china’s healthcare sector is structurally appealing · china’s urban population today is 810...
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China’s healthcaresector is structurallyappealing
www.merrickscapital.com
Fund Details
“Our fund was developed to capture the huge long-term growth potential of China’s economic rise and prosperity. We are dedicated to finding best-in-class companies operating in structurally favourable growth industries that are leveraged to the rising consumerism in China. In particular, we focus on those companies serving consumers with a differentiated product or service or via the use of innovative technologies.”
Jimmy Cheong Portfolio Manager | Equities
Adrian RedlichChief Executive Officer
About the Merricks Capital High Conviction China FundThe Chinese economy is undergoing an unprecedented expansion and structural shift, transitioning from a debt-fuelled infrastructure and export-driven economy to one that is powered by a growing number of middle-class consumers.
This economic transition and structural shift is unmatched in scale and the Merricks Capital investment team is dedicated to finding the best-in-class companies in those industries most exposed to the benefits of the dislocation. The focus is on those sectors servicing the consumer with innovative products and services or disruptive technologies.
Some of the current themes include healthcare; information technology such as internet media, e-Commerce and 5G; “The Belt and Road Initiative”; education; environmental protection; insurance; and the broader ‘catch-all’ theme of rising consumerism.
The Merricks Capital High Conviction China Fund adopts a private equity approach to public markets investing. We believe success in Chinese equities requires a long-term horizon, deep bottom-up fundamental analysis and investors who think like business owners rather than investment analysts. As such, we specifically concentrate our portfolio (typically holding 10-15 stocks at any one time) and hold positions for many years to see strategies play out and insights pay off. This long-term approach allows us to ignore near-term earnings trends, ride through short-term bumps in stock price volatility and focus on where competitive advantage and management talent is likely to translate into the highest long-term earnings growth.
The portfolio applies a disciplined investment process which focuses on organic idea generation and fundamental analysis of sectors and companies using Merricks Capital’s proprietary models. The distinctive Merricks Capital investment approach is accompanied by an experienced and skilled team. Our China team has spent over 20 years travelling extensively around China, seeking the best companies and business models; building a wide range of contacts with both public and private companies and with local investors.
1
China’s healthcare sector is
structurally appealing
E X E C U T I V E S U M M AR Y
China has achieved rapid economic growth and the health status of the Chinese population has seen considerable
improvement, with life expectancy increasing from 35 years in 1949 to 76 years in 2015. The demographic profile
of high birth rate, high death rate, communicable diseases epidemics and malnutrition has gradually been
transformed into one of lower birth rate, lower death rate, and prevalence of non-communicable chronic diseases.
According to the World Health Organisation (WHO), China is now the second largest healthcare market in the world.
While still some way behind the US, China leapfrogged Japan in 2013 and is bigger than Germany and France.
Rapid economic growth has resulted in urbanisation and industrialisation, large-scale migration, and population
aging. Consequently, according to the China Centre for National Health Statistics and Information 2012, risk factors
related to lifestyle and environmental pollution have become serious health concerns for its citizens. Addressing
these issues has become a key focus for policy makers.
The Chinese healthcare market is still relatively immature despite its size. According to business intelligence from
the China Briefing Magazine (http://www.china-briefing.com), although healthcare expenditures have increased
more than four times – from Rmb 1,096.6 billion (US$126 billion) in 2006 to Rmb 4,634.5 billion (US$698 billion) in
2016 – healthcare spending per capita is still only around 6% of GDP. This compares with 17% in the US, 10% in
Japan and Europe, and the average 9% in OECD countries. By 2020, China’s healthcare spending is expected to
account for 6-7% of GDP, which is around US$1 trillion. And by 2030, China’s healthcare market is targeted to
reach Rmb 16,000 billion (around US$2 trillion), as stated in the Plan of Health China 2030 released by the State
Council in October 2016.
Merricks Capital is optimistic about China’s healthcare sector. We see the future growth drivers coming from: 1)
aging population; 2) rising household incomes; 3) increasing life expectancy; 4) improving insurance coverage
and 5) government policy support. Due to its size and growth potential, every health sector – from biologics to
pharmaceuticals to medical devices – will have attractive investment opportunities over the next ten years. Two
companies we own based on this theme are AK Medical Holdings and China Biologic Products.
2
The Aging Population
During the 1950s, Communist Party Chairman Mao Zedong launched the “great leap forward” to rapidly convert
China into a modern industrialised state. "A larger population means greater manpower," reasoned the government
at the time. Chairman Mao encouraged large families and outlawed abortion and the use of contraception. He urged
women to produce offspring who would boost the workforce and the ranks of the Peoples’ Liberation Army. This
strategy caused China’s population to double from about 500 million in 1949 to nearly a billion by 1979.
However, Mao’s ideology did not go according to plan and proved to be nearly as destructive. As many communities
collectivised and converted from farming and agriculture to steel production, food supply slipped behind population
growth and in 1962, the Great Chinese Famine had caused some 30 million deaths. In the aftermath, officials quietly
resumed a propaganda campaign to limit population growth, only to be interrupted by the turmoil of the Cultural
Revolution in 1966. With population growth not slowing, officials were prompted to implement more drastic
measures, culminating in the 1979 policy requiring couples from China's ethnic Han majority to have only one child
widely known as the “one-child policy”.
The above background brings us to the point at hand. These enormous number of Chinese citizens born in the
1950s, 1960s and 1970s are aging. The world’s most populous country is getting older and, according to the United
Nations (UN), it is getting older faster than anywhere else in the world. China’s percentage of population aged 60
years or over was 16.2% in 2017 and, the UN estimates this will rise to 35.1% by 2050. The UN also estimates it
will take China just 20 years for the proportion of the elderly population to double from 10% to 20% (between 2017-
2037). This will raise the median age of the population in China from 37 to 48 by 2050.
