China’s healthcaresector is structurallyappealing

www.merrickscapital.com

Fund Details

“Our fund was developed to capture the huge long-term growth potential of China’s economic rise and prosperity. We are dedicated to finding best-in-class companies operating in structurally favourable growth industries that are leveraged to the rising consumerism in China. In particular, we focus on those companies serving consumers with a differentiated product or service or via the use of innovative technologies.”

Jimmy Cheong Portfolio Manager | Equities

Adrian RedlichChief Executive Officer

About the Merricks Capital High Conviction China FundThe Chinese economy is undergoing an unprecedented expansion and structural shift, transitioning from a debt-fuelled infrastructure and export-driven economy to one that is powered by a growing number of middle-class consumers.

This economic transition and structural shift is unmatched in scale and the Merricks Capital investment team is dedicated to finding the best-in-class companies in those industries most exposed to the benefits of the dislocation. The focus is on those sectors servicing the consumer with innovative products and services or disruptive technologies.

Some of the current themes include healthcare; information technology such as internet media, e-Commerce and 5G; “The Belt and Road Initiative”; education; environmental protection; insurance; and the broader ‘catch-all’ theme of rising consumerism.

The Merricks Capital High Conviction China Fund adopts a private equity approach to public markets investing. We believe success in Chinese equities requires a long-term horizon, deep bottom-up fundamental analysis and investors who think like business owners rather than investment analysts. As such, we specifically concentrate our portfolio (typically holding 10-15 stocks at any one time) and hold positions for many years to see strategies play out and insights pay off. This long-term approach allows us to ignore near-term earnings trends, ride through short-term bumps in stock price volatility and focus on where competitive advantage and management talent is likely to translate into the highest long-term earnings growth.

The portfolio applies a disciplined investment process which focuses on organic idea generation and fundamental analysis of sectors and companies using Merricks Capital’s proprietary models. The distinctive Merricks Capital investment approach is accompanied by an experienced and skilled team. Our China team has spent over 20 years travelling extensively around China, seeking the best companies and business models; building a wide range of contacts with both public and private companies and with local investors.

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China’s healthcare sector is

structurally appealing

E X E C U T I V E S U M M AR Y

China has achieved rapid economic growth and the health status of the Chinese population has seen considerable

improvement, with life expectancy increasing from 35 years in 1949 to 76 years in 2015. The demographic profile

of high birth rate, high death rate, communicable diseases epidemics and malnutrition has gradually been

transformed into one of lower birth rate, lower death rate, and prevalence of non-communicable chronic diseases.

According to the World Health Organisation (WHO), China is now the second largest healthcare market in the world.

While still some way behind the US, China leapfrogged Japan in 2013 and is bigger than Germany and France.

Rapid economic growth has resulted in urbanisation and industrialisation, large-scale migration, and population

aging. Consequently, according to the China Centre for National Health Statistics and Information 2012, risk factors

related to lifestyle and environmental pollution have become serious health concerns for its citizens. Addressing

these issues has become a key focus for policy makers.

The Chinese healthcare market is still relatively immature despite its size. According to business intelligence from

the China Briefing Magazine (http://www.china-briefing.com), although healthcare expenditures have increased

more than four times – from Rmb 1,096.6 billion (US$126 billion) in 2006 to Rmb 4,634.5 billion (US$698 billion) in

2016 – healthcare spending per capita is still only around 6% of GDP. This compares with 17% in the US, 10% in

Japan and Europe, and the average 9% in OECD countries. By 2020, China’s healthcare spending is expected to

account for 6-7% of GDP, which is around US$1 trillion. And by 2030, China’s healthcare market is targeted to

reach Rmb 16,000 billion (around US$2 trillion), as stated in the Plan of Health China 2030 released by the State

Council in October 2016.

Merricks Capital is optimistic about China’s healthcare sector. We see the future growth drivers coming from: 1)

aging population; 2) rising household incomes; 3) increasing life expectancy; 4) improving insurance coverage

and 5) government policy support. Due to its size and growth potential, every health sector – from biologics to

pharmaceuticals to medical devices – will have attractive investment opportunities over the next ten years. Two

companies we own based on this theme are AK Medical Holdings and China Biologic Products.

2

The Aging Population

During the 1950s, Communist Party Chairman Mao Zedong launched the “great leap forward” to rapidly convert

China into a modern industrialised state. "A larger population means greater manpower," reasoned the government

at the time. Chairman Mao encouraged large families and outlawed abortion and the use of contraception. He urged

women to produce offspring who would boost the workforce and the ranks of the Peoples’ Liberation Army. This

strategy caused China’s population to double from about 500 million in 1949 to nearly a billion by 1979.

However, Mao’s ideology did not go according to plan and proved to be nearly as destructive. As many communities

collectivised and converted from farming and agriculture to steel production, food supply slipped behind population

growth and in 1962, the Great Chinese Famine had caused some 30 million deaths. In the aftermath, officials quietly

resumed a propaganda campaign to limit population growth, only to be interrupted by the turmoil of the Cultural

Revolution in 1966. With population growth not slowing, officials were prompted to implement more drastic

measures, culminating in the 1979 policy requiring couples from China's ethnic Han majority to have only one child

widely known as the “one-child policy”.

The above background brings us to the point at hand. These enormous number of Chinese citizens born in the

1950s, 1960s and 1970s are aging. The world’s most populous country is getting older and, according to the United

Nations (UN), it is getting older faster than anywhere else in the world. China’s percentage of population aged 60

years or over was 16.2% in 2017 and, the UN estimates this will rise to 35.1% by 2050. The UN also estimates it

will take China just 20 years for the proportion of the elderly population to double from 10% to 20% (between 2017-

2037). This will raise the median age of the population in China from 37 to 48 by 2050.

