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C&O Pharmaceutical – Full steam ahead Phillip Securities Research Pte Ltd

05 May 2010 Exchange Singapore Stock Exchange Sector Biotechnology & drugs Reuters COPT.SI Bloomberg COPT SP

BUY( Initiation)

Closing PriceS$0.39

12-month Target PriceS$0.53(+35.9%)

Major Shareholders % 1 Gao Bin 58.17 2 Lee Chong Min 7.81 3 Other Directors 2.08

Analyst Toh Wei Kiong

65 6531 5440 FAX 65 6536 4435

[email protected] Web: www.poems.com.sg MICA (P) 153/01/2010 Ref No: SG2010_0144

C&O is a leading fully integrated pharmaceutical company in China. Its business model spans the entire value chain of the industry; from research and development to manufacturing as well as marketing and distribution of C&O branded and third party pharmaceutical products. It has a distribution network of 3,000 distributors and over 300,000 hospitals, clinics and pharmacies. Currently it has a portfolio of 28 C&O branded products and 7 exclusive drugs.

• Beneficiary of the RMB850b healthcare reform

Part of the healthcare reforms by the Chinese government was the introduction of national essential drug list, a list of low-cost generic drugs that will be completely covered by insurance. C&O have 8 drugs in the list, and the inclusion of drugs in the list will definitely result in more sales as the government is essentially doing the marketing for the drugs. However there could be price pressure on those drugs as the government will seek to introduce a price ceiling on these drugs to ensure it is affordable to everyone, we are confident the experienced management will be able to work around this hurdle.

• Strong performance by C&O branded drugs C&O branded drugs have been showing double-digits growth for the past 10 quarters except 4Q08 where the government restricted the sale of drugs during the Beijing Olympics. We are forecasting the double-digits growth of C&O branded products to continue and contribute roughly 40% to their revenues in the next 3 years up from the current 30%. • More exclusive distribution agreements There could be more opportunities for C&O to collaborate with foreign companies to introduce more generic drugs in China through exclusive distribution agreement. It would allow C&O to expand their product lineup without incurring R&D costs and historical figures have shown that gross margins for exclusive products like Amoxycillin and Meiact are as high as its own branded products. With the success of its R&D program, we could see more C&O branded drugs being introduced into the market and be a major revenue driver for C&O in the future. • Strong balance sheet with negligible debt C&O is currently sitting on a cash stash of about HK$233m, and they have been in a net cash position ever since they were listed in 2005. With no major capital expenditure expected in the near future, and its ability to continue generating strong cash flow every quarter, we are forecasting for a higher payout of dividends. After announcing special and interim dividends totaling S$0.04 for HY2010, we are hopeful they will announce additional dividends for FY2010 with the exceptional gain of HK$17.7m arising from its disposal of subsidiary in February 2010. • We are initiating coverage on C&O Pharmaceutical with a BUY rating and fair value

estimate of S$0.53 representing a potential upside of 35.9% Conso' Profits EPS DPS BV ROE P/E Yield P/BVEnding HK($m) HK$ SG cents HK$ (%) (x) (%) (x)06/07 A 77.6 0.12 0.35 0.91 13.6 17.9 NA 2.406/08 A 110.3 0.17 0.67 1.06 15.7 13.3 1.7 2.106/09 A 108.8 0.16 0.70 1.19 13.8 13.5 1.8 1.906/10 E 149.4 0.23 4.00 1.36 11.5 9.8 10.1 1.606/11 E 164.0 0.25 3.09 1.38 12.0 8.9 7.8 1.6

Last Price 0.39 52w k High (3/29/2010) 0.44 52w k Low (5/4/2009) 0.12Shares Outstanding (mil) 663.36Market Cap (S$ mil) 258.71Avg. Daily Turnover (mil) 1.10Free f loat (%) 31.98PE (X) 11.95PB (X) 1.81

1M 3M 6MAbsolute -7.1% 41.8% 56.0%Relative -5.7% 36.1% 46.5%

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C&O Pharmaceutical 05 May 2010

2

Company Profile C&O Pharmaceutical was listed on SGX mainboard in Oct 2005; it is a fully integrated pharmaceutical group that has its own research & manufacturing capabilities, marketing and distribution of its own branded products and exclusive products throughout China. Business model Fig 1: Business model

Research and Development It has 2 research labs located in Biomedicine Industry Base of Zhangjiang Hi-Tech Park, Shanghai and Xin’gang high-tech development zone of Nanjing with a total of about 100 researchers. The research team is in charge of synthesis and screening of new chemical compounds, pre-clinical research, clinical research and product registration. It focuses mainly on anti-infection drugs, medicine for ageing adults and medicine on digestive system. It has a strong pipeline of more than 50 potential new C&O products and 10 new compounds with potential for international patent application. Manufacturing Its GMP certified production facilities are located in Nanjing, spanning an area of 50,000m2