We believe this aging population demographic trend creates attractive investment opportunities in China’s
healthcare sector. The two charts below indicate the aging profile of the population as predicted by 2020 and 2050.
P O P U L A T I O N P R O J E C T I O N F O R C H I N A : 2 0 2 0
Source: CSIS China Power Project, United Nations World Population Prospects
3
P O P U L A T I O N P R O J E C T I O N F O R C H I N A : 2 0 5 0
Source: CSIS China Power Project, United Nations World Population Prospects
4
Growing demand for healthcare driven by an aging population and other demographic changes
According to the UN’s Population Division, by 2020 there will be 248 million people in China aged 60 years or
above, many of these requiring specialist healthcare services. This number will rise to 437 million by 2050.
Along with the aging Chinese population there will also be rising incomes, increased longevity, and increasing
urbanisation. The factors along with government’s health insurance initiatives will be key factors contributing to the
growing demand for healthcare products and services.
Rising incomes
China has experienced rapid growth in household income over recent decades. China’s economic development
has lifted hundreds of millions of Chinese out of poverty and resulted in a burgeoning middle class.
According to a study by consulting firm McKinsey & Company, 68% of China’s urban population was middle class
in 2012. McKinsey forecasts this will increase to 76% by 2022. Middle class is defined as urban households earning
US$9,000 - US$34,000 a year. That might not sound like a lot but adjusted for prices (in purchasing-power-parity
terms) that range is between the average income of Brazil and Italy and it delivers a roughly "middle class" existence
compared to other countries. In 2000, just 4% of the urban population was considered middle class in China.
Middle class households typically have more than enough income to satisfy their primary needs – food, clothing,
and shelter – with excess disposable income left over for additional desired consumption and upgrading quality of
life. A sub-set of improving the quality of living, particularly in one’s latter years, is to spend more on healthcare.
Previously for example, osteoarthritis sufferers could only to manage their condition with pain killing medication but
now with rising incomes, patient quality of life can be extended for many years with affordable hip/knee replacement
surgery. China’s growing and aging middle class presents an array of new investment opportunities in the
healthcare space.
C H I N A H O U S E H O L D P E R C A P I T A A N N U A L D I S P O S A B L E I N C O M E ( U S D )
Source: National Bureau of Statistics China
5
Increased longevity
The life expectancy of Chinese people rose to 76.3 years in 2015, 18 months longer than in 2010, according to the
latest official NBS survey. That means the average Chinese person lives 4.7 years longer than the world average.
In 2018, China overtook the US in terms of ‘healthy life expectancy’ at birth for the first time (versus actual life
expectancy), according to WHO data. Chinese babies can look forward to 68.7 years of healthy life ahead of them,
compared to 68.5 years for American newborns.
The increased longevity of Chinese citizens can be attributable to the nation’s economic prosperity. With rising
incomes comes a better standard of living: people can afford better food clothing and shelter and have greater
access to healthcare and medical services.
L I F E E X P E C T A N C Y A T B I R T H - C H I N A
Source: United Nations Population Division
Increasing urbanisation
Over the past 40 years of economic reform and opening-up, China’s urbanisation rate has increased from 17.9%
to 58.5%. During this period, 640 million people migrated from rural to urban areas - equal to 46% of China’s
population. In 1980, the migrant population was 5.45 million; it grew to 6.55 million in 1990. But since 1995, more
than 20 million people have migrated from rural to urban areas every year, with 25 million rural residents migrating
to urban areas in 2012 alone.
China’s urban population today is 810 million, compared with the urban population of only 170 million in 1978, while
the rural population is 570 million. This is a drastic change – from more than 800 million farmers, China now has
more than 800 million urban residents. China’s rural population reached its peak of 860 million in 1995. But it has
rapidly reduced since 2000.
The pathways through which urbanisation affects the increased demand for healthcare include: (1) the urban
environment itself poses chemical, biological, and physical hazards, which can lead to injury and illness in urban
residents; (2) urbanisation triggers changes in occupational activities, socioeconomic status, and social structures
that can promote illnesses such as neuropsychiatric disorders, cardiovascular disease, and other non-
communicable chronic diseases in society. Hence, the growing disease burden in urban areas attributable to
nutrition and lifestyle choices is fast becoming a major health challenge for the government and healthcare
policymakers. As a result, we see increasing demand for healthcare products and services over a multi-year
timeframe which should give rise to attractive investment opportunities.
6
U R B A N P O P U L A T I O N G R O W T H A N D U R B A N I S A T I O N R A T E S - C H I N A
Source: Bloomberg, United Nations Aquastat Source: National Bureau of Statistics China
Government policy support
According to China’s National Health and Family Planning Commission, China has spent over USD 1 trillion since
2009 to improve its healthcare system. Healthcare reform is designed with the goal of creating a universal health
security system which focuses on equal access to basic public health services for all. Moreover, the government
also permits private payors and providers to play a role in healthcare delivery, especially addressing the needs of
higher-income patients. Life expectancy has risen significantly, child mortality rates have fallen, China has markedly
more hospital beds than it did a decade ago. All these health sector statistics are expected to continue their upward
trajectory in the coming years.
Almost all of China’s population is now insured. To achieve this feat, China created two insurance programs for
low-income citizens: Urban Resident Basic Medical Insurance (URBMI) and a New Rural Cooperative Medical
System (NRCMS). In addition, an increasing number of Chinese – those working for private or state-owned
enterprises – are eligible for Urban Employee Basic Medical Insurance (UEBMI) which is China’s most established
and comprehensive health insurance plan.
