Hutchison China MediTech — Update 27 May 2016

HCM, a Hong Kong-based healthcare company, was established in 2000 as a wholly-owned subsidiary of Hutchison Whampoa (now part of CK Hutchison) to commercialise on the opportunities arising out of the Chinese healthcare market. HCM has two business units: Innovation Platform (Hutchison MediPharma), the research and development arm, which is mainly focused on developing highly targeted oncology therapies and immunology therapies (tyrosine kinase inhibitors) for the global and domestic markets; and Commercial Platform (a profitable, cash-generative, drug distribution business wholly based in China), which comprises of a number of joint ventures with established Chinese players and wholly owned subsidiaries.

HCM’s business diversity means the best approach is a sum-of-the-parts valuation. We use earnings-based multiples for HCM’s Commercial Platform (subs and JVs) or China Healthcare business, and a risk-adjusted NPV model for Innovation Platform, the MediPharma unit. We use a 22.5x multiple (in line with the sector average for comparable Chinese companies) on our forecast 2016 net attributable profit (equity in earnings of equity investees, net of tax) for the SHPL and HYBS JVs of $29.2m, which results in a valuation of $657m (722p/share). We use a risk-adjusted net present value (rNPV) method to discount future cash flows for the Innovation Platform division, which yields a valuation of $1,712m (1,882p/share). Adding in net cash and netting out unallocated costs results in a value of $2,342m (2,575p a share) or $19.31per ADS (£ share price is based on 60.6m ordinary share and equivalent US$ price is based on 121.3m American depositary shares, 1 ADS = 0.5 ordinary shares). Approval(s), clinical data and/or deals should increase our risk-adjusted valuation.

CK Hutchison’s involvement in HCM materially reduces the myriad of risks associated with any direct investment in China; however, it does mean investors are minority shareholders. Additionally, the limited available free float reduces the shares’ liquidity. HCM is subject to the usual biotech and drug development risks, including clinical development delays or failures, regulatory risks, competitor successes, partnering setbacks, and financing and commercial risks. Expectations for the pipeline have increased and while our risk-adjusted NPV highlights the future sources of upside to the shares, failure of one or more products to succeed would have a negative impact on the shares; savolitinib, fruquintinib and sulfatinib contribute ~65% to our valuation of HCM.

With the secondary listing (Nasdaq) underway, HCM reported 2015 financials under US GAAP (2013 and 2014 were consequently restated). At the group level, 2015 revenues were reported at $178.2m (+104%), with net profits attributable of $8m versus a loss in 2014 of $7.3m. Revenues reported at the group level do not include the reported revenues of the Shanghai Hutchison Pharmaceuticals (SHPL) and Hutchison Baiyunshan Chinese Medicine Co (HBYS), 50/50 joint ventures that are accounted for using the equity method, with only the net profit contribution recorded. At 31 December 2015 the company held $31.9m of cash and cash equivalents at the group level, with $76.9m in further cash and equivalents held at the 50/50 JV level, which is not consolidated at the group level. The 2015 year end reported cash additionally does not include the gross proceeds of ~$110.2m raised from the Nasdaq listing in March 2016, nor the expected $73.9m (at the JV level) property compensation payments expected from the Shanghai government in 2016 ($33.1m at the JV level was reported in 2015). All told, with HCM’s additional access to a total of $66.9m of bank facilities, we do not envisage any funding gap in our near-term forecast period despite the additional R&D investment requirements.

HCM was established in 2000 as a wholly owned subsidiary of CK Hutchison. HCM is dual listed; the company floated on AIM in May 2006 and on Nasdaq in 2016 (~40% listing), with CK Hutchison retaining a majority and management control. HCM is a complex business with multiple moving parts since inception (Exhibit 1 provides details on the group’s complicated organisation structure and ownership). Investors should focus on the Innovation Platform unit, as ultimately valuation will be driven by this division over the near term as the eight tyrosine kinase inhibitors maintain their clinical progress, with potential first regulatory filings (savolitinib and fruquintinib) anticipated in 2016/17 followed by China and or US/International launches. The legacy China Healthcare (Commercial Platform) business remains an important cash cow with stable growth in cash from operations as well as significant property windfalls ($73.9m) due at the JV level in 2016.

From inception HCM built a China-based fully integrated, manufacturing, marketing and distribution business (for prescription drugs, consumer health products), referred to as its ‘Commercial Platform’, through acquisitions and the formation of joint ventures with established drug distribution peers in China (including Shanghai Pharmaceuticals and Baiyunshan). The aim was to build a profitable and cash-generative China-based healthcare business that could aid in the long-term funding of an innovative biopharmaceutical drug portfolio. Since 2002 HCM has steadily invested in its R&D capabilities: the ‘Innovation Platform’ Hutchison MediPharma (HMP) unit. To date around $330m has been invested, resulting in the building of a high-grade discovery facility in China, which comprises a fully integrated drug discovery and development operation covering chemistry, biology, pharmacology, toxicology and chemistry, in addition to manufacturing controls for clinical and commercial supply. The result of 14 years of investment is a rich oncology and immunology, mainly tyrosine kinase inhibitor based, pipeline that has been developed by a China-based development team of over 290 scientists and staff.

The core focus of the Innovation Platform is to develop innovative, highly selective, tyrosine kinase inhibitors with activity against multiple novel and validated molecular targets in oncology and immunology indications. A medicinal chemistry based approach is used to engineer highly selective drug candidates against these targets, with the aim to improve on efficacy and or toxicity versus available drugs to deliver best-in-class, next-generation compounds. HCM’s approach has generated a number of candidates that address both existing, well-validated targets (which is typically associated with a lower clinical risk) as well as more novel targets (where the as yet unproven nature of the mechanism means the clinical risk is higher). It uses the vibrant and accessible clinical trial environment for oncology drug candidates in China to rapidly progress through to proof of concept trials at a much lower cost versus drug development in the Western hemisphere. The result is a portfolio of novel and differentiated next-generation compounds that potentially could compete successfully in the global markets. Furthermore HMP is well placed to tap into compounds that demonstrate only equivalence to the existing globally-marketed compounds by developing these for sale by its Commercial Platform unit for the domestic Chinese market.

The company has built a substantial platform: eight tyrosine kinase inhibitors are spanning 19 active clinical trials (with six more trials in planning for 2016). Exhibit 2 summarises the R&D pipeline.