We believe this aging population demographic trend creates attractive investment opportunities in China’s

healthcare sector. The two charts below indicate the aging profile of the population as predicted by 2020 and 2050.

P O P U L A T I O N P R O J E C T I O N F O R C H I N A : 2 0 2 0

Source: CSIS China Power Project, United Nations World Population Prospects

3

P O P U L A T I O N P R O J E C T I O N F O R C H I N A : 2 0 5 0

Source: CSIS China Power Project, United Nations World Population Prospects

4

Growing demand for healthcare driven by an aging population and other demographic changes

According to the UN’s Population Division, by 2020 there will be 248 million people in China aged 60 years or

above, many of these requiring specialist healthcare services. This number will rise to 437 million by 2050.

Along with the aging Chinese population there will also be rising incomes, increased longevity, and increasing

urbanisation. The factors along with government’s health insurance initiatives will be key factors contributing to the

growing demand for healthcare products and services.

Rising incomes

China has experienced rapid growth in household income over recent decades. China’s economic development

has lifted hundreds of millions of Chinese out of poverty and resulted in a burgeoning middle class.

According to a study by consulting firm McKinsey & Company, 68% of China’s urban population was middle class

in 2012. McKinsey forecasts this will increase to 76% by 2022. Middle class is defined as urban households earning

US$9,000 - US$34,000 a year. That might not sound like a lot but adjusted for prices (in purchasing-power-parity

terms) that range is between the average income of Brazil and Italy and it delivers a roughly "middle class" existence

compared to other countries. In 2000, just 4% of the urban population was considered middle class in China.

Middle class households typically have more than enough income to satisfy their primary needs – food, clothing,

and shelter – with excess disposable income left over for additional desired consumption and upgrading quality of

life. A sub-set of improving the quality of living, particularly in one’s latter years, is to spend more on healthcare.

Previously for example, osteoarthritis sufferers could only to manage their condition with pain killing medication but

now with rising incomes, patient quality of life can be extended for many years with affordable hip/knee replacement

surgery. China’s growing and aging middle class presents an array of new investment opportunities in the

healthcare space.

C H I N A H O U S E H O L D P E R C A P I T A A N N U A L D I S P O S A B L E I N C O M E ( U S D )

Source: National Bureau of Statistics China

5

Increased longevity

The life expectancy of Chinese people rose to 76.3 years in 2015, 18 months longer than in 2010, according to the

latest official NBS survey. That means the average Chinese person lives 4.7 years longer than the world average.

In 2018, China overtook the US in terms of ‘healthy life expectancy’ at birth for the first time (versus actual life

expectancy), according to WHO data. Chinese babies can look forward to 68.7 years of healthy life ahead of them,

compared to 68.5 years for American newborns.

The increased longevity of Chinese citizens can be attributable to the nation’s economic prosperity. With rising

incomes comes a better standard of living: people can afford better food clothing and shelter and have greater

access to healthcare and medical services.

L I F E E X P E C T A N C Y A T B I R T H - C H I N A

Source: United Nations Population Division

Increasing urbanisation

Over the past 40 years of economic reform and opening-up, China’s urbanisation rate has increased from 17.9%

to 58.5%. During this period, 640 million people migrated from rural to urban areas - equal to 46% of China’s

population. In 1980, the migrant population was 5.45 million; it grew to 6.55 million in 1990. But since 1995, more

than 20 million people have migrated from rural to urban areas every year, with 25 million rural residents migrating

to urban areas in 2012 alone.

China’s urban population today is 810 million, compared with the urban population of only 170 million in 1978, while

the rural population is 570 million. This is a drastic change – from more than 800 million farmers, China now has

more than 800 million urban residents. China’s rural population reached its peak of 860 million in 1995. But it has

rapidly reduced since 2000.

The pathways through which urbanisation affects the increased demand for healthcare include: (1) the urban

environment itself poses chemical, biological, and physical hazards, which can lead to injury and illness in urban

residents; (2) urbanisation triggers changes in occupational activities, socioeconomic status, and social structures

that can promote illnesses such as neuropsychiatric disorders, cardiovascular disease, and other non-

communicable chronic diseases in society. Hence, the growing disease burden in urban areas attributable to

nutrition and lifestyle choices is fast becoming a major health challenge for the government and healthcare

policymakers. As a result, we see increasing demand for healthcare products and services over a multi-year

timeframe which should give rise to attractive investment opportunities.

6

U R B A N P O P U L A T I O N G R O W T H A N D U R B A N I S A T I O N R A T E S - C H I N A

Source: Bloomberg, United Nations Aquastat Source: National Bureau of Statistics China

Government policy support

According to China’s National Health and Family Planning Commission, China has spent over USD 1 trillion since

2009 to improve its healthcare system. Healthcare reform is designed with the goal of creating a universal health

security system which focuses on equal access to basic public health services for all. Moreover, the government

also permits private payors and providers to play a role in healthcare delivery, especially addressing the needs of

higher-income patients. Life expectancy has risen significantly, child mortality rates have fallen, China has markedly

more hospital beds than it did a decade ago. All these health sector statistics are expected to continue their upward

trajectory in the coming years.

Almost all of China’s population is now insured. To achieve this feat, China created two insurance programs for

low-income citizens: Urban Resident Basic Medical Insurance (URBMI) and a New Rural Cooperative Medical

System (NRCMS). In addition, an increasing number of Chinese – those working for private or state-owned

enterprises – are eligible for Urban Employee Basic Medical Insurance (UEBMI) which is China’s most established

and comprehensive health insurance plan.

