Due to Popular Demand Fiat Economics is Expanding and has moved to its own Domain:

Monday, August 25, 2008

A Look at China’s P/E Ratios:

Quite a few readers have been wondering whether the relatively high P/E valuations of China’s equity markets were justified. This is my response: I would say that type of PE valuation is reasonable for most of the Chinese companies. As everyone knows, growth in China has been very robust over the past several years, and should remain strong over the next several, despite a slowdown in the rate of growth. To quickly quantify this argument we can take a look at the Shanghai SE Composite’s 2Q08 aggregate PE and divide that by China’s YoY GDP growth for the same period, and compare the data to against other markets (see chart below).

Select market PE's to underlying country's GDP growth

Source: Bloomberg

Looking at the chart above, despite China’s seemingly high PE valuations, in terms of PE to GDP they are actually the cheapest market in the set with a PE/GDP ratio of 2.1. Looking ahead, Chinese growth will continue outpacing its industrialized counterparts over the next several years, and this should help support its market. In fact, during this period we will likely see China’s domestic sector replace the export sector as the main engine of growth. This should partly be catalyzed by higher domestic incomes and growing domestic demand, coupled with a slowdown in consumption by industrialized nations. Of course from my experience, one of the big question marks for China’s market is the impact of any new government policies. However, given the expected weakness in the export sector, recent inflation moderation, and the slowdown of the GDP growth rate, I expect future policy to be accommodative to domestic growth.

Also, I will be traveling for the next couple of weeks, so I may be slow to post new entries. However, I will randomly be checking email.


Saturday, August 23, 2008

Mengniu, A Look at A Chinese Dairy Company


Chinese Mengniu Dairy: China’s Mengniu dairy was founded in 1999 by a group of seasoned dairy market professionals previously employed by the state-owned Yili Dairy. Mengniu began trading on the Hong Kong Stock Exchange in June 2004.

Our DCF based price target is currently HKD26.16: Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance.

New high-value added products should help sustain Mengniu’s robust growth: We believe that Mengniu through its strong brand, innovative products, and efficient distribution network will be able to ride the wave on the transitioning

ASP should remain stable or see a slight increase as higher value products reach market: A recent increase in government price caps coupled with solid performance of Mengiu’s products should help sustain Mengniu’s ASP for the foreseeable future.

Higher costs should be offset by rising and eventually stable ASP coupled with falling raw milk prices: Higher costs via new product development, company branding and distribution could place downward pressure on Mengniu’s margins.

The Details:

China’s Mengniu dairy was founded in 1999 by a group of seasoned dairy market professionals previously employed by the state-owned Yili Dairy. Mengniu began trading on the Hong Kong Stock Exchange in June 2004. The company’s products include UHT milk, yoghurt, milk beverages, ice cream, milk powder and milk tablets. In 2007 Mengniu reported holding a market share of 40.7% in China’s liquid milk market. This is a significant increase from the 33.3% market share Mengniu held at the end of 2006. Mengniu has experienced significant growth since its creation, primarily through the introduction of UHT milk. As you can see from the chart below the majority of Mengniu’s revenue is derived from the liquid milk business.

Mengniu’s composition by product

Source: Company

Mengniu’s management has brought the company from an industry start-up in 1999 to a market leader in less than 10 years. They have achieved this by developing a strong brand and implementing an innovative business model that led to the successful introduction of new products, such as UHT. However, the biggest challenge for Mengniu’ management will be keeping up with the changing Chinese dairy sector. As we mentioned in the industry outlook section, the industry is undergoing an important transition, where UHT will likely no longer be the dominant force behind the industry’s growth. As it currently stands, management not only seems to be aware of this shift, but appears to once again be positioning itself on the cutting edge. They have started to invest more heavily in R&D projects aimed at designing higher-end products, and are training its raw milk suppliers on how to increase productivity and reduce disease. Nonetheless, it will be very important for management to maintain stable margins amid potential pricing pressure from increased competition and rising marketing costs. Unlike the western dairy market Chinese consumers are more brand conscience, so it will be essential for Mengniu to continue building its name. This notwithstanding, we believe Mengniu is well positioned to take advantages of the changes in the dairy sector given management’s strong track record of innovation, brand development, and efficient distribution networks.

Investment Thesis:

New high-value added products should help sustain Mengniu’s robust growth: We believe that Mengniu through its strong brand, innovative products, and ultra efficient distribution network will be able to ride the wave on the transition from traditional milk products to higher value dairy products. Mengniu has already demonstrated its ability to take advantage of new products and markets when it first introduced UHT milk to the Chinese market. Concurrently, we believe growing UHT sales to rural communities should help off-set someone of the growth slow-down from near saturated urban markets.

