Healthcare Observer Oct 2013
Transcription
Healthcare Observer Oct 2013
Healthcare Observer Oct 2013 Med-Tech Multinationals Moving Toward Moats in China’s Burgeoning Health-Care Market As medical technology companies shift their attention to emerging markets, we think China’s potential for growth in its health-care market—$1.7 trillion by 2022—is the key growth opportunity spurring multinationals to set up shop there. China has already overtaken Japan as the second-largest med-tech market, and we anticipate robust double-digit growth to continue, especially considering the still-low penetration rates of common medical procedures such as angioplasty, hip replacement, and cardiac resynchronization. We take a closer look at how Abbott ABT (FVE: $40), Boston Scientific BSX (FVE: $9.50), General Electric GE (FVE: $27), Medtronic MDT (FVE: $60), Stryker SYK (FVE: $70), and Zimmer ZMH (FVE: $80) have created economic moats around their businesses in China. Of the med-tech companies, we think Medtronic is relatively undervalued, and the best-positioned, to penetrate the Chinese market with its wide-ranging product portfolio. 2 Potential to Tap Into Immense Growth by Digging Med-Tech Moats in China 3 China’s Health-Care Spending Set to Triple by 2022 on Rising Incomes, Aging Population 20 Medical Technology Market in China: Awakening Giant and Emerging Dragon 31 Chinese Challenges to Digging Moats in the Stent Business 39 Orthopedics: Translating Wide Moats in China 45 General Electric’s Emerging-Market Strategy Starts With Service Networks 47 Outlook for Industries in Health-Care 47 Healthcare Focus Lists 49 Healthcare Calendar 50 Coverage List Debbie S. Wang, North America Senior Analyst, Devices 1 312 384-3937 [email protected] Daniel Rohr, CFA, North America Strategist, Basic Materials 1 312 384-4836 [email protected] Alex Morozov, CFA, North America Director, Devices 1 312 696-6159 [email protected] Damien Conover, CFA, North America Director, Pharmaceuticals 1 312 696-6052 [email protected] Contributing Morningstar Healthcare Observer Analysts Daniel Holland, North America Senior Analyst, Industrials 1 312 696-6589 [email protected] Karen Andersen, CFA, North America Senior Analyst, Biotechnology 1 312 384-4826 [email protected] John Zecy, North America Associate Analyst 1 312 384-3734 [email protected] Vishnu Lekraj, North America Senior Analyst, Healthcare Services 1 312 244-7021 [email protected] Kai Bi, Asia-Pacific Associate Analyst, Healthcare 86 755 3311-0000 [email protected] Iris Tan, Asia-Pacific Senior Analyst, Banks and Insurance 86 755 3311-0980 [email protected] Healthcare Observer October 2013 2 Potential to Tap Into Immense Growth by Digging Med-Tech Moats in China by Debbie S. Wang Executive Summary A potent combination of GDP growth potential and a massive (and aging) population suggest tremendous growth prospects for health-care demand in China. We attempt to gauge the magnitude of the opportunity at 30,000 feet by assessing macroeconomic and national data on demographics. Then, we focus more tightly on the medical-technology opportunities, challenges, and risks in China. Finally, we take a close look at several key markets to see how well the multinational med-tech companies have replicated their economic moats in China, and the various strategies for doing so. Key Takeaways 3 We size the Chinese health-care market at $1.7 trillion in 2022. Using international and Chinese data sets on health spending, income, and demographics, we find the growth potential for Chinese health spending is far greater than that for GDP. If China follows the “typical” path as it grows richer and older, we would expect health care’s share of GDP to grow by 40% by 2022. 3 China’s med-tech market is already $21 billion—second in size only to the U.S.—and has been growing in the high teens. We think there is plenty of room for further growth in cardiology, orthopedics, and neurology thanks to rising demand through nearly universal health insurance, rising middle-class expectations, and the shift in disease burden to chronic conditions. Simultaneously, supply is increasing as more physicians are trained to use devices and more hospitals offer more sophisticated medical services. Despite the real regulatory, reimbursement, price control, piracy, and corruption risks in China, multinational med-tech firms have already put down stakes there in the hopes of capitalizing on expected growth. 3 We think multinationals in the narrow-moat business of making drug-eluting stents will face major challenges to digging moats in China. Abbott, Boston Scientific, and Medtronic rely heavily on efficient scale as a source of economic moat in developed markets, where they operate as a rational oligopoly. The competitive landscape in China includes formidable local competition that act as fast-followers and have successfully innovated their way up the value chain. 3 We are confident the orthopedic multinationals can translate their wide moats in developed markets to the burgeoning Chinese market. Unlike the stent makers, Johnson & Johnson, Stryker, Medtronic, and Zimmer all benefit greatly from the high switching costs that characterize orthopedic products. We think this dynamic will compensate for weaker intellectual property protection in China through the midterm. Orthopedic multinationals have also bolstered this competitive advantage through savvy acquisitions of local midtier competitors. Healthcare Observer October 2013 3 China’s Health-Care Spending Set to Triple by 2022 on Rising Incomes, Aging Population by Daniel Rohr, CFA We see tremendous growth prospects for health-care demand in China thanks to the combination of GDP growth potential and a massive (and aging) population. We attempt to gauge the magnitude of the opportunity using international and Chinese data sets on health spending, income, and demographics. We find the growth potential for Chinese health spending is far greater than that for GDP. If China follows the “typical” path as it grows richer and older, we would expect health spending to triple to $1.7 trillion (purchasing power parity) by 2022, as its share of GDP rises by 40%. 3 China spends roughly 5% of GDP on health care, far below the global average of 10%, but commensurate with what we’d expect for its income level. 3 Rising incomes are strongly associated with a rising health-care share of GDP in the international data set. A review of Chinese health spending since 1995 reveals no reason to believe China will break from this global trend. We strongly expect health spending will grow faster than GDP as China climbs the income ladder. We expect rising incomes to deliver a 1-percentage-point boost to the health-spending share of GDP by 2022. 3 China’s rapidly aging population also will be a major driver behind the “GDP-plus” growth we expect in health spending. By 2022, China will attain income levels Mexico and Turkey possess today, but will be far older. We expect aging will add 1 percentage point to health spending’s share of GDP in China. 3 Continued urbanization also augurs rising health-care outlays, but the effect is largely subsumed in the broader income-health spending linkage. Adjusted for income, urban and rural Chinese spend a roughly identical amount on health care. 3 In total, tailwinds from income and aging suggest a tripling of the Chinese health-care market by 2022, assuming the sort of 7% GDP growth embodied in consensus. Even under our more bearish “rebalancing” GDP growth expectation of 5%, the health-care market would nonetheless more than double by 2022. 3 We expect public sources to foot a growing share of the bill for health spending. This trend is suggested by the global data set, a multiyear trend in Chinese spending composition, and is explicitly targeted in its 12th Five-Year Plan. Healthcare Observer October 2013 4 Massive Economy, but a Fairly Modest Market for Health Care China punches below its demographic and economic weight in terms of health-care spending. China accounts for 19% of the global population. On a purchasing power parity, or PPP, basis, 14% of global economic activity happens in China, close on the heels of the United States’ 18% share.1 But China is only 7% of global health spending. Measured relative to the size of its economy, China spends 5.2% of its GDP on health care, well below the global average of 10.1%. Measured in absolute terms, Chinese health spending clocks in at $583 billion (PPP) annually. That ranks second globally, but it’s far behind the leader: the United States at $2.7 trillion. And it’s not much more than the health spending of much smaller economies. Put in perspective, China’s market for health products and services is roughly the same size as that of Germany ($357 billion) and France ($269 billion) combined, even though China’s economy is twice as large. Exhibit 1: China Punches Below Its Demographic Weight in Heath Spending Population GDP (USD, PPP) Health spending (USD, PPP) Rank Country Millions % share Rank Country Billions % share Rank Country Billions % share 1 China 1,344 19.3 1 United States 14,991 18.4 1 United States 2,677 32.7 2 India 1,221 17.5 2 China 11,301 13.9 2 China 583 7.1 3 United States 312 4.5 3 India 4,536 5.6 3 Japan 401 4.9 4 Indonesia 244 3.5 4 Japan 4,325 5.3 4 Germany 357 4.4 5 Brazil 197 2.8 5 Germany 3,227 4.0 5 France 269 3.3 6 Pakistan 176 2.5 6 Russia 3,204 3.9 6 United Kingdom 208 2.5 7 Nigeria 164 2.4 7 France 2,312 2.8 7 Brazil 204 2.5 8 Bangladesh 153 2.2 8 Brazil 2,291 2.8 8 Russia 199 2.4 9 Russia 143 2.1 9 United Kingdom 2,233 2.7 9 Italy 188 2.3 10 Japan 128 1.8 10 Italy 1,983 2.4 10 India 175 2.1 Source: United Nations Population Division, World Bank, World Health Organization, Morningstar analysis Chinese Health Spending Will Grow Faster Than GDP in the Next Decade China’s low health spending as a share of GDP is mainly a function of income level. As shown in the exhibit below, which compares health spending’s share of GDP against GDP/capita, Chinese health spending isn’t unusual after taking into account income. In fact, most middle income countries spend a share of GDP on health care similar to what we see in China—around 4%–6%. Meanwhile, higher income countries tend to spend a greater share of their incomes on health care—around 8%–12%. The link between rising incomes and rising health-care share of GDP is rather robust. And with a few notable exceptions, it’s very consistent.2 Healthcare Observer October 2013 5 Exhibit 2: Health spending consumes a larger share of income as GDP rises China Other Countries Health spending (% GDP) 20% U.S. Source: World Health Organization, United Nations Population Division, World Bank, Morningstar analysis 18 16 14 Note: Bubble size denotes population 12 10 8 6 4 2 0 10,000 GDP per capita, PPP (current international $) 20,000 30,000 40,000 0 50,000 Why do higher-income countries spend proportionately more on health care than their middle-income counterparts? We’d suggest this is largely a function of the fact that richer countries have more income available for discretionary consumption.3 And while a good deal of health care is decidedly nondiscretionary, past a certain point, health-care products and services are increasingly “elective” in nature: tied more to “quality of life” than “quantity of life.” Indeed, the rising health spending share of GDP fits a broader trend that accompanies economic growth: a rising services share of GDP. Exhibit 3: Services Share of GDP Rises with Incomes Too China Other Countries Services (% GDP) 80% Source: United Nations Population Division, World Bank, Morningstar analysis U.S. 70 60 50 40 30 20 10 0 10,000 GDP per capita, PPP (current international $) 20,000 30,000 40,000 50,000 Looking at how China’s health spending has evolved as incomes have risen suggests little reason to believe China will break from the global trend as it scales the income ladder. As Chinese GDP has grown, health care has claimed a bigger share of the pie. In 1995, the earliest year for which we have comparable figures on health spending, China was a decidedly lower middle-income country. Health spending 0 Healthcare Observer October 2013 6 as a percentage of GDP was 3.2%. By 2011, the last year for which we have comparable figures on health spending, Chinese GDP per capita had quadrupled to $8,408 on a PPP basis, placing China solidly in upper-middle income territory. Health spending as a percentage of GDP has risen to 5.2%. Exhibit 4: Chinese health spending has claimed rising share of GDP since 1995 China Health spending (% GDP) 6.0 Source: World Health Organization, World Bank, Morningstar analysis 5.5 5.0 2011 4.5 4.0 3.5 3.0 2.5 1995 2.0 1.5 1.0 0.5 0 1,000 2,000 3,000 GDP per capita, PPP (current international $) 4,000 4,000 4,000 4,000 4,000 9,000 China’s Health-Care Market in 2022: Rising Incomes Suggest a Near-Tripling in Size It therefore seems highly likely that Chinese health spending will claim a larger share of GDP as incomes continue to rise, growing faster than the economy as a whole in the process. But how big is the growth opportunity? We can get a rough gauge of the China’s health-care market’s potential by overlaying a GDP growth assumption against the “trend line” for health spending’s share of GDP implied by the international data shown in Exhibit 2. In other words, we can simply push China along the trend line as incomes rise and then work out how much it would spend on health care at any given point. For example, 7% annual GDP growth (roughly equivalent to prevailing long-term consensus) in the 10 years to 2022 would boost Chinese GDP per capita to about $17,700 in current PPP terms. This would be roughly double current levels. Assuming that the health spending share of GDP were to rise to slightly above 6%, this implies health spending would reach $1.5 trillion in current PPP terms, about two and a half times 2011 levels.4 0 Healthcare Observer October 2013 7 Exhibit 5: Rising Incomes Imply Sharp Increase in Chinese Health Spending Income effect Health spending, USD billions PPP 3,000 Source: World Health Organization, World Bank, Morningstar analysis 2,500 2,000 1,500 1,000 500 United Kingdom France Germany Japan China 2011 China 2022 United States 0 Under more modest GDP growth assumptions incorporated in our rebalancing thesis5, which results in a slightly lower point along the trend line (health spending grows to 5.7% of GDP), annual health spending would nonetheless nearly double to about $1.2 trillion. The enormous growth China’s healthcare market would see even under this comparably bearish GDP outlook underlines the magnitude of the opportunity. A doubling of China’s health spending would put its outlays on par with health-care spending across the entire eurozone and about 3 times that of prevailing Japanese spending. Owing to the rather strong relationship we observe between health spending and income levels in the cross-country data set, we think this simple model for estimating future growth in Chinese health spending is a reasonable one. But as with any long-term economic forecast, it’s clearly fraught with uncertainty. At the most basic level, GDP growth is difficult to get right. And there are numerous factors that could push Chinese health spending above or below the trend line for a given amount of GDP growth. Will Demographic Tailwinds Drive Chinese Health Spending Higher Than “Normal”? In fact, one might argue that big demographic trends could push China’s health spending above the trend line in the decade to come. Over the next 10 years, China will grow older and more urban. Both developments are typically associated with strongly rising health spending. But before we try to gauge the incremental impact of demographic change on China’s health spending, a word of caution is warranted. While the foregoing exercise that focused on the linkage between income and health spending did not directly address the impact of demographic change, in some ways it did so indirectly. That’s because rich countries tend to be older and more urban than poor countries. As a