Drug price cuts looming

Last Thursday the National Development and Reform Commission (NDRC) has proposed another round of drug price cuts for drugs in the National Drug Reimbursement List (NDRL), which led to Friday’s sell-off in some Healthcare counters. It proposes to set a maximum retail mark-up for drug distributors, a maximum operating margin and a maximum expense ratio for manufacturers (see tables 1 and 2). Some sources suggest that price cuts could be as high as 30-40% and that the implementation may take place this month with a transition period of three months.

IMPLICATION

Drug manufacturers could be affected by the policy move, such as TUL (3933.HK) and possibly Chinese medicine manufacturer Shineway (2877.HK).

TUL has a projected operating margin of 16.8% for FY10F which is at the high end of the proposed margin, but still in the range (8-18%). The company has an operating expenses ratio of 23.6%, which is lower than the proposed one (30-45%). The company enjoys a higher price allowance due to higher shelf-life of their products than competitors. We spoke to the management of TUL and they think, that they will not be affected, because there is no room for lowering prices. We think, in the worst case, the company could lose its higher pricing allowance.

Chinese medicine producer Shineway (2877.HK) has an operating margin of 42.6% for FY10F and an expense ratio of 31% vs. the proposed maximum of 23% and expense ratio of 30-45%. The difference here is bigger and it seems that this company is more likely to be affected.

From companies that we don’t currently cover but have looked at Sino Biopharmaceuticals (1177.HK) could be negatively affected as they also have special pricing allowances.

We think that distributors will be affected, especially the small ones. However, we do not see that this will affect Sinopharm (1099.HK) in the long run.

The uncertainty in the drug sector could lead to some weakness across the Healthcare sector in the short run. Smaller distributors which cannot easily change to products that earn them a higher margin will suffer and drug manufacturers are also likely to suffer.

So far, medical devices manufacturers are not affected such as Mingyuan (233.HK), Golden Meditech (801.HK) and Shandong Weigao (8199.HK). However, if this policy is implemented then there is no reason, why it should not be also applied to medical devices over time.