Robert Hsu is having an easier time selling his service these days, I imagine — things were pretty quiet on the teaser front for his China Strategy newsletter when China was in full-fledged stock market collapse, but the remarkable bounceback from those lows this year has made us all love the Middle Kingdom again (even if the “bubble” talk is also back).
So today, a teaser from his most recent ad — his shtick now is that Hu Jintao is running China like a “real” capitalist country, unlike our current leadership, and that China is like the U.S. during the start of the industrial revolution, with massive stimulus from the government helping to amplify the possible returns.
And of course, he teases us about his favorite companies — the special report he’s pitching as a reward for subscribing to his China Strategy newsletter is called “Robert Hsu’s 13 Fastest Growing Chinese Companies” … today we’ll look at the first one he teases as a “Profit Maker,” I’m sure I’ve mentioned several of the others before, but if there’s interest I’ll keep digging for more in the days to come.
So here goes — “Profit Maker #1: China’s Emerging Drugstore Chain” … here’s the pitch:
“In April, the Chinese government committed $124 billion over the next three years to reform its corrupt prescription drug system. The goal is to separate the sale of prescription drugs from hospital-run pharmacies.
“In China, until now, hospitals, rather than independent pharmacies, were where patients went to fill prescriptions. As a result, hospitals controlled 70% to 75% of the country’s pharmaceutical sales.
“The problem was that Chinese hospitals relied on income from selling prescriptions as a major source of revenue. On average, more than 40% of their profits came from the sale of drugs. It’s not surprising therefore, that hospitals pressured doctors to prescribe unnecessary and overpriced medicine to increase hospital earnings and boost their own paychecks.
“That’s why the Chinese government has acted to eliminate the inherent conflict of interest by removing drug prescription and distribution from hospitals. The plan is to make it easier, cheaper and more convenient to purchase medication at independent drug stores rather than at hospitals.
“Obviously, this move bodes well for Chinese drugstores, as they currently account for less than 2% of the country’s total pharmacy sales. But one company in particular will enjoy a disproportionate gain.”
And some clues:
“China’s Own “Walgreens” Could Triple Overnight
“Based in Shenzhen, this NYSE-traded company is what I think of as “China’s Walgreens.” Just 14 years ago, the company actually pioneered the idea of chain pharmacies in China, growing from a single shop to the biggest retail drugstore chain in China. Today, it has more than 2,300 drugstores in 63 cities, offering more than 1,000 private label products that include prescription drugs, over-the-counter medications, nutritional supplements, herbal products, consumable medical devices and personal care products.
“Its modern drugstores are becoming a familiar fixture in many Chinese neighborhoods. With its high-quality product offerings, professional pharmacy services and convenience, the company has built a strong brand name and captured a leading market position in China.
“Because of the company’s impressive success over the years — opening more than one new store per day between 2005 and 2006 — my former employer, investment bank Goldman Sachs, was an early investor in the company. Today, the Wall Street giant still owns a 24% interest in the company and has representation on the company’s board.
“In 2008, revenues grew 23% to $351 million, while net income rose 30% to $28 million. Gross margin – one of my favorite indicators of a company’s operating performance – jumped to 47.5%. And it has an excellent balance sheet with $363.2 million in cash without any liabilities — just the cash alone is worth $3.50 per share! You can own it for about $6.10 a share, still down substantially from its pre-slump high of $20! That’s why this stock has the potential to triple over night. Don’t wait even a single day to buy shares.”
So who is it? Don’t even have to pull out the trusty old Thinkolator for today’s stock — this is China Nepstar Drug (NPD — free stock trend analysis here), a company I’ve been watching with half an eye since they went public right at the absolute peak of the market at the end of 2007. If nothing else, their timing was impeccable, the price was close to $20 at the IPO and, after collapsing down to $3 or so last Winter, when China was a naughty word for investors, is now right around $7.50.
I actually came very close to writing about Nepstar as my “Idea of the Month” for the Irregulars a couple weeks ago (it was around $6 at the time), but I was just a bit too skittish about the valuation. Here’s what I was thinking for the pros and cons of the stock:
Pro: it is indeed nice to have GS with a big ownership position, but the real plus for China Nepstar Drug is that they represent remarkable potential growth — this is a business model with some similarity to Walgreens or CVS, both of which are excellent businesses here, so we assume that similar businesses would work well in China, and would inevitably grow to dominate the market there as the large chain drugstores do here. Nepstar tries to differentiate itself, and boost margins, by having a very high proportion of private label products.
Con: that potential growth isn’t guaranteed, despite their heavy investment in expansion — there’s a reason why Hsu’s teaser uses the 2008 numbers, 2009 has been a year without growth so far, and while things were especially tough late last year they scaled back some of their expansion plans, and the weaker economic picture in some areas of China led to weak same store sales results. All that expansion is very expensive, sucking up their free cash flow and cutting into what would otherwise be fairly decent earnings. But the concern that has held me back from buying shares is the fact that this is a very competitive business, in China as elsewhere, with very tight margins and a significant government presence as China builds a health safety net. I may end up kicking myself for not buying shares (or I may still buy in if I talk myself into it later), but I still have a hard time with the cost — it’s definitely a much more appealing value now than it was in the high teens when I first started looking at the shares, but you’re still paying almost 2.5X sales for a very competitive, tight margin retailer (CVS and Walgreen, by way of comparison, trade at about .5X sales, and Walgreen and NPD have about the same profit margin numbers).
But there is, of course, that intoxicating whiff of future growth to make the tough current valuation (forward PE above 30) look potentially reasonable — I know very little about the drug store business in China other than Nepstar, other than to say that from what I read Hsu is correct in saying that the Chinese government is pushing to get drug retailing out of the hands of the hospitals and into pharmacies. There is at least one other large private drug store chain in China, Laobaixing, which is still controlled by the founders and management but got a big private equity investment last year and is expected to go public within a couple years, and while Nepstar now has more directly-operate outlets than anyone else, it is still a very fragmented business. That means room for growth, and competitive pressure.
The news out of the company continues to look good, they’re bringing ATMs into their stores, they’re starting to provide bill payment and other convenience services for their customers, they focus on neighborhood convenience retailing instead of large stores, which we know is a pretty profitable model at least for lazy Americans, they’re still expanding pretty quickly (now in 67 cities, with 2,337 outlets per their website) … it’s just the current valuation that keeps me a bit spooked. I’m probably being a fuddy duddy on this one, and it could well grow into a dominant drug retailer in what will eventually be the world’s largest market for everything … and heck, they are paying a decent annual dividend (35 cents this year, for a yield of nearly 5%), so my qualms could certainly be overdone.
I should probably have bought this one six months or a year ago, when the shares were far lower — but at the time, of course, I felt more like buying big, safe stocks and burying my gold coins … and I don’t want to give you the impression that I think this is a bad stock, but at six or seven dollars a share I’m just not sure. I’m not nearly as worried about the valuation as I was when they were selling for more than 7X sales in early 2008, but for some reason I’m still a little worried. Perhaps I’ll remember to look at this one again if (when?) the Chinese market takes another big hit.
What do you think? A fan of the “what works in America will probably work in China” convenience and chain store investment thesis? Like the huge growth potential for this Chinese pharmacy chain? Am I being a baby in thinking it’s a bit expensive? Let us know with a comment below.
And if you’ve ever subscribed to Robert Hsu’s China Strategy, by all means, click here to review it for us and let us know what you think — it currently sits as the second-favorite China-focused newsletter among my readers, but that’s a short list of just four or five letters at this point. (You can see all the reviews of newsletters that focus on foreign stocks and investments here, FYI.)