Savolitinib, fruquintinib and sulfatinib are the most advanced compounds, with Phase II or III registration trials currently enrolling patients either in China and/or internationally. HMP has a proven track record of establishing collaborations with multinational companies. Savolitinib and fruquintinib are being developed with partners AstraZeneca and Lilly, respectively, whereas the reformulated version of HMPL-004, a botanical based drug, is about to re-enter Phase I under a joint venture with Nestlé Health Science (NSP). These three collaborations could contribute materially with up to $1.2bn in aggregate upfront, option and contingent milestone payments to HMP/NSP; this is in addition to tiered royalties on net sales. The $330m cost of funding investment in R&D to date (from establishing facilities through to clinical trial programme funding) has been borne through a variety of sources, including cash flows generated from the commercial platform business; external cash from global partners (equity injections, licensing and developmental milestones); and funds raised from public offerings (AIM and Nasdaq listings). Furthermore HCM holds sole rights to Sulfatinib, Epitinib, Theliatinib, HMPL-523, HMPL-689 and HMPL-453; these have potential for new licensing deals depending on the outcome of ongoing and future clinical trial programmes; future deals could be predicated on retaining an optionality to commercialise alone in certain territories (ex-China) to enhance economic returns.

HCM’s Innovation Platform reported $52m in revenues (+156%) in 2015, benefiting from developmental milestone payments from partners AstraZeneca and Lilly in the year. The division’s net attributable loss was reported at $3.8m (-83%), despite the major investment in clinical trials in the year.

Over the past 15 years, HCM has built a broad prescription drug, consumer health, and over the counter (OTC) fully integrated, manufacturing, marketing and distribution business under its Commercial Platform (CP) business division, which reaches across multiple provinces in China. The aim is to continue building this sizeable sales and manufacturing infrastructure (currently 1,900 prescription drugs and 1,300 OTC salespeople in over 300 cities) to harness the considerable growth opportunities that currently exist and will arise from partnering with third parties and launching in-house developed innovative therapies. CP reported total sales from subsidiaries and JVs from continuing operations of $519m in 2015 ($465.4m in 2014), with net profit attributable to the group of $25.2m in 2015 ($22.8m in 2014).

CP comprises Prescription Drugs (marketing and distribution of own and third party) and Consumer Health:

The Commercial Platform is a stable growth business in China, and we expect above-market growth rates to continue into the near term. We forecast 12.5% and 5.0% sales growth in 2016 for SHPL and for HBYS respectively. Importantly the China-based prescription platform will be invaluable once the R&D pipeline comes to fruition and will enable rapid commercialisation of products once regulatory approved in China. We would anticipate operational leverage from the two businesses after the initial launch infrastructure costs have been met. We describe later in the note how in our view domestic players are at a better vantage point than the global multinationals in China.

Hutchison MediPharma’s platform has established a broad portfolio of small molecule, orally active tyrosine kinase inhibitors (TKI), eight of which are in clinical trials for a variety of cancers. Tyrosine kinases are an attractive drug research area since they play important roles in the modulation of growth factor signalling, being involved in tumour cell growth and proliferation, creating apoptosis resistance, and promoting angiogenesis and metastasis.

A number of tyrosine kinase inhibitors have been global commercial successes; for instance, Novartis’s Gleevec (imatinib), Roche’s Tarceva (erlotinib), AstraZeneca’s Iressa (gefitinib), Bayer’s Nexavar (sorafenib) and Pfizer’s Sutent (sunitinib) to name a few. In 2014 global sales of small molecule kinase inhibitors totalled $18bn (source: Visiongain). Although an increasingly competitive field, advances in the understanding of tumour biochemistries are creating exciting opportunities for novel next-generation inhibitors, particularly in stratified patient populations. Overall the small molecule TKI market will continue to grow, driven by product innovation and use of combination targeted therapies against the overall backdrop of cancer patient growth rates in the global setting. Advances in other modalities of cancer treatment, for example immunotherapies, will additionally expand the cancer drugs market.

HCM’s approach has generated a number of candidates that address existing, well-validated targets (which is typically associated with a lower clinical risk) as well as more novel targets (where the as yet unproven nature of the mechanism means the clinical risk is higher). Clinical trial programmes for many compounds in development span multiple tumour/immunology indications and differing patient stratifications and multiple treatment paradigms that include monotherapy and in combination with other cancer treatments. Combinations of targeted therapies (TKI, monoclonal antibodies and immunotherapies) and chemotherapy is increasingly becoming the best approach to treating the complex and constantly mutating disease that is cancer. The collaboration on savolitinib with AstraZeneca exemplifies this as its development programme includes clinical studies of savolitinib added to AstraZeneca’s Iressa and Tagrisso. Additionally AstraZeneca and HCM plan to initiate several combination trials evaluating savolitinib plus immunotherapy in patients with renal cell carcinoma.

Sustained effort with around $330m invested has resulted in the building of a high-grade discovery facility, and all the elements to create a fully integrated drug discovery and development operation are in place, including versatile discovery and screening platforms. This taps into the wealth of talent and opportunities that are presenting in China right now, capitalising on the cost efficiencies and speed benefits associated with performing R&D there. The attraction of China as a research base is confirmed by the high-profile formation of sizeable R&D units by a number of multinational pharmaceutical companies. For instance, Eli Lilly, Roche and Novartis have established laboratories at the Zhang Jiang High Tech Park in Shanghai. They and HCM cite the quality of the young research scientists available, the ease of recruiting treatment patients and the speed and cost efficiencies of undertaking high-quality clinical trials as critical reasons for being there. Incidentally, Hutchison MediPharma was one of the first tenants in Zhang Jiang, in 2002, in what has become the centre of the Chinese biotech industry.

The aim has been to tap into the receptive environment in China for high-technology clinical projects by undergoing the proof of concept studies (Phase II trials) in China before a decision to either partner or initiate global trials is made. These clinical trials are performed to Western standards and generate high-quality data that allow a go or no-go decision to be made quickly and, more importantly, relatively cheaply. Once proof of concept in Chinese patients has been achieved, additional data requirements for Caucasian patients can be generated from bridging studies in Australia or by initiating larger trials internationally.

