Are Pharmacy Closures the Tonic Behind Deshengtang’s Profits?

The druggist, which has applied for a Hong Kong IPO, reported a tiny profit in the first nine months of last year, possibly due to savings after large-scale store closures

Key Takeaways:

• Deshengtang’s revenue has grown steadily in recent years, even as it closed over 1,000 stores during the Covid pandemic
• The company is a relatively small player in China’s fragmented and competitive retail pharmacy market, which could limit its prospects

By Ellie Si

Surging Covid cases after China drooped its pandemic controls in early December – and the mad scramble for drugs that followed – made people realize anew the importance of local pharmacies in an e-commerce age. Now, one of those, mid-sized operator Deshengtang Pharmaceutical Co. Ltd., is hoping such memories will be strong medicine to draw investors to its planned IPO in Hong Kong. The company made its first filing for that listing last week, with Huatai International as its sole sponsor.

Established in 1999 in Northwest China’s Gansu province, Deshengtang is a typical traditional druggist and clinic operator, providing pharmaceutical and medical services across the healthcare, pharmaceutical, insurance and nursing sectors. It had 1,047 pharmacies by the end of last September, as well as one internet hospital, 50 offline clinics and 24 offline nursing centers.

In an age when such services are increasingly moving online, the company is still highly dependent on traditional offline retail drug sales. Those reached 1.26 billion yuan ($186 million) in the first three quarters of last year, accounting for about three-quarters of its revenue.

Its newer online-to-offline (O2O) retail revenue has also been rising, though it’s much smaller at 150 million yuan for the first three quarters of last year, up 115.3% from the year-ago period. That part of the business now accounts for nearly 10% of total revenue, roughly double its contribution the previous year. Most of its operations are concentrated in Gansu and other areas of Northwestern China, one of the country’s poorer regions.

Brick-and-mortar pharmacy chains tend to attract local clients, and thus tend to have more regional rather than national footprints, according to third-party research cited in Deshengtang’s preliminary prospectus. The company was Gansu’s largest offline pharmaceutical retailer in 2021 with about a quarter of the province’s offline retail pharmaceutical market, and was No. 3 in in Northwestern China.

Deshengtang plans to use money from the listing to invest in offline pharmacies, open and buy clinics, improve the operation of its internet hospitals, enhance its O2O and business to consumer (B2C) servicing capacities, and to broaden its product and service offerings.

Alibaba-backed

Deshengtang counts e-commerce giant Alibaba as one of its backers, with the separately listed Alibaba Health (0241.HK) investing nearly 200 million yuan in the company through two injections. Alibaba Health and Jiangsu Zijin Hongyun, which is also invested by Alibaba Health, now each hold 5% of the company, while founder Long Yan had a big majority 70.56%.

But Alibaba Health isn’t placing all its bets on Deshengtang, and holds stakes in a number of rival companies like ShuYu Civilian Pharmacy, Anhui Huaren Health Pharmaceutical and Guizhou Yishu Pharmaceutical. The presence of so many players, and resulting market fragmentation, means Deshengtang is likely to face intense competition in the future in the absence of any eventual consolidation.

Its prospectus shows the company’s revenue has grown steadily in recent years, rising 14.8% from 1.75 billion yuan in 2020 to 2.01 billion yuan in 2021. The figure grew by a similar 16.4% year-on-year to 1.71 billion yuan in the first nine months of last year.

The revenue rise owes largely to growth in the company’s newer channels as well as its health management services. Pharmaceutical sales continue to be the main revenue source, contributing nearly 98% of the company’s total income.

After years of losses, Deshengtang finally turned a profit in the first nine months of last year – but barely. Its profit of 772,000 yuan for the period reversed a 40.86 million yuan loss in the year-earlier period. But the company may have trouble posting a full-year profit due to strict Covid control measures in the fourth quarter, which restricted people’s movement and forced many brick-and-mortar shops to close or limit their operations.

The rare profit in the first three quarters of 2022 could also be partly tied to a large wave of permanent store closures during that time. Its prospectus shows that Deshengtang has closed over 1,000 stores since the pandemic began in 2020, including 574 in the first three quarters of last year. That may have helped it to pare its revenue costs to 65% of revenue in the latest nine-month period from 66.4% a year earlier, while sales expenses fell to 24.7% of revenue from 26.1%.

Intensifying competition

The pharmaceutical business has relatively lower barriers to entry within the healthcare sector, making it easy for companies to enter the field. That means any future expansion by Deshengtang is likely to bump up against other rivals, especially as it moves further from its home base in Gansu.

Third-party market data in its prospectus shows that China’s top 10 pharmacy chains combined accounted for less than 20% of the market in 2021. And Deshengtang wasn’t one of those. Even when only offline retail pharmaceutical sales are considered, Deshengtang only ranked 16^th in terms of operating revenue, taking 0.3% of that market.

Deshengtang would become just the latest from its class to go public. In 2014, Yixintang Pharmaceutical (002727.SZ) became China’s first pharmacy to list, floating shares on Shenzhen’s Nasdaq-style ChiNext board. It was followed by Yifeng Pharmacy Chain (603939.SH), LBX Pharmacy Chain (603883.SH) and DaShenLin Pharmaceutical Group (603233.SH), which all went public in Shanghai. Those four all reported annual revenue above 10 billion yuan in 2021, more than five times Deshengtang’s.

In such a fragmented market, such bigger names have been locked in an ongoing battle for  share. Yixintang and Yifeng opened more than 1,000 each in 2021, and LBX and DaShenLin added 800 and 900, respectively. That contrasts sharply with Deshengtang’s recent store reductions.

And Deshengtang isn’t the only pharmacist lining up to list, with smaller players Quanyuantang Pharmacy, Anhui Huaren Health Pharmaceutical, Dajiaweikang Pharmaceutical and Yontinhe Pharmaceutical all gearing up for their own IPOs. With so much competition for investor dollars, Deshengtang might need to find a better way to differentiate itself to stand out in this increasingly crowded field.

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