According to Xinhua news on 23 July, since the implementation of new medical reform for Beijing in early 2017, the hospitals and medical clinics in China’s capital have diagnosed and treated over 60m patients. At the same time, it has already saved the country RMB35m each day compared to last year’s figure. This included the saving of drug procurement cost of RMB1.4bn, with Class III and II (the country’s highest grade) hospital revenue derived from drug sales reduced to 34% of total from 42% on average in previous years. The market expects this will save as much as RMB3bn annually on medicine procurement cost. Overall, the drug selling price in Beijing has been cut 8% y-o-y in 1H17.    On an interview by Sina News (dated 6 Aug) with an official of Beijing Municipal Commission of Health and Family Planning (北京市卫计委), the long-awaited “Hierarchical Medical System (分级诊疗)” has started to be effective, with Class III and II hospitals’ outpatient usage reduced by 13% and 5% y-o-y from 8 April to 5 July. Over the same period, its outpatient usage of Class I hospitals and some grass-root medical clinics has risen by a combined 9% y-o-y. Note that, within Class III hospitals, the outpatient visits to deputy physician-in-charge, chief physician in residence, and specialist doctors have also been cut by 10%/23%/15% y-o-y respectively. In particular to patients with chronic diseases, some visits are clearly diverted to lower-cost community clinics or other lower-grade hospitals.    On this revamp, each patient with more complicated illness would generate at least RMB200 per diagnosis or treatment to hospitals, compared to a patient with chronic disease paying RMB10 - RMB20 per visit. Note that, Beijing was ranked #2 of 2016’s total drug sales among 31 provinces, making up 8.3% of China’s total.    We believe that the success of Hierarchical Medical System to allocate patients by severity of illness increases the Class III/ II hospital efficiency to treat patient with complicated cases, without significantly lowering their hospital revenue from reduced patient numbers with chronic disease or other simpler cases. As we flagged in our 18 April 2017 note, the current medical reform is consistent with the government’s long-term policy, targeting to save up its unnecessary spending on reimbursement to patients. This includes (1) stripping out big mark-up for hospital drug sales to patients; (2) curbing over-prescription of high priced drugs; and (3) controlling of reimbursement of patient’s medical cost (for example, drug cost). The reform has already involved: (1) zero mark-up for western drug/ certain Chinese medicines sales to patients; (2) further price cut on negotiation post tender biddings; (3) “Two Invoice System” to remove layers of distributors; and (4) smaller drug tender sizes on control of reimbursement to patient’s medical cost.    Stock impact: We continue to see the longer-term policy winner would be Chinese medicine formula granule (CCFG) producer, HK-listed China TCM (570.HK, BUY, TP:HKD5.80), on its CCFG enjoying the 25% mark-up for hospital sales to patients until 2030 versus zero mark-up for other medicines. Its CCFG profit is forecast to make up over 70%/74% of China TCM’s FY17F-18F earnings (FY16: 76%). Instead of having hospital revenue derived from drug sales, we expect to have more and higher charges for surgical operations in China hospitals, likely to benefit (1) Microport (853.HK, NR) - China’s leading heart stent and device producers; and (2) LifeTech Scientific Corp (1302.HK, NR) - China’s leading heart valves producers with other areas in minimal invasive devices on heart and blood vessel disorders.

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