CFA Institute Research Challenge

CFA Institute Research ChallengeHosted by Local Challenge Vietnam Team06 VIETNAM MARKET LEADER IN PHARMACEUTICAL DATE: NOV 23, 2012 PHARMACEUTICALS TICKER BLOOMBERG: DHG_VN HO CHI MINH S

CFA Institute Research Challenge

Hosted by Local Challenge (Vietnam)

Team06

VIETNAM MARKET LEADER IN PHARMACEUTICAL

DATE: NOV 23, 2012 PHARMACEUTICALS

TICKER BLOOMBERG: DHG_VN HO CHI MINH STOCK

Prime position thanks to economies-of-scale and long experience: DHG accounts for 5.1 percent

of the total market, 9.8 percent among domestic companies In addition, the company is on the top five leading pharmaceutical manufacturers

Functional foods - long-term strategy of DHG: The two functional foods, Spivital and Naturenz, have the highest growth rates among 11 main brands (75 percent and 52 percent respectively) This business line is expected to expand further and become the strategic sector of the company

Wide distribution network - key driver of success: DHG owns a valuable asset to help surpassing competitors Its branches are available all over the country, cover in 98 percent of state general hospitals

Debt-free balance sheet: DHG reduces financial risks by holding a low equity multiplier with no long-term debt Debt ratio stayed at one percent mostly assisting for cash needed in operation cycle

A strong cash fund also supports the company’s liabilities

Team 06 Student research

This report is published for educational purposes

only by students competing in the CFA Institute

Per share data

Earnings per share VND7,701

Increasing manufacturing capacity owing to new plant accomplishment:

The construction of the new plant in Tan Phu Thanh industrial park will be finished in 2013 After then output will increase successively and is expected to double by the year of 2017

Main risks to our target price are failure to gain back market share due to the increase in the level of competition in current market and the excess of supply over demand Other risks come from not being able to meet the planned capacity, volatility in exchange rates, and a stronger than expected increase in materials In addition, 43.4 percent of DHG’s equity belongs to the government while individual shareholders account for only 2.2 percent Investors should be aware of certain risks such as low liquidity and small floating

EV/EBITDA Multiple

Target price

FCFE

Relative P/B VND 63,500

VND 78,500

VND 85,500

VND 89,500

Relative P/E

Figure 2: DHG noble titles

Forbes Asia 200 Best Under A Million 2011

First – class Labor Medal by State President

Second – class Independence Medal by State President

Special awards for Annual Report in three successive years

Prestigious stock in Vietnam Stock Market in 2010 (04 successive years)

“Vietnam high quality product”

(16 successive years)

Source: Team’s estimateInvestment summary

We initiate coverage of DHG with an ADD rating and a target price of VND78,500, offering a 20 percentage-point upside from its current stock price DHG is currently the key player in Vietnam Pharmaceutical market with a CAGR of 18 percent during the last five years There was a decrease of five percentage points in gross profit margin from 2010 (50.1 percent) to 2011 (48.5 percent) due to the impact of material cost However, we forecast profit margin will rise again after 2013thanks to economies of scale of Tan Phu Thanh new plant and the efficient distribution network

Demographic factors in Vietnam such as population, urbanization and awareness

to improve living standard, etc have recently changed It spurs DHG’s expansion to meet the surging demand in the future Although pharmaceuticals are still dominant at 87.7 percent, functional food segment is expected to bring more and more profit and its proportion will go up to 16 percent in 2017.The new factory will start operating in Q2/2013 and reach full capacity in 2020 once the production will be double Sales are estimated to grow at the rate of 15 percent of CAGR over the next five years Consequently, CFO will also increase DHG is expected to obtain EBITDA CAGR of 14.3 percent and EPS CAGR of 13.5 percent during period of 2012-2017

Our target price of VND78,500 is based on the FCFE and multiple analysis Our FCFE model covers high growth stage and second stage value plus the terminal value of company After 2020, new company reach full capacity, terminal value

is based on EV/EBITDA We use the average of current EV/EBITDA ratio of 14peer companies, which have a similar market capitalization DHG forecasted EBITDA to derive enterprise value at the end of 2020 In our multiple analysis, the average multiple price is adopted to be DHG share price Weighs for FCFE and multiple analysis are 0.5 and 0.5 respectively

We rate DHG stock Medium risk Main risks related to the fluctuation of material price and exchange rate as well as the price control of the government could affect directly to the DHG’s operating margin

Business description

DHG Pharma - For a more beautiful and healthier life!