Government support is also coming in the form of policy initiatives to encourage greater fitness and participation in

sporting activities. President Xi Jinping says fitness is the basis and guarantee for all people to live a healthy life

and it plays an important part in China’s transition from a big country to a strong nation in sports. Xi’s initiatives

were included in the work report of the 18th National Congress of the Communist Party of China. Under the national

plan for developing mass fitness issued in 2016, China aims to have 435 million people (a third of the population),

regularly doing physical exercise by 2020.

Moreover, in a national strategy spearheaded by the General Administration of Sport, China plans to build 100

towns dedicated as centres of sporting excellence for various disciplines in coming years. The campaign is part of

China’s effort to grow its domestic sports industry and provide more facilities for people to exercise and lead

healthier lifestyles. According to the 13th Five-year Plan unveiled by the authorities, China aims at increasing the

sports area per capita from 1.4 sq metres to 1.8 sq metres by 2020 and 2.0 sq metres by 2025.

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Universal health insurance coverage

Source: Ministry of Health, Ministry of Human Resources and Social Security

G O V E R N M E N T H E A L T H E X P E N D I T U R E P E R C A P I T A

Source: World Health Organisation Global Health Expenditure

Summarising the above, as China’s population moves to cities and wages increase, healthcare is becoming a

greater focus. Chinese citizens have greater access to healthcare knowledge and, with increasing insurance

penetration, have a greater ability to pay for medical related expenses. Healthcare now comprises the largest

segment of household consumption in China (NBS China, 2017).

Rising incomes and urbanisation have also given rise to China’s current obesity problem as more citizens adopt

western diets and habits. According to a Xinhuanet news article (dated 25 May 2017 and quoting figures from the

Chinese Centre for Disease Control and Prevention), about 30% of Chinese adults or approximately 320 million

people, are overweight, while 11.9% of adults are obese.

The World Health Organisation (2015 report), also sees the opportunity for considerable growth in China’s

healthcare market, with per capita health spending at just US$426 compared to an average of over US$5,200 for

the world’s top eight healthcare markets (US, Japan, Germany, France, UK, Italy, Brazil and China).

Urban Employee Basic Medical Insurance

(UEBMI)

• Mandatory basic health insurance for urban

employees of private or state-owned enterprises

• Funded by employers and employees (via salary

deductions)

• Annual premiums approx: USD 150-300

Urban Resident Basic Medical Insurance

(URBMI)

• Voluntary basic health insurance for urban residents

not eligible for UEBMI (e.g. seniors, disabled,

unemployed, students, children)

• Funded by government and individuals

• Annual premiums USD 20-100

New Rural Cooperative Medical System

(NRCMS)

• Voluntary basic health insurance for rural residents

• Funded by government and individuals

• Annual premiums USD 30-80

8

In 2016, the Chinese government responded to growing healthcare concerns by launching the “Healthy China 2030

Plan”, which is a national initiative that emphasises exercise, fitness, diet and a healthy lifestyle with greater access

to healthcare services.

If all goes according to the Healthy China 2030 Plan, China’s healthcare market will reach US$2.4 trillion (Rmb 16

trillion) by 2030.

The healthcare industry currently makes up around 6% of China’s GDP, and challenges still exist given the

contradiction between the limited supply of healthcare services and growing demand.

More developed nations such as Australia, France, Germany, Japan and the US spend between 10-17% of GDP

on healthcare. “China is still at an initial stage of healthcare development,” said Ran Wei, Vice President of China

Health Management Association.

As the world’s most populous nation, the addressable market in China is gigantic. The purchasing power of the

Chinese consumer is reshaping the world’s market and has created a strong demand for healthcare products and

services. Household per capital expenditure on healthcare has grown at a compound annual growth rate of 10.1%

over the past ten years.

Merricks Capital sees attractive investment opportunities in the Chinese healthcare and related healthy lifestyle

industries.

Companies we currently own based on the healthcare and healthier lifestyle theme are:

• AK Medical Holdings – China’s premier domestic orthopaedic medical device company

• China Biologic Product – A pioneer in the fast-growing Chinese blood plasma market with huge potential

• Anta Sports Products – China’s leading activewear company with a multi-brand and omni-channel approach

9

AK Medical Holdings Three key reasons we are positive about AK Medical

• Import substitution: The Chinese government listed import substitution in the medical device sector as a major

focus in its “Made in China 2025” strategy, released in early 2015. The government has instituted policies to

encourage the use of medical devices produced in China over imported products. The National Health and

Family Planning Commission in 2015 began discussions with top-tier hospitals’ executives on the purchase of

more domestic alternatives.

• Comparative pricing advantage: For a similar quality product, AK Medical’s prices are circa 40%-50% lower

than foreign counterparts. Total hip and knee replacements are costly procedures, and the artificial joint is the

major cost component, accounting for circa 70% of the total inpatient cost. AK Medical’s price advantage versus

western peers should see it gain incremental market share over the long-run. Moreover, favourable

reimbursement rates (close to 100% reimbursement) from various State and Rural Medical Insurance schemes

favour domestic brands over more costly international brands (with large gap payments).

• Leadership in 3D printed implants with a key focus on R&D: AK Medical is the only company to receive

CFDA approval for 3D-printed orthopedic devices. This will offer a distinct edge over competitors. AK Medical

has a strong focus on research and development. AK Medical’s continuous commitment to R&D sees it hold 29

CFDA Class III medical device certificates compared to 10 held by the next closest competitor. To date, its R&D

activities have yielded 36 invention patents, 140 utility patents and 2 patents under the Patent Cooperation

Treaty (PCT). AK Medical also has 134 pending invention patents, 77 pending utility patents and 6 pending

patent applications filed under the PCT. This huge library of patents and certificates creates a consistent product

pipeline for many years to come.

