China Nepstar (NYSE:NPD), the largest drugstore chain in China, filed to make its IPO on the NYSE. The registration fee implies the company will seek to raise as much as $250 million in the IPO. As usual, the first filing did not include the price of the offering, the expected number of shares or the number of shares outstanding after completion of the IPO. Nevertheless, the F-1 Registration Document included a number of interesting insights into the selling of pharmaceuticals in China.
First of all, China Nepstar is growing fast. On September 30, it operated 1,791 stores in 62 cities, which were located in the ocean-bordering provinces in the east and south of China. That number is a large increase (almost a triple) from the 668 stores the company had just three years earlier, as of December 31, 2004. From 2004 to 2006, China Nepstar produced a CAGR of 43.4%. Although its 1,791 outlets make Nepstar the biggest chain in China, they represent less than .5% of all the retail non-hospital pharmacies. It is a very fragmented industry.
In the first six months of 2007, China Nepstar made a profit of $4.6 million on $124.3 million of revenues. That was an 18% increase in revenues over the year earlier, which moved the company to a profit from a loss of $2.6 million. In the third quarter of 2007, however, the unaudited data showed revenues were up only slightly – less than one percent – over the second quarter, even though Nepstar opened 177 new stores over the course of the three months.
Nepstar explains that it decided to cut certain low margin products, hoping to replace them with high demand and/or high margin products, a process that has introduced some disruption among customers. But the decision seems to be wise. Despite the revenue disappointment, Nepstar said earnings were 56% higher that Q2 at $6.2 million on revenues that were essentially flat. Gross margins climbed to 47.1% from 42.6%.
To help increase its gross margins, Nepstar began introducing private label brands in 2005. Nepstar now offers 1,108 number of private label items that contributed 17.6% to revenues in the first half of 2007 and 31.2% of the earnings. Prescription drugs accounted for 24.3% of Nepstar’s revenues during the first half of 2007; OTC drugs were 35.4%; while the rest (40.3%) came from nutritional supplements, herbal products and personal care, family care and convenience products.
Drugs that are part of national or provincial medical insurance catalogs are subject to mandatory price controls and as such represent low-margin products, though they increase store traffic. The PRC is on record as wishing to diminish the dominance of hospital-affiliated pharmacies. This represents an opportunity for Nepstar and other independent retail pharmacies, though the products will not be the most profitable of the company’s offerings.
Frost & Sullivan estimates that, because of the initiative, sales from non-hospital drugstores will increase to 41.0% of all drug sales in 2011 from 28.4% in 2006. Like most China-based companies, the corporate structure for Nepstar is Byzantine. Regulations in China dictate that pharmacies can have a maximum of only 49% foreign ownership. Each of the pharmacy operating divisions of the company is, therefore, only 49% owned by Nepstar Pharmaceutical. Other individuals, primarily Liping Zhou, control the remaining 51%. However, through contractual arrangements with other Nepster companies, including Nepstar IT Service and Nepstar Management Consulting, China Nepstar (which owns the other two organizations) effectively controls each of the regional pharmaceutical operating divisions. Is that clear?
In October 2004, an affiliate of Goldman Sachs invested $25 million into Nepstar via Series A redeemable convertible preferred shares. That investment bought the Goldman Sachs affiliates at 30.3% share of the company. The majority ownership of the company remained with Neptunus BVI, the parent organization. Goldman Sachs will be running the books for the IPO.