Our  recent  meeting  with  management  shed  some  light  on  Caring’s outlook. Maintain NEUTRAL with a lower MYR1.70 TP (from MYR1.95), a 4.3%  upside.  After  the  disappointing  FY14  (May)  performance, management is taking a step back and re-strategising expansion plans. We expect 1HFY15 performance to be rather muted, in view of growing competition and low contribution from new outlets. 

Making the necessary changes. Management said it was reviewing its expansion strategy in light of the recent  FY14 earnings disappointment. Caring admitted to being too aggressive with its expansion plan post IPO and, therefore,  expected to be more selective in opening its  future  new outlets, taking into account important criteria like: i) good customer flow, ii)  affluent  and  educated  population  catchment,  and  iii)  matured townships  with  a  considerable  aged  community.  Caring’s disappointing FY14  earnings  were  mainly  attributed  to  underperforming  new  outlets, which led  to  an  increase  in  operating  costs  on  a  rise  in marketing  and promotional activities undertaken to boost customer flow.  

FY15 expectations. While we expect FY15 revenue to continue growing by  12.7%  on  increasing  contributions  from  existing  and  stable  new outlets, we  expect 1HFY15 to be a rather muted period for Caring as it gradually  tries  to  get  back  on  track  and  take  control  of  its  spiralling operating  costs.  We  believe  full-year  margins  will  be  squeezed  on  the back of intensifying competition from independent retail pharmacies and its  continuing  expansion  plans.  However,  we  expect  conditions  to improve in 2HFY15 onwards on the aforementioned positives.

Risks.  These  include:  i)  scarcity  of  good  locations, ii) lagging  business processes, iii) increasing number of independent retail pharmacies, and iv) longer-than-expected gestation period for new outlets.

Forecasts.  We  slash  our  FY15/FY16  earnings  forecasts  by  11%  and 15% in view of Caring’s increasingly challenging operating environment.

Stay NEUTRAL. After revising our earnings forecasts, our new MYR1.70 TP  (vs  MYR1.95)  is  pegged  to  18x  CY15F  P/E.  Our  target  P/E  is  a discount  to  bigger  healthcare  stocks  like  KPJ  Healthcare  (KPJ  MK, NEUTRAL,  TP:  MYR3.67)  at  26x  FY15F  P/E.  As  we  expect  Caring’s earnings growth to be capped by its expansion plans and operating cost pressures, we maintain our NEUTRAL call.

Taking a Step Back To Re-strategise

Changing course. Management told us Caring will take a step back and reorganise its expansion strategy for FY15 onwards. This decision was mainly due to the high amount  of marketing  and  startup  costs  incurred  during  the  opening  of  some  of  its new  outlets.  The  company  managed  to  open  19  new  outlets  in  FY14  vs  its  initial target  of  12-15  new  outlets  annually.  Most  of  these  outlets  are  in  newly-opened shopping malls that have yet to build up their visitor traffic and are currently seeing low tenancy. This has led management to increase its marketing efforts through the issuance of promotional  pamphlets and discounts, which  resulted in lower revenue contribution in FY14. Management said its 4QFY14 marketing expenses shot up to MYR1m (from ~MYR350,000 in the previous quarter).

Moving forward,  Caring  has  decided to  be more  selective  as  to  where  it opens  its new  outlets.  Management  is targeting malls  and  areas  with:  i)  good  traffic flow, ii) affluent and educated population catchment, and iii) a matured township, preferably one with a considerable ageing community. Caring expects this strategy to allow the company  to  reduce  the  escalating  marketing  costs  brought  about  by  the underperformance of  its new outlets. Typically, an outlet will take 12-18 months to break  even.  However,  due  to  its  latest  series  of  new  outlets  opening  in  less populated or visited areas, Caring is increasing the gestation period for these outlets to  24 months  vs  18 months  previously.  Management  said each  outlet  requires  an initial investment of MYR250,000-300,000.

Additionally,  Caring  said  it  plans  to  appeal  to  a  wider  target  market  by  either providing increasing  diversity  in  terms  of its  product  offerings,  or  by  undertaking  a more catered approach to merchandising at its outlets.

FY14 earnings recap. Caring’s FY14 earnings came in short, meeting only 70-75% of our and consensus forecasts. Though revenue came in stronger by 8.1% QoQ in 4QFY14,  net  profit  contracted  by  79.4%,  registering  only  MYR1.4m  (3QFY14: MYR6.6m).  

