AK Medical

Winners Keep Winning

AK Medical is a family owned Chinese medical device company, engaged in research and development, production and marketing of orthopedic Joint, Trauma and Spine implants. Listed only 3 years ago, AK has managed to almost triple revenue while maintaining software-like profit margins and, most importantly, giving shareholders a +500% total return.

Thesis
Fearing that centralized procurement will devastate profits, the whole Medical Devices sector in China is down -40 to -50%, in just a short couple of months. I will argue that the actual impact will be minimal, and I consider this undiscriminating index-selling as a unique opportunity to grab shares at a discount, in a world-class compounder.

1. The China Healthcare Opportunity

In just 15 years, China’s senior citizen population (age over 60) is expected to reach 400 million, representing 28.5% of the total population (WHO). China’s younger population is unable to tilt this ratio in a meaningful way due to the lingering impact of the country’s one-child policy. In short, China is facing one of the worst demographic pyramids in the world and it will inevitable lead to an immense demand for healthcare services. According to WHO and UN standards, China is defined a aged society as it today have 249 million people aged 60 or older, compared to 248 million people aged 15 or younger.

DINKS - Double Income No Kids - is a rising phenomenon in China. According to HSBC research, China currently have 47 000 000 households where income exceeds USD $50 000 per year. While impressive on its own, it’s projected to reach 200 million in 15 years. On top of this, home ownership (country wide) exceeds +85% compared to 64% in Sweden and 72% in Italy.

2 months ago, Credit Suisse published its yearly Global Wealth Report (below). From societies achieving this kind of wealth accumulation, we know that consumers trade up (LVMH, Starbucks, Nike etc.) - but also that spending tilts to quality of life purchases, such as discretionary healthcare.

China is the second largest healthcare market in the world, surpassing Japan 4 years ago. Healthcare spend per capita, and spend as a percentage of GDP, lags the world average and severely lags the G10. As affluence is rising in tandem with an already low healthcare expenditure % to GDP, the growth trajectory is indisputable pointing up, and considering aging is unavoidable: the runway is long.

Total healthcare expenditure is projected to reach $964 billion this year (McKinsey & Co) and CAGR 8% to 2030, making it not only one of the largest healthcare markets in the world - but also one of the fastest growing.

1.2 The China Healthcare Opportunity: Implants

Orthopedic devices is one of the largest sub-sectors in the medical device industry world wide. Orthopedic devices are designed to manage, or prevent, musculoskeletal problems: artificial parts are partially or totally implanted into the human body to replace, support or repair bones, joints and other body parts. Orthopedic implants are generally categorized Joint(hip, knee & shoulder), Spine and Trauma. AK Medical have products in all categories, while Joint being their biggest business area.

External forces, such as injuries, can cause fractures or joint dislocation - but the most common disease leading up to a partial, or full, joint replacement by prosthesis is Osteoarthritis. Osteoarthritis occurs when mechanical stress breaks down the cartilage (the smooth cushions between your bones), which in turn cause pain and impaired movement. Osteoarthritis has often been referred to as a "wear and tear" disease as it normally occurs in people aged 50 or older, often by regular aging and living. However, it’s important to note that it also has heredity characteristics and it can be compounded by obesity, other diseases or external injuries, lack of exercise and by the nature of your profession.

You probably have a older relative or friend receiving a Hip Prosthesis, which is one of the most common orthopedic medical devices. In that case, a hip joint that was affected by severe osteoarthritis was replaced entirely with a new artificial hip. This procedure is called total hip arthroplasty and involves replacing both the hip socket and the head and neck of the femur with implants. Another similar example would be total knee arthroplasty.

2012 marked Chinas first year with Universal Healthcare Insurance (link), covering 95% of the population. The inclusion of medical devices in medical care insurance coverage under the healthcare reform has increased the demand and acceptance for orthopedic implants. Last year 823 000 surgeries requiring partial or full joint replacement was performed, up from 473 000 in 2015. This is quite a feat considering it’s still a hefty individual out-of-pocket expense for most procedures, as triage is still stringent for national insurance to cover 100% of the cost. However, joint replacement surgery is still lagging most developed countries making the growth prospects very enticing with a expected CAGR 25% to 2024. Put in perspective, Global SaaS grew 16% this year according to Gartner.

China had a life expectancy of 43 years in 1960, but today it’s 76 years (USA: 78). Meaning, almost 30 more years of living and mechanical stress on the joints. Understandably, knee, shoulder and hip replacement implants to relieve severe pain, and restore functionality and range of movement are going through the roof.

1.3 The China Healthcare Opportunity: Domestic Producers

Issuing of the 13th National Scientific and Technological Innovation Planning (“the 5 year plan”) implants was considered a strategic product and knee implant was explicitly emphasized. As with 5G, Electrical Vehicles, AI, Solar, Gigafactories (link), etc. it has been very painful betting against China’s conviction dominating certain strategic areas.