ASP should remain stable or see a slight increase as higher value products reach market:
A recent increase in government price caps coupled with solid performance of Mengiu’s products should help sustain Mengniu’s ASP for the foreseeable future. We anticipate that despite some downward pressures Mengniu’s new higher value products and price cap increases should help maintain or slightly improve its 2008 ASP.

Higher costs should be offset by rising and eventually stable ASP coupled with falling raw milk prices:
Higher costs via new product development, company branding and distribution could place downward pressure on Mengniu’s margins. Yet, we anticipate that in 2008 margin pressure will be more than off-set by reductions in raw milk prices and increases in the ASP for Mengniu’s products. We currently expect Mengniu’s gross margin to improve to 22.8% in 2008 vs. 22.5% in 2007 and to remain somewhat stable in 2009. Since Mengniu owns only a very small percentage of its own livestock and pastures, it remains extremely susceptible to changes in raw milk costs, both on the upside and downside. Meaning a continued moderation in raw milk prices could have a large positive impact on Mengniu’s bottom line. Based on the current inflation outlook we expect raw milk prices will continue to moderate, eventually stabilizing by year end.

Our DCF based price target is currently HKD26.16:
Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. Please take a look at the chart below for our model’s sensitivities to changes in WACC and the terminal growth rate. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance as can be seen in the chart below.

Mengniu's price vs. PE Ratio

Source: Bloomberg

DCF Sensitivities to Changes in WACC & Terminal Growth Rates

Source: My Calculations

As you can see from the performance chart above Mengniu’s share price has fallen significantly from its peak in October 2007. Year over year Mengniu is down 12%, while ytd the stock is down 26%. The primary driver behind this weak performance was escalating raw milk prices coupled with price controls in the dairy sector. Raw milk prices have begun to retreat over the past several months as overall food inflation in China begins to moderate. This should help alleviate some of the downward pressures the stock has been facing in the short-term. Also, on August 1st 2008 company employees sold 57mn existing shares into the market at a selling price of HKD22.02, or a 6.7% discount to the market price. This may have led to some downward pressure on the stock during that period. Important to note is that none of the company’s senior management sold shares during the swap.

Key Risks:

There are several significant risks to our forecast. First and foremost, any significant spikes in raw milk prices or supply constraints could have a detrimental impact on Mengniu’s business. Raw milk is the essential input for all of Mengniu’s products, and unlike some of its competitors Mengniu does

not own its own livestock or pastures making the company extremely vulnerable to price shifts or supply shocks in the raw milk market. With this said, given the current CPI outlook we believe raw milk prices will continue to moderating and remain flat by year’s end. Also important to note is that Mengniu has setup an extremely efficient supply chain in Inner Mongolia to source raw milk. It essentially holds a duopoly with Yili Dairy on all raw milk sources in Inner Mongolia, so a supply shock is unlikely.

Another risk is Mengniu’s new higher value added products failing to capture market share. This would significantly hamper Mengniu’s business given the expected slowdown in its core UHT milk sales. However, based on Mengniu’s prior track record of successfully developing and introducing new products we do not find this outcome to be very probable. However, there is a real possibility Mengniu may not meet our aggressive sales forecast.

A number of factors could put downward pressure on Mengniu’s ASP: We expect the higher value dairy products market to become increasingly competitive as China’s other dairy producers introduce new high-value products. We also anticipate higher penetration and sales volumes through China’s hypermarket/supermarket format retail chains. These format stores, given the large volumes purchased, tend to place considerable pricing pressure on producers, adversely effecting ASP. Mengnui’s strong brand name and innovative products should help buffer some of these negative effects on ASP. Lesser risks are potential changes to the 2008/09 effective tax rate, and any potential increase in sales and distribution costs effecting bottom line margins. Additionally, there is always a possibility new government policies related to the price caps of dairy products could adversely affect Mengniu’s future performance.

A Look at the Financials:

Turnover: We anticipate turnover will continue to grow at a healthy pace of around 33% for FY2008. This will be in response to a combination of higher sales volumes and better than market anticipated ASP. We expect yoghurt to experience the highest level of growth for the year at 44%. However, UHT will remain the dominant product consisting of 59% of Mengniu’s sales, but only growing 32%y/y. We believe the recent moderation in overall CPI should help benefit Mengiu as middle class consumers may be more inclined to spend as incomes and disposable income continue to rise.

