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Wednesday, July 1, 2009

AOB: Looking to China for Pharma Exposure with Steady Free Cash Flow

This is another lengthy post - please feel free to read thoroughly, skim briefly, or skip if the detail makes your head hurt. We promise to publish some shorter posts in the coming weeks.

American Oriental Bioengineering (AOB, $5.29)

Market Capitalization: $394 million (assuming diluted shares of 74.5 million, excluding out-of-the money convertible notes of $115 million convertible at $8.08 per share)
Net Debt as of 3/31/09: $52.7 million
Enterprise Value: $447 million
2008 Operating Income: $77 million (adjusted for IPR&D charge in 4Q08)
2008 Net Income: $60 million (adjusted for IPR&D charge in 4Q08)

American Oriental Bioengineering is a Chinese based company that develops, manufactures, and sells a range of pharmaceutical and healthcare products. The products are primarily derived from traditional Chinese medicines (TCM) and manufactured using plant based materials. Through organic growth and acquisitions, revenue increased 65% Y/Y to $265 million in 2008 while operating income increased 29% Y/Y to 77 million (29% operating margin, adding back 4Q08 charge for purchased in-process R&D). Despite impressive top- and bottom-line growth, AOB's shares are down 47% over the past year compared to the S&P's down 28% performance and trade at 8 times 2008 adjusted net earnings (13% earnings yield) and 7 times 2009E earnings (14% yield). While shares are up 61% since touching $3.29 in March, the stock remains near the low-end of AOB's three-year trading range:

We believe shares are out of favor and inexpensive for a number of reasons, including (1) questionable capital markets actions and capital allocation decisions in 2008, (2) expected Chinese government/regulatory changes impacting the health care industry, (3) perceived risks of Chinese companies and inability to understand AOB's products and market position, (4) slower growth and margin compression, (5) AOB's concentrated product portfolio, and (6) general market malaise toward pharmaceutical companies.

However, we believe risk factors are more than discounted at current levels and are willing to purchase the stock because we believe AOB has established a business that is difficult to replicate and should generate large, consistent, growing free cash flow in 2009 and beyond. We believe new product launches expected in 2H09 and seasonally stronger financial results could prove positive near-term catalysts for the stock.

Company Description and Products

American Oriental Bioengineering, Inc., along with its subsidiaries, engages in the development, manufacture, and commercialization of a range of Chinese State Food and Drug Administration (SFDA) approved pharmaceutical and healthcare products. The company offers prescription and over-the-counter pharmaceutical products (85% of 2008 revenue), and nutraceutical products (13%). In addition, AOB expanded the company's direct distribution business through the purchase of Nuo Hua Investment company in October 2008, which contributed 2% of AOB's 2008 revenue. AOB currently markets more than 40 SFDA-approved products and has a portfolio of over 400 prescriptions and OTC pharmaceutical products approved by SFDA but not yet commercially launched.

AOB had 4,076 employees as of 12/31/08, with approximately 1,238 principally engaged in manufacturing and services activities, 2,133 in sales and marketing, 122 in research and development and 583 in management and administration.

The company's prescription pharmaceutical products include (1) Shuanghuanlian Lyophilized (SHL) injection powder, an anti-viral injection for the treatment of flu symptoms (including swine flu), upper respiratory infections, mild pneumonia, and tonsillitis; and (2) Cease Enuresis Soft Gel (CE Gel) to alleviate pediatric bedwetting. AOB markets the SHL products under SHJ brand name; the CE Gel under the brand name, Three Happiness; and AOBO-001, an oral capsule developed from traditional Chinese herbal medicine for the treatment of urinary incontinence, which is in the phase one clinical trial.

AOB's over-the-counter pharmaceutical products comprise (3) Cease Enuresis Patch for the treatment of bedwetting and incontinence; (4) Jinji Capsule (*now also RX per 1Q09 call) for the treatment of endometritis, annexitis, and pelvic inflammations; (5) Jinji Yimucao for the treatment of premenstrual syndrome (PMS), and other PMS and menopause-related symptoms; and (6) Boke nasal spray for the treatment of sinus congestion from common cold, stuffy nose, chronic rhinitis, allergic rhinitis, and nasosinusitis (note: per company, Boke is plant-based and contains NO zinc, unlike Zicam which received an FDA warning on 6/16/09).

The company's nutraceutical products include soybean peptide based drinks, tablets, powder, and instant coffee for health and well-being. AOB sells its products primarily to hospitals, clinics, pharmacies, and retail outlets in China.

Management, Insider Ownership, and Corporate Governance

Tony Liu is the principal founder of AOB and has served as Chief Executive Officer and Chairman of the Board of Directors since 2001.

