Brazil Health Care Struggling to Meet Demand

Transcription

1 Brazil Health Care Struggling to Meet Demand September 06, 2012 LatAm Team Gustavo Wigman +55 (11) Clarissa Berman +55 (11) Claudio Lensing +55 (11) Paulo Albano +55 (11) Adjusting Strategies for Fiercer Competition Unlike other research houses, we include health care under the umbrella of consumer goods and retail. We understand their nuances but believe they are all fighting for the same thing: a larger share of Brazilians wallets. Competition is getting fiercer while wallets are getting tighter, and this combination may have deep implications for players unable to adjust their strategies to a new and tougher reality. Signs of changes are visible, and market valuations should adjust accordingly. Assuming Coverage of the Brazilian Health Care Sector We are assuming coverage of AMIL3, DASA3, FLRY3, and ODPV3 and initiating on BPHA3. To maintain consistency in the scenarios used in our DCFs, we are updating our estimates for HYPE3, RADL3, and QUAL3. Despite their unique characteristics, these stories are all exposed to the core theme explored in this report: rising health care costs. In this note, we explore the themes we believe will drive industry discussions and discuss the implications for each sector and company under our coverage. Trading Ideas in the Sector Under the scenario analyzed, we see higher upside for pharma chain players. Setting short-term challenges aside, the outlook for service providers in the health care chain is also appealing. Our stock preferences are HYPE3 (+25%), AMIL3 (+27%), QUAL3 (+18%), and RADL3 (+14%). DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. FOR OTHER IMPORTANT DISCLOSURES, visit research disclosures or call +1 (877) U.S. Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Table of contents Executive Summary...3 Health care inflation, in our view, is an inexorable trend and we dedicate this report to analyze its implications on growth and profitability for sector players, both in the health services and pharmaceutical chains. Sector Debate: Dealing with Rising Medical Inflation...11 Health care service supply is failing to meet the rising demand, supporting higher and stickier medical inflation going forward. As detailed in this chapter, trend will be positive some players but very negative for others. Health Services Value Chain: Tailwinds for Providers...19 Strong demand for services, lack of interest to expand supply due to historically subpar ROIC and growing presence of individuals on health care purchasing decisions should gradually transfer pricing power to providers. Pharma Value Chain: Positive Outlook for Generics...27 The growing presence of generics should have deep implications for the entire pharma chain: it enhances the addressable market for drugs, it helps on the control of medical inflation, and improves the margins of drugstores. Dental Value Chain: Is There a Case for Individual Plans?...37 Dental plan operators have shown a remarkable track record of growth and ROIC in the past decade. Now operators face the challenge (and struggle) to replicate the same success at the individual plan segment. Companies Section...41 New in This Report We include the health care space in our broader consumer coverage to maintain consistency across our forecasts for consumer spending categories We explored our CS Consumer database to get insights into healthcare spending patterns across the value chain. It provided us with the granularity needed to explore trends on a micro level. We take a comprehensive approach to analyze the entire health care value chain (vs. the traditional segmented view), which allows us to cross-check profit pools and fully understand value transfer trends in the sector Brazil Health Care: Struggling to Meet Demand 2

3 Section subtitle Executive Summary Health care inflation appears irreversible unless profound changes in the structure of the health care industry are made. Organic growth opportunities are not obvious, and players will need to rely on market share gains to maintain top-line momentum. We assume coverage of the health care sector with the same core theme as that of our consumer report ( the past is no longer a good guide for the future ) and explore in this report the key issues we believe will drive discussions (and stock performance) in the years to come. We are assuming coverage of AMIL3, DASA3, FLRY3, and ODPV3 and initiating coverage on BPHA3. We are also updating our models for HYPE3, RADL3, and QUAL3 to keep consistency across forecasts and DCF results. Ask any middle-class Brazilian about his or her aspirations and you will hear four key items: a house, a car, good education for the kids, and health care coverage for the family. Unfortunately, the average middle-class income does not allow for all four but rather only one or two of these items. Despite their limited budgets, lower-income people already represent a significant share of the health care market in Brazil, particularly for pharmaceuticals. Looking at the 2009 Survey of Household Spending (POF) published by the Brazilian Statistics Bureau (IBGE), summarized in Exhibit 1, we see that families earning R$2,450 per month or less spent R$37 billion on health care products and services in that year, or one-third of total expenditures. If we consider only the pharma segment, their stake in total expenditures rises to 50%. As discussions on health care inflation intensify, one of first questions that emerges is whether this new middle class can afford higher out-of-pocket expenses. They already commit a much higher share of their earnings to health care than richer families do, but it is hard to assess whether they have reached their limit. What we do know is that over 25-40% of these families claim to have difficulties surviving on their monthly income, which does not suggest much room for additional expenditures. Despite the slowdown in the economy, the outlook for wage growth in Brazil remains quite positive, particularly for lower-income workers. The question then moves from capacity to willingness of middle-class families to spend more on health care. If we calculate health care costs as percentage of total household expenditures, instead of total income (i.e., by excluding savings from income), we find a fairly constant ratio across all income bands. The picture is completely different for other true necessities, such as housing or food, for which poorer families spend a significantly higher share of their budgets. The low priority for health care is also illustrated by qualitative consumer spending surveys frequently released by the media. Exhibit 2 summarizes such surveys, published recently by Valor Econômico, but there are many others like them. When asked about new services purchased in the past two years, new middle-class families did mention health care, but it ranked far below other services such as cable TV, prepaid cell phone time, and internet access. These wish lists apparently suggest that the true dream of a Brazilian is to get a good education (free if possible) and find a good job that will provide family health care coverage as part of the compensation package. Brazil Health Care: Struggling to Meet Demand 3

4 Exhibit 1: Household expenditure profile Type of expenditure Household income bands (R$/month) Up to to to to More than HC as % of income # of families (mn) Income (R$/month) Recurring expenditures Food Housing Difficulty to get to the end of the month with current income Clothing Transportation HPC HC as % of expenditures Healthcare Education Leisure Tobacco Personal services True necessities as % of expenditures Housing Food Other Up to to to to More than Source: POF/IBGE, Credit Suisse Either due to the low affordability of private health care services or the unwillingness of Brazilians to spend their money on health care, the fact is that much of the burden has fallen on the government. The 1988 Brazilian constitution recognized health care as a citizen's right and a duty of the state and established the basis for the creation of the United Healthcare System (SUS), based on the principles of universal access, full coverage, and social participation. Since then, public expenditures on health care have increased roughly ten times. Exhibit 2: Discrepancy between what people wish and what they buy Pay-TV Prepaid cell phone Services used for first time in the past two years (in %) Internet Credit card Bank account Health care plan 1 Source: Press, Credit Suisse Own home Car Education Computer Travel in Brazil Home appliances Furniture Aspirational The achievements of the SUS have been noteworthy. The system has increased access to health care for a substantial proportion of the population, reached universal coverage for vaccinations and prenatal care, improved public awareness of health care as a citizen's right, and made several investments in the expansion of human resources and technology, including fulfillment of most of the country's pharmaceutical needs. Despite the remarkable investments and achievements of the SUS, the public health sector is struggling to keep up with rising demand. Infrastructure and human resource constraints are notable across the country, and service levels are often deplorable. Patient satisfaction is low, and not surprisingly the main issue raised by voters in every election is health care. The government has strict budget limitations. Health care expenditures may appear low compared to developed countries (as a percentage of GDP), but they far surpass emerging market peers such as China, India, or Mexico. The bad news for the Brazilian government is that rising medical inflation and the rapid aging of the population will likely continue to pressure the federal budget and force the government to accelerate any restructuring plan it may have for the sector. Brazil Health Care: Struggling to Meet Demand 4

5 A New Approach to Clustering and Analyzing Brazil s Social Classes Since the most common approach in Brazil to defining class distinctions (based on household income) could limit understanding of demographic shifts in Brazil, we have decided to segment the population into ten equally sized groups. Instead of migrating people up as income improves, we estimated income growth in each segment and analyzed that growth in conjunction with social demographics. We ended up with one rich class, two poor classes, and the middle class divided into seven smaller subgroups. This higher granularity allows us to understand consumption patterns and elasticity of demand in detail, particularly among the rapidly growing middle class. (For further details on our CS Consumer Database, please refer to our March19 report entitled The Only Constant Is Change. ) Aside from the often-mentioned drivers of health care spending (income and aging), our database provides some insightful data on health care consumption patterns. For example, consumption patterns for households whose head of household is a woman also tend toward a basket of goods more apt to be chosen by female consumers (more HPC). Also, the higher the education level, the more likely an individual is to consume health care products. Exhibit 3: Summary of population groups identified Decile $ INCOME $$$ X IX VIII VII VI V IV III II I Avg Family Size (# of persons) # of children % of woman as household's reference Years of study of household's reference Credit Card Penetration Average income (R$/month) 0.9% 3.6% 7.3% 12% 23% 35% 53% 73% 87% 98% ,195 1,484 1,864 2,368 3,131 4,596 11,745 Total Annual Health Expenses (R$ Mn) 3,185 3,185 4,179 5,121 6,159 7,609 9,599 12,163 17,451 38,338 Health Care Expenses Breakdown (R$ Mn) Medicine 1,480 2,306 2,863 3,303 3,744 4,264 4,870 5,714 7,272 14,246 HC plans ,215 1,800 2,621 3,880 6,204 15,296 Dental Consultations and Treatment ,274 Health Consultations ,385 Hospital related ,182 2,728 Expenses with Exams Other health expenses ,789 Source: IBGE, CS Consumer database Brazil Health Care: Struggling to Meet Demand 5

6 Along with the higher efficiency in the public system, we see a successful pathway for solutions involving the private sector. Players will need to adapt their strategies, but we believe the companies included in this report are well-positioned to succeed in this new scenario. We believe challenges are greater for the health services sector (vs. pharma) and expect a strong wave of consolidation that should shift power across the chain. In this report, we explore the key themes we think will gain traction in the years ahead. Although it is hard to predict changes in an industry that is heavily regulated, we trust the analytics and scenarios presented here will help readers with their investment decisions. Struggling to Meet Demand The research work behind this report followed the same thought process as our initiation on the consumer sector (Brazil Consumer: The Only Constant Is Change, March 2012). Based on interviews with investors, consultants, and companies across the chain, we selected ten themes that we believed were most crucial for forecasting the future performance of industry players. Medical inflation is the first topic of analysis and merits a full chapter due to its importance for our macro scenario. The other nine themes are looked at within the context of each subsector (health care services, pharmaceuticals, and dental services), but we acknowledge that some of them have cross-sector implications. Themes Debated in This Report Sector Debate 1 Dealing With Rising Medial Inflation Health Services Value Chain Disappointing Growth Value Shifting to Providers Growing Role of Financial Services Consolidation & Vertical Integration Pharma Value Chain Implications of Generics Growth Rethinking Pharma Distribution Growth of HPC in the Drugstore Channel Pharma Retail Consolidation Dental Value Chain 10 Challenges to Grow in Individuals Dealing with Rising Medical Inflation For the past 5 years, medical inflation has outpaced GDP growth by 280bp, a trend that is being watched carefully by all stakeholders in Brazil. Inflation has historically been driven by a combination of technological advances, restricted supply, and increasing labor costs. As rising demand meets a constrained supply, we believe medical inflation will remain higher and stickier than many believe. The regulation agenda is clearly set to fight this trend by improving transparency and competitiveness among players. In light of rising medical costs (and the fact that companies are not obligated to subsidize health plans), corporations may rethink labor expense allocation, either by reducing wage increases, hiring fewer workers, or modifying health plan structures. With health care costs rising disproportionally compared to income, individuals will have to deal with a new burden in their budgets, making individual purchases of insurance potentially prohibitive. Notably, medical inflation is not necessarily positive for the healthcare sector as it poses downside risk to growth rates. A simple illustration of the impact of medical inflation shows that if it outpaces wage growth by 250bp in the next decade (which we see as conservative in light of recent trends), nearly 10% of Brazil s population will be forced out of the potential market. Tailwinds for Providers Unless the trend reverts, health care service capacity should continue to fall short of potential demand, restoring (partially) the bargaining power that service providers have lost to payers in the past years. Potential efficiency gains are sizeable and should be kept by consolidators, but in our view they are not enough to attract significant investments to the sector. The payment system used for the sector needs to be updated to achieve lower transaction costs and properly reward for quality. The good news for providers is that the ANS is analyzing ways to improve it. Payers will work fiercely to moderate the growth of this expenditure category by implementing tighter process controls, but the evolution of electronic payment systems should work against them and in favor of providers. We also see consolidation and verticalization as a natural evolution of payers business model to fight back the losses of bargaining power. The market remains highly fragmented and synergies could be sizeable. The consolidation trend should also be observed among providers, adding further pressure on payers power. Source: Interviews, Credit Suisse Brazil Health Care: Struggling to Meet Demand 6