Mengniu's Sales Growth by Product

Source: The Company & My Forecasts

Margins: We believe that given the increase in price caps for Mengniu’s products, coupled with the moderation in raw milk prices, gross margin should regain some footing lost in 2007. We are currently forecasting the gross margin to finish 2008 at 22.8% vs. 22.5% in 2007. For 2009, we expect the gross margin to remain relatively stable finishing the year at 22.9%. Mengniu’s gross margin will likely remain below that of its major competitors, primarily due to the company’s limited scope. On the plus side, if raw milk prices continue their current decline until year end, then we could see higher than anticipated margins, given Mengniu’s susceptibility to input prices. At the same time, given increased marketing and selling costs we anticipate operating and net margins to remain in-line with 2007’s level of around 5.3% and 4.4%, respectively.

COGS & Selling, Distribution Costs: A significant portion of Mengniu’s COGS is raw milk prices, which up until the beginning of this year have experienced a sharp rise. Raw milk prices have begun to moderate, but given the strong base increase at the beginning of the year we are anticipating COGS to increase around 33% for the year versus 31.2% in 2007. Compared to its competitors Mengniu maintains among the lowest selling and distribution expenses. This is primarily due to management’s ability to conduct concise and effective marketing and the company’s strong distribution network. We believe Mengniu’s strong distribution network and talented marketing team will off-set some of the costs pressures to the new Chinese dairy market dynamics leading to an increase in selling distribution of around 33% for 2008, permitting the company to maintain its competitive advantage vs. its competitors in this area.

Net Profit: We are currently forecasting net profit growth of 34.6% for 2008 and 32.7% in 2009. This would imply a net profit margin of 4.4% for both 2008 and 2009. We believe increased in the effective tax right will likely prevent these margins form realizing any significant upside.

Tuesday, August 19, 2008

An Overview of the Chinese Dairy Market

China’s robust economic growth has led to significant increases in wealth, which has ultimately led to a shift in consumer preferences. This shift has been especially realized in the food and beverage industry. Chinese caloric intake has increased substantially over the past decade, and will continue to climb likely doubling over the next decade. The Chinese dairy sector has been no exception to this trend. As you can see from the chart below, dairy consumption experienced a considerable increase over the past several years, and is showing no signs of diminishing. In 2006 Chinese dairy consumption stood at 0.012kg/capita, in comparison Japan’s per capita milk consumption totaled 2.08kg, implying significant growth potential as the Chinese market catches up to its peers. But what does this mean for the future of the industry?

Chinese Dairy Consumption 2003-10

Source: KPMG 'The milk and dairy market in China'

Over the past 8 years the bulk of the dairy sector’s growth came through liquid milk, specifically ultra high temperature (UHT) milk. However, we believe as consumer tastes become more sophisticated and income rises the primary growth engine will shift to higher value products such as ice cream, yoghurt, and milk based products, especially in China’s urban centers. Currently, studies imply that the CAGR 2005-2010 of cheese desserts (38%), milk beverages (22%), infant formula (17%), and yoghurt (31%) will all match or exceed that of milk (17%). (Please see the chart below for a more detailed breakout). These growth rates are congruent with bringing China’s dairy distribution in-line with that its major Asian peers. China’s increased consumption of dairy products is also being assisted by the government’s ‘500 Gram Declaration’ which essentially is the government’s hope that every Chinese citizen, especially children, are able to drink 500 grams of milk on a daily basis. This initiative was primarily motivated by the potential health benefits of dairy products. One of the major roadblocks for the dairy industry is the dispersion of Chinese consumers between urban areas with easy access to a wide variety of dairy products and rural sections with limited access and infrastructure challenges. Nevertheless, infrastructure in China is slowly being developed and the large untapped potential of China’s rural areas should continue to be unlocked.

Chinese dairy industry revenue distribution

Source: McKinsey 'China's booming dairy market'

In 1998 only 29% of China’s milk sales were made at modern supermarket/hypermarket stores, but by 2005 this number totaled 58% and is expected to reach 2/3’s of total sales by the end of the decade. China’s entry into the WTO, among other things, significantly reduced barriers for foreign retailers to start or expand operations in China. Based on this fact and the continued development of rural infrastructure we expect the penetration of foreign and domestic supermarket/hypermarket style retail chains to continue growing sharply in China. However, this can be a double edge sword for the Chinese dairy industry. While sales volumes are likely to increase dramatically through higher consumer access to super/hypermarkets, we anticipate greater pricing pressures on dairy manufacturers as these companies tend to have strong bargaining power. This could potentially place stress on dairy products ASP, leading to a reduction in margins. To counter this, dairy companies will need to increase spending on brand recognition and developing new innovative products. Chinese consumers, unlike western consumers, tend to be very brand conscience in relation to the dairy industry.