HCM has to date established major collaborative agreements with AstraZeneca, Lilly and Nestlé Health Science, the latter through a JV structure. These three collaborations could contribute materially with up to $1.2bn in aggregate upfront, option and contingent milestone payments to HMP/NSP; this is in addition to tiered royalties on net sales. As of 31 December 2015 HCM had received $96.5m in upfront payments, milestones and equity injections from partners. Subject to future clinical success, HCM could receive up to a further $360m in future development and regulatory approval milestones, up to $145m in further option payments and up to $560m in commercial milestones from existing partners.

HCM is likely to seek approval for at least three compounds under the US FDA breakthrough therapy designation. This includes savolitinib for papillary renal cell carcinoma, non-small cell lung cancer and gastric cancer, sulfatinib for neuroendocrine tumours and epitinib for non-small cell lung cancer with brain metastasis. Breakthrough therapy designation was introduced by the 2012 Food and Drug Administration Safety and Innovation ACT (FDASIA) as a process to expedite the development and review of drugs that are intended to treat a serious condition where preliminary clinical evidence indicates that the drug may demonstrate substantial improvement over available therapy on a clinically significant endpoint(s). We cite AstraZeneca’s Tagrisso as a recent example of a TKI that demonstrated rapid clinical development and regulatory approval for resistant non-small cell lung cancer (NSCLC). Tagrisso received FDA approval in 2015, just over two and a half years from the start of clinical trials to approval for the treatment of patients with metastatic epidermal growth factor receptor (EGFR) T790M mutation positive non-small cell lung cancer under the FDA’s accelerated approval process based on tumour response rate and duration of response through breakthrough therapy designation.

According to Frost and Sullivan, in 2014 the value of the global oncology drug market was $102bn, while the oncology market in China alone was $11bn. While older established chemotherapies are a large share of the pie, targeted therapies as a therapeutic strategy have been well validated with several first-generation VEGF inhibitors having been approved globally since 2005 and 2006. These include both small molecule TKI drugs such as Nexavar and Sutent as well as monoclonal antibodies such as Avastin, which had combined global sales of approximately $8.7bn in 2015 across multiple tumour types. In China, targeted therapies represent 20.9% of the $11bn oncology market and growth in this territory will depend on ability to pay and pricing strategies. We detail the China healthcare market including oncology opportunities in more detail later in the note.

Savolitinib (AZD6094) is a novel, small molecule TKI that is being developed with partner AstraZeneca for the treatment of EGFR TKI resistant cancers. It is being assessed across an extensive global clinical trial programme that spans 12 clinical trials (nine active and three due to start in H116) across papillary renal cell carcinoma, clear cell carcinoma, non-small cell lung cancer and gastric cancers, both as monotherapy and in combination with approved or investigational targeted therapies (see Exhibit 3). Savolitinib targets patients with resistant cancers whose tumour type tests positive for c-Met amplification or overexpression; for example C-met amplification occurs in 40-70% of papillary renal cell carcinoma (PRCC) patients. Importantly c-Met amplification is uncommon in previously untreated patients (note 2-4% of untreated NSCLC, Bean et al 2007) but plays a role in acquired resistance to EGFR inhibitors) of patients with EGFR-mutated tumours and can be seen in 5-20% of patients in this setting. Furthermore as MET amplification occurs independently of EGFR (T790M) mutations Met is a clinically relevant therapeutic target for some patients who acquire resistance to AstraZeneca’s Iressa and Roche’s Tarceva.

Savolitinib is a highly selective inhibitor of the c-Met signalling pathway (also known as hepatocyte growth factor receptor, HGFR). It has been structurally designed to address the kidney toxicity issues that have prevented the c-Met drug class from gaining approval by the replacement of the quinolone region of the compound; and it has not displayed any material renal toxicity to date. Savolitinib is most advanced in its PRCC and NSCLC indications. PRCC accounts for 14% of the 366,000 new kidney cancer cases that occur worldwide; while clear cell renal carcinoma accounts for 74%. A number of targeted therapies (including Roche’s Avastin, Pfizer’s Sutent and Bayer’s Nexavar), immunotherapies and immune checkpoint inhibitors are approved to treat advanced renal cell carcinoma; however there are no currently approved treatments for PRCC. Given that savolitinib has demonstrated partial response in several solid tumours (Phase I overall response rate of 38% compared to GSK’s Foretinib 13.5% in Phase II), it is conceivable that savolitinib could be a global, first in class c-Met inhibitor to reach the market. Importantly the level of response to savolitinib by each patient correlated closely with the level of c-Met amplification. Positive data from the Phase II in PRCC in 2016 (the study completed enrolment in October 2015) could enable a US NDA submission (under the breakthrough therapy designation) by end 2016 with potential US launch in 2017.

Savolitinib has additionally demonstrated synergistic effects with other cancer drugs in pre-clinical models, hence its expansive clinical trial programme includes combination with other targeted therapies and immune therapies. For example, the combination of savolitinib with AstraZeneca’s Tagrisso could shut down two resistant pathways accounting for 60-70% of all EGFRm+ TKI resistant NSCLC patients. A Phase Ib expansion study in NSCLC is underway (second-line in combination with Tagrisso); if positive, this could lead to the initiation of global Phase II or III programme by end 2016 and potential US submission under breakthrough therapy designation late 2017/ early 2018. The NSCLC indication could be savolitinib’s largest opportunity given 1,690,000 new cases a year (8-10% c-Met amplification rate in NSCLC, source Frost & Sullivan). Exhibit 3 highlights the ongoing or soon to start clinical trials across all indications.

In 2011, HCM granted AstraZeneca co-exclusive rights to develop manufacture and commercialise Savolitinib globally. HCM received an initial $20m non-refundable licence fee with up to a further $120m in clinical development and early sales milestones payable (as of December 2015 HCM had received $10m of those milestones) in addition to significant further milestone payments based on sales. This is in addition to a 30% royalty rate payable on sales in China and tiered royalties of 9-13% of sales outside China. AstraZeneca will fund global development and share costs for development in the Chinese market. Notably the collaboration with AstraZeneca has resulted in the addition of Savolitinib to AstraZeneca’s Tagrisso and Iressa in two separate Phase Ib trials to address the opportunity for combination therapy as second- and third-line treatment for NSCLC.