Company description

AK Medical is a leading orthopaedic medical device maker in China involved in the design, development, production

and sales of orthopaedic implants. AK Medical primarily focuses on hip and knee joint implants and those products

are stipulated for primary surgeries as well as revision surgeries. AK Medical was the first (and is currently the only)

medical device manufacturer to commercialise the application of 3D-printing technology in orthopedic joint and

spine replacement implants in China.

Key beneficiary of China’s aging population

We believe AK Medical Holdings is a stock which benefits hugely from the aging population theme, where a

demographic change expands the patient pool suffering from age-related joint disorders. Additionally, modern

stressful lifestyle contributes to the incidence of obesity and lack of exercise, thus potentially increasing the joint

disease population.

Rising prosperity and steady economic growth has greatly increased income levels and health awareness of

Chinese citizens, allowing more orthopaedic patients to consider join implant surgery as a viable solution to treating

discomfort or pain in the joints. The government also continues to improve universal insurance coverage and raise

reimbursement rates to improve joint implant affordability.

As per the company’s prospectus, in 2016 the company was the top ranked orthopedic joint implant maker in terms

of sales with a 14.3% market share and ranked 6th in terms of revenue with 6% market share.

10

Government support on “import substitution”

Under Made in China 2025, unveiled by China’s State Council in 2015, China wants to catch up with rivals in sectors

including robotics, aerospace, clean-energy cars and the medical device industry. The strategy is at the core of

efforts to move up the value chain and achieve the vision of turning the country into a global superpower by 2050.

The Made in China 2025 ten-year plan has seen the Chinese government list import substitution in the medical

device sector as a key focus. The National Health and Family Planning Commission began discussing domestic

alternatives with hospital executives across the country in 2015. The policy is also consistent with the macro trend

of cost containment in healthcare spending.

The supportive government policy for domestic players represents a sweet spot for sustainable growth. According

to international research consultancy firm Frost & Sullivan, the orthopaedic joint implant market in China grew from

Rmb2.4bn in 2012 to Rmb4.1bn in 2016, (at a CAGR of 13.9%) and is estimated to grow to Rmb7.8bn by 2021,

representing a CAGR of 13.7%.

At present, given their longer operating history, imported foreign implants such as those made by Zimmer, Stryker

and DePuy still have a larger market share of around 60% compared to domestically manufactured products.

However, government policies to encourage greater use of domestic implants mean patients using domestic

orthopaedic implants could enjoy a higher reimbursement rate than foreign products (reimbursement rate of 55%-

80% for domestic devices vs. 30%-65% for imported ones).

First-mover advantage in 3D-printed implants

AK Medical has China’s first 3D-printed orthopedic devices, which we believe holds enormous potential. The

company commenced the 3D-printed orthopaedic implant study in 2009 and obtained China Food and Drug

Administration (CFDA) registration certificates for its 3D-printed hip implant, artificial vertebral bodies and spinal

interbody cages in 2015-2016. They were the first and are the only 3D-printed metal orthopedic implants approved

by the CFDA.

The 3D-printed implants have several advantages over traditional products. The key advantage is an almost perfect

fit to the patient’s anatomy as they are precision printed from a patient’s CT scan. In medical terms, it means better

biological fixation with trabecular structure versus generic ‘off-the-shelf’ implants.

Sales from the company’s 3D-printed products are expected to be a major growth engine for AK Medical in the

coming years. Annual financial results to 31 December 2018 saw 3D-printed products revenue grow 109% year-

over-year. Representing just 6% of total revenues a year ago, it has grown to 12% in the latest reporting period

(2018 annual result) and is expected to rise in the future. Such rapid growth has been possible due to AK Medical

being the only provider of such 3D-printed products in China and the increasing recognition among orthopaedic

surgeons of the structural advantage of 3D-printed products. 3D-printed products also have much higher gross

margins than traditional products, making it more profitable for the company to sell.

Long term growth potential in China due to low penetration of joint replacement surgeries China’s penetration of knee and hip replacement surgeries lags most of the developed world. In its 2017 Health

Statistics Report (with a full set of 2015 data), the rate of hip and knee replacement surgeries recorded a penetration

rate of 23 and 9 per 100,000 population respectively in China (in 2015 survey data), vs. the OECD average of 160

and 118.

Goldman Sachs [Research Report January 2018] estimates that circa 1.4 million patients in China needed a hip

reconstruction or replacement and circa 1.8 million needed knee reconstruction or replacement in 2016. Only

around 495,000 cases were completed, including around 10% revision replacement, implying a penetration rate of

approximately 15%.

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The low penetration rate of joint replacement surgery in China is likely attributable to:

• Low number of qualified specialist orthopaedic surgeons per capita versus the developed world

and their knowledge and experience with arthroplasty surgeries;

• High cost of the implant itself, plus the surgeon’s fees, would particularly be meaningful for those

in rural areas;

• Historically, the implant and the operation were not well covered by medical insurance schemes

Merricks Capital believes a variety of factors should drive the increased prevalence of joint replacement procedures

in China, including rising health insurance penetration, improving reimbursement policies, more affordable domestic

implant brands like AK Medical helped by the government’s import substitution policies, an increase in a surgeon

knowledge and experience, and more surgical facilities. This bodes well for the sector’s long-term growth.