DHG Pharma is one of the five leading manufacturers (by value) of Vietnam pharmaceutical market.DHG has the highest revenue (VND2,490bn in 2011) among domestic competitors, accounting for 5.1 percent of the total Vietnamese pharmaceutical market and 9.8 percent among domestic companies The total revenue in the first three quarters of 2012 is VND2,025bn, or equivalent to 73.6 percent of this year target Its success relies on the expansive distribution network It is primarily engaged in producing generic drugs like antibiotics (contributing 43.1 percent to the company’s 2011 revenue), functional food such

as vitamins and cosmetics The company was honored in Top 200 Performing

Figure 1: Price system

Figure 3:

GMP: Good manufacturing Practice

GLP: Good Laboratory Practice

GSP: Good Storage Practice

Figure 4: Pharmerging markets definition

Emerging markets targeted by pharmaceutical companies

Pharmerging = [Pharm(aceutical) + (e)merging]

(Source: Schott’s Vocab)

Pharmerging Countries Developed Countries

Small and Medium Enterprises (SMEs) in the Asia-Pacific region by Forbes Magazine in 2011

Established in 1974, DHG was formerly a state-owned enterprise DHG Pharmaceutical Joint-stock Company was officially operated in 2004 with the initial charter capital of VND80bn Company held its Initial Public Offering (IPO) in December 2006 DHG has a modern and integrated factory system meeting WHO-GMP/GLP/GSP standards with the total production capacity of 4.1 billion units in 2011

The new factory under construction in Tan Phu Thanh Industrial Park will start operating in 2013 It is expected to double the company’s capacity in 2017, helping DHG meet the increasing domestic pharmaceutical demand DHG is alsoboosting production of functional food, which is planned to contribute 15 percent of total DHG's revenues in 2017

Industry overview and competitive positioning Solid foundation for further growth

In 2011, the total value of Vietnam pharmaceutical market reached USD2.4bn, ranked as Third Tier: “Fast Followers”, which have good opportunities for growth According to IMS Health, CAGR of the Vietnam pharmaceutical industry will be 16.5 percent for the period of 2012-2015 and the market value isestimated to reach USD3.5bn in 2015

Strong boost from swelling demand

Being essential goods, demand for pharmaceutical products is inelastic As a result, expenditure on healthcare is not affected much by the fluctuation of economic factors Furthermore, demand for pharmaceuticals is growing rapidly, fueled by demographic changes, expanding economies, and government initiatives In 2010, Vietnam total healthcare expenses per capita were USD83, four fold increasing compared to USD21 in 2000

As an emerging economy, Vietnamese people's healthcare expenditure is far behind the numbers of developed countries (Appendix 6) However, while growth in the major developed markets has continued to slow down from the beginning of this century, healthcare expenses per capita in Vietnam has been growing at an impressive rate of 15 percent per year in the same period This illustrates the promising prospect of Vietnam's pharmaceutical industry in the coming years

Demand climb’s motivation in expanding production

To meet increasing pharmaceutical need, the pharmaceutical industry has boosted total output with a jump by 24 percent from 2010 to 2011 Along with improving the total output, pharmaceutical companies have also diversified products porfolio In recent drugs registration phases, there are now over 2,000 new registered medicines, compared to just 700 in the year 2003 Due to a considerable amount of capital accumulated through soaring consuming output, domestic enterprises can concentrate on expanding investment to upgrade production capacity

Heavy reliance on imported materials, mainly from China

At present, 80 percent of materials are imported, dropped by ten percent in

2008 China is the largest producer (15 percent of global market share) of penicillin, cephalexin and its derivatives, which are Active Principle Ingredients (API) for antibiotics Antibiotics accounts for 60 percent of Vietnam

pharmaceutical industry’s total revenue As a result, API’s prices in China have major influence on Vietnam’s price

Until now, just few domestic manufacturers have been able to sign long–term contracts with their suppliers Moreover, materials account for over 50 percent of

Figure 5: CAGR of total health expenditure per

capita 2000-2010

Source: WHO

Figure 6: Main imported materials suppliers

Inner: 2010 Outer: 2011Source: Vietnam Customs

cost of goods sold (COGS), so gross profit depends significantly on material’s price