result, movement along the trend line already accounts for a certain amount of aging and urbanization. It would only be if China ages or urbanizes faster than normal for a country of its income level that these demographic factors would push it above the trend line instead of merely along the trend line. (That’s what we’ll evaluate next.) Healthcare Observer October 2013 8 China Isn’t “Old” Yet, but Will Age Rapidly We begin by looking at age. At present, China isn’t very “old.” According to the 2010 census, China has 113 million people aged 65 or older, a modest 8% of the country’s total population of 1.36 billion. But the size of that age group is set to swell significantly, to 187 million by 20256, pushing the “senior share” of China’s population to 13%. Through 2022, China will add more seniors than will the EU, U.S., Japan, Russia, and Brazil combined. China is at the vanguard of the broader global aging trend. Exhibit 6: China’s Senior Population Will Double in Two Decades Population (000s) China’s senior population 250,000 Source: U.N. Population Division, Morningstar analysis 200,000 150,000 100,000 50,000 1990 1995 2000 2005 2010 2015E 2020E 2025E 2030E 0 Exhibit 7: Top Seven Countries by Population 65+ 2011 2022 Million persons 200 180 Source: U.N. Population Division, World Bank, Morningstar analysis 160 140 120 100 80 60 40 20 China EU India United States Japan Russia Brazil 0 Healthcare Observer October 2013 9 China’s rapid aging unquestionably signals higher health spending in absolute terms, as health spending is highest for individuals closer to end-of-life. But to determine whether this aging process will lift health spending above what we typically observe for countries of China’s income level, we must assess whether China is aging more rapidly than “normal” for its income level. To answer that question, we’ll use a simple measure demographers call the old-age dependency ratio.7 The old-age dependency ratio tells us how many individuals past working age there are for each person of working age. For international comparisons, working age is defined as 15–64. For the sake of comparability, that’s the definition we’ll use here. China’s old-age dependency ratio in 2011 was 11.6, meaning China had only 11.6 seniors per 100 workers. As shown in Exhibit 8, that’s a fairly typical ratio for a country of China’s income level. This, in turn, suggests we ought to observe a fairly “normal” health spending share of GDP—relative to countries of similar income. And, of course, that’s exactly what we saw when we compared health spending and GDP/capita. Exhibit 8: Richer countries tend to be “older” China Other Countries Old age dependency ratio 40 35 Source: United Nations Population Division, World Bank, Morningstar analysis 30 Note: Bubble size denotes population 25 U.S. 20 15 Turkey 10 Mexico 0 10,000 GDP per capita, PPP (current international $) 5 20,000 30,000 40,000 50,000 Fast forward to 2022 in the United Nations’ “medium fertility variant,” and China’s old-age dependency ratio jumps to 17.8. By this measure of societal “age,” China would no longer be a spring chicken. And it will have aged very quickly in a short period of time. China’s rapidly rising old-age dependency ratio stems from both a low replenishment rate in the working-age population (the denominator of the ratio) and a surge in the senior population (the numerator). The former effect is attributable to the One Child Policy, which, along with more “natural forces,” sent Chinese fertility rates plummeting since 1980 and will mean far fewer individuals reaching working age over the next decade than in the past decade. The result is a population age distribution with an appearance some have described as akin to a “snake eating a water buffalo.” 0 Healthcare Observer October 2013 10 Exhibit 9: A Snake Eating A Water Buffalo: China Population by Age Group China’s population Million persons 120 Source:National Bureau of Statistics, Morningstar analysis 100 80 60 40 20 0–4 5–9 10–14 15–19 20–24 25–29 30–34 35–39 40–44 45–49 50–54 55–59 60–64 65–69 70–74 75–79 80–84 85–89 90–94 95+ 0 Getting Old Before it Gets Rich: China Will Be a “Gray” Middle-Income Country To put the rather “dry” old-age dependency ratios in context, China’s current ratio is similar to that of Japan in 1975 (11.6). By 2022, it will be slight above Japan’s in 1990 (17.1).8 Remarkably, China will have covered as much demographic ground in 10 years as Japan did in 15 years. Aging 33% faster than Japan did, it should come as little surprise that China would be aging far more rapidly than countries of comparable income levels. Looking back at Exhibit 8, we can see that a 17.8 old-age dependency ratio would easily rank China the “oldest” of major middle-income countries. Mexico, for example, has a GDP/capita of $16,013 (PPP) and a 9.5 old-age dependency ratio. Turkey, another rung up the income ladder at $17,242/capita has a 10.8 old-age dependency ratio. Ten years from now, China would be far older than these countries are today, but roughly just as rich. Impact of Rapid Aging on China’s Health Spending We think this strongly suggests China’s health spending share of GDP will exceed “typical” levels for a middle-income country in the decade to come. In effect, this pushes China “above” the trend line established in Exhibit 2. We estimate this would be worth about 1 percentage point of incremental GDP share going to health care. Adding this “aging” effect to the “income” effect on health spending and making no other adjustments to our model would increase the estimated size of China’s 2022 health spending from $1.5 trillion to $1.7 trillion, assuming GDP growth approximates prevailing consensus. Healthcare Observer October 2013 11 Exhibit 10: Combined Income and Aging Effects Could Boost China’s Health Spending to $1.7 trillion Aging effect Income effect Health spending, USD billions PPP 3,000 Source: World Health Organization, World Bank, Morningstar analysis 2,500 2,000 1,500 1,000 500 United Kingdom France Germany Japan China 2011 China 2022 United States 0 We arrive at that 1 percentage point estimate a couple ways. First, it seems reasonable in the context of the international data set. A 1-percentage-point increase to the health spending share of GDP at the $17,700/capita mark would push China’s health share of GDP from 6% to 7%. Although this would put China at the higher end of health spending share of GDP at that income level, it wouldn’t be “out of range.” Second, we use morbidity statistics from China’s Ministry of Health to gauge how usage of the health-care system varies with age. Morbidity in the context of Chinese public health statistics refers to the number of health-care system users per 1,000 persons over a two-week period. A recent major study conducted by the Ministry of Health, reproduced in Exhibit 11, found a two-week morbidity rate of 145 per 1,000 persons. Looking at how morbidity changes with age gives us some sense of how health spending may change as China ages. As expected, the morbidity rate among those aged 65 or older was the highest at 303, equivalent to twice the average. More relevant to our discussion of the likely increase in Chinese health spending over the next 10 years, the transition from the 55-64 bucket to the 65-plus bucket meant a 40% increase in morbidity. Healthcare Observer October 2013 12 Exhibit 11: Seniors Use Healthcare System 40% More than 55–64 Year-Olds Morbidity per 1,000 persons (2 week period) Morbidity rate 350 300 Source: China Ministry of Health, Morningstar analysis 250 200 150 100 50 Total Age Group 0–4 5–14 15–24 25–34 35–44 45–54 55–64 0 65+ Overlaying these morbidity statistics against China’s age composition in 2022 ought to give us a general sense of how health-care usage will change solely due to demographic effects. Exhibit 12 below presents the results of this exercise. We estimate that Chinese health-care usage would rise 14.0%, with a little more than two thirds of that increase attributable to aging of the population and a little less than one third due to population growth. Interestingly, while the increase in the 65 and older group has the single largest effect on health usage (rising 34% to generate a 7.4 pp lift to the total), growing 45–54 and 55–64 groups are major contributors too, delivering 3.5 pp and 6.0 pp lifts, respectively. Exhibit 12: Population-Driven Healthcare Demand Growth: Contribution by Age Group Contribution by age group Percentage Points 8 Source: Morningstar analysis, China Ministry of Health data 6 4 2 0 –2 0–4 5–14 15–24 25–34 35–44 45–54 55–64 65+ –4 Healthcare Observer October 2013 13 Continued Urbanization Will Drive Health-Care Spending, but Not Beyond What Might Be Expected for Income Level Next, we look at another demographic mega-trend in China: the continued urbanization of the population. With little more than half of its population technically classified as “urban,” China is roughly as urbanized as we might expect given the typical relationship between urbanization and income level. Exhibit 13: Richer countries tend to be more urban China Other Countries Urban population (% total) 100 90 Source: United Nations Population Division, World Bank, Morningstar analysis 80 70 60 50 40 30 20 10 0 10,000 GDP per capita, PPP (current international $) 20,000 30,000 40,000 0 50,000 Setting aside the worthwhile debate on whether the official figure accurately reflects China’s “true” level of urbanization as well as the question of causation, it seems reasonable to expect China will continue to urbanize as its income levels rise.9 Not only is further urbanization strongly implied by the global data set (richer countries tend to be more urban), but it’s also a stated policy of Beijing. The government aims to add roughly 250 million people to the urban rolls by 2025, which would make China roughly 68% urban by that time. This would be accomplished by a mix of migration, new births, and reclassification. The U.N. Population Division’s medium fertility variant, reproduced below, expects a 65% urban share by 2025. Exhibit 14: China’s Urban Population Should Continue to Grow Urban Rural Urban share (%) Source: United Nations Population Division, World Bank, Morningstar analysis Million persons % total population 1,600 70 1,400 60 1,200 50 1,000 40 800 30 600 20 400 10 200 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 0 Healthcare Observer October 2013 14 As tends to be the case in most countries, on average, China’s urban residents spend more on health care than their rural counterparts. Data from China’s National Bureau of Statistics puts the urban-rural health spending ratio at more than two-to-one: $231 versus $105 per capita (in PPP terms).10 But this does not mean urbanization should be considered a distinct health spending tailwind, above and beyond income and aging. Although China’s urbanization is clearly a positive for health spending, we suspect the boost to spending would come mainly from the fact that urban residents are richer than rural residents. That’s because, after we adjust for income, there seems to be little difference in health spending between China’s city- and country-dwellers. If, instead of comparing the “average” rural resident (income of $1,667/capita) to the “average” urban resident ($5,210/capita), we were to compare him with an urban resident of comparable income, the difference in health spending almost vanishes. The typical urban resident making as roughly the same money as the average rural resident (represented by the bottom urban income decile with income of $1,643/capita) spends $116 annually on health care. Exhibit 15: Adjusted for income, urban health spending is equivalent to rural health spending Left axis Disposable Income USD,PPP USD,PPP 500 15,000 Right axis Cash expenditures on health care 400 10,000 300 Source: National Bureau of Statistics, Morningstar analysis 200 5,000 100 0 Urban resident (average) Rural resident (average) Urban resident (bottom income decile) Urban resident (top income decile) 0 This suggests urbanization is unlikely to provide any special lift to health spending above and beyond that associated with rising incomes. Bringing it back to our basic framework, China’s continued urbanization implies movement along the trend line defined by the income-health spending relationship, as opposed to movement above the trend line. As such, we make no additional adjustment to our estimate to account for urbanization. Public Outlays Likely to Drive Majority of China’s Health Spending Growth Our forecast of a threefold increase in Chinese health spending by 2022 that would far outstrip overall economic growth begs the question: who will pay for it? If China follows the path set by wealthier countries, it’s highly likely public sources will largely foot the bill. As shown in Exhibit 16, private health Healthcare Observer October 2013 15 spending tends to be around 2%–4% of GDP regardless of income level.11 This implies private spending on health care grows more-or-line with household incomes.12 By contrast, public health spending tends to grow at a faster pace than incomes. It is public health spending that typically drives the “GDP-plus” growth of overall health spending. Exhibit 16: Private health spending tends to consume consistent share of GDP China Other Countries Health spending, private (% GDP) 20 18 Source: World Health Organization, United Nations Population Division, World Bank, Morningstar analysis 16 14 12 10 8 6 4 2 0 10,000 GDP per capita, PPP (current international $) 20,000 30,000 40,000 50,000 0 Exhibit 17: Growing public health spending drives overall increase in health spending China Other Countries Health spending, public (% GDP) 20 18 Source: World Health Organization, United Nations Population Division, World Bank, Morningstar analysis 16 14 12 10 8 6 4 2 0 10,000 GDP per capita, PPP (current international $) 20,000 30,000 40,000 50,000 For countries of China’s income level, public health spending accounts for about half of total health spending.13 China is roughly in line with the average: public health spending is 56% of total health spending. We might reasonably expect this share to grow to around 65% by 2022, assuming a doubling of Chinese GDP per capita over this interval. 