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Daihan Pharmaceutical co.

July 10, 2014 | About:
Value Inv. in Korea

Value Inv. in Korea

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Daihan Pharmaceutical co. TICKER: XKRX:023910

Daihan Pharm. Co. markets both types of Intravenous (IV) Therapy products “High nutrient IV” and “Basic IV”. 80% of Daihans total revenue is driven by IV products, where “High Nutrient IV” takes up 30% of total IV related revenues and the remaining 70% come from “Basic IV” products. Of the remaining 20% in total revenue, 15% of total revenue is driven by IV like products such as ampule. Daihan’s stock are currently trading at $18.5, and I see an upside potential of 84% resulting to a target price of $34 for the following reasons.

  1. Steady rise in Demand

  2. Product prices to rise or at the least maintain current levels

  3. Market stability

  4. New factory

  5. Income Statement

  6. Risk Factor

  7. Final valuation

Steady Rise in Demand

There is a strong correlation between the number of inpatients and demand for Daihans products such as IV therapy or Ampule. In turn, an older population causes the rise in the number of inpatients, as people in their later stages go to hospitals much more often. South Korea as of current has been struggling with an aging population where the pace seems to be much faster than that of Japan in the past. Japan first became an “Aging society” (The % of people 65 and older is greater than 7%) in 1970, and became an “Aged society” (The % of people 65 and older is greater than 14%) in 1994. South Korea became an “Aging society” in year 2000 and as of now looks to become an “Aged society” in year 2018. Compared to Japan it takes 6 less years for Korea to go from an “Aging society” to an “Aged Society”.

Here is a link to the summary of the population and the number of inpatients in South Korea:

http://ahnreagan.blogspot.kr/2014/06/population-of-south-korea.html

Not only is the population aging, there is a social trend towards the elderly leaving for nursing homes, as explained in this article.

http://koreajoongangdaily.joins.com/news/article/Article.aspx?aid=2990887

With more elderly people in South Korea and a growing percentage of them leaving for nursing homes, there is a growing supply of inpatients that lead to greater use of IV therapy products. Due to this strong trend the Korea IV market have grown at a yearly rate of 5~10%.

Product prices to rise or at the least maintain current levels

Unlike drug prices in the U.S., medicine prices of Korea are heavily monitored by the Government’s Ministry of Health. The Ministry of Health reevaluates drug prices every year and if they conclude that prices are too high at current levels or/and if the Health Insurance Review and Assessment Service (a branch of the Ministry of Health) show high expenses the Ministry of Health lowers drug prices. Due to this effect, even though pharmaceutical companies have seen large increases in demand lately, the Ministry of Health has actively lowered their drug prices, pressuring profits to stay at similar levels. This lowering of drug prices look only to increase in the future as even higher demands would mean higher expenses that the Ministry of Health would look to lower even further.

The lists of drugs that are excluded from such price lowering are called “Exit prevention drugs”. These are drugs the Korean government views as essential to the health of its citizens. In order to secure production of these drugs, the government by law does not lower the costs of these products so that companies producing these drugs would not take losses in these product lines and continue to produce the drugs. IV Therapy products and Ampule products are on this list meaning their prices have never and will never drop in the future. Instead the Ministry of Health has been increasing the prices of major product lines in years 2009, 2011, 2012, and 2013. Despite recent increases in price, the price of IV Therapy products are still very cheap, meaning prices are likely to increase even more in the future. “Basic IV” products are currently priced at an average $1.4 which is cheaper than water or energy drinks while producing these products are far more difficult (one example is that when producing an IV product it is a 13 step procedure that involves intensive monitoring, compared to water or energy drinks that go through much less regulation and production levels). As for “High nutrient IV” products prices are at average $30 and a maximum of $100, which are more than 5 times cheaper compared in other countries such as the U.S. or Europe. In effect prices look to go up in the future, or worst case scenarios maintain current prices.

Market stability

Most of Daihans IV Therapy revenue comes from “Basic IV” products. There are only 3 firms producing “Basic IV” products in Korea due to the high initial capital investment (Minimum of $100m), comparably low product prices, and high logistical costs. The three firms are Daihan Pharmaceuticals, JW Pharmaceuticals, and CJ Pharmaceuticals. Out of the three firms in the IV industry Daihan stands to be the only firm to fully reap the benefits of an improving IV market. IV related revenue take up 80% of Daihans revenue whereas for CJ, and JW they take a small portion (20% of total revenue for JW); in addition CJ does not have publicly traded stocks making it difficult to invest in the firm. These three firms have dominated the “Basic IV” market for years, and have small risk concerning new market entrants as it is a very difficult industry to profit in.

New Factory

In the last months of 2012 Daihan invested $20m (Shareholders equity at that time was $55m) and built a new 2,400 meter squared factory over its old one. Of the 2,400 meters squared, 40% of it is used as an automated storage room and the other 60% is currently unused. Talking with the IR representative of Daihan I suspect Daihan to use the remaining space to increase production capacity in order meet rising demands. One aspect that supports this is the operation ratio of existing factories. The Operating Ratio for Daihan rose from the mid 80’s to a high 95.8%. This ratio only looks to go up even further, where Daihan would need more production capacity. For now, with the new automated storage room I expect to see cost reductions and shorter time in making products.

Income Statement

Here is a link with a summary of Daihan’s Income Statement:

http://ahnreagan.blogspot.kr/2014/06/summary-of-income-for-daihan.html

As can be seen in the income statement, margins have increased significantly compared to revenue. This is due to higher drug prices and operating leverage caused by greater sales.

