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A Case Of Two Pharmacies

|Includes: China Jo - Jo Drugstores, Inc. (CJJD), NPD

I've been looking at Chinese companies lately with the idea of finding opportunities from the current pessimism in Chinese Reverse Takeover (RTO) stocks. Investors have been avoiding these companies due to rising fraud. However, I believe there can be value found in this area, and the rising value of Chinese assets from the appreciation of RMB will provide an additional margin of safety.

This search led me to an interesting small-cap Chinese company, China Jo-Jo. China Jo-Jo is a Chinese pharmacy with 49 locations in the city of Hangzhou, Zhejiang, China. Most of the company's revenue is derived from OTC and Prescription drugs. The company faces stiff competition in Hangzhou due to China's fragmented drug distribution industry. Despite this, according to management, China Jo-Jo's outsourced distribution system has allowed the company to keep its costs significantly lower than other companies'. Combined with the the decrease in decent real estate locations, China Jo-Jo's existing locations have enjoyed significant competitive advantages and barriers to entry amongst new competitors. The company reported revenues of $55.2 million in 2009 with an adj. EBIT of $9.2 million. The company returned an impressive 98% on invested capital, and trades at ~5x EV/Adj. LTM EBIT. While at first glance, there seems to be significant value and growth potential in China Jo-Jo, another issue may be at hand causing investors to avoid this company. We will highlight this issue later on in the article.

This interesting value play led me to another Chinese pharmacy. This time it's an established player, China Nepstar, which had 2,479 locations across China at the end of 2009. China Nepstar is the largest pharmacy chain in China and also the largest chain in Hangzhou with 195 stores as of November 2010. Nepstar had revenues of $324.9 million in 2009 with adj. EBIT of $16.5 million. The reason for this small operating margin is due to its distribution netweork. Nepstar runs its own distribution centres whose costs accounted for in SG&A accounted for 38.7% of the company's revenues in 2009. This greatly affects its bottom line. In 2009, China Nepstar made an ROIC of approximately 9% and is currently selling at 16.8x EV/Adj. 2009 EBIT.

At first glance, it seems that China Jo-Jo is a much better investment than China Nepstar, with stronger growth potential, higher ROIC, and cheaper valuations. However, the question soon becomes: how does China Jo-Jo with only 2% stores of Nepstar's stores achieve almost 17% of China Nepstar's revenue? Somehow, China Jo-Jo has found a way to sell almost 8.6 times as much product per store as China Nepstar.

After a quick analysis, we see that even with an aggressive estimate of $25 per person spending each month, given Hangzhou's population density, the spending per sq. km. is only around $12,000 per month. Given the nature of these neighbourhood stores, it seems unlikely that each China Jo-Jo store can reach a sq. km. coverage of over 7 km. sq.

This raises several questions:

1) Is China Jo-Jo doing something that's so dramatically different from Nepstar that their stores are able to generate ten times more revenue?
2) What is a realistic number for the revenue per store in an operation like China Jo-Jo or China Nepstar?

To answer this question it would involve understanding:
a) What is the size of the market?
b) How many drug stores are in the city?
c) What is the population density of the city and the area coverage of all the drug stores?
d) What is a realistic spending amount per person on health care products?
e) What is the breakdown of population density and drug store density?

One last interesting point to note, China Jo-Jo's auditor was Frazer Frost, a company that has recently disintegrated to Moore Stephens Wurth Frazer Torbet, LLP and Frost, PLLC.

To me, this all seems conclude that China Jo-Jo's reported numbers is quite suspect. However, I can not be certain. Perhaps, China Jo-Jo has found a secret formula to success? I'm curious to hear what do you think of China Jo-Jo. Is there something that I'm missing or do not know?

This uncertainty of China Jo-Jo's financial report does account for the "cheap" valuation in its shares and the investor's aviodance of the company. Sometimes, it takes a little more digging than just the financials of a company to understand whether true value exists in an investment.

The take-away from this is to always be careful when investing in foreign, especially emerging market companies where disclosure lacks transparency. It is difficult to know whether China Jo-Jo's numbers are actual reflections of its operations. However, if there are any doubts when investing in such companies, it is better to avoid them, than to suffer a permanent capital loss when the numbers do turn out fraudulent. Like Warren Buffett notes, you should be comfortable sleeping at night know that you understand investments.

Disclosure: I am long NPD.