0 Healthcare Observer October 2013 16 Exhibit 18: Public share of health spending rises with incomes China Other Countries Health spending, public (% total) 100 90 Source: World Health Organization, United Nations Population Division, World Bank, Morningstar analysis 80 70 60 50 40 30 20 10 0 10,000 20,000 GDP per capita, PPP (current international $) 30,000 40,000 50,000 60,000 0 A review of Chinese health spending reveals no reason to believe China will meaningfully deviate from the global trend. As shown in Exhibit 19, since 1995, public health spending has steadily risen as a share of GDP amid increasing GDP/capita: from 1.8% in 1995 to 2.9% in 2011. Meanwhile, private spending on health care isn’t materially higher as a share of GDP than it was in 1995. Government policy suggests this trend is likely to persist. In particular, the 12th Five-Year Plan makes strengthening the public health-care system a policy priority and lays out the objective of limiting out-of-pocket private spending. Exhibit 19: Rising Public Outlays Have Led Overall Increase in China's Health Spending Private Public Total Health expenditure (% GDP) 6 5 Source: World Health Organization, World Bank, Morningstar 4 3 2 2011 1995 0 1,000 2,000 3,000 GDP per capita, PPP (current international $) 1 4,000 5,000 6,000 7,000 8,000 9,000 0 Healthcare Observer October 2013 17 Private health spending’s falling share of GDP over the past decade—from 3.1% in 2002 to 2.3% in 2011—is noteworthy as it mirrored a broader trend in Chinese household consumption over the period. As the boom in infrastructure and real estate came to dominate economic activity, household consumption declined from 44% of GDP in 2002 to 34% in 2011. The declining household consumption share reflected both a decline in the household income share of GDP and an increase in household savings rates. If, as we expect, Chinese households are likely to enjoy a rising share of GDP amid a rebalancing from the investment-led growth that defined the past decade, the recent trend of falling private health spending share of GDP seems likely to reverse. A transition from labor surpluses to labor deficits ought to put upward pressure on wages, which, for the past decade, mostly lagged advances in worker productivity. Meanwhile, the expansion of China’s modestly sized service sector also augurs a higher household income share of GDP, as the “labor content” of services is higher than that of industry. Exhibit 20: Falling Private Health Spending Share of GDP Reflected Broader Decline of Consumption Share of GDP Household consumption Gross capital formation % of GDP 60 Source: World Bank, Morningstar 50 1995 40 2011 30 0 1,000 2,000 3,000 GDP per capita, PPP (current international $) 4,000 5,000 6,000 7,000 8,000 9,000 20 Rising Incomes and Aging Population Will Make China a Top Growth Market for Health Care Rising incomes and a rapidly aging population ought to generate rapid growth in China’s health spending in the next decade. Not only do we expect health care will claim a larger share of China’s economic pie, but Chinese health-care spending is likely to dramatically rise in relative importance for the global health-care sector. The opportunity is partly obscured by China’s comparably modest health-care market. While China is the world’s second-largest health spender in purchasing power parity terms, it ranks far behind the U.S. and doesn’t spend much more on health care than much smaller economies. Looking ahead, while we do not expect China’s health spending to surpass that of the United States in the next 10 years, we believe China will rank an increasingly dominant No. 2. Healthcare Observer October 2013 18 Just as important for investors, we also anticipate China will be, along with the United States, the biggest growth market over this period—in terms of its incremental demand for health-care products and services. Assuming prevailing consensus GDP forecasts, we anticipate China’s health-care market would grow by about $1.1 trillion through 2022. This incremental demand would be roughly equivalent to the total current spending of the next four largest health-care markets combined: Japan, Germany, France, and the U.K. China’s Health-Care Demand Growth Trajectory Puts That of Fellow BRICs in the Shade In our view, the potential far exceeds that of China’s fellow BRICs, a differential tied to China’s unmatched mix of demographic heft, aging population, and income level. While India’s population is just as large (and would surpass China by 2028 in the U.N.’s medium fertility population forecast), it’s far younger and far poorer. Russia and Brazil are both wealthier on a per capita basis, but their combined populations are only 25% of China’s. And while both are older than China, they’re not aging as rapidly, with more modest increases to the old-age dependency ratio. Using the same income-aging model to extrapolate health spending for India, Russia, and Brazil and making what we believe to be fairly non-contentious GDP growth assumptions14, we estimate the collective incremental spending growth of these three countries to be 50% that of China’s incremental growth. As far as the health-care opportunity is concerned, only one BRIC truly merits its capital letter. K Endnotes: 1 PPP measures somewhat flatter the size of China’s economy. Using market exchange rates, China’s economy is 10% of the world total versus the United States at 21%. 2 Exceptions to the usual relationship are instructive. The United States spends 18% of GDP on health care, considerably more than what we might expect given the usual relationship between health spending and income. African countries with high incidence of HIV also spend substantially more on health than might otherwise be expected given their income level. 3 Some might be attributable to the higher prevalence of non-communicable diseases in wealthier countries: diabetes and heart disease, for instance. 4 Countries with incomes between $15,000 and $20,000 spend a weighted average of 6.1% of GDP on health care. 5 See “China’s Rebalancing Act,” Morningstar Basic Materials Observer, August 2013. 6 On its way past 300 million in the late 2030s according to the U.N.’s Population Division. The U.N. Population Division produces multiple sets of population forecasts that make different assumptions pertaining to fertility, mortality, and immigration. For the purposes of our analysis, we’ve used the “medium fertility” variant. But through 2025, there is no difference in old age dependency ratio among the scenarios as all individuals of working age population by 2025 have already been born. 7 We’re excluding children from the discussion mainly because 1) they don’t work and 2) other than the very young, they don’t consume as much health care. 8 And like Japan of 1990, China of 2022 will be sitting on the verge of major additional societal aging. But China will be quite a bit poorer than Japan of 1990. 9 Because there’s no standard definition of what constitutes “urban,” cross-country analysis needs to be conducted with an abundance of caution. We’ve previously argued that China’s official figure seriously understates the percentage of the population living in urban areas owing to an unusually strict population density hurdle to achieve urban classification. Additionally, many suggest large swaths of China’s hard-to-measure urban migrant population continue to be misclassified as “rural” despite living more than half the year in urban areas. The underestimated figure has been pegged as high as 100 million, which would add 7 percentage points to China’s official figure. 10 These figures refer to private outlays on health care and would not include government-paid health care, for example. 11 Private health expenditure includes direct household (out-of-pocket) spending, private insurance, charitable donations, and direct service payments by private corporations. 12 Once again, the United States is a notable exception, with private health spending consuming nearly 10% of GDP. 13 Public health expenditure consists of recurrent and capital spending from government (central and local) budgets, external borrowings and grants (including donations from international agencies and nongovernmental organizations), and social (or compulsory) health insurance funds. 14 We assume 6.5% for India, 3.5% for Russia, and 4% for Brazil. The IMF’s World Economic Outlook assumes average growth rates of 6.5%, 3.6%, and 4%, respectively, through 2018. Healthcare Observer October 2013 19 Exhibit 21: Population, Economy, and Health Spending Statistics Year China Brazil Russia India United States 2012 1,351 199 144 1,237 314 2022 1,383 214 139 1,379 340 2012 699 169 106 392 259 2022 868 186 106 494 288 2012 651 30 37 845 55 2022 516 27 34 886 52 2012 243 49 22 364 62 2022 247 44 24 359 65 2012 991 135 103 808 209 2022 964 148 93 928 216 2012 117 15 19 64 43 Population (millions) Total Urban population Rural population Ages 0–14 Ages 15–64 Ages 65+ Total dependency ratio Old age dependency ratio Child dependency ratio Fertility rate 2022 172 22 22 92 59 2012 36.4 46.8 39.7 53.0 49.8 2022 43.5 44.3 48.9 48.6 57.4 2012 11.8 10.7 18.1 7.9 20.4 2022 17.8 14.8 23.2 9.9 27.3 2012 24.5 36.1 21.6 45.0 29.4 2022 25.6 29.4 25.8 38.7 30.0 2011 1.58 1.81 1.54 2.59 1.89 2022 1.53 1.66 1.67 2.26 2.08 2012 12,471 2,366 3,373 4,793 15,685 2022 24,532 3,502 4,758 8,998 20,473 Economy GDP ($PPP, billions) GDP/capita ($PPP) CAGR 7.0% 4.0% 3.5% 6.5% 2.7% 2012 9,233 11,909 23,501 3,876 49,965 2022 17,732 16,390 34,185 6,523 60,238 2011 583 204 199 175 2,677 2022 1,732 333 357 450 4,121 2011 432 1,026 1,384 142 8,527 2022 1,252 1,557 2,564 326 12,124 2011 5.2% 8.9% 6.2% 3.9% 17.9% 2022 7.1% 9.5% 7.5% 5.0% 20.1% Healthcare Health spending ($PPP billions) Health spending per capita ($PPP) Health spending as % GDP Source: World Bank, Morningstar estimates Healthcare Observer October 2013 20 Medical Technology Market in China: Awakening Giant and Emerging Dragon by Debbie S. Wang Against the backdrop of growing health-care spending in China, we take a closer look at the $21 billion Chinese medical technology market—already the second-largest after the United States. As many moaty multinational med-tech companies venture into the Chinese market, we think investors should appreciate both the immense potential of the market, as well as the challenges and risks that med-tech moats face. Large, Fragmented Field There are an estimated 11,000–12,000 domestic medical technology companies in China, fueling 15%–20% annual growth in this med-tech market. Up until recently, local med-tech companies have concentrated on manufacturing low-tech and disposable devices, but we now see them making inroads with more technologically advanced and higher-risk implantable devices. We expect Chinese companies to continue moving up the value chain thanks to government emphasis on the development of the native med-tech industry. The central government has specifically called out med-tech as a key area for increased expertise and growth. Consistent with this mandate, China has made substantial progress in the last decade toward reaching global manufacturing standards for medical devices. More and more facilities are ISO 13485-certified, which means they have demonstrated the ability to produce medical devices that consistently meet customer and regulatory requirements. By no means have all the quality issues been resolved, but China is on the path toward global standards. We think this will be helped along as more Chinese device makers set their sights on exporting these higher-value products outside of China, and Western-trained ethnic Chinese return to China to set up shop. We anticipate there will be robust growth in cardiology, orthopedics, and neurology. Historically infectious disease and infant mortality were the largest public health concerns. Thanks to the aging population, high smoking rates, lifestyles that are more sedentary, and pollution, we have seen a shift in the disease burden in China. Cardiovascular disease and cancer have grown more prominent. Exhibit 22: Disease Burden in China Cause of Death % Cerebrovascular disease 18 Chronic obstructive pulmonary disease 14 Ischemic heart disease 8 Stomach cancer 5 Liver cancer 4 Lung cancer 4 Perinatal conditions 3 Tuberculosis 3 Lower repiratory infections 3 Source: Ministry of Health, Centers for Disease Control 2010 Healthcare Observer October 2013 21 Moreover, there is pent-up demand for these treatment options and devices because the technology was not accessible until relatively recently. First, there were few physicians and hospitals with the training and expertise to do large joint replacements or implant coronary stents. Second, there were few patients who could afford these interventions on an out-of-pocket basis. China has now reached a point where we see a window that is extremely favorable for the spread of med-tech. On the demand side, we think patients are increasingly interested in spending on health now that insurance has spread to cover more people, rising incomes can better absorb out-of-pocket expenses, and there are heightened consumer expectations for quality. On the supply side, more doctors have been trained to perform these procedures and more hospitals now offer them. Exhibit 23: Spread of Angioplasty in China Number of Hospitals offering PCI Number of Angioplasty procedures 1996 2001 2007 2010 51 200 1078 870 6,200 16,345 147,300 290,000 Source: Chinese Society of Cardiology Angioplasty and the use of coronary stents remained extremely small for the first decade after the procedure was made available in China (1986–96). However, it has grown tremendously in the last decade, especially after the introduction of drug-eluting stents in 2003. We think there is still plenty of runway left for drug-eluting stents in China--an estimated 230 million Chinese suffer from cardiovascular disease. Regulation Remains More Uncertain in China While the Chinese regulatory process for medical devices is similar to that in the U.S., the regulatory landscape still changes with some frequency as the Chinese Food and Drug Administration (or CFDA, formerly known as the State Food and Drug Administration, or SFDA) makes modifications along the way to address new dynamics in the growing medical technology industry. Fortunately, there is some consistency in how the CFDA and the U.S. Food and Drug Administration classify medical devices. Both agencies put them into Class I, II, and III buckets, depending on how invasive and risky the device is. Lower-tech, disposable devices (for example, thermometers, eyeglass frames, and tongue depressors) that are not intended to support or sustain life are subject to the lightest regulation. Chinese medical device companies have mainly focused on manufacturing these types of products in the past. Class II devices, which include infusion pumps, ceramic dental restorations, and trocars, are subject to mandatory performance requirements, but typically do not need to submit clinical trial data before approval. Class III devices encompass implantable pacemakers, heart valve replacements, and coronary stents and are the most tightly regulated. Unfortunately, China’s regulatory process is not completely centralized, and manufacturers may need to apply to other governmental bodies for clearance. Lower-risk lower-tech products may need to seek Healthcare Observer October 2013 22 provincial or municipal approval, resulting in the need for additional resources to gain approval through a patchwork of geographies. So far, Class III devices have not run into any particular pitfalls with the CFDA. We think this is because most of these higher-risk, sophisticated products are produced by multinationals that have already met developed-world regulatory standards. However, the main complaint by multinationals is that the CFDA approval process is very slow. The current state of events was driven by the exposure of flagrant corruption at the SFDA in 2007. That is when it was discovered that Zheng Xiaoyu, former head of the SFDA, had taken $850,000 in bribes from eight large companies to approve drugs, including six that were fake. In the wake of this scandal (and Zheng’s execution), the level of regulation and scrutiny of applications has risen significantly, slowing down the process. Even though the CFDA regulations state that the approval time frame for clinical studies is 60–90 days, it usually takes about 12 months to secure approval before moving into trials. Another difference between the CFDA and the FDA is the former’s emphasis on clinical trial stage. The biggest hurdle at the CFDA is getting approval for the clinical trial. It is at this stage that the CFDA does a very slow and detailed examination of the application. Once trial approval is secured, regulation becomes much lighter, and product marketing approval and production can happen faster and with less scrutiny. This stands in direct contrast with the FDA, where it is relatively easy to gain approval on the trial design, but much tougher to withstand the closer examination of the product’s safety and efficacy to determine marketing approval. We do not see any shifts on the horizon that would cut down this waiting time for multinational companies. If anything, we think new proposals at the CFDA could leave multinationals at a disadvantage when it comes to the time frame for trial approval. The CFDA is drafting guidelines to create an accelerated review process for domestic device companies. This change is in keeping with the central government’s goal of developing national competency in medical technology, according to the current Five-Year Plan. Multinational device companies and their investors should be prepared for more political changes of this ilk that will further tilt the playing field in favor of local Chinese device firms. Nevertheless, the sheer