The following piece discusses China Cord Blood Corporation (CO). The company has a market cap of $280M. I believe that the value of CO is close to $11.00/share compared to today's market price of $3.80.
China Cord Blood Corp. is a leading cord blood banking operator in China, providing cord blood stem-cell processing and storage services for subscribers exclusively in the Beijing municipality, Guangdong province, and Zhejiang province. It owns 24% of Qilu, which operates in Shandong province. It also benefits from an exposure to Southeast Asia, with a 14% stake in CBB (India, Indonesia, Philippines) and Cordlife Singapore (Singapore, Hong Kong).
China Cord Blood Corp. is the first and largest operator in China with the longest track record in providing blood stem-cell processing and storage services. It has access to four of the seven authorized licenses, which represents 45% of the total newborn population in the seven authorized provinces and municipalities.
The cord blood banking industry in China is set up in a way where only one operator per region is given a license to operate by the PRC government. Therefore, in a specific region the license owner enjoys a monopoly. To date, only seven licenses were awarded: China Cord Blood Corp. operates three, and has a 24% stake in a fourth. The PRC government intends to issue only up to 10 licenses in total before 2015.
Strong Barriers to Entry: Very Costly and Lengthy License Application
Even in the event of a regulation change, where the PRC government decides to abolish the one-license per region rule, it would take numerous years and substantial investments for a potential entrant to complete the application process to be eligible to operate a cord blood bank:
Following the submission of a written notice to the Department Of Health, the applicant usually would be required to incur significant initial investments, including costs associated with the construction of facilities, to demonstrate to the Department Of Health that it is capable of meeting the stringent application requirements for a license prior to the receipt of such a license. For example, the cord blood bank in Beijing operated by Jiachenhong took six years to obtain its license, during which time it incurred substantial costs to construct facilities meeting the stringent application requirements prior to obtaining a license.
The requirements include:
- Setting up laboratories that comply with national standards;
- Collection of minimum number of donated samples and preserved for a certain time period;
- Successfully completed required number of transplants.
Economies of Scale
It would take a small incremental cost to store an additional unit as the costs of maintenance of storage cylinders and automated monitoring systems are fixed.
China Cord Blood Corp.'s business model is subscription-based. A typical contract runs for 18 years and includes:
- One-time processing fee (RMB 6,800).
- Annual storage fee (RMB 860/year) for 18 years.
The following model generates superior cash flow over the years. In fact, operating cash flow exceeds operating income on a regular basis as 40%-45% of new subscribers fully prepay the 18 years of services while enjoying a 20% discount.
Profitability and Debt
- FCF margin>50%.
- Gross Margins>75% since 2009
- Operating margins>35% since 2009
- Net margins>20% since 2009
- CROIC > 26% since 2011 (CROIC = FCF / (Equity + Debt - Cash + .02*Sales)
- 2013 CROIC=65%
- Total Debt/FCF = 2.3
- Total Debt/equity = 0.65
Yuen Kem, Chairman of China Blood Cord Corp. owns 11% of the company and has over 20 years of experience in China's healthcare industry. He is the founder and CEO of Golden Meditech, which is a leading integrated-healthcare enterprise in China listed on the GEM of the stock exchange of Hong Kong since 2001. Golden Meditech has a 42% stake in CO. Ting Zheng, CEO, owns 1.5% of the company. She has over 10 years of experience in the field of corporate strategy in China's healthcare industry. She has been in charge of operations since 2003.
- Price on October 28 2013: $3.80
- Diluted P/2013FCF: ~5 exc. net cash
At $3.80 one is buying the business at $2.40, which represents ~five years of non-growing FCF, while revenue has been growing at around 27% per annum.
- March 2016 Target = $9.5 Assumptions: P/FCF = 10; Rev. Growth per annum = 20%; FCF margin = 45%
- March 2016 Target = $12 Assumptions: P/FCF = 14; Rev. Growth per annum = 23%; FCF margin = 55%
Private Market Value
CO acquired 4% of Qilu in February 2013 at $8.65M, which values Qilu at $212M. Qilu serves a market of newborns more or less similar to Guangdong. Adjusting for the markets of Beijing and Zheijang. PMV of CO = $390 M in 2013. Note that CO acquired 20% of Qilu in May 2010 for $20.5M, suggesting that Qilu's value grew more than doubled in less than three years (30% CAGR).
- Change in China regulation of one license/region.
- Change in China regulation towards private cord blood and/or pricing: In Italy and France, private banking was banned 10 years ago, however there is heavy pressure from parents and doctors on the governments to relax the regulations and allow private cord blood banking, as an additional amount of parents are turning towards private storage in neighboring countries such as Switzerland and Belgium,
- Private storage vs. public storage benefits.
- Shareholder dilution -- additional convertibles notes?
- Controversy around aggressive advertising of private cord blood banking, which could affect sentiment.
- Market penetration: Cord blood banking as a precautionary healthcare measure is still a relatively new concept in China, with penetration rates at less than 1% of China's overall newborn population. The estimated penetration rate in CO's regions was approximately 3% in 2011 and 2010. Deloitte expects the penetration rate to grow by 23% per annum until the end of 2015.
- Large number of newborns: China had 16.1 million newborns as of and for the year ended Dec. 31,2011, according to National Bureau of Statistics of China. Guangdong had a population of 105 million people in 2011, with over 1M newborns.
- Growth in urban disposable income and increasing focus on healthcare.
- M&A targets: Management look to acquire or partner with operators in other regions.
- Growth in China's middle-class population from 290M in 2011 to 590M in 2025.
- One-child policy that makes it difficult to obtain matching cells.
- Potential for additional diseases that stem cells can be used to treat that are yet to be found.
China Cord Blood Corp. operates a very profitable business model with recurring cash flows. The business is protected by an economic moat thanks to the license-based industry and the high entry costs. Cord blood banking enjoys strong tailwind from China's one child policy that incites parents to spend additional income towards the health of their only child. And with China being the second country in terms of newborns per year (trailing India), it is a great country for a cord blood bank to operate in. Taking into account the low market penetration rate, which is expected to grow from around 3% to 6% in 2015 as well as the growing middle class population, I would expect CO's client base to keep on growing at a fast rate.
I would keep an eye on the regulations in China that could affect CO's business model and especially the regulations regarding private banking vs public banking. If the Chinese government decides to regulate private banks then CO's business model would be at great risk. I understand that the odds are that if any regulation is to happen it would be to regulate quality and pricing rather than ban private banking all together. Most importantly, buying CO at $3.80/share offers huge upside to a fast growing business and industry and a potential multi-bagger for the patient investor.