comprising of 5 separate production buildings. It has capabilities to manufacture tablets, capsules, gelatine, creams, ointment, freeze-dried powders, granules and active pharmaceutical ingredients (API). Finally it has a fully-automated multi storey centralized warehousing facility with climate control to store all the drugs produced or imported. We visited the Nanjing manufacturing plant in March’10; we were very impressed by the strict hygienic rules being observed when entering the production facilities to prevent contamination and the amount of automation used in their production process which greatly reduces the number of manpower needed. Marketing and Distribution C&O has in place a well established hospital distribution network since 1997 which has been further strengthened over the years through acquisitions. Now it has a well diversified marketing and distribution system with over 50 sale branches, 3,000 distributors and 900 salespersons spread across the whole of China. Its sales team is further divided into hospital sale, rural market (third terminal), downstream distributors and pharmacy chains. They have secured exclusive distribution rights with international pharmaceutical companies like Meiji Seika (Japan), Bright Future (Hong Kong) and Helixor Heilmittel (Germany). Joint venture with XBL It has teamed up with XBL (FDA, EPA and USDA registered, inspected and audited) to establish a US GLP compliant laboratory specializing in Contract Research Organisation (CRO) services. The joint venture company, XBL China (37.5% owned by C&O), is capable of conducting drug mass balance and metabolite profiling studies using radioisotope labeled drugs. This segment could contribute strongly in the future as we foresee foreign pharmaceuticals who wish to introduce new drugs into the Chinese market will leverage on XBL China capabilities and track record to conduct clinical trials in China.


3

Business Segments C&O has 3 major business segments: C&O branded drugs, exclusive distribution drugs and non-exclusive drugs. We have listed the breakdown of revenues for FY09 and HY10 in Fig 2 and the drug portfolio in Fig 3: In HY10, C&O branded drugs accounted for 32% of C&O’s total revenue an improvement of 2% from FY09. Going forward, we see the sales of C&O branded drugs improving steadily, and replacing Amoxycillin as the major revenue driver in the future. Fig 2: Breakdown of Revenue for FY09 and HY10 FY09 HY10

Non-exclusive 4%

C&O branded 30%

Amoxycillin52%

Other exclusive

drugs13%

Others1%

Other exclusive

drugs13%

C&O branded 32%

Amoxycillin52%

Non-exclusive 3%

Source: Phillip Securities Research Fig 3: Drugs portfolio

C&O Branded Products Anti-infective 1 Amoxicillin Granules 2 Amoxicillin and Clavulanate Potassium Chewable

Tablets* 3 Amoxicillin and Clavulanate Potassium Tablets

(7:1)* 4 Azithromycin

Dihydrochloride for Injection

5 Cefadroxil Capsules 6 Cefoperazone Sodium and Sulbactam Sodium for

Injection 7 Cefuroxime Sodium for Injection* 8 Clarithromycin Dispersible Tablets 9 Clindamycin Phoshate for Injection* 10 Ofloxacin Gel 11 Ketoconazole Cream 12 Miconazole Nitrate Cream* 13 Netilmicin Sulfate for Injection 14 Cefuroxime Axetil Capsules

Drugs for Aging Adults

15 Diclofenac Sodium Gel 16 Diclofenac Sodium Sustained Release Capsules* 17 Calcium Dobesilate Tablets 18 Irbesartan Tablets Gastrointestinal 19 Vitamin U Aluminium Hydroxide & Magnesium

Trisilicate Capsules 20 Somatostatin for Injection 21 Pantroprazole Sodium for Injection 22 Pantoprazole Sodium Enteric- Coated Capsules 23 Domperidone Maleate Tablets*

Others 24 Lomerizine Hydrochloride Tablets 25 Sibutramine Hydrochloride Capsules 26 Exemestane Capsules 27 Thymopentin for Injection 28 Levocarnitine Injection

Exclusive Products Anti-infective 1 Amoxycillin Capsules* 2 Cefditoren Pivoxil Tablets (Meiact) 3 Cefradine Capsules 4 Flucloxacillin Sodium Capsules

Anti-cancer 5 HELIXOR® A for Injection

Respiratory 6 Ambroxol SR Capsules 7 Compound Pholcodine Syrup

Highlighted in red are drugs included in Essential drug list

Top 5 selling drugs Exclusive C&O Branded 1. Amoxycillin 1. Diclofenac Sodium Sustained Release 2. Meiact 2. Pantoprazole Sodium for Injection 3. Clindamycin Phosphate for Injection

Source: Company, Phillip Securities Research


4

Industry Outlook China has a highly fragmented and inefficient pharmaceutical industry, there are about 6,000 pharmaceutical manufacturers and about 14,000 pharmaceutical distributors in China producing mainly generics with minimal innovation. There are many small manufacturers will little or no R&D capabilities in new drug discovery and are highly dependent on distributing drugs for their survival. The pharmaceutical industry lacks the expertise and financial resources to develop their own products and depend on low value added bulk pharmaceuticals and imitation drugs. With the recent emphasis and support on research, development of new drugs and the protection of IP rights, companies with strong research capabilities and GMP certified manufacturing plants will benefit strongly. In April 2009, China announced a RMB850 billion (US$124 billion) 3-year healthcare reform plan to improve the access, quality and affordability of healthcare to everyone. The 5 key priorities of the 3-year plan (2009-2011) are:

1. Provides basic medical coverage to everyone in China with a minimal per capita subsidy of RMB120 by 2011

2. Implementation of essential drug list (307 drugs) 3. Expand the network of local-level hospitals and clinics 4. Improve the access to and equality of public health services 5. Initiate pilot programs to reform select public hospitals

