Sector Report

Healthcare: Pain before gain

by David Li / Jan 12, 2018

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Drug sales growth has slowed since 2013 mainly due to China’s healthcare reforms. While the policies are painful now, the remedy should create a healthier industry in the long run. Drug manufacturers are hurting more as their wider margins get squeezed. Structural reforms will lead to consolidation, benefitting the larger players. Our preference is for drug distributors, whose historical-low valuations are attractive.

Consolidation underway Pharma distribution is slowing due to structural reform and headwinds from recent policies, especially the “Two-invoice” system – where the drug manufacturer issues one invoice to the distributor followed by the distributor issuing one invoice to the end customer (ie, the hospital). However, demand for healthcare services remains solid given the expanding ageing population and increasing proportion of healthcare expenditures in GDP. Market consolidation is currently underway and we expect the sweet spot to come after the pain ends around 2020.

Sanming model All the aggressive reforms, such as the two-invoice system, the lowest bidding price and drug monitoring list, originated from Sanming City. While these have proven successful, we don’t believe the model can be replicated nationwide as it requires all parties in the value chain to agree. Because of the severe drug price cuts, many manufacturers and distributors quit the Sanming market. This resulted in drug shortages and lower-quality medicine.

Our understanding We have several different understandings from street views. First, the Sanming model is an extreme trial where the policies are not feasible for the whole nation. Second, distributors would be less impacted than manufacturers given their limited margins. Third, the purpose of healthcare reform is to eliminate small distributors rather than all of them. As consolidation continues, we expect large distributors to enjoy higher growth, outpacing the industry average.

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