7 Positive Outlook for Generics Generics are still underpenetrated in Brazil: they represent only 23% of pharma sales (up from 16% in 2008) and are sold in no more than 15% of Brazil s 60,000 drugstores. The growing presence of generics has deep implications for the entire pharma chain: it enhances the addressable market for drugs, works in favor of medical inflation, and improves the margins of large retail chains. While this trend favors domestic pharma companies, which have historically focused on building generic portfolios, we are not implying that global players will struggle. Research shows that, in a similar pattern observed in consumer goods, consumers are willing to pay a premium for trustworthy brands. In the pharma value chain, we also highlight two trends that should prove transformational for the sector: the need for pharma distribution to evolve from its current state and further consolidation of the retail channel. Brazilian distributors work under a buy-and-hold agreement that leads wholesalers to maintain higher levels of inventory for speculation purposes. That has many negative implications, including the potential for massive overstocking, an issue that Hypermarcas faced in The Brazilian drugstore sector has gone through steady consolidation since the beginning of the last decade, driven by the erosion of the competitive position of independent players, as well as by M&A among top chains. We believe the consolidation trend is structural, as independent chains will likely continue to suffer from increased competition. Our analysis actually shows that 80% of drugstores in Brazil fail to meet cost of capital and that rationalization lies ahead. Lastly, we highlight the evolving role of drugstores as a key channel for health and personal care (HPC) companies. Drugstores have far outpaced traditional channels by offering consumers a more targeted shopping experience and solid expansion plans. Rewards are starting to surface, with gross margins being positively influenced by a changing mix (HPC has higher margins than branded drugs) and by increased trade marketing incentives granted by the industry. Is There Room for Individual Plans? Dental plan operators have shown remarkable growth and returns in the corporate segment in the past decade. They also have enjoyed lower regulatory risks vis-à-vis health plans, especially in relation to price adjustments. Looking forward, growth in the corporate segment is still available (mostly within medium-sized corporations), but becoming increasingly scarcer. That leads operators to face the challenge of replicating the same success for individual plans, which remain relatively underpenetrated (there are only 5.6mn people covered either by individual or affinity plans). Rationale for Our Preferences We are using the same framework introduced in our consumer report to rank the stocks covered in this note. A few changes were introduced to incorporate the feedback received from investors in the past few months, but the structure remains quite similar. The selected variables aim to account for long-term attractiveness of the subsector in which the companies are inserted, their strategic positioning, the residual upside for investors, and potential triggers for the stocks. The metrics can be clustered around three key dimensions: 1. Intrinsic value drivers: Growth and macro themes explored in this report are used to feed DCF models and rank healthcare subsectors and players according to potential growth in the gross profit pool. 2. Residual upside to investors: Ranking based on the upsides from our DCF and target multiples. 3. Stock catalysts: Growth and return metrics were benchmarked against street estimates, and stocks were ranked according to recent trends. The consensus analyses were later combined with technical analyses to identify potential catalysts for the stocks. Exhibit 4: Stock-picking framework Growth 1 Deviation to Consensus 6 Triggers to Stock Performance Technical 5 Indicators Source: Credit Suisse 4 Trading multiples Intrinsic Value Drivers Peer 1 Peer 2 Residual Upside to Equity Investors Return on 2 Invested Capital 3 Upside to DCF Below we explore a few possibilities for pair trades in the sector. Some of them do not result in a high conviction call as to long-short ideas, but we explored them anyway to register our views on the possible trades. Brazil Health Care: Struggling to Meet Demand 7

8 Potential Trading Ideas 1 6 Pharma 5 Health We Prefer the Pharma Chain Over Health Care Services The pharma chain has more growth potential and faces lower regulatory risk. Middle-class families prioritize pharma expenditures over health services when money is tight. Health services enjoy higher demand elasticity but medical inflation offsets it partially. Pharma enjoys the positive tailwinds from generics: they expand addressable market for drugs, have positive effect on drugstore margins and help the government to control inflation. With the exception of a select group of high-return business models (e.g. Qualicorp, Odontoprev), health service generates lower ROICs compared to pharma players. 1 Choice Between Health and Dental Services Depends on Investment Horizon 6 Medical 2 In the long-run, health care prevails as it is a true need and aspiration for Brazilians. In the shortterm, however, dental plan providers provide higher resilience in performance. Lower ticket size on corporate dental plans fuels growth and lowers delinquency rates. Over the mid-term, however, growth into SMEs and individuals may deteriorate risk profile. Also, entry barriers are low and competition is intensifying. 5 Dental 4 3 Health services offer a more compelling long-term growth story. Entry barriers are higher and regulatory constraints are forcing small players out of the market. 1 Providers Should Outperform Payers, But in the Long Run Only 6 Payer 5 Provider Service supply scarcity shifts bargaining power to providers. Payers strategy to offset higher costs by increasing cancellations ( glosa ) is at risk with the advances of electronic payment systems. Consolidation among payers could shift part of pricing power back to them but success will depend on the level of consolidation observed on the side of providers. Vertically integrated payers should outperform pure HMOS/insurers, specially in times of rising medical costs (see below). Outperformance is expected since verticalization adds exposure to providers upside. 1 Amil Is Better Positioned than SulAmerica to Cope with Medical Inflation Headwinds 6 Amil 2 Amil has exposure to higher-margin products (dental from Amil is more profitable than auto or life insurance from SulAmerica) % of Amil s costs are generated at its own hospitals while SulAmerica fully depends on third party providers. Consequently, MLR for Amil is lower SulAmerica is regulated by SUSEP (Brazil s insurers regulator), which requires much higher technical provisions (i.e. cash reserves). Interest income on cash reserves have been penalized by the low SELIC rates in the recent past. 1 We Prefer DASA Over Fleury on Valuation Grounds 6 Fleury 2 Regardless of the nuances on strategies, both appear well-positioned to succeed. Despite ST operating/execution challenges, DASA has plenty of growth potential if it succeeds on its strategy capturing the untapped demand from lower-income customers. 5 4 Dasa 3 Fleury deserves a premium for its noteworthy execution and brand/quality recognition. However, the challenges with the expansion of its A+ format should not be neglected. Fleury also needs to cope with increased competition from high-end hospitals extending their reach into diagnostics (i.e. Einstein, Sirio Libanes). Brazil Health Care: Struggling to Meet Demand 8

9 Assuming Coverage of Health Care Below we summarize our views for the companies for which we are assuming coverage. Please refer to page 41 for a complete description of investment cases, key risks, and financial estimates. Amil (AMIL3, Outperform, TP R$26.0) We are assuming coverage of AMIL3, maintaining the OUTPERFORM rating and the TP of R$26. Although we question the growth potential of health plans, we believe Amil is well positioned to benefit from the consolidation trend expected for this market. The company has shown pricing discipline and has a good track record in keeping MLRs under control, which should contribute to positive margin momentum. The company will likely revise downward its guidance of a 100bp reduction in G&A expenses per year, but we still believe it can achieve savings in the long run. Trading at 7.2x 2013e CS EBITDA, AMIL offers 27% upside to our TP. Key risks include lower-than-expected volume growth and a reduction in consensus estimates to reflect lower guidance for G&A expenses. Brazil Pharma (BPHA3, Neutral, TP R$14.5) We are initiating coverage of BPHA3 with a Neutral rating and a TP of R$14.5. We believe BPHA should benefit from the several tailwinds that favor the Brazilian drugstore sector. While we recognize the challenges of integration, we see upside and earnings momentum from increased operating efficiencies. Our Neutral rating is on valuation grounds, after a 50% run YTD. The stock trades at 13.3x 2013e CS EBITDA, and the TP offer limited upside potential (13%). Key risks include the obvious integration challenges for the several acquisitions, limited (unaudited) visibility of historical operating performance, high dependence on previous owners to operate subsidiaries, conflicts of interest in capex allocation decisions, and high financial leverage. DASA (DASA3, Neutral, TP R$15.0) We are assuming coverage of DASA3 with a Neutral rating and TP of R$15. Supply scarcity among health care providers should enhance its pricing power and scale gains could expand operating margins. We are also supporters of the strategy to invest in branding and improve goodwill among physicians. Despite the longterm attractive scenario for DASA, we believe investors will wait for clear signs of performance improvement (from the strategic and management changes). Upside to TP (20%) is higher than the sector average, and the valuation discount to Fleury is arguably unfair. However, we maintain the Neutral view until short-term triggers become clearer. Key risks include execution challenges, pricing pressure from payers, and failure to regain confidence. As upside risk, we highlight sequential margin improvement in 3Q and higher-thanexpected growth in the next 2-3 years. Fleury (FLRY3, Neutral, TP R$25.0) We are assuming coverage of FLRY3, maintaining the Neutral rating and TP of R$25. In the near term, we expect Fleury to benefit from the investments made in selling area expansion as well as from synergies emerging from the merger with Labs D Or. The company is highly respected among physicians for its service quality and is well positioned for what we believe will be a transformational long-term trend for the sector: the shift from executing exams prescribed by doctors to testing for diseases for patients. The stock currently trades at 9.2x 2013e CS EBITDA and offers 11% upside to our TP. Key risks to our call include disappointing returns on the A+ brand, higher cancelation levels, and a disruption due to recent management changes. Hypermarcas (HYPE3, Outperform, R$16.0) We are upgrading HYPE to Outperform to reflect our view of better performance in the pharma division. After a solid 1H12, we expect sustained momentum in 2H12 on the back of easy comps and stronger cash flow generation. We see upside potential to 2013 consensus estimates, driven primarily by a higher top line. We also forecast lower capex and working capital requirements in 2013, which would lead to a significant deleveraging of the company. HYPE3 performance has showed a close correlation to the company s bond performance, which already reflects the improving scenario for the company. Our R$16 TP implies 25% upside, the second-highest in the health care universe after Amil. The stock currently trades at 9.8x our 2013e EBITDA forecasts, which is below the weighted average multiple of its pharma and consumer peers. Key risks include pace of cash flow generation (with special attention to working capital trends), sharp FX devaluation (affecting its USD-denominated debt), and delays in capturing synergies expected by the market. Odontoprev (ODPV3, Neutral, R$11.0) We are assuming coverage of ODPV3 with a Neutral rating and a TP of R$11. Odontoprev s remarkable past performance may not be a good proxy for future trends as growth now shifts towards SMEs and individuals. On the bright side, marginal growth comes with a much higher ticket. On the down side, it should increase delinquency rates and churn. We believe the alliance between health and financial operators is a winning Brazil Health Care: Struggling to Meet Demand 9

10 strategy and that the deal with Bradesco will bring positive synergies for both companies. We recognize that new growth frontiers should bring new challenges for the company, but Odontoprev appears well-equipped to cope with them. The valuation premium to the sector is deserved (19x 2013e CS EBITDA), but the upside left is insignificant, justifying the rating. Key risks to our call include pace of growth (and adverse selection) in the SME and individual segment, higher competition from health operators and dental coops, and increasing cost inflation. Qualicorp (QUAL3, Outperform, R$22.5) We are updating our model to incorporate 2Q12 results with no major changes in forecasts. Despite the more challenging growth scenario for healthcare plans, there is still room to expand the affinity market, and we believe Qualicorp is well positioned to succeed in the segment. Payers are reacting by penetrating SMEs, but there is room for both to grow, organically or through M&A. QUAL3 currently trades at 12.3x 2013e CS EBITDA, and our R$22.5 TP offers 18% upside. Key risks to our call include SME regulation changes, a slowdown in growth, and churn pressures from the integration of Padrão and Aliança. RaiaDrogasil (RADL3, Outperfom, R$25.0) We are updating our model to incorporate 2Q12 results and increasing our DCF-based TP from R$20 to R$25 to reflect a better outlook for long-term growth. We see several tailwinds blowing in favor of the Brazilian drugstore sector, making it a core holding in the retail space. Valuation multiples (for the drugstore sector in general) may appear stretched as new stores typically perform poorly in the first year of operations and RADL is going through a strong cycle of store openings. However, it appears to us that investors understand that nowadays. The company started to use its tax credits in 3Q12, and inventory levels should normalize in the next 2 4 quarters, driving up cash flow conversion in 2H12 and Key risks to our call include the strong store expansion plan along with integration and regulation. Labor inflation remains a key risk for RADL and the drugstore sector in general. Exhibit 5: Comparables Company Market Cap (USD mn) Target Price Upside ADTV (USD mn) EV/EBITDA 2012E 2013E 2012 P/E 2013 Healthcare Services Brazilian Healthcare Qualicorp Dasa Fleury Amil Odontoprev Brazilian Brokers Brazilian Average US Healthcare Management US Healthcare International Healthcare International Brokers International average 2,466 1,906 1,718 3,621 2, % 20% 10% 27% 0% Pharmaceutical Chain Brazilian HPC & Pharma Raia Drogasil Brazil Pharma Hypermacas Profarma Natura Brazilian Average International HPC Peers Internatinal Drugs Retailing International Pharmaceuticals International average 3,564 1,501 3, , % 14% 25% -19% * Using Bloomberg consensus for non-covered companies Source: Bloomberg, Credit Suisse Brazil Health Care: Struggling to Meet Demand 10

11 Long-Term Trends Dealing with Rising Medical Inflation The future, according to some scientists, will be exactly like the past, only far more expensive. John Sladek The one thing that seems assured is that in the future Brazilians will spend more on healthcare than they have in the past. This supposition is based not just on changing socio-demographic factors, but also on the expected improvements in medical technologies and the evolving attitudes toward healthcare consumption. Health care companies, corporations, individuals, and Brazil s Regulatory Agency for Private Healthcare Plans and Insurance (ANS) are watching health care spending with alarm. For the past years, spending has grown in excess of GDP and, if current trends persist, Brazil may start committing to health care expenditures might reach unsustainable leves. Stakeholders obviously hope that the projections are off the mark. If health care spending keeps growing much faster than GDP or household income, health insurance will become less affordable and a larger share of the population will remain uninsured and will depend solely on the Unified Health Care System (SUS). Those who currently can afford coverage will find that premiums and payments for medical care not covered or paid for by insurance are increasing over time in relation to income. At the same time, government leaders are recognizing that costs of existing federal commitments to finance health care are already crowding out other public spending priorities, increasing pressure for higher tax rates and leading to higher deficits. There is extensive literature examining which factors play the largest roles in explaining increases in health care spending over time. In this chapter, we summarize these findings and explore the consequences on individuals, corporations and health care players. Health care inflation will have great impact on both the health services and the pharma value chains and should, in our view, accelerate industry consolidation. Exhibit 6: Health care plans vs. GDP growth % GDP Var (YoY) Health Plans Source: ANS 7.5 Brazil Health Care: Struggling to Meet Demand 11