Government support is also coming in the form of policy initiatives to encourage greater fitness and participation in
sporting activities. President Xi Jinping says fitness is the basis and guarantee for all people to live a healthy life
and it plays an important part in China’s transition from a big country to a strong nation in sports. Xi’s initiatives
were included in the work report of the 18th National Congress of the Communist Party of China. Under the national
plan for developing mass fitness issued in 2016, China aims to have 435 million people (a third of the population),
regularly doing physical exercise by 2020.
Moreover, in a national strategy spearheaded by the General Administration of Sport, China plans to build 100
towns dedicated as centres of sporting excellence for various disciplines in coming years. The campaign is part of
China’s effort to grow its domestic sports industry and provide more facilities for people to exercise and lead
healthier lifestyles. According to the 13th Five-year Plan unveiled by the authorities, China aims at increasing the
sports area per capita from 1.4 sq metres to 1.8 sq metres by 2020 and 2.0 sq metres by 2025.
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Universal health insurance coverage
Source: Ministry of Health, Ministry of Human Resources and Social Security
G O V E R N M E N T H E A L T H E X P E N D I T U R E P E R C A P I T A
Source: World Health Organisation Global Health Expenditure
Summarising the above, as China’s population moves to cities and wages increase, healthcare is becoming a
greater focus. Chinese citizens have greater access to healthcare knowledge and, with increasing insurance
penetration, have a greater ability to pay for medical related expenses. Healthcare now comprises the largest
segment of household consumption in China (NBS China, 2017).
Rising incomes and urbanisation have also given rise to China’s current obesity problem as more citizens adopt
western diets and habits. According to a Xinhuanet news article (dated 25 May 2017 and quoting figures from the
Chinese Centre for Disease Control and Prevention), about 30% of Chinese adults or approximately 320 million
people, are overweight, while 11.9% of adults are obese.
The World Health Organisation (2015 report), also sees the opportunity for considerable growth in China’s
healthcare market, with per capita health spending at just US$426 compared to an average of over US$5,200 for
the world’s top eight healthcare markets (US, Japan, Germany, France, UK, Italy, Brazil and China).
Urban Employee Basic Medical Insurance
(UEBMI)
• Mandatory basic health insurance for urban
employees of private or state-owned enterprises
• Funded by employers and employees (via salary
deductions)
• Annual premiums approx: USD 150-300
Urban Resident Basic Medical Insurance
(URBMI)
• Voluntary basic health insurance for urban residents
not eligible for UEBMI (e.g. seniors, disabled,
unemployed, students, children)
• Funded by government and individuals
• Annual premiums USD 20-100
New Rural Cooperative Medical System
(NRCMS)
• Voluntary basic health insurance for rural residents
• Funded by government and individuals
• Annual premiums USD 30-80
8
In 2016, the Chinese government responded to growing healthcare concerns by launching the “Healthy China 2030
Plan”, which is a national initiative that emphasises exercise, fitness, diet and a healthy lifestyle with greater access
to healthcare services.
If all goes according to the Healthy China 2030 Plan, China’s healthcare market will reach US$2.4 trillion (Rmb 16
trillion) by 2030.
The healthcare industry currently makes up around 6% of China’s GDP, and challenges still exist given the
contradiction between the limited supply of healthcare services and growing demand.
More developed nations such as Australia, France, Germany, Japan and the US spend between 10-17% of GDP
on healthcare. “China is still at an initial stage of healthcare development,” said Ran Wei, Vice President of China
Health Management Association.
As the world’s most populous nation, the addressable market in China is gigantic. The purchasing power of the
Chinese consumer is reshaping the world’s market and has created a strong demand for healthcare products and
services. Household per capital expenditure on healthcare has grown at a compound annual growth rate of 10.1%
over the past ten years.
Merricks Capital sees attractive investment opportunities in the Chinese healthcare and related healthy lifestyle
industries.
Companies we currently own based on the healthcare and healthier lifestyle theme are:
• AK Medical Holdings – China’s premier domestic orthopaedic medical device company
• China Biologic Product – A pioneer in the fast-growing Chinese blood plasma market with huge potential
• Anta Sports Products – China’s leading activewear company with a multi-brand and omni-channel approach
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AK Medical Holdings Three key reasons we are positive about AK Medical
• Import substitution: The Chinese government listed import substitution in the medical device sector as a major
focus in its “Made in China 2025” strategy, released in early 2015. The government has instituted policies to
encourage the use of medical devices produced in China over imported products. The National Health and
Family Planning Commission in 2015 began discussions with top-tier hospitals’ executives on the purchase of
more domestic alternatives.
• Comparative pricing advantage: For a similar quality product, AK Medical’s prices are circa 40%-50% lower
than foreign counterparts. Total hip and knee replacements are costly procedures, and the artificial joint is the
major cost component, accounting for circa 70% of the total inpatient cost. AK Medical’s price advantage versus
western peers should see it gain incremental market share over the long-run. Moreover, favourable
reimbursement rates (close to 100% reimbursement) from various State and Rural Medical Insurance schemes
favour domestic brands over more costly international brands (with large gap payments).
• Leadership in 3D printed implants with a key focus on R&D: AK Medical is the only company to receive
CFDA approval for 3D-printed orthopedic devices. This will offer a distinct edge over competitors. AK Medical
has a strong focus on research and development. AK Medical’s continuous commitment to R&D sees it hold 29
CFDA Class III medical device certificates compared to 10 held by the next closest competitor. To date, its R&D
activities have yielded 36 invention patents, 140 utility patents and 2 patents under the Patent Cooperation
Treaty (PCT). AK Medical also has 134 pending invention patents, 77 pending utility patents and 6 pending
patent applications filed under the PCT. This huge library of patents and certificates creates a consistent product
pipeline for many years to come.