Key players in the Chinese dairy market:

In 2006 China’s four largest dairy companies represented 44% of the total dairy market share. The largest of these was Mengniu with a market share of 16% during the period followed by Yili with 15% market share. Market share for both of these companies has been increasing over the past several years, while China’s other top two companies by market share Bright (5%) and Sanlu (8%) have been decreasing. The remaining 56% of market share is split between over 1000 other smaller dairy companies. (See chart below for further details). Mengniu and Yili were the first companies to introduce UHT milk into China, which was an important driver behind their substantial market share growth. However, we have already begun seeing a

Chinese companies market share in 2006

Source: China Dairy Yearbook 2006

A major challenge for China’s dairy producers is the distribution and price sensitivity of raw milk (the sector’s primary input). Throughout 2007 raw milk prices grew substantially as food inflation rose. Raw milk prices were further exacerbated by droughts, the EU’s removal of milk powder export subsidies, and livestock being slaughtered due to higher feed costs. Making matters worse for Mengniu and Yili, neither own significant cattle ranches, forcing them to source raw milk from third parties, making these companies even more susceptible to increases in raw milk prices and supply disruptions. Mounting raw milk prices coupled with the government’s dairy price controls have placed significant pressure on the industry. Nevertheless, on a positive note food inflation has begun to moderate, and the government recently approved price increases for a number of dairies. All in all this should help alleviate some of the pressure the sector has experienced over the past year.

Foreign competition has been somewhat limited in the Chinese dairy sector, primarily existing only in the powdered milk segment. Given entry barriers to the sector and China’s, in many cases, inefficient raw milk suppliers we do not expect foreign competition to increase significantly in the short-term. Moreover, we expect to see considerable consolidation in the domestic Chinese dairy industry. Many of China’s smaller dairies are regionally focused in China’s rural areas. As China’s larger dairies continue accessing these areas, smaller producers will likely be unable to compete in terms of costs, and could be forced out of business our acquired by bigger names. Furthermore, given the increased competition amongst domestic players and the likely shift to higher value added products in urban areas dairies will need to increase spending on R&D and marketing to for product development and brand recognition. Only those companies with strong cash flow and significant market share will likely be able to cannibalize these necessary extra expenses.

Thursday, August 7, 2008

Chinese Healthcare Sector ADRs

As an additional follow-up to my ADR series, I am going to take a look at the Chinese and Hong Kong healthcare sector. There are 6 key Chinese and Hong Kong ADRs within the GICS healthcare sector: Mindray Medical International (MR), Chine Medical Technologies (CMED), Wuxi PharmaTech (WX), Simcere Pharmaceutical (SCR), 3SBio (SSRX), and Tongjitang Chinese Medicines (TCM)

Chinese & HK Helathcare Sector ADRs

Source: Bloomberg (Closing prices 8/7)

The Companies:

Mindray Medical International (MR, Outperform): Mindray Medical International Limited develops, manufactures, and markets medical devices. The Company offers patient monitoring devices, diagnostic laboratory instruments, and ultrasound imaging systems. (Bloomberg)

MR’s outlook in a nutshell: Unlike the other companies discussed in this piece MR has significant exposure to both Chinese and ex-China markets; it is also the country's largest medical device company. The medical devices sector is still in its infancy in China, and MR is well poised to benefit from an expanding market. MR specializes in patient monitors, diagnostic lab equipment, and anesthesia & ultrasound machines. Earlier in 2008 MR acquired a U.S. patient monitoring business from Datascope (DPM). MR is currently in the process of integrating DPM's operations; it will likely take 1.5 to 2 years for the full synergies of this deal to be unlocked. Nonetheless, unlike MR, DPM's sales were mostly targeted around hospitals in the U.S. and Europe, this should prevent most sales cannibalization, and give MR good exposure to new markets and technologies. This acquisition adds significant upside potential to MR's future growth potential. Looking at the immediate impact, MR just received FDA approval for DPM’s next generation AS3000 anesthesia delivery system, which is a strong entry into a USD250mn a year market. On the home front, MR has been partially supported by public healthcare reforms, and an initiative to provide medical equipment to rural hospitals; this trend will likely not let up anytime soon. Additionally, MR's robust pipeline should continue supporting the companies bottom line. MR's pipeline includes digital radiography equipment, a digital defibrillator, and various other patient monitoring and chemical analysis equipment. The digital radiography system is a high-res X-Ray machine utilizes digital vs. traditional film, allowing for simpler analysis and digital storage. I see significant upside for MR given its strong domestic position, and growing international presence. This together with stronger medical device demand in China, a successful integration with DPM, and its innovative product line MR should continue to experience strong growth for the foreseeable future. (Expected Q208 Earnings Report 8/20/08)

Events which could improve outlook:

  • Exceeding 2008’s company guidance of USD560-580mn in revenues and USD132-134mn for income.
  • Successful integration of DPM, with stronger than anticipated synergies (i.e. cross-selling)
  • Stronger domestic and international demand for MR’s product line.