12 Modeling Heath Care Cost Inflation The correlation between GDP and the number of health plan beneficiaries is overwhelming; as one fluctuates, so does the other. While GDP appears to be the engine driving fluctuations in spending growth, we see other important forces determining the shape of the health care spending curve relative to GDP that are worth exploring before we delve into the growth estimates for our coverage universe. Exhibit 7: Health care plans: new additions yoy growth, % Source: ANS New members Group / Affinity Plans GDP Growth (% YoY) For political reasons, the health care sector is not structured as a free market. Given that consumer do not bear the true costs, the line between supply and demand is sometimes blurred and factors that that should mainly affect supply often have immediate effects on demand. But, regardless of its configuration, this sector can still be treated as a market. Below we explore the key forces expected to shape the industry and sector players performance in the years ahead. Drivers of Demand Health care demand is amazingly subjective. Two employees catch a cold, one goes to the doctor, the other goes to work. A show on TV highlights a new technology promising to detect early signs of a particular disease, and traffic at clinics rises the following day. Diagnostic clinics have less traffic on rainy days, but no abnormal flows are observed on the following sunny days. Despite the subjectivity, we see three fundamental factors driving health care demand. The first is wealth. When people can afford to do so, they will spend almost any amount on their health and well-being. The second, which typically comes first in sector debates, is aging. The third is social norms, which dictate the frequency with which people consume health care products and services. 1. The Impact of Income Rising household income leads to higher spending on health care because medical care is a desired service for most families. However, the elasticity of health care spending is debatable. Beyond some point, devoting an increasing share of income to health care without associated improvements in health and well-being becomes unsustainable. The trend would reduce individual standards of living and damage government budgets. Academic research suggests that growth in average income could account for anywhere from 5 to 20 percent of long-term spending growth, but estimating the exact elasticity is not a trivial task. Poorer families typically face worse living conditions, which have direct effects on their wealth. Correlations are also contaminated by the fact that people in poor health often spend a lot on health care but have lower incomes. Given the limitations that sickness imposes on the ability to work, income generation is often penalized. Exhibit 3 on page 5 showed the average spending of Brazilian families on health care, including health plans and out-of-pocket expenses for health services and pharmaceutical products. Each group represents 10 percent of Brazil s population, X being the poorest decile and I the richest. As expected, the richest group spends more on health care without committing a larger share of its budget to this category. Among the poorer groups, the larger share of budgets committed to health care probably explains the higher churn and delinquency rates observed in the sector recently. Although income is the key driver for out-of-pocket expenditures, employment is perhaps more important for the health services industry in the near term. The vast majority of lives covered by health plans are under corporate plans, and growth in the sector has followed employment levels very closely, as shown in Exhibit 8. Exhibit 8: Growth of healthcare plans vs. employment Jan-03 Source: ANS Beneficiaries of health care plans Jul-04 Annual Salary Report (RAIS) Payroll jobs Jan-06 Jul-07 Jan-09 Jul-10 Jan-12 Brazil Health Care: Struggling to Meet Demand 12

13 The positive trend in payroll job creation in Brazil is explained by a combination of lower growth in the working-age population, an aging workforce and lower activity among the younger population. Unemployment rates should continue to decline in the next two years (our economists expect it to decline from 6.0% observed in 2011 to 5.2% in 2013), which is positive news for corporate plan providers. We remind our readers, however, that companies are not obligated to fully subsidize health plans for employees. As discussed later in this chapter, we believe corporations may start shifting health care costs to their employees, either by reducing wage growth, hiring fewer workers, or modifying health plan structures, forcing employees to pay a larger share of premiums. If this scenario materializes, the discussion will shift back to income. 1. Impact of Ageing Although elderly people generally incur higher costs for health care than younger people, and much of the spending on health care goes toward treating the elderly, the contribution of an aging population to the growth in that spending over the long term is smaller than is commonly perceived. Most studies project that aging increases spending by less than 0.7 percentage points per year, and more sophisticated studies tend to result in the lowest numbers. While we could not find similar studies for Brazil, we believe results should not be materially different. One thing that calls attention in Brazil is the speed at which population is aging. Through 2030, the group of Brazilians above 55 years will grow 88% on aggregate, whereas the 0-25-years age group is expected to decrease 20% in size during the same period, pushing median age of population up at almost twice the world s pace. Since the law forbids health plans to adjust pricing freely on individual plans according to the medical loss ratios observed at each age group, payers are forced to inflate pricing free for younger groups. As population ages, this strategy becomes unsustainable since high health plan prices could prevent younger and healthier lives from being included in plans and thus accelerate adverse selection for plans. 3. Impact of Social Norms If an individual is part of a group that smokes, drinks and/or overeats, that person will probably do the same. The same holds true if that group exercises regularly and eats well. The expectation of having the same medical problems as friends and neighbors, going to the doctor as often, and receiving the same level of care is also observed within clusters of the population. One can argue that social norms are somehow related to wealth, since population often segregates itself geographically according to income. Despite the correlation, it is still an important driver to be analyzed separately. Social norms undergo constant change, and the history of smoking illustrates the cyclical behavior. If social norms were to shift dramatically so that overeating and under-exercising became as repulsive as smoking, demand for health care could potentially fall. On the other hand, if income rises and people see friends consulting their doctors for some obscure health problem, medical costs would continue to rise. Exhibit 9: Impact of ageing on healthcare spending R$ per capita (left) million (right) 3,000 2,500 Men yrs old -20% from 2011 to ,000 Men avg. 60 1,500 1,000 Women avg Above 55 yrs old +88% from 2011 to 2030 Women years years years years years years years years 80 years or more Source: SUS, IBGE, Credit Suisse Brazil Health Care: Struggling to Meet Demand 13

14 Although our forecasts do not incorporate any major shift in social norms, we acknowledge that improvements in the education level and income of Brazilian families expected in the next decade suggest upside risk to our demand scenario. Drivers of Supply 1. Impact of Technology Most studies suggest that the bulk of the long-term health care inflation is driven by the use of new medical services that are made possible by technological advances, or what some call the increased capabilities of medicine. Major advances in medical science have allowed health care providers to diagnose and treat illness in ways that were previously impossible. These new services are generally very costly, and the few that are relatively inexpensive typically raise aggregate costs quickly as a growing number of patients start using them. Technological innovation should theoretically reduce costs, and for many types of goods and services it often does. Historically, however, the nature of technological advances in medicine have tended to raise, not lower, spending. New technologies are generally delivered inefficiently, both by using high levels of inputs per service and by using the technologies not only for patients who derive large benefits from them but also for those for whom the benefits are questionable. Looking forward, we believe that the progress of technology will keep raising the cost of health care but that the bulk of economic profit, in our view, should continue to be captured by technology providers (typically multinational companies that do not fall under our coverage). We also expect the fast pace of technology development to fuel consolidation among providers, since smaller players will likely fail to keep up with rising capex. It should also help providers increase their stake in the value chain of economic profit, one of the industry trends explored in the next chapter. 2. Impact of Capacity Patients often neither bear nor understand the full costs of the health services, and in our view providers are in a better position to judge whether or not a particular procedure is needed. Although supplier-induced demand does not tend to appear on lists of drivers because of the controversy about its existence or magnitude, even without inducement increases in supply typically lead to higher spending. Exhibit 10: Supply trend falls short of demand # of hospital beds and doctors per 1,000 habitants # of Bed s Per 000 s Habitants 2.61 # of Doctors Per 000 s Habitants Source: ANAHP, CREMESP, ANS, IBGE, Credit Suisse Compared to other countries, Brazil appears underdeveloped in medical infrastructure, and recent trends have been mixed for providers. The number of doctors, although still below the global average, has increased faster than population growth, but the number of hospital beds has decreased, primarily in non-public hospitals. Capital controls limiting foreign investments slow supply expansion and quality improvement. However, local players (e.g., Amil and BTG) have been driving the consolidation process, and barriers should ultimately fall. Exhibit 11: Major consolidation moves Date Feb-10 Mar-10 Apr-10 May-10 Aug-10 Sep-10 Sep-10 Sep-10 Oct-10 Dec-10 Dec-10 Feb-11 Apr-11 May-11 Jul-11 Jul-11 Jul-11 Dec-11 Feb-12 Apr-12 May-12 Aug-12 Target ESHO ASL Pró-Cardíaco DI Serviços MD1 Excelsior Assunção Hospital São Luiz Hospital Cerpe Samaritano Lab s D Or Diagnoson Pasteur Lincx Previlab Cytolab Cardiolab Pardini Ns. Sra. Lourdes Santa Luzia Santa Lúcia Digimagem Consolidator Source: Companies, press Brazil Health Care: Struggling to Meet Demand 14

15 3. Impact of Incentives Offered to Providers A good way to illustrate the effects of incentives is to benchmark production levels under fee-for-service and capitated pay systems. In fee-for-service systems, providers are paid for each unit of activity delivered and tend to overproduce. On the other hand, in the capitated pay system, in which providers are given a set fee per patient, providers tend to underproduce. The sector in Brazil currently uses the fee for service system, but the ANS is actively looking into ways of changing it. Since the vast majority of providers are not yet ready to assume any risk, changes need to be well planned and initially focused on procedures where predictability of outcomes are high. The first step would be to force payers and providers to use a unique coding system for procedures and exams, which would help the sector benchmark service quality and prices. The standard coding would also enable payers and providers to agree on procedures that could be packaged and charged for at a fixed fee. Other Factors Affecting Supply Besides the three drivers described above, we see two other forces influencing supply: productivity gains and administrative costs. Although both forces could have a positive effect on supply efficiency and ultimately slow down health care inflation, we do not incorporate any benefit into our models. Although hard to measure, we believe productivity has a positive impact on supply. Growing administrative costs, however, should continue to offset productivity gains, in our view. Productivity Trends. The characteristics of the health care industry limit productivity gains over time: (i) there is very little competition among providers on the basis of price, (ii) extensive third-party coverage limits consumer incentives to be price-conscious, and (iii) benefit structures offer little reward for choosing a low-priced provider. Reflecting on these perspectives, we expect the health care industry to have lower productivity increases than the general economy. Administrative Costs. Estimating the contribution of changing administrative costs to growth in overall health care spending is complicated. Even if comprehensive data were available, they would be difficult to interpret because certain types of administrative activity probably reduce health care spending. We rely on academic research, which estimates the contribution of administrative costs to health care spending in the range of 3 to 10 percent. Regulation Brazil s National Health Agency (ANS) established a regulatory agenda for , laying down a series of high-priority initiatives to foster better quality and transparency of the healthcare system. Through this Regulatory Agenda (see page 18), ANS highlights four major themes in our view: 1. Focus on Prevention and Disease Management Policies aimed at promoting health and reducing the occurrences of sickness and injury decrease the demand for medical services and may produce better health outcomes with lower cost in the mid to long term. Initiatives put in place so far have been primarily focused on enhancing access of poorer families to basic sanitation infrastructure, with limited impact on the private health care sector. The debate on the benefits of prevention are intense. On the positive side, initiatives lower short-term medical losses. On the negative, individuals end up spending more on health care as life time expands. 2. Higher transparency The quality and efficiency of any health care system can be improved through value-conscious consumption, but that is difficult to achieve when customers don t know what constitutes superior quality and what that quality costs and are not financially accountable for their decisions. Political support and the proliferation of consumerism should bring about greater transparency in health care pricing. As consumers play a bigger role in health care decisions, transparency will be in greater demand to assist in making the appropriate choices.. The ANS has already started work on the standardization of procedures among providers as well as the implementation of a consolidated source of quantitative information on provider quality in order to better inform the population. Both these measures should help increase the sector s quality standards. We believe it is too early to tell whether or how greater transparency will affect trends, but clearly one of the goals of the initiative is to reduce the variability in pricing for similar services across facilities within a market. Many believe this will result in greater price competition among hospitals and serve to lower the trend, although that is likely to be a market-by-market phenomenon, in our opinion. 3. Fostering competition Providers must have the right incentives to optimize costs in both the delivery of services (or goods) and the Brazil Health Care: Struggling to Meet Demand 15

