We held an investor conference call with the management of Dongyang Guangyao last Friday.

We believe that the price-to-earnings ratio valuation of shares is difficult to be revalued to about 15 times their previous levels because of increased risks associated with volume procurement and a lack of catalysts for shares.

We lowered our annual net profit forecast for 2020-21-22 by 10% / 6.4% by 7.9%, mainly reflecting the decline in the visibility of Kewei's growth.

We have lowered the target price from HK $53.09 (9 times 2020 price-to-earnings ratio; 1 share for every existing share) to HK $15.23 (6 times 2020 price-earnings ratio, about 1.5 standard deviation lower than the average of 9.8 times for the past 12 months, and has taken into account the impact of one bonus share per existing share and the softening of the RMB exchange rate). The lower valuation reflects the increased risk of volume procurement. Demoted to "hold".

Why downgrade again?

In November 2019, we downgraded the company to "hold" due to corporate governance problems arising from the acquisition of two diabetes drugs. At the end of March, as the company's valuation became attractive and the COVID-19 epidemic was expected to boost Kewei sales, we upgraded it to "overweight". Now we have downgraded to "hold" because things have changed in the past few months: 1) the COVID-19 epidemic may not drive Coway sales as expected, as wearing masks helps prevent the spread of influenza (figures 2 and 3). The domestic COVID-19 epidemic is under control faster than we expected; 2) in the past few months, the risks associated with Kewei's volume procurement have increased.

Increased risks associated with volume procurement of Kewei

We have seen an increase in risks associated with volume procurement due to the increase in the number of ostavir BE (bioequivalence) registered in the past few months (for example, Zhong run Pharmaceutical registered BE in June 2020, Wanhan Pharmaceutical registered BE in May 2020, Shenzhen Beimi Pharmaceutical registered BE in April 2020). We expect the second Ostavix Pharmaceutical (perhaps Chengdu Beit Pharmaceutical or Xintai Pharmaceutical) to be available as early as the end of 2020 at the earliest. As Coway has about 90 per cent of the Ostaville market, once Ostaville is included in centralized procurement (which we think may be completed in about two years given the development of Ostaville BE), Coway will lose market share significantly and have the opportunity to significantly reduce prices, meaning that the company's profits will be significantly adversely affected from 2022.

It is difficult to get a revaluation, but the dividend yield is still attractive

At this stage, we do not see any catalyst that will lead to a significant increase in share valuations in the foreseeable future (the current price-to-earnings ratio valuation is medium units). On the contrary, we believe that the following factors may affect the revaluation: 1) the market may be worried about its corporate governance in the long run; 2) the launch of Ostevix Pharmaceuticals and the increased risk of Kewei's volume procurement; 3) the company has no plans to launch significant new products (we think the domestic insulin market is already quite competitive, while the HCV market is very limited) 4) the RMB is weak, which will lead to exchange losses on convertible bonds denominated in US dollars. As a result, we think it is difficult to revalue the company to about 10-15 times what it was a few years ago. We believe that the company may become a company with plenty of cash flow, offering a dividend yield of more than 5% a year. We estimate that the company is in a net cash position and expect its operating cash flow to exceed 2 billion yuan in 2021, which may help the company ensure its dividend.