H I P R E P L A C E M E N T S U R G E R Y P E R 1 0 0 , 0 0 0 P O P U L A T I O N

Source: OECD Health Statistics 2015

292

283

276

246

243

242

238

236

227

216

204

183

171

166

150

137

136

127

107

88

63

44

33

23

20

8

Switzerland

Germany

Austria

Belgium

Norway

Finland

Sweden

France

Denmark

Netherlands

United States

United…

Australia

Italy

New Zealand

Hungary

Canada

Ireland

Spain

Portugal

Israel

Turkey

Chile

China

South Korea

Mexico average 160

12

K N E E R E P L A C E M E N T S U R G E R Y P E R 1 0 0 , 0 0 0 P O P U L A T I O N

Source: OECD Health Statistics 2015

226

215

202

190

187

180

176

167

166

145

141

135

118

115

112

104

94

89

67

62

59

53

50

11

9

3

United States

Austria

Finland

Germany

Belgium

Australia

Switzerland

Denmark

Canada

France

United Kingdom

Sweden

Netherlands

South Korea

Spain

Italy

New Zealand

Norway

Turkey

Portugal

Hungary

Israel

Ireland

Chile

China

Mexico average 118

13

China Biologic Products Three key reasons we are positive about China Biologic Products

• China’s blood plasma market is still in its infancy with huge potential: Per capita usage/consumption of

plasma products in China is low versus other developed nations. We like the plasma sector for its long-term

growth opportunities (estimated 10-year CAGR 15%). The Chinese plasma market is also unique versus other

healthcare segments, with constraints in supply, which results in a major supply-demand imbalance and notably

stronger pricing power compared with other pharmaceutical products. The industry also has high barriers to

entry (imported products are banned except for albumin) and there have been no newly licensed domestic

players since 2001, which limits competition.

• Expansion of product offering will be a key driver; only direct play outside of China: China Biologic

Products is the best quality player in the China plasma sector and the only direct plasma company listed outside

of China. While leading global plasma companies like CSL can derive 20+ blood products from plasma as well

as producing recombinant protein technology-based alternatives, China Biologic Products can only fractionate

11 blood products at most. The gap is particularly significant in coagulating factors, which are used in treating

bleeding disorders (e.g. haemophilia). However, we see Chinese players such as China Biologic Products

stepping up its portfolio through research and development (e.g. China Biologic has built a pipeline that covers

cytomegalovirus immunoglobulin, fibrinogen, factor IX, antithrombin III and fibrin sealant). We believe China

Biologic’s recently approved products will gradually capture the undersupplied market.

• Market driver should migrate from Albumin to IVIG benefiting China Biologic: Though China is the second

largest plasma market in he world, the market is largely closed as imported products are banned (except

albumin) and domestic players focus only on the Chinese market. Albumin (currently over 60% of the market by

sales) was the key market driver in the past 10 years and subject to aggressive competition from foreign players.

We believe the demand for plasma will shift to IVIG as leading blood product companies are shifting their

marketing focus to educating physicians on the clinical applications of IVIG. We believe this represents a step

change that will benefit domestic leaders like China Biologic. The IVIG market is distinct in that it is a market

that has less competition (imports are banned) with more price hike upside and greater potential on clinical

demand, driven by evidence-based clinical application / indication expansion.

Company description

China Biologic Products Holdings Inc, or CBPO as it is commonly referred to in investment circles (being its

NASDAQ code), is a leading fully integrated producer of plasma products in China. The company is principally

engaged in the research, development, manufacturing and sale of plasma-based biopharmaceutical products.

Based in Beijing, CBPO has three production facilities and is one of the top three domestic suppliers in China for

the principal plasma products of albumin and IVIG. The company was founded in 2002 and was listed on NASDAQ

in 2009. CBPO is the only directly investable plasma play outside of China.

Plasma is essential in the treatment of various blood disorders and chronic diseases, including emergency blood

loss, burns, hepatitis B, liver/kidney disease, haemophilia, post-surgery recovery, clotting and other bleeding and

immune disorders of the elderly, and it also assists in the treatment of tumours.

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Composition of human blood

Source: wikipedia

Human blood contains plasma (~55%), red blood cells

(or erythrocytes ~45%), white blood cells (leukocytes)

and platelets (~<1%).

Plasma is made of water (90%) and protein (7%).

Plasma-based products are different proteins derived

from human blood using separation and purification

technologies.

Currently, there are 20 different types of plasma-based

products that are produced and used. The major ones

include human albumin, immunoglobulin, blood

coagulation factors and inhibitor.

The China blood plasma market has huge potential

The blood plasma industry’s leading international data provider, the Marketing Research Bureau (MRB), estimates

the China market will grow to US$6.2 billion in 2019, up from around US$2.5 billion in 2015 and US$3.6 billion in

2016. According to the MRB, the compound annual growth rate (CAGR) of the industry was a stellar 22% p.a.

between 2006-2015. [In our opinion, there is no reason to doubt a CAGR of say 15% cannot be sustained over the

next ten years].

This sustained growth should be primarily driven by China’s aging population, rising consumption of healthcare

products, and expanded use of blood plasma products with significant unmet clinical demand. This includes

increasing awareness of the therapeutic benefits of plasma products and expanding health insurance coverage.

While China’s 2015 market size was US$2.5 billion, its per capita penetration is still a fraction of that of the US,

intimating a huge runway for growth as China’s economic expansion continues. The MRB estimates per capita

consumption of albumin in the US is 2.5x that of China. For coagulation factor VIII, US per capita consumption is

7.7x that of China and for IVIG, US per capita consumption is 15.2x that of China.

In absolute terms:

• China albumin usage is 223grams per 1,000 people, compared to 557grams per 1,000 people in the US.

Albumin was one of the first plasma products introduced into the market.

• China IVIG per-capita consumption is only 11grams per 1,000 people compared to 168 grams per 1,000 people

in the US.

• China Factor VIII consumption is 0.09grams per 1,000 people compared to 0.70grams per 1,000 people in the

US.

Lower China usage penetration is predominantly due to later stage development of plasma products, lack of clinical

practice and experience from physicians as well as short supply (collection and fractionation centres take time to

roll out across the country). As a result, we think there is an attractive multi-year growth story here.