Domestic manufacturers are in a sweet spot when China is expanding healthcare insurance to cover more health procedures - such as hip and knee joint replacements. As mentioned earlier, public medical insurance programs finance some or all of the human joint surgeries in public hospitals. To control expense and alleviate financial pressure on those programs, more and more provinces have placed a price cap on human joint procedures. Furthermore, the government have launched favorable economic incentives to encourage domestic products (graph below).

According to Frost & Sullivan, prices of joint prosthesis manufactured by domestic players are up to 60-70% below imported products. Meaning, a hip prosthesis leaving a AK Medical’s Beijing factory is not only cheaper than a equivalent from Zimmer Biomet leaving a Germany factory; the hospital in Bejing, performing the hip arthroplasty, is also reimbursed higher for choosing a domestic producer. Not surprisingly, market share of domestic producers of hip joint prosthesis breached 60% this year, according to DBS Research.

Central Procurement

As mentioned earlier, a big chunk of the medical device sectors in Hong Kong, Shenzhen and Shanghai respectively are down close to 40-50% the 4-5 months. Reason being centralized procurement. There are a couple of reasons arguing the correction is overdone, namely:

- In 2019, when Jiangsu Province initialized centralized procurement AK declared that sale contribution from centralized procurement still was below 10% of total revenue. Most importantly, that the ex-factory price still was below the final tender price.

- Anli Research titled their research note “Centralized procurement will benefit the company” and kept its BUY with a price target of $24.40 - signaling a +70% upside. Reasoning that Pharma will be heavily impacted, while Medical Devices with high production complexity, and sometimes personal customization, less so. They also argue, similar to what AK stated, that the ex-factory price is drastically lower compared to the ultimate price. My humble conclusion would be: distributors along with hospitals will take a cut on their mark-up. In a worst case scenario, I’m not terrible concerned regarding ASP at this stage, considering overall penetration is still drastically below most other countries.

And since the product ex-factory price originally is just one-tenth of the ultimate retail price (Hip implants product exfactory price: RMB$3,000 VS retail price RMB$10,000-$30,000), indicating large sum of dealer cost can be removed under this policy, ASP may not be affected but even able to go up. - Anli Research

2. AK Medical - The China Hustle

In september 2017, founder Zhang Yiming (seen with a black cap in the middle) held a 1-year anniversary for his startup called Douyin. At age 34 he and his team developed Douyin in just 200 days. Today you might know it better as TikTok and they are valued far above $100 billion dollars - amassing over 1 billion users to date.

20 years ago, the same year Backstreet Boys released their 4th album called ‘Millenium’, a English teacher named Jack Ma decided eCommerce was his next thing. In 1999, Jack Ma established Alibaba Group from his apartment and today it’s the largest B2C & B2B company in the world.

October 2003, some 3 years later, Jack Ma and his team celebrated the first Alipay transaction. Today Alipay, or Ant Group, is the largest Fintech company in the world with a value north of $300 billion dollars.

In 1971a guy called Ma (Pony) Huateng was born. In his college years he won hacking contests, and being a early adopter of the bulletin board systems, he befriended upcoming tech-legends Lei Jun (Xiaomi) and Ding Lei (NetEase) this way. In late 1998, Pony Ma started Tencent and in June of 2004 it was listed in Hong Kong to a market cap of $650m dollars. This summer, 16 years later, Tencent was the 5th largest company in the world.

This photo is from 10 years ago, the same year the first iPad was released, and when Pony Ma instructed the genius Allen Zhang to create Wēixìn. Today, WeChat has over 1.2 billion users and WeChat Pay have a larger market share of payments in China, compared to what Visa have in the US.

With a feast of plain white rice, Lei Jun inaugurated the creation of Xiaomi in april of 2010. Last quarter, Xiaomi had a market cap of $612 billion HKD and outsold Apple in smartphones.

In 2003, when surgeon Li Zhijiang was unable to find the right-size implants for his grandmothers’s hip replacement surgery, he quit his medical practice and founded AK Medical. 1 year later China’s first domestically researched, produced and commercially approved knee implant was manufactured in a factory north of Bejing - by AK Medical.

Ten years later, AK was the first company in China to receive NMPA (China) regulatory approval for a 3D-printed orthopedic joint replacement implant. Today, AK is the only Chinese orthopedic medical device manufacturer having NMPA, FDA (USA) and CE (Europe) approval. When Goldman Sachs took the company public 3 years ago, Li Zhijiang won Ernst & Young’s Entrepreneur Of The Year: Life Science Award and legendary investor Hillhouse Capital (Link) became the second largest shareholder, while Li and rest of management remain the largest shareholders. Oversubscribed with 2000%, the stock went from $3 in January 2018 to 27$ in July 2020, netting investors a 800% gain in just 2.5 years.