16 purchase and management of inputs in other words, the productivity of processes must be improved. As providers are generally paid on a fee-for-service basis, costs rise whenever providers increase their fees, provide more services, or substitute more expensive services for less expensive ones and providers have the incentive to do all three. In that context, progress should be made in realigning provider reimbursement mechanisms over the next few years. The ANS is already initiating discussions of potential new provider payment models, yet we do not see any clear signs of such changes coming to fruition in the short term 4. Improve finance mechanisms Sustainable health care systems require efficient financing mechanisms to match supply and demand. Health care intermediaries should examine alternative sources of financing and match them with the needs and economic characteristics of populations in a way that helps to control overall prices. A more graduated coverage structure could improve the system s overall efficiency, reduce costs, and increase the amount that consumers save for their health care by helping them to understand the economic trade-offs between health care and the alternative uses of these funds. Impact on Individuals Health benefits provided by employers are part of the total compensation paid to workers. As health insurance premiums become more expensive over time, employers will tend to reduce other elements of an employee s compensation, including cash wages and retirement benefits. Employers may also start sharing the higher cost of health benefits with their employees by requiring higher premium contributions and/or higher out-of-pocket expenditures, through higher deductibles or copayments. Purchasing insurance individually will be more expensive and, in many cases, prohibitive. A relatively simple simulation illustrates the pressure on worker s wages. Assume total compensation starts at its 2012 level and grows at the recent historical rate of about 2 percent, reflecting average gains in an employee s productivity. If total health care costs (the employer s and employee s share of premiums and employee s out-of-pocket costs) grow at twice the rate of compensation (4 percent) per year, disposable income would grow, but only slightly. If health care costs grow at four times the rate of compensation (8 percent) over a ten-year period, all other compensation net of health care actually falls by 11 percent. Impact on Corporations As discussed above, we believe most of the impact of rising health care costs on corporations will be shifted to their employees by reducing wage growth, hiring fewer workers, or by modifying health plan structures, forcing employees to pay a larger share of premiums. Given that companies are not obligated to offer health plans to employees, some firms may eventually eliminate them altogether. For firms who largely employ minimum-wage workers, the impact of health plan inflation is far greater. Employees at these firms, particularly in the services sector, are less likely to have employer-provided insurance coverage in the first place, and if they do the plans are likely poorer than what larger firms offer. As health coverage gains importance in compensation plans, smaller firms may have a tougher time keeping up with compensation packages offered by larger corporations. Impact on Health Care Players Just because health care spending is set to increase at rates in excess of GDP growth, that does not necessarily mean that health care companies (and stocks) are positioned to outperform the economy in every scenario. The way health care spending is distributed across the system has important ramifications for all industry constituents, in both the health services and pharmaceutical value chains. Each chain is discussed at length in the next two chapter, but a summary follows. Impact on Payers. Conventional wisdom suggests that the payer cycle is shaped by the spread between premiums and costs. As long as pricing outpaces costs, companies will outperform. Our view is that payers have enough pricing power to adjust to deviations in the spread relatively quickly and that any shifts in the medical loss ratio due to either overpricing or underpricing are soon reversed in conjunction with the following year s renewal cycle. The first tangible implication we see for payers is a slowdown in volume growth. As premiums rise, products become less affordable for individuals (and firms), and the sector generally decelerates the growth rate observed in the past. The second potential implication is a squeeze in profitability coming from higher SG&A expenses; selling expenses for SME and individual plans tend to be higher as sales are more time-consuming. Impact on Providers. While outpatient trends are likely to remain the fastest-growing component of medical costs, we believe payers will work fiercely to moderate the growth in this category of expenditures through the Brazil Health Care: Struggling to Meet Demand 16

17 implementation of tight networks, strict authorization requirements, and case reviews. Providers could also feel some pressure on receivables. Impact on Physicians. Despite the changes taking place that could impact physician reimbursement, we have very little visibility on the future direction of physician cost trends. While we are inclined to believe that most of the changes would serve to reduce physician costs, we note that this class of providers is very resilient to reimbursement changes and is likely to develop ways to replenish any loss of revenue. Impact on pharma manufacturers. Rising income has fueled pharma consumption in the past few years, but consumption remains low compared with developed markets. Aging of the population should also increase drug consumption levels. It is important to note that list prices for drugs in Brazil are regulated by the government and adjusted yearly using a formula that accounts for IPCA (consumer price) inflation as well as other adjustment factors. All in all, drug prices are rising overall and the aging effect on the mix should also add some pressure. On the other hand, we see strong growth on the generics front in the coming years, as generics prices are on average ~35% lower than those of branded drugs, which should help alleviate such inflationary pressures. Also, the development of PBM (by drug retailers in Brazil) could also help alleviate inflation as it would put pressure on pharma manufacturers high ROICs, since suppliers would then have to deal with a large purchaser with higher bargaining power. Impact on pharma retail. The high growth trend in generics should be a main driver for drug retailers as well. We understand this as neutral for top line, as higher volumes are offset by lower average prices, but positive for margins, as generics carry a higher gross margin than other products in the portfolio. For income, any compressions in purchasing power due to higher health care inflation will probably not have a heavy impact on continuous prescription or over-the-counter drug usage, yet we acknowledge that (superfluous) HPC sales could decelerate. Brazil Health Care: Struggling to Meet Demand 17

18 ANS Regulatory Agenda 1 Financing Model for the Sector The ANS is reviewing the pricing mechanism for individual health plans, taking into account regional cost characteristics and the effects of aging on MLRs. It is also analyzing the possibility to price health plans with a capitalization payment structure, where part of payments by younger consumers are saved to reduce payments later on in their lives. The new structure would lower the perceived inflation and improve the solvency of health plans. 2 Guaranteed Access to High-quality Care The ANS wants to ensure that beneficiaries receive the medical care that has been contracted, with adequate levels of quality. It will monitor intervals between authorizations for examinations and treatments and their effective execution, and it will assess whether health plans are offering enough options for plan physicians, clinics, laboratories, and hospitals. Information on service quality will be disclosed to help consumers decide which plan to pick. 3 Service-Provider Payment Model The current model encourages service providers to focus on volumes, not quality. The new payment model is based on a standard coding system, which reduces paperwork required of clinics, laboratories, and hospitals while ensuring faster services for consumers. The new model would allow the ANS (and payers) to compare quality and costs of service providers, fostering healthy competition among them and helping consumers in their decision making. 4 Pharmaceutical Care Medications covered by health plans are limited to inpatient care and certain types of outpatient cancer treatment. The goal of the ANS is to extend benefits to patients being treated outside hospitals, particularly those with chronic diseases (e.g., diabetes and high blood pressure) who must take medications constantly. The goal is to improve the quality of treatment and avoid repeat hospitalizations caused by inadequate initial treatment. 5 Incentive for Competition A higher number of health plans in the market increases competition and improves consumer's options. One of the initiatives to increase competition is to enhance the information available on health plans, helping consumers in their decision process. Another is the possibility for plan portability without the need for new waiting periods. The ANS is also working on ways to promote individual plans to expand the range of consumer choices. 6 Guaranteed Access to Information The ANS is reviewing a series of protocols to enhance communication: (i) its web portal is becoming more interactive, (ii) comparative data on health insurers and service providers will be reorganized, (iii) sector legislation will be structured and updated, (iv) ANS directives on matters related to supplementary health care will use simpler (less technical) language to facilitate comprehension, and (v) updates on mandatory coverage will be structured more effectively. 7 Old Contracts The ANS wants to ensure that consumers holding old plans have the rights and guarantees assured by the regulator. It is working on the procedures to adapt and migrate contracts preceding Law No. 9656/98. 8 Geriatric Care Brazil s elderly population is expanding steadily, and the group generally demands health care services more frequently. To ensure the group's access to high-quality services, the ANS is considering successful initiatives focused on geriatric care, including the sale of specific plans for senior citizens and the assessment of service levels provided to elderly beneficiaries. It is also encouraging the creation of health monitoring programs for them. 9 Integration of the Supplementary Health Care Sector with Brazil s Unified National Health System (SUS) The ANS plans to increase dialogue among stakeholders in Brazil's health care system and explore potential partnerships between the public and private sectors. The idea is to start by establishing a common identification system for patients in both sectors and to introduce, in a later phase, a computerized system to store medical records. Brazil Health Care: Struggling to Meet Demand 18

19 Health Services Value Chain Tailwinds for Providers A first glance into Brazil s private health care plan penetration grabs the attention of investors looking at the sector. With nearly 147mn Brazilians, or 76% of the population still uninsured, the growth potential appears immense. The scarcity of medical providers and medical inflation, however, should limit growth forecasts and trigger important changes across the value chain, shifting the balance of power among sector players. While we see plenty of organic growth opportunities for providers, players will need to push pricing and market share to keep top-line momentum. Brokers face limited short-term pressure but will need to adapt strategies to survive. Much of the health care debate has centered on the inefficiencies of Brazil's public system and the attractive opportunities for private providers, particularly among the new middle class. We share the positive view of Brazil s long-term socio-demographic trends and acknowledge that being freed from the public system is one of the greatest desires of all Brazilians. Most discussions, however, do not explore with the appropriate depth the implications that medical inflation will have on sector dynamics in the years to come. The first implication we see is a slowdown in private health plan growth. Today, only 47.6mn people (or 24% of the population) is covered by the private system, and growth potential for payers appears incredibly high. However, if we adjust estimates for the affordability of plans and limit growth to regions where private service providers are available, the total addressable market would fall to 72 million lives, or only 37% of Brazil s population. Medical inflation poses downside risk to this estimate. If health care costs continue to outpace average wage growth, families will need to commit a higher share of their household budget to health, which may be unbearable for a large percentage of low-income consumers. To illustrate the impact, if we assume medical inflation grows 250bp above wage growth, an additional 10% of the population would be forced out of the market in the next decade. One of the reasons why health care costs are mounting is because service capacity has not been keeping up with the rising demand. The tighter supply scenario, in our view, should transfer pricing power to providers, which is the second trend discussed in this chapter. Higher medical inflation will also have a transformational role in forcing health operators into a new situation where the decision-making process will be in the hands of individuals, not their employers. The trend will force payers to offer new and more sophisticated products and pressure providers to improve quality of services delivered. These three forces favor providers, but we do not believe payers will sit quietly while value is transferred downstream. Reaction should come in the form of consolidation among payers and vertical integration of certain health services. The market is still fairly fragmented, and we believe smaller players may fail to survive. Also, in some regions vertical integration is a must, and such a move may help payers bring some of their value back. Brazil Health Care: Struggling to Meet Demand 19

20 Exhibit 12: Health care services value chain SERVICE PROVIDERS PAYERS INTERMEDIARIES BENEFICIARIES Hospitals (e.g, São Luis, Einstein) # of beds, per 10k inhabitants US Arguably Brazil s major bottleneck in health care. Restrictions to foreign capital restricts expansion Significant opportunities to improve operating efficiency Laboratories (e.g, DASA, Fleury) # diagnostic clinics, per Mn inhabitants Nov Increasing demand for exams improves providers pricing power Higher focus on will push sector consolidation Health Professionals (Dentists and doctors) # of doctors, per 10k inhabitants US # of doctors rising faster than population, but density is still low Commissions earned from hospital suppliers affect payers profitability HMOs (e.g, Amil) # of Lives, Millions Fragmented: Top 3 players have only 21% of the market Trend to vertically integrate and sophisticate products Dental (e.g, Odontoprev) # of Lives, Millions Low ticket attracts lower income consumers Large supply of dentists gives payers negotiation power # Gross revenues, R$ bi Insurers (e.g, Sulamerica) # of Lives, Millions Typically higher tickets compared to HMOs Should lead the conversion of health and financial services Medical Cooperatives (e.g, UNIMED) # of Lives, Millions Captured 50% of growth in the past 5 years Strong regional players, often vertically integrated Brokers (e.g, BR Insurance) Number of brokers, Relative good margins for generally poor service levels As market becomes more complex, competition from global brokers should intensify Benefit Administrators (e.g, Qualicorp) # of lives, 2011, Millions * 3.4 Total lives Lives under HMOs/Insurers Lives under Ben. Adm. HMOs and insurers are forbid to sell affinity since 2009 Market dominated by one large player (Qualicorp) Individual Plans # of Lives, Millions Heavily regulated, limiting supply (lack of interest from payers) Highly expensive (new plans), limiting demand Corporate Plans # of Lives, Millions Stronger penetration in the industrial sector, weaker in services (where the economy grows faster) Medical inflation could force employers to increase coparticipation from employees Affinity Plans # of Lives, Millions Higher growth opportunities vs. other health plan segments Exclusivity agreements with associations increase entry barriers for newcomers Source: ANS, SUSEP, ANAP, Credit Suisse Disappointing Growth Ahead Statistics released by the ANS, typically used as guideline for health plan penetration and growth in Brazil, should be analyzed carefully. First of all, the agency tracks the number of contracts and not beneficiaries, which doublecounts individuals covered by multiple plans. Second, it does not account for plans covering public employees, estimated at roughly five million lives. Third, data prior to 2005 fails to capture all lives covered at the time, and growth estimates (for start dates prior to 2005) are overestimated (existing old contracts being registered in the system give the false impression of growth). We prefer to analyze numbers from the National Survey of Households (PNAD), which captures the number of beneficiaries rather than contracts. Unfortunately, the most recent surveys were conducted in 2002/3 and 2008/9. Nevertheless, the compound growth rate observed in this period well illustrates the issue with the ANS's numbers. While the compound annual growth rate (CAGR) of the PNAD's numbers is 2.7% p.a. ( ), this rate rises to 7% for the same timeframe using the ANS's figures. Exhibit 13: Growth in ANS figures is misleading PNAD CAGR 2.7% CAGR ANS % Source: ANS, IBGE/PNAD Assessing Health Plan Market Potential According to numbers extracted from the PNAD, families commit, on average, 12% to 13% of their monthly income to private health plans. Looking into commitment levels for each income class (Exhibit 3 on page 5), we see that lower income classes dedicate 16% of their budgets to health plans while upper income families spend only 4-6% on plans. Brazil Health Care: Struggling to Meet Demand 20

