American Oriental Bioengineeri AOB
February 23, 2007 - 7:40pm EST by
thoreau941
2007 2008
Price: 12.28 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 784 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Thesis:
American Oriental Bioengineering (“AOB”) is a producer of Chinese Traditional Medicine (“CTM”) and nutritional supplements with operations in China.  The stock trades at 15.5x 2007 earnings (ex. cash on the books), and is growing at more than 90% per year (50% organic).  Trailing twelve month return on equity is 50% with return on tangible equity of 53%.  We believe it represents a compelling value. 
 
The opportunity in this investment lies in the unique position the company is in to buy state-owned Chinese CTM companies at incredibly cheap prices. For example, the company closed on its acquisition of GLP in April of 2006. AOB paid $25MM for the business. Projected 2007 operating income of this business should be $16MM resulting in an acquisition multiple of 1.6x operating income. We believe AOB’s ability to complete further attractive acquisitions like this, combined with its growing core business, will result in a significantly higher stock price.
 
The main fear investors have about AOB is the fact that it is a Chinese company that may lack transparency, have room for error in the reporting, and be lax on corporate governance.  We have done significant research to explore these issues and are comfortable with the risks. AOB trades on the NYSE and follows US GAAP. It has a US-based VP of finance (based on Park Avenue in NYC), US lawyers, US board members, and US auditors. Management frequently attends conferences in the US.
 
We would rank management on par with the better management teams among many of the companies we follow in the US. They are highly passionate and focused on the business, are strong operators, and have a history of allocating capital well. Moreover, we have visited AOB’s plants in China and came away very impressed with the company’s winning-oriented culture and quality of operations.
 
Given the strength of management and operations, we believe the risk-adjusted returns here are much more compelling than any investments we can find in the US. Put simply, we can’t find investments domestically at 15.5x forward earnings with 90% growth.
 
Company History:
The original company was formed in Harbin PRC under the name of Harbin Three Happiness Bioengineering Co., Ltd. and merged with a BVI shell and US listed entity in June of 2002.  The original operations of the project consisted of a factory and offices in Harbin, PRC, with a GMP (Good Manufacturing Practices) certified facility capable of manufacturing pills and soft gels, derma delivery patches, liquid medicine, soy peptide powder, and bottled health beverages. 
 
Since its first full year as a publicly traded entity in 2003, AOB has acquired two additional product lines and manufacturing facilities, HSPL (Harbin, PRC) in 2004, and GLP (Guangxi, PRC) in 2006.  All of the facilities have been fully certified with regards to GMP.  The company has also acquired a distributor, HQPL with over 90,000 points of distribution throughout the nation.  They have opened a Hong Kong office and a Hong Kong retail location to increase brand recognition and penetrate the southern China demographic.  Most recently the company announced it is relocating its headquarters Shenzhen to improve its access to sophisticated human capital.
 
Valuation Rationale:
 
The stock currently trades at 15.5x forward earnings with the potential to grow revenues organically at nearly 50%.  The company recently put out guidance implying between $106MM and $107MM in revenue and EPS of $0.47.  We expect revenue in 2007 to be and $161MM with EPS of $0.72.  We expect growth to be 40% organically in the near term with additional upside through acquisition. 
 
Current Price (ex Cash)
 $           11.21
 
2006 Earnings
 $           0.47
24.7 x
2007 Earnings
 $           0.72
15.6 x
 
In 2005 the company exhibited a core revenue growth just over 40%.  The recent quarters have demonstrated core revenue growth greater than 75% suggesting that the current year is above trend.  Management is confident, and has said publicly, that the company has the potential to maintain a 40% organic growth rate going forward.  We anticipate that the blended tax rate will be from 13% - 19% over the next 5 years eventually reverting to the 20% - 24% range as the GLP tax abatement expires. 
 
Overall growth rates greater than 90% over the last several years have been fuelled by excellent execution on the acquisitions and are expected to repeat themselves.  After the first year with HSPL (2004 acquisition), the company had grown revenues nearly 3x, and by our estimate, is on track to grow sales another 50% in 2006.  GLP (2006 acquisition) has shown a high level of performance thus far growing company revenues from $10MM in 2005 to a run rate of $34MM in Q406, again a 3x increase in sales.  We believe that GLP may be slightly ahead of trend, but fully expect revenues to continue to grow at a rate higher than the core company revenues through 2007.  The mid January 07 announcement of the release of a new product in the GLP family makes this estimate conservative in our view.
 
