwide. Essentially, China wants to establish 90 percent medical coverage for the nation by 2011. This is a very ambitious goal. Currently, there are three different insurance policies that China uses. One is called the urban employment policy, another is called the urban residence policy, and the third is called the rural cooperative policy. In the current rural cooperative policy, the per-capita coverage is about RMB 80 (approximately $11.72) per year. This is a very small number. But multiplied by a population of 1.3 billion, it’s a significant amount for the central government. So the government is trying to boost the per capita reimbursement rate to RMB 120 by 2010. This year, they want to boost it to RMB 100.

Crocker: How should investors think about playing that trend?

Katherine: I think the direct benefit from this would be first to the pharmaceuticals market as a sector. A substantial amount of the reimbursement will be toward drug reimbursement. So the pharmaceuticals sector will benefit. Also, some domestic hospitals will benefit, because insurance will be used to pay for clinical visits and service fees.

Crocker: Speaking of hospitals, I know that China’s government is also putting a lot of energy into cleaning up the drug distribution business in China. How much bribery is involved in moving these products into hospitals right now?

Katherine: Historically, distributors charge a substantial markup, and that could vary sometimes from 10 to 15 percent. The Chinese government wants to cut that markup down to 5 percent or even less. This is another way the government is trying to get drug expenditure under control, because they can lower drug costs by the streamlining the distribution channel.

Crocker: I know that in China there’s a very fragmented pharmaceuticals industry – I believe there are thousands of different pharmaceutical companies. How do you expect the consolidation of this industry to play out over the next several years?

Katherine: Two trends will probably evolve. Some pharmaceutical companies will focus on low-margin but high-volume essential drugs, and become huge generic players. Another group will probably develop into those innovative players with a strong scale, so they can leverage their high margin with just a reasonable volume. Currently, there are 3,000 to 4,000 players in the market. I think consolidation is inevitable in the next two to three years.

Crocker: One thing that a lot of U.S. investors have trouble understanding is traditional Chinese medicine, or TCM. How big a market share does TCM have today?

Katherine: Traditional Chinese medicine actually plays a big role in China’s pharmaceuticals market. Right now, roughly 35 percent of China’s market actually belongs to traditional Chinese medicine. TCM is a homegrown business, so the Chinese government wants to help to develop this industry. The drug pricing for TCM actually remains quite stable. Interestingly, TCM’s consumer price index (CPI) is among the highest in the healthcare industry. It trended roughly 3 percent year-to-date so far, versus the CPIs of Western drug companies or medical device companies, which are relatively flat from last year.

Crocker: How rigorously do they have to demonstrate the efficacy of these TCM drugs?

Katherine: The SFDA tried to improve the regulatory process to be in line with the Western drug approval process. But honestly, TCM is based on perceived efficacy. Now these TCM companies need to conduct clinical trials to show the efficacy and safety of those products, but the standard is less stringent than the Western drug approval standard. I don’t see the Chinese government pulling substantial numbers of TCM drugs from the market due to efficacy but only for those specific products which carry serious safety issues,. For some cardiovascular diseases, the top-selling drugs in China are still TCMs, believe it or not.

Crocker: Can you give us a little bit of background on the medical device industry in China? What kind of growth rates do you see in that industry? How significant a role do domestic players have versus multinationals?

Katherine: The medical device market in China is about 2/3 the size of China’s pharmaceuticals market, or about $28 billion in 2008. But it is growing at a very respectable rate, about 30 to 50 percent on a year-over-year basis in the past 12 to 24 months. Government spending is also going to be a key factor to drive industry growth in the next few years. Recently, central government allocated first batch of RMB 10 billion to improve hospital standards, and we imagine part of that will go to the medical device industry.

Purchases in the medical device industry will come from two different sources. One is through government tender; the government buys medical equipment and distributes it to rural hospitals or to the facilities they think should improve. Generally, government tender carries a lower price. In terms of global players versus domestic players, I think global players actually have a substantially higher market share in the high-end instruments right now. But they also carry a substantial market share in the low-end instrument, for example, the patient monitoring system. I think China’s device market will become a hot investment area for global players.

In terms of pricing for medical devices, the government wants to control the pricing for those high-end implantable devices. In China, this is also a substantial payment from the government.

Crocker: In this industry, do you see any made-in-China innovation, or are the local players essentially offering lower-priced copycat products of the Western multinationals?