15

China plasma products market size

Source: Company presentation, Marketing Research Bureau

Per capita consumption of plasma products

Source: Company presentation, Marketing Research

Bureau

To put one major use of plasma into perspective, China holds the honour of being the world leader in liver disease

and is one of the highest consumers of albumin in the world, using 300 tonnes annually (or roughly half of total

worldwide use) according to an article in the Financial Times. Liver disease is a growing problem in China, primarily

because of the high burden of viral hepatitis x but also because of the growing prevalence of non-alcoholic fatty

liver disease. Advanced stages of liver disease are characterised by protein wasting and can result in albumin

depletion, which can have a major effect on the cardiovascular and renal system. Albumin has long been used for

treatment of liver disease and is generally accepted as a useful treatment for those with liver damage.

Increasing product suite ensures robust pipeline for growth

Human albumin and IVIG products have long been CBPO’s two largest sales contributors, and its market share for

these two products ranks among the top three domestic Chinese suppliers in China, as measured by total

production volume in 2017. Additionally, several other new products launched in recent years, such as Factor VIII

and Polypeptides, are also experiencing rapid growth in market share.

The company currently derives 19% of sales from high margin specialty products such as placenta polypeptides

and coagulation factors, with 36% of sales still coming from lower margin albumin plasma. Contrast this with CSL

Ltd, with a 100 year operating history, which has over 40% of sales coming from high margin coagulation and

specialty products and only 14% from albumin.

With the expected slowdown in albumin products, continued IVIG growth and the approval and ramp up of higher

margin coagulation factors and specialty products will play a large role in sustaining CBPO’s growth and market

share expansion into the future. Specialty products can be defined as all those outside of IVIG, coagulation products

and albumin. In addition to providing growth, specialty products are important as they are ‘infra-marginal’ (margin

accretive) products. They can be produced using the plasma that remains once the IG, FVIII and albumin have

been fractionated and, due to being specialised (i.e not commoditised), they can be sold for higher prices.

CBPO received CFDA approval for its pipeline products, human fibrinogen, in October 2017 following a five-year

phase III clinical trial. ASP (average selling price) of fibrinogen has tripled since the removal of a price ceiling in

2015, and we believe that CBPO will be able to gradually capture this undersupplied market.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2006 2009 2012 2015

USD billions

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

Albumin IVIG Factor 8

2.5x

15.2x

7.7.x

Per capita usage in U.S/Per capita usage in China (x)

16

A snapshot of some of the products in the pipeline, including research stage, clinical trials stage readying for CFDA

approval, and commercial launch are:

• Caprylate/Chromatography Purified

• Human Antithrombin III

• Human Cytomegalovirus Immunoglobulin

• Human Coagulation Factor IX

• Human Fibrin Sealant

CBPO sales split by product

Source: Company Annual Report

CSL sales split by product

Source: Company presentation

IVIG, 31.7%

Albumin, 35.8%

Other immunoglobulins,

13.5%

Placenta polypeptides, 13.3%

Specialtyproducts, 5.7%

IVIG and other IG, 47.0%

Coagulation, 22.0%

Specialty products, 17.0%

Albumin, 14.0%

17

Plasma market has high barriers to entry limiting competition

The Chinese plasma market is heavily regulated with very high barriers to entry. As a result of the blood

contamination scandals in the early 1990s, where hundreds of thousands of citizens contracted HIV/AIDS due to

unsafe blood collection programs, China’s blood collection and plasma market is now one of the most stringently

regulated in the world. There is a five-stage process to identify the pool of healthy donors including facial

identification, fingerprint identification, ID card identification, physical examination, and single-use disposable

medical instruments. And that is before a single drop is collected. After blood is collected, there is a waiting period

of at least 110 days where the plasma is checked three times before the fractionating station stage. After it passes

through the triple virus detection defence system, only then does it go into production. The set-up of collection

stations and fractionation facilities is a capital-intensive process. Moreover, the Chinese government ceased issuing

new plasma fractionation licenses since 2001. There are currently 30 licensed producers of plasma products in

China, and less than 25 are in operation. The entry barriers for new players is very high and international investment

in domestic manufacturers of plasma products is restricted and subject to a stringent approval process. As a result,

existing players, especially industry leaders such as CBPO, should be key beneficiaries amid this favourable policy

backdrop.

F I V E S T E P P R O C E S S T O A S S U R E S A F E B L O O D P L A S M A D O N O R S

Source: China Biologic Products investor presentation

Albumin comparative

Albumin is used to treat a variety of liver diseases (cirrhosis, liver cancer, hepatitis, hypoalbuminemia, fatty liver

disease and other alcohol-related liver problems). China consumes about 300 tonnes of albumin per annum, which

is roughly half the global total. About 60% of China’s albumin is imported and analysts estimate the demand is

growing at 15% annually. Albumin is naturally produced by the liver and is harvested by fractionation of donated

blood plasma. While the necessary supply could be provided by the Chinese population, many are afraid to donate

blood. The reason is a well-remembered 1990s health scare in which tens of thousands of farmers who had been

paid to donate blood acquired HIV from infected needles. The ensuing scandal was covered up by the government.

As a result, with the huge demand, China has had to import 60% of its albumin - and the ever-rising demand has

driven up prices. Under China’s Article 49, albumin is the only blood plasma product the government has allowed

to be imported to meet domestic demand.

18

Albumin is more expensive in China than elsewhere in the world. Prices in China are around USD4.00 for 1 gram,

compared to approximately USD2.50 a gram in the US; around USD2.25 in Europe and around USD2.00 in the

rest of the world including Australia. Hence, China is a very lucrative market for overseas players like CSL, Baxter

and Grifols.

With advances in technology, extremely stringent government regulations regarding blood collection from healthy

donors and the attractive monetary incentives for donating blood, the blood donor collection market is growing

again. Total US blood plasma collection was 31,000 metric tons last year, compared to only 7,000 metric tons

collected in China − even though China has four times as many people. There is a clear pathway to future growth

by rolling our more collection stations.

