Shenzhen Kaisite Medical Technology Co., Ltd

The distribution field of medical devices presents a pattern of being small, scattered, and disordered, with relatively more intermediate links. Consolidating medical device distribution companies through mergers and acquisitions is one way for pharmaceutical distribution companies to expand into the national market.

The Guangdong Provincial Pharmaceutical Trading Center recently released the specific “Two-Ticket System Plan” and entered the substantive implementation phase. Given the large scale of Guangdong’s pharmaceutical economy, the implementation of the “two-ticket system” further deepens its impact on pharmaceutical distribution companies. Since the issuance of the policy by the State Council Medical Reform Office and other ministries two years ago to promote the “two-ticket system” in public medical institutions’ drug procurement, the “two-ticket system” has been gradually implemented year by year and province by province.

“The two-invoice system” corresponds to the previous multiple invoicing by multiple pharmaceutical distribution suppliers, which is changed to a direct process from pharmaceutical manufacturers to medical distributors, and then directly to medical institutions and other terminals, with no other distribution links in between. In this round of policy reform, pharmaceutical distribution companies are facing industry reshuffling and re-strategizing.

As the medical reform gradually enters the deep-water zone, after the establishment of the Medical Insurance Bureau, it will deeply participate in the pricing, procurement, and payment processes. Distribution companies need to strengthen their connections with upstream manufacturing enterprises and downstream hospitals regarding overall procurement, usage, inventory data, and other aspects. In the process of medical reform involving the linkage of the three medical sectors, the social functions of distribution enterprises will gradually expand from traditional delivery and capital padding to supply chain management, comprehensive hospital services, academic promotion, etc.

On the other hand, the circulation industry is moving from a state of low concentration, many levels, and inefficiency towards a path of increasing concentration and economies of scale. Building a nationwide marketing network through mergers and acquisitions has become an important strategy for some pharmaceutical distribution companies.

“The market size of the pharmaceutical distribution industry is close to 2 trillion yuan, and the concentration and scale of industry leaders continue to increase. The industry is transitioning from a period of high growth to a period of stable growth. However, there is still considerable room for growth in the medical device sector.” Rui Kang Medicine President Zhang Renhua told the 21st Century Economic Report that the profit margin of medical devices is much higher than the gross profit margin of drugs, and there are more opportunities in terms of terminal service value and integration potential.

Cash flow needs optimization

Circulating enterprises bear the dual responsibilities of financing and logistics distribution in the industrial chain, and financing is part of the business of circulating enterprises.

“The reasons for the extension of accounts receivable aging are, firstly, after the implementation of the two-invoice system, the proportion of pure sales in distribution companies has increased, and the aging of pure sales business is longer than that of transfer business. This is basically the situation faced by all distribution companies,” Lin Na, pharmaceutical industry analyst at UBS Securities China Stock Research Department, told 21st Century Business Herald. “Secondly, the aging of hospitals’ accounts is extending, and thirdly, the business structure of some enterprises is changing, with the proportion of medical device and consumable distribution increasing. Compared to the 3-6 month aging period for drugs, the aging period for medical device payments can be as long as 6-12 months.”

According to the 2017 annual report and the 2018 first quarter report previously released by Rui Kang Medicine (002589.SZ), the company achieved a revenue of 23.294 billion yuan in 2017, an increase of 49.14% compared to the same period last year; the net profit attributable to the parent company was 1.008 billion yuan, an increase of 70.66% compared to the same period last year. In the first quarter of 2018, the revenue was 7.129 billion yuan, an increase of 43.2% compared to the same period last year; the net profit attributable to the parent company was 280.3 million yuan, and under the same口径 (after excluding the one-time impact factor of the change in accounting estimate in Q1 2017), it increased by 53.84% year-on-year.

Zhang Renhua stated that the growth in revenue and profit mainly stemmed from the completion of the national marketing network layout and the rapid growth of the medical device business.