Complex and unstructured distribution network

The success of distribution system network relies on personal relationships between medical sales representatives and doctors, hospital directors, pharmacist, etc All the domestic companies currently have developed a strong network of medical sales representatives Each of them plays an important role

in approaching doctors, hospitals, pharmacies Sales representative is the key driver to make a strong distribution network Counting on well-known international brands and good product quality, multinational companies can compete equally to domestic ones

Strategies of multinational and domestic companies in distribution (Appendix 7)

Multinational companies rely on advantages of strong brand name and high–tech products that are not produced in Vietnam They do

not have to spend much on commission cost for hospitals, doctors, and pharmacies As a result, the commission cost, mostly

lobbying cost represents only five to six percent of their total revenue in Vietnam

As all domestic pharmaceutical manufacturers produce similar kinds of medicines, they have to build strong relationship with

interlocutors to persuade hospitals and doctors to prescribe their drugs Therefore, selling expenses can grow up to 30 percent of the

total revenue

Growing trend in M&A

M&A has been blooming in Vietnamese pharmaceutical industry in recent years with many remarkable successful deals This proves that the industry in general

is perceived to be currently performing well and has an inviting prospect

Table 2: Vietnamese pharmaceutical M&A transaction

before M&A

AfterM&A

Value

CFR International

TRAPHACO (Vietnam) Dak Lak Pharma 0% 24.5% VND7,930mn

Fortis HealthCare (India) Hoan My

estimate

Government regulation from legal instrumentPrice control policy

There are many loopholes in the pharmaceutical price control code and its practice, so drug prices are not well-regulated Since retail

prices are not allowed to exceed registered prices, some firms initially register at high prices to leave room for increases afterward

Consequently, it is difficult for government to administer the exact prices, leading to prices manipulation Moreover, bidding process

for prescription drugs in hospitals is not transparently controlled, resulting in harsh competition among pharmaceutical companies

Barriers to multinational corporations

Figure 7: Number of sales representatives

Source: Company data

Table 3: Target market share of domestic

companies

Source: Vietnam Customs

Figure 8: Prescription and OTC sales forecast

Imported drugs have no choice but to go through a local distributor to reach consumers Multinational companies are usually present at Vietnam as representative offices, thus cannot sell directly their products Nonetheless, theserestrictions have to be gradually lifted in the process of opening the market according to WTO’s guideline The government is aiming to raise the proportion

of domestic drugs in total drug expenditure to 80 percent in 2020 However, unless there are more policies supportive towards domestic companies, it is not feasible to achieve this figure

Drugs market forecast to 2015Prescriptions pass over – the – counter (OTC) medicines

The growth of the prescription medicines market will outpace the OTCs’ one, mainly due to the influx of expensive patented products from abroad and increasing demand for sophisticated drugs Prescription medicines will be worthUSD2.6bn by 2015 with a CAGR of 16.9 percent In percentage terms, prescription drugs will account for 74.2 percent of the total market

Patient expirations help generic companies

Since 2001, more than USD126bn in brand sales all around the world has lost patent protection Many of the soon-to-be expired patents belong to drugs for symptoms such as diabetes, cancers, high blood pressure, etc., which are common in Vietnam (Appendix 9) In the next five years (2012-2016), an additional USD96.5bn in brand drugs annual sales is at risk of losing patent protection to the hands of generics competitors

Generics probably continue to dominate Vietnamese market in terms of volume The forecasted value is USD1.8bn in 2015, or 6.4 percentage-point increase in the total market compared with 2010

Competitive landscape: challenge for domestic pharmaceutical company

The transference of market share to hands of multinational competitors

Imported drugs take up over 50 percent of the total medicine consumption of the Vietnamese pharmaceutical market Foreign brands will maintain their market position in the coming years, due to rising demand for sophisticated

pharmaceutical products which are studied and manufactured abroad The EU is the main partner with 45 percent (USD557mn) of the market, followed by India, South Korea and ASEAN bloc

In self-manufactured medicines sector, domestic manufacturers are losing their market share due to drawbacks in capital budget, technique, R&D activities, manufacturing capacity, etc Eight out of ten top pharmaceutical companies in the domestic market are multinational corporations The government has planned to have domestic output meet 70 percent of domestic demand by 2015 This plan seems impractical as over a haft of the market belongs to multinational firms

