Investment Highlights

• We maintain Overweight stance on the healthcare sector. In this report, we focus on the pharmaceutical (pharma) industry against the backdrop of a spike in active pharmaceutical ingredient (API) prices globally, ongoing drug shortages and return of influenza (flu) cases in Malaysia, as well as stronger MYR against US$. Despite recent media reports of a spike in API prices in late-Dec 2022 which could pose some margin risks to Apex Healthcare (Apex) and Duopharma Biotech (Duopharma), we believe these pharma players will be able to pass on the higher raw material costs to their customers to cushion the earnings impact. In the near term, Apex and Duopharma are poised to benefit from persistent medication shortages and resurgence of flu cases in Malaysia. Meanwhile, Duopharma could gain from the continued strengthening of MYR against US$ since early Nov 2022.

• API prices increased in late Dec 2022…The relaxation of China’s zero-Covid policy in early-Dec 2022 led to the spike of Covid cases. Consequently, demand increased dramatically for flu-related medicines, which are used to treat viral symptoms like fever and coughing. On the supply side, there have been stringent controls on the purchase of flu-related drugs during the last 3 years, including the requirement that customers provide personal information and proof of infections. Due to these restrictions, Chinese pharmacies reduced inventory levels, while pharmaceutical companies slashed production amid stock expiry concerns. These controls were lifted in late-Nov 2022. Nevertheless, as a consequence of the earlier restrictions, China experienced severe drug shortages, leading to the Chinese government’s export restrictions on APIs. As a result, there was a 12%-25% price hike in lateDec 2022 in India, based on BQ Prime (Exhibit 1). China accounted for 40% of global API supply, according to Optima Insights.

• … but expected to ease in Feb/Mar 2023. Several regional governments have reinstated drug rationing as part of efforts to combat drug shortages (Exhibit 2). In addition, the Chinese government has pushed major pharmaceutical companies to produce at maximum capacity. Several media reports have led us to believe that drug shortages could ease within 1 or 2 months following Chinese New Year. However, we see some downside risks to the timeline given that the return of hundreds of millions of migrant workers for the Chinese New Year celebrations could spread the pandemic across the country.

• Pharmaceutical players can pass on higher costs. On average, APIs contribute 40% of medicine costs. The spike in API prices could have a negative impact to pharmaceutical players’ margins, as we believe that the majority of API inventories could be depleted by end-2022, given Duopharma’s 5-year average inventory turnover ratio of 2.2x annually. We believe the manufacturing division of Apex should have a similar turnover ratio. On a positive note, pharmaceutical players under our coverage have exhibited pricing power to pass on higher costs to customers by increasing product selling prices. This is underpinned by their sustainable gross profit margin (GPM) trajectory since 1Q2021 to 2Q2022 (Exhibit 3), despite API prices registering a consistent 3%-8% sequential increase over the same period, according to IIFL Securities’ API/KSM pricing Index. Notably, Malaysia does not implement any drug price control mechanism.

• Ongoing drug shortages increase manufacturers’ bargaining power. To recap, elevated flu cases coupled with Omicron becoming a community respiratory illness have led to drug shortages (mainly flu-related medicines) in Malaysia since the end of 1Q2022 (Exhibit 4). Despite the government releasing federal medicine stockpiles to private hospitals and clinics, drug inventories in the private sector remain tight in Jan 2023, such that drug distributors can only fulfil 30%-40% of pharmacies’ orders, according to Free Malaysia Today. Consistent drug shortages bode well for Duopharma and Apex, giving them leverage over pharmacies, private clinics and hospitals while passing on the potential increase in API prices. Furthermore, the return of Chinese tourists could raise demand for flu-related medicine in view of severe shortages in their own country.

• Flu cases in Malaysia on the rise again. According to data from World Health Organisation (WHO), the number of flu cases in Malaysia peaked in mid-Jul 2022, then steadily fell until mid-Oct 2022 and subsequently reversed to an uptrend again (Exhibit 5). This is in tandem with the trend of flu cases in the northern hemisphere (Exhibit 6). According to CodeBlue, the flu virus circulates year-round in Malaysia due to its tropical climate. While temperate countries in northern hemisphere typically experience flu season during the winter months (December to March), the flu season began since early-Oct in 2022. Hence, we believe the return of flu cases in Malaysia was largely imported via international travellers. According to a study from Journal of Travel Medicine, seasonal flu is one of the most prevalent infectious diseases among travellers. We believe this could exacerbate drug shortages and increase the bargaining leverage of pharma manufacturers.

• Further strengthening MYR boon to pharmaceuticals. As MYR has strengthened against US$ by 11%-12% since early Nov 2022, this will generally benefit pharma companies as almost all of their APIs are imported and denominated in US$. For companies under our coverage, we believe Duopharma will gain the most from this currency trend given that the majority (>90%) of the group’s sales are domestic. Based on our estimates, for every 10% strengthening of MYR against US$, Duopharma’s FY23F core earnings could increase by 13%-14%, assuming that 40% of Duopharma’s cost of goods sold (COGS) is denominated in US$, the company has no hedging arrangements and does not pass back lower costs to their customers. Separately, our latest checks reveal that Apex will be relatively neutral to such currency movements due to its higher export exposure from the group’s 40%-owned Straits Apex.

• Top pick is Duopharma (FV: RM1.89/share). We continue to like Duopharma as the largest local pharmaceutical manufacturer which can leverage on: (a) the rising take-up of generic drugs in Malaysia, (b) upcoming industry’s patent cliff in 2022-2026 and booming biosimilars with the company’s strength in R&D and state-of-art manufacturing facilities; and (c) ever-growing Vitamin C market with its popular brands, Champs and Flavettes. Furthermore, Duopharma holds a better position to ride on the higher government allocation (+11% YoY) to Ministry of Health (MoH) in 2023 and the addition of 5 public and 19 private hospitals over the next 3 years. In addition, ongoing drug shortages and rising flu cases in Malaysia, coupled with the strengthening MYR against US$ could boost near-term investor sentiments. In terms of valuation, Duopharma has a higher upside of 16% vs Apex’s (FV: RM3.73/share) 10%.

Source: AmInvest Research - 27 Jan 2023