111, Inc.: Privatization With An Interesting Twist (NASDAQ:YI)

111, Inc. (NASDAQ:YI) is a pharmaceutical distributor in China, with a primary focus on the wholesale segment. The company first attracted my attention in Oct’22, shortly after non-binding privatization proposal at $3.66/share ($3.61/share after ADS fee) was announced and the spread settled at 30%. I highlighted the idea to my Special Situation Investing subscribers saying:

The market seems to be highly skeptical of the proposal being serious, despite multiple arguments suggesting otherwise. Similarly to the recently highlighted OIIM privatization, this could be one of those cases where the situation has been temporarily mispriced due to investors’ skepticism towards anything China-related. I expect the timeline till definitive agreement to be short – for reasons outlined below management can’t afford long reviews and delays, which are quite common in Chinese privatizations at the non-binding stage.

Arguments in support were:

• YI has an unusually reputable management for a micro-cap Chinese ADS. Founders led executive roles at Dell (DELL) and Amazon (AMZN) and also launched other businesses that were eventually sold Walmart (WMT) or JD.com (JD). YI also was repurchasing shares, which is quite rare for US-listed Chinese micro-cap.
• The transaction has been financed by a Chinese government-controlled entity, confirming that co-founders’ privatization intentions were serious.
• The privatisation had a very important strategic reason. YI has been struggling to raise new capital in the US and therefore has been seeking to tap into the domestic STAR market of Shanghai Stock Exchange since 2020. This situation forced the company into a pretty bad deal whereby as part of a 2020 equity raise round YI agreed to redeem certain investors’ equity interests if the company is not listed on STAR by Jun’23. These liabilities stand at around $150m and YI does not have sufficient liquidity to cover it, so it simply must re-list on the STAR exchange.
• The buyers are getting a real bargain here buying YI at 85% discount to fair value based on 2020 equity raise valuation of its principal operating subsidiary and cents on a dollar of the IPO price.
• A bit later after my initial post, another reputable party – a subsidiary of J.P. Morgan – joined the buyer consortium in Oct’22.

The whole thing turned out even better than I expected. While the special committee is still reviewing the offer, YI share price has soared 21% over the last 5 days, jumping to as much as $4/ADS before settling at current levels slightly below the offer price. Interestingly, 8m YI shares were traded on December 12-13 – this compares to much lower average 3-month daily volume 0.24m.

One of the potential catalysts for the recent share price move could have been China’s relaxation of COVID controls last week. Notably, YI’s operations have been impaired due to lockdowns in China, resulting in supply chain and logistics issues which weighed down on the company’s stock. A boost for YI and other pharmaceutical distributors is also expected to come on the demand side. China’s health experts have already noted that diseases are “spreading rapidly”, with one top official predicting at least 60% of the population (847m individuals) will be infected during the current wave. This is expected to lead to individuals purchasing much larger quantities of COVID tests as well as medicine needed to fight the infection.

The deal still appears likely to close. Given YI’s gross cash position ($122m) and the recent cash burn rate ($81m YTD and $11m in Q3’22), the company seems highly unlikely to be able to fund the redemptions (recorded at $147m as of Q3’22) if a STAR listing is not completed. Delisting from US seems like a necessary step to facilitate tapping into the domestic STAR market. Moreover, YI’s management is getting an even better deal now with COVID lockdown/supply chain issues passing sooner than expected.

Having said that, the market seems to be pricing the chances of a higher offer too aggressively here and the recent share price volatility rather resembles the usual pump and dump. Several arguments suggest that a higher offer might not materialize. Firstly, YI’s management is in full control here, holding 92% of the voting power. This implies that the minority shareholders, represented by the special committee, do not have much leverage in the ongoing privatization talks. Secondly, it is still questionable how sizeable of an impact recent COVID policy shift will have on YI’s business. The company predominantly operates in B2B segment (95% of 2021 revenues) which has been much less significantly impacted by COVID measures compared to the retail business. As noted by YI’s management during Q3’22 earnings call:

Fortunately, for us, that we’re more focused on the B2B, and that’s the majority of our business. So the impact [of COVID zero policies] to us is a lot smaller than the rest of the other guys in the industry.

This suggests that COVID policy changes might not boost YI’s operational performance as much as the market apparently expects.

Playing The Current Setup

Overall, there are two ways to play the current setup. The first option is to acquire YI stock, expecting a higher offer from the buyer consortium. Given high likelihood of transaction closing and recent macroeconomic tailwinds, the downside seems rather limited in this scenario.

Alternatively, investors might wait for $4/share price for a potential short-term shorting opportunity. At current YI price levels, I am inclined to stay on the sidelines here, waiting for either a price normalization to below current levels or YI share price getting closer to $4/share for a potential shorting opportunity.

Business

YI has online retail pharmacy (B2C) + telehealth (online hospital) operations, but the main business of the company is B2B wholesale drug distribution. The company started expanding into wholesale back in 2016 and B2B quickly became the largest segment of YI.

YI partners with 500+ global and domestic pharma suppliers and provides services to 410,000+ Chinese pharmacies, covering 70% of China. The company itself operates 8 regional fulfillment centers, double from the 4 in 2018. YI has recently started a new initiative called ‘the franchise fulfilment center program’, where it onboards third-party fulfillment center operators to allow YI’s clients to use their facilities. So far, 11 third-party centers have been signed up, putting the total count fulfillment center count at 19.

The company is able to deliver to 270 Chinese cities. Clients in major cities get their orders within 24 hours, and others within 72 hours.

Conclusion

The ongoing management privatization seems highly likely to close. YI stock might potentially present either an interesting merger arb opportunity if share price normalizes to lower levels or a short trade setup if it gets closer to or even above $4/ADS. At current share price levels, I am keeping YI on my watchlist.