Domestic competitors: diversified competing strategies

The rising of foreign competitors has narrowed the competitive territory of domestic ones, forced them to seek for opportunities in various segments

• Traditional medicines: Domestic manufacturers can exploit domestic diversified natural resources (more than 4,000 herbal plants) to inflate its domestic drug-manufacturing sector With a shift in demand towards herbal medicines, the market for this segment can be enlarged There are 80 herbal drugs manufacturers, among them key players are Traphaco in the Northern market and OPC in the Southern one Resemblance in products portfolio and prices leads to severe competition in this segment

• Generics are typical of pharmaceutical manufacturing in Vietnam To make different, domestic companies are penetrating into different market segments For instance, Imexpharm targets at treatment channel while Domesco focuses onprescription drugs 50 percent of Imexpharm’s total revenue is gained from treatment channel A majority of generic products manufactured by domestic companies are for common diseases treatment Meanwhile, Domesco’s key

Legend: Source: Team’s estimate = lowest, = highest

Figure 11: Imports worldwide 2011

Figure 13:

Imported materials

R&D activities Building product lines Marketing staff

and distribution network

DHG’s operations (Particular value chain of Vietnam pharmaceutical industry) Global pharmaceutical value chain

products are sophisticated drugs for diabetes and heart problems (accounting for

30 percent of total revenue)

Research and development: simple and unexploited

Research and Development activities of domestic pharmaceutical companies are very simple They just add some ingredients such as excipients (non-active ingredients) into the formulas to make new medicines The total spending for R&D accounts for only six percent of the total revenue in 2011 This proportion

is much less than the average one of the world (12-16 percent)

Due to lack of high technology and interest in R&D, domestic enterprises’

products do not have any differences from the others

Company analysis The peak position of DHG on its developing path

With over 35 years of experience, DHG is always maintaining its prime position

in top five leading pharmaceutical companies (Appendix 8) However, DHG’s market share has been gradually lessened in recent years, partly due to multinational companies’ penetration While healthcare demand is still on the rise, DHG’s goods sold ratio dropped from 87 percent in 2006 to 64 percent in

2011 In addition, the company’s revenue growth rate also experienced a 35 percentage-point decrease during the period of 2006-2011 On the other hand, there is a shift in demand towards functional food and herbal medicines

Therefore, taking advantage of economies-of-scale, DHG is expanding its production, especially functional food sector to recover its market share

The value chain

Currently DHG is operating in three bottom phases of the global pharmaceutical value chain: Formularization, Manufacturing, Marketing and Distribution Like many other domestic manufacturers, DHG spends on imported materials instead

of doing research and manufacturing active ingredients itself

New plant improves manufacturing capacity

Currently, DHG has a production capacity of 4.1billion units, with five workshops, operating at full utilization rate Since 2009, DHG has to take inconsistent ways to raise output such as outsourcing or building small factories

The company needs new plants to take advantage of economies-of-scale and newtechnologies to operate more efficient Since this new plant will double the output capacity, DHG will have enough production room for growth in the following years as well as expand its products portfolio We believe DHG can take advantage of efficient distribution system to sell out extra produced goods

After 2013, total revenue will sustain at 17.1 percent of annual growth and reach VND4,760bn in 2016

DHG’s business today1

DHG competes in three main lines of business: prescription medications, OTC medications, materials and exports trading

1 The “revenue” in this part is revenue from self-manufactured products

Source: EU Economic and Commercial Counselors

Figure 12: Revenue (VNDbn) and growth rate

Source: Company data

The pharmaceutical value chain

Active ingredient Manufacturing Marketing and distribution

Source: Jaccar

Figure 14: Sales structure of DHG 2011

2006 to 43.1 percent in 2011 However, this is offset by increasing contribution

to revenue of other prescription categories such as central nervous system, cardio-vascular, muscular skeletal and sensory organs

OTC sales

DHG’s OTCs growth is estimated at 22.1 percent per annum (2006-2011) Pain and fever relief medicines still make up a large proportion of the company’s revenue However, the number dropped from 17.7 percent in 2006 to 13.8 percent in 2011 In this segment, DHG’s cash cow is Hapacol, which generated 18.8 percent of the total revenue