size of this market, along with its robust growth potential, has led most of the multinational med-tech firms to set up shop in China, though the level of investment has varied. Some firms, including Medtronic, Abbott, and General Electric, see China as a strategic priority and invested heavily to put down roots there. On the other hand, Edwards EW and CR Bard BCR have invested far less extensively in China and do not seem to view penetration of this market as a corporate priority. Overall, we think greater presence and investment in China translates into greater familiarity with regulatory agencies, distributors, and customers that can pay off in many ways. For example, if a foreign firm has already made it through the lengthy regulatory gauntlet at the CFDA to commercialize a product in China, it becomes far easier to go through that process again with additional products (even unrelated ones) because the firm has established a track record with the government. Healthcare Observer October 2013 23 Exhibit 24: Multinational Med-Tech Companies in China Medical Equipment/ Device Firms in China Key Products in China Sophistication of Timing of Technology China Entry Local Partners Investments in China Abbott Coronary and endovascular High Very early None in medical devices Device training center in Shanghai; Manufacturing facility for vision care products (for export) >$650mm Becton Dickinson Safety sharps, diabetes care Low-Mid Very early None Manufacturing and R&D facility in Suzhou since 1995, 3000 employees <$800mm Boston Scientific Drug-eluting stents, endscopy, cardiac rhythm management High Late None R&D center in Shanghai >$200mm CR Bard Vascular, urology, oncology Mid-High Late None None Coloplast Ostomy, wound care Mid-High Early None Major manufacturing facility in Zhuhai (for export); Training center in Shanghai Covidien Endomechanical, Mid-High energy, vascular, airway & vent, pulse oximetry Mid None* (looking aggressively into local distributors) R&D and Technology center in Shanghai Edwards Lifesciences Surgical heart valves Mid None None Johnson & Johnson Orthopedics, neurovas- Mid-High cular surgery, vision care, diabetes care, infection prevention, diagnostics, cardiovascular disease, sports medicine, and aesthetics Early Acquired Guangzhou Bioseal Biotech R&D center in Suzhou Medtronic Spine, trauma, Mid-High cardiac rhythm management, vascular Early Acquired China Kanghui; prior minority investments in Shandong Weigao, and previous distribution JV with Shandong Weigao R&D center in Shanghai; Patient Care Center in Beijing; Pacemaker manufacturing facilities in Shanghai $664mm Mindray Patient monitoring and Mid-tier life support, in-vitro diagnostics, ultrasound systems (black/white and color), digital radiography, orthopedics, endoscope devices Early Acquired Dragonbio, Shenke, Hyssen Global HQ in Shenzhen, R&D centers in Beijing, Chengdu, Nanjing, Shangahi, Xi'an $473mm St. Jude Medical Surgical heart valves, High cardiac rhythm management Late None Training center in Beijing Smith & Nephew Coronary and endovascular High Early None Wound management manufacturing facility in Suzhou (for export) $150mm Stryker Trauma, spine, reconstructive Mid-tier Late Acquired Trauson Manufacturing facility in Suzhou $279mm Zimmer Reconstructive, surgical Mid-tier instruments Late Acquired Beijing Montagne R&D and manufacturing center in Beijing $120mm Source: Company filings. Morningstar estimates *Medical device/equipment revenue only High 2012 Estimated China Revenue* >$90mm $72mm $300mm $70mm >$450mm > $115mm Healthcare Observer October 2013 24 For those multinationals that would like to create a footprint on the ground, setting up a training center is a natural first step. This allows the firm to begin building relationships with the practitioners, which is part of what creates a med-tech moat. It also helps the firm influence the supply side of the health-care equation by increasing the number of physicians and nurses who are trained to use their products. Some multinationals go a step further by locating R&D centers in China, thereby taking advantage of the robust pool of talented scientists in the country. This also means these firms can tap into local market knowledge to help tailor and innovate the products to address local needs. A few very determined multinationals have actually built manufacturing facilities in China, despite the risk of intellectual property leaking out. Thus far, most of these facilities manufacture lower-tech products, such as Coloplast COLO.B and Smith & Nephew’s SNN wound management items. Medtronic was one of the earliest when it opened a pacemaker manufacturing line in Shanghai back in 1996. As multinationals contemplate the real risk of protecting intellectual property and trade secrets against the prospect of lower manufacturing costs and more opportunities to penetrate the Chinese market, we expect more firms will migrate more resources to China over time. If China can demonstrate that it is strengthening its protection of IP, this shift could happen more quickly. We note that some med-tech firms have taken a slightly different approach to putting down roots in China through joint ventures or outright acquisition. In the past, Medtronic had formed a joint venture with Shandong Weigao Medical Group, which makes trauma and spinal products. Singapore-based Biosensors did the same with Shandong Weigao to make drug-eluting stents. For various reasons, both Medtronic and Biosensors have ended those JV arrangements. Acquisition of Chinese orthopedic firms seems to be in vogue now, with Medtronic, Stryker, and Zimmer all making purchases in the last three years. We think this model holds more potential (we discuss this in detail starting on Page 40 ). The Reimbursement Picture is Mixed Accessibility to health care in China has improved greatly over the last few years. Thanks to historic and comprehensive health care reform that was rolled out in 2009, nearly 95% of Chinese citizens now have basic medical coverage under some sort of health insurance scheme (and many receive subsidies to pay for coverage). One major goal of the reform was to lessen the disparity between urban and rural residents’ access to care. The introduction of these new schemes has helped address that gap. Exhibit 25: Population Covered by Insurance 2003 2011 Urban residents 55% 89% Rural residents 21% 98% Source: Ministry of Health Healthcare Observer October 2013 25 This new coverage whetted patient appetites for more and better health care services. It has allowed them to receive care for ailments that they might have simply ignored in the past. Nonetheless, we note that the coverage is many miles wide, but only an inch deep, at this point. For example, the New Rural Cooperative Medical Scheme that covers the rural population provides reimbursement only for 20 selected diseases at this point, including lung and stomach cancer, heart attack, and cleft palate. The government’s goal is to gradually evolve to more comprehensive coverage, and has launched a number of disease “pilots” to investigate the cost and benefits of reimbursement for breast cancer, end-stage renal failure, and HIV/AIDS. Capitation on reimbursement remains fairly low at CNY 200, which translates into $48 in purchasing power parity. We note that coverage provided to urban employees and government workers through long-standing insurance programs tends to offer more expansive and generous benefits. We think China has definitely made considerable progress toward spreading a wide insurance net and reducing the gap between urban and rural residents. But, it will likely be a number of years before the depth of coverage for rural residents is comparable with what urban employees enjoy, and benefits are beefed up to provide a real safety net. Another change in reimbursement that we view positively for med-tech companies is the government’s intention to keep the proportion of out-of-pocket spending at roughly 30% of total health-care outlays over the longer run. This is a marked change from 10 years ago when out-of-pocket spending accounted for more than 50% of total health-care spending. Meeting this objective will necessitate increasing government-funded health care spending through the midterm. Even as health-care inflation may cause total spending to rise faster than GDP, targeting out-of-pocket outlays at 30% should help the accessibility and affordability issue for Chinese patients. Private insurance remains an option for more affluent consumers to plug the gaps that go beyond basic medical insurance. While we think growth in demand is a favorable harbinger for med-tech, we are less optimistic about government reimbursement policies, which can change at the drop of a hat. In particular, we anticipate the government’s concern about holding down total health-care spending will result in reimbursement and procurement policies that are disadvantageous to multinational firms. We have already seen some of these policies take shape. For example, hospitals are now limited to two suppliers for any type of device—one domestic, and the other can be foreign. Multinational device makers are now subject to tendering processes for virtually all types of products. Even winning the tender may not necessarily be positive. If actual volume used falls below the units outlined in the original bid, the supplier has very little recourse and must provide fewer units than expected at the cited price, which can hurt profitability. In some cases, the government has instituted price ceilings on certain procedures that make it more economically attractive for hospitals to use products from local suppliers. This means multinationals must often rely on affluent patients to cover the excess device cost through out-of-pocket payment. In 2005, the government also implemented a purchasing review process for large-ticket equipment, including robotic surgical systems and gamma knives. This process is similar to what the U.K.’s National Institute for Health and Care Excellence, or NICE, does when it reviews new technologies for its costs and benefits. This amounts to another hurdle that multinationals face as they attempt to penetrate China with innovative med-tech. As long as multinational firms offer devices at a substantial premium to local Healthcare Observer October 2013 26 competitors, we think the government will pull any available levers to apply pricing pressure and slow the growth of health-care spending. Health-Care Provider System: On Balance, Favorable for Med-Tech The provider system in China remains motivated to use more med-tech, which bodes well for the multinationals. On the whole, we think the tangled factors that have created this incentive system will be quite difficult to unwind and may require a wholesale reinvention of the financing of health care, which is unlikely in the midterm. As China made its move to a market economy over the last 30 years, the former state-supported provider system, which focused on primary care and geographical reach, withered. As a result most of China’s provider resources are concentrated in hospitals and in the urban areas, though health-care reform efforts have managed to redirect some resources to less urban areas most recently. The critical turning point came when public hospitals were expected to be economically self-sufficient. This, coupled with a fee-for-service framework, greased the skids for the current incentive system where most procedures and services are reimbursed at low levels. To compensate, hospitals and doctors rely on selling high-margin drugs and medical devices. This activity enhances both hospital profitability, as well as doctors’ incomes. This has led to documented overprescription of antibiotics, injections, and corticosteroids in China. The government has countered with its Essential Drug List, which puts price controls on key commonly used or high-health benefit drugs to keep them affordable to the general public. There is the distinct possibility that the government might institute similar measures for medical devices in the future. In the meantime, physicians continue to press the use of certain drugs and devices for economic gain. These financial incentives are also conducive to crossing the line into corruption, including kickbacks and bribes by multinational firms. Please see page 27 for our perspective on recent Chinese crackdowns on corruption by multinational pharma companies and the implications for med-tech. China’s current provider system remains heavily based in state-funded public hospitals, though we expect some care to migrate into lower-acuity settings—more health clinics, more primary care on an outpatient basis, more care outside large urban areas. The best-funded and best-staffed institutions remain the Class III hospitals, which are located in the largest urban areas. These hospitals attracted the better-trained physicians, allow them to practice more sophisticated medicine, have the leading-edge technology available, and are more prestigious partly because they tend to be more research-oriented. Not surprisingly, patients have a strong preference for the Class III hospitals based on perceptions of high-quality care. Class II hospitals are located in less-urban markets, tend to be smaller, have fewer resources, and less access to technology and highly trained staff. Class I hospitals in the rural areas lag even farther behind. Healthcare Observer October 2013 27 Exhibit 26: Growth in Hospitals 2005 2006 2007 2008 2009 2010 2011 June 2013 1,692 Class III 946 1,045 1,182 1,192 1,233 1,284 1,399 Class II 5,156 5,151 6,608 6,780 6,523 6,472 6,468 6,626 Class I 2,714 2,738 4,685 4,989 5,110 5,271 5,636 6,173 Source: Ministry of Health Through reform efforts, the state has attempted to shift both supply and demand to Class II and I hospitals. Despite some success in moving supply to these hospitals, patients continue to prefer the Class III hospitals, especially now that most Chinese have some health insurance coverage. Changing patient perceptions and behavior will take time. The government has indicated it would like to see private hospitals increase in order to help the provider system meet growing demand. However, we are somewhat skeptical that this can happen in the absence of changes to reimbursement policies. Currently, close to 90% of patient volume is handled through public hospitals. Private hospitals exist in a smaller niche where one segment specializes in traditional Chinese medicine, another segment mainly cater to the Western ex-patriate community, or provide specialty care. One key obstacle that keeps the private hospitals from expanding is current reimbursement policy that prevents state reimbursement to private hospitals for any procedures or services. This would be the equivalent of withholding all Medicare reimbursement from private hospitals in the U.S. Thus, most Chinese private hospitals rely on patients with private insurance or sufficient wealth to cover charges out-of-pocket. Even as the government lifts restrictions that limit foreign ownership and streamlines the approval process for foreign-funded hospitals, we think the current reimbursement issue will slow down the development of this segment. Nonetheless, the existing number of public hospitals and the volume of patients they care for still offer very attractive growth prospects for med-tech firms as physicians and patients seek to access technologies that have, until recently, been unavailable to most Chinese people. by Damien Conover & John Zecy Risk of Corruption in China: Lessons From Pharmaceuticals While investors should remain cognizant of the potential for corruption allegations in China’s medical device market, we do not believe these issues will have a structural impact on the market’s long-term opportunities. Fair warning to investors Before taking a position in China’s medical device market, we think investors should take notice of corruption allegations in China’s pharmaceutical market that are gradually shedding light on similar practices in