Katherine: At this moment, I think it is more of a copycat market in China for domestic players. But even in the United States, I would say that the product differentiation among manufacturers on the medical device side is much less than on the drug side. I think the intellectual property component is a little bit less in the device area. Definitely domestic device players’ competitive edge is to provide similar products at a much lower cost. They try to collaborate with international players to save the cost on the design of the equipment to cater both to domestic demand and international demand.

Crocker: If someone takes the same methods of analysis that they’ve developed in the U.S. or European market, what are the big mistakes they’re going to make when they try to pick stocks in China?

Katherine: The Chinese pharmaceuticals market is essentially a generic market. Investors should avoid using the innovative model to evaluate a company. I think near-term execution will remain the major valuation driver. It’s the same on the device side. I think, in terms of key investment criteria, I would evaluate companies on their earnings. Are they targeting a substantially large market, a growing market? If a market is not growing, I wouldn’t be interested in investing in such a company. Investing in China carries such substantial information asymmetries, so there’s substantial risk. If the investor cannot be compensated by the high growth rate, there’s no reason to invest in such a company.

Second, because of this information asymmetry, sometimes it’s hard to do more detailed due diligence like an investor can do in the U.S. market. I would recommend looking at the track record of the company, which is very important. Find out if the company has had a series of guidance revisions or EPS surprises in the past 12 to 18 months.

Third, I think management is very important. At companies in an emerging market, management usually has a higher share of holding in the company. Our investment thesis on China’s healthcare market is driven by the value and the growth.

Crocker: Based on those factors, can you give us your top picks right now in the pharmaceuticals sector, the TCM sector, and the medical device sector?

Katherine: On the pharmaceuticals sector, our top pick right now is 3SBio Inc. (NasdaqGS: SSRX); it is a company focused on biogenerics. The reason we like the stock is because the valuation is still very attractive. The stock closed at roughly $7 but has a per-share cash value of $5. It is trading at just 4x expected earnings, which we believe is very attractive. The company is expected to grow their top line at over 20 percent in the next three years. Their operating leverage is limited, but nevertheless we think it is an undervalued story.

On the TCM front, we like American Oriental Bioengineering (NYSE: AOB). The reason we like the story is because the company has a solid track record of meeting its guidance and beating street consensus. The company is trading at 5.8x expected earnings. The company focuses on the rural market, which we think will substantially benefit from China’s healthcare reform. We do see some near-term volatility for the healthcare sector overall in 2009 because there are still some details in this healthcare reform that are going to play out. But we believe the long-term growth outlook will be very positive.

On the device side, we only cover Mindray Medical International (NYSE:MR) right now. We think Mindray has a very robust domestic business. Their domestic business is targeting those low-end medical instruments – patient monitoring systems or biochemistry analyzers – and we think those products will benefit from the government’s increased spending. But there are some risks involved in that story, especially on the international side, because we right now we expect over 50 percent of Mindray’s top line to come from international sales and we would expect foreign exchange could pose an additional risk. Further deteriorated hospital spending trends may drag down their international growth in the next 12 to 18 months. The valuation is on par with its peers.

Crocker: Are there any stocks you would advise investors to take a pass on right now, in your universe?

Katherine: I would think investors should take a pass or take a profit on Tongjitang Chinese Medicine (NYSE: TCM), a traditional Chinese medicine company. There’s some risk related to this company. The Company tried to go private last year, but the deal didn’t go through. Their underlying business has been deteriorating for four consecutive quarters. Ever since we downgraded the stock in 2007, it just seems that the top line continues to deteriorate. First of all, Tongjitang is a one-product company and it has had integration issues with acquisitions during the past 12 to 24 months. Second, its valuation has run up substantially.

Crocker: Last question: If you were to fall ill – which I hope never happens – would you seek medical treatment in the United States, China, India or somewhere else?

Katherine: It depends on where I am at the time. Overall, the United States definitely offers best-in-class medical treatment. If I run into a life-threatening disease like cancer or cardiovascular disease, just because of the variety of choices of those innovative products, the United States really offers the best standard of care. But if I get sick with some common cold, I wouldn’t mind being treated even with traditional Chinese medicine. I’ve never been to India, but I’ve heard from my coworkers that India has been developing very well on the generic side.

Crocker: Thank you very much, Katherine, this has been very illuminating.

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