When considering the fact that in 2013 there was a onetime cost of $2.2m related to the recognition of the removal of the old factory, without this onetime cost year 2013’s pre-tax profits would be $11.7m, where net income would be $9m.

Risk Factor

If another company ever does enter the “Basic IV” Market this could pose a great threat to the 3 companies in this industry. Without large sales that produce operating leverage for Daihan, Daihan would have difficulty improving or even maintaining current profit levels. This however seems unlikely as a market entrant would be aware that entering this market would require great capital investment with a small possibility of making great profits with 4 companies competing in this industry. In addition, a new market entrant would rather enter the “High nutrient IV” market rather than the “Basic IV” market. The only difference in producing the “Basic IV” and “High nutrient IV” products are its contents. Meaning the same capital investment and production system goes in making the two except what goes inside it. Yet “High nutrient IV” products are sold at a price over 20 times that of “Basic IV” products. Therefor the risk of a new market entrant in a “Basic IV” market seems minimal

The greatest realistic risk would be if the Ministry of Health does not approve an increase in price despite rising costs in raw materials. This especially seems so when looking at Daihans current margins. Daihans profit margins at current are a high 12% raising possibilities for the Ministry of Health on deciding not to raise prices any further. This however doesn’t seem the case because Daihan is the only firm in this market making such profits.

Here is a link to JW’s Income Statement:

http://ahnreagan.blogspot.kr/2014/07/summary-of-income-for-jw-pharmaceutical.html

As can be seen from JW’s income statements, the larger firms who make up the other 65% of the market are barely over break-even at current price levels. This is due to the fact that Daihan is the only medium sized firm producing IV Products. CJ and JW’s revenue are on average 4 times that of Daihan. As a larger firm JW and CJ have more overhead costs such as advertisements, R&D, higher wages, and higher depreciation that reduce margins compared to Daihan. R&D highlights this case. R&D for JW takes up 7.1% of revenue whereas for Daihan this is 0.09% of revenue. By stripping the firm of all unessential costs, Daihan is able to realize high profits other firms are unable to.

In addition the Ministry of Health has become more supportive of the IV therapy industry in the past years. One evidence of this is when the Korean Government, in September 2013, started including logistical costs as a factor when deciding to raise IV prices. As one might imagine, logistical costs take up a large portion of expenses for IV Therapy companies. Carrying large sums of liquid and containers are an expensive task. Now that the Government has chosen to include logistical costs when evaluating IV prices, the possibility of price upside seems more likely.

Valuation

The stock price of Daihan has been going up in the past as higher sales and greater product prices improved operating margins from a 4% in 2009 to a 12% in year 2013. The stock reached an all-time high in mid-2013 when it reached $23.47 per share. The stock price since then struggled despite rising profits and took a final blow when 20141Q results came out. Margins were good, and compared to 13Q1 profit rose by 27%. The reason the stock price dropped was because sales only rose by 2% compared to last year. JW Pharmaceuticals employees went on strike in 2012, and the strike ended at the end of 2013. Thus the low rise in sales of Daihan this year (compared to its 11% increase in 2013 and 13% increase in 2012) then made the market think JW Pharmaceuticals were taking market share from Daihan.

There are three reasons why I think this is not a big risk factor. First, even before JW’s employees went on strike Daihans revenues have grown at double digit figures. Therefore JW rebounding from a strike is unlikely to cause Daihan’s low revenue growth. I expect this to be a temporary phase Daihan has experienced several times before (In years Daihan had slow growth it was usually followed by years of strong revenue growth that compensated for weaker years). Second, since the products are identical, taking market share from another firm involves mostly rebates to hospitals. Unlike most pharmaceutical firms in South Korea JW has high debt levels (Liabilities/Equity= 178% for JW) where JW’s FCF barely pay interest on debt. Therefor it is unlikely that JW is taking market share, and if they ever do take market share through rebates, it is most likely going to be in “High nutrient IV” products that have much higher margins. Third, in a rapidly growing market, if Daihan ever does lose small market share it isn’t a big worry. If the IV therapy market was likes Korea’s Telecom market where 3 firms (LG, SK, & KT) are competing to capture an essentially non-growing market, then margins are traded in for greater market share. However as said earlier the IV therapy market has grown at a yearly 5~10%. This growth rate will only speed up in the future as Korea’s population age at a faster rate. In a fast growing market if Daihan ever do lose a small portion of its market it can still gain higher revenue through its growing market.

Just to get a general value of Daihan before getting to specifics, we can take a look at a recent transaction that occurred in the IV industry. In July, 2012 CJ Pharmaceuticals bought an IV factory from Medepharmaplan for $52m. This was 2.31 times the factories revenue. Applying this valuation to Daihan’s 2013 Sales of $106.8m we could get a valuation of $246.7m for Daihan. Using this as reference here is a link of my final valuation:

http://ahnreagan.blogspot.kr/2014/07/final-valuation-for-daihan.html

Using my conservative valuation seen on the link, I got a final valuation of $206m for Daihan, or $34 per share.

*Additional information

-Higher revenues are shown in months of April to June as people spend longer time outdoors, and from July to September as waterborne diseases are more widespread.

- In quarters 2 & 4 employee rewards are handed out, resulting to higher SG&A costs.

-Upon visiting the headquarters of Daihan, in contrast to their modern factories, the headquarters building was old even without an elevator where employees had to walk up to the 4th and 5th floor to get to work. This is evidence of how rigorous the company is in reducing costs.

You can e-mail me with questions on "ahn_Reagan@naver.com"


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