PSB Monthly Issue September 2009
September 2009
WITH A BIT OF TRADITIONAL CHINESE MEDICINE
This month we’re venturing into the Traditional Chinese Medicine (TCM) industry.
We’ve found an amazing little company sporting our favorite investment characteristics… strong growth with a misvalued stock price.
But first, a little background on this fascinating branch of medicine.
TCM includes a range of traditional medical practices originating in China. These practices have evolved over the past several thousand years. As you can imagine, they’re deeply rooted in Chinese culture.
One of the most popular forms of TCM is herbal medicine.
The traditional method of preparing herbal medicine is called decoction. A mixture of herbs (and sometimes animal parts and minerals) is boiled in water to create a medicinal tea. The tea is usually consumed by the patient several times per day.
But, there are problems with this antiquated process.
It’s often inconvenient for patients to prepare the medicinal teas. Dosages can be inconsistent due to varied methods of preparation. And, effectiveness is not reliable due to differences in the quality of the ingredients.
Now, that’s all changing.
Chinese pharmaceutical firms are moving TCM into the 21st century. They’re using modern technologies to extract the active ingredients and formulate them into tablets, capsules, and granules.
This emerging industry is called Modernized TCM.
Modernized TCM products offer patients several advantages. The quality of ingredients is higher and more consistent. Tablet, capsule, and granule forms make them easier to take. And, dosage precision is more exact.
The combination of traditional therapies with modern forms is proving extremely popular amongst the Chinese. From 2002 to 2004, sales of prescription and over the counter TCM products grew 60% a year.
Now, many of you probably think TCM is just a bunch of hooey. Maybe it is, and maybe it isn’t. We don’t think it really matters.
What matters is most Chinese believe in TCM.
They think it’s safe, effective, and causes fewer side effects than Western medicines. Furthermore, Chinese patients are just as likely to select TCM as Western medicine when choosing treatment.
Strong government support gives Modernized TCM an air of legitimacy.
First, TCM products are covered under the government’s National Medical Insurance Program. With 300 million participants, this program is the largest medical insurance provider in China. Only drugs approved by the government are covered by this program.
Second, the government’s industry development plan serves as a clear endorsement of Modernized TCM. An industry doesn’t get a development plan unless the government wants to promote it. More importantly, the plan provides funding and tax breaks to stimulate industry growth.
Given the cultural attachment and solid government support, TCM clearly is and will remain mainstream medicine in China.
Now, here are a few industry statistics.
China’s pharmaceutical market is growing 20% annually. That’s nearly twice as fast as the global market. This $20 billion market is expected to grow into the third largest worldwide by 2013.
Here’s the key… TCM products account for 30% of the market.
A number of Chinese pharmaceutical firms make TCM products. But, one company stands out from all the rest.
Introducing, Tianyin Pharmaceuticals (TPI).
Name: Tianyin Pharmaceuticals Ticker Symbol: TPI Market Cap: $62 million Recent Price: $3.37PSB Rating System 4.8 Stars Raging Revenue: (5.0 stars) Management expects revenue to jump 40% to over $59 million. Strong demand, new products, and increased production capacity are driving this amazing growth. Beautiful Books: (5.0 stars) Management expects net income to rocket 42% higher to over $10.5 million. Earnings per share are expected to jump 24% to $0.57. And, the balance sheet is strong with $10.5 million in cash and virtually no debt. Stellar Structure: (4.5 stars) Insider ownership is solid at 5%. Institutional ownership is on the low end at 12%. Valuation Verification: (4.7 stars) The stock is greatly misvalued by the market. Based on our valuation analysis, we think the stock is worth at least $8.55 a share. That’s upside potential of 153% or more. Meaningful Milestones: (5.0 stars) TPI had 10 new drugs gain regulatory approval in the past fiscal year. Their third production facility is ready to begin operations. And, the stock was just added to the Russell Microcap Index in June. |
THE MODERNIZED TCM BUSINESS
TPI develops, manufactures, and markets modernized TCM and other pharmaceutical products in China. They have two state of the art manufacturing facilities. And, they boast an extensive nationwide sales and distribution network.
The company’s large product portfolio is a good place to start.
