After Tough 2011 For Chinese Healthcare IPOs, Policy And Cost Relief Could Be On The Way

China's pharma IPOs didn't meet the hype in 2011. Government action may now ease speculation mania.

The past year has been tough for Chinese healthcare initial public offerings. The majority of the 30 companies that went public saw shares dip roughly 60% below their IPO prices at year-end, while some were available at a 70% discount to their listing prices.

The first-day success rate, a measurement of a company’s closing price above its issue price on the first day of trading, was also at a record low, according to a Morgan Stanly report released Jan.10.

A good performance on day one is a crucial factor in forecasting a company’s six-month share price amid a tough market, explained the report. Around 77% of the companies followed the same stock trajectory as their first trading day.

Chinese healthcare companies nevertheless remain keen to get funded through public listings. Last year saw 30 new IPOs (valued at $5.56 billion), down from the record-high of 34 China healthcare IPOs (valued at $6.88 billion) in 2010. Although IPO momentum has slowed since 2010, it is still strong given a tough year, noted report author Bin Li.

The majority, or 87% of the companies were listed in China's domestic A-share market, higher than 71% in 2010 and a historic average of 65%, due to a high valuation in Cina’s A-share market and unfavorable views toward Chinese companies among overseas investors, Li said.

Distributors Impacted By Policy And Fiscal Tightening

The poor performance for Chinese pharma distributors in 2011 is particularly noticeable. Due to their large sizes, vast distribution networks and potential to benefit from China’s massive healthcare reform, the sector has been a bellwether for Chinese healthcare IPOs in recent years.

In a 2009 IPO, China’s largest pharma distributor Sinopharm Group Co. Ltd. raised its goal of HK$8.73 billion ($1.13 billion). Investors flocked to the IPO; it had already attracted more than $28 billion of institutional orders even before subscriptions began for individual investors (Also see "The Year Of The Tiger Looking Strong For IPOs In China Following Sinopharm Success" - Scrip, 4 Dec, 2009.).

The second-largest distributor, Shanghai Pharmaceuticals Holding Co. Ltd., was hoping to repeat Sinopharm’s success. Its May 2011 IPO in Hong Kong was priced at HK$23 per share, or almost $2 billion in total. The record-breaking IPO attracted investment from Pfizer Inc. which invested $50 million in the company. By the end of 2011, however, Shanghai Pharma shares had dropped to HK$12.5, 46% lower than its listing price (Also see "With Pfizer As Cornerstone Investor, Will Shanghai Pharmaceutical Be Largest Pharma IPO Ever?" - Scrip, 10 May, 2011.).

Distributor NT Pharma Group was hit even harder in its 2011 debut in Hong Kong. NT's shares tanked from an initial price of HK$4.54 to 1.01, down by 78%.

Analysts point to two factors for the poor performance of China's IPOs. For one, the initial listing prices have been historically set too high; another is policy impact and the increasing cost of materials and labor, Kan Ye, a healthcare analyst for Shanghai-based Xiangcai Securities told PharmAsia News.

According to Ye, the negative impact came mainly from China's tightened fiscal policy. Aiming for a soft landing, China's Central Bank raised interest rates three times in 2011, adding borrowing costs for distributors.

China’s EDL Also Pinches Distributors

The implementation of China's Essential Drug List also negatively impacted distributors’ revenues. In China, hospital pharmacies are the major outlet for drugs because physicians and hospitals get a big portion of their incomes from drug sales. Since the central and provincial government explicitly limited price markups for drugs listed on the EDL, hospital pharmacies suffered reduced income from drug sales. In return, these pharmacies delayed payment to drug distributors.

The stricter cash flow and larger accounts receivable were major causes for drug distributors’ poor showings, said Kan Ye of Xiangcai Securities.

In addition, profit margins of these distributors were squeezed by the higher inflation rate throughout 2011. China's consumer price index increased 5.4% for 2011, much higher than Beijing’s target of 4% and 2010’s 3.3%, according to China Statistics Bureau data.

While the cost of raw materials, labor and power increased multiple times, drugs were hit by rounds of price cuts, forcing many small-sized sellers to exit due to a loss of revenue.

Meanwhile, China's drug distribution industry is going through earthshaking consolidation. The industry’s 12th five-year plan has called for the formation of one to three national and 20 regional distributors (Also see "China Likely To Strengthen Distribution Regulations To Force Consolidation" - Scrip, 9 Nov, 2011.).

Unlike in the U.S. where a balance between supply and demand is in control, China IPOs are heavily influenced by policies.