The current cash balance of approximately $70MM allows the company the flexibility to pursue further acquisitions.  To be considered a serious bidder for government assets in china, the company must have full cash amount of balance sheet at the time of bid.  To meet the balance sheet needs associated with making acquisitions form the PRC government, the company did an equity raise at the of 12.5MM shares at a price of $4.80 with 3.75MM warrants struck at $6.50 at the end of 2005.  Due to an increased number of shares the company has not had its EPS grow in 2006 at the same rate as revenues or net income.  We are comfortable that the cash on hand to be used as a “bargaining chip” mitigates any need for the company to raise additional capital and potentially dilute the existing equity base.  In 2007 the company should have rapid acceleration of EPS growth given that the share count is flat year over year. 
 
Chinese Pharma Market Outlook:
Manufacturers in China can easily depend on the growth of the healthcare spending market to fuel the expansion of their product lines.  According to a McKinsey Study, the Chinese healthcare market is expected to grow to $323BN by 2025 from the current $32BN level compounding at approximately 15% annually.  Distributors on the ground working with AOB’s product confirmed a consistent and material increase of consumer spending for healthcare products.  The distributor’s daily focus is: “having to cater each day to thousands of new individuals who could not afford the same product the day before.”  Conversations with the company indicate that AOB has approached the market as one that is growing, but must be dominated through branding, proper advertising, and a controlled expansion of the distribution chain to maintain growth and margins in the long term.  Organic growth in demand will fuel the demand for products in all categories, but the company has stated they hope to be the leader in the categories they focus on. 
 
The Products:
AOB’s product mix is highly attractive allowing them to maximize profit through the flexibility to target the hospital as well as consumer markets.  The company sells products in two segments, Plant Based Nutraceuticals (“PBN”) and Plant Based Pharmaceuticals (“PBP”).  PBN products can best be compared to nutritional supplements we are familiar with in the US including vitamin liquids, protein nutrition products, and packaged health drinks.  AOB’s PBP products are both OTC and prescription based and are packaged, branded and marketed as appropriate.  Both product categories are natural Chinese Traditional Medicine as defined by the Chinese government and contain no synthesized chemicals.  The greatest differentiator between the PBP and PBN segments is the need for the SFDA (equivalent to US FDA) approval for PBP products.  Several of the major products are discussed below. 
 
Prescription PBP:
Cease-Enuresis Soft Gel – Bed wetting and incontinence – 20% of sales, 131% 1H06 growth
Shuanghuanglian Lyophilized Injection Powder – Antiviral – 27% of sales, 69.3% 1H06 growth
 
OTC PBP:
Cease-Enuresis Patch – Bed wetting and incontinence  - No segment data
JinJi – Gynecological inflammation and women’s health – 7% of sales, Acquired 1H06
UrineStopper Patch - Bed wetting and incontinence – 5% of sales, 180.2% 1H06 growth
 
PBN Products:
Protein peptide products – Beverage tablets for warm water – 28% of sales, 101.5% 1H06 growth
Vitamate Nutritional Oral - Immune System – 3 % of sales, 70.5% 1H06 growth
 
We have been pleased to see growth across all categories, and among existing as well as acquired brands. 
 
Manufacturing, Distribution, and Competitive Advantage:
The company recently invested in upgrading its peptide factory from an output level of 1,000 tons/year to 10,000 tons/year.  The full capacity of the plant will not be used immediately, but the company intends to produce peptide for sale on a wholesale level as well as continue the growth of its Protein Peptide line.  The HSPL plant has been improved to handle the increased demand of Shuanghuangliang, and the company was completing additional renovations during our visit to the facility in August 2006.  The newly acquired GLP plant is the focus of management as they work to bring the level of efficiency up to that of the other plants.  Key personnel have been added to the plant and the workforce has been tested for competency and culled in accordance with PRC employment laws. 
 
Control of the distribution channel is a key to preserving margins and diversifying the geographic regions into which the company sells its products.  In the early 2006, AOB completed its acquisition of HQPL, a national distributor with over 90,000 distribution points.  According to the company, this increased their distribution to 100,000 locations from 10,000 enabling them to sell all regions of China.  Distributors, their sub-agents, and reps take a 50%-100% markup on product.  By capturing some of the spread, AOB can mitigate margin compression and grow revenue dollars based on capturing markup and increasing unit volume. 
 
The existing product lines are highly appealing when compared to standard pharmaceutical companies selling into the Chinese market.  AOB produces no generic products and does not compete directly with high volume low margin suppliers of generic western drugs to the market.  Several of the major products face limited competition within the market.  By government mandate, Shuanghuanglian powder is produced by only two companies, AOB and Harbin Pharmaceutical Group No. 2.  The company has four competitors that produce a similar product to the Cease Enuresis Soft Gel.  While the drug can be produced by other companies, unlike AOB, the existing competitors have not taken the necessary steps necessary to market and brand their versions as the premium brand.  The GLP JinJi brand has a 30 year history and two competing products in the market.  To ensure brand dominance, AOB has initiated a national marketing campaign, point of sale promotional items, and an updated package that differentiates the product on the shelf from its competitors.  Our pharmacy visits and conversations with merchants in China have confirmed that the success of the program as the JinJi brand has pulled away from its competitors in the short time it has been under AOB’s control.  The recently introduced GLP Jinji Yi Mu Cau product will be placed in existing channels and piggyback on the success of the existing Jinji marketing campaign.
 
