China Nepstar: Market Leader with Opportunity to Expand

| About: China Nepstar (NPD)

Buy Price: $4.02

Overview: China Nepstar Chain Drugstore, Ltd. (NYSE:NPD) is the largest drug store chain in China with over 2,600 stores located mainly in eastern China's urban centers. Nepstar's story is one of consolidation. China's drug store industry is highly fragmented, with Nepstar accounting for only .5% of the country's drug store revenues. Instead, China's drug store industry is dominated by "mom and pop" stores, and local chains, similar to the United States before the wave of consolidation resulting in the Walgreens (WAG), Rite-Aid (NYSE:RAD) and CVS behemoths. Through consolidation, Nepstar will continue to develop its brand value, with the goal of becoming the "go-to" drug store (or one of them) for China's enormous urban population. It is also in the process of developing a higher-margin private label line of OTC medicine and other health products, which thus far is largely absent from the Chinese market.

Nepstar is a market leader with the financial capacity to take advantage of a highly fragmented but stable industry, without the use of any leverage. While we generally place little emphasis on macro trends because of our firm belief that we can't predict the future, we also cannot ignore China's increasing urbanization, enormous population, increasing use of western medicine, and high personal savings rate. Each of these macro factors certainly bode well for the nation's largest drug store chain.

While investing in emerging market companies certainly comes with higher risk than domestic companies, we find some comfort in the fact that Nepstar has a big-four auditor (KPMG), trades on the New York Stock Exchange and is owned 25% by Goldman Sachs (its IPO underwriter).

Management Effectiveness: Nepstar's return on invested capital (assets-unused cash/securities) of 19% in 2007, and roughly 13% annualized thus far in 2008 (probably more realistic given the costs of being a public company) are very good for a chain retailer. While not a perfect comparison, note that US retailers and drug stores operate with far less ROIC. In 2007, WMT had return on invested capital of roughly 8%, TGT less than 7%, CVS 6%. This solid ROIC can translate to a high ROE once Nepstar's cash is either returned to shareholders (see below) or used to develop/acquire stores.

Cash Flow: In 2007 and 2008, cash flow provided by operating activities was/is greater than net income.

Balance Sheet (so good it's almost bad): As of September 30, 2008, Nepstar was holding $200M cash and $169M investment securities and had $0 long term liabilities. This cash is either slowly being returned to shareholders or used to acquire/develop shares. Nepstar pays a 3% dividend (modest given its cash position), and is in the middle of executing a $40M share buyback. In 2007 Nepstar articulated a target of 1,050 new stores in 2008.

Risks: Investing in Nepstar comes with several risks. The Chinese medicine industry is substantially regulated and a significant number of Nepstar's products are subject to price controls. Future regulation could collapse Nepstar's margins, or in the worst case, prohibit Nepstar from selling certain products. China's economy could fall into a long and protracted recession, pinching consumers and hurting Nepstar's revenues. In addition, the founder and CEO of Nepstar owns approximately 50% of the Company. While this position ensures that he has a vested interest in increasing shareholder value, his ownership could prevent the future acquisition of Nepstar or other transactions that return value to shareholders. We will be closely monitoring any related party transactions between the CEO and Nepstar. Note also that Goldman Sachs could decide to liquidate its position in Nepstar. If this were to occur it would put substantial pressure on Nepstar's stock price.

Valuation: Nepstar has a market cap of 438 with a P/B ratio of roughly 1. Its cash and investment securities give it an EV of roughly $59M. Based on 2007 earnings, EV/EBITDA* is roughly 2.5 (after discounting for minority interest), a very low multiple. Given recent market turmoil and the unpredictable nature of an emerging market stock, we believe that any estimates of an intrinsic value are academic at best so we won't venture a guess. Our opinion is that if rational pricing prevailed Nepstar would be valued substantially higher than an EV/EBITDA of 2.5.

*For those who are unfamiliar with the concept of Enterprise Value: EV is the value the market places on the "enterprise", independent of how that enterprise is capitalized (capitalization is subject to change - see the dividend and share buyback).