Company description
AK Medical is a leading orthopaedic medical device maker in China involved in the design, development, production
and sales of orthopaedic implants. AK Medical primarily focuses on hip and knee joint implants and those products
are stipulated for primary surgeries as well as revision surgeries. AK Medical was the first (and is currently the only)
medical device manufacturer to commercialise the application of 3D-printing technology in orthopedic joint and
spine replacement implants in China.
Key beneficiary of China’s aging population
We believe AK Medical Holdings is a stock which benefits hugely from the aging population theme, where a
demographic change expands the patient pool suffering from age-related joint disorders. Additionally, modern
stressful lifestyle contributes to the incidence of obesity and lack of exercise, thus potentially increasing the joint
disease population.
Rising prosperity and steady economic growth has greatly increased income levels and health awareness of
Chinese citizens, allowing more orthopaedic patients to consider join implant surgery as a viable solution to treating
discomfort or pain in the joints. The government also continues to improve universal insurance coverage and raise
reimbursement rates to improve joint implant affordability.
As per the company’s prospectus, in 2016 the company was the top ranked orthopedic joint implant maker in terms
of sales with a 14.3% market share and ranked 6th in terms of revenue with 6% market share.
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Government support on “import substitution”
Under Made in China 2025, unveiled by China’s State Council in 2015, China wants to catch up with rivals in sectors
including robotics, aerospace, clean-energy cars and the medical device industry. The strategy is at the core of
efforts to move up the value chain and achieve the vision of turning the country into a global superpower by 2050.
The Made in China 2025 ten-year plan has seen the Chinese government list import substitution in the medical
device sector as a key focus. The National Health and Family Planning Commission began discussing domestic
alternatives with hospital executives across the country in 2015. The policy is also consistent with the macro trend
of cost containment in healthcare spending.
The supportive government policy for domestic players represents a sweet spot for sustainable growth. According
to international research consultancy firm Frost & Sullivan, the orthopaedic joint implant market in China grew from
Rmb2.4bn in 2012 to Rmb4.1bn in 2016, (at a CAGR of 13.9%) and is estimated to grow to Rmb7.8bn by 2021,
representing a CAGR of 13.7%.
At present, given their longer operating history, imported foreign implants such as those made by Zimmer, Stryker
and DePuy still have a larger market share of around 60% compared to domestically manufactured products.
However, government policies to encourage greater use of domestic implants mean patients using domestic
orthopaedic implants could enjoy a higher reimbursement rate than foreign products (reimbursement rate of 55%-
80% for domestic devices vs. 30%-65% for imported ones).
First-mover advantage in 3D-printed implants
AK Medical has China’s first 3D-printed orthopedic devices, which we believe holds enormous potential. The
company commenced the 3D-printed orthopaedic implant study in 2009 and obtained China Food and Drug
Administration (CFDA) registration certificates for its 3D-printed hip implant, artificial vertebral bodies and spinal
interbody cages in 2015-2016. They were the first and are the only 3D-printed metal orthopedic implants approved
by the CFDA.
The 3D-printed implants have several advantages over traditional products. The key advantage is an almost perfect
fit to the patient’s anatomy as they are precision printed from a patient’s CT scan. In medical terms, it means better
biological fixation with trabecular structure versus generic ‘off-the-shelf’ implants.
Sales from the company’s 3D-printed products are expected to be a major growth engine for AK Medical in the
coming years. Annual financial results to 31 December 2018 saw 3D-printed products revenue grow 109% year-
over-year. Representing just 6% of total revenues a year ago, it has grown to 12% in the latest reporting period
(2018 annual result) and is expected to rise in the future. Such rapid growth has been possible due to AK Medical
being the only provider of such 3D-printed products in China and the increasing recognition among orthopaedic
surgeons of the structural advantage of 3D-printed products. 3D-printed products also have much higher gross
margins than traditional products, making it more profitable for the company to sell.
Long term growth potential in China due to low penetration of joint replacement surgeries China’s penetration of knee and hip replacement surgeries lags most of the developed world. In its 2017 Health
Statistics Report (with a full set of 2015 data), the rate of hip and knee replacement surgeries recorded a penetration
rate of 23 and 9 per 100,000 population respectively in China (in 2015 survey data), vs. the OECD average of 160
and 118.
Goldman Sachs [Research Report January 2018] estimates that circa 1.4 million patients in China needed a hip
reconstruction or replacement and circa 1.8 million needed knee reconstruction or replacement in 2016. Only
around 495,000 cases were completed, including around 10% revision replacement, implying a penetration rate of
approximately 15%.
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The low penetration rate of joint replacement surgery in China is likely attributable to:
• Low number of qualified specialist orthopaedic surgeons per capita versus the developed world
and their knowledge and experience with arthroplasty surgeries;
• High cost of the implant itself, plus the surgeon’s fees, would particularly be meaningful for those
in rural areas;
• Historically, the implant and the operation were not well covered by medical insurance schemes
Merricks Capital believes a variety of factors should drive the increased prevalence of joint replacement procedures
in China, including rising health insurance penetration, improving reimbursement policies, more affordable domestic
implant brands like AK Medical helped by the government’s import substitution policies, an increase in a surgeon
knowledge and experience, and more surgical facilities. This bodes well for the sector’s long-term growth.