Events which could deteriorate outlook:

  • Higher costs and potential FX risk.
  • Increased competition in both the domestic and foreign markets.
  • Changes in government policy reducing domestic sales or prices.

MR vs. Hang Seng

Source: Bloomberg

China Medical Technologies (CMED, Outperform): China Medical Technologies, Inc. is a medical device company that develops, manufactures, and markets products using high intensity focused ultrasound, or HIFU, for the treatment of solid cancers and benign tumors in China. (Bloomberg)

CMED’s outlook in a nutshell: CMED has a unique characteristic when it comes to Chinese healthcare companies; it is the only company in China certified to conduct FISH testing. FISH testing (fluorescence in situ hybridization) is a genetic test that can detect chromosome abnormalities, and can be used prenatally to detect Down’s syndrome among other genetic conditions. Given CMED’s currently monopoly and China’s untapped potential, this segment should help support CMED in both the short and long term. CMED’s other primary segments include ECLIA (electrochemiluminescence immunoassay) and HIFU (high intensity focused ultrasound). These segments should also continue to demonstrate growth, but at a slower pace than the company's FISH business. It is expected CMED will be granted further approvals by the SFDA that will permit it to increase FISH advertising, and and widen the scope of the testing. Additionally, we seen significant improvements in the company’s margins, primarily due to an increased emphasis on high margin reagent products, and limiting the sale of low margin equipment, such as microscopes. This strategy has led to a non-GAAP margin increase to 79.1% from 72.3% for 1Q08 vs. 1Q07; I anticipate this growth rate will moderate, yet remain slightly above current levels. Recently, the company initiated a new business model where by it gives free ECLIA equipment to new customers, who in turn end up purchasing high-margin reagent products to operate the machine. In the short-term this may add some pressure onto CMED's bottom-line, but will be more than offset via longer-term reagent sales. All in all, I believe CMED is a great play in the Chinese healthcare industry given its unique position regarding the FISH test, and new strategy emphasizing higher margin products. (1Q08 Earnings Report 8/04/08 Est: 0.52 Act: 0.42)

Events which could improve outlook:

  • Further SFDA approvals for new FISH probes.
  • Continued growth in company margins.
  • Reaching or exceeding expectations of 500 hospitals with FISH capabilities by the end of 2008.

Events which could deteriorate outlook:

  • Increased competition.
  • Lower than anticipated FISH sales.
  • Changes in government policy adversely affecting the sector.

CMED vs. Hang Seng

Source: Bloomberg

Wuxi PharmaTech (WX, Neutral): WuXi PharmaTech Cayman Inc. provides pharmaceutical and biotechnology research and development outsourcing. The Company's services include discovery chemistry, service biology, analytical, pharmaceutical development, and manufacturing. (Bloomberg)

WX’s outlook in a nutshell: While the CRO business should remain robust in China, WX's recent acquisition of AppTech, a biologics manufacturing company raises some concerns. WX is a market leader in China’s CRO industry, and this portion of its should remain strong over the next several years. In fact, on June 24th 2008 WX announced a memorandum of understanding to create a 50-50 joint venture for contract research with Covance. The joint venture will be located at WX’s Suzhou facility; specific financial terms are expected to be released once the deal is complete. This deal should help bolster WX’s CRO business over the next several years. However, WX’s USD169mn acquisition of U.S. based Apptech add a cloud of uncertainty over the company's overall outlook. It is likely this deal will create significant cost pressures, and lead to higher earnings variance due to the volatility of biologics manufacturing. All in all, given the recent Apptech acquisition and the potential for increased costs and compressed margins we do not see much upside potential for WX. (Expected Q208 Earnings Report 8/13/08 Post-market)

Events which could improve outlook:

  • Strong demand for biologics manufacturing.
  • Significantly higher CRO business in China.
  • Streamlined integration of Apptech combined with successful cross-selling initiative.

Events which could deteriorate outlook:

  • Increased costs from Apptech acquisition.
  • Decrease in biologics demand.
  • Slow-down in CRO business

WX vs. Hang Seng

Source: Bloomberg

Simcere Pharmaceutical (SCR, Neutral): Simcere Pharmaceutical Group manufactures and supplies branded generic pharmaceuticals to the China market. The Company's products include antibiotics, anti-cancer medications and anti-stroke medications. (Bloomberg)