We forecast global peak sales for Savolitinib of $3.4bn across the potential PRCC, CRCC, NSCLC and gastric cancer indications. Exhibit 4 details Savolitinib’s peak sales potential by indication, incident rates and penetration assumptions. We assume pricing of $10,000 per month in the US and ROW ex-China with a treatment course duration of 12 months, with China priced at a 50% discount. We believe this is conservative given that AstraZeneca’s Tagrisso, a third-generation TKI, is priced at $12,750 per month, which is in line with the pricing being attached to most of new lung cancer drugs, including ALK (anaplastic lymphoma kinase) inhibitors such as Pfizer's Xalkori and Novartis's Zykadia (source: Reuter’s). Furthermore, savolitinib could be moved into earlier lines of therapy as part of combination treatments, increasing the market opportunity, depending on the results of ongoing trials. Our model assumes a 30% royalty on China sales and 11% ROW sales payable to HCM from AstraZeneca and up to $110m more in milestone payments. We have not included milestone payments on further sales after initial launch, which would significantly enhance our valuation.

We have assumed higher overall penetration rates for PRCC given the 40-70% c-Met amplification and NSCLC 79% c-Met over expression rates. Our China penetration rates for NSCLC and gastric cancer err on conservatism. While we expect initial launch in 2017 for PRCC in China and the US, it follows that NSCLC and gastric cancer are larger opportunities given the patient populations. Note we forecast peak sales in China as seven to eight years from launch, and five years from launch in the rest of the world.

Fruquintinib is an oral small molecule that is a highly selective VEGFR inhibitor (anti-angiogenesis) and shows high potency at low doses. Fruquintinib’s broad development programme in China is in partnership with Lilly. Fruquintinib’s selectivity for VEGFR 1, 2 and 3 results in fewer off-target toxicities, allowing higher drug exposure that enables improved target coverage. The first-generation VEGFR inhibitors (examples include the monoclonal antibody Avastin [Roche], and small molecule TKIs Nexavar [Bayer] and Sutent [Pfizer]) had combined sales of approximately $8.7bn in 2015 across multiple tumour types, according to Frost & Sullivan. These treatments revolutionised the treatment of cancer by targeting the growth of blood vasculature that is essential for tumour growth. The success of these drugs validated VEGFR inhibition as a new class of therapy for the treatment of cancer during the last decade. The aim is to develop fruquintinib as best-in-class due to its better side effect profile to the first-generation drugs, for it to compete in the global setting. Consequently, fruquintinib is being assessed in late-stage clinical trials across multiple indications in China. The global clinical trials will focus on more proprietary combination studies (eg, fruquintinib plus savolitinib in clear cell renal cell carcinoma, fruquintinib plus Iressa in first-line NSCLC, fruquintinib plus Taxol in second-line gastric cancer).

Fruquintinib’s most advanced indications are Phase III development for colorectal cancer (third-line) and NSCLC (third-line) in China, with a POC Phase II gastric cancer (second-line) in combination with paclitaxel in China expected to start enrolling in H216.

Data so far has been encouraging; in the Phase II China colorectal cancer trial assessing fruquintinib as second-line monotherapy, median progression-free-survival (PFS) on the drug arm was 4.7 months versus 1.0 months in the placebo arm (p<0.001), with a disease control rate of 68.1% vs 20.8% and an overall survival rate of 7.6 months versus 5.5 months. Fruquintinib’s safety profile was confirmed in this study.

FRESCO, the Phase III, registration study in third-line monotherapy for CRC in China, was initiated in December 2015. This study is evaluating patients with locally advanced or metastatic CRC that have failed at least two other lines of treatment including fluoropyrimidine, oxaliplatin and irinotecan across 25 centres in China. Enrolment of 416 patients completed in May 2016 and top-line data could be published by Q117. Results from FRESCO will drive the China-based registration strategy (possible China NDA submission 2017), paving the way for a 2018 launch in CRC. The strength of the FRESCO study results additionally would drive the international clinical development plans (decision to initiate studies to support US FDA approval and marketing authorisation in Europe) and could result in Lilly extending the partnership further by exercising the option to develop and commercialise fruquintinib globally. We anticipate US NDA submission in 2016 and the start of Phase I bridging studies in Caucasian patients in 2017 to mark the start of the global clinical development programme. The global development programme could be undertaken relatively quickly, with Phase III trials starting once the Phase I bridging studies complete with positive results. We would anticipate first international launches in 2019/20 across NSCLC, CRC and gastric cancer indications.

FALUCA, the Phase III, registration trial in China, was initiated in December 2015 as third-line treatment for non-squamous non-small cell lung cancer, following a positive Phase II proof-of-concept (POC) trial that reached the primary endpoint of progression free survival (PFS) with no unexpected safety issues. The second-line Phase II study in gastric cancer in China is due to start in H216. We note that the Phase Ib in gastric cancer in combination with paclitaxel (Taxol) is already in progress.

In October 2013 Lilly signed a deal to co-fund development of fruquintinib for the Chinese market, worth up to $86.5m in upfront fees and milestones, with tiered royalties (15-20%), with an option for global development. HCM has received a $6.5m upfront fee (2013), and as of December 2015 $19.2m in development milestones plus $13.9m in reimbursement for certain developmental costs. Furthermore if Lilly exercises its option to develop fruquintinib outside of China, HCM could receive up to an additional $300m of developmental, regulatory and commercial milestones payments. Importantly the partnership agreement with Lilly has enabled HCM to establish a manufacturing facility in Suzhou, China, which is currently producing Phase III clinical supplies and will on approval be used to produce fruquintinib for commercial supply.

We forecast global peak sales for fruquintinib of $2.3bn across the potential CRC, NSCLC and gastric cancer indications. Exhibit 6 details fruquintinib’s full clinical trial programme, incident rates and penetration assumptions. We assume pricing of $5,000 per month in the US and ROW ex-China with a treatment course duration of 12 months, with China priced at a 50% discount. Our model assumes a 20% royalty on China sales and 11% ROW sales payable to HCM from Lilly and up to $60m more in milestone payments. We have not included milestone payments on further sales after initial launch nor sales ex China, which would significantly enhance our valuation, given that if Lilly exercises its option to global development of fruquintinib, HCM could receive up to $300m in additional milestones.

Exhibit 6 details our peak sales forecasts and assumptions by indication. Note we forecast peak sales in China as seven to eight years from launch, and five years from launch for ROW.

Sulfatinib is a novel, highly selective, oral VEGFR /FGFR1 TK inhibitor, being evaluated as a monotherapy for neuroendocrine tumours (NET) and thyroid cancers. VEGFR and FGFR are two tyrosine kinase receptors associated with angiogenesis and tumour growth. NETs are cancers that arise out of cells of the endocrine and nervous systems, predominately the digestive and respiratory tracts. While the current prevalence of NET in the US is ~140,000 patients (incidence of ~19,000 new cases per year), current treatment modalities are limited to subsets of NET with no broadly effective drugs across the NET spectrum.