H I P R E P L A C E M E N T S U R G E R Y P E R 1 0 0 , 0 0 0 P O P U L A T I O N
Source: OECD Health Statistics 2015
292
283
276
246
243
242
238
236
227
216
204
183
171
166
150
137
136
127
107
88
63
44
33
23
20
8
Switzerland
Germany
Austria
Belgium
Norway
Finland
Sweden
France
Denmark
Netherlands
United States
United…
Australia
Italy
New Zealand
Hungary
Canada
Ireland
Spain
Portugal
Israel
Turkey
Chile
China
South Korea
Mexico average 160
12
K N E E R E P L A C E M E N T S U R G E R Y P E R 1 0 0 , 0 0 0 P O P U L A T I O N
Source: OECD Health Statistics 2015
226
215
202
190
187
180
176
167
166
145
141
135
118
115
112
104
94
89
67
62
59
53
50
11
9
3
United States
Austria
Finland
Germany
Belgium
Australia
Switzerland
Denmark
Canada
France
United Kingdom
Sweden
Netherlands
South Korea
Spain
Italy
New Zealand
Norway
Turkey
Portugal
Hungary
Israel
Ireland
Chile
China
Mexico average 118
13
China Biologic Products Three key reasons we are positive about China Biologic Products
• China’s blood plasma market is still in its infancy with huge potential: Per capita usage/consumption of
plasma products in China is low versus other developed nations. We like the plasma sector for its long-term
growth opportunities (estimated 10-year CAGR 15%). The Chinese plasma market is also unique versus other
healthcare segments, with constraints in supply, which results in a major supply-demand imbalance and notably
stronger pricing power compared with other pharmaceutical products. The industry also has high barriers to
entry (imported products are banned except for albumin) and there have been no newly licensed domestic
players since 2001, which limits competition.
• Expansion of product offering will be a key driver; only direct play outside of China: China Biologic
Products is the best quality player in the China plasma sector and the only direct plasma company listed outside
of China. While leading global plasma companies like CSL can derive 20+ blood products from plasma as well
as producing recombinant protein technology-based alternatives, China Biologic Products can only fractionate
11 blood products at most. The gap is particularly significant in coagulating factors, which are used in treating
bleeding disorders (e.g. haemophilia). However, we see Chinese players such as China Biologic Products
stepping up its portfolio through research and development (e.g. China Biologic has built a pipeline that covers
cytomegalovirus immunoglobulin, fibrinogen, factor IX, antithrombin III and fibrin sealant). We believe China
Biologic’s recently approved products will gradually capture the undersupplied market.
• Market driver should migrate from Albumin to IVIG benefiting China Biologic: Though China is the second
largest plasma market in he world, the market is largely closed as imported products are banned (except
albumin) and domestic players focus only on the Chinese market. Albumin (currently over 60% of the market by
sales) was the key market driver in the past 10 years and subject to aggressive competition from foreign players.
We believe the demand for plasma will shift to IVIG as leading blood product companies are shifting their
marketing focus to educating physicians on the clinical applications of IVIG. We believe this represents a step
change that will benefit domestic leaders like China Biologic. The IVIG market is distinct in that it is a market
that has less competition (imports are banned) with more price hike upside and greater potential on clinical
demand, driven by evidence-based clinical application / indication expansion.
Company description
China Biologic Products Holdings Inc, or CBPO as it is commonly referred to in investment circles (being its
NASDAQ code), is a leading fully integrated producer of plasma products in China. The company is principally
engaged in the research, development, manufacturing and sale of plasma-based biopharmaceutical products.
Based in Beijing, CBPO has three production facilities and is one of the top three domestic suppliers in China for
the principal plasma products of albumin and IVIG. The company was founded in 2002 and was listed on NASDAQ
in 2009. CBPO is the only directly investable plasma play outside of China.
Plasma is essential in the treatment of various blood disorders and chronic diseases, including emergency blood
loss, burns, hepatitis B, liver/kidney disease, haemophilia, post-surgery recovery, clotting and other bleeding and
immune disorders of the elderly, and it also assists in the treatment of tumours.
14
Composition of human blood
Source: wikipedia
Human blood contains plasma (~55%), red blood cells
(or erythrocytes ~45%), white blood cells (leukocytes)
and platelets (~<1%).
Plasma is made of water (90%) and protein (7%).
Plasma-based products are different proteins derived
from human blood using separation and purification
technologies.
Currently, there are 20 different types of plasma-based
products that are produced and used. The major ones
include human albumin, immunoglobulin, blood
coagulation factors and inhibitor.
The China blood plasma market has huge potential
The blood plasma industry’s leading international data provider, the Marketing Research Bureau (MRB), estimates
the China market will grow to US$6.2 billion in 2019, up from around US$2.5 billion in 2015 and US$3.6 billion in
2016. According to the MRB, the compound annual growth rate (CAGR) of the industry was a stellar 22% p.a.
between 2006-2015. [In our opinion, there is no reason to doubt a CAGR of say 15% cannot be sustained over the
next ten years].
This sustained growth should be primarily driven by China’s aging population, rising consumption of healthcare
products, and expanded use of blood plasma products with significant unmet clinical demand. This includes
increasing awareness of the therapeutic benefits of plasma products and expanding health insurance coverage.
While China’s 2015 market size was US$2.5 billion, its per capita penetration is still a fraction of that of the US,
intimating a huge runway for growth as China’s economic expansion continues. The MRB estimates per capita
consumption of albumin in the US is 2.5x that of China. For coagulation factor VIII, US per capita consumption is
7.7x that of China and for IVIG, US per capita consumption is 15.2x that of China.
In absolute terms:
• China albumin usage is 223grams per 1,000 people, compared to 557grams per 1,000 people in the US.
Albumin was one of the first plasma products introduced into the market.
• China IVIG per-capita consumption is only 11grams per 1,000 people compared to 168 grams per 1,000 people
in the US.
• China Factor VIII consumption is 0.09grams per 1,000 people compared to 0.70grams per 1,000 people in the
US.
Lower China usage penetration is predominantly due to later stage development of plasma products, lack of clinical
practice and experience from physicians as well as short supply (collection and fractionation centres take time to
roll out across the country). As a result, we think there is an attractive multi-year growth story here.
