Description

Overview

China Pharma Holdings, Inc. ("CPHI") is a leading Chinese generic drug manufacturer which will be a major beneficiary of the Chinese government's recently announced plan to increase spending on healthcare by an astonishing 44% annually (vs. 2007) for 2009-2011.  The company is also well positioned to capitalize on the aging and increasingly affluent Chinese population, which will create increasing demand for the Western drugs that CPHI manufactures.  Over the next few years, the company will also benefit from the introduction of several blockbuster new drugs that are currently underdevelopment.   Finally, CPHI is a natural beneficiary of the significant consolidation that is occurring in its market   While CPHI manufactures and sells all of its products in China, it is publicly traded in the USA. The company has grown revenue 48% annually over the past two years, is projected to grow EPS at least 40% over the next two years, has no debt and trades at only 2.2x 2008E EBIT, 1.8x 2009E EBIT, 2.7x 2008E EPS, 2.3x 2009E EPS, 1.9x 2010E EPS.  If the valuation isn't attractive enough on these multiples, consider that earnings growth should begin to grow even more significantly after 2010 when (i) some of the company's new products that are currently under development finally hit the market and (ii) the increased government spending (discussed below) really kicks in.  Importantly, CPHI's president/CEO owns over 25% of the company's stock, so she is clearly motivated to create shareholder value.

Description

Located in China's Hainan Province, CPHI develops, manufactures and markets off-patent blockbuster drugs, targeting those with $1bn+ in cumulative global sales.  The company has a diversified portfolio of over 30 drugs and specifically targets high incidence, high mortality diseases.  CPHI's portfolio of drugs focus on four major segments:

• 1) Cardiovascular & Cerebrovascular diseases (41% of revenue)
• 2) Infections diseases (24% of revenue)
• 3) Central nervous system diseases (23% of revenue)
• 4) Cold and flu (12% of revenue)

The first two of these segments are among the leading causes of death in China, so clearly there is a critical need for these products.

Despite the company's significant historical growth, the company's products will continue to experience increasing demand as a result of China's:

• 1) Improved affluence/quality of life, which creates greater demand for healthcare;
• 2) Aging population which creates additional age-related disorders; and
• 3) Increasing government healthcare coverage (as discussed below)

The company is developing many new products and expects 8 -11 new product to be approved by the government by 2010.  Most exciting is a new generation antibiotic that is currently under clinical trials.  Analysts estimate that if the trials are successful, sales of this product in the first three years should exceed $40mm, which is highly meaningful considering the company's total 2008 revenues are projected to be $48mm.  Note that analysts' estimates do not include any sales of this product. 

Much of CPHI's growth has come from the introduction of its new drugs, in addition to organic sales growth of existing products.  Over the past three years, the company has had 9 new products approved by the SFDA (China's regulatory body).  As an example of how effective these new product launches can be, consider CPHI's leading cold & flu medicine, Pusenok, which is similar to Bayer's Aleve.  It was introduced in 2006 and its revenue increased 128% in 2007 to $4.1 million.  YTD September 2008, its revenues were up another 125%.  Revenue growth of this product will continue as the product is rolled out to new distribution points and as consumer acceptance of the product increases.

The company distributes its products through 16 sales offices in 30 provinces and is expanding its distribution network.

The company has modern, scalable and cost efficient manufacturing and does not need to invest heavily in PP&E to accommodate future growth.  The company has 8 production lines whose capacity utilization is currently between 23% - 77%.  We have visited the company's manufacturing facility and were favorably impressed.

Industry Overview

CPHI is well positioned in the Chinese market.  Generic western medicine (CPHI's core business) makes up approximately 75% of China's drug market, with the remaining 25% representing traditional Chinese medicine (i.e. herbs).  In China, 80% of the drugs are generic, an area which is CPHI's focus.  Finally, imported medicines are generally not covered by China's Social Medical Insurance so there are huge barriers to entry for foreign players.