Early Phase I data in China demonstrated sulfatinib has highly promising activity in neuroendocrine tumours, achieving an objective response rate (ORR) of 44.4% in 18 evaluable NET patients with 100% disease control rate (meaning no progression of disease). So far, the results of an ongoing Phase Ib/II trial assessing 81 NET patients are in line with expectations and importantly demonstrate that sulfatinib so far has superior ORR to Pfizer’s Sutent and Novartis’ Afinitor (currently approved treatments for pancreatic NET), as neither Sutent nor Afinitor have in clinical trials demonstrated an ORR of greater than 10%, and both drugs are only approved for pancreatic NET, which represents 10% of all NET. Sulfatinib is being evaluated across the spectrum of NET in pancreatic and non-pancreatic NET. A Phase III registration trial in China on non-pancreatic NET has started. International development plans are ongoing, with a Phase I US study that started in Q415 and a Phase II US study in broad spectrum NET patients is due to start in H216 once the Phase I concludes on the Phase II dose schedule.

Sulfatinib is additionally being evaluated for thyroid cancers; a Phase II study in China (thyroid cancer patients refractory to iodine treatment) started in March 2016. It also has potential in other tumour types, eg breast cancer with FGFR1 activation. Our current forecasts only include NET and thyroid opportunities as these indications are in active clinical stage development.

Importantly HCM currently retains all rights to the products worldwide, and we believe a licensing deal could materialise as data from the US Phase II reads out. In our sulfatinib valuation, we assume a partnering deal worth $80m with a $20m upfront payment in 2017, and a further $60m in development milestones. Our partnering deal assumption takes a ballpark figure in between the initial deals established with AstraZeneca ($140m) and Lilly ($86.5m). However, future deals could be predicated on retaining an optionality to commercialise alone in certain territories (ex-China) to enhance economic returns. We assume a 30% royalty rate on China sales, and 11% ROW.

We forecast global peak sales for sulfatinib of $1bn across the NET and thyroid cancer indications. Exhibit 8 details the full clinical trial programme, penetration/incident rates and penetration assumptions. Our peak sales forecasts for sulfatinib in NET are conservative as at this point we assess mainly the US market, given a lack of meaningful statistics for either China or ROW across the broad spectrum of NET. We have assumed a 50,000 prevalence rate in China for modelling purposes. In our sulfatinib valuation, we assume a partnering deal worth $80m with a $20m upfront payment in 2017 and a further $60m in development milestones.

Epitinib is an oral small molecule EGFR inhibitor for the treatment of NSCLC with brain metastasis that has been designed for optimal brain penetration. Unlike currently available EGFR inhibitors (Iressa and Tarceva) that have been revolutionary for the treatment of NSCLC with EGFR mutations, epitinib can cross the blood-brain barrier and reach effective concentrations to treat patients with solid tumours who develop brain metastasis. According to OncoLink, the exact incidence of brain metastases is not known. Studies suggest brain metastases occur in 10-30% of patients with cancer, including NSCLC. Furthermore, an estimated 50% of NSCLC patients who eventually develop brain metastasis do not have effective treatments. In pre-clinical studies, epitinib demonstrated better brain penetration and efficacy than Tarceva. A Phase Ib proof of concept trial is ongoing in China evaluating epitinib 160mg once a day as first-line in EGFRm+ NSCLC patients with brain metastasis. Full results are expected in 2016; if positive, a Phase III in China will be initiated in 2016. This could pave the way for international studies and a potential application for US approval under the FDA’s breakthrough therapy designation.

We forecast epitinib peak sales of $905m for the NSCLC with brain metastasis indication, based on a 5% penetration of the NSCLC patient population with brain metastasis (20% of the 1,690,000 global new cases of NSCLC patients worldwide, 623,000 new cases in China), $5,000 per month ex-China (50% discount on price in China) and 12 months’ duration of treatment. HCM currently retains all rights to the products worldwide. In our epitinib valuation, we assume a partnering deal worth $80m with a $20m upfront payment in 2019, and a further $60m in development milestones. We assume a 30% royalty rate on China sales, and 11% ROW.

Theliatinib is an oral small molecule EGFR inhibitor that has shown potent preclinical activity against tumours with EGFR-activating mutations and those without (known as wild-type). The hypothesis is that tumours with wild type EGFR activation (gene amplification or protein over-expression) are less sensitive to TKI treatment due to less optimal binding affinity. Theliatinib has been specifically engineered to have significantly greater binding affinity to wild type EGFR proteins; in pre-clinical models the drug demonstrated 5-10x more potency than Tarceva. EGFR over-expression as a validated target has been proven by BMS/Merck/Serono’s Erbitux, a monoclonal antibody approved for use in head and neck and colorectal cancer. However, there are many other EGFR over-expressed tumour types, notably oesophageal, NSCLC, gastric cancers and glioblastoma, where there are no approved targeted therapies.

Theliatinib is being assessed for maximum tolerated dose in Phase I in China as a third-line therapy in patients with wild type EGFR gene amplification or EGFR over-expression NSCLC; data so far shows that while MTD has not yet been reached, theliatinib has achieved effective plasma concentrations. Safety and PK results are good and dose escalation is continuing. Once the Phase II dose is established, multiple Phase Ib studies in oesophageal and head and neck cancers will commence.

We forecast theliatinib peak sales of $860m in our model; Exhibit 9 details our peak sales forecasts and assumptions by indication. Note our peak sales assumptions in China are seven to eight years from launch, and five years from launch ROW. HCM currently retains all rights to the products worldwide. In our theliatinib valuation we assume a partnering deal worth $80m, with a $20m upfront payment in 2018, and a further $60m in development milestones. We assume a 30% royalty rate on China sales, and 11% ROW.