medical devices, namely bribery. The nation’s large network of state-run hospitals must survive on skimpy reimbursement for medical services, and salaried doctors are not compensated well compared with their Western peers. Salaries are set to the pay scale of government work, and even doctors with 10 years of experience earn around CNY 10,000 a month (about $20,000 a year) in Beijing15. To compensate for the bare-bones reimbursement on services, hospitals, and doctors rely on selling drugs Healthcare Observer October 2013 28 and medical devices, which are typically acquired at wholesale prices and then marked up substantially to patients. Although these practices are legal and aboveboard, they also have cultivated an environment that is conducive to kickbacks and outright bribery. Bribery has consequently become a means of survival for state-backed physicians and hospitals that must contend with the government’s suppression of medical costs for its citizens. Furthermore, competition among pharmaceutical and device firms makes the ground for corruption even more fertile as companies try to penetrate the market through acts of paid education that borderline on bribery, including direct payments and travel vouchers. In some cases, firms tap their regional sales networks to pay kickbacks to doctors for using and prescribing their products. This also typically involves some sort of price fixing, giving the firm an upper hand and inflating prices for consumers. China’s current regulatory framework is also partly to blame. The purchasing process for pharmaceuticals and devices can prove cumbersome given the restrictive list of medicines covered by the national insurance system and provincial red tape for market introduction. While the process for essential medicine in primary care facilities is centralized, the tendering process for medicine outside this scope is fragmented and can leave room for illicit markups despite government regulated prices. Oversight of these transactions is not as formalized and creates hurdles for the tendering process, particularly in medical devices with regulation occurring at different bureaucratic levels and standards.16 Regulatory issues in China’s health-care industry first surfaced in 2008 in the nutritional market. Six infants fell victim to tainted domestic baby formula and spurred consumer preference for foreign brands that were viewed as safer. As foreign formula began to consequently dominate the market, the National Development and Reform Commission, or NDRC, accused foreign manufacturers of gouging prices and issued fines to six firms (Mead Johnson, Danone, Biostime, Abbott, FrieslandCampina, and Fonterra) totaling $108 million for anti-competitive pricing tactics. When coupled with detected corruption in China’s pharmaceutical industry, increased price scrutiny in the nation’s health-care system has become increasingly warranted, and the government’s crosshairs seem to be set on foreign firms. Patterns emerging in Chinese regulatory oversight as markets grow. As the need for health care in China expands and specific industries grow in size, government oversight seems to follow as issues of pricing and illicit trade practices come to light. China’s burgeoning market for pharmaceuticals (valued at more than $60 billion) serves as the greatest example where at least five cases have been brought against industry titans including Eli Lilly LLY, GlaxoSmithKline GSK, Novartis NVS, Pfizer PFE, and Sanofi SNY, all within a two-month timeframe (July–August 2013). As noted in Figure 1, most cases involved forms of bribery or kickbacks where sales representatives where directed to make payments to hospitals or doctors to influence drug prescriptions, often resulting in higher prices. Chinese authorities seem to be on a warpath to crack down on such practices, and medical device firms are starting to feel the heat. Healthcare Observer October 2013 29 Exhibit 27: Big Pharma Brushes with Corruption Investigations Company 2012 Chinese Manufacturing Sales ($million) Facilities R&D Facilities Corruption Allegations Date Eli Lilly Does not disclose 2 2 Allegedly used about $5 million to bribe doctors in China, offering kickbacks to ensure doctors used its drugs, including its insulin brand. August 2013 GlaxoSmithKline 1,150 6 1 Accused of bribing doctors, hospitals and government officials in an effort to sell more drugs at higher prices. July 2013 Novartis AG Does not disclose 3 1 An employee offered money to doctors to boost sales of its drugs, a practice that led to higher pharmaceutical prices for consumers. August 2013 Pfizer Does not disclose 4 2 Bribed doctors employed by Chinese government healthcare institutions to influence the prescription of Pfizer products between 2003 and 2007. August 2012 Sanofi SA 1,280 6 1 Paid bribes of about $276,000 to a number of doctors and hospitals in Beijing, Shanghai, Guangzhou and Hangzhou in late 2007. August 2013 Source: Wall Street Journal, Company Filings According to media reports, the Commerce Ministry’s anti-monopoly bureau is probing China’s medical device market (valued at $20 billion) with unusually extensive surveys, the questions of which, industry executives report, target all aspects of the device trade such as the value of imported goods, pricing strategies, sales techniques, volume, and workforce size. Two prior cases serve as examples to follow when detecting illicit trading, one involving a bribery charge against AGA Medical (now owned by St. Jude Medical STJ) in 2008 and the other pertaining to the 2012 prosecution of Biomet for delivering cash to surgeons upon completion of surgery and sponsoring questionable travel. While China’s medical device market has historically attracted less scrutiny because of less direct competition between foreign and domestic firms, we expect further incidences could arise as the industry garners more attention. Short-term fines and pushback from Chinese authorities don’t diminish our outlook for health care in China. Despite the potential for these incidents, we think investors would do well to develop a thick skin for short-term noise that we do not believe will structurally affect the long-term opportunities available in China’s medical device market. Using the pharmaceutical companies in Figure 1 as a model, it is apparent that devoted health-care firms are continually allocating capital toward manufacturing plants and R&D facilities to leverage industry tailwinds. As select companies are tried for illicit trading practices, we think the medical device firms with heavy investments in China will remain committed to servicing the nation’s evolving health-care system. The resulting fines are also a concern, but we anticipate that firms will be able to bear the brunt with litigation reserves and that the penalties will be more of a slap on the wrist compared with the size of market opportunities. The $108 million charged to six formula manufacturers in August mark historically significant fines by Chinese authorities. However, the penalties represent only about 3% of the firm’ 2012 sales with the exception of Mead Johnson and Biostime, which were charged 4% for a lack of investigative cooperation and 6% due to the magnitude of the violation, respectively. Four of the firms lowered their prices upward of 20% during the summer investigation, but some expect market Healthcare Observer October 2013 30 share to increase as a result. In the case of AGA Medical and Biomet, both firms’ penalties summed to about 1% of total sales, a cut that we believe does little to discourage them or other incumbents. What comes as more of a shock is the potential $3 billion fine that GlaxoSmithKline may incur with its corruption case, which would represent 3 times its 2012 sales in China. This may stand as a lone outlier and we believe will be re-negotiated with recent rumors pointing to Glaxo’s exit from the Chinese market if the penalty is not tapered. Regardless of the amount, Glaxo has openly responded by dispelling such a move and has reaffirmed its commitment to servicing China, which we would expect given the firm’s robust capital investments in the country and the market’s growth potential. Further, as with the case of lowering nutritional prices, Glaxo also mentioned that it will likely reduce drug prices in China as a result of shifting to a more simplified operating model in China, but we believe the price cuts are largely intended to appease the Chinese government over potentially corrupt practices by Glaxo. As China’s middle class expands and the mainland continues to urbanize, we believe firms will remain eager to capture lucrative opportunities in the medical device market. Oversight can only increase as the nation overhauls its health-care system and adopts the precedents set among foreign governments. Following the example of formula manufacturers and pharmaceutical firms, we think medical device manufacturers should adapt similarly to shifts in the competitive and regulatory landscape. K Endnotes: 15 Oasis International Hospital 16 Professor Lizheng Shi, Tulane University Healthcare Observer October 2013 31 Chinese Challenges to Digging Moats in the Stent Business by Debbie S. Wang Although U.S.-based manufacturers have enjoyed the benefits of economic moats in drug-eluting stents, or DES, as they have branched off into distribution in the developed world, we note that digging a comparable moat in China will be difficult. If anything, the evolution of the drug-eluting coronary stent market in China offers an interesting case study that highlights just how quickly business can be won and lost when multinational companies enter the market. We think the competitive dynamics in the Chinese DES market offer cautionary lessons to medical device makers seeking to penetrate the Middle Kingdom. Ingredients for Stent Moats In general, we view coronary stents as a narrow-moat business. That is, drug-eluting stents are likely to generate economic profits over the next 10 years and allow manufacturers to exert some pricing power. This makes the DES business far more attractive compared with no-moat markets where competitors may simply earn their cost of capital. On the other hand, DES companies do not enjoy the stronger competitive advantages that wide-moat firms possess. We see the cardiac rhythm management and orthopedic segments as wide-moat businesses and less vulnerable to encroaching competitors. In the developed world, DES makers have relied on a few key elements to dig moats around their businesses, and we anticipate these factors may not directly translate in China. First, intellectual property is one major factor underlying DES moats. Boston Scientific, Medtronic, and Abbott (and Johnson & Johnson previously) all possess extensive patents that surround their DES products, and have historically defended this property aggressively. The major stent rivals are typically embroiled in lawsuits and counter-lawsuits involving patent infringement on stents that may have already been rendered obsolete by the introduction of newer, next-generation technology. While the legal costs of dragging these issues out in court over years may seem wasteful, we think the main benefit of all this litigation is to keep potential new competitors from entering the fray. In the grand scheme, it is not particularly financially harmful for large players like Johnson & Johnson and Boston Scientific to fund ongoing litigation over intellectual property—both firms generate plenty of cash and have deep pockets. However, if a small, emerging competitor were to find itself the target of patent litigation by Medtronic or Abbott, the burden of defending itself could hold dire financial implications. Second, DES manufacturers have protected their businesses, to some extent, by building strong relationships between sales reps and physicians, who continue to make the brand choice for these types of implanted devices. This access to the practitioner translates into opportunities to influence the brand choice and introduce new products and technology. Healthcare Observer October 2013 32 Third, and perhaps most important, DES makers in the developed markets benefit from efficient scale. In other words, a highly consolidated set of stent manufacturers can serve a market of limited size in a manner that allows all participants to reap economic profits. In the developed markets, there have historically been three or four major stent makers at any given time, and they operate as a rational oligopoly. We note that this oligopoly is strongest and pricing is most stable with three competitors in the mix; in contrast, price declines tended to be slightly greater with four rivals present. This might have played a part in J&J’s decision to withdraw from the DES market in 2011. Chinese Challenges We contend that it will be substantially more difficult for multinational DES makers to construct narrow moats in China, primarily because the business environment is less conducive to moat-digging. Nonetheless, the considerable potential for profitable growth in China remains a huge attraction that many medical device companies have decided they cannot pass up. First and foremost, the intellectual property protection that the developed markets offer is severely diminished in China. This partly reflects the nation’s millennia-long Confucian-influenced culture of defined hierarchy in which copying was viewed as a form of respect and flattery. As a result, Chinese legal and political culture put little importance on notions of proprietary intellectual property, and the nation was ill-equipped to deal with foreigners who placed emphasis on the issue. That Confucian legacy also means China did not cultivate strong rule-of-law standards and systems that are far more developed in Western countries. It has only been in the last 30 years that China has begun to tackle the slow process of developing legislation to protect intellectual property. We note that China has gradually revised its IP laws to more closely hew to global standards, as the country seeks to play a bigger role in global trade. Although over time China has made some progress, the country remains a hotbed of piracy, and enforcement of recent legislation remains lax. Unfortunately, we think these conditions are unlikely to change in the near term because the government has specifically designated medical technology as an industry that it wishes to develop in China. The quickest way to develop expertise in an industry has been for China to allow multinational firms to enter its market, and then tacitly encourage local firms to reverse-engineer those products and set up shop. But, there is some light on the horizon that we think could change the IP environment in China over the longer run. Healthcare Observer October 2013 33 Exhibit 28: Number of Patents Filed Over Time China US Japan European Patent Office 500,000 Source: WIPO Statistics Database 2013 300,000 450,000 400,000 350,000 250,000 200,000 150,000 100,000 50,000 1980 1985 1990 1995 2000 2005 2010 ‘11 0 Over the last decade, China has significantly ramped up its own patent filing activity, and now leads the U.S. in direct patent applications. While there are some legitimate criticisms about the quality of patents that China has granted, we think the massive volume of patents surely also contains highquality patents, too. Over time, China will find that it is beneficial to have a strong legal system to enforce intellectual property rights, especially when it helps native companies. We think that during this interim as China evolves toward stronger IP protection there will be more opportunities for enforcement. But, the burden of enforcement will lie with the multinational companies. If multinationals pour resources into protecting patents in China, there will be more cases of enforcement going forward. Nevertheless, this additional cost of doing business there and the real risk of losing proprietary technology continue to weigh on multinationals in the meantime. We think the relationship-building aspect of stent moats