Yanchun "Lily" Li is one of AOB's partner founders and has served as Chief Financial Officer since May 2007. Prior to her appointment as Chief Financial Officer, she had been the Acting Chief Financial Officer since May 2002, Chief Operating Officer and Secretary since October 2003 and has worked at the Company and served as a member of the Board since 2002.

Jun Min is one of AOB's partner founders and has served as our Vice President and as a member of the Board of Directors since 2002.

Binsheng Li is one of AOB's partner founders and has served as our Chief Accounting Officer and as a member of the Board of Directors since 2002.

Through direct share ownership and options, management and the Board of Directors owned 16.6 million shares as of 9/15/08, or 19% of fully diluted shares outstanding (87 million assuming note conversion), with CEO Liu the largest holder at 17% (14.4 million shares) and he also owns all shares of Series A preferred stock (1.0 million shares) giving him voting power of 43.5%. We believe management is owner-oriented and, therefore, motivated to create shareholder value.

AOB's board consists of nine directors, five of which are independent, and elections for all positions occur annually. Full bios for management and BOD can be found here.


AOB includes fairly detailed information in the company's annual report regarding the competitive landscape. AOB cites key success factors include managerial and technological expertise, time-to-market, patent position, product efficacy, safety, convenience, reliability, availability and pricing. Primary competitors for each major product are as follows:
  • SHL Injection Powder primarily competes with a similar injection powder product produced by Harbin Pharmaceutical Group; AOB pursues broader marketing strategy across major cities as well as rural markets.
  • CE Gel competes with several other products having similar functionality, including the Jianpizhiyi Tablet produced by Shangdong Zhiling Pharmaceutical Company, Yeniaoying produced by Tianjin Zhongxin Company, Shengjiyiniaokang produced by Shanxi Dingxing Healthcare Scientific Limited and Suoquan Pill produced by Jilin Tianguang Pharmaceutical Limited; despite similar products in the market, AOB's CE Gel is the only SFDA approved first grade medicine for bedwetting and, according to the company, has a leading market position.
  • Jinji Capsule competes with Huahong Pill produced by Huahong Pharmaceutical Group and Qianjin Pill produced by Qianjin Pharmaceutical Group.
  • Boke nasal spray competes with Dezhong Biyankang produced by Guangdong Foshan Dezhong Pharmaceutical Co., Ltd; Zhonglian Rhinitis Tablets produced by Wuhan Zhonglian Pharmaceutical Co., Ltd; and Qianbai Rhinitis Tablet produced by Guangzhou Qixing Pharmaceutical Co., Ltd.
  • Soy Peptide Series competes with Leneng Peptide Powder, produced by Leneng Bioengineering Company and Soybean Protein Peptide, produced by Harbin High-Tech Company Limited.

Management built AOB into an established Chinese pharmaceutical franchise via acquisition of smaller manufacturers of branded traditional Chinese medicines. AOB carefully integrated acquisitions, reduced operating expenses, and increased revenue by leveraging distribution and marketing relationships to expand product reach and recognition. We believe the general view on Wall Street in 2006-1H08 was that a rapid pace of revenue and earnings growth would continue through a healthy pipeline of acquisitions.

Why is the Stock Out of Favor?

(1) Questionable capital markets actions and capital allocation decisions in 2008

On 6/02/08, AOB announced a $75 million share buyback program, which appeared a positive for shareholders since AOB had a net cash position of $148 million as of 3/30/08 with solid, growing cash flow from operations expected for 2008. The next day, on 6/03/08, AOB announced a Private Offering to Raise $125 Million via Convertible Preferred Stock, which was negative given an unclear use for the cash and implied dilution to existing shareholders. Two days later, AOB withdrew the offering. The company came back to the market a month later and priced a $115 million convertible notes offering (5% notes convertible at $8.08 into 14.2 million shares). AOB simultaneously entered into a $30 million forward repurchase contract for 3.7 million shares at $8.08 per share with Merrill Lynch. With a net cash position of $94.2 million at 9/30/08, AOB did ultimately make two acquisitions for $53 million in October and then spent another $70 million to purchase buildings and land in the Beijing Economic-Technological Development Area (BDA). The real estate was/is to serve as a "multi-functional headquarters" and centralize management in Beijing - photo here.

To summarize: capital markets activities were seemingly haphazard, expensive, and a deviation from AOB's past use of capital to make accretive acquisitions, raising questions among U.S. investors about the potential for incremental M&A transactions. AOB ended 2008 with a net debt position of $55 million.