SCR’s outlook in a nutshell: SCR and the Chinese generic drug sector in general face strong competition. SCR’s sales suffered in Q208, primarily due to shifting to a lower margin sales model in the face of potential competition. I expect SCR will continue to face growing competition in many of its existing lines, further compressing margins. Nonetheless, SCR has at least one first-to-market generic expecting approval during 2H08, which could help bolster sales and sustain margins. Given China's untapped potential in the healthcare industry, SCR should continue experiencing sales growth in its generic markets. SCR will likely continue to target the large potential in small & medium sized hospitals and pharmacies, which should help sales volumes. Nonetheless, increased volumes may not be enough to off-set the impact of lower prices in an environment of increased competition. Looking at 1Q08 we can already see some of the potential impact on margins. Furthermore, a SCR competitor that manufactures a Yidasheng rival, is selling its drug slightly below Yidasheng’s current price, which could lead to further pricing pressure. SCR noted on its 2Q08 earnings call that it is considering acquisitions given its strong cash base. All in all, despite the fact that we believe SCR’s sales volume will continue to expand, it will likely be at least partially off-set by lower prices due to increased competition. (2Q08 Earnings Report 8/05/08 Est: 1.44 Act: 1.48)

Events which could improve outlook:

  • Stronger than anticipated drug sales.
  • Competitors bringing rival drugs onto market slower than expected
  • Approval and eventual ability to market drugs in SCR’s pipeline including Biapenem, Palonosetron, Iguratimod, and Levamisole.
  • Any significant acquisition that could improve SCR’s bottom line.

Events which could deteriorate outlook:

  • Continued pricing pressure from competitors.
  • Lower than anticipated drug sales.
  • Rejection of drugs in SCR’s pipeline.
  • Any government regulation regulating drug costs.

SCR vs. Hang Seng

Source: Bloomberg

3SBio (SSRX, Outperform): 3SBio, Inc. is a biotechnology company. The Company researches treatments in the areas of nephrology, oncology, supportive cancer care, inflammation, and infectious diseases. (Bloomberg)

SSRX’s outlook in a nutshell: SSRX is a growing company in a Chinese growth sector. SSRX’s two main products are EPIAO and TPIAO, experienced record sales increases in 1Q08 of 42% and 104%, respectively. EPIAO is an EPO drug, which helps stimulate the body’s red blood cell production that can be prescribed to patients with anemia, or who are undergoing chemo-therapy. According to the company, in Europe roughly 17% of chemo-patients are prescribed EPO, while in China the ratio stands at 2%, implying significant growth potential. TPIAO is a THPO treatment, which increases the body’s production of platelets; this drug can also be prescribed to oncology patients. Looking ahead SSRX has a potentially strong pipeline, with its high dosage EPIAO treatment and second generation IL-2 treatment, both finishing Phase III trials. SSRX expects to file with the SFDA regarding both these drugs during 2H08. By the end of 2008, SSRX also intends on filing with the SFDA in order to be granted permission to use TPIAO as a treatment for ITP, a bleeding disorder. Management expects to continue investing heavily into the company's core business, increasing sales force and expanding capacity. Despite the potential for rising costs due to managements expansion plans, I foresee SSRX further penetrating China’s oncology market while maintaining strong and stable margins. All in all given SSRX’s growth and future pipeline, I believe SSRX is a good play in the Chinese healthcare industry. SSRX is a growth company with a management team who appear to be making wise investment decisions towards long term sustainable growth. Interesting to note is that SSRX has the right to buy-back company shares through March of 2009. Lastly, I expect the company could upwardly revise its 2008 guidance during its Q208 earnings call, this of course depending on 2Q results. (Expected Q208 Earnings Report 8/12/08 Post-market)

Events which could improve outlook:

  • Improved 2008 company guidance.
  • Stronger than anticipated EPIAO & TPIAO sales.
  • Approval of new treatments by the SFDA.

Events which could deteriorate outlook:

  • Strong competition from other market players, which could reduce market share or add pricing pressures.
  • Any pipe-line drugs failing to get approval from the SFDA.
  • Higher than anticipated costs reducing margins.

SSRX vs. Hang Seng

Source: Bloomberg

Tongjitang Chinese Medicine (TCM, Neutral): Tongjitang Chinese Medicines Co. is a pharmaceutical company. The Company develops, manufactures and markets modernized traditional Chinese medicines. (Bloomberg)

TCM’s outlook in a nutshell: I am hesitant on TCM’s outlook for several reasons 1) nearly 80% of TCM’s revenue comes from its Xianling Gubao product alone, which is used to treat osteoporosis; 2) the traditional Chinese medicine industry is extremely competitive; & 3) canceling its privatization due to what was reported as a deteriorations in the credit market. All in all, if it were not for this equities recent sell-off after the cancellation announcement I would have rated them ‘underperform’, but given the sell-off and challenges the company still faces I don’t see much upside or downside for TCM.