Ear, nose and throat medicines (ENT) contribute 16.7 percent of revenue in

2011, generating 31.2 percent more revenue than the previous year The poor environment condition is the key factor for the growing sales in this segment In

2011, Eugica, the rising star of DHG, generated VND183bn, 53 percent higher than the previous year

DHG’s functional food gained VND144bn, contributing 7.1 percent revenue in 2011.This segment is considered the young today but the potential tomorrow, as standards of living have risen together with people’s awareness of healthcare Spivital and Naturenz have grown 75 percent and 52 percent respectively in sales Along with Natto Enzym, which has been launched recently, the three brands are expected to lift up the proportion of revenue of functional food to 15 percent in 2017

After launched in 2008, cosmetic products have not shown much impression, theproportion of revenue dropped from 0.42 percent in 2009 to 0.05 percent in

2011

Exports sales

Revenue from export of the company reached VND27bn, increased by 27 percent from 2011 However, this only makes up a small proportion of the total revenue (1.1 percent) DHG has traded with 15 countries and will expand its foreign market in the next few years

Distribution system: the key to DHG’s successPrescription drugs: Tough market

This sector accounts for 20 percent of total distribution system DHG directly traded with 98 percent of state general hospitals There are over 100 hospitals having trusted and used DHG’s products with the turnover of VND355bn, accounting for 24 percent of general revenue Having a wide coverage of state general hospitals system, however, DHG has faced a strong competition from foreign brands with better quality, diversified products portfolio and strong commission

OTC drugs: Strong development by having a good commercial distribution system

DHG owns a strong distribution network in terms of both sales-point coverage and control over its channel’s end-retailers DHG owns the largest sales system

of Vietnamese pharmaceutical industry which presents at 64/64 provinces with nine subsidiaries, 28 branches and 67 drugstores at hospitals The nationwide network, supported by 946 salespersons, has distributed for more than 20,000 customers (with 9,428 loyal customers) The advantage of wide distribution network helps DHG decrease selling expenses This exceptional partnership is the value of DHG and the reason of future growth

Source: Company data

VND2,491mn

Figure 16: Geographical sales in

2011

Geographical distribution: Being expanding its network into suburban and rural areas

The first-tier cities like Hanoi and HCM City are famous for the biggest markets, the strongest demand and the most suitable places

to launch new products Although these cities account for only 14 percent of the total population, they record 20 percent of total drugs sales The three largest multi-national companies - Sanofi-Aventis, GSK, and Novartis, have a combined market share of over

42 percent of this region Furthermore, some others exclusively concentrate on Hanoi and HCM City

DHG’s management has followed strategies to avoid competing head-on with big pharmacies The company is expanding their subsidiaries and distribution channels to new markets such as rural and suburban regions, specifically in the North and in the Central regions, the Mekong Delta – where consumer revenue contributes 36 percent of the company’s total revenue in 2010 Furthermore, end – users in Mekong Delta are the low – mid income, and they are the target customers of almost DHG products

Distribution subsidiaries system: the most important key to company’s success

DHG has nine distribution subsidiaries, which are almost in Mekong Delta In

2012, DHG passed the guideline to establish three more distribution subsidiaries:

BT pharma, VL pharma, VLP pharma This is an efficient strategy to take advantage of association of significant retails drugstores to make a new subsidiary DHG has been spending capital expenditure on buying plants, buyinghouses for branches and subsidiaries As a result, DHG has its own stable distribution system

Major imported materials supply from EU and USA

Like other domestic companies, 80 percent of materials are imported However,most of DHG’s materials are imported from EU and USA, having higher quality than China, especially API for antibiotics DHG uses semi-synthetic penicillin from EU, which has more resistance to new kinds of bacteria than naturally penicillin (produced by fermentation) from China DHG has built wide network

of reliable suppliers to ensure production, signed annual contracts in large quantity around six months of inventories and up to nine months if the quality is high With each kind of material, DHG sets up contracts with three different suppliers

Ownership structureThe state remains as the main shareholder

The government, represented by SCIC, is still the major owner of DHG with 43.4 percent of its equity Only 2.2 percent of the company’s equity currently belongs to individual shareholders, while there is no more room for foreign investors Hence, there are only limited shares of DHG traded freely on the market, leading to low liquidity, small floating and minor price fluctuation of its stock On a related note, investment funds just acquire DHG’s stocks because of financial purposes, without any intention to enter the management board

