OREANDA-NEWS. Fitch Ratings has published Hua Han Health Industry Holdings Limited's (Hua Han) Long-Term Foreign-Currency Issuer Default Rating (IDR) of 'BB-' and senior unsecured rating of 'BB-'. The Outlook for the IDR is Stable.

KEY RATING DRIVERS

Established, Profitable Business: Hua Han is one of the largest manufacturers of traditional Chinese medicine (TCM) for women's health in China. Its top five products accounted for 67% of total sales in the financial year ended 30 June 2015 (FY15). The five products are all exclusive to the company and are included in the National Medical Insurance Catalogue or Essential Drug List, which allows buyers to be reimbursed for their purchases via the national medical insurance programme.

The company's existing core products have enjoyed high margins over the years and are subject to long patent protection. It plans to expand its product range with the launch of new biotechnical medicines in FY17, for which it is seeking approval from the China Food and Drug Administration. Hua Han's EBITDA margin was at a record high of 44% in FY15; Fitch expects it to narrow to 30%-35%, in line with historical trends.

Strong Financial Profile: Hua Han has maintained a net cash position for more than five years, driven by steady operating cash flow generation and frequent equity issuance. Fitch expects the company to maintain its net cash position even as it embarks on a phase of high capex to construct new hospitals.

Diversification into Hospital Services: Hua Han began its foray into hospital services in 2014 by signing agreements with local governments to manage the supply chain of hospitals under a Trust-Investment-Operation-Transfer (TIOT) model. By 1H15, Hua Han had agreed to manage the supply chains at eight hospitals with 5,151 beds. The four hospitals that have started operations contributed revenue of HKD220m in FY15 and Fitch expects this contribution to surge to about HKD700m in FY16, as the business expands.

Under the TIOT model, which usually has a term of 20 years, Hua Han makes a fixed investment in the hospital to improve medical facilities and clinical services. In return, it receives management fees and income earned from managing the supply chain without consolidating the hospital's financial results. The management fee is a fixed percentage of the hospital's total revenue while income is derived from the revenue earned by certain departments of the hospital, respectively.

Business Mix Drives Margins: Hua Han achieved EBITDA margin of 24% from hospital supply chain management in FY15, which is likely remain stable in the future. However, the increasing revenue from hospital services may result in overall margin contraction, as the core pharmaceutical business generates higher margins. Fitch believes the hospital services venture provides Hua Han with a stable profit source, but it is exposed to any adverse changes in regulation and competition in China's rapidly evolving healthcare industry.

High Capex: Hua Han has begun constructing three new hospitals with 2,560 beds in Guizhou Province, with the bulk of the capex spend in FY16 to FY18, to expand into the majority-owned model from the TIOT model. Under this model, Hua Han will manage a much larger portion of the hospitals' operations and thus, is likely to achieve higher financial returns. Fitch does not expect Hua Han to aggressively expand the majority-owned hospital portfolio given the high capital costs, fewer opportunities, and the company's limited track record in the business.

Small Scale Constrains Rating: Hua Han's rating is constrained by its small operating scale with annual EBITDAR of less than USD100m compared with other global healthcare peers. Branching out into hospital services and expanding its bio-technical products will allow the company to grow at a much more rapid rate and diversify revenue concentration risk, though it exposes Hua Han to execution and regulatory risks.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Capex to be HKD800m in FY16, HKD2bn in FY17, HKD1.5bn in FY18
- 10% annual growth for hospital revenue under supply chain management business
- Stable gross margins for pharmaceutical sales and supply chain management
- Revenue from new bio-technical products to be HKD350m-HKD550m in FY17-FY19

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
No positive rating action is envisaged in the next 12-18 months due to the company's limited scale and new business operations.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- EBITDA margins sustained below 30%
- FFO-adjusted net leverage sustained above 1.0x
- Poor execution of new hospital management service business
- Significant cost overrun in new hospital construction.