21 Exhibit 14: A limited share of Brazil s population falls under private health care plans addressable market Assuming health plan cost moving in line with wage growth, families 195 currently earning less than R$1,950/month are out of the market for individual or affinity plans. A share of this group may get from Medical cooperatives are very strong 86 employers a corporate plan. in the countryside, including larger cities. They are often vertically integrated and offer strong resistance to newcomers ? Assuming health plan costs moving 200bp above wage inflation (historical trend), and household budget commitment to health plans constant, 10% of population would be excluded from the market in 10 years <31 Total Population Income below minimum threshold (health plan affordability) Population with limited access to private providers Addressable market Medical cooperatives (UNIMEDs) Other HMOs and Insurers Apparent growth opportunity Negative effect of medical inflation Addressab le market left Source: IBGE/PNAD, ANS, Credit Suisse Assuming R$70 as the minimum monthly ticket for an individual health plan, an average family of four, and more than 16% of household income spent on health plans, we conclude that only households with monthly income above R$1,950 would be interested in a health care plan, which removes 45% of Brazil s population from our potential market estimates. We acknowledge the existence of plans being sold at lower prices, ranging between R$45 50/month, but we sincerely question the sustainability of such operators. The ANS is becoming stricter on the quality of services delivered to consumers, and in our view operators cannot meet the requirements while charging such low fees. Besides the filter for income, we also exclude from our addressable market estimate the share of the population that is not yet served by private health service providers. Assuming as a proxy for this group the share of the population living in small towns (less than 50,000 inhabitants) in the North, Northeast, and Central West regions of Brazil, another 18% of the population is excluded from our market size assessment. The resulting addressable market estimate, summarized in Exhibit 14, still assumes medical inflation evolving in line with household income, which does not seem to be a fair premise, despite the positive outlook for wages in Brazil. Over the past few years, medical inflation has outpaced wages by ~ bps, and as discussed previously we do not see the trend reverting. Assuming historical inflation will continue going forward, in ten years the prices of health plans may be out of reach for the "C" class. Corporate Plan Growth May Decelerate Today, 63% of the 47.6 million lives covered by private health plans in Brazil are under corporate agreements. Corporate plans have outpaced the sector (individual and affinity) in the past 5 years, and the strength expected in Brazil s formal labor market support the bullish growth scenarios circulating in the market. Although we share the positive view of the labor formalization trend, we note that companies are not obligated to fully subsidize health plans. Contrary to the meals and transportation allowances, health plans need not be offered at all. Although it is a common benefit on the industrial sector, the situation is different in the services sector, which is expected to grow faster. It is also worthwhile to note that individuals may hold more than one plan. A typical situation is a household where two breadwinners are employed by firms offering health care coverage for the entire family. As most corporate plans are entirely subsidized by the employer, the family is covered by both plans but probably uses just one (the best one). The unused plan not only inflates national statistics of the number of covered lives but also artificially lowers aggregate medical loss ratios (the plan not used has a 0% MLR). Even if this household uses both plans, costs would be split between the two, and each plan, independently, does not reflect the true MLR of that family. As employers start sharing the higher cost of health benefits with their employees, we believe families covered by multiple corporate plans will eventually keep just one. As a result, MLR would increase substantially. Brazil Health Care: Struggling to Meet Demand 21

22 Growth in the corporate segment could be boosted by the development of the SME market, now that the risk of strict regulations for this market (similar to the individual segment) are apparently lower. Small and mid-sized enterprises are as unsophisticated as individuals in planning and dealing with medical inflation, and it makes sense to have the ANS regulating SME plans somehow. Payers have avoided the segment for years, fearing regulation regulatory risks, but as current debates point to an apparently light regulation, operators are now paying more attention to the segment. SMEs currently employ 38% of Brazil s labor force and are growing faster than the general economy. Exhibit 15: Health care penetration across sectors Occupation in reference week and grouping by main work activity TOTAL Occupied population By activity Agribusiness Industry Transformation industry Construction Retail and repairing Lodging and food Transportation, warehousing and communication Public Administration Education and health Domestic services Other collective services, social and personal Other activities Broadly defined activities Unoccupied population Source: PNAD, Credit Suisse Corporate Plan ( 000) Access Total Through Company Direct Other 17,963 14,475 10,586 10,009 6,124 4,069 1, ,928 3, , , , , , ,370 3, , , , % of health beneficiaries with plans attained through companies 36% 86% 85% 69% 63% 60% 81% 55% 56% 34% 55% 71% 70% Growth Outside State Capitals Is Not Trivial As highlighted in our report of March 19 ( Brazil Consumer: The Only Constant is Change ), economic growth is moving towards new frontiers, forcing companies across all sectors to increase their coverage radius. Health plan growth is following the trend, and the number of beneficiaries outside state capitals has consistently outperformed that of capital cities. Exhibit 16: Unimed growth vs. sector # of beneficiaries, mn (left) yoy growth (right) % 10% 8% 6% 4% 2% 0% % Unimed (# Beneficiaries) Unimed YoY growth Sector (Ex-Unimed) Sector YoY growth Source: ANS, IBGE Yet, penetration is still low in these regions (18.3%, vs. 42.5% in state capitals). We believe the sector has reached saturation in larger cities, and the bulk of additional growth should continue to come from new frontiers. In order to expand into new frontiers, HMOs and insurance companies will need to face a strong competitor: Unimed (Brazil s largest medical cooperative system, covering nearly 17mn lives in 83% of Brazilian territory). Structured in 370 regional branches, it is a monopoly in several regions and has been the top-ofmind brand for 18 consecutive years. Despite the troubling governance and gap in administrative skills at several branches, Unimed has proved to be a strong barrier for HMOs and insurers to grow in several locations. With strong growth mainly outside capital cities, in which the doctor is an important network provider, medical cooperatives have continuously gained market share, going from 22% in 2005 to 27% in Value Shifting to Providers Unless the trend reverts, health care service capacity should continue to fall short of potential demand, restoring (partially) the bargaining power that service providers have lost to payers in the past years. Both hospital and diagnostic markets remain quite fragmented, and consolidation has become a hot topic in the capital markets, particularly in the hospital space. The sector still faces capital controls that limit foreign investments, but barriers should not last too long. Potential efficiency gains are sizeable and should be kept by consolidators, but in our view they are not enough to attract significant investments to the sector. The payment system used for the sector Brazil Health Care: Struggling to Meet Demand 22

23 needs to be updated to achieve lower transaction costs and properly reward for quality. The good news for providers is that the ANS is analyzing ways to improve it. Cost Efficiencies Alone Are Not Enough Failure to meet cost of capital perhaps explains the low speed of capacity expansion observed lately. Exhibit 17 summarizes our ROIC estimates for hospitals and labs based on publicly available information. Although returns across the sector may change materially, we do not believe the sector median meets cost of capital. Hospitals currently struggle to survive on commissions earned on medical supplies, while smaller labs typically lower the quality of exams to meet revenue stream. As payers and consumers start demanding higher service levels, many providers may fail to meet growing demand complexity (and to survive). Newcomers will likely bring more professionalism to the sector, but medical inflation (and upside to efficient suppliers) appears inevitable. Opportunities to improve efficiency are plenty, but will not be easy to capture. No one seems to know the exact figure, but money wasted on paperwork in the payment process consumes 25% 35% of sector revenues. Duplicate medical procedures, lack of control of costs, and unsophisticated management teams supported by a remuneration structure that does not entice efficiency also add to waste in the system. Improvement opportunities are clear but require a level of coordination across the chain that is hard to imagine happening without some type of government support. We do not see tangible signs of efficiency improvements and do not price in any such benefit in our models. Exhibit 17: ROIC: Hospitals vs. Labs Pre - tax ROIC (%) Hospitals Diagnostics Source: Company data, Credit Suisse estimates EBIT / Sales (%) Hospitals Diagnostics Sales / IC 1.7x 2.0x Hospitals Diagnostics New Payment System Is Needed As highlighted previously, the payment structure in Brazil is based on the fee-for-service system, which induces providers to overproduce (overtreat/ overdiagnose), without simultaneous improvements in quality. The issues with current pricing can be illustrated by the revenue structure of hospitals in Brazil. As shown in Exhibit 18, a large and increasing share of hospital revenues come from the sale of medical inputs (ortheses, prostheses, special medical materials, and drugs). Exhibit 18: Hospital revenue mix evolution % Source: ANAP To control medical inflation, the payment system needs to be revised, improving rewards for quality and ensuring a more rational use of resources. The ANS is currently taking the initial steps toward making such changes by discussing various payment models with players in the health care sector, but there are no tangible signs of when the changes can be implemented. In the model being discussed, service providers would share part of risks with payers, moving from a full feefor-service structure to a system where payment would be defined according to the level of complexity and predictability of the medical procedure. In cases with predictability of outcomes (e.g., appendicitis), payment would be fixed and providers would bear the risks of additional costs in case of medical complications. The procedure would follow a standard protocol and have a preset price to the payer. The providers, in this case, would have the incentive to be as efficient as possible, as any cost savings would be kept by them. In cases where predictability of outcomes is low (e.g., heart attack of a 75-year old patient), the current fee-forservice structure would be maintained. The ANS is planning a pilot project of the new model in 2013 to evaluate its effectiveness. Discussions so far have focused on hospitals, but we believe they should evolve to include other service Other Diagnostics and therapy Medical inputs Daily rates Brazil Health Care: Struggling to Meet Demand 23

24 providers. Similarly to cases where hospitals are paid a fixed fee for a packaged service (vs. separate payments for each input used), labs could be remunerated on the basis of the hypothesis of illness, regardless of how many exams are needed. In many cases, the clinical staff from the diagnostic center is in better position to decide which tests must be made and can actually test hypotheses using fewer exams. Growing Role of Financial Services As consumers take a more active role in saving and paying for their own health care, they will likely start demanding higher bundling of health and financial services (e.g., hybrid retirement and health care products, health savings accounts). Opportunities are sizeable, but the basis for competition and the competitive landscape could change substantially. Payers will need not only to develop innovative products but also to build asset management skills, individual underwriting, and integration of payments from a number of different sources. Providers will have to learn how to compete in a more transparent marketplace with increasing focus on clinical quality, service, and productivity. New intermediaries will emerge to rate the quality of services provided, to advise consumers and to manage their health savings vehicles. Scenario Favors Financial-Services Players The traditional capabilities of financial-services companies increase their chance to succeed in hybrid products: (i) payers will need to extend their capabilities to reach a more fragmented market and financial institutions can leverage their distribution networks and marketing capabilities to make this happen; (ii) health care dedicated savings accounts may result in complex asset management needs that HMOs do not possess; (iii) growth of out-of-pocket spending creates greater need for financing from consumers and for credit risk management on the part of providers; (iv) cards are emerging to support member administration and payment process, and financial institutions can bundle them with their debit/credit card operations. Although financial institutions appear to have strong competitive advantages, partnerships with HMOs and large intermediaries would allow them to improve their knowledge on health care related complexities and minimize execution risks. Financial institutions would bring to the table their large distribution networks, extremely valuable for HMO s looking to expand into the individual segment. A clear examples of such integration is Bradesco, which has recently acquired an equity participation in Odontoprev. Local players could pay a very high price if they fail to improve their management of knowledge, to develop new products and service models, and to use technology to cut transaction costs. Failing to address the industry fundamental weaknesses may lower barriers for newcomers (financial institutions, internet companies offering online services and specialty risk consultants), who may be in a better position to exploit the inefficiencies of an industry that has not been sufficiently focused on the needs of its clients. As the market becomes larger and more complex, local players should also face higher competition from global brokers and their international networks, which use their bargaining power to obtain better terms from insurers. This buying power generates extra revenues that they can use to finance acquisitions and be more aggressive in their commercial negotiations, ultimately translating into higher market share. The best defensive strategy for local players, in our view, is to drive consolidation and gain scale before newcomers arrive. Positive Trend for Brokers Who Upgrade The entire chain, including payers, brokers and providers, will need to adapt product portfolios and commercial strategies to succeed in this new client focused environment. The new market dynamics will require sharper insights on consumer behavior, product management and risk management, as well as a broader retail distribution network. Brokers, in our view, will play a key role to simplify the attrition between the several parts of the chain with services such as call center support, claims processing, billing, etc. Companies should increasingly outsource the administration of benefits, creating sizeable opportunities for both payers and brokers. Some large financial-services players are already investing in human-resources outsourcing (e.g., Bradesco with Orizon) and, given the breadth of their capabilities, have good chances to succeed as benefits administrators. HMOs can respond by extending their relationships with employers and partnering with data processors. However, as in most service industries, we expect the distribution channel rather than the product owner to capture the bulk of profits, and brokers who move quickly, in our view, will be the winners. The use of local brokers could also be a tool for newcomers to lower entrance risks without affecting profitability. Commissioning paid to third party brokers today average 5-7% of premiums, which is often cheaper than hiring and maintaining a sales force team. Brazil Health Care: Struggling to Meet Demand 24