The introduction of national essential drug list, a list of low-cost generic drugs that will be completely covered by insurance, will have the most impact on C&O as they currently have about 7 drugs in the list. The inclusion of drugs in the list will definitely result in more sales as essentially the government is doing the marketing for the drugs. However there will be price pressure on these drugs going forward. Pharmacies and could see more sales in the future as consumers would be able to purchase essential drugs at lower prices without having to travel to the local hospitals. There is significant investment on the basic medical infrastructure where a third of the RMB850 billion will be use to set up community health centres to alleviate the overcrowding experienced in hospitals where waiting times could be as long as a few days. This community health centres could see a surge in volume of patients who are suffering from minor diseases and consumers who wish to stock up on essential drugs. We think that pharmaceutical companies focusing on distributing their medicine to the rural and community health centres will be the main beneficiaries. With these new reforms, the government hopes to reduce the costs of healthcare for everyone, which has been rising steadily along with the country economic growth. We foresee the Chinese government to continue with ongoing efforts to restructure the healthcare sector, which will likely result in further consolidation, weeding out the weaker and lower value-added local pharmaceutical manufacturers focusing on selling drugs through aggressive sales incentives to hospitals. Through acquisitions, mergers and the formation of alliances, Chinese pharmaceutical distributors could realise synergies, streamline operations and generate higher profit margins. China Healthcare Sector According to WHO, China’s healthcare spending as a percentage of GDP is one of the lowest in the world, a stark contrast to its economy; 4.3% as compared to 15.7% in US, 8% in Japan, 10.4% in Germany and 8.4% in UK based on 2008 data. The percentage of healthcare spending as a percentage of total government spending is also one of the lowest at 9.9% as compared to the US: 19.5%, UK: 15.6%, Germany: 18.2% and Japan: 17.9%. On a per capita basis, China’s expenditure on health is only US$108, one of the lowest amongst countries shown in fig 4. We feel that China will have the flexibility to spend more on healthcare due to its massive reserves which would bring them closer to its peers like US, Germany and Japan. The weak spending on healthcare coupled with high pollution emissions and prevalence of tobacco use, we feel is the main reason for the high mortality rates and health problems in China as compared to the other nations listed in Fig 4. The healthcare reforms carried out by the Chinese government through increasing expenditure on healthcare aim to increase the accessibility and affordability of healthcare with the ultimate goal of improving the quality of life for the Chinese. We hope these reforms will lower the mortality rate and reduce the health problems that the Chinese currently faced now.


5

Fig 4 WHO Statistics Source: WHO,Phillip Securities Research

China ageing population (age above 60) is set to increase dramatically over from the current 10% due to the strict one child policy imposed and many young Chinese focusing on their career instead of starting a family. Going forward, the greater proportion of Chinese population aged 60 and above will fuel a tremendous surge in demand for healthcare and medical products. Government spending on healthcare has been growing at 21% CAGR for 4 years since 2003 (shown in Fig 5), and with the healthcare reforms being pushed out by the government, we could see government healthcare spending growing at between 25-30% CAGR for the next 3 years. This would mean good news for both the Chinese residents (cheaper and better healthcare) and more revenues for the Chinese pharmaceutical companies. Fig 5 Government healthcare expenditure

22 27 31 3849

108

8876

59 67

20.0%16.9%

21.7%

27.7%

0

20

40

60

80

100

120

2003 2004 2005 2006 20070.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Per capita total expenditure on health at average exchange rate (US$)Per capita government expenditure on health at average exchange rate (US$)Growth in govt health spending

Source: CEIC, Phillip Securities Research China’s real GDP has been growing 10% annually for the last 2 decades resulting in strong growth of income for both the rural and urban communities (Fig 6). With the rapid economic growth coupled with the higher standard of living, there is increasing awareness of the importance of having quality healthcare. Going forward, with a higher proportion of Chinese in the middle class resulting in greater spending power, we could see medical consumption continue to grow at the current rate of between 10% -15% or even better. Fig 6 Income per capita for Urban and Rural household

11,32110,129

17,06814,909

12,719

9,061

4,6315,791 6,701

5,0254,0403,582

02,0004,0006,0008,000

10,00012,00014,00016,00018,000

2003 2004 2005 2006 2007 2008RMB 0

2468101214161820

%

Income per Capita: Urban Household Income per Capita: Rural HouseholdUrban income growth Rural income growth

Source: CEIC, Phillip Securities Research

Country( Based on 2008 figures) China Germany Japan Singapore USA United Kingdom India Total expenditure on health as % of GDP 4.3 10.4 8 3.1 15.7 8.4 4.1Government expenditure on health as % of total government expenditure 9.9 18.2 17.9 7.2 19.5 15.6 3.7Per capita total expenditure on health at average exchange rate US$ 108 4209 2751 1148 7285 3867 40Per capita government expenditure on health at average exchange rate US$ 49 3236 2237 375 3317 3161 11Adult mortality rate (probability of dying betw een 15 to 60 years per 1000 population 116 81 67 67 109 80 241Prevalence of current tobacco use among adults (Age>15 years) (%) both sexes** 31.8 31.6 29.4 - 23.9 35.7 18.6Population proportion over 60 (%) 11 25 27 13 17 22 8* 2006** 2005


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Fig 7 Urban& Rural consumption expenditure on medical care

528

786699

621601

131 168246210192

11.3%

16.7%

13.5%

5.6%12.0%

0100200300400500600700800900

2004 2005 2006 2007 2008

RMB

0.0%2.0%4.0%6.0%8.0%10.0%12.0%14.0%16.0%18.0%

Urban consumption on medical per CapitaRural consumption on medical per CapitaAverage growth of medical consumption