will translate fairly well in China, which remains an environment where personal relationships are critical to gaining access and opportunities to sell to hospitals. However, this also means that multinationals will need to engage in substantial local hiring in order to assemble a team that already has or can build out the network of relationships. Some stent makers have already embraced this strategy. Two years ago, Boston Scientific shifted its focus and set out to hire 1,000 employees in China. Medtronic aims to double its employees in China to 2,000 by 2015. Though we believe conditions in China are conducive to these relationships, we are cautious about the durability of these relationships as it is not uncommon for employees to switch to competitive companies. Retaining employees will become a more important endeavor in China, especially as the demographic loss of working-age adults grows more pronounced over time. Finally, we are pessimistic that the DES market in China will reach efficient scale anytime soon. By definition, this source of economic moat involves a limited market. For better or worse, China’s DES market will be large, relative to the volume in developed markets. For example, drug-eluting stent volume Healthcare Observer October 2013 34 in China was more than 630,000 last year, which is within striking distance of the estimated 900,000 units used annually in the U.S., making the Chinese stent market roughly $515 million. Notably, while percutaneous coronary procedures have been declining in the low-single digits in the U.S. thanks to concerns about overuse, angioplasty in China has been growing in the high teens over the last nine years as more practitioners were trained to do these procedures and more hospitals began to offer them, in conjunction with increased health insurance coverage and income growth. Exhibit 29: Burden of Coronary Heart Disease (mm) China U.S. Patients with cardiovascular disease 230 26.5 Patients with hypertension 200 67 Number of heart attacks/year 2 0.715 Number of strokes/year 7 0.795 Sources: National Center for Cardiovascular Disease 2010, Beijing; Centers for Disease Control 2011 We expect sizable growth for years to come thanks to the size of the Chinese population, widespread smoking, changing lifestyles and diet, as well as growth of the elderly. Approximately 230 million Chinese suffer from coronary heart disease, compared with 26.5 million in the U.S. Exhibit 30: Drug-Eluting Stent Volume in China 2012 2013E 2014E 2015E 2016E 2017E Continued 10% Growth 633,000 696,300 765,930 Bull Case 14% Growth 633,000 727,950 837,143 842,523 926,775 1,019,453 962,714 1,107,121 Bear Case 5% Growth 633,000 664,650 697,883 1,273,189 732,777 769,415 807,886 Source: Huidian Research, Morningstar estimates If Chinese percutaneous coronary volume continues to grow at the robust pace we project at 10% (significantly lower than the 20%-plus rates seen since 2003), then the stent market could reach more than 1 million units in five years, making China the largest DES market in the world. It is this prospect that has lured multinational DES makers into China and spurred domestic device makers to compete for a piece of the pie. Strategies for Stent Makers in this Evolving Market Over the last decade, since Johnson & Johnson first entered China with its Cypher drug-eluting stent in 2003, we have seen the Chinese coronary stent market evolve very quickly. This has forced Healthcare Observer October 2013 35 multinationals to remain flexible about strategy and its tactics on the ground, and remains an instructive case for any med-tech company that is contemplating entry into China. In the early days of the DES market (as illustrated by the timeline below), J&J and Boston Scientific pioneered and dominated the market in China with an emphasis on its high-quality, premium stents that were not available locally. Exhibit 31: Chinese Drug-Eluting Stent Timeline Boston Scientific Liberte J&J Cypher Select Multinationals J&J Cypher Boston Scientific Taxus Domestic 2003 2004 2005 MicroPort Firebird Lepu Partner Boston Scientific Promus Element Medtronic Endeavor 2006 2007 J&J Cypher Select Abbott Xience Medtronic Resolute Abbott Xience Prime 2008 2009 2010 2011 MicroPort Firebird2 JW Medical Systems* Excel (Bioabsorbable polymer) Lepu Nano (Polymer-free) 2012 2013 MicroPort Firehawk Awaiting approval (Bioabsorbable Polymer) * JW Medical was originally a joint venture between Singapore-based Biosensors and Shandong Weigao. Biosensors bought out its partner in 2011 Source: Company filings However, it did not take long for local competition to spring up. MicroPort, Lepu, and JW Medical Systems flocked to launch their own drug-eluting stents in short order. Most of these local competitors had only come into existence in the late 1990s, and were often led by Western-educated and trained founders who saw an opportunity in the emerging Chinese DES market. As fast-followers, these local rivals could produce products that were of “good enough” quality, which allowed them to develop the nascent midtier market. Local stent makers also flexed their muscle in other ways and have proven themselves formidable competitors. In particular, the local DES makers were manufacturing in China, whereas Boston and J&J were commonly manufacturing in Ireland, the Netherlands, and Puerto Rico, all tax-advantaged locations but not necessarily competitive in terms of cost relative to China. This translates into compelling domestic stent prices for hospitals, especially those that are in Class I and II outside the major urban areas. By focusing on the non-urban markets, domestic stent makers were able to leverage their ability to build relationships, establish solid brand reputations, and work with hospitals that were new to percutaneous coronary intervention. All the while, the multinationals concentrated on selling premium products in the sophisticated, urban Class III hospitals. We note that this cost advantage is a key reason new local entrants have been drawn into the market. MicroPort, the leading domestic DES maker with an estimated 22% market share, enjoys gross margin around 85%, which is comparable with the gross margin multinationals can garner for its drug-eluting stents in the U.S. market. MicroPort can achieve those attractive margins even though it typically prices its stents at a 30%–40% discount to Abbott’s Xience or Boston’s Promus. Taking advantage of this two-tiered approach to the Chinese hospitals and working to expand the stent market, local DES makers Healthcare Observer October 2013 36 were able to take substantial share from the multinationals in dramatic fashion. The prospect of these hefty profits will only attract more local competitors to the field, which leaves the significant consolidation necessary to reach efficient scale very far off in the future. Exhibit 32: Chinese DES Market Share 2004 2009 2010 2011 2012 Multinationals % 80 Local Manufacturers % 20 34 30 35 40 66 70 65 60 Source: In Vivo As we have discussed in the past, low switching costs are another reason why drug-eluting stents are a narrow-moat business. With stents and delivery systems that are fairly interchangeable and a relatively shallow learning curve, it is very easy for interventional cardiologists to move from one brand to another. As a result, stent share is vulnerable to significant change in the space of a few quarters when competitors launch products. Local Stent Makers Up Ante While locally made stents hold the price advantage, we are particularly impressed with the R&D capabilities of MicroPort and Lepu Medical. Even though it is not necessarily difficult to reverse-engineer a middling drug-coated stent, these local competitors have stepped on the gas to rev up innovation. Staffed up with plenty of engineers and scientists, the local companies have not stinted on R&D spending. These dollars were wisely spent in two areas. First, Chinese DES makers invested in clinical studies to demonstrate the comparability of their products when stacked against Boston and J&J’s stents. This data helped to diminish perceptions that the local stents lagged on quality. Second, aggressive R&D efforts have allowed the local DES makers to leapfrog ahead the multinationals on the technology front. While the multinationals have been working on bioabsorbable polymers, polymer-free, and resorbable stents, none has commercialized these technologies yet (the only exception is Abbott’s ABSORB stent that is approved for marketing in Europe). On the other hand, Lepu and JW Medical have already rolled out a bioabsorbable polymer and polymer-free stent in China. MicroPort is awaiting CFDA approval on its Firehawk stent with a bioabsorbable polymer. Healthcare Observer October 2013 37 Exhibit 33: Chinese Drug-Elating Stent Market Strategies Premium Quality Abbott Medtronic Boston Scientific Lepu JW Medical Lower Tech MicroPort Sophisticated Tech Value-tier Efforts by these local DES makers to establish themselves as creators of leading-edge technology may leave multinationals wary and concerned about China. Indeed, these competitive dynamics have forced the multinationals to be nimble about shifting strategy. We suspect it took the dramatic share decline for the multinationals to realize they had lost the edge on technology, and to prod them into lowering their prices and narrowing the gap with domestic products. While these pricing shifts may have helped the multinationals regain some market share in recent years, we think the formidable wave of local competition has fundamentally pushed Abbott, Boston, and Medtronic into defensive mode. In order to compete and maintain pricing, the multinationals will need to out-innovate the domestic competitors and potentially do a better job of tailoring their DES products for the Chinese market. Another strategic option would be to lower their cost structure by moving manufacturing to China. However, we think the multinationals are reluctant to do this because it would leave them vulnerable to piracy, with little recourse in the legal system. If China were to beef up its enforcement of intellectual property rights, then we might see some relocation of manufacturing. A Narrow Moat Becomes Narrower Still in China Overall, we think it will be considerably more difficult for the multinationals to replicate the narrow DES moats they enjoy in developed markets. The scale of the DES market in China and the proliferation in local competitors means that any rational oligopoly is very far off indeed. In the meantime, weak protection of intellectual property and low switching costs will leave the multinationals vulnerable to pricing pressure. Currently, these firms still gain some mileage as foreign “brands” which Chinese consumers tend to prefer. However, we are not entirely confident that this will sustain the multinationals over the longer run, especially since there are some policies in place that tilt the advantage to domestic stent makers. The tendering process limits hospitals to one domestic and one foreign supplier. Additionally, reimbursement favors domestic stents by tying them to higher rates (local stents are reimbursed at 70% of the price versus 50% for imported stents), or by capping reimbursement at a level where the domestic stent is covered but the patient would need to pay out of pocket for the difference on an imported stent. It is not clear how long the multinationals can hold out in the face of this consistent Healthcare Observer October 2013 38 pressure on price, or whether the opportunity to gain a slice of such a large market is too tempting to pass up. Either way, we believe the multinationals will, over the longer term, find themselves competing with the Chinese DES makers outside China. Even though the Chinese companies may not penetrate the U.S. market in the near- or midterm, other markets seem to be fair game, particularly other emerging markets such as Brazil and India. Currently, sales outside of China account for approximately 20% of Lepu Medical’s total revenue, and one of MicroPort’s key strategies is to expand into new geographies. We suspect it is this eventuality that could raise alarm at the multinationals. K Healthcare Observer October 2013 39 Orthopedics: Translating Wide Moats in China by Debbie S. Wang The orthopedic industry in China as followed a similar progression as the drug-eluting stent market, but there are a few distinctions that give us confidence that the orthopedic multinationals can dig wide moats in this geographic area. Like the DES makers, multinational orthopedic firms entered the Chinese market by staking out the premium, high-end portion of the market by focusing on Class III hospitals. This allowed local competitors, such as Shandong Weigao and Trauson, to design and manufacture lesssophisticated and lower-priced orthopedic implants. As a result, domestic manufacturers could establish a foothold with Class II and I hospitals in smaller cities, thereby pioneering the value-segment of the orthopedic market. If it feels like you’ve seen this movie before, you have. But, there are a couple of different twists that lead us to believe the orthopedic multinationals will end up in a stronger competitive position than the DES multinationals. These wide-moat companies are similar to DES makers in that intangibles such as intellectual property and relationships with practitioners are both important sources of competitive advantage. This means that orthopedic multinationals will also find themselves vulnerable to weaker IP protection in China. As noted before in the stent discussion, we think there has been progress on this front as China evolves its laws surrounding intellectual property. However, enforcement remains lax and inconsistent. Though we expect enforcement will improve over the longer term as China seeks to protect its own growing cache of patents, it will take time and multinationals are wise to be wary. Digging Moats on High Switching Costs It’s important to note that orthopedic companies’ wide moats are rooted in high switching costs and we think this aspect of the moat will translate well in China. Unlike drug-eluting stents, reconstructive joint replacements involve using extensive sets of instrumentation that are specific to each competitor. Moreover, surgeon skill and experience are major factors in the clinical outcome. In the developed markets, surgeons stick with their preferred implant vendor and sales rep for 5–15 years, and tend to use that favored vendor for more than 90% of their procedures. We expect similar dynamics should play out in China when it comes to joint reconstruction, which we anticipate will experience major growth thanks to the size of the aging and arthritic Chinese population. Healthcare Observer October 2013 40 Exhibit 34: Patients with Arthritis (mm) China 124.6 U.S. 48.6 India 24.3 U.K. 9.6 Italy Canada 5 4.8 Source: Trauson 2008 In contrast, low switching costs for DES mean that products can be used interchangeably and interventional cardiologists can still reliably reach success rates of more than 95%. Orthopedic surgeons are not in the same position—the learning curve is much longer and steeper, in order to reach optimal clinical outcomes. Unfortunately, high switching costs can be a double-edged sword. On one hand, this means surgeons tend to be very loyal and companies can expect most surgeons trained on their systems to stay put. On the other hand, this dynamic also makes it very difficult to pull orthopedic surgeons away once they are committed to competitive brands. Unlike the significant DES market share shifts that can happen in the space of two quarters, share shifts for orthopedic companies are measured in 100 to 200 basis points over the period of 5–10 years. Historically, orthopedic companies have relied on acquisitions as the primary mode of boosting market share. Lessons Learned That Have Led to New Strategies for China We think the orthopedic companies are well-situated to replicate their wide moats in China by relying on the high switching costs central