25 Payer Consolidation Underway Exhibit 19: Largest health plan operators Since the enactment of the Private Health care Plan Law and the creation of ANS in 2000, the health care industry initiated a strong process of consolidation. The new regulatory framework put in place forced players to meet higher levels of capital requirements and forced smaller (and more capital-constrained) players out of the market. As a consequence, number of health plan operators dropped from 2,003 in 2000 to 1,178 in March Million lives Yet, the industry remains highly fragmented, with the top five operators holding only 28% of lives. Still, nearly 70% of survivors are small companies with less than 20,000 members and we struggle to understand how they generate any return Consolidation makes sense because scale matters. Large payers have higher bargaining power with service providers, and geographical diversification dilutes potential epidemic risks. Also, as fixed administrative costs can represent as much as 25-30% of premiums for small payers, operating leverage gains can be material. Consolidation may come either by large players acquiring smaller peers or through the exit of non-profitable operators and in our view should come as a combination of both trends. Source: Companies Exhibit 20: Profile of operators Revenues (R$ Mn) 57,390 # of players ,830 6, Large Medium Small Large Medium Small Profitability Costs (R$ Mn) Avg. # of members 3,625 47, ,243 Large Medium -350 Small -1,211 15,569 5,021 Large Medium Small 45,940 6,722 Large Medium Small Large players: more than 100k beneficiaries Medium players: 20k 100k beneficiaries Small players: up to 20k beneficiaries Administrative expenses (R$ Mn) 6,453 3,611 2,364 Avg. ticket (R$/month) Large Medium Small Large Medium Small Source: ANS Brazil Health Care: Struggling to Meet Demand 25

26 Vertical Integration Perhaps the key challenge faced by payers moving outside main cities is to build their network of service providers. Not only are (quality) providers in growth frontiers scarce, but they are often vertically integrated into medical cooperatives (best example is Unimed). In any case, newcomers face difficulties in growing in these regions, and vertical integration is a fast track to growth. It is important to highlight that building a strategy solely on a fully closed, verticalized model, that is, a network that only services one player, can prove to be challenging when expanding geographically. The issue for closed models is that the network needs to be built in cities in which demand will be sufficient to financially sustain the service. Partially verticalized or nonverticalized players would face less restrictions in regional expansion, which would depend on making agreements with networks. Amil is one partially verticalized network, as ~20% 25% of its costs are incurred in-house. Their hospitals also bring in an additional source of revenues, since some are not fully utilized by Amil and empty beds are filled by other operators or by out-of-pocket patients. Verticalization can also be a way to tap into lower-income segments. In Brazil, the most successful examples of verticalized strategies are players in the middle-to-low income segments, such as Intermedica, Hapvida and some medical cooperatives (UNIMEDs). Hapvida provides almost all the services it needs in-house, including the architectural drawings of its hospitals, which are made by companies owned by the group. According to its president, Hapvida tries to eliminate most of its intermediation costs; for example, its call center reduces the final price of each plan by R$0.23. We note that for top-notch service providers, especially hospitals, verticalization is not an easy strategy to adopt as this segment requires more specialized services and usually more complex treatments. Verticalization as Hedge against Medical Inflation In times of high medical inflation, owning service providers can be an option to partially or totally hedge payers' costs. Verticalization can bring major cost decreases through better frequency controls for utilization of the proprietary network. The example of Kaiser Permanente in the US shows that the main impact of a verticalized model is the reduction in admissions and lower length of inpatient stays. The lower frequency comes mostly from having the provider aligned with the payer's interest in reducing costs, rather than inducing services demand, and not by denying treatment. Conflict of Interest In order for verticalization to actually decrease costs for the payer, it has to promote a reduction in costs; that is, the frequency and volumes charged to the service provider have to be lower in the owned network. Thus, maximizing results within each of the business units (payer and service provider) in a verticalized structure has an inherent conflict of interest. We believe this is one of the most fragile points of the verticalization model and needs to be carefully addressed. One of the solutions is to clearly define efficiency parameters for each of the units in order to optimize usage and maximize consolidated results. Exhibit 21: Concentration of service providers Total hospitals + ER per mn people 5.2 Diagnosis & Treatment Units per mn 12.1 Clinics 32.1 Total population (mn) 16.2 North Northeast Total hospitals + ER per mn people 7.2 Diagnosis & Treatment Units per mn 19.2 Total hospitals + ER per mn people 16.9 Diagnosis & Treatment Units per mn 57.9 Clinics 65.3 Total population (mn) 53.7 Clinics Total population (mn) 14.3 Mid-West Total hospitals + ER per mn people 11.6 Diagnosis & Treatment Units per mn 44.2 Total hospitals + ER per mn people 15.5 Diagnosis & Treatment Units per mn 62.3 South Southeast Clinics Total population (mn) 81.2 Clinics Total population (mn) 27.6 Source: ANS, IBGE Brazil Health Care: Struggling to Meet Demand 26

27 Pharma Value Chain Positive Outlook for Generics Brazil has the seventh-largest pharmaceutical market in the world, with annual sales of US$22 billion in 2012, and the macro outlook is very favorable for the sector. Organic growth should remain in the double digits for at least another five years (IMS estimates a CAGR of ~14% through 2017), and consolidation should add further top-line momentum for market leaders. Generics are still incipient in Brazil and their development benefits the whole sector. Not only do they expand addressable market but they also have positive impact on retail gross margins. New competitive dynamics, however, should require operating skills that only larger retail chains have. A healthy macro environment has led pharma sales to beat almost every single consumer category under our coverage: IMS estimates 12% volume growth in the past five years (or 17% assuming list prices), which lies well above other discretionary categories such as apparel (3% volume CAGR) or electronics (11% CAGR). Although the short-term macro outlook remains quite favorable for the sector, an already stressed public health care budget combined with a rapidly aging population will likely exacerbate discussions on pharma inflation. As in any other country, health care costs are becoming a central political issue, and consequently the pharmaceutical industry is apt to face increasing pressure to control the high price of drugs. Pharmaceutical experts argue that the true value of drugs far exceeds their price and that drugs play a vital role in preventing and treating diseases. The benefits of the proper use of drugs include fewer trips to hospitals, fewer operations, and better quality of life, resulting in significant cost savings. In other words, there seems to be a strong case for using more medications. Without getting into the political debate, it appears to us that part of the solution would be to foster the generics market, which is still embryonic in Brazil. Out of the 60,000 pharmacy outlets in the country, generics are found at only 8,000, located mostly in developed (and wealthier) regions. We believe the growing presence of generics, the first topic of discussion in this chapter, will have deep implications for the entire pharma chain. Not only does it enhance the addressable market for drugs, but it also improves the margins of larger retail chains with bargaining power. It could also trigger a reaction from global branded manufacturers now that the macro scenario in Brazil has improved relative to their home markets. The inefficiency of pharma distribution in Brazil is also an important topic of discussion. The buy-and-hold agreement currently in place incentivizes wholesalers to maintain higher inventory levels to make money as speculators, not as product distributors. In the second part of this chapter, we highlight the problems with the current model and analyze potential alternatives. The third debate (and arguably the hottest in the capital markets) is the outlook for consolidation of pharmacies in the country. The drugstore sector has gone through a marked consolidation in the past decade, both through M&As and the exit of less efficient independent players, but remains quite fragmented. Further M&A may not be obvious (or easy to price in), but growing operating complexities should continue to force smaller players out of the market. Brazil Health Care: Struggling to Meet Demand 27

28 Exhibit 22: Overview of the Brazilian pharma value chain Industry Pharmaceutical Fragmented: top 3 players hold 31% of overall sales Pharma sales (ex-factory, R$ bn) CAGR % 8.8 Generics 31% Rx 12% OTC 14% Health & Beauty Also fragmented: top 3 retail-focused companies hold 24% market share Health & Beauty sales (ex-factory, R$bn) R$3bn R$7bn R$33bn R$6bn CAGR = 11% 29.4 R$2bn 17.5 R$21bn Source: IMS, Abrafarma, ABIHPEC, Companies, Credit Suisse Rank Pharma Wholesalers National 3 large players reaching 30,000 over drugstores ROIC pressured by low margins (5-7% gross margin) and high working capital needs 1. Santa Cruz 2. Panarello 3. Profarma Gross Sales Market R$ mn, 2011 share, % 5,971 18% 4,312 13% 3,317 10% Regional & Local More fragmented reach into local independent drugstores Some degree of overlap with national players. Offer higher discounts and extend receivables as differentials High degree of informality R$21bn R$21bn Retail Hospitals and Government (SUS) Very fragmented base: current capacity ranges at 500k beds in 7,000 public and private hospitals Drugstore retail channel Top-tier chains Chains with national or R$19bn multi-state presence M&A, organic expansion and formalization of competitive environment driving market share gains Company/group 1. RaiaDrogasil 2. DSP / Pacheco 3. Pague Menos 4. Brazil Pharma 5. Araújo Sales R$ mn, 2011 Stores eop, , , , , Second-tier chains Approximately 3,500 stores with relevant regional presence R$8bn Independent Over 30 thousand small and fragmented players R$28bn Generally independent stores, with high degree of informality Consumer Supermarkets Traditional HPC channel, still holds the bulk the bulk of store-based sales (ex-direct selling) Top 3 chains hold ~40% of overall grocery sales Spotlight on Generics Rising income has fueled pharma consumption in the past few years, but consumption remains low relative to developed markets. According to BMI, average per capita spending on drugs in Brazil currently stands at US$91 per year, which is significantly below the US$575 observed in developed markets. Aging should fuel consumption going forward. Brazil is still a relatively young country, but it is aging fast. The over-55 age group is expected to outpace all other age brackets over the next ten years (growing 41% during the period) and should reach 40 million people by Not surprisingly, the group shows higher purchasing frequency and ticket sizes for pharma products, expanding the potential market size. Exhibit 23 plots the elasticity curves for pharma and personal care products and illustrates the positive impact that rising income and aging have on the consumption of pharma and personal care products. Demand elasticity is high, particularly among lower income classes, and both sectors should enjoy strong top-line momentum for several years. Not only are drug prices rising but the mix is also getting more expensive (as an effect of aging), which accelerates average weighted prices. As health care costs continue to gain political attention, initiatives to control pharma inflation should gain momentum and the generics program will likely be benefited. Generics were officially instated in Brazil in 1999 aiming to increase lower income families' access to medications. The National Health Surveillance Agency (Anvisa) currently has 337 active ingredients registered, comprising more than 100 therapeutic classes that are frequently used in the treatment of chronic diseases. To ensure safety, the technical criteria established to approve drugs in Brazil are similar to those adopted in Canada and in the USA. Despite the efforts made in generics, reflected in the notable growth rates observed in the past decade, penetration remains low in Brazil. It currently represents ~23% of unit sales while participation in more mature markets is 60%, according to IMS. Share will likely improve with patents expiring in the years ahead: IMS estimates annual retail sales of R$1 billion from 2013 to 2016 and R$1.8 billion per year thereafter, based on prescription drug prices. Assuming an average discount of 35% for generics, additional sales may reach R$1.8 billion per year. Brazil Health Care: Struggling to Meet Demand 28

29 Exhibit 23: Demand elasticity for pharmaceuticals and health & personal care (HPC) R$/Household/Year Pharma Demand +55 years old years old R$/Household/Year HPC Demand years old +55 years old 100 X IX VIII VII VI V IV Social Income Group Source: IBGE, CS Consumer Database 100 X IX VIII VII VI V IV Social Income Group Growth should also be fueled by the phase-out of a kind of branded generics known in Brazil as similares, which claim to offer similar effects as those of prescription drugs, but without bioequivalence testing; these will be removed from the market by Manufacturers willing to keep their products in the market will be obliged to perform bioequivalence testing to certify that their effects are in fact similar to their respective counterparts. As such tests demand heavy investments, several products face the risk of being simply retired, and market share should be transferred to generics, in our view. Exhibit 24: Brazilian pharma sales by product Billion units 100% = Rx Similar Generics ~129 ~12 ~25 ~19 CAGR, % benefits generics manufacturers with a strong presence in similares, such as Hypermarcas and Aché. Implications for Margins across the Chain The average retail discount for generics vs. their respective branded versions is still low in Brazil compared to other markets (see Exhibit 25), and many believe it should rise going forward. Investors typically interpret the trend, from a retail drug perspective, as positive for volumes, neutral for top line (higher volumes offset by lower average prices) and negative for margins. It is important to highlight, however, that the larger price gap observed in the US came from much higher inflation in branded drugs and not necessarily deflation in generics. Exhibit 25: Generic price discounts across countries % discount of generics vs. branded drugs, country average S. Korea Brazil France Taiwan OTC ~ Japan China Source: IMS e It is important to note that the geographic reach of generics is still limited. IMS estimates that generics are currently offered only at 8,000 pharmacy outlets, out of a total of 60,000, and that 80% of sales are concentrated within the 3,800 outlets of larger chains (Abrafarma). Independent chains still depend on similares as cheaper alternatives to prescription products, and the phase-out of the category will likely hurt these retailers. While the trend is positive for larger chains, such as RaiaDrogasil and Brazil Pharma, it also UK Thailand US Prescription prices (US$/unit) % 30.1 Branded Source: IMS, Sindusfarma, Credit Suisse +305% Generic Brazil Health Care: Struggling to Meet Demand 29