Mitigating factors: cultural differences that emphasize cash over debt, local currency cash in-the-bank to make acquisitions, and the inability to borrow (use mortgages) to purchase commercial real estate in China. All real estate purchases must be made in cash and, later, a loan or line of credit can be obtained against the property (asset).

(2) Expected Chinese government/regulatory changes impacting the health care industry

The Chinese government is implementing a number of changes to the national health care system to expand/improve coverage across the country, including the publication of an "essential drug list" and "national insurance catalog" which are expected to lower drug pricing and margins. Drug distribution is also expected to be state managed/controlled, although the exact structure is uncertain. More details on the reforms can be found in the article linked to in our introduction above. Management expects the impact to AOB to be positive over the long-term as heath care reaches more persons throughout China, but uncertain in the near-term.

Mitigating factors: a majority of health expenditures in China today are out-of-pocket, cash purchases with government spending less than 20% of all heath care expenditures. According to the article, "the authorities will select several cities to try out the pilot program, which is expected to last three years." Therefore, the shift to increased government insured care is likely to be gradual. While AOB's overall margins may contract, volume growth could offset lower pricing and continued out-of-pocket purchases of branded, higher margin products should enable additional top- and bottom-line growth.

(3) Perceived risks of Chinese companies and inability to understand AOB's products and market position

General market concerns around quality and safety of Chinese products (e.g. lead paint, tainted baby formula) create overhangs on most Chinese companies for outside investors. Company specific risks related to product safety are also real. Last year, an AOB competitor experienced a product recall for an SHL product similar to AOB's, leading to a forecast 30% Y/Y decline in AOB's SHL injection powder for 2009. As with any pharmaceutical company, risk always exists that the company's products could be ineffective or harmful despite government approval.

Mitigating factors: In addition to the below information sourced from AOB's 2008 10-K, our conversations with investors who've toured AOB facilities and conducted retail channel checks in China reveal that products are real, popular, and necessary.
  • Shuanghuanglian Lyophilized Injection Powder (RX) - as noted earlier, SHL Injection Powder is a prescription anti-viral injection for the treatment of flu symptoms (including swine flu), upper respiratory infections, mild pneumonia, and tonsillitis. The drug was commercially launched in China in 1997 by HSPL, which AOB acquired in 2004. AOB is one of only two companies approved by the Ministry of Health to manufacture and commercialize SHL injection powder. Phase 3 clinical trials for SHL Injection Powder were conducted on 489 patients at Harbin University of Medical Sciences First Affiliated Hospital, Heilongjiang TCM Research Institute and Harbin TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.
  • Cease Enuresis Soft Gel (RX) - CE Gel was commercially launched in China in April 2004 and is the only SFDA approved Category 1 new pharmaceutical product for this indication (Category 1 approval provides a product with 12 year protection from other companies replicating the product). Phase 3 clinical trials for CE Gel were conducted on 437 pediatric patients at Beijing Children’s Hospital, China University of Medical Sciences No. 2 Clinical Hospital, Liaoning TCM Institute Affiliated Hospital and Liaoning TCM Research Institute. These trials demonstrated safety and efficacy in accordance with SFDA requirements. Prescription medications cannot be commercially advertised in China. However, the Cease Enuresis brand name is well recognized because of AOB's marketing of its OTC CE Patch.
  • Cease Enuresis Patch (OTC) - CE Patch is marketed for the treatment of bedwetting and incontinence with delivery by a patch. The product consists of the same plant based ingredients as CE Gel and was commercially launched in China in 2005. AOB promotes CE Patch as a branded product through direct-to-consumer marketing on television and in print media. The CE Patch was approved by the Food and Drug Administration Bureau of the Heilongjiang Province, under the medical device regulatory pathway.
  • Jinji Capsule (OTC/RX) - AOB's Jinji Capsule is a pharmaceutical product approved and marketed for the treatment of endometritis, annexitis and pelvic inflammations. The product is proprietary to AOB and has a well recognized brand name in the women's health market because of a very long history. It was commercially launched approximately 30 years ago in China by GLP, which AOB acquired in April 2006. AOB promotes Jinji Capsule through direct-to-consumer advertising, including a nationally televised campaign featuring popular Chinese celebrity Ms. Ni Ping. Phase 3 clinical trials for Jinji Capsule were conducted on 421 female patients at Wuzhou City People’s Hospital, Wuzhou City Workers’ Hospital and Hezhou TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.
  • Jinji Yimucao (OTC) - Jinji Yimucao is marketed for the treatment of premenstrual syndrome, or PMS, and other PMS and menopause-related symptoms. Jinji Yimucao is approved by the SFDA and marketed as a branded generic drug. AOB commercially launched Jinji Yimucao in early 2007 and owns the product through the acquisition of GLP. The company promotes Jinji Yimucao through direct-to-consumer advertising, including an extensive television commercial campaign.
  • Boke Nasal Spray (OTC) - AOB's Boke nasal spray is SFDA approved and marketed under the product name of Ditong Biyanshui Penwuji (“Ditong”) for the treatment of sinus congestion from common cold, stuffy nose, chronic rhinitis, allergic rhinitis and nasosinusitis. Ditong is approved by the SFDA in China and marketed as a branded drug. Ditong was commercially launched by Boke in China approximately 10 years ago, which AOB acquired in October 2007. The company promotes Boke nasal spray through direct-to-consumer advertising, including an extensive television commercial campaign.
(4) Slower growth and margin compression