To be a part of the action, many firms are eager to scale up and expand their footprints. Sinopharm and Shanghai Pharma are acquiring smaller distributors nationwide. Even foreign players like Cardinal Health Inc. have joined the race by acquiring the ninth-largest distributor Zuellig Pharma China (Also see "China’s New Guidelines On Foreign Investment Loosens Restrictions On Drug Distribution" - Scrip, 6 Jan, 2012.).

But the all-out expansion has stretched distributors’ capital flow and damaged their balance sheets.

The healthcare sector is not the only one to see IPOs dip. Among 282 companies that went public in the A-share market in 2011, 27% had shares traded below their issue prices on the first day of debut, and 66% of companies saw prices under water at year-end.

The situation has attracted attention from China’s Security and Exchange Commission, which said it plans to reform the listing system. In particular, the SEC wants to control speculation mania over newly listed stocks and to increase transparency in approval reviews.

Chemicals, Devices and TCM Stand Out

Chinese chemical, medical device and TCM manufacturers fared better in 2011 than their pharmaceutical and biotech peers (Also see "Traditional Chinese Medicines Seen As Global Growth Opportunity" - Scrip, 19 Aug, 2011.).

TCM and chemicals recorded an average return of 41% and 40%, respectively, in terms of price appreciation after six months. On the whole, the sector had an average six-month return of 32%, according to Bin Li.

CSPC-NBP Pharmaceutical Co. Ltd., for example, raised RMB 2.25 billion ($348 million) in a Shenzhen stock market IPO. The Hebei Province herbal medicine firm was listed at a RMB 34.56 price tag, and it ended the year with 8% price appreciation.

Shanghai-based equipment manufacturer Tofflon Science and Technology Co. also went public in Shenzhen in 2011, and its shares had gone up 33% by year-end.

Shenzhen-based Salubris Pharma, listed in 2009, had one of the largest price appreciations among publicly traded Chinese healthcare companies. The chemicals maker and supplier’s shares jumped 85% in 2011.

In stark contrast, drug store chains were the worst-performing subsector, reporting a negative yield of -56% after six months. Shares for major player China Nepstar Chain Drugstore Ltd., listed since 2007 in the U.S., dropped 90% to $1.87 from its IPO price of $16.20 (Also see "Squeezed by Price Caps And Rising Costs, China's Nepstar Drugstore Chain Pushes Its Own Brands" - Scrip, 25 Nov, 2010.).

Unlike in the U.S. where a balance between supply and demand is in control and a bull market brings more IPOs and a bear market fewer IPOs, China IPOs are heavily influenced by policies, noted Kan Ye of Xiangcai Securities. The separation between the market condition and the number of IPOs makes Chinese IPOs prone to oversupply and price deprecation in a down market, such as in 2011, Ye added.

Improvement In 2012 And Return Of Overseas IPOs

Looking ahead, Chinese healthcare firm IPOs will improve in 2012 due to an ease on inflation and decreased costs for raw materials, the Xiangcai Securities analyst said.

Inflation slowed to 4.1% in December, a 15-month low. The rate is only 0.1% higher than the governmental target. “2012 will see costs down for materials and ease of pressure for companies, although labor costs will continue to rise,” Ye said.

Coupled with government encouragement and favorable policies for domestic research and innovation, healthcare companies could embrace a second rush of IPOs in 2012.

The promised reform at China's SEC, if materialized, could produce IPOs with more reasonable prices, added Ye. Besides the pricing strategy, a reformed listing system should prevent jams amid domestic firms aspiring to raise funds through a public offering, according to the analyst.

As the quality of China’s domestic pharmacy industry increases as the country’s new good manufacturing practices become implemented, analysts expect to see more consolidation in the industry and an increasing demand for companies to raise funds through IPOs (Also see "China's Inspectorate Begins Enforcing New Drug GMPs Overseas" - Scrip, 23 Nov, 2011.).

Coupled with government encouragement and favorable policies for domestic research and innovation, healthcare companies could embrace a second rush of IPOs in 2012, predicted Lin Jianning at a Nov. 10 press conference. Lin is director of the Nanfang Research Institute at China’s State FDA.

The year ahead could also see renewed interest from Chinese companies obtaining overseas market listings, especially in the U.S. where many Chinese firms are currently listed. They include the largest CRO WuXi PharmaTech Inc. with its 2007 listing, followed by the second-largest CRO ShangPharma Corp. in a late 2010 IPO on the New York Stock Exchange. Other names include drug and biopharmaceutical companies Simcere Pharmaceutical Group, 3SBio Inc. and device manufacterers Shangdong Weigo and Mindray Medical International Ltd.

Companies should be realistic about actively pursuing U.S. listings, Ye believes. But for firms with an international strategy and heavy focus on overseas expansion, a U.S. listing could help them establish their brand.