Description

A US-listed Chinese pharma distributor 111 Inc is in the process of getting acquired by a management-led consortium at $3.66/ADS. The primary aim of this privatization seems to be the relisting of the company in China - this would not only help settle certain equity redemption liabilities but might also lead to a higher valuation of the business.

The market seems to have given up on this privatization saga. The non-binding proposal was submitted last September, and YI's special committee has been reviewing the offer for 14 months already. Investors are likely fatigued by the extended process. YI shares have plummeted over the last 3 months and currently sit at all-time lows. The spread to the offer price has widened to 70%.

It is quite usual for Chinese privatizations to take a long time in a non-binding stage. There have been multiple cases where it took even longer for the offers to transition from non-binding to binding ones. For example, GTH’s recently signed definitive agreement has taken 14 months to materialize since the initial non-binding bid. Other similar US-listed Chinese cases with prolonged timelines were CYOU – 32 months (non-binding>>binding), JASO – 29 months, KANG – 21 months, KZ -18 months.

Since the offer last year, there have been a couple of positive announcements suggesting the game is still on. E.g. in the most recent update in July, privatization intentions / the offer price were reiterated, and multiple new parties joined the buyer consortium.

YI’s management appears to have a solid reputation/background for a Chinese micro-cap and substantial incentives to proceed with this privatization, which adds some confidence to this setup. One of the co-founders, Gang Yu, has held executive roles at Dell and Amazon and has launched two ventures that were later acquired by US companies. The online grocery business Yihaodian was bought by Walmart in 2015 and then sold to JD.com a year later. Gang Yu also founded CALEB Technologies, an aviation management systems company, which was acquired by Accenture in 2004. The other co-founder, Junling Liu, was Dell's China/HK president and VP before co-founding Yihaodian with Gang Yu. They seem to be smart operators and I don’t think their game plan here is to stay stuck with an orphaned US listing forever.

In case the privatization breaks, the downside is difficult to estimate. The stock already trades below the pre-announcement levels whereas the business continued to perform well financially. However, without relisting in China YI might struggle to settle redeemable equity liabilities next year causing further downward pressure on the share price.

Quick business background

YI is primarily a wholesale pharma distributor to small/medium pharmacies in China. The company has its e-commerce channel through which customers (which are often located in rural areas and are ignored by large traditional distributors), can conveniently place their orders. The company partners with over 435k pharmacies and covers over 70% of China. YI is also offering various data analytics, and supply chain digitization products to clients and for certain products, is partnering with Tencent on the software development side. YI is also the first Chinese company that has a direct sourcing partnership collaboration agreement with European pharma giant Bayer Healthcare. Besides the distribution business, the company also runs a retail B2C online pharmacy and online hospital businesses. It also has a tiny marketplace platform, where customers can order directly from producers with YI only grabbing the commission. All of these are still a very small part of the company’s total revenues.

Revenues are growing fast, at a 50%-120% clip annually pre-COVID and 20% this year so far. The company is on the brink of reaching profitability having already delivered non-GAAP operating profit over a few recent quarters.

Aside from this high-level background info, the visibility into the business and drivers of financial performance is very limited. However, that is standard with most Chinese microcaps and I do not think it is indicative of a likely success/failure of the ongoing privatization - much more obscure Chinese businesses were privatized and delisted from U.S. 

Despite a reputable background, management comes off as a bit promotional. In essence, YI is just a wholesale pharma distributor, that develops various software/digital products (data analytics, etc.) to keep up with the competition, increase customer stickiness, and support margins. However, management is marketing aggressively as some kind of advanced digital healthcare tech player with phrases like “digital technology” or “advanced technology” being used non-stop during conference calls. 

Timeline of developments so far 

• September 2022 - YI’s co-founders made a non-binding privatization proposal at $3.66/ADS. The transaction was set to be financed by a state-owned PE firm Shanghai Guosheng Capital Management, which is focused on innovation and operational improvements in strategic industries. The buyers had 44% economic interest and 92% voting power in the company at the time.

• In October 2022, several more parties joined the buyer consortium, including well-known PE firms e.g. 6 Dimensions Capital, and one of the major YI’s shareholders, ClearVue.

• Then in July 2023, the $3.66/ADS offer was reiterated and a few more additional parties joined the consortium, including SAIF Partners ($4bn AUM). Buyers’ total economic interest and voting power in YI increased to 67% and 95.3% respectively.

Relisting in China is required to settle redemption liabilities

Management needs to take YI private in order to relist the company in China and in turn, settle major redeemable equity liabilities.

In 2020, YI issued around US$130m of unusual redeemable equity for its primary operating subsidiary in China. Besides the 6% interest, the terms also included a redemption option exercisable by investors if YI is not listed on the domestic Shanghai Stock Exchange STAR market (equivalent to NASDAQ in the US) by June 2023. As of June’23, this liability has grown to US$150m and the company did not have sufficient cash resources to settle potential redemptions. In the current environment, raising fresh equity funds in the U.S. to meet the redemptions would be close to impossible, low stock price does not help with this either.

Signals from the redeemable equity investors regarding the ongoing privatization have been very positive so far. As of mid-2023, around 67% of redeemable equity investors agreed to adjourn the redemption by one year until June 2024. Also, two redeemable equity holders showed direct interest in the transaction and joined the buyer consortium - Ningbo Youkai in Oct’22 (but then withdrew in Jul’23), and SAIF Partners joined the buyers’ group in Jul’23.

Re-rating likely after relisting

Another incentive to relist in China is that YI would likely trade higher if the orphaned US listing were to be replaced by a Shanghai STAR listing. This would not only increase the value of management’s stake in the company but also open the path to raise additional equity financing to fuel growth and build scale. 

