Global Cord Blood Corporation: An Undervalued Business But Ownership And Merger Complicate Matters (NYSE:CO)

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Investment Thesis Global Cord Blood Corporation 5-year share price performance. Source: TradingView. Global Cord Blood Corporation (CO) appears to be a relatively straightforward investment opportunity when we consider its current low price, business model that generates recurring revenue streams, addressable market, and dominant market position. GCBC – a dominant player […]

Investment Thesis

Global Cord Blood Corporation 5-year share price performance. Source: TradingView.

Global Cord Blood Corporation (CO) appears to be a relatively straightforward investment opportunity when we consider its current low price, business model that generates recurring revenue streams, addressable market, and dominant market position.

GCBC – a dominant player in China’s cord blood storage market, providing stem cell storage opportunities for expectant parents – posted revenues of $172m in fiscal year 2020, with a net profit margin of 37%, giving it a price to earnings ratio of 6.3x. Additionally, the company has net cash per share of $6.3 – nearly twice the current value of its share price, which stands at $3.51.

As impressive as these figures are, they do not quite present the full investment picture relating to GCBC, which is complicated by several factors – most notably an ongoing wrangle between minority and majority shareholders over a proposed statutory merger of the company with Cordlife Group Limited – a company listed on the Singapore Stock Exchange in which GCBC currently holds a 10% stake – at a price of $7.5 per share.

GCBC is being sued by Jayhawk Capital Management – who hold an 11.5% stake in the company – on the grounds that the proposed consideration does not value the company highly enough, and that the committee set up to review the merger proposal is not sufficiently independent. In August 2019, a consent form was sent to minority investors from a group calling itself the Committee For China Cord Fairness, encouraging investors to object to the way the proposed deal was being handled.

Amongst other things, the committee points out that, should GCBC delist from the NYSE and join the Singapore Stock Exchange, investors would no longer be protected by NYSE regulations and Cayman Islands governance and law, and that there is a conflict of interest relating to the fact that GCBC’s majority shareholder is also a significant shareholder of Cordlife Group, and may use the deal to offload debt from its troubled China mainland corporation Sanpower onto GCBC, further damaging minority shareholder’s interests.

Instead, minority investors would like to see a new management structure, more accountability, and a dividend or share buyback policy introduced – which has been promised for years, they point out.

The deeper you look into the ownership structure of GCBC, the more complex the picture becomes as this article – included in the committee’s website resources – outlines in some detail. There is even a conspiracy theory circulating that GCBC management is attempting to keep the company’s share price artificially low in order to subsequently make an offer to take the company private, by paying a premium of ~20% of its 180-day average price.

One thing we can say for sure is that GCBC stock appears to be trading at a substantial discount to its fair value price, which a DCF analysis suggests to me ought to be ~$16, if revenues continue to grow at ~10% per annum, which is less than the average of the past 2 years, which I calculate to be ~13%.

Back in June, GCBC traded at just $2.5, hence if the private buyout theory proved to be correct, shareholders would realise little or no gain on an investment. But if the reverse merger was to go through, although investors may be left holding a highly illiquid stock with little or no control over the future direction of the company, they would still make a handsome return on investment at a price of $7.5.

If this is the worst-case scenario, then you can still make a case for an investment in GCBC, based on the downside case being negligible – unless the majority owner runs the company completely into the ground with debt – and the upside still being considerable whether the merger goes through or not.

There is also an argument – made in a previous SA article – that the Singapore market would be a better home for GCBC than NYSE, since it gives the company better exposure to Asian markets and investors in Asia.

Weighing it up, the promise of GCBC’s business swings it for me. Although there are some headwinds in the shape of falling new subscription volumes, growing prices and a potential drop-off in overall subscribers when the end of the typical 18-year subscription period comes into play, when the merger business is finally resolved, it is hard not to see GCBC shares quickly gaining in value – whether it is on the NYSE, or SGX.

In the rest of this article, I will take a deeper dive into the company and its business model, and provide some more colour on the implications of the reverse merger.

Company Overview

GCBC is the leading provider of cord blood banking services in China. Cord blood banking essentially gives expectant parents the opportunity to store some of the blood that remains in the umbilical cord and placenta post-delivery, which is rich in hematopoietic stem cells – the kind used for transfusions when treating a host of diseases (as shown below) to help heal and repair damaged cells.

Diseases treatable with cord blood stem cells. Source: GCBC corporate presentation

The Chinese authorities operate a one blood bank per region policy, and have so far granted only 7 regional licenses (out of a possible 31), of which GCBC owns 3 – in Beijing, Guangdong and Zhejiang – as well a ~24% stake in rival Qilu, which operates the Shandong province license, giving GCBC a ~47% market share of the current market in China – or access to ~2.3m newborn children per annum.

GCBC China market share. Source: corporate presentation.

GCBC’s revenue model is made up of 2 components: a processing fee of RMB 9,800 (~$1,400 USD), and an annual subscription fee of RMB 860 (~$125 USD), which lasts for a period of 18 years, or customers can opt to pay the entire fees up-front, or pay the processing fee in installments. In fiscal year 2020, 36.6% opted for the first method, 49.9% chose the second, and 13.5% chose the third. Subscribers also have the option to opt out of the agreement on an annual basis.

