Description

NeoPharm is a very cheap, cash-rich Korean small cap derma-cosmetics company specializing in over the counter and prescription moisturizers for babies and adults. The stock, which has fallen nearly 50% ytd, is incredibly cheap at only 10x trailing P/E, 5.1x trailing EV/EBIT, 45% of market cap in net cash, and a 23% ROE. The company has leading market share of 20-40% in its core product categories and is in the process of expanding international distribution to increase overseas sales. 

NeoPharm has an excellent growth track record with a 25% sales CAGR in the past three years and more than 20% over the past 10 years. Management’s guidance for this year prior to the Covid-19 outbreak was 20% growth in revenue and operating profit.  While we believe there will be some temporary Covid-19-related disruption in sales in the first half of 2020, we believe demand for most of the company’s products is defensive, the temporary impact is more than discounted in the valuation, and the stock offers exceptional value.

Background

NeoPharm was founded in 2000 as an in-house venture of the chemical manufacturer Aekyung Group. At the end of 2000, NeoPharm launched Atopalm, its flagship moisturizer for infants and small children. In 2002, the company launched Zeriod, a clinical strength line of prescription moisturizers. The company IPOed on the KOSDAQ in 2007.  In 2011, the company launched Derma-B, a body moisturizer. In 2015, the company launched Real Barrier, a skin barrier fascial cream. 

In June 2016, Hanbul Cosmetics acquired a controlling stake in NeoPharm from Aekyung for W33,900 per share. In 2018, Hanbul merged with It’s Skin to become It’s Hanbul (226320 KS). It’s Hanbul increased its stake in Neopharm from 28.1% to 37.2% in June 2019 via a private placement at W42,849 per share.

NeoPharm’s four core skin care products account for 89% of sales and all of profits. The company also has a small functional food division and does some limited OEM manufacturing mainly in the U.S.. Currently 93% of sales are from Korea and 7% are international, with China being the biggest export market.  NeoPharm sales grew by +26% in 2019, with domestic sales +25% and exports +42%. 

The table and graphic below summarizes the company’s four key skin care brands.

NeoPharm has a diversified domestic sales channel mix. While we do expect the Covid-19 outbreak to have some negative impact on sales in the first half of 2020, having only 26% of sales exposure to traditional physical retailers should limit the impact to some extent.

Zeroid (26% of sales) – A Key Growth Driver and a Defensive Product

Zeroid accounts for all of NeoPharm’s hospital and prescription sales. The brand grew +47% in 2019 and +61% in 2018.  Part of the reason for the strong growth is that the company developed a stronger prescription strength formula in 2015 called Zeroid MD that is used for more acute skin conditions and light burns, and the brand went from selling to 200 hospitals and clinics in 2016 to now being prescribed out of 3,200 hospitals and clinics in South Korea.  The company expects this product to continue to grow at least 20-30% per annum as usage and channels increase. While this line of products will likely see some impact from the current environment, we think demand for the product is defensive in nature, with 100% of these sales coming from hospital/clinic usage and prescriptions. In addition, management has a strategy to launch new Zeroid product lines to leverage the brand strength outside of the hospital/clinic channel. In Q4 2019, NeoPharm launched a Zeroid Scalp product which is the first example of this.  

Atopalm (36% of sales) – Mature and Stable

Launched in 2000, Atopalm is the company’s most mature product. It has a leading 20% domestic infant and children’s moisturizer market share. Global sales of this product were flat in 2019.  To re-invigorate sales, the company launched a series of new Atopalm SKU’s targeting maternity care, teen use, and sun care in the second half of 2019. Management is guiding for double digit growth in this product line in 2020 as new product sales ramp up and new channels are added.  While we aren’t as bullish as the company on such a mature product, we also don’t expect a severe contraction of sales here as this is primarily product line for infant use, which should be relatively defensive compared to more discretionary or fad driven cosmetics.

Real Barrier (18% of sales) and Dermal B (9% of sales) – Discretionary Spending Geared

These brands represent the more commercial and discretionary demand driven derma-cosmetics brands in Neopharm’s portfolio.  As such, more than half the sales of these two brands is though traditional Korean Health & Beauty specialty stores (H&B). H&B’s are similar to Watson’s stores in greater China (cosmetics, non-pharma health), and they are a major domestic channel for K-beauty products. H&B’s represent about 21% of Neopharm’s total domestic sales and the chain Olive Young represents about 70% of this or 15% of company domestic sales.  Olive Young is Korea’s largest H&B with over 1,300 stores, a consolidated subsidiary of conglomerate CJ Corp (001040 KS), it is multiple times larger than the next largest with several hundred locations. While Neopharm’s products (mostly Real Barrier / Dermal B) are in all 1,300 locations, Olive Young does not currently stock all of NeoPharm’s SKUs for those two brands. NeoPharm is planning to increase shelf space within Olive Young this year with more SKU’s. The company is also planning to expand into more offline channels including EMart, Costco Korea, and some military malls.  FY20 guidance is for 20% growth in Real Barrier and 10% growth in Dermal B.

