Bargain Shopping in China Amidst Trade Wars
Although trade wars are resoundingly negative in the aggregate, not everyone loses or loses to the same degree. There are certainly legitimate reasons for investors to be concerned about China – tariffs are escalating in tandem with an apparent macroeconomic slowdown, with the latter exacerbated by rising U.S. interest rates. Chinese equity markets reflect this pessimism with both the onshore and Hong Kong markets significantly underperforming the S&P 500 through the end of October. The sharp sell-off in Chinese equities has created attractive risk-adjusted opportunities for those willing to consider the second-order implications of the current geopolitical standoff. One such opportunity is Shandong Weigao, China’s largest domestic medical device manufacturer, which trades on the Hong Kong exchange.
It is helpful to begin with a brief discussion of Chinese policy objectives. Although numerous long-standing disputes played a role in motivating U.S. tariffs, the “Made in China 2025” plan was perhaps the primary impetus. Made in China 2025 outlines a series of initiatives to promote the development of domestic high-tech industries. The medical device industry made the list, with China aiming to produce 60% of medical devices domestically by 2020 and 80% by 2025, a substantial increase from present levels. To accomplish this, the government is expanding health insurance coverage and is conducting a series of tender offers for medical equipment, with domestic firms often receiving preferential treatment. Additionally, the plan outlines a “two-invoice policy,” which mandates that a medical product cannot transfer between more than two parties before arriving at a hospital. Previously, up to a dozen distributors would handle medical devices before final delivery, leading to markups much higher than those in developed markets. The intent of the two-invoice policy is to eliminate sub-scale, lower-quality manufacturers, and inefficient layers of distribution. For national manufacturers such as Weigao, the trade-off is that in exchange for price concessions the government will eliminate domestic competitors, handicap multinationals, and expand the addressable market via better insurance coverage. While the transition does entail a degree of pricing pressure, the long-term benefits for the largest medical device manufacturers are evident.
Weigao is positioned to capture market share due to its broad product portfolio, which allows the company to offer bundled solutions that simplify procurement for its customers. Beyond market share, bundled solutions allow Weigao to offset pricing pressure on more commoditized products by establishing purchasing quotas for higher margin, value-added products, such as advanced infusion sets. Thus far, gross margins have been stable despite the fluctuating regulatory environment.
WEIGAO’S GROSS PROFIT MARGINS
Source: Weigao company documents.
Weigao’s organic revenues for the first half of 2018 were up 19% compared to the first half of 2017, outpacing the industry as higher-margin products offset price cuts for older products. Recently, management indicated that organic revenue growth for the second half of 2018 should exceed its full-year guidance of 10%.
Currently, 80% of Weigao’s core medical consumables are sold direct to hospitals. Sub-scale competitors and many multinationals are reliant on distributors and cannot easily replicate Weigao’s footprint. Going forward, Weigao’s direct sales force should continue to drive market share gains in China and a superior cash conversion cycle, as the company can control its marketing message and accounts receivable to a greater degree than firms reliant on distributors.
However, the company is not content to limit itself to the Chinese market. In January, Weigao acquired Argon Medical Devices, a Texas-based manufacturer of biopsy, drainage, and clot management products. Weigao plans to utilize its direct sales force to bring Argon’s products to China, many of which were already approved by the Chinese FDA at the time of acquisition. Eventually, Weigao plans to leverage Argon as a platform to expand its presence into North America and Europe, thereby reducing Weigao’s reliance on China.
Investing in emerging markets presents both corporate governance and country-specific risks. However, the risk-to-reward ratio appears favorable for Weigao with a mid-teens forward price-to-earnings multiple. Weigao is positioned to be a 10% organic grower over the next several years with the ability to supplement organic growth with bolt-on acquisitions. Consensus estimates include intangible amortization (and a fair degree of transaction costs), artificially inflating the multiple by several turns versus most of its international peers.
While we hope for an amicable resolution to the trade dispute, Weigao should be a relative winner in the current economic climate. Competitive advantages including regulatory tailwinds, scale, and an unmatched internal sales force will serve Weigao well as they look to gain market share in China and beyond.
As of October 31, 2018, Diamond Hill owned shares of Shandong Weigao.
Originally published on November 27, 2018.
The views expressed are those of the research analyst as of November 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.