Chinese drug maker seeks Hong Kong listing

IPO investors will need to weigh up United Laboratories' strong structural growth potential and generous valuation against a regulated market with plenty of competition and price controls.
The United Laboratories International (TUL) has started marketing an initial public offering of up to HK$825 million ($105 million), which gives investors yet another chance to gain exposure to ChinaÆs rapidly growing, but heavily regulated, market for pharmaceuticals.

Sources close to the offering say the key selling points for the Chinese manufacturer of generic Western drugs will be its vertically integrated business model which gives it better control over product quality and production costs and also ensures higher margins versus most of its industry peers. It also has a well-recognised brand name, an extensive sales and marketing network and a strong pipeline of 26 new drugs that are expected to come to market over the next three years.

According to fund managers who attended a marketing luncheon in Hong Kong
yesterday, the IPO is also being offered at a significant discount to the average valuation of other Hong Kong-listed drug makers û making it even more appealing.

This may have been deemed necessary as the equity markets havenÆt been overly kind to the Chinese pharmaceutical companies that have listed so far this year, with Wuyi Pharmaceuticals and 3Sbio currently trading well below their IPO prices. Another stock, Tongjitang Chinese Medicines, traded below par for more than a month before starting to edge higher. Weak demand forced the latter to fix its IPO price 33% below the initial price range however, and, as of last Friday, the share price was still hovering about 11% below the bottom of the initial range.

Only Simcere Pharmaceutical Group, which was the most recent listing on April 22, has held solidly above its $14.50 IPO price, closing at $15.73 last Friday. Simcere, Tongjitang and 3Sbio are all listed in the US, while Wuyi trades on the Hong Kong bourse.

ôThe company recognises that the performance in the aftermarket is important and in light of most of the other companies struggling it didnÆt want to be too aggressive on pricing,ö says one source familiar with the deal. Based on the current price range, TUL looks like ôgood valueö, he adds.

But ChinaÆs pharmaceutical drugs market is certainly not without risk, other sources note. For one, it remains highly regulated with government-imposed price ceilings on numerous products. It is also very fragmented with intense competition due to low entry barriers.

At a price range of HK$2.25 to HK$2.75 TUL is valued at 11.1 to 13.6 times its estimated 2007 earnings, which compares with a market cap-weighted average of 20 times for other Chinese drug makers listed in Hong Kong. The valuations vary widely, however, with Wuyi Pharmaceutical at 11.5 times and China Pharmaceutical at about 48 times after it has rallied about 150% since early March on speculation of an asset injection. The latter is widely regarded as the most direct comparable because of its similar product mix, but lags TUL in terms of margins and the number of products covered by the state insurance programme.

Hong Kong-based TUL, which is being brought to market by HSBC, is offering 25% of the company, or 300 million shares, plus a 15% greenshoe which could potentially boost the total proceeds to $121 million. The base deal consists only of new shares, while the 45 million shares that make up the greenshoe are secondary. According to one source this shows the founding Choy family isnÆt keen to part with a bigger portion of the company than it absolutely needs to in order to comply with the minimum free-float requirements.

The deal will have the usual 90-10 split between institutional and retail investors and standard clawback levels will apply in case of strong retail demand. The Hong Kong retail offering will open on June 4 and the books will close on June 7. The final price is expected to be determined after the US markets close on that same day and the trading debut is scheduled for June 15.

TULÆs main business is to manufacture and sell finished antibiotics drugs as well as the bulk medicine and intermediate products used to produce them. It currently has drug registration approval for 119 products, of which 30 are bulk drugs and 89 are finished products. Among the key drivers for its business is ChinaÆs increase in per capita income, ageing demographics and rising awareness of health issues, which is leading to greater affordability of - and higher spending on - health care and medicines.

Pharmaceutical product sales are projected to grow at a compound annual growth rate of 22% in 2004 to 2008, reaching Rmb668 billion ($87 billion) next year, according to Beijing Huayan Century Industry Consulting. Growth is expected to be particularly strong in the rural areas as the government has committed to expand the medical insurance system to cover almost all rural residents by 2010. TUL is expanding its sales of finished drugs into rural areas to capture this growth through its wide-reaching distribution platform.

Over the past three years the company has been able to grow its sales at a CAGR of 31.7% to HK$2.1 billion ($269 million) in 2006, while keeping segmental margins for its finished drugs at 26%-30%. Overall Ebit margins have been steady at 13%-14% despite industry-wide pressure on bulk and finished drug prices. The net profit growth has been lagging, however, due to additional costs associated with the construction of a new plant for the production of three different intermediaries which began operations last year.

According to syndicate analysts, net profit is expected to increase by 30% to 40% this year from the HK$173.8 million ($22 million) achieved in 2006. This will be driven partly by a production increase at the new intermediate plant in Chengdu to 4,000 tonnes of from 3,500 tonnes last year, partly by higher prices for intermediate products due to a tight supply situation at this end of the value chain.

The company will also continue to increase its exports of bulk drugs, including semi-synthetic penicillin and cephalosporins, which reached 21.4% of total sales last year compared with 9.9% in 2004. That, observers say, will allow the company to reduce its exposure to government price controls in its home market.

TULÆs overseas customers include HELM and Indukern Chemie in Germany, Ranbaxy in India and Daewoong Chemical in South Korea.

Meanwhile, the company is expecting to receive approval for two penem-type antibiotics (more advanced) in the second half of this year. These two drugs, a human insulin injection for diabetes and a capsule for treatment of hepatitis B, had a combined market size of Rmb12 billion in 2005, suggesting significant growth potential.

About 44% of the net proceeds will be used for further expansion and upgrades of the companyÆs production facilities, while the remainder will be divided between on the expansion of its sales and marketing network, additional research and development facilities, a partial repayment of two outstanding loans and working capital.
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