Source: CEIC, Phillip Securities Research China Pharmaceutical Market China Pharmaceutical market was valued at around US$24 billion in 2008 (Fig 8) accounting for about 3.5% of the global share, with the US being the largest individual market accounting for 37% of the global market followed by Europe with 32% and Japan with 10%. China pharmaceutical market is relatively small as compare to the size of its economy, we feel that there is lots of room for the pharmaceutical market to grow for the next few years. Fig 8 Global pharmaceutical market

605 608

715773

0100200300400500600700800900

2005 2006 2007 2008

Billi

ons

Source: IMS health, Phillip Securities Research


7

Investment Prospects Healthcare reforms will provide opportunities for C&O to expand We feel that the current healthcare reforms will provide opportunities for C&O to expand through acquisitions of smaller players who are unable to adapt to the reforms introduced by the government, allowing C&O to strengthen its distribution network and expand its production facilities in a short period of time. With the amount of cash sitting in its bank currently, C&O would have no problem funding any potential acquisitions. Ability to ramp up production easily The production plant in Nanjing is currently running at around 30% to 70% capacity depending on the production line and the remaining capacity as reserve capacity. We were told by the management that is normal for pharmaceutical manufacturers to set aside reserve capacity to cater to any sudden surge in demand for the drugs and provide for new drugs registration without having to invest in a new production line. A new plant in China typically takes up to 2 years to attain all the necessary certifications from the authorities and start actual production. More collaboration with foreign pharmaceutical company There could be more opportunities for C&O to collaborate with foreign companies to introduce more generic drugs to China through exclusive distribution agreement. It would allow C&O to expand their product lineup without incurring R&D costs and historical figures have shown that gross margins for exclusive products like Amoxycillin and Meiact are as high as its own branded products. And foreign generic drugs are very popular with the Chinese due to its quality and brand name, and it’s currently their top 2 selling drugs. An exclusive agreement usually last for about 10-20 years depending on the product and could be extended on expiry. Focusing only high margins products C&O has divested its interest in subsidiaries that distribute non-exclusive drugs in 2009 and focusing all their efforts on its own branded products as well as exclusive products in the future. We felt that this was a strategic move by the management as gross margins for non-exclusive products ranges between 5-10% without taking into consideration distribution and administrative expenses. Strong balance sheet with negligible debt C&O is currently sitting on a cash stash of about Hk$233m of cash, and they have been in a net cash position ever since they were listed in 2005. With no major capital expenditure expected in the near future, and operations continues to generate strong cash flow every quarter, we are forecasting for a higher dividend payout for 2011 and 2012. After announcing special and interim dividends totaling S$0.04 for HY2010, we are hopeful they will announce additional dividends for FY2010 with the exceptional gain of HK$17.7m arising from its disposal of subsidiary in February 2010. More emphasis on drug discovery by Chinese government The government is placing more emphasis on drug discovery by Chinese companies through the Mega New Drug Development Program. The program with total funding of RMB6.6 billion will provide subsidies for selected drugs to carry out clinical trials and development. C&O currently have 4 R&D projects selected by the government with total funding amounting to RMB7.5m; a testament to their R&D capabilities. These subsidies will help to alleviate the large of costs involved in introducing new drugs into the market and encourage companies to invest more in R&D. Through these programs it will encourage Chinese companies to move higher up the value chain and place more efforts in developing new drugs rather than focusing on distribution and manufacturing. Sales team and distribution network It’s well established and diversified distribution network spanning both the rural and urban area putting it in a good stead to further expand their business. Building up a distribution network requires a large capital outlay and time to build up the relationships and trust of your customers eg. Hospitals, clinics and pharmacy chains. Over the years, C&O has not spared any efforts to enhance its sales team and market its corporate name. These efforts are slowly paying off as reflected in the sales and the number of exclusive distribution agreement awarded by the foreign pharmaceutical companies. We see the distribution network as the core pillar of C&O success. Success of it’s R&D program C&O highly experienced team of research scientists have successfully expanded C&O drug portfolio over the years which is shown by the y-y increase of revenues of its own branded products. Currently they have about 50 drugs in various stages of development of which 2 will be introduce in 3Q10, namely Cefuroxime Axetil Capsule and Levocarnitine Injection (Both are included in the National Healthcare Insurance Catalog). Another potential category 1* drug, PNA-a drug which can be used to treat Hepatitis B, has received approval from the authorities to carry out clinical trials and we could see it being introduced in the near future.


8

C&O branded drug have been showing double-digits growth for the past 10 quarters except 4Q08 where the government restricted the sale of drugs during the Beijing Olympics. We are forecasting the double-digits growth of C&O branded products to continue and contribute roughly 40% to their revenues in the next 3 years up from the current 30%. *Category 1 drugs- Drugs that are new and have never been marketed before around the world Fig 9 Sales and y-y growth of C&O branded drugs