HMPL-523 is a novel Syk inhibitor for oncology and inflammation with first-in-class potential. Over the last two decades the armamentarium for the treatment of rheumatoid arthritis (RA) has made significant advances with the discovery of biologic agents (eg anti TNFs) that block the cytokine element of the inflammatory cascade response. These intravenous protein based drugs are greatly efficacious but have limitations in terms of side effects. The next generation of oral small synthetic molecules being developed more specifically block the signal transduction pathways that are triggered by the inflammatory cytokines. For example, Syk is a key kinase that plays a part in activating kinases PI3K (delta) and BTK present in the B-cell signalling pathway, therefore Syk is an important target for modulating B-cell signalling. Approved drugs targeting the B cell signalling pathway include AbbVie’s BTK inhibitor Imbruvica (approved for mantle cell lymphoma and CLL) reported 2015 sales of $1.3bn following approval for its first indication in November 2013.

However, to date the biopharmaceutical industry has had little success in developing Syk inhibitors with AstraZeneca/ Rigel Pharmaceutical deciding to discontinue fostamatinib for RA based on the Phase III OSKIRA-2 and OSKIRA-3 studies, which demonstrated mixed top-line results (second-line). Importantly, efficacy was not compelling enough versus the side effect profile (notably hypertension and diarrhoea) compared to established anti TNF drug Humira (AbbVie). HMPL-523 has been designed as a highly selective Syk inhibitor, and its selectivity should lead to less off target toxicities such as hypertension (lack of KDR enzyme inhibition in comparison to fostamatinib).

HMPL-523 is at an early stage of development but is one to watch given its pharmacokinetic and preliminary safety profile and the overall size of the RA and lupus markets plus potential in haematological malignancies. The Phase 1 Australian dose escalation studies in healthy patients have completed. No material off-target side effects (hypertension and severe diarrhoea) were observed. Global phase II proof-of-concept studies in RA and possibly lupus could start in 2016.

Additionally a Phase I Australian dose escalation study is underway to determine HMPL-523 potential utility in haematological malignancies (relapsed and/or B-cell non-Hodgkin’s lymphoma or chronic lymphocytic leukemia). This follows on from proof-of-concept data that has emerged from Gilead’s entospletinib, which is serving to validate Syk as a target for such malignancies.

The immunological disease market is large, with the global market for Rheumatoid arthritis in 2015 was $35.5bn and for lupus $2.1bn. The global prevalence of RA was 19 million in 2015, of which 948,000 cases were in the US. The global prevalence of lupus was 4.2 million, of which 307,000 cases were in the US. There were 983,000 new haematological malignancies in 2015, with a treatment market value of £20bn. Given these statistics, there is a huge global opportunity for a successful Syk inhibitor even assuming low single-digit penetration rates (sources: Evaluate Pharma, HCM reports).

However, given the early stage of development we have erred on the side of caution and forecast only for RA at this stage as we anticipate start of the Phase II in RA in 2016. We forecast $1.6bn peak sales across in RA for HMPL-523. We assume a 20% royalty rate on worldwide sales but do not include any licensing or developmental milestones at this point. We would anticipate introducing peak sales forecasts for other indications as the clinical trial programmes develop and or data become available. HMPL-523 could transform HCM’s prospects even further in the mid- to long-term. HCM currently retains all rights to the products worldwide.

Historically the investment case rested largely on the prospects for the China Healthcare component of this division. While increasing investor focus has shifted to the innovation platform and the pipeline growth opportunities, HCM’s commercial platform is well placed to capitalise from one of the fastest-growing healthcare markets in the world. Importantly cash generated from this business has been reinvested into developing the R&D business over the last 14 years. Unlike unprofitable biopharmaceutical peers, this reduces the need to raise cash to fund research and development as frequently.

Over the past 16 years, HCM has built a broad OTC and Rx (prescription-only drugs) TCM fully integrated, manufacturing, marketing and distribution network that reaches across China. This extensive commercial network consists of 3,200-person sales team; including 1900 medical reps for prescription drugs, 1,300 OTC sales reps covering greater than 300 cities and towns detailing to ~80,000 doctors across ~16,500 hospitals. Importantly this established commercial network will be invaluable in launching the innovative product portfolio in China; we anticipate operational leverage in the medium term from the two platforms after the initial launch infrastructure costs have been met. Exhibits 11 and 12 highlight the breadth of coverage in China and the holding structure.

Commercial Platform reported total sales of subsidiaries and JVs from continuing operations of $518.9m (+11%) in 2015 contributing $25.2m (+10%) net attributable profit (NAP) to HCM equity holders. The Commercial Platform is subdivided into prescription drugs and consumer health. Prescription drugs consist of two pharmaceutical JVs that account for~ 60% of net profits (sales of $286.6m, NAP booked $15.9m in 2015).

Consumer Health consists of two wholly owned subsidiaries and two JVs. Reported combined sales were $232.3m in 2015 and the NAP booked was $9.3m.

We expect the CP unit to continue to post above-market rates in the near term. We forecast 12.5% and 5.0% sales growth in 2016 for SHPL and for HBYS respectively. Furthermore this China based distribution platform will be invaluable once the pipeline comes to fruition. We anticipate operational leverage from the two businesses after the initial launch infrastructure costs and specialist sales rep hires have been met. HCM intends to build an oncology focused sales team under the prescription drugs business for this purpose.

The Chinese healthcare market is a large, untapped and fairly nascent market and like many developing economies in its multiple layers of complexity. This includes:

All this is compounded by various levels of literacy, availability of information and cultural acceptances of treatment normalities.

Despite these complexities, the Chinese healthcare market has demonstrably benefited from governmental social and strategic commitments, a burgeoning middle class (that is educated and understands the importance of non-traditional medicines) and a growth in wealth (polarised between rural and urban and more wealthy provinces) that gives people the ability and willingness to pay for goods where the direct consumer benefit can be seen. We highlight the impact that the growth the Chinese middle and affluent classes have historically contributed to the growth of the luxury goods companies such as LVMH, Prada, Tod’s and Remy Cointreau.

As of 2015 China is estimated to be the second-largest healthcare market in the world, with the US ranked number one. In nominal terms China’s expenditure on healthcare is still a relatively small percentage of its output, at 5.1% of GDP in 2011, or $369bn of $7.325tn. However, by 2020 GDP is forecast to be around $14.6tn and healthcare will represent 8.5% of this: a total of $1.25tn (sources: Forbes, China Ministry of Commence and Ministry of Health 2012).