TPI currently has 39 TCM products on the market. Half of them are prescription based. The rest are sold over the counter.
What’s more, 22 products are included on the National Medical Insurance Program’s essential drug list. Products on the essential drug list are the first line of treatment prescribed by doctors. And, these drugs are subsidized by the government up to 100% of their cost.
An amazing 1 in 5 TCM products on the essential drug list are made by TPI.
The company’s products treat a variety of conditions with large patient populations. The primary ones are heart disease, diabetes, anemia, and arthritis. Not to mention chronic hepatitis, bacterial infections, menstrual cramps, and the common cold.
TPI also has a rich product pipeline to support future growth.
Over 40 products are awaiting regulatory approval. 17 of them are currently under review. Management expects approval for most of them in the next few years.
TPI is no stranger to the regulatory process.
They’ve had great success getting their products approved. In fact, since June 2008, TPI has won approval for 10 new products. An impressive track record to say the least.
And, now is certainly the time to flood the market with TCM products. A number of favorable trends are combining to boost demand.
Lower prices and a reputation for safety are big selling points with the masses. TCM products are generally less expensive than Western medicines. And, most Chinese believe TCM products are safer and have fewer side effects.
TCM products are also extremely popular among the elderly in China. The elderly spend about five times more on healthcare than the national average. Moreover, they’re the fastest growing segment of the population.
Last but not least, the government’s going to expand health insurance coverage to all citizens by 2011. Hundreds of millions will soon have health care for the first time. With TCM products making up a third of the essential drug list, they’re sure to benefit from this important trend.
To meet surging demand, TPI is quickly ramping up production capacity.
The company recently completed construction of a new production facility. With this added capacity, TPI can triple production of its solid dosage drugs.
The facility will also support TPI’s new wholesale drug business.
This business segment will focus on manufacturing and distributing products for other drug companies. Because many small Chinese drug firms lack production facilities, the wholesale drug business is a high growth, high margin business.
All in all, TPI has a recipe for great success… and a higher stock price. Now, let’s take a look at their financials.
THE NUMBERS
Fiscal year 2009 just ended in June. The results will be released later this month. Despite the global economic recession, the company’s expecting another year of solid growth.
Management expects revenue of $42 million and net income of $7.5 million. That’s year over year growth of 25% and 26% respectively. Moreover, earnings per share are expected to soar 48% to $0.46.
And, the outlook for fiscal year 2010 is even better.
Revenue is expected to jump 40% to over $59 million. Net income is expected to rocket 42% higher to over $10.5 million. And, earnings per share are expected to rise 24% to $0.57.
In addition to phenomenal growth, TPI sports a squeaky clean balance sheet.
The company’s sitting on a cash hoard of $10 million. Current assets are nearly 6 times currently liabilities. And, long term debt is virtually zero.
As if that isn’t enough, management’s also enhancing shareholder value.
The company’s going to repurchase $3 million worth of TPI stock this year. A reduction in outstanding shares will give an added boost to earnings.
Even better, TPI is going to start paying an annual dividend of $0.10 per share. Based on the stock’s recent price, that’s a yield of 3%.
INVESTMENT RISKS
Of course, an investment in TPI is not without risks.
The Chinese government sets price controls for prescription and over the counter drugs. If TPI is ever forced to lower prices for its products, it could hurt profits.
Another risk is the government’s total control over economic reforms. If the government reverses course on reform, TPI’s business could suffer.
A third risk is TPI’s reliance on new drugs to support its growth. If they’re unable to get regulatory approval for these products, their growth could slow.
POTENTIAL RETURNS OF 153% OR MORE
We like TPI for several reasons:
Operations in an industry with surging demand, a large and diverse product portfolio, a strong pipeline of new products, numerous products on the essential drug list, increased production capacity, a new high margin line of business, and a substantial annual dividend.
All of these factors point to higher revenue and earnings at TPI for years to come… reasons enough to buy the stock.
But, that’s not all…
We also like the company’s greatly misvalued stock price.
TPI’s P/E ratio based on the 2009 estimate of $0.46 per share is just 7.3x. Its P/B ratio of 1.38x is well below the industry average of 4.61x. And, it’s PEG ratio is way out of whack at just 0.29.
Clearly, TPI is trading well below its fair value.
