China: Where Micro Cap Growth Opportunities Abound

Includes: CJJD, FXI, NPD
by: Joseph Levy

The demographics of China (population 1.34 billion) and India (population 1.19 billion) make them areas equity investors can not ignore. These two countries account for approximately 36.8% of total world population, while the United States ranks as a distant third with a population of 310 million or 4.5% of total world population.

In the future, the U.S. will benefit tangentially from the tremendous economic growth anticipated for China and India. Hopefully this will partially offset the negative economic headwinds fostered by the confluence of “Big Government,” “Big Business” and “Big Labor” (or should I say "Big & Corrupt"). I feel certain that most of us are not happy with the direction of the country, which began years before the current administration in Washington D.C. The recent actions are merely bringing a future crisis to a head at a quicker pace. It is unconscionable that the U.S. keeps falling deeper into debt and at an accelerating pace. We are becoming more and more beholding to China and other foreign nations to bail out our fiscal irresponsibility, which can only end up badly in the future.

I generally advise most individuals to invest in mutual funds to get the proper diversification of investments for areas like China, India and other emerging markets. However, I have come across a number of micro-caps in China that I find appealing for those with a speculative appetite. Recently we purchased shares of a small and rapidly growing Drug Store chain trading under the symbol CJJD.

China Jo-Jo Drugstores, Inc. (NASDAQ:CJJD), through contractually controlled affiliates, operates a retail pharmacy chain in China offering both western and traditional Chinese medicine. The chain currently has 42 stores in Zhejiang Province. The Company had a public offering on 04-28-10, when they sold 3.5 million shares at $5.00 per share and the net proceeds to CJJD amounted to $15.45 million.

The company has a fiscal year that ends on March 31. Prior to raising the new capital in April 2010, they grew the number of directly operated drugstores from 9 at March 31, 2008, to 16 at March 31, 2009 and 25 at March 31, 2010. Since April 1, 2010 to date, they added another 17 stores bringing the current total up to 42 stores in Zhejiang Province. The company’s immediate goal is to have 60 drug stores in Zhejiang Province, which is an area of 39,300 square miles and having a population of 52 million. The Company’s longer term goal is to operate more than 200 drug stores by sometime between the fiscal years ending March 31, 2014 and March 31, 2015.

Other interesting demographics about Zhejiang Province include (source: Wikipedia List of China administrative divisions by GDP):

“Zhejiang is an eastern coastal and best developed province, its annual average GDP growth rate of 12.7% ranked the 2nd from 1978 to 2007, while its GDP per capita in 2007 was 112.2 times in 1978, it ranked 1st in all provincial-level divisions. In 1978, Zhejiang's GDP was only CNY12,372 million (US$7,347 million) and ranked the 12th in all 50 provincial-level divisions, then Its GDP has been Ranking the 4th since 1994, also Zhejiang became the 4th province to reach a GDP of over CNY1 trillion in 2004. In 2008, Zhejiang's GDP rose up to CNY 2,148,692 (US$309,677 million) and it was the first time to reach over CNY2 trillion. Zhejiang's GDP was CNY 2,283,243 million (US$334,247 million) in 2009.”

As of June 25, 2010 the company operated 31 stores. Each of their stores typically carries approximately 2,500 to 7,500 different products. In addition to these products, they have licensed doctors of both western medicine and TCM onsite for consultation, examination and treatment of common ailments at scheduled hours. Two of their stores have adjacent medical clinics offering urgent care (to provide treatment for minor ailments such as sprains, minor lacerations and dizziness which can be treated on an outpatient basis), TCM (including acupuncture, therapeutic massage and cupping) and minor outpatient surgical treatments (such as suturing). Included in their Q-1 2010 press release was the following announcement:

“Another milestone for us was that we are the first non-state-owned enterprise in Zhejiang Province to be able to sell pharmaceutical products online. The online drugstore will not be an immediate revenue generator for us, but over the long term we will use this to further establish our presence throughout Zhejiang Province.”