The reason for a somewhat muted guidance for these products is due to a sales slowdown experienced in Q4 2019.  In the first nine months of 2019, NeoPharm’s offline sales were +33%. In 4Q 2019, offline sales growth decelerated to +14%.  The reason for this slowdown was an inventory adjustment at Olive Young as it was rumored CJ Corp has put the chain up for sale.  While Olive Young officially denied the rumors of the sale in November 2019, Neopharm confirmed a slowdown in orders in Q4. Concurrent with the inventory adjustment, Olive Young has been ramping up their global online store (https://global.oliveyoung.com/). Management said that they believe the Olive Young inventory adjustment is mostly over, but we think the disruption in this channel could continue, especially following the outbreak of Covid-19. 

International (7% of sales) – Strong Medium-term Growth Driver

International is only 7% of sales, but it is growing over 40% per annum and should have a material impact on total sales in the next few years.  40% of international is China (doubled in 2019), 30% is non-China Asia (+9%), 23% is US (+15%), and the remaining 7% is rest of world (doubled in 2019).  The CFDA (Chinese FDA) has already approved Atopalm, Real Barrier and Dermal B. However, NeoPharm only started selling Atopalm in Q3 2019. In Q4 2019, the company started selling Dermal-B and as a result, China sales growth accelerated to 400%.  Neopharm will be adding Real Barrier to the line-up in 2020, as well as seeking CFDA approval for other SKU’s including Zeroid. A similar path of product introductions are occurring in Hong Kong, Taiwan, Singapore and Malaysia. In the US, the company has an OEM business with one major customer, but they are also ramping up Atopalm and Real Barrier sales to CVS and Amazon.  The reviews for their products have been overwhelmingly positive.

https://www.amazon.com/s?k=real+barrier+extreme+cream&crid=2Y7C1BJ4FQ42L&sprefix=real+barr%2Caps%2C165&ref=nb_sb_ss_i_1_9

We expect the international business to normalize post Covid-19 at a pace similar to 2019 and for this business to be a meaningful driver of overall growth in the next 18-24 months.  We believe that as the proportion of international sales increases, the market will begin to ascribe a higher multiple to the stock.

Recent Financial Performance and Forecasts

NeoPharm has consistently grown sales and profit, with strong margins and ROE, which is indicative of the company’s strong brands and pricing power. The company is highly cash generative with free cash flow accounting for at least 80% of net profit in every year. 

Management’s guidance for 2020 prior to the Covid-19 outbreak was for 20% revenue growth and 27% operating margins. However, we have modeled a more conservative 12% revenue growth and 25% operating margin to account for disruptions in the first half of the year. 

Neopharm is very cheap on absolute and relative terms, trading at a steep discount to peers.  While a small cap discount is probably warranted, we think the company will continue to have superior growth vs. peers as the company continues to develop new and existing channels, release new SKU’s based on established brands, and further develop their small but fast growing international business.

NeoPharm has been steadily increasing its dividend, and the payout ratio is around 30%. While we see room for improvement, this is not bad by Korean or cosmetic industry standards.

Risks

Prolonged disruption in H&B channels:  Olive Young channel represents 15% of total revenues and continued disruption here may push out the re-acceleration of growth in domestic offline sales.

A slowdown in penetration of hospitals and clinics:  Zeroid sales grew +46% in the most recent quarter, but sales could be negatively impacted by a slowdown in new hospital penetration and volume of prescriptions.  While we don’t expect a meaningful slowdown, this is an important risk to highlight as continued growth of the Zeroid product is critical to investment case.

China: This is the main driver of growth in the international business and likely a source of multiple expansion for the stock if Chinese sales re-accelerate post Covid-19.  A prolonged period of poor Chinese demand and any negative CFDA regulations or delays in approving pipeline products could create negative sentiment on the stock and depress multiples. 

New product marketing expenses:  In Q4 the SGA/Sales ratio was 48% vs. 45% in Q3 and 42% in 4Q18.  Management attributed this to one-time advertising and promotion expenses for new products.  There is a risk that these expenses will continue longer than expected and depress profit margins.

Catalyst

International/China sales growth

M&A:  The company has said they would be willing to acquire peripheral businesses with their excess cash as opportunities arise.  Valuations in the Korean small cap market have been decimated, so there might be some attractive and accretive deal opportunities. NeoPharm has W80.8 billion (US$67 million) of net cash on the balance sheet as of year-end 2019.