According to GCBC’s annual report for fiscal year 2020, the company has a 793-strong sales team, who have direct access to expectant parents at 367 hospitals in Beijing, Guangdong and Zhejiang thanks to collaboration agreements struck by the company. Between 2007 and 2020, GCBC’s subscriber base has grown from 23,322, to 833,094.

In total, GCBC has ~1,200 employees, and has accredited storage facilities and laboratories, plus office space in all 3 of its operating regions. Overseas, the company has a 10% equity interest in Cordlife Singapore, which operates cord blood banking facilities in Singapore, Hong Kong, India, Indonesia, Malaysia and the Philippines, and has a brand presence in several other Asian countries.

GCBC became registered in the Cayman Islands on June 30, 2009, and listed on the NYSE that year, raising $23 million by selling 3.3m ordinary shares at a price of $6.05.

Recent Performance

GCBC subscriber growth & seasonality. Source: Corporate presentation.

As we can see above, the number of new subscriber signups has fluctuated somewhat in recent years, and is on a slight downtrend, but this has been more than offset by the growing subscriber base, and an increase in the annual processing fee since 2019, from RMB 6,800, to RMB 9,800 (USD $1,000 to USD $1,400).

In fiscal year 2020, GCBC grew overall revenues by 24% to $172.5 million, with storage fee revenues increasing by 17% to $63.8 million, based on 84.2k new subscribers and 833.1k total units deposited. The company posted net income of $67.5m, for EPS of $0.56, achieving an impressive P/E ratio of just 6.3x, with a net profit margin of 39%.

In Q121, GCBC increased revenues by 2.8% year-on-year to $39.8m, adding 17,233 new subscribers and increasing the number of subscribers to 849,933. Operating income was $18.9m, and the net profit margin was 47%. At the end of the quarter, GCBC had $788k of cash, and total liabilities of $477.6k.

Business Headwinds and Tailwinds

GCBC management has put the softness in its new subscriber numbers relative to prior years and quarters – revenues from processing fees decreased by 3.3% year-on-year to $22.9m – down to pandemic pressures, explaining that hospital channels and business operations, as well as general consumer sentiment had been negatively affected, and it also seems likely that the increased fees will have put some customers off in a time of economic hardship.

Changes to the way that the Chinese authorities will distribute licenses in the coming years also look set to affect GCBC’s business, although at this point it is hard to say whether the changes will be negative or positive.

China’s National Health Commission (“NHC”) has said that it will not grant any further licenses in new regions in 2020, but there are plans afoot to approve cord blood bank licenses in 18 pilot Free Trade Zones, which implies (according to GCBC’s 2020 annual report) that the number of licensed regions could grow from 7 to 19 – potentially providing GCBC with the opportunity to expand into new markets – and that additional licenses could be granted in Beijing, Guangdong and Zhejiang – which could erode the company’s market share in its core markets.

A worst-case scenario could see the NHC prohibit fee-based commercial cord blood banking services altogether, which would be disastrous for GCBC, whilst the relaxation of the countries’ one-child policy could mean that cord blood banking falls in popularity, since a sibling could provide matching stem cells.

Cord blood opportunity in global markets. Source: company presentation.

On the flipside, as we can see above, cord blood banking is booming in many countries that don’t operate one-child policies, so this risk may be overstated. Plus, given the medical progress that stem cell technologies are making, in the coming years there may well be more and more reasons for parents all over the world to want to store cord blood.

It is also worth bearing in mind that, despite the pandemic-induced economic downturn, China has a vast and fast-growing affluent middle class – GCBC’s most obvious target demographic. Given that GCBC estimates its current penetration to be just 4% in its current operating regions, its obtainable market may grow exponentially in the coming years.

Fair Value

GCBC stock began the year trading at $4.6. In August 2017, GCBC stock hit an all-time high of $13.5, which can be traced back to a run on the stock caused, I suspect, by the December 2016 sale of a large holding of 78.87m shares – which represents a 65.4% majority holding in the company – from Golden Meditech Holdings Limited, to Nanjing Yingpeng Hulkang Medical Industry Investment Partnership – a private deal which took place at a price per share of ~$10.5.

The shares were subsequently transferred to another entity, Blue Ocean Structure Investment Company Ltd., which still holds them. At the time of the original purchase, GCBC shares traded at $5.74, but the premium paid presumably led investors to conclude that the company was undervalued.

There seems little doubt in my mind that GCBC’s core business is significantly undervalued. The company’s free cash flow over the past 3 years, by my calculation, has been around $45m, $48m, and $54m, and with OPEX only representing ~55% of revenues, and a revenue growth projection of 9-10% per annum (which I calculate using a 5% growth rate in fiscal year 2021 owing to pandemic pressures, added to the average of the past 2 years’ growth), CAPEX of ~$6m (average of the past 3 years), and neutral working capital costs, gives me an FCF of $65m in 2021 and >$100m by 2026.