The Chinese market is dominated by prescribed generic drugs, which accounted for 57% ($35.6bn) in 2010. A large percentage of spend within the healthcare system is on cheaper consumer products, OTC and TCM. Patented branded drugs accounted for only 4.1% in 2010 but this is forecast to rise to 7.9% by 2022. TCM is forecast to lose market share from 13.9% to 9.9% in 2022, while OTC is forecast to increase to 22.6%, from 15.2% (source: Visiongain, Evaluate Pharma, HCM reports). The growth of Western or chemically based drug products in China partly reflects the shift in medical practice as the efficacy of such therapies, especially in treating more debilitating conditions (notably cancer), is more recognised. With the region’s burden of increasing chronic diseases combined with an ageing population, the increase in revenues is mainly from treatments for cancer, cardiovascular diseases, diabetes and central nervous system disorders.

It is estimated that prescription drugs could grow from $60bn in 2010 to $261bn in 2022. This will be driven by ongoing government policies broadening access to healthcare, widening insurance coverage, a growing economy supporting a burgeoning middle class with an ability to pay, higher rates of education and acceptance of efficacious western drugs, with the backdrop of an alarming growth rate in the prevalence and incidence of cancers, diabetes and cardiovascular diseases.

The Chinese government is committed to improving access to healthcare on several levels and this underpins the robust growth rates in the Chinese market. China’s five-year plan sets up strategic goals for each of its major industries and prioritises government support accordingly. The current five-year plan, the 13th, extends to 2020. The 12th five-year plan continued the multifactorial support of past plans and expanded on universal health coverage to a commitment to developing a world-class life-sciences industry backed up with intellectual property support.

The pharmaceutical market is highly fragmented with more than 4,000 domestic manufacturers and, by 2006, over 1,500 foreign owned or joint venture pharmaceutical manufacturers. China has a complicated, multi-tiered pharmaceutical supply chain with more than 12,000 local wholesalers. Improved prospects for pharmaceuticals have attracted many multi-national drug companies, with all of the top 20 global pharmaceutical companies either having a direct presence or established extensive joint ventures. Since 2006, 13 of the top 20 international pharmaceutical companies have established R&D centres in China to access the supportive government environment and unmet need. Pfizer is the leading pharmaceutical group by sales, with just 2% of the market in 2012, demonstrating the highly fragmented market place. The largest three domestic distribution companies accounted for 18% of the $110bn 2010 market (Sinopharm 9%, Shanghai Pharmaceuticals 5% and China Resources 4%).

Despite the challenges faced, there is a significant opportunity for regional players, with extensive local knowledge and competitive pricing strategies. HCM’s domestic player position is of huge importance, as local players with local knowledge will remain at an advantage.

The market for targeted oncology therapies has grown enormously during the last decade, reaching $41.8bn in 2013 and representing 46% of the total cancer therapy market (source: Evaluate Pharma, HCM reports). Oncology in China remains an untapped market and opportunities for cancer treatments are huge; the Chinese Ministry of Health reports that the cancer mortality rate has increased by 80% over the past 30 years with around 1.8 million people dying annually (compared to around 0.6 million in the US according to the American Cancer Society).Yet, despite their proven efficacy, the high cost of targeted therapies has proven to be the major limitation on growth. For example, the 10 main global approved targeted therapies in China range in price from $2,730 per month (AZN’s Iressa for NSCLC) to $16,580 per month (Roche’s Rituxan for NHL, close to its US prices). Local Chinese companies have begun to exploit this by entering the market with ‘me-too’ EGFR products (they are different molecules but their mode of action, efficacy and safety profile is very similar to the originator product). Such undifferentiated products can be developed locally at a lower cost and priced with the domestic market in mind rather than having to work within a global pricing regime. The leading example is Zhejiang Beta Pharma’s Conmana (icotinib), which is similar to Iressa (gefitinib) but priced at around a 30% discount. HCM’s more targeted approach to developing best or first in class will be one differentiating factor (eg novel drugs for unmet needs such as papillary renal cell carcinoma, ones with improved side effect profiles). Another will be its established drug distribution platform. However, regional pricing strategies will also be of great importance to the commercialisation strategies on a molecule-by-molecule basis.

HCM executive and senior management consists of internationally experienced Chinese and British nationals with established track records within multinational businesses. Exhibit 15 outlines management biographies.

HCM is subject to the usual biotech and drug development risks, including clinical development delays or failures, regulatory risks, competitor successes, partnering setbacks, and financing and commercial risks. The key sensitivities for HCM relate to crystallising value from the mid- to late -stage pipeline, in particular savolitinib, fruquintinib and sulfatinib: these three products contribute ~65 % to our valuation. For the earlier-stage pipeline, both clinical development and partnering risks remain. We expect HCM to develop oncology assets epitinib and theliatinib and immunology assets HMPL-523 and HMPL-689 through to Phase II with initial proof-of-concept data before partnering. However, we have limited visibility beyond that on the terms and timing of any potential deal(s).

Economic uncertainties will always exist in China, alongside queries over who will fund healthcare costs. However, we believe government measures to open up the private healthcare insurance market to international players on top of extensive (although less broad) universal state coverage should help acquiesce these concerns. Furthermore, uptake of the more expensive innovative cancer drugs is likely to be skewed to the growing and increasingly affluent middle class population. One need only look to the luxury and branded goods sectors as a benchmark of what consumers will pay if they see a perceived benefit. Regulation and reimbursement risks are pertinent for all drug companies. Navigating the nuances of the healthcare system in China has been particularly troublesome for a number of Western companies, but HCM’s local expertise stands it in good stead.

CK Hutchison’s involvement is a key attraction. The undoubted expertise and presence (commercial, political and corporate governance) materially reduces the myriad risks associated with any direct investment in China. However, CK’s Hutchison holding of 60% of shares does raise concerns for some investors about the pitfalls of being a minority shareholder. The large shareholding also limits the liquidity of the shares, but poor liquidity is a feature of many attractive smaller healthcare companies. The recent NASDAQ listing, however, could improve liquidity.

HCM’s business diversity means the best approach to valuation is a sum-of-the-parts. The innovation platform (R&D unit) is a classic emerging pharmaceutical play and is valued using a discounted cash flow (DCF), with the rNPV of the individual clinical projects (adjusted for the success probabilities) summed and netted against the costs of running the operation. CP is cash and profit generating so earnings-based metrics are appropriate.