C H I N A B I O L O G I C G R O W T H O F P L A S M A C O L L E C T I O N S T A T I O N S

Shandong Opened Population (mn)

Qihe County July 2008 1.8

Xiajin County Oct 1998 1.5

Zhangqiu County Sep 1997 1.1

Yanggu County 1998 2.3

Yunchueng County 2003 1.2

Cao County July 2013 1.6

Yishui County Dec 2010 1.1

Ningyang County July 2011 5.6

Zaozhuang City Oct 2015 3.9

Feicheng City 2017 2.4

Ju County 2017 3.0

Guizhou

Puding County 2008 0.5

Huangping County 2008 0.4

Guangxi Huangjiang Maonan County

Jan 1997 0.4

Fangchenggang City Jan 1998 1.0

Hebei

Xinglong County June 2016 0.4

Daming County 2017 0.9

Hainan

Wenchang City 2018 0.6 Source: Company report

19

Plasma market driver to shift from albumin to IVIG

In China, albumin is currently the single most important market driver for domestic blood product market and the

demand for plasma, contributing roughly 70% of incremental blood product sales in China over the past five years.

However, we believe the market driver is gradually changing. Over the next ten years, we believe IVIG will emerge

to be a new market driver, catching up with the global plasma market trend (i.e IVIG replaced albumin to be plasma

market growth driver since early 2000s outside of China). While albumin will continue to contribute a significant

portion of incremental sales, its growth is likely to be slower than in the past. We see this as very positive news for

CBPO.

Article 49 prohibits the import of IVIG products into China. Human albumin is the only blood product allowed to be

imported into China due to its significance and under-supplied nature. Hence domestic players like CBPO have

been feeling the competitive pressure on albumin pricing. With IVIG and other plasma-related products, foreign

players do not have access to the Chinese market, so there should be much less competition in this market. This,

in our view, should allow key domestic players like CBPO to earn higher margins on IVIG to boost future profitability.

I M P O R T E D A L B U M I N A C C O U N T S F O R O V E R 6 0 % O F T O T A L

Albumin # of vials (10g per vial, mn) Source: National Health and Family Planning Commission; National Institutes for Food and Drug Control; Merricks’ estimates

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0

10

20

30

40

50

60

2011 2012 2013 2014 2015 2016 2017 2018 2019E 2020E

Domestic Imports Albumin y-y growth

20

Risks to the healthcare sector China’s healthcare sector and development is still in its nascent stages when compared with more developed

markets in the western world. Therefore, health sector policy and reform are constantly evolving and developing

to encourage world’s best practices. At times the introduction and implementation of new healthcare reform

measures can affect a company’s short term financial performance. New reform measures could be more

aggressive than expected, which could exacerbate the challenges faced by the industry to comply while trying to

grow sales and profits at the same time.

Two-invoice system

China’s complicated and perplexing medical and pharmaceutical distribution landscape is undergoing reform.

Approximately 180,000 distributors – more than ten times the amount of public hospitals – conduct a wide range of

logistical, financial, and commercial activities in multi-tier networks. Regulators in China have long been concerned

that this multi-tiered network inflates drug prices, due to multiple distributor mark-ups, and facilitates “unchecked”

transactions that could transfer kickbacks to physicians. Some generate very high margins (for not much effort)

which has attracted the attention of regulators looking to contain healthcare costs and tighten compliance.

The Chinese government has acted by implementing a “two-invoice system” for pharmaceutical distribution that

was rolled out nationwide in 2018. The new policy will allow a maximum of two invoices between a manufacturer

and hospital – each manufacturer will sell to a distributor and that distributor will sell directly to hospitals, eliminating

multi-tiered distribution.

The reason for the change is simple: fewer distributor layers will lead to more transparent (and eventually smaller)

distributor margins, more compliant business conduct with less chance of corrupt practices, and very possibly a

consolidation of the distributor landscape.

The ex-factory price set by the manufacturer will now be visible to hospitals procuring the pharmaceutical or

healthcare product. This increased transparency will require manufacturers to adjust their pricing strategy.

Manufacturers choosing to increase the ex-factory price to match the price paid by hospitals (excluding the single

distributor fee) will enjoy higher revenues but at some costs. Chinese authorities and public hospitals may question

the sudden increase in ex-factory price, considering that distributor mark-ups were a significant driver of the price

that the hospital paid prior to the two-invoice system. Additionally, a higher ex-factory price would mean the

manufacturer would be responsible for additional value-added tax (VAT) payable to Chinese tax authorities.

The implementation of the two-invoice policy has had a material impact on many healthcare companies in China

with changes in route to market, channel structures, the roles and responsibilities of manufacturers, distributors and

other service providers, pricing, margin and profit structure, and compliance management. There has been some

turbulence in the supply chain as manufacturers shuffle their distributor arrangements to comply with the new

regulations and it is unclear how long companies will take to fully comply. We highlight this as a risk to the sector’s

thesis in the short-term, but don’t see it as a major long-term concern or risk to the thesis. In our view, this presents

a little bit of short-term pain for longer-term gain for the health and prosperity of the industry.

Zero mark-up policy and the capping drug sales to hospital revenue

at 30%

Since the 1950s, public hospitals have been selling drugs and pharmaceutical medicines at a mark-up. The

maximum is 15%. The mark-ups have been a key source of income and on average draw up to 50% (in some

hospitals up to 80%) of hospital revenue from drug sales. According to the Ministry of Health and Family Planning,

although the policy helped make up for a lack of adequate government healthcare funding, it gradually evolved into

a way to garner excessive profits, contributing to worsening problems like overprescribing, an excessive use (and

21

abuse) of drugs such as antibiotics, and rising medical expenses. Moreover, health industry experts say competition

to get drugs into hospitals has also led to kickbacks and other forms of corruption.