Experienced management with a chairwoman

Ms Pham Thi Viet Nga, a very strong and business oriented woman, is currentlythe president of DHG, the chairwoman of the Directors Board of Vinh Hao algaesubsidiary With over 32 years of attachment to and management of DHG, she has led DHG to become one of the largest enterprises in pharmaceutical industry.DHG’s revenue in 1988 when she started to take over DHG was just

VND895mn At the end of the year 2011, DHG had the total assets of VND1,996bn with nine subsidiaries and 2,629 employees Moreover, Ms Nga can rely on a dedicated and experienced management team who has been with the company since its inception The two notable people are two vice-presidents:

Ms Le Minh Hong and Mr Le Chanh Dao who have long-term attachment to DHG for 33 and 23 years respectively However, as Ms Nga is on the verge of retirement, there are many concerns whether a suitable replacement can be found On the other hand, we believe that she will stay on top of the company for

at least two to three years

However, there is no independent director in Board of Directors as well as in Board of Supervisors All members of these boards hold shares of DHG with the total proportion of insiders’ shares of 0.9 percent This can lead to the imbalance

Source : Company data

Table 4: Domestic companies’ distribution

network

Source: Company data

Table 5: DHG’s imported material

suppliers

Material Application Imported from

Amoxicillin Antibiotics Spain

Cefadroxil Antibiotics Spain

Cefalexin Antibiotics Spain

Acetylcystein ENT-Asthma- Corazy Italy

Lactose

monohydrate Diabetes

NetherlandMannitol Cardio-vascular France

Sorbitol

P20/60 P60W Digestive France

Metformint Diabetes Norway

Source: Company data

Figure 17: Ownership structure

Source: Company data

Figure 18: Revenue structure

(VNDbn)

between benefits of shareholders and the company itself in each business decision.

Financial analysis New plant brings a sustainale development for DHG

DHG is the largest domestic pharmaceutical company in Vietnam The company

is already operating at its maximum capacity amid growing demand In recent years, suitable pricing policy has helped to keep its total revenue surging at a high pace of 19 percent in CAGR Since this new plant will double the output capacity, DHG will have enough production room for growth in the following years as well as expand its products portfolio After 2013, total revenue annual growth will remain at 17.1 percent, and reach VND4,760bn in 2016

Profit margins decrease due to aggressive competition while material costs escalate

Like other Vietnam companies, DHG depends heavily on imported materials, of which prices have volatized drastically in recent years Consequently, cost of goods sold surged 85 percent in the last four years, a 1.3 time higher than sales growth Formerly, the company can prevent negative effects by using pricing policy; however, the government has tightened it to control inflation Strong competition also prevents DHG from raising the price Net profit margin and gross margin dropped 4.4 and 4.1 percentage points respectively from 2009.Despite downward trend, these ratios of DHG are still surpassing its competitors

We keep a positive outlook for DHG margins due to improvement in economies

of scale with the new factory Stronger bargaining power with suppliers is also a driver for lower and stable material cost Impressive management policy also helped to lower selling costs from 35 percent of sales to 22.4 percent in 2011 Furthermore, adapting Enterprise Resource Planning (ERP) system in Q2/2012 will definitely reduce Selling, General and Administrative expenses (SG&A) in order to sustain net profit margin

Table 6: Profitability ratios

Cash is king and

DHG has it

The Capex for the two

coming years is VND650bn,

whose majority is invested

in the under construction plant With VND600bn of cash accumulated, internally generated funds is sufficient to cover this amount Investment in fixed asset made FCF decrease in 2010 and 2011 After 2013, thanks to sales expansion and reduction in Capex, DHG’s FCF will rise sharply to VND570bn in 2016

Instead of short-term investment, DHG tends to distribute its cash As a result, cash dividend in 2011 went up to VND260bn, three times higher than that in

2010 Combining with VND256bn invested in Capex, they made net cash flow negative This does not cause too many harmful effects because DHG has an abundant cash fund We forecast the company’s payout ratio will maintain at 25 percent of face value after launching new factory and sales continue to grow This is a significant strong point compared to current poor performance of Vietnamese companies