15
China plasma products market size
Source: Company presentation, Marketing Research Bureau
Per capita consumption of plasma products
Source: Company presentation, Marketing Research
Bureau
To put one major use of plasma into perspective, China holds the honour of being the world leader in liver disease
and is one of the highest consumers of albumin in the world, using 300 tonnes annually (or roughly half of total
worldwide use) according to an article in the Financial Times. Liver disease is a growing problem in China, primarily
because of the high burden of viral hepatitis x but also because of the growing prevalence of non-alcoholic fatty
liver disease. Advanced stages of liver disease are characterised by protein wasting and can result in albumin
depletion, which can have a major effect on the cardiovascular and renal system. Albumin has long been used for
treatment of liver disease and is generally accepted as a useful treatment for those with liver damage.
Increasing product suite ensures robust pipeline for growth
Human albumin and IVIG products have long been CBPO’s two largest sales contributors, and its market share for
these two products ranks among the top three domestic Chinese suppliers in China, as measured by total
production volume in 2017. Additionally, several other new products launched in recent years, such as Factor VIII
and Polypeptides, are also experiencing rapid growth in market share.
The company currently derives 19% of sales from high margin specialty products such as placenta polypeptides
and coagulation factors, with 36% of sales still coming from lower margin albumin plasma. Contrast this with CSL
Ltd, with a 100 year operating history, which has over 40% of sales coming from high margin coagulation and
specialty products and only 14% from albumin.
With the expected slowdown in albumin products, continued IVIG growth and the approval and ramp up of higher
margin coagulation factors and specialty products will play a large role in sustaining CBPO’s growth and market
share expansion into the future. Specialty products can be defined as all those outside of IVIG, coagulation products
and albumin. In addition to providing growth, specialty products are important as they are ‘infra-marginal’ (margin
accretive) products. They can be produced using the plasma that remains once the IG, FVIII and albumin have
been fractionated and, due to being specialised (i.e not commoditised), they can be sold for higher prices.
CBPO received CFDA approval for its pipeline products, human fibrinogen, in October 2017 following a five-year
phase III clinical trial. ASP (average selling price) of fibrinogen has tripled since the removal of a price ceiling in
2015, and we believe that CBPO will be able to gradually capture this undersupplied market.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2006 2009 2012 2015
USD billions
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Albumin IVIG Factor 8
2.5x
15.2x
7.7.x
Per capita usage in U.S/Per capita usage in China (x)
16
A snapshot of some of the products in the pipeline, including research stage, clinical trials stage readying for CFDA
approval, and commercial launch are:
• Caprylate/Chromatography Purified
• Human Antithrombin III
• Human Cytomegalovirus Immunoglobulin
• Human Coagulation Factor IX
• Human Fibrin Sealant
CBPO sales split by product
Source: Company Annual Report
CSL sales split by product
Source: Company presentation
IVIG, 31.7%
Albumin, 35.8%
Other immunoglobulins,
13.5%
Placenta polypeptides, 13.3%
Specialtyproducts, 5.7%
IVIG and other IG, 47.0%
Coagulation, 22.0%
Specialty products, 17.0%
Albumin, 14.0%
17
Plasma market has high barriers to entry limiting competition
The Chinese plasma market is heavily regulated with very high barriers to entry. As a result of the blood
contamination scandals in the early 1990s, where hundreds of thousands of citizens contracted HIV/AIDS due to
unsafe blood collection programs, China’s blood collection and plasma market is now one of the most stringently
regulated in the world. There is a five-stage process to identify the pool of healthy donors including facial
identification, fingerprint identification, ID card identification, physical examination, and single-use disposable
medical instruments. And that is before a single drop is collected. After blood is collected, there is a waiting period
of at least 110 days where the plasma is checked three times before the fractionating station stage. After it passes
through the triple virus detection defence system, only then does it go into production. The set-up of collection
stations and fractionation facilities is a capital-intensive process. Moreover, the Chinese government ceased issuing
new plasma fractionation licenses since 2001. There are currently 30 licensed producers of plasma products in
China, and less than 25 are in operation. The entry barriers for new players is very high and international investment
in domestic manufacturers of plasma products is restricted and subject to a stringent approval process. As a result,
existing players, especially industry leaders such as CBPO, should be key beneficiaries amid this favourable policy
backdrop.
F I V E S T E P P R O C E S S T O A S S U R E S A F E B L O O D P L A S M A D O N O R S
Source: China Biologic Products investor presentation
Albumin comparative
Albumin is used to treat a variety of liver diseases (cirrhosis, liver cancer, hepatitis, hypoalbuminemia, fatty liver
disease and other alcohol-related liver problems). China consumes about 300 tonnes of albumin per annum, which
is roughly half the global total. About 60% of China’s albumin is imported and analysts estimate the demand is
growing at 15% annually. Albumin is naturally produced by the liver and is harvested by fractionation of donated
blood plasma. While the necessary supply could be provided by the Chinese population, many are afraid to donate
blood. The reason is a well-remembered 1990s health scare in which tens of thousands of farmers who had been
paid to donate blood acquired HIV from infected needles. The ensuing scandal was covered up by the government.
As a result, with the huge demand, China has had to import 60% of its albumin - and the ever-rising demand has
driven up prices. Under China’s Article 49, albumin is the only blood plasma product the government has allowed
to be imported to meet domestic demand.
18
Albumin is more expensive in China than elsewhere in the world. Prices in China are around USD4.00 for 1 gram,
compared to approximately USD2.50 a gram in the US; around USD2.25 in Europe and around USD2.00 in the
rest of the world including Australia. Hence, China is a very lucrative market for overseas players like CSL, Baxter
and Grifols.
With advances in technology, extremely stringent government regulations regarding blood collection from healthy
donors and the attractive monetary incentives for donating blood, the blood donor collection market is growing
again. Total US blood plasma collection was 31,000 metric tons last year, compared to only 7,000 metric tons
collected in China − even though China has four times as many people. There is a clear pathway to future growth
by rolling our more collection stations.
