China Nepstar Chain Drug (NPD)

Overview: China Nepstar Chain Drugstore, Ltd. ("Nepstar") is the largest drug store chain in China with over 2,600 stores located mainly in eastern China's urban centers. Nepstar's story is one of consolidation. China's drug store industry is highly fragmented, with Nepstar accounting for only .5% of the country's drug store revenues. Instead, China's drug store industry is dominated by "mom and pop" stores, and local chains, similar to the United States before the wave of consolidation resulting in the Walgreens, Rite-Aid and CVS behemoths. Through consolidation, Nepstar will continue to develop its brand value, with the goal of becoming the "go-to" drug store (or one of them) for China's enormous urban population. It is also in the process of developing a higher-margin private label line of OTC medicine and other health products, which thus far is largely absent from the Chinese market.

Nepstar is a market leader with the financial capacity to take advantage of a highly fragmented but stable industry, without the use of any leverage. While we generally place little emphasis on macro trends because of our firm belief that we can't predict the future, we also cannot ignore China's increasing urbanization, enormous population, increasing use of western medicine, and high personal savings rate. Each of these macro factors certainly bode well for the nation's largest drug store chain.

While investing in emerging market companies certainly comes with higher risk than domestic companies, we find some comfort in the fact that Nepstar has a big-four auditor (KPMG), trades on the New York Stock Exchange and is owned 25% by Goldman Sachs (its IPO underwriter).

Management Effectiveness: Nepstar's return on invested capital (assets-unused cash/securities) of 19% in 2007, and roughly 13% annualized thus far in 2008 (probably more realistic given the costs of being a public company) are very good for a chain retailer. While not a perfect comparison, note that US retailers and drug stores operate with far less ROIC. In 2007, WMT had return on invested capital of roughly 8%, TGT less than 7%, CVS 6%. This solid ROIC can translate to a high ROE once Nepstar's cash is either returned to shareholders (see below) or used to develop/acquire stores.

Cash Flow: In 2007 and 2008, cash flow provided by operating activities was/is greater than net income.

Balance Sheet (so good its almost bad):As of September 30, 2008, Nepstar was holding $200M cash and $169M investment securities and had $0 long term liabilities. This cash is either slowly being returned to shareholders or used to acquire/develop shares. Nepstar pays a 3% dividend (modest given its cash position), and is in the middle of executing a $40M share buyback. In 2007 Nepstar articulated a target of 1,050 new stores in 2008.

Risks: Investing in Nepstar comes with several risks. The Chinese medicine industry is substantially regulated and a significant number of Nepstar's products are subject to price controls. Future regulation could collapse Nepstar's margins, or in the worst case, prohibit Nepstar from selling certain products. China's economy could fall into a long and protracted recession, pinching consumers and hurting Nepstar's revenues. In addition, the founder and CEO of Nepstar owns approximately 50% of the Company. While this position ensures that he has a vested interest in increasing shareholder value, his ownership could prevent the future acquisition of Nepstar or other transactions that return value to shareholders. We will be closely monitoring any related party transactions between the CEO and Nepstar. Note also that Goldman Sachs could decide to liquidate its position in Nepstar. If this were to occur it would put substantial pressure on Nepstar's stock price.

Valuation: Nepstar has a market cap of 438 with a P/B ratio of roughly 1. Its cash and investment securities give it an EV of roughly $59M. Based on 2007 earnings, EV/EBITDA* is roughly 2.5 (after discounting for minority interest), a very low multiple. Given recent market turmoil and the unpredictable nature of an emerging market stock, we believe that any estimates of an intrinsic value are academic at best so we won't venture a guess. Our opinion is that if rational pricing prevailed Nepstar would be valued substantially higher than an EV/EBITDA of 2.5.