Considerable surge of unsold finished goods

DHG may be having troubles with selling its products, as finished goods have been built up considerably in its storage since 2007 It is unlikely that this situation is due to seasonal reasons (as reported by the company), as the increasing trend repeated throughout the quarters In our calculation, finished goods compound quarterly growth rate (CQGR) stands at 9.1 percent, two times faster than 4.1 percent of sales Consequently, the ratio of goods sold on total output fell sharply Unsold finished goods capture the company’s working capital needed for operating cycle, leading to the possibility of relying on loans

Source: Team’s estimate

Figure 19: Capex, FCF, Cash ratio

Table 10: EV/EBITDA

to stay liquid It also brings about doubts in selling capacity while output will rise significantly after 2014 According to DHG, there will be 85 percent of total sales coming from pharmaceuticals This is a sector with very low comparative advantages especially after the accession in WTO of Vietnam We forecast amount of goods sold on total output will be hard to improve and keep standing

at 65 percent

Debt-free balance sheet

Cash disbursement for new plant will push down current ratio and quick ratio next year, even lower than overall industry in 2013 Since quick ratio is standing

at only 1.4x, any considerable change in inventory like 2011 will lead to direct troubles in liquidity of DHG Net income might be affected by higher financial cost from bank’s loans which aims to sustain liquidity and compensate for cash captured in finished products and materials

DHG reduces financial costs by holding a sound financial structure with no term debt Debt ratio stayed at one percent mostly assisting for cash needed in operation cycle This is a great advantage of DHG when interest rate is still very high in Vietnam Table 8: Key ratios

long-2010 2011 3Q2012 2012E 2013F Industry 2011 Liquidity

Efficiency

Inventories turnover 3.1x 3.0x 2.6x 2.6x 2.7x 2.9xDays sales outstanding (days) 50 47 45 49 51 63Total asset turnover 1.2x 1.3x 0.9x 1.2x 1.0x 1.5xCash conversion cycle (days) 140 144 166 162 163 175

Profitability

Valuation

Our valuation is purely based on DHG’s core business, not taking to account for any extra-ordinary earnings from selling one of its

cough medicine brands, Eugica, that may be finalized this year

Discounted-cash flow approach: free cash flow to Equity (FCFE)

This method is suitable for DHG, since the company has stable capital structure with low debt Revenue growth is driven by clear uptrend of the industry and remarkably high growth prospect of DHG The base price from this model is VND84,493 We estimate this price based on the following assumptions:

In parallel with the increase of medicine expenditure per capita, CAGR of sales

is expected to be 15 percent in the next five years

High growth stage

This period covers the next five years with high growth rate between 15-20 percent Expected sales are broken down into three main sectors, including pharmaceuticals, functional foods, and cosmetics

Pharmaceuticals sector could enjoy stable growth of 13 percent on average

dominate in terms of volume However, severe competition with foreign competitors will lower DHG’s growth rate

Source: Company data

Table 7: Goods sold ratio

Table 9: Cost of equity (Appendix

Source: Team’s estimate

Table 13: Weighted valuation

Sales from functional foods are expected to grow dramatically at 36 percent

goods will reach 14.1 percent in 2017

proportion of cosmetics at 0.002 percent

Second stage

We assume that new factory of DHG almost reach full capacity in the period of 2018-2020 The growth rate will slow down and we expect the output will be double to current one

Terminal stage

We use EV/EBITDA to calculate the terminal value at the end of 2020 through alist of worldwide companies that have similar characteristics as DHG The present value of DHG terminal EV is estimated to be VND2,125bn

Stable structure of SG&A

Applying the ERP system helps integrate internal and external management information across the entire company This enables DHG to keep its SG&A expense at an appropriate level

Decreasing net income due to increasing tax rate

In recent years, DHG is enjoying an incentive tax rate leading to the fact that its tax expense is just approximately 13 percent of pretax income This policy is returning to the normal level after 2013 The new factory continues to enjoy preferable tax for 15 years (Appendix 11)

Valuation summaryTable 12: (VNDmn) High growth

NOPAT 397,335 472,219 503,952 555,937 652,346 769,028 883,48Capex 256,260 300,000 350,000 120,000 100,000 100,000 100,00Non-cash WC

change 161,777 66,255 61,968 147,926 198,571 205,693 213,69FCFF 26,583 190,089 204,790 412,070 485,464 605,087 721,75FCFE 59,063 293,341 232,086 509,539 590,308 736,526 857,36