C H I N A B I O L O G I C G R O W T H O F P L A S M A C O L L E C T I O N S T A T I O N S
Shandong Opened Population (mn)
Qihe County July 2008 1.8
Xiajin County Oct 1998 1.5
Zhangqiu County Sep 1997 1.1
Yanggu County 1998 2.3
Yunchueng County 2003 1.2
Cao County July 2013 1.6
Yishui County Dec 2010 1.1
Ningyang County July 2011 5.6
Zaozhuang City Oct 2015 3.9
Feicheng City 2017 2.4
Ju County 2017 3.0
Guizhou
Puding County 2008 0.5
Huangping County 2008 0.4
Guangxi Huangjiang Maonan County
Jan 1997 0.4
Fangchenggang City Jan 1998 1.0
Hebei
Xinglong County June 2016 0.4
Daming County 2017 0.9
Hainan
Wenchang City 2018 0.6 Source: Company report
19
Plasma market driver to shift from albumin to IVIG
In China, albumin is currently the single most important market driver for domestic blood product market and the
demand for plasma, contributing roughly 70% of incremental blood product sales in China over the past five years.
However, we believe the market driver is gradually changing. Over the next ten years, we believe IVIG will emerge
to be a new market driver, catching up with the global plasma market trend (i.e IVIG replaced albumin to be plasma
market growth driver since early 2000s outside of China). While albumin will continue to contribute a significant
portion of incremental sales, its growth is likely to be slower than in the past. We see this as very positive news for
CBPO.
Article 49 prohibits the import of IVIG products into China. Human albumin is the only blood product allowed to be
imported into China due to its significance and under-supplied nature. Hence domestic players like CBPO have
been feeling the competitive pressure on albumin pricing. With IVIG and other plasma-related products, foreign
players do not have access to the Chinese market, so there should be much less competition in this market. This,
in our view, should allow key domestic players like CBPO to earn higher margins on IVIG to boost future profitability.
I M P O R T E D A L B U M I N A C C O U N T S F O R O V E R 6 0 % O F T O T A L
Albumin # of vials (10g per vial, mn) Source: National Health and Family Planning Commission; National Institutes for Food and Drug Control; Merricks’ estimates
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
0
10
20
30
40
50
60
2011 2012 2013 2014 2015 2016 2017 2018 2019E 2020E
Domestic Imports Albumin y-y growth
20
Risks to the healthcare sector China’s healthcare sector and development is still in its nascent stages when compared with more developed
markets in the western world. Therefore, health sector policy and reform are constantly evolving and developing
to encourage world’s best practices. At times the introduction and implementation of new healthcare reform
measures can affect a company’s short term financial performance. New reform measures could be more
aggressive than expected, which could exacerbate the challenges faced by the industry to comply while trying to
grow sales and profits at the same time.
Two-invoice system
China’s complicated and perplexing medical and pharmaceutical distribution landscape is undergoing reform.
Approximately 180,000 distributors – more than ten times the amount of public hospitals – conduct a wide range of
logistical, financial, and commercial activities in multi-tier networks. Regulators in China have long been concerned
that this multi-tiered network inflates drug prices, due to multiple distributor mark-ups, and facilitates “unchecked”
transactions that could transfer kickbacks to physicians. Some generate very high margins (for not much effort)
which has attracted the attention of regulators looking to contain healthcare costs and tighten compliance.
The Chinese government has acted by implementing a “two-invoice system” for pharmaceutical distribution that
was rolled out nationwide in 2018. The new policy will allow a maximum of two invoices between a manufacturer
and hospital – each manufacturer will sell to a distributor and that distributor will sell directly to hospitals, eliminating
multi-tiered distribution.
The reason for the change is simple: fewer distributor layers will lead to more transparent (and eventually smaller)
distributor margins, more compliant business conduct with less chance of corrupt practices, and very possibly a
consolidation of the distributor landscape.
The ex-factory price set by the manufacturer will now be visible to hospitals procuring the pharmaceutical or
healthcare product. This increased transparency will require manufacturers to adjust their pricing strategy.
Manufacturers choosing to increase the ex-factory price to match the price paid by hospitals (excluding the single
distributor fee) will enjoy higher revenues but at some costs. Chinese authorities and public hospitals may question
the sudden increase in ex-factory price, considering that distributor mark-ups were a significant driver of the price
that the hospital paid prior to the two-invoice system. Additionally, a higher ex-factory price would mean the
manufacturer would be responsible for additional value-added tax (VAT) payable to Chinese tax authorities.
The implementation of the two-invoice policy has had a material impact on many healthcare companies in China
with changes in route to market, channel structures, the roles and responsibilities of manufacturers, distributors and
other service providers, pricing, margin and profit structure, and compliance management. There has been some
turbulence in the supply chain as manufacturers shuffle their distributor arrangements to comply with the new
regulations and it is unclear how long companies will take to fully comply. We highlight this as a risk to the sector’s
thesis in the short-term, but don’t see it as a major long-term concern or risk to the thesis. In our view, this presents
a little bit of short-term pain for longer-term gain for the health and prosperity of the industry.
Zero mark-up policy and the capping drug sales to hospital revenue
at 30%
Since the 1950s, public hospitals have been selling drugs and pharmaceutical medicines at a mark-up. The
maximum is 15%. The mark-ups have been a key source of income and on average draw up to 50% (in some
hospitals up to 80%) of hospital revenue from drug sales. According to the Ministry of Health and Family Planning,
although the policy helped make up for a lack of adequate government healthcare funding, it gradually evolved into
a way to garner excessive profits, contributing to worsening problems like overprescribing, an excessive use (and
21
abuse) of drugs such as antibiotics, and rising medical expenses. Moreover, health industry experts say competition
to get drugs into hospitals has also led to kickbacks and other forms of corruption.