China Risk:
Risks associated with Chinese companies tend to discourage investment for fear of fraud, poor corporate governance, misstated results and the inability to communicate with management when necessary.  As mentioned above, we have done extensive due diligence regarding the company including multiple meetings with management on the ground in China.  We have had opportunity to tour both of the factories, and the corporate office located in Harbin, the Hong Kong retail location, and the Beijing office. 
 
Early February 2007 press has brought forward several stories relating to the sale of fraudulent or dangerous medicines in China and the related government investigation.  The PRC regulators will review over 170,000 production licenses issued by the State Food and Drug Administration, with particular focus on the permits issued between 1999 and 2002.  The company has commented that none of their product licenses have been granted during that period.  We anticipate that there will be no effect on AOB.  Industry growth may slow slightly, but acquisition multiples may be cheaper. 
 
Operationally, AOB is one of the most impressive working environments we have seen.  Due to the filing requirements associated with a US listing, the company financials provide the same data as would be expected with a US company.  We are confident in the control and reliability of the information provided as the company made plans early on to be SOX 404 compliant by the end of the 2006.  Furthering our confidence in the financial controls of the company is the US VP of finance who has substantial experience as an employee of the large auditing firms.  Access to the company is easy with the New York office having the appropriate infrastructure to support the inquiries and demands of US institutional investors.  The COO and co-founder of the company is fluent in English, and spends a significant amount of her time in the US; her ability to communicate the details of their strategy and to demonstrate a depth of operational understanding more poignant that that of some US management teams has further reinforced our confidence in the company’s foundation.  The board includes sophisticated independent individuals consisting of two former auditors and a former NASD arbitrator. 
 
The recent announcement that they have elected to move the corporate headquarters to the developmentally focused area of Shenzhen in the south of China will allow them access to a more sophisticated talent pool on both the R&D and managerial sides of the business than would otherwise be available in the current home base of Harbin in northern China. 
 
We had the opportunity to visit the Harbin headquarters, HSPL, and Harbin Bioengineering.  Operations and facilities were extremely impressive, with a highly organized structure and knowledgeable staff.  The company is run with a level of discipline and pride that would be equivalent to that which might be found among employees of IBM in the 1950s.  The company has several mottos that are posted throughout the organization including “Discover needs and realize value” and “AOBO Dedicated to your health improvement.”  The corporate culture is quite impressive with a morning oath and staff uniforms.  One would be had pressed to find a company in the US with comparably dedicated and motivated staff. 
 
Growth Through Acquisition:
The company has made three acquisitions in the last several years including the above mentioned HQPL distribution platform.  The acquisitions of HSPL and GLP in 2004 and early 2006 respectively were made at excellent prices showing management’s exemplary ability to deploy capital efficiently.  The subsequent operational improvements to sales and manufacturing practices allowed the company to receive a significant return on investment.  Because they were state owned, the companies were inefficiently run before acquisition.  Unnecessary employees, poor expense management, mediocre marketing, and a fantastic, but underutilized brand were hallmarks of the targets. 
 
The HSPL acquisition solidified the company’s position in a prescription drug practice that is protected by government regulations allowing only them and one other company to make Shuanghuanglian.  The efficiency of the plant at acquisition left opportunity for improvement operationally, and for the expansion of a well known product to other parts of the country.  The ability for management to improve the operation of a target company is the evidenced by HSPL’s first full year of sales exceeding the previous by approximately 325%.  Operating margin improvement from a blended rate of approximately 15% pre acquisition to 32%-34% post acquisition demonstrates both the strength of management and their ability to find highly attractive areas in which to invest capital.  The trend has continued with first half 2006 sales for the same unit exceeding those in 2005 by 70%.  A cash on cash analysis considering both the operating margins and tax rate of 33% specific to HSPL yields a 62% return. 
 
