SHANGHAI - While many investors are looking forward to a rebound in the second half of 2011 following a disappointing first half, analysts from Morgan Stanley poured cold water on investor hopes in Hong Kong by downgrading pharma and distribution sectors in a July 7 research note.

Like other investors two months ago, Morgan Stanley anticipated a better second half for China's healthcare industry (Also see "After A Record Year, China Healthcare IPOs Have Endured A Tough 2011" - Scrip, 6 July, 2011.). However, after revisiting Chinese companies recently, the investment brokerage firm revised its earnings forecast down by 2% to 34% from the previous forecast.

A bigger-than-expected impact of the Essential Drug List and resulting price reductions by provincial governments are the main reasons for the downgrade, analysts said. The degree of the revised downgrade depends on the level of impact companies experience from the EDL and price cuts.

The investment firm says that lower tender prices will start to impact company profits beginning this month. "Although the impact will not be seen until 2H11 earnings in April/May 2012, we expect market sentiment to remain subdued and hence we are downgrading the drug distribution and pharma industries, as well as cutting our earnings forecasts and price targets. We do not expect visibility to increase in 2011," analysts said.

"There will be no impact if they [the pharma companies] decide not to participate in the EDL tender. However, that is pretty rare for companies carrying EDL drugs," Bin Li, managing director at Morgan Stanley's research team in Hong Kong, told PharmAsia News.

Li named five companies under his coverage immune to pricing risk because they have no exposure to price cuts and thus may remain healthier: biopharma companies Sinobiopharm and 3SBio Inc., medical devices producers Weigao and Kanghui and contract research organization Wuxi PharmaTech.

Short-term Blip, But Devices Better Bet For Now

Morgan Stanley encouraged investors to revisit the pharma and distribution sectors "once policy headwinds weaken," and said recovery and long-term growth is expected. However, analysts said the medical device industry was "relatively safe while the government's focus is on drug prices."

Although big companies are trying to stay away from the EDL to avoid price reductions, "most of them have some degree of exposure to the low-end of the market. Therefore, there will be some incremental impact," Li explained, adding that the bigger risk is whether some provinces will borrow some EDL tender mechanisms for upcoming tenders for drugs on the national drug reimbursement list, which see prices slashed on a broader list of drugs.

For example, the Anhui tendering model reduced EDL drug prices 40% to 50% last year, and many provinces are adopting the model. The Anhui model awards a single supplier for each drug on the Essential Drug List, setting up a winner-take-all bidding process Also see "In China, A Province's Drastic Price Cut Model Is Being Modified To Fit A Nationwide System: A Look At The Anhui Model" - Scrip, 7 April, 2011.).

Morgan Stanley analysts said investors should watch government tenders in Jiangsu, Fujian, and Sichuan, which could have important implications for non-EDL drugs.

In Jiangsu, where EDL sales account for 25% of total drug sales, the tendering official told analysts that sales of EDL drugs were down 60% in the first five months of 2011 in Jiangsu, compared with the same period last year. EDL sales were only RMB 1.2 billion, having lost RMB 1 billion from fewer drugs being listed in primary medical institutions, and another RMB 1 billion disappeared due to price cuts, the official said.

More Price Cuts On The Way

China's healthcare industry "traded down 13% and is close to historical lows," analysts said, which may last for the remainder of 2011.

During the last decade, China's healthcare industry saw two setbacks: In 2008 during the global financial crisis and in 2005-2006 when drug industry growth was affected by a major round of price cuts and an anti-bribery campaign. During that period the market stayed low for about 18 months due to "deteriorating fundamentals as government initiatives had direct impact on manufacturers, distributors and other players along the value chain," analysts said.

In March, China's powerful National Development and Reform Commission announced price cuts by an average of 21% on 162 products in the two largest therapy areas, antibiotics and cardiovascular drugs. That round of cuts impacted many blockbuster products including Pfizer Inc's Lipitor (atorvastatin), Merck & Co.'s Cozaar (losartan) and Novartis AG's Diovan (valsartan) Also see "Big Pharma Takes Another Haircut As China Slashes Drug Prices In Two Largest Therapy Fields" - Scrip, 8 March, 2011.).

In December, NDRC for the first time cut prices by an average 19% on certain drugs with independent pricing power due to higher production quality. The cuts, which also focused on cardiovascular drugs and antibiotics, impacted multinational companies more than local manufacturers. Companies like Bristol-Myers Squibb Co. and Roche saw price cuts of 30% and higher (Also see "China's NDRC Releases First Set Of Price Cuts; MNCs See Deepest Cuts As Expected" - Scrip, 1 December, 2010.).

Recently, market rumors have circulated about another round of price cuts around 20% for endocrinology, and central nervous system drugs.

UBS analyst Ding Ding said in a July 7 note that she anticipates reference price reductions for CNS and endocrinology drugs to average 15%, with proprietary and innovative products seeing cuts of 5% to 12%.

"We believe the real impact for individual products is likely to be much smaller, given the tender price (the price that really mattered for pharma manufacturers) is typically lower than the reference price; in some cases, by a large margin," she wrote.

Deutsche Bank analyst Jack Hu noted July 5 that upcoming price cuts would also target oncology and metabolic drugs.

-Dai Jialing (j.dai@elsevier.com)

China Pharma And Distributors Suffer From Essential Drug System And Price Cuts

More from Archive

More from Scrip