Management  said  the  big  plunge  in  4Q  was  mainly  attributable  to  the underperformance of its new outlets and higher operating costs originating from an increase in headcount.  Caring opened a total of 19 outlets in FY14, surpassing its initial target of 12-15 new outlets annually until 2016.   1HFY15 unexciting. In view of the change in its expansion strategy, the increase in competition and lower contribution from new outlets, we expect Caring’s 1HFY15 to be a rather muted period for the company. We believe  earnings will continue to be squeezed by higher costs arising not only from its increasing number of new outlets,  but  also  the  expenses  involved  in  the  upgrading  of  its  business  processes.  This includes:  i)  hiring  talent  with  experience  in  retail  pharmacy,  and  ii)  upgrading  the information  systems  with  regards  to  financial  management,  which  management estimates will cost the company around MYR1m. We  also  note  that the  potential longer-than-usual  gestation period  for some  of  the new outlets could potentially hurt Caring’s margins further. This warrants a cautious outlook on its earnings for 1HFY15 as we await the recovery from the recent surge in operating costs.

No  M&As  in  the  near  future.  Despite Caring’s healthy cash  flow  and  net  cash position,  the  company  is  not  looking  to  undergo  any  M&A  exercise  in  the  near future.  This  is  because  management  would  like  to  concentrate  on  the  current expansion  plan  and  improve  its  earnings  visibility  before  it  starts  looking  for  more opportunities outside the group.

Risks.

Management  said Caring is facing several challenges that could potentially affect  its topline and bottomline.  Currently, its main concern  is the scarcity of good locations  to  open  new  outlets.  As  many  areas  with  good  traffic  flow  and  matured townships  have  already  been  penetrated  by  fellow competitors  with loyal  followers of their own, Caring finds it hard to create flow to its new outlets at these locations. Additionally,  the  company  needs  to  keep  up  in  terms  of  its  business  processes, which  currently  lag  vis-à-vis  its  competitors.  An  end-to-end,  robust  and  efficient system – from supply chain to logistics and, subsequently, delivery to customers – is something  that  Caring  is  working  on  now.  Without  it,  the  company  would  be  at  a disadvantage in terms of not being able to manage its inventory well. It will also be unable  to  capture  its  target  market  via  a  wide  range  of  product  offerings  at  its outlets.  

Also, the increase in number of independent retail pharmacies poses a challenge to Caring  by  increasing  the  competitive  levels  in  the  retail  pharmacy  industry. Independent  pharmacies  such  as  Alpha  (29  outlets),  Vitacare  (16  outlets)  and D’Apotic (12 outlets) are beginning to gain traction amongst pharmacy-goers due to their close proximity to residential areas. Currently, Caring’s top competitors are the likes  of  Cosway,  Guardian  and  Watsons,  with  145,  101  and  62  pharmacy  outlets respectively.   

Forecasts. We reduce our FY15/FY16 earnings forecasts by 11%/15% respectively in  view  of  Caring’s  increasingly  challenging  operating  environment.  We  have incorporated in the new forecasts  the expected lower  number of new outlets, ie  12 outlets in FY15-16 vs 14 outlets previously, and revised revenue assumptions (see Figure 2). Additionally, we also expect 0.4% to 3% increase in marketing expenses in FY15-16 (FY14: 2.6% increase).  

Valuation  and  recommendation.  Our  earnings  cut  leads  us  to  lower  our  TP  to MYR1.70 (from MYR1.95). This is pegged to 18x CY15F P/E, ie a discount to bigger healthcare  stocks  such  as  KPJ  Healthcare  at  26x  FY15F  P/E.  We  deem  this justified, as Caring is currently trading at 23.6x vs peer Apex Healthcare (APEX MK, NEUTRAL, TP: MYR3.75) at 13.8x. Apex Healthcare  also has  a larger market cap at MYR452.2m vs Caring’s MYR363.5m. We also expect the company’s earnings to only  come  in  stronger  in  2HFY15,  provided  that  its  previously-opened  new  outlets start contributing more  to topline  and  if operating costs  are back under control. As 
such,  we  think  that  Caring’s  growth  is  capped  for  the  time  being.  Maintain NEUTRAL.

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Company Profile

Caring Pharmacy (Caring) is a leading community pharmacy chain operator. It operates Malaysia’s third-largest chain of pharmacies by number of outlets, with a dominant presence in the Klang Valley.

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Source: RHB