Description

Summary: Beijing Tong Ren Tang Chinese Medicine (3613.HK) is a high quality franchise, which is evident just looking at the financials – a fortress balance sheet (cash over 20% of market cap), consistently high margins (70%+ gross margin, 45%+ EBIT margin) and ROE, and high FCF. The moat comes from an unparallel brand that just celebrated its 350^th year anniversary, which 3613 celebrated by paying a special dividend under 7% of market cap. After years of steady growth since coming public in 2012, the company saw a rough 2019 due to unique macro headwinds (Hong Kong protest and recession). While 2020 will remain difficult, a significant price increase (16%) implemented at year end in its key product should lead to an earning recovery. Stock is trading at 10x 2021 ex-cash, a trough multiple.

Company Background: Traditional Chinese Medicine is a controversial topic in China, often leading to spirited debates along the lines of religion and politics. Skeptics would point to the fact that most medicine are not standardized, and more importantly, not scientifically tested with double blinded studies. Even the ones that appear to have some therapeutic effect often fail to definitively isolate the actual ingredients responsible. Advocates will instead rally around its rich history, supposedly “personalized prescription”, and “effectiveness” in many diseases that Western medicine fail to address properly (often chronic diseases). I am firmly in the skeptic camp, as I believe most of the Chinese medicine on the market are at best placebos, and at worst questionable products that prey on people’s fear and desperation (as in the recent COVID episode).

But Tong Ren Tang (“Common Benevolence Court”) is a special case. Founded 350 years ago, TRT is undoubtedly the golden brand in Chinese Medicine. For generations, its controlling family has strictly adhered to the founding principle of “Premium Ingredients and Quality Production”. Combined with the legend that it is the Royal Court’s pharmacy, TRT has built and solidified a golden image and strong mindshare amongst Chinese, which has allowed the company to command premium pricing.

Today, TRT is a state-owned group that controls 3 publicly listed companies, which have some cross-ownership. The subject of this write-up is 3613.HK, which is primarily responsible for the overseas business (the majority in HK), and derive 60%+ of sales from 2 key products. An Gong Niu Huang Wan is TRT’s #1 drug (arguably the most famous Chinese medicine), and by my estimate accounts for over 40% of 3613’s sales and 50%+ of gross profits. It is a drug that helps resuscitate patients suffering from cerebral strokes, and families with old people will often keep a few pills around. The other product is Ganoderma spore Powder, to boost immune system mostly targeting cancer survivors. There is no patent protection for these two drugs (or for matter most Chinese medicines), but TRT consistently commands a price premium over its competitors and dominates the market – customers simply have faith in their ingredients and manufacturing process. Personal anecdotes from friends and family and customer reviews on JD and Tmall served as my channel checks. When dealing with life threatening diseases like stroke or cancer, prices are quite secondary considerations.   

The results are some of the prettiest financials you can find in Chinese listed companies. When I first looked at 3613’s financials, I immediately thought of See’s Candy. Disclosure is very limited. Even the sales composition mentioned above are my best estimates examining the IPO prospectus and several bread crumbs in the annual reports.    

Why the opportunity? 2019 was obviously a year of two halves, with 1H continuing the steady growth trajectory, while 2H literally fell off a cliff. The culprit was quite simple – the social unrest that had plagued Hong Kong for much of 2019. The weakness had continued into 2020 with Covid and the deepest recession in years. 3613 was well on pace to earn over 80c+ in 2019, and instead had a down year, and most likely will have a flattish year in 2020. One important factor is that a significant % of sales in HK are made by Mainland tourists, which obviously grinded to a complete halt and likely exacerbated the sales weakness for products that otherwise should be fairly macro agnostic.

Aside from the drop in stock price, what piqued my interest is a long awaited price increase that finally got announced at end of 2019 – TRT raised the price on AGNHW in mainland from 560 RMB/pill to 780/pill, almost 40%, while 3613 simultaneously raised the price from HKD $770 to $890 (last price increase was $720 to $770 two years ago). While there is some serious inflation in some of the ingredients, most of the price increase will undoubtedly drop to the bottom line, which underwrites my earning recovery in 2H 2020 and 2021. One other potential positive is that for the first time in years, the ASP in HK is now on par with the ASP in mainland. While TRT has over 800+ retail locations in mainland China, most mainland consumers still have more faith in authenticity of products purchased in HK. So when COVID passes and HK becomes a tourist destination again, I expect tourist purchase will prove a nice tailwind for 3613 again.

Corporate governance is average at best. Dividend payout is around 30%, and I won’t hold my breath on another special dividend or buyback. The “upside” of these state owned enterprises is that mgmt. don’t have the incentives to screw you. The inefficient balance sheet is just something investors have to live with. I don’t have huge expectation for the stock, but I think it has a place in today’s world.

Catalyst

1. Covid passing and resumption of travel.

2. Price increase working through the P&L in 2020.