Current privatization would cash out minority shareholders at a fraction of the 2020 redeemable equity financing valuation. YI currently trades at a $350m market cap and $440m EV, whereas the $3.66/ADS offer values the company at $700m EV. YI owns 86% of its onshore operating subsidiary and the remaining 14% is held by redeemable equity investors. Issued at the peak of COVID in 2020. This redeemable equity valued the operating subsidiary at $1.6bn post-money, implying a $1.45bn valuation for YI’s 86% stake. Management has also participated in the financing investing $3.5m of their own funds.

YI also trades much lower vs its locally listed peer. YI currently trades at 0.23x TTM sales, while the offer values the company at 0.35x multiple. YI's close peer YSB Inc (9885.HK) with a very similar business model and identical revenue size was listed in Hong Kong this summer at a substantially higher 0.75x revenue multiple. Following the IPO, YSB's stock went up over 100% reaching 1.8x TTM sales valuation at one point, and then surprisingly crashed this week by more than 50% and is now back to IPO levels (I am not aware of any news that might have affected this). A part of the valuation difference could be explained by YSB's net cash balance sheet, faster historical revenue growth, and higher margins, although YTD growth and margins of both companies are fairly similar. Even after YSB share price crash the valuation gap between YSB and YI is still too wide and should incentivize management to proceed with privatization and subsequent relisting of YI on the local exchange.

China healthcare reforms

A major uncertainty for this setup are healthcare industry reforms that are currently taking place in China. My understanding of these developments is very limited and I find it difficult to determine whether this could be a real threat to YI's operations and the ongoing privatization of the company. Sharing some details I have gathered on the topic below.

The Chinese healthcare system has been built on kickbacks and huge marketing spending from pharma companies so that doctors would prescribe more expensive medicines than needed. The government is now cracking down on this hard with dozens of drugmakers and doctors put under scrutiny, and some doctors sent to jail. At least two pharma IPOs in China were suspended this year. The government has also introduced several big reforms, including the Chinese healthcare insurance, which as I understand will put a toll on pharma sale volumes in the short term, but might be a big tailwind to the pharma sector in the long term. Here's how YI's management commented on the situation in the Q2 call:

So obviously, you noticed and we noticed there is suddenly a pretty big change in our general population's medical insurance. So for those people who do not understand the Chinese Medicare system. So anybody's Medicare system is divided into 2 accounts. One account is called the personal account and the other account is called the unified account. And the recent change in the policies that used to be majority of the money is deposited into the personal account. And now it's reversed. Majority of the money in the account has been distributed to the unified account, which means customers are not able to spend at their own discretion as before. Our understanding of the implications is such that, first of all, more and more pharmacies will be included in the group of pharmacies that can provide reimbursement services to customers. And those numbers will grow. We anticipate that a majority of the pharmacies will be entitled to provide the reimbursement services to their customers.And #2, the consumers' personal account is reduced. So their ticket size will be somewhat reduced. This will also impact the pharmacy. Those are the negative impacts to pharmacies and to a certain degree to us. But we actually take this as a tremendous opportunity because what this will do is to drive a lot of traffic to pharmacies. And because more and more pharmacies will be joining the group that can do the reimbursement services. And therefore, they need to purchase more drugs, they need to purchase more medicines. Furthermore, they have the opportunity to upsell their products and services. So this clearly is going to drive those pharmacies to enrich their offerings. They will have to introduce more categories and more services. So our understanding from the government is that there is a clear trend that the government is intending to separate the consultation from drug sales, which was the fundamental problem of the Chinese healthcare system.And it is not an easy reform as we understand but we are very encouraged to see the government's determination to head towards this direction, which will be great news for the pharmacy sector and not necessarily the best news for the hospitals.

However, this potential shift of hospital revenues to pharmacies is likely to result in higher competition for smaller players like YI and YSB. YI's/YSB's business model so far has been to grab market share in the distribution to small/medium pharmacies via offering convenient B2B marketplace/logistics services. These clients are often located in more rural locations and were not interesting for big and well-funded traditional distribution players or online B2C pharmacies backed by tech giants like Alibaba Health Information Technology and JD Health. The recent reforms could change this and one analyst tried to address the issue during Q2 conference call:

Analyst: Because of the recent regulatory changes, we have seen a more emphasis on the out-of-hospital channel, including the pharmacies. But at the same time, we do see a lot of the players mentioned they want to enter into this specific sector. So I want to get your thoughts on the revolving competitive landscape for the sector going forward. And in terms of competitive landscape -- sorry, advantage. What competitive advantage does 111 have as compared with other players in the market?

Junling Liu: Yes. So obviously, any attractive business will attract a lot of competitors here in China. It's an extremely competitive market. But we feel pretty good about where we are. If you look around the competitive landscape, I think our biggest competitor will have to be those traditional players because they take majority of the share over the past few decades. And -- but our advantage is very, very clear. We are a digital player. And furthermore, we actually cover our end customers. We are not simply a distributor. And our digital capabilities would certainly give us the edge, especially when it comes to operational efficiency. As you can tell, our size in this industry is not that big yet. But we -- even at this size, we already operate at a pretty efficient way, 6.3% of total OpEx is the current rate. And we believe by RMB 20 billion size, we should be operating in the 5 or even sub-5 range of OpEx.And if there are newcomers and we believe there will be even more newcomers and we are very fortunate to enter this space over 10 years ago. We've already established ourselves as the leading digital player. And even with the reasonable sized competitors, I think we do a far better job than anybody in the industry when it comes to the small to medium-chain pharmacies.

Catalyst

Completion of privatization