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China’s unprecedented economic growth during the past decade has generated incredible wealth, but the country’s population is also demanding a higher standard of living. As the result, the government plans to spend some $124 billion over the next three years to provide accessible and affordable healthcare to the country’s 1.3 billion people.

Under the program, the government will expand the sponsored medical insurance network to cover 90% of the population. The universal healthcare account is expected to reach the entire population by the year 2011, with each person receiving an annual subsidy of around 120 yuan. Meanwhile, the government will also further regulate the industry as a whole.

Southern Medicine Economic Research Institute’s Tao Jianhong predicted that China’s healthcare reform would boost the market share of China’s top three drug manufacturers to 10% of the total market over the next few years. According to the institute, China’s top 100 drug manufacturers had sales of RMB246.9 billion in 2008 – up 26% from 2007.

All in all, China is expected to become the fifth largest pharmaceutical market by the year 2010, with pharmaceutical sales growing at a compounded annual growth rate of more than 15% between 2005 and 2010, according to Boston Consulting Group. Meanwhile, the elderly population will grow from 144 million in 2005 to 171 million by 2010.

Three Pharmaceutical Plays in China

Dragon Pharmaceuticals (DRUG)

Dragon Pharmaceuticals is a leading manufacturer of generic antibiotic products with strong relationships with global drug companies. Over the past four years, the company saw an EBITDA CAGR of 101% with proven products and solid manufacturing process. However, the company trades at just 7x last year’s earnings, despite this rapid growth.

Dragon Pharmaceutical’s leading product, clavulanic acid, prolongs the effectiveness of antibiotics like Amoxicillin by breaking the development of resistance. Meanwhile, its 7-ACA product is a key intermediate to produce more than 50 types of cephalosporin antibiotics. The company also has one early stage product and two promising new products in development.

Going forward, Dragon Pharmaceuticals plans to enhance its leadership position in clavulanic acid, develop downstream products to take advantage of industrial consolidation, and leverage its nationwide sales and marketing network to capture growth driven by healthcare reform. In the end, investors may see these actions lead to additional value being unlocked in its stock.

Lotus Pharmaceuticals (LTUS.OB)

Lotus Pharmaceuticals is a leading drug distributor in China, with four products that are covered by the National Health Insurance Program. The company has seen its sales grow at a CAGR of 59% over the past four years, with its gross margins more than doubling over the same time period. Still, the company trades at just 2.77x last year’s earnings, despite the growth.

Lotus saw its shares drop after revenues fell as part of a restructuring plan aimed at transitioning from retail to wholesale sales. Meanwhile, its balance sheet was impacted by a one-time hit to accounts receivables. However, the company’s quick ratio and cash position remain strong, while its turnaround plan appears to be showing signs of success.

Going forward, Lotus plans to continue developing the strong drugs in its pipeline, including one Class 1 drug, and should continue to see strong growth with many of its drugs covered by China’s health insurance programs. Given its cheap valuation, this is one stock that investors should watch going forward.

China Sky One Medical (OTCPK:CSKI)

China Sky One Medical is a leading developer of over-the-counter branded nutritional supplements and herb based pharmaceutical and medicinal products focused on Traditional Chinese Medicine (TCM). While not focused on hard pharmaceuticals, this type of medicine is extremely popular in China and around the world.

Last quarter, China Sky One Medical reported a 16.6% increase in net income on a 35.5% increase in sales to $32.2 million. Total revenues for the first half of 2009 increased 57.6% over sales a year ago thanks to expanded distribution channels and successful acquisitions. The company also reported $48.2 million in cash, $66 million in working capital, and no debt.

Going forward, China Sky One Medical will focus on increasing market share by strengthening and refining its sales and distribution network, building and enhancing their brand, and making strategic acquisitions that could support growth. Despite this strong growth and financial condition, however, the company continues to trade at just 7.8x earnings.

Disclosure: Author and company has no positions in companies mentioned.

Source: Three Beneficiaries of China's Healthcare Reform