Using the drug industry’s average P/E of 14x this year’s estimate, TPI is worth at least $6.44. And, if we apply that same P/E to next year’s estimate of $0.57, you get a price of $7.98.
A P/B analysis yields an even higher price. Using the drug industry’s average P/B ratio of 4.61x, TPI is worth $11.29.
Based on our analysis, we think the stock should trade up to at least $8.55. Buy TPI now for potential gains of 153% or more.
ACTION RECOMMENDATION
BUY Tianyin Pharmaceuticals (TPI) up to $4.27 per share.
Recent price is $3.37.
Use a stop-loss of $1.68 on this position.
Don’t forget your position sizing and stop-loss rules.
THIS CHINESE GENERIC DRUG STOCK
Normally, we don’t like to recommend two stocks from the same sector in the same issue. But, the growth potential and misvalued stock prices in China’s pharmaceutical industry are just too good to pass up.
We want to strike while the iron’s hot.
Our second pick this month comes from China’s generic drug industry. Although still early in development, the industry already serves a $20 billion market.
The market is small by Western standards. But, China’s market is growing much faster. 20% annually! In fact, China should have the third largest market by 2013 and the largest by 2050.
To foster growth, the government protects its fledgling domestic firms from more established foreign competitors. As a result, domestic drug companies hold a commanding 65% share of the market.
Right now, generic drug makers dominate China’s pharmaceutical market. About 98% of drugs manufactured and 80% of drugs sold in China are generics.
These companies are about to cash in on the biggest opportunity in the history of China’s pharmaceutical industry.
I’m talking about the transition to universal healthcare coverage.
The Chinese government is going to spend a whopping $125 billion on healthcare reform over the next three years. The centerpiece of the plan is expanding coverage under the National Medical Insurance Program to all citizens by 2011.
The program is already the largest health insurance plan in China. It covers some 300 million participants. (That’s roughly equal to the entire U.S. population.) Over the next year, it will be expanded to cover all of China’s 1.3 billion citizens.
Expanding coverage should significantly boost demand for generic drugs.
You see, generic drugs make up about 90% of the National Medical Insurance Program’s essential drug list. The drugs included on the list are usually the first prescribed to patients because they’re eligible for 100% cost reimbursement.
Of the small Chinese generic drug makers, one company stands out from the rest. That company is China Pharma Holdings (CPHI).
Name: China Pharma Holdings Ticker Symbol: CPHI Market Cap: $96 million Recent Price: $2.28PSB Rating System 4.6 Stars Raging Revenue: (4.7 stars) Revenue is expected to pop 20% this year and 26% next year. Expansion of health insurance coverage to all citizens in China should drive demand for CPHI’s products. Beautiful Books: (4.7 stars) Earnings are expected to rise slightly this year before jumping 26% next year. Profitability should get an added boost from improvement in accounts receivable. Stellar Structure: (4.7 stars) Insider ownership is very high at 61%. They obviously believe the stock’s headed a lot higher. Institutional ownership is a solid 13%. Plenty of room for substantial institutional buying which would send the shares soaring. Valuation Verification: (4.5 stars) The stock is badly mispriced by the market. Based on our valuation analysis, we think the stock is worth at least $5 a share. That’s upside potential of 119% or more. Meaningful Milestones: (4.5 stars) The company just received approval of its treatment for gastroesophageal reflux. It’s a generic version of AstraZeneca’s Losec and Prilosec drugs. |
THE PHARMACEUTICAL BUSINESS IN CHINA
CPHI is a fully integrated pharmaceutical firm. They develop, manufacture, and market both new and generic drugs in China.
The company’s strategy is absolutely ingenious.
They target off-patent drugs with total global sales over $1 billion. Under Chinese law, CPHI is able to get exclusive marketing rights for three years on new generics it brings to market.
CPHI is well on its way to becoming a major player in the industry.
They already have a diversified product portfolio of 18 approved drugs on the market. These drugs treat a wide variety of conditions with large patient populations. Most of them focus on central nervous system, cardiovascular, and infectious diseases.
CPHI’s cardiovascular drugs in particular have amazing growth potential.