2730

38 3633

4044 45 44

5230%

32%

9%

31%

17%

24%

31% 30%31%

25%

0

10

20

30

40

50

60

1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10

Millio

ns

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10.0%

15.0%

20.0%

25.0%

30.0%

35.0%Sales Revenue Y-Y growth

Source: Phillip Securities Research Key management Gao Bin (Executive Director/ Chairman) Mr Gao is one of the founders of the group, he is responsible for the overall strategic planning and business development of C&O. Mr Gao graduated from Nanjing Technical Training Institute in 1979 and obtained the professional qualification of senior economist in 1999. Mr Gao has over 27 years of experience in sales and marketing of pharmaceutical products in PRC from which he has created a vast network in the pharmaceutical sector and has gained good knowledge of the development in the industry. Prior to establishment of the group, he worked in Nanjing Yangtze Development Corporation Co Ltd as a manger in charge of the company’s pharmaceutical business. Ma Lai Chi (Executive Director/ Deputy Chairman) Mr Ma is one the founders of the group, he is responsible for overseeing the administration functions of the group. He graduated from Xiamen Diyi High School in 1966 and has over 26 years of experience in international trading of pharmaceutical products. Prior to founding the group, he worked for Singee International Company Limited, Alpha Chemicals Limited and Prosperous Star Pharmaceutical Ltd. Song Ming (Executive Director) Mr Song is an executive director of the group and also the chairman of Nanjing Chang Ao Pharmaceutical Co Limited, he is responsible for overseeing the PRC operations. Mr Song obtained a bachelor’s degree in chemical engineering from Sichuan University in 1982 and a bachelor’s degree in law from Nanjing university in 1989. Prior to joining the group, he was a teaching staff at China Pharmaceutical university for more than 11 years and the general manager of CPU Pharmaceutical Co Ltd. Li Zhan ( Executive Director) Mr Li is an Executive Director and also the general manager of Nanjing Changao Pharmaceutical Science and Technology Co Limited and Changao Bio-tech Development Co Limited. He is responsible for overseeing the research and development functions of the group. Mr Li obtained his bachelor degree in pharmacology from China Pharmaceutical University in 1994, master’s degree in business administration in 2000 and doctorate’s degree in pharmacology in 2008. He was awarded second prize for scientific and technological advancement by the Nanjing Municipal People’s Government in 2001. Prior to joining the group, he was an instructor at China Pharmaceutical University and employed by Jiangsu Changao Pharmaceutical to research on new pharmaceutical products. Wu Su Min (Executive Director) Mr WU is an Executive Director and also the general manager of Nanjing Chang Ao Pharmaceutical Co Limited. He is responsible for overseeing the manufacturing of the group. He obtained a bachelor’s degree and master’s degree in pharmacology from China Pharmaceutical university in 1987 and 1997 respectively Prior to joining the group, Mr Wu was employed by CPU Pharmaceutical Co Ltd.


9

Investment Risks Changes in Chinese regulations The government could introduce more healthcare reforms to ensure it achieves its targets as mentioned earlier in the report, the additional reforms may further depress the price of essential drugs. The government may also issue restrictions on the sales of drugs during major international events like the one we saw during the Beijing Olympics resulting in a huge drop of C&O’s revenues and profits for that period. Price pressures from the introduction of Essential Drug list The introduction of essential drug list seeks to reduce the price of essential drugs through imposing a price ceiling on essential drugs. This drug list will hurt the prices of C&O’s drugs that are included in the list compensated by an increase in volumes. At this current juncture, it’s best selling drug Amoxycillin, is classified under a single pricing regime and not subjected to any price adjustment announced by the authorities. Reliance or Importance of Amoxycilin C&O historically derives about 50% of its revenues from Amoxycillin, and any replacement drug that is cheaper and more effective could affect the sales of Amoxycillin and affect C&O revenues. Amoxycillin is a moderate-spectrum ß-lactam antibiotic used to treat bacterial infections caused by susceptible microorganisms. It is usually the drug of choice within the class because it is better absorbed by the human body. However it might cause allergic reactions like rashes to certain people especially children. We understand from the management that the Amoxycillin it distributes is much safer and less likely to develop allergic reactions as compare to the ones available in the market, which explains its popularity despite its expensive price tag of RMB15.70 for a box of 24 capsules. The success could be attributed to its formula which contains no impurities and uses raw materials from Europe. Exclusive agreement may not be renewed after it ends There could be a possibility the exclusive agreement might not be renewed after it expires resulting in a loss of revenues from the drug and the money spent on marketing over the years. The chances of this happening looks rather remote as C&O has done well for all the drugs that it is currently distributing and we feel that the foreign companies will want to continue this successful partnership. Porter’s Five Forces of Competitive Position Porter's five forces is a framework to derive five forces that determine the competitive intensity and therefore attractiveness of the industry. It allows us to understand the firm’s strategic position in the industry. Fig 10 Porter 5 forces Source: Phillip Securities Research

Supplier Power (Weak) • Raw materials make up a small

portion of the drugs cost, most of the costs are attributed to R&D and marketing

• Raw materials are widely available and there are many manufacturers in China

Competitive Rivalry (Weak) • Most of C&O drugs have exclusive

agreement for 10-20 years or develop in house

• Most of the pharmaceutical companies in China deals mainly with manufacturing and distribution-little or no R&D capabilities

Buyer Power (Strong) • Consumers can choose the type of

generic drugs they wish to purchase as there are different brands available

• Consumers will look at the pricing and quality of drug when making a purchase

Threat of Substitutes (Semi-Strong) • Most of the drugs on C&O portfolio

are generic drugs which can be manufactured by everybody

• C&O conducts R&D on generic drugs to further improve the efficiency and quality of drug

• Buyers are concerned about the quality, effectiveness and price of the substitute products