Events which could improve outlook:

  • Higher than expected earnings.
  • Re-initiating privatization.
  • Creating a more robust product base.

Events which could deteriorate outlook:

  • Slower than anticipated sales of Xianling Gubao.
  • Earnings below expectations.
TCM vs. Hang Seng

Source: Bloomberg

Tuesday, August 5, 2008

Chinese Financial Sector ADRs

As a follow-up to my energy sector ADR piece I am going to take a look at the Chinese and Hong Kong Financial sector ADRs. There are 3 Chinese and Hong Kong ADRs within the GICS financial sector: China Life Insurance (LFC), E-House (EJ), and Xinyuan Real Estate (XIN).

Chinese & HK Financial Sector ADRs

Source: Bloomberg

The Companies:

China Life Insurance (LFC, Outperform): China Life Insurance Co., Limited offers a wide range of life, accident, and health insurance products and services. LFC is the largest life insurance provider in China. (Bloomberg)

LFC’s outlook in a nutshell: Several factors have gone into LFC’s poor ytd performance, including large potential payments due to the Sichuan earthquake and poor overall market performance. But in retrospect, it does not appear Sichuan earthquake related payments will be as high as some analyst had anticipated. In fact, it appears the Sichuan earthquake may have increased demand by Chinese consumers for life insurance related products; this should help bolster LFC's premium growth through-out 2008. Recently, it was estimated that LFC’s life insurance premiums increased 50% during the first 5 months of 2008. Based on continued strong demand and LFC’s vast potential client base and large distribution network, especially in rural China; I expect strong premium growth to be supported for the foreseeable future. Nonetheless, LFC could face some downward pressure from its investment business and the possibility of compressed new business margins due to the increased sale of single-premium products vs. regular premium. Investment income could also be affected this year by a recent rule preventing insurance companies from guaranteeing Chinese corporate debt. The Chinese government has also recently introduced new solvency rules for the insurance industry. The new solvency rule break insurance companies into three categories based on their solvency margins, insolvent (<100%),>150%). The good news is as of Dec. 2007 LFC’s solvency margin was over 5x the government minimum, so we expect the regulations to have minimal short-term business impact. All in all I believe strong demand for insurance products coupled with the under-development of the Chinese insurance industry and LFC’s strong distribution network, LFC could see some considerable upside in the future. (Expected Q208 Earnings Report 8/25/08)

Events which could improve outlook:

  • Continued premium growth through the second half of 2008.
  • Strong performance of Chinese equity markets.
  • Higher than anticipated investment yields.

Events which could deteriorate outlook:

  • Slow-down in premium growth and/or tightening margins.
  • Poor equity market performance.
  • New government regulation affecting LFC’s bottom line.
LFC vs Hang Seng
Source: Bloomberg

E-House (EJ, Outperform): E-House China Holdings Ltd. offers real estate services. The Company offers primary real estate agency services to residential real estate developers; lists and brokers properties for resale; and offers land acquisition consulting and property development consulting services. (Bloomberg)

EJ’s outlook in a nutshell: The Chinese real estate sector has been facing significant downward pressure. Unlike the US however, the primary catalyst for this adjustment is derived from escalating government restrictions targeting the sector. These regulations include everything from restrictive lending policies to quotas for land development. (Click here for a more comprehensive list) Consequently, the performance of all real estate related equities has suffered including EJ. Nonetheless, despite this EJ was still able to post solid 1Q08 numbers beating analysts’ estimates, demonstrating 107%yoy revenue growth. Looking ahead to 2Q08 earnings EJ has affirmed its revenue projections of between USD41mn to USD44mn, or a roughly 75% increase from the year prior. We believe that EJ is also in a relatively good position for the remainder of 2008 for the following reasons: 1) Continued growth in EJ’s real estate consulting and information services segment. This should be driven by EJ’s leading market position in the real estate consulting service industry and by subscriptions to EJ’s innovative CRIC information database; 2) Developers demand for increased cash flow and sales turnover should help sustain revenues and growth for EJ’s primary real estate agency services, which could also lead to further developer alliances. Given current conditions it is also likely some developers are holding off some projects until the end of 2008, which could help 2H08 earnings for EJ, or at least indicate a potential turn-around for the sector; & 3) A potential loosening of restrictive government policies related to the real estate sector. The recent slowdown in economic growth will likely cause the Chinese government to reconsider certain restrictions placed on the sector to help bolster domestic growth. Based on analysts’ earnings projections and our back of the envelope discounted free cash flow model we believe a target price of $18.00-$20.00 would be a fair value for EJ. Regardless of the current conditions in the Chinese real estate industry, we believe EJ is well positioned for growth and is a good play in the Chinese financial sector ADR universe. (Expected Q208 Earnings Report 8/20/08 Pre-market)

Events which could improve outlook:

  • Government easing restrictions related to the real estate sector, especially leading to easier credit.
  • Increased consulting fees or higher than expected subscriptions to the CRIC system.
  • Growth in home prices and/or real estate transactions.
  • Announcing additional alliances with developers.

