Description

Company Overview

Founded in 2001, Yifeng is a leading pharmacy chain in China with significant offline and online presence helmed by its founder Gao Yi (高毅). Under its banner there are 13k stores, of which 10k are directly operated and 3k are franchised. Yifeng predominantly operates in East and Southcentral China with a much smaller presence in Northern China; it is either the largest or second largest pharmacy chain in its core regions. Roughly speaking, ¾ of total revenue is from prescription and over-the-counter (OTC) drugs with prescription representing the larger share, the remaining ¼ is split evenly between Traditional Chinese Medicine (TCM) and non-medicine products.

Investment Thesis

1. The pharmacy industry in China is very fragmented offering Yifeng the ability to gain share.
   • Over the years, Yifeng went from being the 15^th largest pharmacy in 2009 to the fifth in 2016 and has maintained a position within the top-5 ever since. The offline pharmacy industry in China is incredibly fragmented with the top-5 pharmacy chains having ~10% market share and the top-100 having ~1/3 market share. In comparison, ~80% of the US market is dominated by three pharmacy chains; there is ample opportunity for growth and consolidation in China.
   • Although online has taken significant share from offline pharmacy since the onset of Covid, the emphasis of online sales is on non-prescription drug products and skew more towards consumer health products (i.e. vitamins). The government loosened online doctor consultation and pharmacy regulations to cope with Covid, but after significant abuse of the system, they reversed course and started to tighten regulations on how online pharmacies can operate since 2022. In addition, ¾ of customers who frequent offline pharmacies require consultations on the specific products they require (brand, dosage, strength, etc.), which is not something easily replicated online. Even assuming significant penetration of online to over 1/3 of the overall industry, the offline pharmacy market will continue to grow at a high-single digits to low-double digits CAGR.
2. Strong external tailwinds for the business.
   • The Chinese government is looking to shift prescription drug sales from in-hospital settings to pharmacies as hospitals in China are overcrowded. As of today, only 1/3 of prescriptions are filled by non-hospital institutions (i.e. retail pharmacies) and this number is increasing by ~1pt per year. When compared to developed market peers such as the US, there is meaningful opportunity to double the share of prescription drug sales being filled by retail pharmacies in China. We expect this trend to be a multi-decade tailwind for the offline pharmacy industry.
3. Yifeng’s management team has demonstrated a consistent track record for execution.
   • Again, we zero in on management’s ability to allocate capital. Historically, Yifeng has been aggressive in growing its business through acquisitions as it can realize significant synergies, especially through group purchasing of inventory, which typically leads to a 10pt increase in gross margins post-acquisition. As more peers started to emulate Yifeng’s acquisition strategy, acquisition valuation multiples became inflated. Yifeng did not participate in the bidding war and remained disciplined on acquisition valuations, thus it shifted its focus to greenfield builds to realize better ROIC. At the same time, Yifeng typically expands through a franchise model in new markets where it has less experience in. This helps Yifeng gain valuable insights into local markets with minimal business risk before it makes the decision to enter the region with its own directly operated stores.

Dollar-flow analysis

Yifeng is a B2C business, therefore we need to fully understand the buying habits of its consumers. Yifeng has multiple store formats ranging from flagship stores (over 600sqm per store) down to small community stores (~90sqm per store). These small community stores represent over 85% of total directly operated store count and over 70% of total directly operated store revenue (ex-franchisees). From visiting multiple store locations in lower-tier cities, we found that the majority of Yifeng’s customers are the elderly who not only view Yifeng stores as retail stores, but also as community gathering spots, which leads to a stronger stickiness with its customer base. Many of these elderly customers see Yifeng as part of their daily or weekly routine and have a strong relationship with the store employees and pharmacists who are in-turn knowledgeable on their customers’ personal lives and medical needs.

Key Insights

This insight is quite simple, but is the core to any offline retail business: foot traffic needs to increase for the business to be successful. Every other retail metric (i.e. average order value or items per basket) is a derivative of or incremental to foot traffic trends. Simply put, same-store revenue growth from an increase in foot traffic is infinitely better than price hikes as it is far more sustainable and durable. With China emphasizing prescription outflow from in-hospital to retail pharmacies, we can be sure that Yifeng as an offline pharmacy business will continue to prosper for the long-term.

Valuation and Margin of Safety

Over the last few years, during Covid and post-Covid, Yifeng’s financial performance has been somewhat volatile. Counterintuitively, during Covid there were times where the Chinese government restricted the sale of cough, cold, fever, and congestion medication, putting downward pressure on financial performance. Conversely, we saw strong personal protective equipment sales (i.e. gloves, masks, and alcohol wipes and sprays, etc.) over the three years of Covid (start of 2020 to the end of 2022) which led to downward pressure on financial performance in 2023 as we started lapping those product sales. Due to the volatility in its financials, investors have been cautious on Yifeng, leading to the business trading at its trough multiple of ~20x forward P/E. We believe this undervalues a business that has ample room for future consolidation, a track record of consistent execution, and an earnings growth rate of 25%+ per year over the medium-term.

Catalyst

Continued growth in earnings