Threat of New Entrants (Weak) • High barriers of entry • Takes 10-15 years to release an in

house developed drug in the market • Takes 3-5 years to release a foreign

import drug into the Chinese market • Significant capital and resources

outlay to set up a distribution network • Setup of R&D team & facilities

requires large amount of capital


10

SWOT Analysis SWOT analysis is a strategic planning method used to evaluate the strengths and weaknesses of the company against its opportunities and threats. It involves identifying the internal and external factors that are favorable and unfavorable to the company. Fig 11 SWOT analysis

Strengths Weaknesses • Strong and wide distribution network • Good relationships with foreign

pharmaceutical companies eg Meiji Seika • GMP certified production facilities • Good margins from its operation • Stringent cost management

• Highly dependent on Amoxycilin for its revenues

• Revenues is relatively small as compare to the whole pharmaceutical market

Opportunities Threats • Collaboration with foreign

pharmaceuticals who wish to enter the Chinese market

• Potential contracts secured by its JV company XBL China

• Introduce more new & innovative drugs into the market

• Distributing more to the rural areas which is the focus of the government

• Expansion through M&A

• Local distributor vying for exclusive distribution agreement from foreign pharmaceutical companies

• Margins could take a hit as the government continues to introduce reforms to the healthcare sector

• Similar drugs introduced by competitors

Source: Phillip Securities Research Financial Review Income Statement Revenues were up 21.5% y-y for HY2010 to HK$295.8m due to increased efforts in marketing of C&O corporate name among doctors and surge in demand after the implementation of essential drug list. Historically from their quarterly results, 3Q and 4Q are their strongest quarters as most of their best selling products are anti-biotics where there is much higher demand during winter and spring (cold and fever are more prevalent). Gross profit came in at HK$184.3m (+34.9% y-y) due to the drop in import costs of drugs. In fig 13, gross margins have been increasing steadily over the years reaching 62.3% for HY2010 which is highly commendable due to the management decision to divest its non-exclusive distribution segment. Going forward we could see gross margins maintaining in the 55%-65% range as the management focus on the exclusive distribution and C&O products. Net profit of HK$55.7m (+31.7% y-y) was recorded for HY2010 which is about 50% of FY09 earnings, as mentioned earlier 3Q & 4Q tend to be stronger quarters therefore we are forecasting C&O to achieve a record year of profits for FY2010 ending June’10. In February’10, it announced that it has divested its 100% equity interest held in Meizhanli Pharmaceutical resulting in an exceptional gain of HK$17.7m which will be recorded in 3Q10 results. We forecast revenues for FY10E and FY11E to grow 19.7% and 11.8% to reach HK$657m and HK$735m respectively based on the improved outlook of the pharmaceutical sector and addition of C&O branded drugs. Net profit could reach HK$149m in FY2010E representing a y-y growth of 37%. Fig 12 Revenue, Operating profit, net profit

680

565 549

296

657

79119

6778109

56116

152110

149

0

100

200

300

400

500

600

700

800

FY07 FY08 FY09 HY10 FY10E

Mill

ions Revenue Operating profit Net profit

Source: Phillip Securities Research


11

Fig 13 Gross, EBIT, Net margins

48.4%

31.2%

48.7%

61.6%

58.7%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

FY06 FY07 FY08 FY09 FY10F

Gross margin EBIT margin Net margin

Source: Phillip Securities Research Fig 14 Revenue, gross and net profit growth

-16.9%

19.8%17.1%25.7%

-34.3%

42.1% 37.4%

-2.9%

17.5%

95.7%

29.5%26.3%15.4%

-1.4%

23.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

FY06 FY07 FY08 FY09 FY10F

Revenue growth Gross profit growth Net income growth

Source: Phillip Securities Research Balance Sheet C&O has been in a net cash position ever since it was listed in 2005, currently the cash at bank stands at HK$233.4m which put C&O in a very good position to carry out any M&A activities without having to borrow. It continues to generate strong cash flow every quarter further strengthening its cash position; which has enabled them to pay a special dividend of S$0.04 representing a yield of 10%* to reward its shareholders. C&O has a low level of debt which can be easily mitigated from its cash hoard, representing a lower risk for potential investors. Furthermore, C&O’s debt to equity ratio is a mere 6.2% for FY2009 and 4.6% for HY2010. We like the strong operating cash flow generated by its operations every year and the amount of cash less debt per share alone is worth about 5.3 Singapore cents. * Based on the closing pricing S$0.395 on 03 May 2010 Valuation and Recommendation We are initiating coverage on C&O with a Buy rating and a fair value estimate of S$0.53 using the discounted cash flow model, the model is based on a risk free rate of 2.78%, 9.5% cost of equity and 1% terminal growth. C&O prospects for 2010 and beyond looks rosy and we expect them to achieve another year of record earnings for FY2010. We see C&O’s earnings extending their double-digit growth for the next 3 years as they introduce more of their own branded drugs into the market. C&O is currently trading at a P/E of 13.5X based on FY09 and forward P/E of 9.8X FY10E earnings respectively, a steep discount of 48% to the industry average of 20X. Based on our fair value estimate of S$0.53, it will be trading at 18X FY09 and 13.1X FY10E earnings respectively, which is still relatively cheap as compare to its peers. We are initiating coverage on C&O Pharmaceutical with a BUY rating and fair value estimate of S$0.53 representing a potential upside of 35.9%.


