1.3 Billion People Need Soap

Wednesday, November 18, 2009 - 4:05pm

by Tom Hutchinson

People in the United States only hear about "the middle class" in an election year, when candidates promise not to raise taxes. The rest of the time, Americans don't think much about the middle class, even though that's where most people find themselves.

That hasn't been the case in China, where people have tended to be either very wealthy or extremely poor. The middle class -- a position of relative affluence that means a car, a modest home and some measure of financial security -- is something the Chinese aspire to and are achieving in greater numbers. And while this trend has been featured on magazine covers and talked about in sound bites on the news, it's worthwhile for investors to fully consider what changing the social order of the most populous country in the world can mean.

Here are the numbers: China's dynamic economic growth -- at an average of +9% during the past decade -- has created a middle class of some 80 million people. But the International Monetary Fund estimates that population will expand to 700 million by 2020.

Middle class might as well be code for "disposable income." And disposable income means consumption. Consumption drives economies. In the United States, for example, consumer spending accounts for roughly two-thirds of the economy.

The entry point for the Chinese middle class is low, estimated as income equivalent to $10,000 a year. So while it might be a while before every household has a Chevrolet Suburban and a home theater, it won't be long before hundreds of millions of Chinese can afford such quotidian luxuries as soap, razors and medicines.

China Nepstar (NYSE: NPD, $7.00) is the largest retail drugstore in China. The company sells prescription drugs, over-the-counter medicines, nutritional supplements and other drug-store products. It operates 2,709 stores in 64 cities across China. The stores are generally located in the very heart of Chinese middle-class growth -- well established residential communities in major Chinese cities.

In short, China Nepstar sells basic necessities everyone needs. And these products are becoming affordable to more and more Chinese.

Has the company been successful so far?

China Nepstar began in 1995 with one store. By the end of 2006, the company had 1,446 retail stores. That number grew to 2,709 at the end of 2008. That's a sizzling rate of growth, about two new stores every day for the past two years.

Revenue growth has been just as stunning. Sales have soared +35%, +44.1% and +47.5% during the past three years.

That growth may only be the beginning.

One study estimated that there are 319,000 drugstore outlets in China. Even though China Nepstar has more stores than any other retail outlet, it still has less than 1% of the market.

The company started paying a dividend in 2008. One dividend of $0.12 was paid to American shareholders last year; it was nearly tripled to $0.35 this year. The company also declared a special cash dividend of $1.50 per share, payable before or about December, 31 2009, to shareholders of record on September 25.

The company doesn't have a specific dividend policy, and dividends will vary with earnings. Also, dividends are subject to 10% withholding.

With the special dividend, Nepstar's trailing 12-month yield is a gargantuan 26.4% ($1.85/$7.00). Such a dividend can't be counted on going forward. But even at $0.35 per year, the stock yields are still a respectable 5.0% ($0.35/$7.00), which is a solid dividend for such a growth company.

As promising as things may appear, however, the company has some risks, not the least of which are the potential effects of government policy. Recently, government policies have helped the company with efforts to separate hospitals' roles in prescrialink_57028ng and dispensing drugs, but the government may also start selling the most widely used drugs at zero markup.

In addition, Nepstar faces fierce competition from hospital pharmacies, discount stores and supermarkets. However, Nepstar has a strong and widely recognized private label for many of its brands that should give it a leg-up on the competition. And, at this point, there's a lot of business to go around.

Also, Nepstar has a solid balance sheet. You would think that a company growing so much so fast would have accumulated a lot of debt. But, Nepstar has zero debt. And, the recent special dividend was paid entirely with cash.

Medicine and practical necessities never go out of style. China is expected to continue to grow at a fast rate. China Nepstar is in an excellent position to benefit from China's long-term growth and to pass its increasing profits onto shareholders.

Tom Hutchinson does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.