The Chinese pharmaceutical industry is highly fragmented and is rapidly consolidating.  There are currently over 3,000 pharmaceutical companies, with the top 10 accounting for only 15% of total industry sales.  The consolidation is being driven by the usual forces (i.e. economies of scale) and equally important, the increasingly stringent governmental regulations.  Anyone who has followed the tainted milk scandal in China understands the government's increased emphasis on quality control for many products.  Given its high profile nature, the pharmaceutical industry is of particular interest to the government, so it reacts quickly if it determines a company's products or manufacturing may be deficient.  As a result, smaller industry players with less sophisticated manufacturing capabilities are being forced out of business or into a competitor's arms as a result of the tighter and more expensive government regulation.  This consolidation trends benefits CPHI is several ways.  First, it will gain market share as many smaller players leave the industry.  Second, it can acquire other smaller competitors at very attractive valuations.  Thirdly, CPHI may be an acquisition target for a larger domestic or foreign player.  Considering many larger drug companies trade at significantly higher multiples than does CPHI, these companies could pay a huge premium for CPHI and still have the acquisition be accretive.

Management

Management is strong and is lead by President and CEO Li Zhilin who owns 25% of CPHI's stock.  Unfortunately she does not speak English well, but there are people at the company who do speak English and can help translate should you wish to call her or the CFO.  The company's NY based investor relations firm can also be helpful and can provide CPHI's latest investor presentation.  On a related note, we speak Chinese and also have staff in China who meet or speak with the company on a regular basis.

Valuation

Below is the company's valuation.  Several important factors to consider include:

• 1) Projections do not include any new drugs that have not yet received government approval;
• 2) Projections have not been increased to reflect recent government increases in healthcare;
• 3) Projections do not include any acquisitions, which if consummated could be highly accretive given the consolidation occurring;
• 4) Projections are not dependant on the company raising more capital;

Most comparables stocks trade at high-single digit or low double digit 2009 P/Es.  Most of these companies are larger than CPHI but have significantly lower growth rates.  We will let you determine what's an appropriate multiple for this stock, but the below table illustrates that significant stock price appreciation should the company's multiple increase from its currently ridiculous level to a variety of more reasonable multiples.  For example, if the stock were to trade at a 5x 2009 p/e, CPHI would trade at $2.50 per share, up over 100% from current levels.

Why is the stock trading so cheaply

• 1) It is a microcap and the entire sector has been crushed due to hedge fund liquidations. In 2008, CPHI's stock was down 62% even though 2008E eps (not yet released) is projected to grow 27%.
• 2) The Chinese market also got crushed last year.
• 3) It is a relatively unknown company with only limited sell side coverage. The company recently hired a new, NY based investor relations firm and is committed to increasing its awareness among U.S. investors. In November, 2008 management spoke at two conferences in the USA. We expect management to be in the USA meeting with investors on a regular basis.
• 4) The company has relatively high accounts receivable balances. Most of the company's sales are to government owned hospitals in China. While the company has never not collected on a receivable, it sometimes takes a while for the hospitals to pay the company, which negatively impacts CPHI's working capital. The company is working with the hospitals and outside financing sources in an effort to improve this situation.
• 5) The stock is relatively illiquid given its small market cap and concentrated shareholder base. We do not believe any of the major shareholders are interested in selling their shares, but as we have seen on numerous occasions with these kind of stocks, a stock's liquidity often increases dramatically once the stock begins to get some investor attention.
• 6) Management does not speak English well - While this may scare away some investors, it creates a significant opportunity for investors willing to do a little extra work. As mentioned, there are people at the company who can translate during a call with the CEO or CFO and the company's i.r. firm can also be helpful. On a related note, we speak Chinese and also have staff in China who meet or speak with the company on a regular basis.

Recent Regulation

On January 21, 2009 the Proposal of China Healthcare Reform was released by the Chinese government.  According to Susquehanna Financial Group, " The Chinese government will increase its spending on healthcare by 44% annually (vs FY 2007) to ~$42 billion for 2009- 2011, up from 15% growth of government healthcare spending over the past five years.  Part of the new budget will be used to increase the government subsidy for 84% of the Chinese population by 20%-50% each year, starting in 2010.  The new guidelines also established a more aggressive timeline on providing basic national insurance coverage by 2011, instead of 2020.  Based on these new details, we estimate a potential $31 billion annual increase of drug sales (domestic drug sales in China reached ~$67 billion in 2008) benefiting directly from the healthcare reform."

Catalyst

• - Increased awareness of CPHI from increased investor relations
• - Increased interest in Chinese stocks (Cramer very bullish on them)
• - Increased awareness in USA regarding new China health plan
• - EPS results expected in March
• - New drug approvals
• - Possible acquisition of the company - it is just too cheap and there are many logical buyers