In 2017, all public hospitals were told to end the long-time practice of drug price mark-ups as part of the ongoing

healthcare reform. The government also introduced regulation which caps drug sales revenue to 30% of total

hospital revenue. A key objective is to separate hospital and doctor incomes from pharmaceutical and drug sales,

which have been too closely linked. Public hospitals' loss of revenue will be offset for the most part by an increase

in the prices of patient services, and more government investment and subsidies can be expected according to a

statement by the National Development and Reform Commission.

As hospitals around the country adjust to the zero mark-up policy, drug and pharmaceutical companies have seen

periods of greater price competition (to clear excess inventory), slower sales, margin pressure and inventory build

as they adjust pricing and rationalise the whole supply and distribution chain. We do not see this as a long term

thesis-breaking phenomenon and expect companies to return to growth once the new regulations have been

bedded down.

Recent lacklustre company financial performance has been triggered not by a drop in demand – on the contrary,

China’s need for medicines has never been greater – but by structural problems in the country’s healthcare system

that are gradually being rectified with carefully considered policy measures.

Again we see the capping of drug sales to hospital revenues and the zero mark-up policy as good regulation for the

long-term health of the industry to curb abuse and promote the availability, safety and appropriate use of essential

drugs in China.

Government approval process tends to be slow and arduous

Healthcare, pharmaceutical and medical device companies rely on continuous innovation and a strong research

and development pipeline to provide the latest products and medicines to the population and to stay on top of

competition. However, government approvals for new drugs and devices are notoriously slow and cumbersome

and delays are not forecastable with any degree of accuracy. This represents a real risk when investing in

healthcare companies.

Typically, a new drug or device appears on the Chinese market five to seven years later than in Europe or the US,

because many aspects of the approval system slow down the entry of new drugs.

China’s State Council has pledged to speed up the country’s drug-approval process through a set of new policies,

which include permitting for the use of data from overseas clinical trials for the first time. The policies also include

a promise to re-evaluate existing drugs on the market and to promote the production of generic drugs.

The new policies target China’s large backlog of drug approval registrations, which stood at 6,000 applications at

June 2017, down from a 2015 high of 22,000. Regulators in developed markets approved 433 new drugs between

2001 and 2016, while China approved just over 100.

NDRC has all-encompassing powers over the healthcare sector

The National Development and Reform Commission (NDRC), China’s economic planning agency, is a formidable

power centre within China’s government regulatory bodies, and its portfolio ranges from approving high-speed

railway projects to household electricity rates. It will remain one of the key regulators of the healthcare sector.

The NDRC has powers over anti-monopoly behaviour, misuse of market power, collusive behaviour to manipulate

market prices, and misleading and deceptive conduct. In 2016 it investigated price collusion between domestic and

foreign pharmaceutical manufacturers.

The NDRC has wide-ranging remedial and punitive powers from mandating price cuts and setting ceiling prices to

punishing offending firms through punitive damages and imprisonment terms for company executives. NDRC

mandated directives and decisions represent a key risk for companies operating in China’s healthcare industry.

22

Why Merricks Capital? The Chinese economy is undergoing an unprecedented expansion and structural shift, transitioning from a debt-

fuelled infrastructure and export-driven economy to one that is powered by a growing number of middle-class

consumers.

This economic transition and structural shift are unmatched in scale and the Merricks Capital investment team is

dedicated to finding the best-in-class companies in those industries most exposed to the benefits of the dislocation.

The Merricks Capital China portfolio is a concentrated long only portfolio of quality Chinese companies operating

in structurally favourable growth industries. The portfolio applies a disciplined investment process which focuses

on organic idea generation and deep fundamental analysis of sectors and companies using Merricks Capital’s

proprietary models.

The distinctive Merrick Capital investment approach is accompanied by an experienced and skilled team. Our China

team has spent over 20 years travelling extensively in China, seeking the best companies and business models;

building a wide range of contacts with both public and private companies and with local investors.

Experience

• Established in 2007, Merricks Capital has raised over USD2 billion in capital and invests using a multi-strategy

approach across a variety of traditional and specialist asset classes and investment structures. Asian equities

and specifically, Chinese equities is a key focus. Merricks has a long history of investing in Asia and has built

strong relationships with key industry players. We maintain regular contact with the company’s we invest in

giving us understanding of the key sensitivities enabling us to interpret changes quickly and act with high

conviction. The investment team has significant experience across core industrial, capital goods, technology,

consumer, financials and materials sectors conducting regular research trips into China.

• Jimmy Cheong, Portfolio Manager, has been working in equity markets since 2000. Prior to joining Merricks

Capital, Jimmy spent 13 years working in Hong Kong researching China and Asia Pacific equities across

both sell side and buy side roles with leading institutions and asset managers such as Macquarie Group,

J.P. Morgan and BNP Paribas. Jimmy has travelled extensively around China (which includes living in

Beijing for six months), meeting company executives, conducting site visits and getting to know his

companies at the coalface. Jimmy’s extensive Asian markets experience has enabled him to forge and

maintain valuable industry contacts.

• Adrian Redlich, Chief Executive Officer, has over 20 years’ experience investing in China. Prior to founding

Merricks Capital in 2007, Adrian worked at Citadel Investment Group (Chicago) as the Head of Quantitative

Alpha Generation, Global Equities. The global equities group consisted of nine sector teams and ran the

world’s largest fundamental long/short market neutral portfolio. During this time Adrian was also directly

responsible for an Asian focussed derivative portfolio. Prior to Citadel, Adrian was a Director at Merrill Lynch

(New York & Hong Kong), where he was Head of the Global Valuation and Analytics Group.