AOB expects revenue to grow 30% Y/Y in 2009 compared to 65% growth in 2008 and 46% growth in 2007 (including acquisitions). Excluding $50 million in 2009E revenue from Nou Hua (the distribution company), implied Y/Y growth is in the low teens. In addition, the company experienced approximately 400 basis points of operating margin compression in 2008 on the back of increased cost of goods sold as well as higher marketing & selling expense. Higher D&A related to the property purchase is also reducing margins and interest expense on the convertible note is reducing AOB's pre-tax margin. Lastly, the acquisition of the low-margin Nuo Hua distribution business (low single digit net margin) will bring down overall margins in 2009.

Mitigating factors: it is not always a bad thing for companies to reign in top-line growth following several years of M&A activity to regroup, streamline processes, and/or centralize operations. A changing regulatory landscape also provides reason to move cautiously. Regarding distribution, AOB's view is that the most successful pharmaceutical companies in China have their own distribution networks and believes the company can leverage its new platform to increase product sales.

(5) AOB's concentrated product portfolio

AOB's top six products, which comprise Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, CE Gel, Jinji Capsule, Jinji Yimucao, Soybean Peptide Tablets and Boke Nose Spray, constituted approximately 71% of total revenue in 2008 and 81% of our total revenue in 2007.

Mitigating factors: the products are all well established and we believe no single product is more than 20% of total revenue, although specific product contributions are not reported by the company aside from 2007 acquisitions Boke at 14% and the CCXA RX/OTC family at 9% for 2008. AOB plans to commercially launch three new products during 2H09 and at least ten new products in 2010, which should further diversify the portfolio over time.

(6) General market malaise toward pharmaceutical companies

Major, diversified pharmaceutical companies are trading at relatively low multiples and offering nice dividends, such as Merck (MRK) trading at 10 times trailing earnings with a 5.6% dividend and Novartis (NVS) at 12 times earnings with a 4.2% dividend. Slower growth and concerns over patent expirations may be weighing on the broader sector. Wider valuations are awarded to Chinese based pharmaceutical companies that trade on U.S. exchanges such as Simcere (SCR) and China Sky Medical (CSKI) are trading at 13 times and 7 times trailing earnings, respectively. As noted previously, AOB trades at 9 times trailing earnings.

Mitigating factors/comment: over time, we believe AOB's multiple can expand as investors appreciate the company's large, growing free cash flow generated by the company's increasingly diversified product portfolio.