Last year, global cardiovascular drug sales were nearly $105 billion. That’s about 20% of total drug sales worldwide. More importantly, they’re the second best selling drugs in China with a market share of 15%.
CPHI is also positioning itself for the future.
Nine new drugs are in various stages of development. One drug is currently awaiting regulatory approval. And, a new generic treatment for gastroesophageal reflux just got approved.
This strong pipeline should yield a number of new products. Management certainly thinks so. They plan on launching 7 to 10 new generics and one brand medicine in the next three years alone.
All of the company’s products are manufactured at their facility in the tax-free industrial zone in Hainan Province. This facility has eight modern, GMP (Good Manufacturing Practice) certified production lines. And, these production lines are scalable to match production levels with demand.
CPHI markets its products through an extensive distribution network. They have 16 sales offices and 1,250 sales agents throughout China.
Now for a peek at the company’s impressive financials.
THE NUMBERS
CPHI has been growing by leaps and bounds.
Over the past four years, revenue has exploded at a compound annual growth rate of 68%. Gross profit has mushroomed more than five-fold. And, net income has more than tripled. Extraordinary growth to say the least.
Last year was yet another year of stellar growth.
Revenue jumped 53% to over $50 million. Gross margins expanded to nearly 50%. Net income popped 39% to almost $18 million. And, earnings per share rose 28% to $0.44.
Driving revenue was a huge 76% increase in sales of the company’s flagship product. It’s the only generic version of Aleve-D sold in China. This product is the most effective, non-drowsy, slow release 12 hour cold remedy on the market.
So far in 2009, CPHI is overcoming some challenges.
Revenue growth slowed in the first half. Uncertainty surrounding the government’s proposed healthcare reform plan is to blame. Bulk buyers were delaying purchases in hopes of getting lower prices and subsidies under the new plan.
Now that the new insurance catalogue and essential drug list are out, we should see orders pick up. Management certainly thinks so. They’re sticking by their forecast for 20% top line growth this year.
Another challenge has been collecting accounts receivable.
Delayed payments from a few large customers have hurt CPHI’s numbers. However, management is focusing on collections and expects further improvement in coming quarters.
Despite these challenges, CPHI is still expected to grow in 2009.
Revenue is expected to jump 20% to $61 million. Net income is expected to increase slightly to $19 million. And, earnings per share are expected to rise 2.3% to $0.45.
Next year is when things should get real exciting.
We’re looking for revenue, net income, and earnings per share to all increase 26% from 2009 levels. And, we’re expecting earnings per share of $0.57.
Through it all, CPHI is maintaining a strong balance sheet.
They have $3.6 million in cash on hand. Long term debt is virtually zero. And, with a current ratio of 8.1, current assets amply cover current liabilities.
INVESTMENT RISKS
That’s not to say an investment in CPHI is completely without risk.
One risk is the company’s ability to raise additional capital to fund its growth. A lack of funding could cause the company to delay, reduce, or even eliminate certain product development programs.
Another risk is the company’s ability to collect its receivables. If a significant amount is not collected, the company’s profitability could suffer.
A third risk is fluctuations in currency exchange rates between the Chinese Remnibi and the U.S. Dollar. These fluctuations can negatively affect the company’s financial results which are reported in U.S. Dollars.
POTENTIAL RETURNS OF 119% OR MORE
Now’s a perfect time to grab shares of CPHI.
Universal health insurance is certain to drive demand for generic drugs. With a large product portfolio and several new drugs coming to market, CPHI is perfectly positioned to cash in on this trend.
Furthermore, the shares are currently misvalued by the market.
The stock’s P/E ratio of 5.2x is well below the industry average of 18x. Using a conservative P/E of just 10x, the shares are worth at least $4.50. That’s nearly double the recent price.
Applying a P/E of 10x to next year’s earnings estimate of $0.57, we get a price of $5.70. That’s upside potential of 150%.
Based on our analysis, we see the stock trading up to at least $5.00. Buy CPHI now for potential gains of 119% or more.
ACTION RECOMMENDATION
BUY China Pharma Holdings (CPHI) up to $3.08 per share.
Recent price is $2.28.
Use a stop-loss of $1.14 on this position.
Don’t forget your position sizing and stop-loss rules.
Category: PSB Monthly Issues