30 While the retail discount appears low, it is much higher at the industry level. As seen in Exhibit 30, the difference between sales based on full list prices and actual prices increases as the share of generics and similares rises. The intense competition for shelf space has led to a sharp increase in the discounts granted by generics manufacturers to pharmacies, supporting the industry view that a disproportionate share of the value pool is still kept by the retail channel. Exhibit 26 illustrates the pricing dynamics for drugs in Brazil. The left-hand side summarizes a theoretical scenario, based on reference formulas set by the government. Assuming a hypothetical reference product whose factory price is set at 100, the maximum retail price at drugstores would be 133 (maximum markup is 1.33x). The maximum retail price for the generic version would be 86 (government demands a minimum discount of 35%), and producers would sell it for 65 (same 1.33x markup is applied). The right-hand side, on the other had, reflects our understanding of current industry dynamics. Manufacturers give a 10% discount on the factory price for branded products and retailers give consumers a 20% discount on the maximum retail price, which implies a gross margin of 18% for branded products at drugstores. The discount given by manufacturers on generic versions, however, is much higher (~60%), and the nominal discount is fully transferred to end consumers. Implied margin for drugstores reaches then 50%, which is significantly above levels achieved in branded products. Competitive dynamics may shift dramatically across different markets, and the numbers shown in the exhibit do not reflect the conduct of all market participants. However, relative margins should not be materially different from those highlighted in the chart. Exhibit 26: Understanding drug pricing in Brazil Indexed at 100 for factory price of branded products Branded Generic Retailer s Mg a Source: Credit Suisse Theoretical Pricing Factory Price 100 d 65 (d=c/1.33) Branded = 25% Generic = 24% Maximum Retail Price b 133 (b=a x 1.33) c 86 (c=b x 0.65) Discount given by Industry Industry Practice Discount applied to Retail Price Branded = 15% Generic = 50% If we use the US as a reference for profitability trends, then Brazilian drugstores are safe. Despite the higher retail price discounts applied to generics (above 80%) and the existence of large PBMs negotiating drugs in the country, margins on generics remain healthy and far superior than on branded products (63% vs. 7%, according to the NACDS). Looking at the returns of local chains, we also get the impression that margins are safe in the near term. According to public information released by the companies, EMS, a pure generics player in Brazil, had a pre-tax ROIC of 83% in 2011, while the figure for Aché (81% of sales coming from prescription drugs, 8% from generics and 11% from OTC products) was 72%. Exhibit 27: Discounts offered by product Real price divided by theoretical price Source: IMS Similars Rx Generics OTC Drugstores, on the other hand, generated pre-tax returns in the 20% 50% range, but assuming a higher penetration of generic drugs (or 60%, in line with developed economies), ROIC would rise by an additional ~18% (see simplified calculation in Exhibit 29). The chart illustrates well the high profitability of the chain, but the apparent advantage of manufacturers may suggest that they would be the first ones to take the hit. PBM: Game Changer in the Medium Term? Discussions regarding the potential of Pharmacy Benefit Managers (PBMs) in Brazil are starting to intensify. Through agreements with payers and/or large corporations, PBMs aggregate the purchasing of medications to increase bargaining power with manufacturers and lower prices for end consumers. In addition, PBMs may exploit the efficiencies of mailservice pharmacies, encourage use of generics and improve patients' adherence to their treatments. PBMs emerged in the 1960s in the US, when prescription drug benefits became available to employees, retirees and their dependents, and have become the largest buyers of medications in recent years (Exhibit 28). Brazil Health Care: Struggling to Meet Demand 30

31 We see large pharmacy chains as the natural owners of this model in Brazil, following the examples of CVS and Caremark. Among the initiatives currently in place, the People's Pharmacy Program (Farmacia Popular) is perhaps the closest model to the US PBMs and is managed by the retail channel. The program provides heavy subsidies for ~100 drugs for diseases such as asthma, diabetes and hypertension that are distributed by retailers accredited by the government. Retail margins on these products are reduced, but experience so far has shown positive cross-selling synergies. According to our channel checks, sales per square meter of accredited stores increased by up to 30% after sales began under the program. PBMs are expected to increase in Brazil with the emergence of larger collective buyers of drugs. Triggers could come from new regulations, including drug benefits in health plans, or from corporations extending the benefit to employees. Despite their relatively high bargaining power, PBMs should benefit manufacturers with increasing generics consumption. On the payers side, adding drugs to existing health plans is not necessarily negative, as the proper use of medication should reduce occurrences of more severe diseases. Exhibit 28: PBM gaining ground in the US % of new prescriptions by payer in the US Source: IMS Cash Medicaid PBMs/ Third Party Exhibit 29: Comparing returns across the value chain Pre-Tax ROIC excl. Goodwill % EMS Aché 1 2 Drugstores* Drugstore Scenarios: Revenues breakdown Rx Generics Other 1 65% 0% 35% 2 0% 65% 35% Source: Companies, Credit Suisse Consolidation among Manufacturers EBIT Margin, % EMS Aché 1 2 Drugstores* Capital Turnover (Sales / IC) 3.7x 3.9x The top-ten pharmaceutical manufacturers jointly hold ~40% of the market in Brazil, a similar ratio compared to the global arena. The particularity is that the ranking is clearly split between traditional global players focusing on patent-protected prescription drugs and domestic companies that sell mostly generics, similares and OTC products. The rapid increase in the sales of generics and similares in the past decade and the lack of interest from global players in these sectors have pushed local companies to the top of the ranking: local players now hold over 50% of the market in unit terms, compared to 37% in The Brazilian government has also played a role by supporting the local industry via special credit lines ( Profarma ) and subsidies for innovation. Consolidation among manufacturers has been slower compared to the retail sector, but growing interest from global players has generated a few sizeable deals. The largest includes the acquisition of Medley by Sanofi in 2010 for R$1.5 billion, giving the French group leadership of the local market and a complementary generics portfolio. Pfizer also struck a deal for a 40% stake in local player Teuto for R$400mn (with a call option to acquire the remaining stake by 2014). Among locals, Hypermarcas stands out, with multiple acquisitions to build a strong portfolio of OTC and similares: DM (2007), Farmasa (2008), Neo Química (2009) and Mantecorp (2010). 6.5x 5.1x EMS Aché 1 2 Drugstores* Brazil Health Care: Struggling to Meet Demand 31

32 Exhibit 30: Top pharma manufacturers in Brazil Product portfolio breakdown Average discount (%) Sales based on list prices (R$ bn) Sales based on actual prices (R$ bn) x = Generic Similar Rx Source: IMS Game Not Over for Rx A survey conducted by McKinsey in the second half of 2010 of over 800 middle-class patients showed that 63 percent of them felt that brands were very relevant for medications and that they would pay a premium for trustworthy ones, a finding commonly observed across consumer goods categories. The survey, however, showed little or no awareness of corporate brands, which is possibly a reflection of the low investments made by global pharma companies for this segment of the population. Nearly half of middle-class patients interviewed (53%) relied on public health services and purchased less expensive generic drugs. The remaining group, however, declared they would to pay to have access to better health care and believed more strongly in a direct relationship between price and effectiveness of medicines. They were willing to pay extra for more effective drugs with fewer or less intense side effects and for well-known brands. The study also found that 40 percent of physicians treating the middle class perceived branded medications as more effective and appropriate for their patients (for this survey, McKinsey also conducted interviews with more than 400 doctors serving middle-class patients). The challenge for prescription drug manufacturers, however, is that physicians see affordability as a major barrier and tend to segment the prescriptions they write for their patients by perceived social status. (When physicians were presented with profiles of different patients, accent and appearance determined the prescription). Global pharma companies have so far focused on Brazil s wealthiest consumers, leaving the middle-class market to the local manufacturers of generics and similares. It is true that middle-class patients are more cost-conscious and that pharmacists (of independent chains) often switch to less expensive generics, even when physicians prescribe branded drugs. Consequently, this segment of the population does not spend as much per capita on drugs as the upper classes do. However, its sheer size translates into total spending almost twice as much as that of wealthier segments, and with the macro scenario in Brazil improving relative to developed economies we do not believe global pharma companies will keep ignoring this opportunity much longer. Distribution Needs to Be Redesigned There are nearly 60,000 pharmacy outlets in Brazil demanding daily delivery of pharmaceutical drugs. To simplify sourcing, pharmacies and hospitals typically order from two or three wholesalers only (as an onestop shop) rather than dealing with various manufacturers. This way, they receive a few mixed-load shipments from wholesalers. As a typical practice, pharmacies and hospitals tend to push inventory back to wholesalers and rely on them for full service. In 2011, the top-three wholesalers: Santa Cruz, Panarello and Profarma, captured about 40% of all Brazil Health Care: Struggling to Meet Demand 32

33 wholesale drugs revenue in the country. Combined, these three wholesalers generated R$13.6 billion in revenues. As a reference, the top-three in the US (AmerisourceBergen, Cardinal Health and McKesson) have a market share of 85%. With the exception of these, all other players in Brazil are quite small and operate within limited regions. Manufacturers and wholesalers in Brazil have a buy and hold agreement in which manufacturers compensate drug wholesalers by allowing them to purchase more products than required to meet customer needs. Consequently, wholesalers intentionally and actively seek to maintain higher inventory levels to make money as speculators, not as product distributors (a/k/a investment buying). Among the many problems that this system causes for drug distribution, we highlight the massive overstock in the channel and the false demand signals. The problems faced by Hypermarcas in 2011 clearly illustrates these issues. The carrying cost of highly valued inventory also erodes supply chain profitability. Profarma (PFRM3, not covered), for example, has booked single-digit ROICs in the past 5 years, and not surprisingly the company trades at 0.7x its book value. In the US, channel relationships began to change when manufacturers and wholesalers began signing inventory management agreements (IMAs) in Under these contracts, wholesalers agree to reduce or eliminate investment buying of a manufacturer's products in return for a fee structure or payment from the manufacturer. This offsets some of the wholesaler's economic loss from the discontinuation of investment buying. Exhibit 31: Different distribution models 1. Buy-and-hold Manufacturer 2. Fee-for-service Manufacturer 3. Third Part Logistics Manufacturer Source: Credit Suisse Distributor Distributor Distributor Pharmacies Pharmacies Pharmacies Exhibit 32: Reach of Brazilian drug distributors Number of stores, thousand Source: IMS Total POS Served mainly by national distributiors (POS #22,103) 14.8 Served mainly by local and regional distributors (POS #33,368) %-75% 75%-50% 50%-25% 25%-0% Market Share from National Distributors Another structure tested was fee-for-service (FFS) agreements, which add performance-based metrics to the IMA concept. Wholesalers receive additional payments for meeting performance targets established in negotiations with a manufacturer. Although IMA and FFS agreements have reduced the inventory of the US pharmaceutical wholesale industry from days in March 2003 to about 28 days in March 2012, they did not completely eliminate investment buying. An alternative to the three structures discussed above is the direct-to-pharmacy (DTP) model. Under this agreement, the manufacturer maintains ownership of products throughout the supply chain until they reach retailers. The wholesaler manages drug distribution for the manufacturer for a fee and the manufacturer receives payment directly from retailers. Under the DTP agreement, the wholesaler continues to provide the same services to the manufacturer as they did under the FFS agreement. Additionally, the pharmacy and hospitals receive the same services under both agreements. Thus, the material-handling and transportation costs are identical under all agreements. The new flow of drugs remains the same, but the flow of money is different. The direct-to-pharmacy model appears to be the most suitable solution for the pharma chain. As it is hard to foresee when (or if) this structure will be implemented in Brazil, our models do not incorporate any upside to our estimates. However, we acknowledge that the benefits for pharma manufacturers could be sizeable. Selfwarehoused pharmacies may continue to do investment buying but they would also be benefited by better service levels. As for distributors, adopting this structure appears to be the only way to survive. Brazil Health Care: Struggling to Meet Demand 33

34 Positive Outlook for Drugstores Exhibit 33: Drugstores increasingly a key channel for HPC industry Pharma Grocery Health & beauty spending, channel breakdown (% of sales) Traditional Source: AC Nielsen, Credit Suisse Hair color Skin care Diapers Conditioner Deodorant Shampoo Soap Share of sales through pharma channel (%) Drugs (with or without a prescription) may be sold only at pharmacies in Brazil. Thus far the government has blocked several requests for relaxation of rules to extend OTC and prescription drug sales to other channels, forcing grocers to create their own drugstores. However, supermarkets have not yet been successful in capturing a significant share of pharma sales, with a market share of only 3% currently. On the other hand, in the last few years the drugstore channel has transitioned from a secondary sales channel towards a key investment focus of the Brazilian health and personal care (HPC) industry. Exhibit 34 details our channel checks across direct sellers and brick & mortar retailers of shampoo. To our surprise, the number of brands and SKUs available among leading chains closely matches the assortment at larger stores such as Extra. It is also important to note that the shopping experience at drugstores is more targeted (fewer categories) and therefore more prone to uptrading. Data from AC Nielsen shows that the HPC mix at drugstores tends to be composed of a much larger share of premium-priced products (57%) compared to only 32% at regular grocery chains. We view the increased interest in the drugstore channel as an opportunity for companies to enhance gross margins by better exploiting selling space and capturing trade marketing investments. Not only are top drugstore chains increasingly treated as key accounts by the industry, but the premium product portfolios they carry generally command a higher share of trade spend vs. other marketing/media investments. This combination of factors has pushed the share of HPC spending at drugstores up by ~700bp in the past few years; pharmacies now account for ~42% of overall store-based HPC sales (excluding direct selling), according to AC Nielsen. Exhibit 34: Benchmarking HPC assortment at different consumer channels in Brazil Shampoo consumer prices by company/channel, R$ per 100ml; prices as of May # of skus # of brands Drugstores carry a comparable Direct selling assortment vs. other channels Grocery retailers Source: Store visits, Credit Suisse Brazil Health Care: Struggling to Meet Demand 34