Long Thesis - Established Asset Light Franchise Difficult to Replicate

Our preference is for asset light business models that generate steady cash flow. Furthermore, we submit that the pharmaceutical industry and regulatory environment is often difficult to understand/predict in markets around the world, not just in China but also in the U.S. However,
drawing a parallel between Berkshire Hathaway's long-standing investment in Sanofi-Aventis (SNY): our guess is that Berkshire probably views Sanofi-Aventis as a leading pharma company (1) with products that people need/want and (2) that throws off huge free cash flow, thereby allowing Berkshire to become comfortable with operating/regulatory risks. In a similar sense, we see numerous reasons to own AOB:
  • Established market position in China with real products that people need/want in a large addressable market. The company's stated objective is to become a top-five pharmaceutical company in China, up from top fifteen today (per management). As noted earlier, checks/feedback by investors who know China as well as Chinese contacts confirm that products are real, popular, and necessary. We believe additional product launches may include additional product extensions that leverage existing AOB brand names to drive sales. Adding strength to AOB's products and brands, the company holds a number of PRC patents and trademarks, with a total of 40 patents and 86 trademarks plus 161 trademarks in process as of 2/28/09. We suspect patents and trademarks will become more valuable as China's legal-regulatory framework further develops. The pharmaceutical market in China was estimated at $27.7 billion in 2005 with the TCM market segment estimated at $5.8 billion and current growth rates in the low teens for both markets.
  • Increasing scale with established distribution (indirect and now direct) and large pipeline (per management) of new products for market introduction over near/medium-term. AOB manufactures and markets more than 60 products in China today including pharmaceuticals and nutraceuticals. The products are marketed to hospitals, clinics, pharmacies and retail stores at over 100,000 distribution points. To achieve such broad distribution, AOB maintains 28 regional representative offices throughout China and employs approximately 2,133 sales and marketing professionals. AOB owns five manufacturing facilities with "fully integrated manufacturing support systems including quality assurance, quality control and regulatory compliance." Historically, transportation of products was through a third-party, nationwide distribution network of over 300 distributors, although AOB may strive to shift some business to its Nuo Hua distribution company. According to the company, through Nuo Hua’s subsidiary and affiliated company, AOB now distributes "more than 6,000 pharmaceutical products through an extensive sales network covering major urban and rural areas in China." Finally, as mentioned previously, AOB plans to launch three new products in2H09 and at least ten new products in 2010, all of which we believe are currently SFDA-approved.
  • Real estate purchase and Chinese culture. From our experience, we know leading technology companies in China such as Hua Wei own large campuses with numerous buildings as well as dorms and recreational facilities for employees. Chinese corporate culture is to take care of people. If AOB needed to do this to remain a leading player and grow the business, the decision makes strategic sense. As noted earlier, we understand that commercial real estate purchases require outright cash payment as mortgages for initial purchase are not allowed.
  • Management has long-standing relationships with government/regulators. Local connections, presence, and “know-how” create barriers to entry for foreign players as well as smaller Chinese competitors without such connections. Management partially explained its Beijing real estate purchase as positioning AOB to "secure government support in various forms, such as R&D grants related to the PRC's stimulus plan as well as potential low-interest bank loans." So, while investors reacted negatively to the purchase, we believe political/cultural/strategic motives were behind the move, strengthening the company's presence in the Beijing region and enabling future opportunities. Shortly after the purchase, the Chinese government granted high tech status to AOB and its subsidiaries, bringing lower tax rates and other benefits.
  • Relatively stable, growing business with high margins that should generate large free cash flow for the foreseeable future. AOB guided to +30% Y/Y revenue growth for 2009 (low teens organic growth) with net income of $65 million excluding an estimated $7 million of interest and amortization expense related to the convertible notes. Since the convert is presently out of the money and the interest expense will hit net income and operating cash flow, we're assuming net income of $60 million (flat Y/Y, 18% net margin versus 23% in 2008) on a share count of 74.5 million for EPS of $0.80. Adding an estimated $8 million of D&A to net income and subtracting estimated capex of $10 million for completion of several facility expansions started in 2008, we're left with owner free cash flow of $58 million, or $0.77 per share (14% yield). Given large, increasing cash flow from operations for 2006-2008 ($29, $45, and $78 million, respectively), we are comfortable that AOB can deliver meaningful free cash flow generation going forward, especially assuming normalized capital expenditures of perhaps $10 million per year (depends on future growth and resulting capacity needs). A 10% owner free cash yield would imply a share price of $7.80 today, up 47% from current levels.
  • Large cash flow eliminates need to return to capital markets and enables reinvestment, acquisitions, and share repurchase. Management does not expect to return to the capital markets in the next two years and plans to use internally generated cash flow to grow the business, make selective acquisitions, and potentially repurchase additional shares. The company has a successful track record acquiring businesses and, while near-term activity may be limited given regulatory change, AOB should have solid negotiating power in M&A discussions as cash builds on the balance sheet. In addition, we would be pleased to see incremental buyback activity to remove capital from the business and increase AOB's return on equity and invested capital metrics (2008 ROE was 18% adding back IPR&D charge to net income in 4Q08 and assuming a tax rate of 17%).
Conclusion: Although the real estate purchase and facility expansions in 2008 both consumed capital and raised questions, we believe AOB's core business is stable, asset light and should generate meaningful free cash flow. Moreover, we think the company's franchise is protected by numerous competitive advantages, including recognized brands/products that people need/want (customer habit/frequency), scale (manufacturing, marketing/selling, indirect/direct distribution partners), and intellectual property (patents/technology/know-how). On top of these advantages, differences in culture, language, and politics establish barriers to entry for outsiders. While some of these attributes may make investors run scared from foreign companies such as AOB, we believe these attributes are the very reasons investors should consider AOB, especially since China remains poised for above average GDP growth over the long-term and the U.S. Dollar will likely depreciate relative to the Chinese Yuan.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
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