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Fig 17 Peers comparison Source: Bloomberg, Phillip Securities Research

Fig 15 Historical P/E

Source: Phillip Securities Research Fig 16 Sensitivity Analysis

Terminal growth 9.50 10.00 10.50 11.000.50 0.51 0.48 0.46 0.431.00 0.53 0.50 0.48 0.451.50 0.56 0.53 0.50 0.472.00 0.59 0.55 0.52 0.49

Cost of equity

Source: Phillip Securities Research Industry Peers We have listed some of C&O’s peers in Fig 17 for comparison purpose. C&O is currently trading at 12.0X; a steep discount of 70.8% to the industry average of 20.5X, C&O with it’s better margins and lower debt as compare to its peers we feel that C&O should command a P/E similar to or better than its peers.

Name Listed Last Px Mkt Cap P/E P/B ROE Debt/Equity Gross Margin Net MarginS$ m (X) (X) (%) (%) (%) (%)

SIMCERE PHARMACEUTICAL-ADR US USD$8.06 641 27.10 2.94 5.52 12.87 83.13 3.27LUYE PHARMA GROUP LTD Singapore S$1.03 506 19.90 2.49 13.66 18.33 89.74 9.23REYOUNG PHARMACEUTICAL HLDS Singapore S$0.36 120 23.26 1.09 4.78 82.03 32.81 -5.13C & O PHARMACEUTICAL TECHNOL Singapore S$0.395 262 12.02 1.82 16.02 4.62 62.36 17.59STAR PHARMACEUTICAL LTD Singapore S$0.145 34 0.72 -18.97 19.81 33.46 -140.76UNITED LABORATORIES Hong Kong HK$8.97 1894 20.42 3.46 18.02 76.14 41.76 15.86Average 576 20.54 2.09 6.50 35.63 57.21 11.49


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FinancialsProfit & loss (HK$m) 2007 2008 2009 2010E 2011E Balance sheet (HK$m) 2007 2008 2009 2010E 2011ERevenue 680.0 564.8 548.6 656.9 734.7 Inventories 48.3 79.2 74.7 82.9 91.0Cost of w ork done -467.5 -289.8 -226.6 -252.2 -288.9 Trade & other receivables 228.7 205.2 200.1 207.0 221.4Gross profit 212.4 275.0 322.0 404.8 445.8 Other receivables and prepayment 9.1 12.9 9.0 9.0 9.0Other revenue and income 2.9 8.9 10.4 8.0 8.0 Others 6.7 6.3 0.0 0.0 0.0Distribution expenses -69.7 -100.2 -143.3 -174.1 -183.7 Financial assets 76.9 0.0 79.4 100.0 100.0Administrative expenses -64.9 -64.1 -69.8 -85.4 -91.8 Cash and equivalents 91.5 104.8 113.8 217.6 162.5Other operating expenses -1.5 -3.4 -0.2 -1.0 -1.0 Total current assets 461.1 408.4 477.1 616.5 584.0Operating Profit 79.2 116.2 119.0 152.3 177.3 Property,plant & equipment 103.4 132.4 200.1 199.5 210.0Finance costs -0.7 -0.2 -0.7 -1.1 -0.7 Investment properties 4.2 4.7 46.4 27.3 27.3Interest income 4.3 3.9 0.9 1.2 1.2 Intangible assets 42.6 44.8 54.5 53.3 53.2Share of losses 0.0 0.0 -0.7 -3.2 1.0 Land use rights 91.7 82.2 49.9 48.4 47.0Exceptional gain 0.0 0.0 0.0 17.7 0.0 Goodw ill 16.3 16.0 43.2 43.2 43.2Income tax -6.3 -9.7 -10.0 -18.4 -15.2 Interest in jointly controlled entities 0.0 37.4 36.7 33.5 34.5Net profit 76.6 110.1 108.5 148.6 163.6 Others 8.4 106.5 11.7 11.7 11.7Minority interest -1.0 -0.1 -0.3 -0.8 -0.4 Total non-current assets 266.8 424.0 442.4 416.9 426.8Net profit attributable to equity 77.6 110.3 108.8 149.4 164.0 Total assets 727.9 832.3 919.5 1033.4 1010.8

Trade & other payables 111.7 73.6 22.7 31.1 33.2Growth and margins (%) 2007 2008 2009 2010E 2011E Accrued expenses 33.1 43.1 45.0 47.9 43.3Revenue 95.7% -16.9% -2.9% 19.8% 11.8% Short term bank loans 1.5 0.0 48.9 35.0 0.0Gross profit 26.3% 29.5% 17.1% 25.7% 10.1% Income tax payable 6.2 7.0 7.9 7.9 7.9EBIT -41.5% 46.6% 2.5% 27.9% 16.4% Total current liabilities 152.6 123.7 124.5 121.9 84.4Net income -34.3% 42.1% -1.4% 37.4% 9.8% Deferred income on grants 0.9 0.8 0.6 0.5 0.3Recurring EPS -34.3% 34.4% -1.4% 37.4% 9.8% Deferred tax liabilities 4.8 4.0 7.5 7.5 7.5

Total non-current liabilities 5.6 4.8 8.1 7.9 7.8Gross margin 31.2% 48.7% 58.7% 61.6% 60.7% Share capital & reserves 566.0 703.2 786.9 904.4 919.8EBITDA 13.9% 24.0% 26.7% 27.8% 28.4% Minority interest 3.7 0.7 0.0 -0.8 -1.2EBIT margin 11.7% 20.6% 21.7% 23.2% 24.1% Shareholder's equity 569.7 703.9 786.9 903.6 918.6Net margin 11.4% 19.5% 19.8% 22.7% 22.3% Total liabilities and equity 727.9 832.3 919.5 1033.4 1010.8

