2020 #1 - Dawnrays Pharmaceutical

Pharmaceutical Company price like a Value Stock?

Some industries are just harder to understand. A few industries will take you a lifetime to understand and even if you have understood, you would have no inkling if the company is cheap or not. One industry that had dumbfounded us is the Pharmaceutical Industry.

In the US, we have branded drug companies like AbbVie (NYSE:ABBV), Amgen (NASDAQ:AMGN), Bristol-Myers Squibb (NYSE:BMY), Merck (NYSE:MRK) and Pfizer Inc (NYSE: PFE). These are companies companies who are involved in the manufacturing and development of prescription drugs and over-the-counter products that are used to prevent illnesses in humans.

The US Pharmaceutical industry as a whole have been able to develop new drugs, get them tested and approved while continuing to juice their soon to be off and off-patent products. With a high barrier of entry to what they are doing, they are able to maintain a good level of profitability and return on investment to keep their shareholders happy. Over the very long term, if we are able to purchase these companies at a fair value, we are very sure that the returns would be much acceptable. The question is fair value. With a myriad of drugs coming on and off patent and the potential of the drugs all in questions, we are just basing our investment on the belief that these companies corporate structure will continue to allow them to prosper.

At the same time, in the developed markets, you can find a ton of early stage pharmaceutical companies like Moderna Inc (NASDAQ: MRNA) and late stage - MEI Pharma Inc (NASDAQ: MEIP) pharmaceutical companies who are doing R&D on drugs possibly solving ever possible conceivable disease. While that is exciting to read, we could really never ever been able to have an edge over people who may have an edge in understanding why and which drugs will pass FDA's approval.

If you are in the developing part of the world, most of the listed pharmaceutical companies are in the generic drug space. Technically, they make copies of the branded drugs which are off patent. In South-East Asia, we have Pharmaniaga Berhad (KLSE: PHARMA) and Kotra Industries Berhad (KLSE: KOTRA) from Malaysia, , Kalbe Farma Tbk PT (IDX: KLBF) from Indonesia. In India, there is a ton of such firms with the top 10 listed companies as below.

Other than the intense competition on manufacturing and selling generic drugs, we will need to understand the type of drugs they are manufacturing, their manufacturing capacity, the type of competitions they are facing  and finally if what they make is the real stuff. Just go and read the book below and you will know what we meant.

To properly analyse a company in such an industry for investment seems like an impossible task unless you have a totally unique insight into a company. That means that you would have followed the company for a long time and understand its portfolio of drugs and their positioning very well.

Our Insight:

One company that had us at hello is Dawnrays Pharmaceutical Holdings Ltd - HKG: 2348. Look at that beautiful chart that been treading down from 2015 to 2020. In 2013, Credit Suisse rated it as a buy at HKD 4.30. In 2020, at HKD 0.92, we believe this is a steal!

Introduction:

Dawnrays Pharmaceutical Holdings Ltd was founded on 8 December 1995 and listed on the Main Board of the Stock Exchange of Hong Kong on 11 July 2003. Dawnrays started their business in bulk medicines. As the margin for that product compresses in 2006, they proceed to moved into manufacturing of system specific finished drugs with the transformation completed in 2011 when the finish drug segment take centre stage.

In 2011, Dawnrays business include the R&D, manufacturing and sales of

1. antibiotics intermediates and bulk medicines,

2. and other system specific finished drug products.

and their finished drug portfolio includes

• anti-hepatitis drugs

• anti-hypertensive drugs

• anti-allergic drugs

Management:

We missed the bulk medicine to system specific to finished drugs transformation in 2011 which was easy pickings. We started following the company in 2013 when they are struggling with new regulation from the Chinese government. Dawnrays subsequently announced a new CEO and we are hoping to see some changes in the business operations to improve profitability. But the new CEO swiftly reigned and the ex CEO/Chairman/Majority shareholder Ms Li Kei Ling retake the realms in 2014.

The current CEO, Mr Chen Shaojun was appointed in 18th April 2016 and had been at the helm since then. Ms. Li Kei Ling was subsequently appointed as an Executive Chairman.

Mr Chen Shaojun joined the sales and marketing department of Dawnrays before rising to area manager in August 2002 and was responsible for developing area market of the Group’s new specific medicines and managing sales business. He was appointed as executive vice president of the Company in December 2014.

Business Model:

It is rare that there is no medical specialist on the board of directors of a pharmaceutical company. Instead, Dawnrays has always approached this business with a quality branding/sales mindset. Instead of talking about their possible next blockbuster drugs, they are perpetually working towards improving the quality of their manufacturing process, getting the approval process for their generic brands and the branding and distribution of their product in China.