Events which could deteriorate outlook:

  • Further government restrictions in the real estate sector
  • Lower than expected consulting fees and CRIC subscriptions
  • Missing 2Q08 earnings target of USD41 – USD44mn or 2008’s, which could put in question 2008’s full year target of USD210mn to USD240mn.
EJ vs. Hang Seng
Source: Bloomberg

Xinyuan Real Estate (XIN, Neutral): Xinyuan Real Estate Company, Ltd. is a residential real estate developer that focuses on Tier II cities in China. The Company develops large scale residential projects that include multi-layer buildings, sub-high apartment buildings, hospitals, schools, and others. Xinyuan also develops small scale properties as well. (Bloomberg)

XIN’s outlook in a nutshell: Due to credit restrictions and other policies aimed at real estate developers we believe XIN will remain under pressure for the rest of 2008. Nevertheless, XIN primarily focuses on tier II Chinese cities with projects primarily centered in Chengdu, Zhengzhou, Hefei, & Jinan. On average these cities have fared better than tier 1 cities in terms of slowing home price growth and diminishing demand. However, while year over year housing prices remain positive in these cities, we have begun to see a significant slow-down in recent data. June’s yoy housing price growth in Chengdu and Zhengzhou has slowed by -19.6% and -10.0%, respectively, from the month prior. The drop-off in demand for housing will likely continue to strain prices and sales in XIN’s target markets. However, any pro-real estate shifts in government policy that would bolster demand (i.e. increase credit), could have a significant impact in XIN’s business. XIN like many developers are likely in a wait in see mode when it comes to future expansion plans. We believe given the current stress on the Chinese real estate industry, and XIN’s front-line position we would prefer waiting for clear indications of the sectors recovery before considering an investment. We anticipate having a clearer picture of the Chinese real estate developer landscape by the end of 2008.

Events which could improve outlook:

  • Government easing restrictions related to the real estate sector, especially leading to easier credit
  • Strong sales on current projects.
  • Recovery in real estate transaction volume combined with stable or rising housing prices.

Events which could deteriorate outlook:

  • Further restrictions on credit availability.
  • Rising construction costs on current projects.
  • Deterioration of sales on current projects.
  • Continued slow-down of housing price growth in target cities.
XIN vs. Hang Seng
Source: Bloomberg

Chinese Government policies on real estate sector (Supplement)

This is a working list of Chinese government policies aimed at stemming growth in the Chinese real estate sector. Please feel free to comment if there is something I am missing. A major source for this was E-House's annual report.

The following regulations were put in place in 2003:

  • Real estate developers are required to internally finance 35% of the total projected capital outlays for new developments vs. 20% previously.
  • Monthly housing expenses, which include mortgage payments and property service fees, cannot exceed 50% of the borrowers’ monthly income. Additionally, borrowers’ total debt servicing payments cannot exceed 55% of total income.
  • The government also tightened regulations around mortgage lending and restricted the approval of areas for new developments.

The following additional regulations were put in place in 2006:

  • 70% of land approved for residential development for any year must be used to develop low to medium and small to medium sized unites and low cost rental policies.
  • 70% of any construction which commenced on or after June 1st 2006 within each city or county consists of units with floor areas of less than 90 square meters.
  • The minimum down payment for the purchase of any property over 90sqm was increase to 30% of the purchase price vs. 20%.
  • A business tax was put in place for re-selling properties held for less than 5 years.

The following additional regulations were put in place in 2007:

  • Down payments for first time home owners buying properties larger than 90sqm were increase to 30% from 20%.
  • Minimum down payment for second-time home owners were increased to 40% and the minimum home mortgage rate was set at 110% of the benchmark index.
  • On the commercial real estate front, banks are not permitted to finance purchases of pre-sold properties, minimum down payment was increased to 50%, minimum interest rate of 110% of benchmark, and loans can be for no more than 10 years. At the same time, banks are permitted some flexibility based on its own risk assessments.
  • Minimum down payments for dual listed residential/commercial properties were increased to 45%.

The following additional regulations were put in place in December 2007:

  • The National Development and Reform Commission and the Ministry of Commerce issued a new regulation, effective Dec 1, 2007, which placed real estate brokers and agencies in a restricted category of foreign investment industries.
  • Credit curbs were put in place to cap total lending for 2008 at RMB3.6trn, matching the previous year’s level.