China Nepstar (NPD, profile) was slammed lower in trading yesterday, shedding about 11% on above average volume. Over the past two days, the stock shed about 13%, making it one of the worst performers in the universe of US-listed China stocks.
Although there were no major news items to point the finger to, there was broad selling in China's domestic stock markets which could have led to Nepstar falling in sympathy. Shanghai-listed No. 1 Pharamacy (600833) dropped nearly 8% on Tuesday, and other drug and pharma names were also lower on the day. Investors were selling across all sectors of the market on Tuesday, and didn't leave drugs stores or related pharma names untouched.
Nepstar has been trading lower after an underwhelming Q3 (the company reported late November) which although included revenue growth, was coupled with margin weakness. Tuesday's drop brought the post-Q3 slide to a total loss of nearly 25%.
At the close of trade yesterday, China Nepstar's market cap was about 131 million USD, or about 64,000 USD per store. Considering that it takes approximately 70,000 USD to open a new store (not including inventory of over 30,000 USD), the stock was trading below the replacement value of the existing store network. (For those interested in the math, replicating the company's 2,050 store chain would take over 140 million USD, which does not include inventory or any of the necessary overhead expenditures.)
By trading so cheaply, the stock price seems to imply relatively heavy operating losses, but is that reasonable?
The fourth quarter is seasonally strong for drug stores in China, owing in part to the winter cold and flu season. So far in FY2014, Nepstar has been delivering higher revenues based on strong comparable store sales, which speaks well of the quality of revenue growth (more organic vs. opening new stores), a trend which could continue. The problem for the company has been in dealing with costs, creeping higher due to government-imposed price controls as well as overall wage and rent inflation. Management has made some progress streamlining the company, but did report a loss in Q3 on weaker gross margins, something which seems to have spooked investors.
Based on discussions with the company, those fears might be overblown. Costs of goods sold were higher in Q3 not because of pricing pressure from suppliers, but due to promotion activities aimed at attracting customers.
In the post-Q3 call, management said that it had already re-worked its approach to promotions, therefore suggesting that gross margin recovery could be right around the corner.
If this is true, what could it mean for the stock?
Revenues in FY2014 have averaged a YoY growth rate of about +8% for the first three quarters of the year. Conservatively assuming that Q4 has a similar degree of growth, Q4 revenue would be about 810 million RMB. If gross margins recover in Q4 to normalized levels of about 42%, gross profit could be approximately 340 million RMB.
Assuming flattish operating expenses of about 300 million RMB, operating profit would be about 40 million RMB, or an OPM of about 5%. Note that the flattish operating expense assumption relies on a degree of leverage from the existing cost base; if sales and marketing expenses increase with sales, the result would be lower operating margins.
Achieving an operating profit margin of 5% would be a definite positive for the company, which has reported operating losses during Q1-Q3 FY2014. So although that might be a 'blue-sky' scenario, a more realistic goal might be less (a positive 1-2% margin perhaps).
For China Nepstar, the operating profit line is the clearest angle to look at the company, due in part to legacy tax issues affecting net income (and earnings per share). As a technical matter, tax losses of subsidiaries can't be used to offset tax exposure of profitable subsidiaries, which distorts the company's effective tax rate. This situation should reverse over time as the company closes unprofitable stores, cleaning up the store network.
There are a lot of assumptions in the logic above, but hopefully the discussion illustrates why the recent selling could actually be deviating significantly from the fundamentals. Sure, Q3 wasn't great, losses never are, but there are a few positive factors working in the company's favor, and a stock trading at less than the store network is worth hints at some intrinsic value.
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