In the company’s conference call they played down the current impact of getting licensed to sell pharmaceuticals online but indicated this could have a big impact in the more distant future.

Their store locations vary in size, and the 31 stores operated as on June 25, 2010 averaged approximately 3,592 square feet. I believe the larger store size is one of the distinguishing factors, which accounts for the better operating results of CJJD versus other drug store chains operating in China, such as China Nepstar Chain Drugstore Ltd. (NYSE:NPD), whose ADS shares are traded on the NYSE.

Sales of CJJD grew from $31.3 million in the FYE 03-31-08 to $44.8 million (up +43.0%) in the FYE 03-31-09 and to $55.2 million (up +23.2%) in the FYE 03-31-10. Operating Income, as well as Net Income and EPS all grew at a faster pace than the growth in sales. This was all accomplished prior to the April 28, 2010 public offering resulting in the Company raising $15.45 million in additional capital. Sales increased by +30.2% and net income by +34.6% in the first quarter ended 06-30-10. Because of dilution from the 04-28-10 public offering, EPS declined by -16.0% versus the same period in the prior year. Consensus estimates call for sales of $78.1 million and $0.83 EPS for the fiscal year ended 06-30-11 and sales of $122.5 million with EPS of $1.16 in fiscal 2012.

At the closing price of $5.53 on August 20, 2010, CJJD shares are priced 5.2X EPS in the trailing twelve months ended 06-30-10 and its market cap at $70 million (based on 12.7 million diluted shares outstanding) was just 1.2X sales of $58.7 in the 12 months ended 06-30-10. Based on the company’s strong prospects for future growth, I look for the shares to trade above $10 within one year.

For operating data, balance sheet info and other metrics, see here.

As with any company (and especially Chinese companies) the importance of the integrity of the “accounting” by both company management and outside auditors is critical.

When looking for what can go wrong with a “China growth company”, CJJD’s competitor NPD is a classic example. China Nepstar Chain Drugstore Ltd. (NPD) is China's largest retail drugstore chain based on the number of directly operated stores. As of June 30, 2010, the Company had 2,582 stores across 74 cities, one headquarter distribution center and 13 regional distribution centers in China.

On November 9, 2007, the NPD completed an IPO and received net proceeds of $355.8 million. The timing of the IPO was perfect for NPD since China companies were being significantly overvalued at that time. The closing price on 12-31-07 was $17.58, which translated into a market cap of $1.14 billion. This was 4.3X sales of $268 million in the year 2007 and 2007 EPS totaled only $.28, resulting in a whopping 62.7X PE ratio.

The number of stores operated by the company increased from 1,446 at the end of 2006 to 2,002 stores on 12-31-07 and then 2,709 at 12-31-08 but then declined to 2,479 at 12-31-09. Earnings per ADS shares (one ADS share is equal to 2 ordinary shares) have been declining over time and for the six months ended 06-30-10, NPD reported a net loss of $(1.6 million) equal to a net loss per share of 2 cents on approximated 105 million weighted average ADS shares outstanding.

The stock price has been on a steady downward spiral from a peak of $21.25 in 2007 to $5.05 at 12-31-08, getting back to $7.29 at 12-31-09 and has since fallen to a closing price of $2.76 on August 20, 2010. The company has tried mitigating damages to its stock price by repurchasing shares and paying out dividends ($0.12 per ADS share in 2008, $0.35 in 2009 and $0.28 so far in 2010). This has contributed to a significant decline in the company’s cash and equivalents (including long-term investments) from $330 million at 12-31-08 to $171 million on 06-30-10.

For a more complete history of NPD's operating data, balance sheet info and other metrics, see here.

In summary, I’ve tried to point out the potential for large price gains or losses using two China companies in the same industry, which have been marketed as growth stocks prior to their public offerings. Future execution by management, plus proper dilligence and valuation at the time of purchase, are important ingredients in making a successful investment. I believe CJJD has the potential to provide handsome future returns if management is able to execute their business plan and because the shares are at an attractive entry point at this point in time.

Disclosure: Long CJJD; no position in NPD