At the same time, the capital market has raised questions about its operating cash flow deficit. Rui Kang stated that in the first quarter report, accounts receivable increased by 1.6 billion yuan, advance payments increased by 350 million yuan, and other receivables increased by 550 million yuan. In terms of business, the medical device business grew rapidly (the payment term for devices is shorter than that for drugs, while the collection term is longer than that for drugs). Consolidated companies brought accounts receivable, advance payments, and other receivables. Due to the impact of the Spring Festival vacation in the first quarter, collections are usually worse. The company will strictly control the difference in account periods, increase collection efforts, optimize payment methods, and combine ABS, supply chain finance, and other methods to promote the improvement of operating cash flow.

Rui Kang Pharmaceutical’s Chief Operating Officer and Strategy Officer, Wei Qingyi, stated, “Under the two-invoice system, the time difference between payment and receivables causes tight cash flow, and such a commercial environment typically leads to trade deficits. This year, the Shandong region began generating a surplus from the second quarter, by encouraging hospitals to pay back earlier or coordinating with suppliers, with some payments made through acceptance bills. Thus, the industry can be managed in a centralized and refined manner. As the company’s purchase and sales scale expands, our ability to negotiate business terms with upstream and downstream partners is also increasing. By combining innovative tools such as supply chain finance, the company’s cash flow can continue to be optimized.”

“The main accounts receivable of distribution enterprises are from hospitals, especially the receivables from Class Three Grade A hospitals, with low risk of bad debts. The bad debt provision accrued by distribution enterprises is sufficient to cover actual bad debts; moreover, accounts receivable can be monetized after incurring certain capital costs through means such as ABS, so there’s no need to overly worry about the cash flow and accounts receivable status of pharmaceutical distribution enterprises,” Lin Na stated.

Device opportunities

RuiKang Medicine has started to go beyond Shandong Province and layout nationwide through the “merger and acquisition + partner” mechanism in the past two years.

Zhang Renhua stated that the average valuation of companies acquired in 2017 was relatively low, with a committed revenue growth rate of 25%-30% over the next three years, and most acquisitions could recoup the investment within 3-4 years. Without any grand moves catching the industry’s attention, RuiKang Medicine chose to acquire business lines complementary to its existing operations with staged payments. The acquired enterprises mostly had characteristics of being small in scale, strong in specialization, and prominent in marketing capabilities, possessing advantages in细分 fields, and could quickly integrate into the RuiKang system, forming a synergy with the company’s existing business lines.

In addition, entering the medical device sector is one of the future opportunities for distribution enterprises. The primary reason is that, compared to pharmaceuticals, medical device consumables require deeper and more specialized services for medical institutions, resulting in operating gross profit margins that are much higher than those of pharmaceuticals.

In the context of a slowing growth rate in the total sales of the pharmaceutical distribution market, medical devices and consumables are still maintaining a high growth rate. The promotion and distribution business of medical devices has characteristics such as strong demand, a wide variety of products, high professional requirements, and a fast innovation speed. The annual growth rate of medical device distribution exceeds 20%, while the annual growth rate of pharmaceutical distribution is approximately 10%.

Rui Kang’s annual report shows that the proportion of medical device sales revenue in operating revenue has been rising year by year. The company entered the equipment distribution business in 2013, and in 2017, it achieved a sales scale of 7.333 billion yuan. In the past three years, the revenue of this sector was 1.051 billion yuan, 2.899 billion yuan, and 7.333 billion yuan respectively, accounting for 10.77%, 18.56%, and 31.48% of operating revenue respectively.

In fact, the medical device distribution field is also an entry point for local distribution companies to expand their national layout. With leading enterprises such as Sinopharm, Shanghai Pharmaceutical, and CRH holding large market shares in pharmaceutical distribution, the IVD, high-value consumables (orthopedics, interventional) and other medical device markets offer large scales, high gross profit margins, and numerous细分fields.

“Circulation enterprises available for mergers and acquisitions with revenue scale exceeding 1 billion yuan have become fewer, and the era of expanding scale through large-scale mergers and acquisitions has passed.” Lin Na believes that, however, the circulation field of medical devices still presents a pattern of being small, scattered, and chaotic, with many intermediate links. Merging and acquiring medical device circulation enterprises as a way to integrate the market is also a path to expand the national market.