2.2 AK Medical

AK Medical is a medical device company that has commercialized the application of 3D printing technology in orthopedic joint, trauma and spine replacement implants in mainland China, rising to a leading position in the Chinese orthopedic implant market. The company designs, develops, produces and markets orthopedic implants for either full, or partial, replacement. Furthermore, it has developed a proprietary system assisting surgeons in simulating and planning for implant surgeries, as well as to model and produce customized 3-D printed implants.

Being a total-solution provider in orthopedic medical devices, AK's products have been made available at +6700 hospitals and in 30 countries. International revenue grew +45% YoY last year and constituted 13.7% of total revenue. Demonstrating its R&D capabilities, AK currently have 3x the patents compared to its closest peer and have a long-standing postdoctoral workstation collaboration with Peking University, ranked 2nd best in all of China.

In 2019 revenue grew +54% YoY and profits grew +82.2% YoY. Gross profit margin improved 1.3 ppt to 69.4% thanks to faster growth in high-margin products. Hip implants grew +55%, Knee implants grew +58% and the fastest growing area of 3D-printed implants grew +76% YoY.

A central component when I invest is market share, and I want my companies to be market leaders. 4 years ago, AK Medical was the leading producer of orthopedic joint implants in China (Frost & Sullivan).

Considering the whole market is experiencing rapid growth, it's beyond impressive AK have managed to increase its leadership. In my experience, Winners Keep Winning.

2.3 AK Medical - R&D

AK Medical made global headlines after producing the first metal 3D-printed vertebrae that was successfully implanted. The patient was paralyzed and unable to walk after doctors removed a malignant tumour on his spine - along with a large chunk of backbone. 5 vertebrae, or approximately 19 cm of spine, were sliced out and then replaced with 3D-printed artificial replacements. 6 weeks later he was able to walk again. Modeling of the implant, as well planning and practicing on the surgery was performed on AK Medicals proprietary 3D ACT PTIP system.

While being the global pioneer of this technology in a research setting 6 years ago, NMPA approved of this procedure for commercial use in late 2020 - making it another area of growth the coming years.

The 3D Accurate Construction Technology solutions, or “3D ACT”, was first introduced in 2014. It was later integrated with another proprietary system called PTIP - Physician-Technician Interaction Platform. The 3D ACT PTIP is a comprehensive one-stop solution to assist surgeons in simulating and planning for implant surgeries. Also, the ability model and produce customized 3-D printed implants and surgical instruments.

While selling the consumable (implant) is a great revenue leader on its own: providing a system to several critical parts of the whole value-chain creates significant barriers to entry, not to mention the high switching costs. This system, as of June 2020, is deployed at 900 hospitals of which almost 600 are Class III hospitals.

2.4 AK Medical - M&A and Production

In 2018 AK acquired British JRI Orthopaedics. JRI contributes with 50 years of research and development, but also in-house production capacity and EU certification. Illustrating JRI leadership they have several ODEP 13A* rated implants in their portfolio. ‘A’ indicates strongest evidence, ‘13’ indicates (in a scale of 1-13, 13 being the max) number of years providing follow-up data. Lastly, the ‘star*’ indicates that the replacement rate of the implant is <5%. This type of offensive technology acquisition is not completely different to when Geely acquired 100% of Volvo in 2010, grabbing 90 years of know-how in one single purchase.

This year, AK acquired Libeier from Medtronic:

AK Medical is currently the largest 3D-printing center for metal orthopedic implants in Asia. AK have 4 factories of which Beijing “HQ” have a yearly capacity of 120 000 kits per year, Changzhou “ITI” 100 000 kits, Sheffield (United Kingdom) “JRI” 60 000 kits and recently acquired LBE from Medtronic (kits unknown). Important to note that the Changzhou factory was recently built, and when completed have a capacity of 300 000 sets per year.

2.5 AK Medical - Pipeline

When looking at a company that has managed to 10x its revenue in less than a decade, a common mistake is to assume that peak growth has been passed. The product launch pipeline and R&D efforts of AK Medical, however, is nothing but mind-blowing.

3D-Printed:

Joints:

Spines:

Coming product launches in regards to tooth- and bone is ridiculously interesting:

2.6 AK Medical - The Numbers

Before I starting throwing numbers I’ll provide you with a small cheat-sheet below:

Below is historical data since 2015 and my forecast. I’m lower compared to consensus for 2020 and 2021. Furthermore, I’ve forecast a substantial slow-down in growth for 2022 and 2023, compared to historical performance.

The share price reached $27 this summer, corresponding to a EV of $27 billion. I believe a -50% correction is too much of a draw-down for a market leading company within a sector with at least a decade of growth ahead. And finally, Winners Keep Winning.


2021-08-16: I currently no longer own shares in AK Medical.

Thank you for reading,

Alexander Eliasson

Disclaimer


- Before investing please read all chapters regarding “Risks” in the Annual Reports
- Do your own due-diligence before investing

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