For the innovation platform, our DCF-based calculation of the clinical projects gives a risk-adjusted value of $1,712m (equivalent to 1,882p a share), with the later clinical stage of assets savolitinib, fruquintinib and sulfatinib carrying the most value (at $1,512m and 1,662p per share) within our model. These quickly progressing TKIs have the scope to add more value as regulatory filings and potential approval trigger milestone payments, and the probability of success alters our risk-adjusted discount rate. HMPL-523 for RA now contributes a risk-adjusted value of $64m (we apply 10% probability of success) to our valuation but progress could result in a material uplift given the numbers of patients afflicted with RA/lupus and haematological malignancies. Understandably, it follows that the later projects have a higher current value, with the step change occurring at Phase II when proof of principle largely occurs. Assuming even modest success within this element of the development pipeline could see a material uplift in our valuation for HMPL-523.

Exhibit 17 details the breakdown of contribution from products by indication to our risk-adjusted NPV. However, we have included the non-risk adjusted NPV (in grey) to illustrate the potential value of the pipeline should all projects in our forecasts succeed. Projects in pre-clinical development or very early Phase I are not yet included in our valuation.

With the commercial platform we look at the earnings multiples of peers quoted on the Chinese stock exchanges. Using a 22.5x multiple (in line with the sector average for comparable domestic Chinese companies) on the 2016 forecast net attributable profit of $29.2m for the commercial platform unit results in a valuation of $657m (722p per share). The net cash forecast for December 2016 is to $39.6m (44p a share) and subtracting unallocated corporate costs (valued using an NPV) of $66.8m (73p a share) results in our sum-of-the-parts valuation of $2,342m (2,575p a share).

It is worth noting that under US GAAP, jointly controlled entities (JCEs) are no longer consolidated proportionately, with attributable profit only shown on the P&L. JCE assets are now effectively off-balance sheet. For our valuation this means the cash held by the JCEs is not included in our valuation of the group.

The change of reporting from IFRS to US GAAP in 2015 had a significant impact on the historical consolidated financial statements before the restated years of 2013 and 2014. This includes two main changes. First, revenue recognition of upfront and milestone payments under US GAAP is now recorded in its entirety when received as opposed to a percentage of completion method to recognise milestones under IFRS. Second, the accounting treatment of redeemable convertible shares under US GAAP these will be classified as mezzanine equity.

At the FY15 results revenue from continuing operations grew by 104% from $87.3m to $178.2m, with the IP division contributing $52.0m (largely attributable from payments by partners) and consolidated CP sales contributing $126.2m. We forecast IP revenues of $40m in 2016 and $70m in 2017 largely driven by developmental milestone payments from partners AstraZeneca and Lilly for progress of savolitinib and fruquintinib respectively. We expect CP to continue posting double-digit top-line growth and forecast $140.4m in 2016 and $156.0m in 2017 respectively. These CP revenue numbers do not take into account revenues reported by the Shanghai Hutchison and Hutchison Baiyunshan joint ventures. Only the net attributable profit of the JV contribution is reported as equity in earnings of equity investees, net of tax below the PBT line. In 2015 this was reported as $22.6m and we forecast this to grow to $54.2m in 2016 and $38.1m in 2017. A major component in the uplift is the distribution of profits from the land compensation which we book as $30m in 2016 and $15m in 2017. Importantly net attributable profit of the JV contribution also includes a negative contribution from the Nestlé JV (NSP), which is not recording revenues at present but is investing around $3m a year for the development of HMPL-004 (reformulation to enter Phase I trials in 2017). Exhibit 19 details the historic and forecast breakdown of CP revenues and profit. Note the revenue and net profit breakdown include all subsidiaries and 100% of the JV contribution. However, under US GAAP only the net profit/(loss) attributable to HCM is recorded in the consolidated P&L at PBT level. PBT at the HCM consolidated level therefore includes contribution from the consolidated CP subsidiaries, the innovation platform segment and unallocated costs.

For valuation purposes we do not include the NSP negative contribution as we include R&D associated with this in unallocated costs, given we do not explicitly model forecasts for HMPL-004.

Profit before tax at the group level reported a loss of $10.5m in 2015, largely due to the increase in R&D ($47.4m in 2015 versus $29.9m in 2014), S&M ($10.2m in 2015 versus $4.1m in 2014) and administrative expenses ($19.6m in 2015 versus $12.7m in 2014). We expect R&D expenses to increase to $70.1m and $78.2m in 2016 and 2017, reflecting the substantial need for investment in the burgeoning clinical trial programmes across the IP division. We expect S&M and admin costs to increase marginally and, given higher cost assumptions, we forecast operating losses of $46.8m in 2016 and $25.2m in 2017 due to higher R&D costs in 2016 and 2017. In 2015 net income from continuing operations, which includes the profit contribution from JVs (see above), reported at $10.4m and we forecast $2.5m in 2016 and $8.1m in 2017. After stripping out minorities we forecast a net loss attributable to the company of $0.3m in 2016 and a net profit of $3.6m in 2017.

HCM retains a healthy gross cash position. At year end 2015 there was $31.9m in cash and bank balances, offset by $50m in bank loans at the group level. At the JV level, not consolidated by the group, Hutchison Baiyunshan and Shanghai Hutchison had cash and equivalents of $76.9m (offset by a $0.6m loan) at the end of December 2015. This does not include gross proceeds of $110.2m raised from the Nasdaq listing in March 2016. We forecast a net cash position of $39.6m at end 2016 versus a net debt position of $18m at year end 2015.

Property windfalls aid additional cash injections; the appreciation in land values has benefited SHPL and HBYS old factory sites in Shanghai and Guangzhou, which are now in prime residential locations. The growth in production volumes and tighter regulations in China mean new, modern factories are needed. Around 90% of the ~ $140m capex requirement has been invested (funded internally at the JV level) in two new factories in Shanghai and Anhui province and are expected to come online in mid and late 2016 respectively, enabling triple production capacity for own brand labels. Fortunately, the compensation formulas (c 40% of land auction values) mean the total cash compensation is significant even after the JV capex requirements. The group is to receive $105m total cash compensation for the SHPL sites from the Shanghai government over 2015 and 2016 with $31.1m received in H215. A further $73.9m from the Shanghai property compensation is expected at the JV level in 2016. HCM’s share of this should feed in through special dividends over a number of years and we forecast an increase in dividends received from equity investees in 2016 to $32m from $6.4m in 2015. Further compensations are anticipated for the Guangzhou sites and we include a minor contribution only in our 2017 and 2018 forecasts, erring on the side of conservatism due to the uncertainty of the timing and outcome of any deal.