35 More Consolidation Underway The drugstore sector has been going through steady consolidation since the beginning of the past decade, driven by both the continued erosion of the competitive position of independent players as well as by M&A among the top players (most notably in 2011). Nevertheless, in comparison to other retail segments, the drugstore sector remains relatively fragmented: the top-three grocery players in Brazil hold ~40% of the their market, which is higher than the combined share of the top-ten pharmacies. We believe sector consolidation at the expense of independent players will continue in the coming years, and we see many drivers influencing this trend. First, scale is becoming increasingly important, as larger players have access to better purchasing conditions. Chains with a broad geographic reach (and strong organic growth plans) also capture the bulk of trade marketing spent as both pharma and HPC manufacturers continue to fight for shelf space. Also, as competition levels increase, so does the need for higher management sophistication, which, again, smaller players lack access to. Trends also suggest higher pressure on marginal returns on invested capital for less efficient players. Consumers are becoming more demanding and retailers will need to address their needs more granularly. An obvious consequence is the expansion of the SKU (stockkeeping unit) offering, which on the positive side may help drugstores drive sales volumes and fine-tune pricing. However, it also adds operating complexities that may limit (or even deteriorate) marginal returns for players not able to keep up with the growing challenges of logistic operations and higher working capital requirements (higher inventories). Exhibit 35: Larger chains are gaining market share Share of total pharma sales, percent per format Independent chains Supermarkets Mid-large chains Top 10 chains Source: Abrafarma, IMS ~37 ~5 ~ e Exhibit 36: Breakdown of Brazil s drugstore sector Revenue category 6 4 Stores per category (#) 3 2 Source: IMS, Credit Suisse estimates Avg. sales per store per year (R$ mn) Estimated pre-tax ROIC % , , , , , , Small drugstore owners typically do not account for their own salaries or remuneration of their real estate when assessing the economic return of their business. The false sense of profitability is further enhanced by tax evasion and the illegal sale of prescription drugs without prescriptions, and this combination of factors has historically helped them resist tighter competition from larger chains. In recent years, however, the government has implemented a set of regulatory changes to reduce sector informality, including a tax substitution scheme that eliminated the tax evasion advantage and reduced net margins of smaller players. With the help of IMS data that dissects the Brazilian drugstore sector into eight deciles (i.e., eight groups generating the same aggregate amount of sales, R$4.7 billion) and determines the number of stores in each group, it is possible to estimate the average sales per store. Based on this information we estimated the average pre-tax ROIC by group assuming benchmark levels of capex, working capital and operating margins for each one. Although it is only an estimate, we believe it provides an important argument for the continued consolidation that we expect to take place: categories 7 and 8, which include over 80% of all stores in Brazil, generate sales of just R$15,000 per month. We believe that the returns of those stores trail the cost of capital by a wide margin, even under optimistic scenarios for margins and Brazil Health Care: Struggling to Meet Demand 35

36 capital turnover. Their current existence, in our view, is explained only by the lack of formal competition. Exhibit 37: Mapping Brazil s largest drugstores M&A activity in the sector in 2011 was considerable, showing that there are important scale synergies to be captured in such transactions. The main highlight would be better purchasing conditions, as well as logistics optimization and securing better locations in particular geographies (first-mover advantage). Targets appear aplenty, but given current multiples and recent deals it seems unlikely that large cash transactions would occur. In addition, equity combinations could prove delicate as most of the large chains are still family owned and could face governance issues. Nonetheless, geographically relevant chains could be an interesting gateway for international players looking for emerging markets growth platforms (see Exhibit 37 for an overview of the regional positioning of Brazil s top-20 chains). Chain RaiaDrogasil DPS Pacheco Pague Menos Brazil Pharma Araújo Panvel Nissei Onofre Imifarma Drogasmil Venâncio Drogal S SE CW NE N All factors combined, we believe greenfields will be the most important growth vehicle for formal players going forward. With high marginal store returns (ROICs in the range of 20% 25%) and ample room to gain market share over independents, it is not a surprise to see top players with plans to open a total of over 600 new stores per year. Angélica Drogacenter Indiana A Nossa Drog. Permanente São Bento Moderna Santa Lúcia Minas Brasil Source: IMS, Credit Suisse Brazil Health Care: Struggling to Meet Demand 36

37 Dental Value Chain Is There Room for Individual Plans? Brazil has nearly 230,000 registered dentists, more than the US and Canada combined. Still, 40 million Brazilians lack some (or all of) their teeth and 30 million have never visited a dentist in their lives. Such incredible supply-demand discrepancy explains much of the excitement over dental plans, which have so far experienced strong and profitable growth within the corporate segment. Despite the apparently untapped demand, penetrating the individual market has proven to be more challenging, and most dental operators may disappoint in growth and marginal profitability going forward. Winner strategies, in our view, will combine scale, IT skills and broad reach. Despite the fact that Brazil has a large number of certified dentists and a population that exhibits surprisingly high attention to its oral health (evidenced by a high consumption of oral health products, on par with developed countries), low availability and quality of government-provided dental care services has left most of the population without access to dental care services. The high untapped demand for dental care has created an attractive opportunity for dental plan operators, who have experienced strong growth rates in the past decade (Exhibit 38). The relatively low ticket of dental plans has made them attractive benefit options for employers, which explains the high contribution of the corporate segment to sector growth. Initially restricted to large corporations, plans are now growing into SMEs and are the fourth-most-common benefit offered to employees, according to Towers Perrin. Dental plan operators have shown remarkable trends in top-line growth and profitability, and the challenge now is to replicate the success in the individual segment, which has proved far more challenging. Contrary to health plans, individuals do not purchase dental coverage to hedge against unpredictable risks of casualty, but as a financing option for their treatment. Adverse selection is more problematic in dental than it is in health care and delinquency rates in the segment tend to be higher. While the low ticket allows operators to capture a larger addressable market, it also limits their margin for mistakes. The secret is to maintain rigid control of expenses, but most sector players lack the capabilities for that. There are a few exceptions, however, and these players should drive sector consolidation in the years ahead. Scale gains are attractive, but in our view they will likely be used to remunerate dentists better. Exhibit 38: Impressive historical growth of dental plans Millions % 20% 12 Growth 15% 10 (% YoY, RHS) 8 10% 6 # Dental Members (LHS) 5% 4 2 0% Source: ANS Brazil Health Care: Struggling to Meet Demand 37

38 Seizing Growth Opportunity According to the ANS, the exclusive dental plan industry grew from 3.8 million members in 2002 to 17.3 million in March 2012, a CAGR of 18%. Enrollment in dental care plans represented only 12% of the total number of health care plan members in 2002 and increased to approximately 36% in March 2012 (roughly 9% of the population). Despite the visible growth, the ratio is still low compared to mature markets like the United States. Penetration seems low, but we need to consider a few important characteristics of this market before delving into growth estimates for dental players. First of all, and as highlighted before, consumers typically look at a dental plan as an alternative to finance their dental treatment. With the exception of accidents and acute toothaches, dental treatment is rarely considered an emergency and untreated cases hardly ever damage the health of individuals. Consequently, individuals can plan their treatment without much rush and opt for the best economic option. Regulation further stimulates such behavior since operators can only cancel plans for delinquency after 60 days of arrears. This makes it possible for consumers to complete a 90-day treatment while paying only one monthly installment. Second, growth is taking place within a segment of the population that has had poor (if any) dental treatment in their lives, which substantially increases initial loss ratios. We understand that after an initial peak the cost of dental care diminishes, regardless of the age of the individual, but we argue that many individuals abandon their plans at that moment. There is a clear market for players willing to finance dental treatment, but we do not believe it is part of the agenda of dental operators. Exhibit 39: Largest dental plan operators Million lives Odontoprev Amil Interodonto Tempo Odonto System Prodent Sulamérica Metlife Uniodonto - Curitiba Uniodonto - Campinas Impao Belo Dente Source: Companies Finally, the bulk of growth potential lies outside traditional (and wealthier) regions, where income and availability of dentists are notably lower. Today, 67% of all dental plan members are located in the Southeast region of Brazil, followed by 16.9% in the Northeast and 9.0% in the South. The state of São Paulo alone accounts for almost 40% of all dental plan members. The geographic expansion of the economy naturally enhances growth potential in other states, but players will need to adjust strategies and pricing to succeed in those regions. In our view, the key barrier in new frontiers is the cooperatives of the Uniodonto system. As in the case of the Unimeds for the health plan sector, the Uniodontos are strong regional players. While structured as a regional cooperative, there is an agreement of fees in which beneficiaries can use services outside the cities in which the plan was acquired. Their governance model and management skills are far inferior than large players such as Odontoprev, but their strength should not be underestimated. The Uniodonto system has roughly 20,000 dentists working exclusively for its plans and is the best tool dentists have to fight the increasing bargaining power of dental plan operators. Exhibit 40: Supply-demand of dental services Tooth Issues Dentists per 1000 inhabitants North Northeast Mid-West Southeast South Source: CFO, Ministry of Health Brazil Health Care: Struggling to Meet Demand 38

39 Exhibit 41: Dental plan operator profile Revenues (R$ Mn) 1,448 # of players 301 Profitability Large Medium Small Costs (R$ Mn) Large Medium Small Avg. # of members 550, Large Medium Small Large players: more than 100k beneficiaries Medium players: 20k 100k beneficiaries Small players: up to 20k beneficiaries Large Medium Small Administrative expenses (R$ Mn) ,937 5,328 Large Medium Small Avg. ticket (R$/month) Source: ANS Large Medium Small Large Medium Small In our view, the clear long-term top-line driver for large operators will be market consolidation. According to the ANS, the sector still has 429 active providers (as of March 2012), but most are too small and unsophisticated to survive the growing competition. Lower Operating Risks Support Lower Loss Ratios The risk profile of dental care is different from medical care in many important aspects. If we had to pick just one, it would be its capability of tracking procedures more easily. Clinical exams, x-rays and photos not only confirm the procedure but also assist operators in the assessment of quality. Besides the higher control over events, we also highlight five other characteristics that support the lower loss ratios observed in dental plans (vs. health plans): 1. Medical care costs increase with the aging of health plan members as well as with the introduction of new, more expensive and irreplaceable technologies. In contrast, aging does not entail cost increases for dental and new technologies tend to replace previous technologies without entailing large cost increases. 2. Dental diseases are easily diagnosed using simple x- rays done at the dentist office, while doctors typically require more complex tests done in labs. In other words, the costs and demand for resources required to identify dental pathologies are much lower. 3. For dental treatments, patients (and plan operators) typically have a good idea of the cost and timing of the treatment. For health care in general, on the other hand, outcomes are often unpredictable. 4. Most dental procedures can be repeated or corrected in case of mistakes. Dentists are typically responsible (and bear the cost) of follow-up procedures when necessary, and in cases where a second professional needs to be involved the first dentist is not paid for the mistake. For health care, many procedures are not revertible. 5. Authorizations are obtained prior to treatment, and dental operators generally have a good idea of the costs to be incurred. Dental plan operators have been able to maintain dental loss ratios fairly controlled in the past few years, at much lower levels than those of health plans. It is also interesting to note the gap between efficient operators, such as Odontoprev, and smaller players, which include dental cooperatives. Cost advantages of larger players gain importance as the sector grows into the individual segment (where customers are more price-sensitive) and will certainly fuel sector consolidation. Brazil Health Care: Struggling to Meet Demand 39

40 Lower Risk of Government Intervention Private dental plan providers are subject to governmental legislation as well as to regulations imposed by the ANS. Today, there is no regulation in place controlling premium adjustments for dental plans, and we do not see compelling reasons why this would change due to the relatively low tickets of dental plans. Aside from changes in regulations, the government could also intervene in the sector by raising investments in public dental care. After a survey showing the pitiful situation of dental health among Brazilians, carried out in 2003, the government launched the Brazil Smile program. The initial goal was to distribute dental care kits (toothbrushes and toothpaste) to 500,000 public school students, to build 354 dental care centers in municipalities with poor access to dental services, and to set up 559 dental clinics as part of the government's Family Health Plan. Another objective of the program was to provide fluoridation nationwide. Adding fluoride to water is cheap (around R$1 per year per inhabitant), and currently only half the population (70 million people) has access to water with fluoride. The Brazil Smile program also planned to provide needy families with complete dental treatment, including periodontal care, surgery, orthodontic procedures, and assistance with mouth lesions and cancer. But, despite the aggressive goals, the program has not evolved much since its launch, and we do not see it as a major threat to the growth potential of dental plan operators. Exhibit 42: Evolution of Brasil Smile program Nov Nov Nov ,205 41% R$56 Source: Ministry of Health 59,258 85% R$600 # dentists in SUS # cities teams are present R$ mn spent Brazil Health Care: Struggling to Meet Demand 40

41 Companies section Amil Medical Loss Ratios Under Control Brazil Pharma Balanced Risk-Reward; Initiate as Neutral DASA Growth Story Overshadowed by Low Visibility Fleury Quality Player Already Priced In Hypermarcas Buy Pharma and Get Consumer for Free Odontoprev Superior Cash Flow But Limited Catalysts Qualicorp Attractive Growth and ROIC Combination RaiaDrogasil Preferred Vehicle in Our Preferred Sector Brazil Health Care: Struggling to Meet Demand 41