to orthopedic surgery in the near- and midterm. This will allow some time for the intellectual property environment to evolve, which will strengthen moats over the long run. The orthopedic history of “market share by acquisition” has resulted in the current land grab in China for local orthopedic companies. We think this strategy of co-opting the strongest local competitors is a savvy approach—one that the DES device makers missed and probably now regret. Over the last three years, Medtronic purchased Kanghui Medical for roughly $755 million; Stryker acquired Trauson for $764 million; and Zimmer bought Beijing Montagne for an estimated $57 million. With the various segments of the orthopedic market growing nearly 20% annually, there is more upside to be had. Healthcare Observer October 2013 41 Exhibit 35: China's Orthopedic Implant Market (Rmb bn) Other Spine Joint Trauma 12 10 8 Source: Frost & Sullivan 6 4 2 2006 2007 2008 2009 2010 2011 2012 0 We think the orthopedic multinationals learned a valuable lesson from how the DES market evolved in China. While J&J, Boston Scientific, Abbott, and Medtronic were focused on organically penetrating the advanced Class III hospitals with sophisticated technology, this left the vast middle market of Class II and I hospitals receptive to overtures and attention from new local suppliers such as MicroPort and Lepu Medical. Now the DES multinationals lack the product depth to appeal to the middle market, and also lag behind the local rivals in terms of building out relationships with hospitals and practitioners outside the large urban areas. From a strategic and portfolio perspective, we think the orthopedic acquisitions make sense. The trauma segment continues to account for approximately 35% of China’s orthopedic market, and most Chinese orthopedic surgeons start out doing trauma before specializing in spine, large joint reconstruction, or extremities. The local orthopedic device makers tend to hold extensive portfolios of trauma and spine products, while they lack the higher-tech, more sophisticated large joint implants. The multinationals offer a mirror image—smaller trauma offerings and a robust portfolio of hip and knee replacements. Melding the product portfolios together makes for a complementary fit. In the case of Medtronic which does not have hip and knee implants, the acquisition of Kanghui means Medtronic now has a strong trauma offering when it had none before. Additionally, Kanghui has rolled out its own hip and knee systems recently, and also has licensed joint replacement designs from Consensus Orthopedics. Now Kanghui can strengthen its spinal portfolio with Medtronic’s expertise in that segment. In general, the trauma segment—with its lower-tech nails, plates, and rods—is dominated by local companies. On the other hand, the spinal and joint implant markets are still weighted primarily toward multinational firms. We expect the multinationals to approach the trauma market in China mainly through their acquisitions on the ground. This is partly because these less highly engineered products are more prone to generic competition (and thus, margin pressure), and partly because the cost structure of locally manufactured products will be more competitive. We think Stryker and Zimmer will be selective about Healthcare Observer October 2013 42 which foreign-produced trauma products it imports to China, at least through the midterm. We anticipate the growing middle-class demand for joint replacement will be a boon to orthopedic multinationals, both with its high-end premium products, as well as with the possibility of engineering lower-cost, more basic implants (manufactured in China) for the widening swath of the middle market. We also note that the acquisition strategy has helped the multinational companies avoid the key strategic pitfall that DES makers ran into. Similar to the local DES manufacturers, the main local orthopedic firms have primarily concentrated their efforts on penetrating the middle-market through Class III hospitals in smaller cities, and Class II hospitals outside urban areas. By acquiring these local competitors, the multinationals can continue to focus on offering high-end products at the Class III hospitals in the premier cities, but they will also reap the benefits of a presence (albeit with different brands) in the non-urban middle market. As a result of this acquisition spree, we think the market share split between locals and foreigners has shifted. Exhibit 36: Local vs. Foreign Share of China Orthopedic Market Multinational Companies Local Orthopedic Companies Source: Frost & Sullivan, Morningstar estimates 49% 51% 2009 36% 64% 2013 Three Additional Strengths of Acquisition Strategy: Distribution, R&D/Manufacturing, and Tailored Products First, medical device distributors in China exercise considerably more influence than in developed markets, and it can be difficult for multinational companies to grow their own distribution network in the vast and fragmented Chinese system of approximately 22,000 hospitals (the U.S. has about 5,700 hospitals, for perspective). Aside from complementary product portfolios, local competitors’ distribution networks are extremely valuable to multinationals. Healthcare Observer October 2013 43 Exhibit 37: Local Orthopedic Distribution Networks Distributors Hospital Customers Kang-Hui Medical (MDT) 335 2,969 Trauson (SYK) 663 3,840 Shandong Weigao 995 2,963 Source: Comapany filings We think this could be the most valuable aspect of what the multinationals have purchased. By law, foreign device makers must go through Chinese distributors. The time, effort, and man hours necessary to replicate these distribution networks are sizable for multinational companies. Now Medtronic, Stryker, and Zimmer will be able to funnel their high-end products through these distribution networks that will reach much further into the group of Class II hospitals. Second, these purchases also give the multinationals R&D and manufacturing facilities in China to produce those middle-market products at an advantageous cost structure, while they still retain the flexibility to keep manufacturing of their premium products elsewhere, and lessen the risk of piracy. Currently, multinationals can mark up their large joint implants to roughly 3 times the local device price. However, we think these prices may come under pressure as joint reconstruction volume grows through the mid-term in developed markets. Having facilities on the ground will give multinationals an opportunity to test out the manufacturing waters, in the event that they eventually move some manufacturing of premium products over to China. Finally, these newly acquired Chinese facilities mean the multinationals will be better able to tailor their products to the local market. Orthopedic surgeons and regulators have raised concerns about the differences in skeletal structure between Chinese people and Western people for whom premium orthopedic products have been designed. The more multinationals can demonstrate that their products are tailored for Chinese physiology, the better reception they will receive. Market Potential Outweighs Reimbursement and Regulatory Risks Overall, we contend the orthopedic multinationals, compared with DES multinationals, will have an easier time of translating their wide moats to China thanks to the high-switching costs of their products and timely strategies to purchase the largest local competitors. However, we recognize that the Chinese orthopedic market will be subject to many of the same governmental and regulatory policies that favor local med-tech firms over multinationals. Furthermore, we would not be surprised to see more local competitors attempt to penetrate the premium segments that are currently dominated by multinational companies. MicroPort, the native DES company that has given Abbott, Boston, and Medtronic a real run for its money in the Chinese stent market, has purchased Wright Medical’s reconstructive orthopedic business. This gives MicroPort a strong reconstructive technology platform relative to other local competitors (and importantly, it also provides MicroPort with entry into the U.S. orthopedic market). All of this should be a wake-up call to all med-tech companies. Even those with the widest moats will Healthcare Observer October 2013 44 need to continually enhance their innovation in order to compete. But, considering the sheer size of the Chinese market, this seems to be an opportunity that orthopedic multinationals cannot pass up. Medtronic Well-Situated to Ride China’s Rise Of the medical device multinationals, we think Medtronic is best positioned to benefit from the rise of Chinese spending on med-tech. Even though it may be hampered by competitive forces behind its control in the stent market, Medtronic faces far more upside than other device manufacturers because of its extensive product portfolio. With the addition of Kanghui’s strong distribution network, Medtronic now has an avenue through which to move all of its devices into Chinese hospitals, including pacemakers, implantable cardioverter defibrillators, insulin pumps, and heart valves. Medtronic will be there with products just as access is improving, and demand is growing among previously untreated or undertreated patients. For example, the Ministry of Health has just included type I diabetes as a condition that will be covered under the insurance schemes; the insulin pump market is dominated by type I diabetic patients. In our universe of med-tech companies, Medtronic remains relatively undervalued with shares trading roughly 10% below our fair value estimate of $60 per share. K Healthcare Observer October 2013 45 An Informative Case:General Electric’s Emerging-Market Strategy Starts With Service Networks by Daniel Holland Having entered the China market decades earlier, General Electric moved forward in the health- care market with fresh strategies that have paid off. GE laid out a two-pronged strategy that involved a grassroots “made for China” focus and relied on its proprietary data collection and high-touch service to lay the groundwork for an economic moat. Creating Indigenous Products for China First, it did not take long for GE to realize that its initial strategy—relabeling stripped-down versions of American products for China—would not work because the working conditions in China were fundamentally different from those in developed markets. For example, American hospitals can count on having reliable, consistent power available. However, installing a magnetic resonance imaging machine in a remote area of China comes with the risk of intermittent power, and consequently, poor utilization of the equipment. These types of issues required GE to re-think and re-engineer how to design products especially for the region. GE elected to make significant capital investments in the region, with the objective of locally engineered, locally manufactured, and locally consumed products. Approaching the market in this way allowed the firm to create indigenous products that met a specific local need. Additionally, this strategy allowed GE to control more of its intellectual property, controlling the introduction of technology to the market and the pace of innovation (instead of contracting with local manufacturers). Enhancing Service amd Proprietary Features Second, GE elected to focus on not only the product, but also on establishing a regional network of service centers addressing clinics and smaller hospitals, which are generally less interested in pricier medical equipment. This segment of the market lacks both financing and often the expertise to take advantage of the equipment, and instead opts for more basic tools that are easier to use and can address a broad audience. As a result, large multinational equipment makers expended little effort on penetrating this part of the market. GE’s service centers provide remote diagnostics and monitoring services, which help the users become more proficient, mitigating a key hindrance to higher-equipment utilization. It’s also important to note that GE has found a way to lessen the threat of technology infringement, by focusing on the moatier software element. The value of GE’s equipment is less dependent on the hardware solution, and more concentrated in the software embedded within the product. Similar to how GE approaches remote monitoring and diagnostics in its jet engines and gas turbines businesses, the company collects and retains proprietary data on all units in the field that can be used to engage Healthcare Observer October 2013 46 customers after the initial point of purchase. The rise of digital imaging, in particular, has enhanced the value of software in medical equipment. While counterfeiters can copy the physical likeness of the medical equipment, it is far more difficult to replicate the requisite software backbone or the service network built by General Electric. As a result, competitors aiming to replicate particular features of the device will be unlikely to deliver the same level of value to the end user as the GE solution. The portable ultrasound machine, launched in 2009 is one example of GE’s approach to building a product designed for local market needs and then using service and software to make the equipment more valuable. This product has been successful in China, so much so that it has also been exported to rural settings in developed regions. GE’s Success Has Left Philips and Siemens Struggling in China GE’s successes with its novel strategies stand in large contrast to the struggles of its competitors. Whereas GE has reported double-digit order growth in the region and profitability consistent with the global business, both Siemens SI and Philips PHIA have taken impairment charges on their health- care businesses in the last two years as growth lagged managements’ expectations. Despite stated intentions to focus on lower-cost middle-market products, Philips and Siemens have yet to expand beyond their key large, technologically advanced cities. We view the next couple of years as critical in determining whether either of these firms can regain their footing in the Chinese markets or will concede the region and return to their core competency in big-ticket equipment sales in Western regions. In our opinion, GE’s key challenge is to retain the customers that they have invested in and educated, even as the market evolves and matures. Among multinational firms selling any type of capital equipment, service attachment rates in China tend to be lower than in Western markets. Once local customers understand the product well enough, the tendency has been for them to perform their own maintenance and develop their own innovations around the existing technology, allowing them to avoid longer-term service contracts that have been a mainstay in capital equipment sales. To the extent that the customers view GE’s altruism as their opportunity to walk up the learning curve without bearing the full cost, customers may decide to abandon GE for a competing technology. We still view this as a more mediumto long-term threat as there is a significant runway for growth in the second- and third-tier cities, and GE’s head start in building out its service network has helped to establish a commanding lead in its respective markets. K Healthcare Observer October 2013 47 Outlook for Industries in Healthcare Five-Star Four-Star Three-Star Two-Star One-Star 100% Data as of August, 2013 50 Services Medical Medical Instruments Devices Pharma Managed Biotech Care/PBMs 0 26 24 30 6 Number of Companies 14 26 The biotechnology industry now represents the only industry with 5-star stocks. Including both 4-star and 5-star stocks, the managed-care and PBM industry is at the top along with the biotech and pharmaceutical industries. The industries with the worst rankings are services and medical instruments. Looking at the entire health-care sector, the number of 5-star stocks is at a very low level with only two stocks with 5-star ratings. Healthcare Large Cap Focus List Company