In 2017, all public hospitals were told to end the long-time practice of drug price mark-ups as part of the ongoing
healthcare reform. The government also introduced regulation which caps drug sales revenue to 30% of total
hospital revenue. A key objective is to separate hospital and doctor incomes from pharmaceutical and drug sales,
which have been too closely linked. Public hospitals' loss of revenue will be offset for the most part by an increase
in the prices of patient services, and more government investment and subsidies can be expected according to a
statement by the National Development and Reform Commission.
As hospitals around the country adjust to the zero mark-up policy, drug and pharmaceutical companies have seen
periods of greater price competition (to clear excess inventory), slower sales, margin pressure and inventory build
as they adjust pricing and rationalise the whole supply and distribution chain. We do not see this as a long term
thesis-breaking phenomenon and expect companies to return to growth once the new regulations have been
bedded down.
Recent lacklustre company financial performance has been triggered not by a drop in demand – on the contrary,
China’s need for medicines has never been greater – but by structural problems in the country’s healthcare system
that are gradually being rectified with carefully considered policy measures.
Again we see the capping of drug sales to hospital revenues and the zero mark-up policy as good regulation for the
long-term health of the industry to curb abuse and promote the availability, safety and appropriate use of essential
drugs in China.
Government approval process tends to be slow and arduous
Healthcare, pharmaceutical and medical device companies rely on continuous innovation and a strong research
and development pipeline to provide the latest products and medicines to the population and to stay on top of
competition. However, government approvals for new drugs and devices are notoriously slow and cumbersome
and delays are not forecastable with any degree of accuracy. This represents a real risk when investing in
healthcare companies.
Typically, a new drug or device appears on the Chinese market five to seven years later than in Europe or the US,
because many aspects of the approval system slow down the entry of new drugs.
China’s State Council has pledged to speed up the country’s drug-approval process through a set of new policies,
which include permitting for the use of data from overseas clinical trials for the first time. The policies also include
a promise to re-evaluate existing drugs on the market and to promote the production of generic drugs.
The new policies target China’s large backlog of drug approval registrations, which stood at 6,000 applications at
June 2017, down from a 2015 high of 22,000. Regulators in developed markets approved 433 new drugs between
2001 and 2016, while China approved just over 100.
NDRC has all-encompassing powers over the healthcare sector
The National Development and Reform Commission (NDRC), China’s economic planning agency, is a formidable
power centre within China’s government regulatory bodies, and its portfolio ranges from approving high-speed
railway projects to household electricity rates. It will remain one of the key regulators of the healthcare sector.
The NDRC has powers over anti-monopoly behaviour, misuse of market power, collusive behaviour to manipulate
market prices, and misleading and deceptive conduct. In 2016 it investigated price collusion between domestic and
foreign pharmaceutical manufacturers.
The NDRC has wide-ranging remedial and punitive powers from mandating price cuts and setting ceiling prices to
punishing offending firms through punitive damages and imprisonment terms for company executives. NDRC
mandated directives and decisions represent a key risk for companies operating in China’s healthcare industry.
22
Why Merricks Capital? The Chinese economy is undergoing an unprecedented expansion and structural shift, transitioning from a debt-
fuelled infrastructure and export-driven economy to one that is powered by a growing number of middle-class
consumers.
This economic transition and structural shift are unmatched in scale and the Merricks Capital investment team is
dedicated to finding the best-in-class companies in those industries most exposed to the benefits of the dislocation.
The Merricks Capital China portfolio is a concentrated long only portfolio of quality Chinese companies operating
in structurally favourable growth industries. The portfolio applies a disciplined investment process which focuses
on organic idea generation and deep fundamental analysis of sectors and companies using Merricks Capital’s
proprietary models.
The distinctive Merrick Capital investment approach is accompanied by an experienced and skilled team. Our China
team has spent over 20 years travelling extensively in China, seeking the best companies and business models;
building a wide range of contacts with both public and private companies and with local investors.
Experience
• Established in 2007, Merricks Capital has raised over USD2 billion in capital and invests using a multi-strategy
approach across a variety of traditional and specialist asset classes and investment structures. Asian equities
and specifically, Chinese equities is a key focus. Merricks has a long history of investing in Asia and has built
strong relationships with key industry players. We maintain regular contact with the company’s we invest in
giving us understanding of the key sensitivities enabling us to interpret changes quickly and act with high
conviction. The investment team has significant experience across core industrial, capital goods, technology,
consumer, financials and materials sectors conducting regular research trips into China.
• Jimmy Cheong, Portfolio Manager, has been working in equity markets since 2000. Prior to joining Merricks
Capital, Jimmy spent 13 years working in Hong Kong researching China and Asia Pacific equities across
both sell side and buy side roles with leading institutions and asset managers such as Macquarie Group,
J.P. Morgan and BNP Paribas. Jimmy has travelled extensively around China (which includes living in
Beijing for six months), meeting company executives, conducting site visits and getting to know his
companies at the coalface. Jimmy’s extensive Asian markets experience has enabled him to forge and
maintain valuable industry contacts.
• Adrian Redlich, Chief Executive Officer, has over 20 years’ experience investing in China. Prior to founding
Merricks Capital in 2007, Adrian worked at Citadel Investment Group (Chicago) as the Head of Quantitative
Alpha Generation, Global Equities. The global equities group consisted of nine sector teams and ran the
world’s largest fundamental long/short market neutral portfolio. During this time Adrian was also directly
responsible for an Asian focussed derivative portfolio. Prior to Citadel, Adrian was a Director at Merrill Lynch
(New York & Hong Kong), where he was Head of the Global Valuation and Analytics Group.
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