Using a WACC of 8% (expected market return of 8% due to the downturn, and a conservative beta of 1 (compared to the 0.4 quoted by Google Finance), and RFR of 1.6%, I calculate a present day firm value of $1.9bn, and a present FVP of $16. The company’s current market cap is just $427m.

The Ownership/Takeover question

Whether or not GCBC has the opportunity to exploit its current market and achieve my projected growth rates remains the key question however. The proposed merger with Cordlife could in theory give GCBC much better access to markets such as India, which are even larger than the Chinese markets, but will GCBC’s majority shareholder allows this to happen.

Not according to the literature and arguments supplied by Jayhawk and minority shareholder groups. In these, the majority shareholder is identified as Nanjing-based entrepreneur, Yuan Yafei, who owns 97.5% of business conglomerate Sanpower, which is the majority shareholder of Nanjing Yingpeng Hulkang Medical Industry Investment Partnership – the majority shareholder of GCBC. Yafei apparently also holds a 31% stake in Cordlife Global.

The minority shareholder’s argument goes that Yafei wants to merge these two entities to extract cash to fund his other failing businesses, have them purchase his indebted assets, thereby achieving a higher valuation which he can use to collateralise his company’s debts.

The relationship between GCBC and Cordlife goes back many years to when Cordlife was listed on the Australian stock exchange, with GCBC assisting with various fundraising efforts by buying shares in Cordlife, before Cordlife eventually delisted. A third company, Golden Meditech (remember them?) makes most of its revenues selling goods and services to GCBC.

The document I shared in the introduction from the Committee For China Cord Fairness contains many more tales of market manipulation and so-called “self-dealing” and I would certainly encourage investors to review. I do see one or two holes in some of the arguments however.

Firstly, the document accuses GCBC of being a failing business, with demand for its services dropping and the stored cord blood rarely, if ever used.

GCBC cord blood units used in medical treatments past 3 years. Source: company Form 20F FY20.

Whilst it’s true, as we can see above, that the samples are rarely used, this is not necessarily a persuasive argument against using GCBC’s service – the 55 samples used in 2020 might have saved 55 children’s lives. Also, it is a strange line of argument to pursue when trying to argue that GCBC ought to have a much higher valuation.

Secondly, it is extremely hard to know what plans Sanpower may have for GCBC, and much of the evidence submitted regarding its plans is highly speculative. GCBC has not responded in kind to the claims, and in fact, little seems to have happened in the past quarter, or indeed since the reverse merger was originally proposed and minority investors protested. GCBC does state the following in its annual report however.

GCBC statement regarding Jayhawk court case. Source: company Form 20F FY20.

GCBC also adds:

if the plaintiffs are successful in obtaining an injunction prohibiting the defendants from completing the merger on the agreed-upon terms, then such injunction may prevent the merger from becoming effective, or from becoming effective within the expected timeframe.

To my mind, GCBC would seem to be simply too small a company to be able to realistically assist with wiping out the $7.3bn of debt Sanpower is allegedly being pursued for, and the complex web of different companies and ownership structures may be difficult to unpick, but is not necessarily proof of anything other than the fact that multi-billionaire entrepreneurs tend to move in mysterious ways, and it isn’t easy to second guess them.

Conversely, minority investors have every right to challenge majority shareholders and put up a fight when actions are taken that they do not approve of, and they may well succeed in pushing up the price of any deal to merge GCBC, or take it private, or prevent any such deal taking place at all.

Conclusion

Ever the optimist, and despite the ongoing legal battles, I think that GCBC presents an interesting investment opportunity at this time and still feel bullish.

On the strength of its business alone, an investment is a no-brainer – the company’s shares are worth perhaps 5x more than their current price, based on my analysis. Yes, there are some headwinds: are prices going up because subscriptions are going down, and if so, will revenues decline long term, and will the Chinese market become fragmented when new regulations come in? But there are also promising tailwinds. Penetration is only 4% in the Chinese market, and there are also opportunities to move into overseas markets. When pandemic pressures ease, the stock price may jump significantly on improved earnings.

Regarding the rest, I see one of three scenarios playing out. GCBC remains on the NYSE, and when the dust settles, the share price grows to reflect the company’s true value. GCBC merges with Cordlife, and the company is transferred to Singapore – this deal could take place at $7.5 per share, or perhaps as high as $10, if minority shareholders get their way, and may give the company fresh momentum. Or, GCBC is eventually taken private at a lower price than the $7.5 on the table from Cordlife, but still, most likely, at a premium to the current share price.

Hence, for me, the upside potential outweighs the downside, which makes GCBC a potential “Buy” for a risk-on investor. Personally, I intend to do some further due diligence before making a final decision whether to invest, but I hope in this article I have laid out some of the key arguments for and against opening a position in GCBC.

I would look to get in at a price below $4, and not delay a decision for too long, as the stock is currently on an uptrend and could move upward quickly if the next set of earnings impresses or there is movement on the merger front.

Gain access to all of the market research and financial analytics used in the preparation of this article plus exclusive content and pharma, healthcare and biotech investment recommendations and research/analytics by subscribing to my channel, Haggerston BioHealth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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