Total cash consideration:
7,228,916
 
Revenue Generated (Approximate 2H05 & actual 1H06 sales
20,764,840
Operating Margin (decreased by 2% due to lower gross at HSPL)
32%
Operating Income
6,644,748
Tax Rate
33%
Return
4,451,981
Cash on Cash Return
62%
 
The GLP acquisition demonstrates very similar return characteristics to the HSPL acquisition.  Acquired in April of 2006, the company had approximately 10MM in sales in 2005 with an operating margin of between 4%-8%.  In the last two months of Q206, immediately after the acquisition, the company produced sales of approximately $3MM out of the GLP unit, putting them on a run rate of $18MM.  While not a perfect proxy, management has released that the Q406 sales orders within GLP have already reached $6MM.  According to the company approximately 70% of orders for a quarter come in before the quarter, therefore grossing up the sales one can expect approximately $8.5MM in sales during Q406.  This produces a run rate of $34MM per year.  Given conservative estimates regarding the success of the Jinji Yi Mu Cau product, the 2007 GLP sales should near the $47MM level.  Management expects GLP margins to be at the corporate average by the close of the year compared with 4% at the time of acquisition.  A forward looking cash on cash analysis considering operating margins of 34% and tax rate of 0% due to a tax holiday yields a 63% return. 
 
Total consideration
25,409,837
 
 
Revenue
47,285,714.29
Operating Margin
34%
Operating Income
16,077,142.86
Tax Rate
0%
Return
16,077,142.86
Cash on Cash Return
63%
 
Proper deployment of capital to projects such as HSPL and GLP is demonstrative of a diligent and effective management team making selective acquisitions. 
 
Pricing & Margin Pressure:
AOB currently has operating margins of around 33% while margins in the industry are somewhat lower at around 20-25%.  The most important risk to get comfortable with for this investment is margin sustainability. As explained below, we believe that AOB is somewhat insulated from margin pressure in the Chinese pharmaceutical industry. Our view is that there may be some margin pressure over time, but that it will come some years into the future and will be mitigated by AOB’s focus on high-end products, Traditional Chinese Medicine, strong in-house distribution, and proprietary products.
 
Within the past year, the government has put in place measures which have fixed prices on some drugs, with a focus on “western style” style medicines.  The reason for the price ceiling is that the health care system is supported almost entirely by the government.  Income to the hospitals by means of prescription sales is a source of revenue which helps to defer healthcare costs on a national level.  Further reinforcing the government's intentions, in March of 2006, kickbacks from distributors were deemed a crime.  According to the company, sales directly to hospitals and clinics represented approximately $7MM in 2005 directly to hospitals/clinics or about 13% of total revenues.  Those sales directly to hospitals will be the first to experience any margin pressure if the government imposes price restrictions on AOB’s prescription products.  We are comfortable with the government pricing risk as it is focused on western style medicine rather than CTM.  Further raising our comfort level is the company’s recent announcement that the two of the Company's leading products, Cease-Enuresis Soft Gel and Jinji Gel, have been selected to join in the International Traditional Chinese Medicine Program for Cooperation in Science and Technology.  This program recognizes the usefulness of CTM as a lower cost means of treating patients than western medicine, and demonstrates that the government is generally pleased with AOB and will be less prone to interfere with their development and marketing efforts. 
 
The overall demand for the OTC products in the country and the company’s early efforts to brand its products and promote quality will protect them from shrinking margins.  On a recent visit to China, we spoke with a pharmaceutical distributor in Harbin who reported that there had been no margin pressure to date in pharmaceutical or OTC medications.  His outlook for the future contemplated no immediate need for price reductions, but rather a slow change in pricing which would effect selling agents and third tier distributors.  Given the acceptance of AOBs products, and the anecdotal information gathered form the marketplace, the demand for OTC product and the need for CTM, prescription products will continue to give the company pricing power and mitigate the risk of near term margin compression. 
 
Looking into the future, the company has made an impressive effort to brand its new JinJi product acquired through GLP.  The company began a national advertising campaign with the Chinese talk show celebrity Ni Ping to promote and represent the product  The JinJi women’s health product has a 30 year brand history, that has significant equity.  The company recognizes this equity and has chosen to take the product to the next level through national advertising and aggressive distribution.  The intention is clearly to establish their product as the household name in women’s health.  As they repeat this process with other products, and solidify their position in each market, they will establish themselves as the “name brand” and provide sustainable margins, aided by the increased revenue amounts that can be captured by selling directly to vendors through the use of the proprietary HQPL distribution network.  Given the current growth profile, we would be comfortable taking a position in the company even if margin were to compress by 10 points resulting in a multiple closer to 23x 2007 earnings. 

Catalyst

Next year’s EPS growth will be calculated on a consistent number of shares. An offering in December 2005 has obscured the increase in profitability to those not willing to study the financials and growth profile of the company.
Blended margins for the company, lowered slightly by recent acquisition integrations, will improve to core levels by 2007 further contributing to bottom line growth profile.
The company has completed two acquisitions, and has indicated another in the coming year. Integration experience and a proven eye for excellent capital allocation opportunities will position the company target and transform inefficient state run assets.
The company is trading at a 15.5x forward earnings and 24.7x current year while growing at greater than 90%. Closing of the valuation gap as investors look towards forward numbers will result in above average returns in the near term.
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