Per share data (HK$) 2007 2008 2009 2010E 2011ECash flow (HK$m) 2007 2008 2009 2010E 2011E Recurring EPS 0.124 0.166 0.164 0.225 0.247Profit before tax 82.9 119.8 118.5 166.9 178.8 Dividend (SG cents)* 0.35 0.67 0.70 4.00 3.09Depreciation 9.3 11.2 17.0 18.5 19.5 Book value 0.91 1.06 1.19 1.36 1.38Amortisation 6.2 8.4 10.3 11.7 11.6 Tangible book value 0.81 0.97 1.04 1.22 1.24Gain/loss on disposal PPE 0.1 -6.8 0.0 0.0 0.0 Free cashflow to equity -0.08 -0.12 0.17 0.21 0.14Deferred income 0.3 -0.1 -0.2 -0.2 -0.2 Net cash after debt 0.27 0.16 0.22 0.43 0.40Others 0.1 12.5 -3.7 3.1 -1.5 Key ratios 2007 2008 2009 2010E 2011EOperating cash f low before WC 99.0 145.1 141.9 200.0 208.2 ROE (%) 13.6% 15.7% 13.8% 11.5% 12.0%Working capital changes -98.4 -57.0 -12.6 -3.7 -25.0 ROA (%) 10.7% 13.2% 11.8% 14.5% 16.2%Income tax paid -27.9 -11.7 -8.6 -18.4 -15.2 Payout ratio 16.0% 22.5% 29.3% 99.5% 70.0%Net cash from operations -27.4 76.4 120.6 177.9 168.1 Effective tax rate (%) 7.6% 8.1% 8.4% 11.0% 8.5%Purchase of PPE -37.3 -33.1 -38.9 -18.0 -30.0 Debt/ Equity (%) 0.3% 0.0% 6.2% 3.9% 0.0%Purchase of intangible assets -13.3 -3.9 -7.6 -9.0 -10.0 Debt/Total assets (%) 0.2% 0.0% 5.3% 3.4% 0.0%Purchase/sale of f inancial assets -32.4 77.9 -77.4 -20.6 0.0 Current ratio (x) 3.0 3.3 3.8 5.1 6.9Investment in subsidiary 13.7 0.0 -9.9 0.0 0.0 Quick ratio(x) 2.7 2.7 3.2 4.4 5.8Others -66.9 -97.7 -2.1 19.1 0.0Net cash from investment -136.2 -56.7 -135.8 -28.5 -40.0 Average receivable days 123 133 133 115 110Shares issues 77.8 0.0 0.0 0.0 0.0 Average payable days 87 93 37 45 42Borrow ings 1.5 0.0 48.9 0.0 0.0 Average inventories days 38 100 120 120 115Repayment 0.0 0.0 0.0 -13.9 -35.0 Valuation 2007 2008 2009 2010E 2011EDividends -30.8 -12.4 -24.8 -31.9 -148.6 Recurring P/E (x)* 17.9 13.3 13.5 9.8 8.9Others 3.6 1.7 0.2 0.2 0.5 Recurring P/E at target price (x)* 23.9 17.8 18.0 13.1 12.0Net cash from financing 52.2 -10.8 24.3 -45.7 -183.1 Dividend yield (%)* NA 1.7% 1.8% 10.1% 7.8%

P/FCFE -28.5 -18.9 13.2 10.7 15.8Net changes in cash -111.4 9.0 9.1 103.8 -55.0 Price/Book(x) 2.4 2.1 1.9 1.6 1.6Cash at beginning 198.5 91.5 104.8 113.8 217.6 Price/NTA (x) 2.7 2.3 2.1 1.8 1.8Cash at ending 91.5 104.8 113.8 217.6 162.5 Total economic value(S$m) 222.9 244.0 276.5 239.5 213.9

TEV/EBIT 15.8 11.8 13.0 8.8 6.8Cash and Cash equivalents 91.5 104.8 113.8 217.6 162.5 TEV/Net profit 16.1 12.4 14.2 9.0 7.3Source: Company, Phillip Securities Research *Based on exchange rate of S$1:HK$5.6


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Appendix: Manufacturing and research facilities we visited in March’10 Fig 18 Research facilities

Fig 19 Research facilities

Fig 20 Manufacturing facilities in Nanjing

Source: Company, Phillip Securities Research


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Ratings History C&O Pharmaceutical Technology

Rating Date Closing price (S$) Fair value (S$) Remarks

Buy 05 May 2010 0.39 0.53 Initiation

TRADING BUY Share price may exceed 10% on the upside over the next 3

months, however longer-term outlook remains uncertain BUY >15% upside from the current price HOLD -10% to 15% from the current price SELL >10% downside from the current price TRADING SELL

Share price may exceed 10% on the downside over the next 3 months, however longer-term outlook remains uncertain

Phillip Research Stock Selection

Systems We do not base our recommendations entirely on the above quantitative return bands. We consider qualitative factors like (but not limited to) a stock's risk reward profile, market sentiment, recent rate of share price appreciation, presence or absence of stock price catalysts, and speculative undertones surrounding the stock, before making our final recommendation

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