Instead of seeing them as a generic drug manufacturer, it would be fairer to view them as a branded generic pharmaceutical company with manufacturing, direct selling and distribution capability throughout China.

The distribution network in China could be understood by their anti-hypertensive drugs. Dawnrays' antihypertensive drugs cover all market tiers at different prices.

• Anneizhen is widely available at drug stores for the use of basic medication.

• Anneiqiang is also a low- cost drug, often sold at mid-end hospitals. Anneixi and

• Anmeiping are more expensive and target patients at high-end hospitals.

Financial:

Dawnrays revenue in 2014 hit their multi-year low at RMB 783m with revenue bouncing between RMB 824m and RMB 985m from 2015 - 2019. While revenue continue to be stagnant, gross margin of the drugs continue to tread up from 2014 (58.75%) to  2018 (62.76%) before tendering price cut mandated by the Chinese government hit their gross margin in 2019.

The state's policies of group purchasing organization and negotiation on the inclusion of drugs in the medical insurance scheme have caused a decrease in the supply prices of major drugs. Under such a policy environment, the gross profits of products will continuously be squeezed.

While gross margin will continue to tread lower, Dawnrays had embarked on a series of acquisition which will drive their revenue growth.

Acquisitions:

In 2019, Dawnrays acquired the entire equity interest in Top Field Limited (TFL) in cash, bringing the cardiovascular drug business - Atorvastatin Calcium Tablets into their portfolio of drugs. Immediately after the acquisition, Dawnrays won the bid for Atorvastatin Calcium Tablets in the centralised procurement of drugs organised by the state.

In addition, Dawnrays also accepted the transfer of the marketing authorisation holder in respect of Febuxostat tablets (40mg, 80mg), a drug for gout treatment, and bulk medicines.

With the new products coming online we will expect revenue to continue to tread towards RMB 1,000m, with gross margin decreasing closer to 50%. Total operating expenses should be cap around 22% - 26%, bringing net margin to be around 24% - 28%.

The utilisation of the cash on the balance sheet is something that we are keen to see. The additional drugs taps upon their existing distribution network among the drug stores, mid-end hospitals and high end hospitals. The additional complexity and higher quality requirement within China healthcare system will also deter competitors from entering the market while driving the marginal players out of the market. While there would be additional marketing dollar to be expensed, the bulk of the margin will flow down to the bottomline.

While revenue treads higher (due to new products and higher volume of sales), and gross margin treads lower (due to national tender), we will expect ROE to improve closer to its historical number of 15% as turnover/equity increases due to the higher turnover with final net margin remaining stable. We believe that this action of bringing back growth back to Dawnrays will bring about a re-valuation in the market.  

The other aspect of the deal which we really liked is that the portfolio of drugs that they are purchasing is targeting diseases which require recurring consumption similar to the anti-hypertensive drugs. Since they are consumed on a regular basis, branding do play a part in the consumers' decision. If the drugs work for the patient, it is highly unlikely that the patient or the doctors would request for a change in drugs.

Financial Alignment:

In addition, Dawnrays had been repurchasing shares on the market as their shares prices treaded lower for the whole of 2019.

In addition, the directors are all substantial shareholders of Dawnrays. Ever since Mr Chen Shaojun had become CEO, he had also been given share option to align his interest towards the majority shareholders. Mr Chen Shaojun has 64m shares which will only be in the money if the share price stays above HKD 1.38.

In addition, Ms Li Kei Ling and Mr Chen Shaojun, the two person who are responsible for the company's strategic and operational direction had been purchasing shares on the market.

Valuation:

In term of valuation, we have the belief that the company can be most conservatively valued based on its balance sheet and the moat around their business operation. With zero long term debt, Dawnrays Current Assets (RMB 1,715) minus Current Liabilities (RMB 619m) bring us to a valuation of RMB 1,096.

With current valuation of RMB 1,430m, we are paying RMB 334m for

• Property Plant and Equipment valued at RMB 462m

• Their generic drug portfolio of antibiotics intermediates, anti-hepatitis drugs ("Leiyide"), anti-hypertensive drugs (" Anneizhen") and anti-allergic drugs ("Ruifuen", "Xikewei") which should consistently net around RMB 200m per year.

• The newly acquired company TFL at HKD 436m

• The newly transferred marketing authorisation holder of Febuxostat tablets (40mg, 80mg) and bulk medicines for gout treatment purchased for RMB 240m.

At current price, we think that Dawnrays is a steal!

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Disclosure: At the time of publishing Wee Hiang has a position in the above company. Holdings are subject to change at any time. This report, and disclosure, should not be considered to be a recommendation.