The healthcare companies grew their net profits in several ways in 1H2017: 1) M&A;2) ramp-up of existing key products via expanding hospital coverage and enhancedmarketing; 3) economies of scale to improve the gross margin; and 4) opex control.    The 1H2017 results of upstream drug manufacturers varied, with some deliveringsolid results and others not. There were both industry-wide and company-specificproblems that prevented some drug manufacturers from meeting marketexpectations. Distributors reported bottom-line growth that was generally in line withexpectations, mainly because of opex control and margin improvement. The poorresults of downstream hospitals confirmed our gloomy view of the sub-sector in thenext 1-2 years. Overall, we continue to prefer leading players with visible highgrowth and attractive valuation. Our conviction calls for 2H2017 are HEC [1558.HK;BUY] and CTCM [0570.HK; BUY].    1Varied drug manufacturer results: In 1H2017 the results of drug manufacturersvaried considerably. The leading manufacturers with exclusive innovative drugsmaintained strong growth. For example, CSPC’s [1093.HK] NBP injection (for stroke)recorded 41% YoY growth, and its oncology drugs grew 74% YoY, CMS’s [867.HK]Plendil (for hypertension) ended its revenue downward trend, and 3SBio’s [1530.HK]TPIAO reported strong growth of 21.5% YoY. Some companies delivered weaker-than-expected results, manly due to a slowdown in sales of their existing products. Butthere were also industry-wide factors that were responsible for the slowdown, such astender price cuts, channel destocking caused by two-invoice system execution, andpublic hospital reforms, which are likely to put pressure on terminal sales. There werealso company-specific problems, including 1) channel inventory destocking due to poorshipment management (such as Luye’s Lipusu and TUL’s recombinant human insulin);and 2) sales team structure changes, such as 3SBio’s Yisaipu team. Going forward,we expect industry-wide negative factors to continue to put pressure onmanufacturers, while some company-specific issues may be relieved, and related coreproducts are expected to recover growth (3SBio’s Yisaipu and TUL’s recombinanthuman insulin). The major positives for leading pharmaceutical manufacturers in2H2017 will be 1) execution of the 2017 version of NRDL in each province starting inSeptember 2017; 2) a potential announcement on the national medical reimbursementpolicy, which is expected to call for more precise usage of the medical insurance fundfor clinically indispensable and therapeutic drugs; and 3) the launch of new drugs(company pipelines, mainly in the oncology, CCV and diabetes fields).    M&A trend to boost growth: We note that some companies reported strong growththrough the consolidation of acquired business: for example, 3SBio (Yisaipu, GLP-1),Luye Pharm [2186.HK] (consolidated Acino’s central nervous system business) andCMS (consolidated Plendil). Overall we expect the prevailing trend of local drugmanufacturers’ acquiring products from international companies in order to 1) boostgrowth, 2) enrich their product portfolio, and 3) provide access to the internationalmarket to continue for the foreseeable future, given the stringent healthcare industryenvironment in China. From this angle, companies with a relatively low-geared balancesheet, such as HEC, CMS and SinoPharm [1099.HK], may have an advantage.

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