PV of FCFE 293,341 199,626 376,976 375,650 403,144 403,65

PV of FCF from

PV of terminal value of relative method 2,125,206Total PV of FCFE 4,993,066Cash and cash

Value of equity per shares (2012) 84,493VND

Peer valuation

We pick up a list of 14 peers which have the same market capitalization and products portfolio (Appendix 12) We evaluate DHG’s share price based on three multiples: EV/EBITDA, P/B and P/E The price we obtain for DHG is VND78,500

Source: Team’s estimate

Figure 20: Exchange rate fluctuation

Source: Bloomberg & SBV

Since we concern more about how the market valuates the stock price, the target price and weight are given in table 14 The weighted target price is VND78,500-upside 20 percent Our recommendation is ADD (Appendix 13)

Risk analysis Strategic risks

Tougher competition Full WTO membership will create a severe competition between DHG and foreign brands, while domestic companies with similar activities and products have never been minor threats This may cause severe reductions in sales and market share Nonetheless, we believe that DHG can neutralize these problems, as its signature expansive distribution system cannot

be mimicked by foreign competitors in one day or two, while there is still a relatively big gap between the brands of DHG and the rest of domestic companies

Overstock The ratio of goods sold on total produced has fallen considerably from 93 percent in 2008 to 64 percent in 2011 Unsold finished goods are also onthe rise Meanwhile, the company is constructing a new factory to raise its capacity If sales keep lagging behind production output, this can harm DHG’s expected sales and net income DHG should do market research carefully to avoid this problem

Financial risksExchange rates volatility As 80 percent of DHG’s materials are imported, exchange rates volatility will have a great impact on its COGS Moreover, the company’s USD supply is very limited since its export activities are

underdeveloped According to the company’s calculation, in 2011, an 8 percent weakening of VND against USD would have taken away VND4.6bn from its netprofit However, DHG has been hedging this risk by signing contracts to transferparts of the risk to its partner banks In addition, VND’s value has been stable in

2012 due to efforts of the SBV

Operation risksHigher input costs Raw materials, whose prices have been widely volatile in recent years, weigh for about 55 percent of DHG’s total production and business costs (Appendix 14) Price of medicines, however, is under strict control of the government, so it may not be easy to pass the higher input costs to customers Nevertheless, given the size of its storage system, the company can keep enough materials in storage to operate during rough times DHG also aims to improve the efficiency of its production procedure to cut unnecessary wastage in production

Non-compliant suppliers Almost all input factors of DHG’s production chain

is from outside suppliers, so a problem in this stage may have negative effects onthe continuity of its activities DHG has been building up a reliable supplier network to defend against this risk

Regulation risk DHG pharma operates in a highly regulated industry Companies have to satisfy mandatory requirements about Good Practice standards, as well as price control policies

AppendixAppendix 1: Balance sheet (VNDbn)

Cash & near cash items 467,084 602,558 513,908 579,951 866,715 1,201,545 1,656,329 2,111,199

Accounts & notes receivable 338,733 394,448 388,910 418,935 490,824 586,541 685,983 788,926 Inventories 514,191 603,883 532,799 574,650 674,275 809,035 948,247 1,093,358 Other current assets 170,683 161,093 185,027 199,312 233,513 279,052 326,362 375,338

Net fixed assets 455,602 493,772 864,823 1,185,637 1,295,630 1,387,291 1,478,952 1,570,613 Gross fixed assets 643,502 718,009 943,502 1,293,502 1,413,502 1,513,502 1,613,502 1,713,502 Accumulated depreciation 187,900 224,237 266,579 374,445 492,317 618,528 753,079 895,968 Other long-term assets 49,412 46,804 49,412 49,412 49,412 49,412 49,412 49,412

Accounts payable 123,619 102,173 126,148 136,056 159,644 191,550 224,511 258,868 Short-term borrowings 21,116 17,658 52,410 47,843 63,384 56,384 73,138 91,649 Other short-term liabilities 399,290 485,473 476,693 513,496 601,611 718,933 840,820 966,999

Other long-term liabilities 58,224 57,276 58,224 58,224 58,224 58,224 58,224 58,224

Total liabilities & equity 1,995,707 2,302,558 2,534,880 3,007,898 3,610,369 4,312,876 5,145,286 5,988,846

Source: Team’s estimate

Appendix 2: Income statement (VNDbn)