China Nepstar Chain Drugstore (NYSE: NPD) is China’s largest retail drugstore chain based on the number of directly operated stores. Established in 1995, China Nepstar has grown from a single shop into a chain of 2,337 directly operated outlets covering 67 cities in China by September 30, 2009.

China Nepstar Chain Drugstore Ltd. went public on November 9, 2007, through an IPO of 23,718,750 American Depository Shares (including green shoe) offered at a price of US$16.20 per ADS and raised US$334 million capital. This was the first time a retail chain from China was listed on NYSE. It was also the largest Chinese pharmaceutical company ever listed in US.

The success of China Nepstar is a legend in mainland China. There are many media reports about it. By reading those reports, it is interesting to learn that the company had made a record of opening one new drugstore every 15 hours, and that China Napstar had actually suffered losses for 10 years in a row till 2005, just 2 years before its debut on NYSE.

Shenzhen Nepstar Medical Co. Ltd. was established in June 1995 in Shenzhen, the China city on the boarder of the then British colony Hong Kong.  Seeing that there was not even one drug chain store in China, Simin Zhang, the founder of China Nepstar started to build his drug chain store empire. Shenzhen Nepstar then joined the National Association of Chain Drug Stores (NACDS) as its first Chinese member in January 1996.

Owing to regulatory restrictions, China Nepstar was at first only allowed to establish the chain stores in Shenzhen.  By the year 2000, there were less than 120 outlets.  After 2000, the regulations limiting drug retails gradually abated, and China Nepstar quickly increased its outlets to 550 directly owned drug stores in the southern provinces of China by 2004.

The rapid expansion created financial problems for China Nepstar.  Between 2002 and 2003, its inventories, current liabilities and accounts payables were more than doubled. Its current ratio dropped to 0.9 from 1.33.  Due to continuous losses, shareholders’ equity had decreased from RMB 70 million to RMB 56 million. In 2004, China Nepstar’s net loss was RMB 20.8 million with a chain of 668 drugstores.

During its difficult time, the white knight appeared.  Goldman Sachs had been studying the pharmaceutical companies in China for quite a while and China Napstar was their focus.  In the later half of 2004, China Nepstar made agreements with 5 institutional investors affiliated with The Goldman Sachs Group (GS).  China Nepstar was restructured in order to raise capital.   Simin Zhang incorporated China Neptunus Drugstore Holding (Neptunus BVI) in the British Virgin Islands.  China Nepstar issued 115 million ordinary shares, of which 93.7% were issued to Neptunus BVI so that the former became the holding company of the Nepstar group.  The remaining shares were issued to China Star Chain owned by the management team of Nepstar Health.  China Nepstar then issued a total of 50 million Series A redeemable convertible preferred shares to the Goldman Sachs Funds at an average price of US$0.5 per share for US$ 25 million in October and December 2004. Hence, GS, Neptunus VBI and China Star Chain owned 30.3%, 66.06% and 3.64% equity interest in China Nepstar, respectively.

Unproved reports from mainland China said the above share placement agreement with GS required China Nepstar to fulfill a Valuation Adjustment Mechanism (VAM).  China Nepstar had to achieve the following targets under such VAM.

First, China Nepstar must be able to achieve financial targets set by GS in 2004 , otherwise, GS could acquire half of the issued Series A convertible preferred shares at face value of US$ 0.0001, i.e.  GS would obtain an additional 15 million shares almost free.

Second, China Nepstar must be able to realize an effective IPO, i.e.  China Nepstar’s assessable value must be over US$ 250 million before submitting the IPO application, and China Nepstar must be able to raise at least US$50 million after deducting IPO expenses.  Therefore, China Nepstar must achieve adequate net income to support its IPO application.

Third, China Nepstar must expand its retail chain to 2000 – 2500 stores in 5 years with annual revenue of RMB 4,000 million and annual net income of RMB 100 million.

In order to achieve these targets, China Nepstar had to expand rapidly.  In 2004, the number of stores and the revenue increased by 52.86% and 55.19%, respectively.  In 2005, the number of stores surpassed 1000 units to 1115, a 66.92% increase year-on-year.  Revenue rose 55.8% to RMB 1,310 million.  In 2006, China Nepstar made a record of opening a new drugstore every day.  The number of stores increased 29.96% to 1,446 and the revenue increased 31.93% to RMB 1,730 million in the same year. In 2007 the above record was broken by opening a new drugstore every 15 hours!  The pressure to achieve those targets was so high that some senior executives including the general manager left China Nepstar.

To increase gross profit, China Nepstar launched private label products in September 2005 and since then its private label portfolio had increased to 1356 products marketed under 133 private labels, accounting for 18.7% of their revenue and 30% of its gross profit by December 2007. The rapid growth in company size strengthened its buying power and harsher terms were imposed on suppliers in favor of China Napstar.  More aggressive marketing strategies were adopted and customer loyalty programs were launched successfully.

By December 31, 2007, there were 2002 drugstores and the revenue had increased to RMB 1,955 million.  In 2005 China Nepstar still suffered a RMB 17.95 million net loss, but in 2006 it turned the loss to a profit of RMB 13.6 million, which was further increased to a net income of RMB 148 million in 2007, far above the target of RMB 100 million.

Although China Nepstar achieved less than 50% of the revenue target RMB 4,000 million, overall the rest of the targets were accomplished and it was able to submit its IPO via Goldman Sachs’ recommendation.  

After its IPO issuance in 2007, China Nepstar’s revenue increased to RMB 2,397 million (US$351 million) with a net income of RMB 19.27 million (US$2.83 million) in 2008.  The total number of drugstores was 2709. Though this number was further increased to 2337 by September 2009, unproved reports said in the first half of 2009, China Nepstar closed 77 drugstores, i.e. closing one drugstore every 2.3 days!  China Nepstar’s success has also invited competition. Some famous drugstores in China are following China Nepstar’s path, opening chain stores to compete with China Nepstar.

By the third quarter of 2009, revenue was further increased by 8% year-on-year to RMB 556 million (US$ 81million) with a net income of RMB 37 million (US$ 5 million). In its official quarterly report, Nepstar said it opened 47 new stores and closed 22 stores during the first 3 quarters of 2009.

The performance of China Nepstar in the stock market was lackluster.  Since its debut on NYSE in November 2007, its has dropped 60%. Attribution to economic recession is not justified because it has underperformed many indices since 2008, e.g. Shanghai Composite Index, Dow Jones Industrial Average Index, Nasdaq China Index and Hong Kong Hang Seng China Enterprises Index. Its share price closed at $7.11 on January 15. It has been unable to break the $8 resistance for the past few months. Technical indicators like RSI are weak, though it has strong support between the $6 and $6.5 range. If you bought China Nepstar in the past few months to capture the rush for pharmaceutical stocks, you have chosen the wrong one. Sinopharm (Hong Kong stock code 1099) has risen over 60% since its debut on Hong Kong Stock Exchange last October.  Another H share Guangzhou Pharm (Hong Kong stock code 0874) which has been listed in Hong Kong since 2003, has also risen over 50% since last October.  On November 12, 2007 Guangzhou Pharm was HK$6.85 and on Jan 15, 2010 it was still HK$6.8, while China Nepstar dropped 60% during the same period.

Some cynical people in China say China Nepstar, and actually its founder, is a lucky star because it has been chosen by Goldman Sachs. The founder Simin Zhang invested RMB 130 million in China Nepstar from 1995 to 2007 at a loss. The value of China Nepstar shares held by him was worth RMB 6875 million at US$17.58 per ADS on December 31 2007, which was 52 times of what he had invested!

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