Name Moat Uncertainty Price to Fair Value Star Rating Analyst Express Scripts ESRX Wide Medium 0.70 QQQQ Lekraj Sanofi SNY Wide Medium 0.74 QQQQ Conover Teva TEVA Narrow Medium 0.78 QQQQ Waterhouse WellPoint WLP Narrow Medium 0.83 QQQQ Lekraj Valeant Pharmaceuticals VRX Narrow Medium 0.85 QQQQ Krempa Medtronic MDT Wide Low 0.90 QQQQ Wang Gilead GILD Narrow Medium 0.91 QQQQ Andersen Covidien COV Narrow Medium 0.93 QQQQ Morozov Quest Diagnostics DGX Narrow Medium 0.95 QQQ Wang Amgen AMGN Wide Medium 0.98 QQQ Andersen Data as of September 20, 2013 Since the August 2008 inception, our focus list has outperformed the iShares Dow Jones U.S. Healthcare ETF Index IYH by 59% and the S&P 500 by 91%. On an absolute basis, the focus list has returned 127% since the initial launch. We measure our performance by equally weighting each holding and rebalancing at the end of each month. This month, we are not making any changes to our large-cap list. Healthcare Observer October 2013 48 Healthcare SMID Focus List Company Name Moat Uncertainty Price to Fair Value Star Rating Nordion NDZ Narrow High 0.79 QQQQ Krempa Myriad Genetics MYGN Narrow High 0.83 QQQQ Morningstar Analysts Edwards Lifesciences EW Narrow High 0.91 QQQ Wang Charles Rivers Labs CRL Narrow Medium 0.93 QQQ Morningstar Analysts LabCorp LH Narrow Medium 0.94 QQQ Wang VCA Antech WOOF Narrow Medium 0.95 QQQ Wang Varian VAR Narrow Medium 0.97 QQQ Morningstar Analysts Paladin Labs PLB Narrow High 0.98 QQQ Krempa Smith & Nephew SNN Narrow Medium 1.00 QQQ Wang Given Imaging GIVN Narrow High 1.03 QQQ Wang Data as of September 20, 2013 Analyst Since our recent launch at the beginning of September 2010, our focus list has outperformed the iShares Dow Jones U.S. Healthcare ETF Index IYH by 11% and the Russell Mid Cap Index by 27%. On an absolute basis, the focus list has returned 100% since the initial launch. We measure our performance by equally weighting each holding and rebalancing at the end of each month. This month, we are not making any changes to our SMID-cap list. Healthcare Observer October 2013 49 Healthcare Calendar October 2013 Event Date Location Oct. 2–5 Copenhagen 6 7 8 9 10 11 12 European and Americas Committee for MS (ECTRIMS/ ACTRIMS) 13 14 15 16 17 18 19 American College of Gastroenterology (ACG) Oct. 11–16 San Diego 20 21 22 23 24 25 26 FDA Panel on JNJ's simeprevir for hepatitis C Oct. 24 — 27 28 29 30 31 1 FDA Panel on GILD's sofosbuvir for hepatitis C Oct. 25 — American College of Rheumatology (ACR) Oct. 26–30 San Diego Transcatheter Cardio Therapeutics (TCT) Oct. 27– Nov. 1 San Francisco Event Date Location American Association for the Study of Liver Disease (AASLD) Nov. 1–5 Washington DC 1 2 3 4 5 November 2013 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 FDA Panel on MRK's ATI drug for allergy Nov. 5–6 — 17 18 19 20 21 22 23 American Society of Nephrology (ASN) Nov. 5–10 Atlanta 24 25 26 27 28 29 30 Society of Immunotherapy of Cancer (SITC) Nov. 6–10 National Harbor, MD American Heart Association (AHA) Nov. 16–20 Dallas Healthcare Observer October 2013 50 Biotechnology Companies Company Ticker Analyst Star Rating Market Cap Price Fair Value Price/FV Moat Uncertainty Rating Actelion Ltd. ATLN Karen Andersen QQ 7,734 64.30 49 1.31 None High 15.6 Alexion Pharmaceuticals, Inc. ALXN Lauren Migliore QQQ 22,299 114.03 115 0.99 Narrow High 37.0 Alnylam Pharmaceuticals, Inc. ALNY Karen Andersen QQ 3,627 57.61 42 1.37 None Very High NM Amgen Inc AMGN Karen Andersen QQQ 88,280 117.18 119 0.98 Wide Medium 14.3 Biogen Idec Inc BIIB Biomarin Pharmaceutical, Inc. BMRN Karen Andersen QQ 58,938 247.98 210 1.18 Wide Medium 34.4 QQQ 10,983 78.38 71 1.10 Narrow Medium NM Celgene Corporation CELG Karen Andersen QQ 61,083 148.52 123 1.21 Narrow High 20.6 Cubist Pharmaceuticals, Inc. CBST Dendreon Corp DNDN Karen Andersen David Krempa QQQ QQQQ 4,259 64.44 60 1.07 None High 24.8 506 3.21 3.8 0.84 None High NM Elan Corp PLC ELN Karen Andersen QQQ 7,981 15.60 14 1.11 None High NM Exelixis, Inc. EXEL Lauren Migliore QQQQQ 1,033 5.61 11 0.51 None Very High NM Gilead Sciences Inc GILD Karen Andersen QQQQ 98,450 64.32 71 0.91 Narrow Medium 21.5 Grifols SA GRFS Karen Andersen QQQ 11,025 32.07 30 1.07 Narrow Medium 16.8 Incyte Corp Ltd INCY David Krempa QQ 5,535 36.16 24 1.51 None Very High 116.3 InterMune, Inc. ITMN Lauren Migliore QQQQ 1,261 15.39 25 0.62 None Very High NM Lexicon Pharmaceuticals, Inc. LXRX Karen Andersen QQQQ 1,173 2.28 3.5 0.65 None Very High NM MannKind Corporation MNKD Karen Andersen QQQ 1,796 5.95 6.5 0.92 None Very High NM Novo Nordisk A/S NVO Karen Andersen QQQQ 95,040 172.80 209 0.83 Wide Medium 17.5 Onyx Pharmaceuticals, Inc. ONXX Karen Andersen QQQ 9,144 124.53 125 1.00 None High QLT, Inc. QLTI Michael Waterhouse QQQ 231 4.52 4.5 1.00 None Very High Regeneron Pharmaceuticals, Inc. REGN Stefan Quenneville QQQ 30,327 307.11 291 1.06 Narrow High Roche Holding AG RHHBY Karen Andersen QQQ 227,855 66.04 68 0.97 Wide Low 4.3 Seattle Genetics, Inc. SGEN Lauren Migliore QQ 5,816 47.73 30 1.59 None Very High NM Shire PLC SHPG Karen Andersen Q 23,040 122.80 81 1.52 Narrow Medium 33.6 Vanda Pharmaceuticals, Inc. VNDA Karen Andersen QQ 369 12.94 10 1.29 None High NM Vertex Pharmaceuticals VRTX Stefan Quenneville QQQ 17,761 76.29 88 0.87 None High NM ViroPharma, Inc. VPHM Lauren Migliore 2,618 39.96 25 1.60 None Very High Karen Andersen QQ Fwd P/E 138.9 NM 36.9 38.5 Healthcare Observer October 2013 51 Diagnostics & Research Companies Market Cap Price Fair Value Price/FV Moat Uncertainty Rating QQQ 16,864 50.98 46 1.11 Narrow Medium 15.2 Morningstar Analysts QQQ 2,600 31.80 28 1.14 None High 14.8 BIM Morningstar Analysts QQQ 2,864 CRL Lauren Migliore QQQ 2,288 72.60 72 1.01 Narrow Medium 15.7 46.64 50 0.93 Narrow Medium 14.8 Covance, Inc. CVD Lauren Migliore QQ 4,783 85.56 71 1.21 Narrow Medium 21.6 Icon PLC ICLR Lauren Migliore Idexx Laboratories IDXX Debbie Wang QQQ 2,374 39.00 36 1.08 Narrow High 19.8 QQ 5,153 98.08 88 1.11 Narrow Medium 23.8 Laboratory Corporation of America Holdings LH Debbie Wang QQQ 8,988 99.76 106 0.94 Narrow Medium 12.6 Life Technologies Corp Lonza Group AG LIFE Morningstar Analysts QQQ 12,927 74.87 76 0.99 Narrow Medium 15.9 LONN Morningstar Analysts QQ 3,904 75.20 63 1.19 None High 14.9 Mettler-Toledo International, Inc. MTD Alex Morozov Q 7,215 240.95 167 1.44 Narrow Medium 19.2 Myriad Genetics, Inc. MYGN Morningstar Analysts QQQQ 2,067 25.69 31 0.83 Narrow High 12.4 Nordion, Inc. NDZ David Krempa QQQQ 535 8.64 11 0.79 Narrow High 13.6 Parexel International Corporation PRXL Lauren Migliore QQ 2,809 49.96 38 1.31 Narrow High 23.2 Company Ticker Analyst Star Rating Agilent Technologies Inc A Morningstar Analysts Alere Inc ALR BioMerieux SA Charles River Laboratories International Inc Fwd P/E PerkinElmer Inc PKI Alex Morozov QQ 4,322 38.58 31 1.24 Narrow Medium 16.0 Qiagen NV QGEN Morningstar Analysts QQQ 4,987 21.28 22 0.97 None Medium 18.4 Quest Diagnostics Inc DGX Debbie Wang QQQ 9,388 61.81 65 0.95 Narrow Medium 12.4 Quintiles Transnational Holdings Inc Q Lauren Migliore QQQQ 5,673 44.00 50 0.88 Narrow Medium 18.8 Thermo Fisher Scientific Inc TMO Alex Morozov QQ 33,975 94.24 80 1.18 Narrow Medium 15.3 Waters Corporation WAT Alex Morozov QQQ 9,071 106.44 105 1.01 Wide Medium 17.2 WuXi PharmaTech (Cayman), Inc. WX Lauren Migliore QQ 1,920 27.02 20 1.35 None High 14.8 Company Ticker Analyst Star Rating Market Cap Price Fair Value Price/FV Moat Uncertainty Rating AbbVie Inc ABBV Damien Conover QQ 75,149 47.40 41 1.16 Narrow Medium 14.6 AstraZeneca PLC AZN Damien Conover QQQ 64,883 51.82 56 0.93 Wide Medium 9.9 Bayer AG BAYRY Damien Conover QQ 96,877 117.15 99 1.18 Narrow Medium 13.6 Bristol-Myers Squibb Company BMY Damien Conover QQ 78,250 47.53 39 1.22 Wide Medium 22.4 Eli Lilly and Company LLY Damien Conover QQQ 60,681 53.86 52 1.04 Wide Medium 16.4 GlaxoSmithKline PLC GSK Damien Conover QQQ 123,023 50.27 56 0.90 Wide Medium 19.0 Johnson & Johnson JNJ Damien Conover QQQ 253,824 90.07 90 1.00 Wide Low 15.0 Merck & Co Inc MRK Damien Conover QQQ 141,212 48.25 52 0.93 Wide Medium 13.3 Novartis AG NVS Damien Conover QQQ 186,241 76.11 78 0.98 Wide Low 13.6 Pfizer Inc PFE Damien Conover QQQ 190,929 28.84 30 0.96 Wide Medium 12.1 Sanofi SNY Damien Conover QQQQ 135,447 50.84 65 0.78 Wide Medium 7.7 Major Drug Manufacturers Fwd P/E Healthcare Observer October 2013 52 Specialty & Generic Drug Manufacturers Market Cap Price Fair Value Price/FV QQQ 18,430 138.40 127 Michael Waterhouse QQQ 27,073 91.20 RDY Michael Waterhouse QQQ 6,388 ENDP Lauren Migliore QQ 5,056 Forest Laboratories, Inc. FRX Damien Conover QQQ 11,921 H.Lundbeck A/S LUN David Krempa QQ 23,140 Hikma Pharmaceuticals PLC HIK Michael Waterhouse QQQ 2,062 Hospira, Inc. HSP Michael Waterhouse QQQ Mallinckrodt PLC MNK David Krempa QQQ Merck KGaA MKGAY David Krempa QQ Momenta Pharmaceuticals, Inc. MNTA Michael Waterhouse QQQ Mylan Inc MYL Michael Waterhouse QQ Paladin Labs, Inc. PLB David Krempa QQQ Perrigo Company PRGO Michael Waterhouse Teva Pharmaceutical Industries Ltd TEVA Michael Waterhouse UCB SA UCB Lauren Migliore QQ Valeant Pharmaceuticals International Inc VRX David Krempa QQQQ Warner Chilcott PLC WCRX David Krempa QQQ Zoetis Inc ZTS David Krempa Q Company Ticker Analyst Star Rating Aetna Inc AET Vishnu Lekraj Catamaran Corp CTRX Vishnu Lekraj Cigna Corp CI Express Scripts ESRX Humana Company Ticker Analyst Star Rating Actavis Inc ACT Michael Waterhouse Allergan, Inc. AGN Dr. Reddy Laboratories, Ltd. Endo Health Solutions Inc Moat Uncertainty Rating 1.09 Narrow High 13.6 100 0.91 Wide Medium 16.4 37.56 34 1.10 Narrow High 17.5 44.27 33 1.34 Narrow High 14.3 44.41 40 1.11 Narrow High 43.3 118.00 100 1.18 Narrow High 26.5 1043.00 1000 1.04 Narrow High 17.7 6,803 41.07 37 1.11 Narrow High 17.9 2,463 42.68 42 1.02 None Medium 17.0 33,394 51.20 42 1.22 Narrow Medium 4.3 Fwd P/E 819 15.67 16 0.98 None Very High 50.5 14,635 38.33 25 1.53 Narrow High 11.4 1,214 58.77 60 0.98 Narrow High 21.0 QQ 11,810 125.33 102 1.23 Narrow Medium 18.9 QQQQ 31,628 37.43 48 0.78 Narrow Medium 7.3 8,317 45.34 37 1.23 None High 19.8 35,324 106.12 125 0.85 Narrow Medium 12.0 5,536 22.04 20 1.10 Narrow High 16,255 32.51 24 1.35 Wide Medium Market Cap Price Fair Value Price/FV Moat Uncertainty Rating QQQ 24,127 64.84 65 1.00 Narrow Medium 10.2 QQQ 10,727 52.04 57 0.91 Narrow Medium 19.7 Vishnu Lekraj QQ 21,982 77.72 62 1.25 None High 10.2 Vishnu Lekraj QQQQ 50,431 61.94 89 0.70 Wide Medium 12.1 HUM Vishnu Lekraj QQ 14,819 94.71 82 1.15 None High 10.1 UnitedHealth Group Inc UNH Vishnu Lekraj QQQ 72,023 70.84 76 0.93 Narrow Medium 11.5 WellPoint Inc WLP Vishnu Lekraj QQQQ 24,673 82.53 100 0.83 Narrow Medium 9.0 Company Ticker Analyst Star Rating Market Cap Price Fair Value Price/FV Moat Uncertainty Rating Fwd P/E Kindred Healthcare, Inc. KND Michael Waterhouse QQQ 728 13.44 13 1.03 None Very High 8.0 7.2 20.2 Health Care Plans Fwd P/E Long-Term Care Facilities Healthcare Observer October 2013 53 Medical Care Companies Market Cap Price Fair Value Price/FV Moat Uncertainty Rating 644 14.01 13 1.08 Narrow High 17.8 QQ 12,443 58.53 50 1.17 Narrow Medium 11.5 Michael Waterhouse QQQ 19,894 32.72 32 1.02 Narrow Medium 9.8 HCA Michael Waterhouse QQQ 18,934 42.34 35 1.21 None Very High 10.7 Select Medical Holdings Corporation SEM Michael Waterhouse QQQ 1,151 8.24 9 0.92 None Very High 7.0 Tenet Healthcare Corp THC Michael Waterhouse VCA Antech, Inc. WOOF Debbie Wang QQQ 4,346 42.77 36 1.19 None Very High 11.9 QQQ 2,515 28.38 30 0.95 Narrow Medium 15.0 Tenet Healthcare Corp THC QQQ 4,084 40.19 36 1.12 None Very High 14.4 VCA Antech, Inc. WOOF Debbie Wang QQQ 2,516 28.39 30 0.95 Narrow Medium 17.3 Company Ticker Analyst Star Rating Market Cap Price Fair Value Price/FV Moat Uncertainty Rating Abbott Laboratories ABT Debbie Wang QQQQ 54,923 35.34 40 0.88 Narrow Low 13.5 Abiomed, Inc. ABMD Julie Stralow QQ 866 22.04 17 1.30 None High 50.5 Boston Scientific, Inc. BSX Debbie Wang QQ 15,765 11.74 8 1.47 Narrow High 22.9 Edwards Lifesciences Corporation EW Debbie Wang QQQ 7,939 70.71 78 0.91 Narrow High 18.8 Given Imaging, Ltd. GIVN Debbie Wang QQQ 586 18.50 18 1.03 Narrow High 20.8 Medtronic, Inc. MDT Debbie Wang QQQQ 53,863 54.00 60 0.90 Wide Medium 13.3 Nobel Biocare Holding AG NOBN Michael Waterhouse QQQ 1,708 13.80 13 1.06 Narrow Medium 25.1 Smith & Nephew PLC SNN Debbie Wang QQQ 11,190 62.33 61 1.02 Narrow Medium 42.2 Sonova Holding AG SOON Alex Morozov QQQ 7,699 114.70 109 1.05 Narrow Medium 21.6 St Jude Medical, Inc. STJ Debbie Wang QQQ 15,477 53.89 49 1.10 Wide Medium 13.3 Stryker Corporation SYK Debbie Wang QQQ 27,086 71.63 70 1.02 Wide Medium 15.3 Thoratec Corporation THOR Julie Stralow QQQ 2,152 37.40 34 1.10 None High 19.1 William Demant Holding A/S WDH Alex Morozov QQQ 30,138 516.50 466 1.11 Narrow Medium 19.8 Zimmer Holdings Inc ZMH Debbie Wang QQQ 14,159 83.51 80 1.04 Wide Medium 13.0 Thoratec Corporation THOR Julie Stralow QQQ 2,076 36.09 34 1.06 None High 20.8 William Demant Holding A/S WDH Alex Morozov QQQ 29,204 500.50 466 1.07 Narrow Medium 20.6 Zimmer Holdings Inc ZMH Debbie Wang QQQ 13,538 79.85 80 1.00 Wide Medium 13.9 Company Ticker Analyst Star Rating AMN Healthcare Services, Inc. AHS Vishnu Lekraj QQQ DaVita HealthCare Partners Inc DVA Michael Waterhouse Fresenius Medical Care AG & Co. KGaA FMS HCA Holdings Inc Michael Waterhouse Fwd P/E Medical Device Companies Fwd P/E Healthcare Observer October 2013 54 Medical Distribution Companies Market Cap Price Fair Value Price/FV QQ 14,369 62.23 47 Morningstar Analysts QQ 18,144 53.45 HSIC Michael Waterhouse QQQ MCK Morningstar Analysts QQ Owens & Minor, Inc. OMI Morningstar Analysts Patterson Companies, Inc. PDCO Michael Waterhouse Company Ticker Analyst Star Rating AmerisourceBergen Corp ABC Morningstar Analysts Cardinal Health Inc CAH Henry Schein, Inc. McKesson, Inc. Moat Uncertainty Rating 1.32 Narrow Medium 16.7 40 1.34 Narrow Medium 13.3 Fwd P/E 9,120 105.44 99 1.07 Wide Medium 18.4 30,181 132.01 100 1.32 Narrow Medium 15.6 Q 2,223 35.12 27 1.30 None Low 15.3 QQQ 4,338 41.20 39 1.06 Wide Medium 17.9 Moat Uncertainty Rating Medical Instruments & Supplies Companies Company Ticker Analyst Star Rating Market Cap Price Fair Value Price/FV Baxter International Inc. BAX Karen Andersen QQQQ 39,189 72.20 80 0.90 Wide Low 13.5 Becton Dickinson & Co BDX Alex Morozov QQQ 19,979 102.87 103 1.00 Narrow Low 15.5 C.R. Bard, Inc. BCR Debbie Wang QQ 9,506 120.10 107 1.12 Narrow Medium 16.5 CareFusion Corp CFN Michael Waterhouse QQQ 8,140 37.97 37 1.03 Narrow Medium 15.3 Coloplast COLOB Debbie Wang QQ 63,347 329.50 294 1.12 Narrow Medium 23.5 Cooper Companies COO Michael Waterhouse QQ 6,461 131.99 99 1.33 None High 17.8 Covidien PLC COV Alex Morozov QQQ 29,067 63.19 68 0.93 Wide Medium 14.8 DENTSPLY International, Inc. XRAY Michael Waterhouse QQ 6,305 44.31 39 1.14 Narrow Medium 16.4 Essilor International SA EI Michael Waterhouse QQ 17,835 83.06 67 1.24 Wide Medium 23.9 Hologic Inc HOLX Morningstar Analysts QQQQ 5,444 20.13 26 0.77 Narrow Medium 15.6 Illumina, Inc. ILMN Morningstar Analysts QQ 10,219 81.67 65 1.26 None High 37.7 Insulet Corporation PODD Debbie Wang QQ 2,054 37.75 27 1.40 None High Intuitive Surgical, Inc. ISRG Alex Morozov QQQ 14,692 369.98 400 0.92 Wide High 19.5 Mindray Medical International Limited MR Morningstar Analysts QQQ 4,994 42.53 42 1.01 None High 17.9 Varian Medical Systems, Inc. VAR Morningstar Analysts QQQ 8,138 75.59 78 0.97 Narrow Medium 16.2 Fwd P/E Healthcare Observer October 2013 55 Pharmaceutical Retailers Market Cap Price Fair Value Price/FV QQQ 73,456 59.80 62 Vishnu Lekraj QQQ 11,797 58.97 WAG Morningstar Analysts Q 52,911 Company Ticker Analyst Star Rating Sigma-Aldrich Corporation SIAL Morningstar Analysts QQQ Company Ticker Analyst Star Rating CVS Caremark Corp CVS Vishnu Lekraj Shoppers Drug Mart Corporation SC Walgreen Company Moat Uncertainty Rating 0.96 Wide Medium 13.4 61.54 0.96 None Medium 19.0 55.99 35 1.60 Narrow Medium 16.8 Market Cap Price Fair Value Price/FV Moat Uncertainty Rating 10,581 88.00 81 1.09 Narrow Medium Fwd P/E Specialty Chemical Retailers Fwd P/E 18.9