The Model:

The following model projects a conservative snapshot of the business in 3 years. We will assume that costs stay relatively stable, and that Nepstar will be able to acquire or create essentially as many stores as it is financially able to (which appears to be a realistic assumption given how fragmented the industry is). For purposes of this model we will ignore dividends and share buybacks. We will present a model using conservative assumptions and then for reference provide moderate and aggressive alternatives.

In 2007, Nepstar added roughly 556 stores. In 2008, Nepstar anticipated adding approximately 1,050 new stores (as of Nov. 2008 there were 665 new stores added in 2008).

New Stores: Nepstar estimated that it would spend approximately $42M in 2008 building and acquiring 1,050 stores, which equals roughly $40K per store. Three acquisitions thus far roughly confirm this number - Nepstar has purchased stores in 2007/2008 for roughly $55K per store. It would be expected that organic store openings require less money than store acquisitions. When acquiring stores, Nepstar must pay a goodwill premium instead of merely purchasing the assets required to open a new store.

Nepstar has available capital of $369M to open/acquire stores. If we assume that Nepstar can spend $150M of this in the next three years acquiring stores - at a conservative projection of $50K per store - this would equal roughly 3,000 more stores over a three year period (Nepstar's 2008 goal was 1,050 stores). Nepstar also anticipates spending approximately $20M on two new distribution centers. Assuming these capital expenditures, and a conservative estimate of cash flows, less the capital required to open new stores, of roughly 20M per year (2007 operating cash flow equaled approximately 23M) for each of the three years, the cost of the additional store openings and the distribution centers would result in the use of approximately $110M. Nepstar would retain roughly 259M in cash/securities on its balance sheet (again we are not accounting for share buybacks and dividends).

Revenue/Earnings: In 2005 and 2006 Nepstar stores averaged annual revenue of approximately $165K per store. In 2007 this number was roughly $133K. According to management, the difference is explained by the rise in revenue after a store ages beyond three years - following Nepstar's IPO many of its stores are less than three years old. This model assumes a conservative $125K per store.

With an increase of 3,000 stores following 2008 Q3, Nepstar would have roughly 5,600 stores in three years. Our conservative estimate of revenue would be $700M.

Nepstar's operating margin was roughly 10% in 2007 and roughly 7% in the first three quarters of 2008 (a more realistic margin given the costs of being a public company). American drug stores generally have operating margins in the 6% range. A gross margin of 7% on 700M results in EBITDA of approximately 49M.

ROIC: As of September 30th Nepstar had $212M of invested capital. Following the $150M in store openings and acquisitions, and $20M for distribution centers, invested capital would equal $382M. At a tax rate of a 27% ROIC would be approximately 9.5%, a reasonable figure.

EV/EBITDA calculation: American drug stores (CVS, RAD, WAG), which have lower ROIC, lower margins and arguably less growth potential, trade in today's market turmoil at roughly 7-9 EV/trailing EBITDA, and historically at a higher rate. We think a conservative EV/EBITDA ratio (without today's market dislocation) of Nepstar in three years is 8 (which would roughly equal a PE ratio, after subtracting the cash which is being slowly returned to shareholders or used in the business, of around 11). This ratio would result in the market pricing the value of Nepstar's business at approximately $400M. Combining the additional cash of $259M results in a market cap of approximately $660M, for a annual ROR of approximately 15.5% which beats the S&P 500s historical return by over 6%. We believe this conservative model leaves substantial room for better margins, greater cash flow, and perhaps most importantly, multiple expansion.

Model #2 (moderate):

Cost of additional stores: $45K (3,333 additional stores)
Revenue per store: $140K ($830M total)
Free cash flow per year: $25M ($275M cash at end of period)
Operating Margin: 8% ($66M EBITDA)
Mkt Cap: ($935M)
Annual ROR: roughly 30%

Alternative Model #2 (aggressive):

Cost of additional stores: $40K (3750 additional stores)
Revenue per store: $155K ($984M total)
Free cash flow per year: $30M ($290M cash at end of period)
Operating margin: 9% ($88M EBITDA)
EV/EBITDA: 12 (PE, after subtracting cash, of approximately 16.5)
Mkt Cap: ($1,346M)
Annual ROR: roughly 46%

Bottom Line:

Long 5%. We will continue to monitor Nepstar's expansion and margins.

Disclosure: Long NPD.