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Friday, August 7, 2009

AOB Reports, Lowers, Launches, and Responds

This week presented much to digest regarding American Oriental Bioengineering (AOB, $5.14). The company reported June quarter results, lowered 2009 net income guidance, launched new product (Jingwei Capsules), and responded to a short seller's research report published on 8/5/09 that significantly pressured AOB's shares.

Results reported this morning fell slightly short of Wall Street expectations, posting revenue of $71.2 million (+21% Y/Y) and diluted earnings per share of $0.17 compared to expectations of $74.9 million (+27% Y/Y) and $0.18, respectively. Operating margins declined to 25.7% in the quarter compared to 31.7% in the year ago period on lower gross margins (58.4% versus 68.0%, pressured by new distribution segment), higher selling/marketing expense (+22% Y/Y), and higher depreciation & amortization expense (+83% Y/Y, related to real estate purchase and plant expansion). AOB maintained its 2009 revenue target for growth of +30% Y/Y, but lowered net income guidance to $55 million from $65 million (excluding interest expense related to convertible preferred stock), citing the following reasons:
  1. rising variable costs, mostly related to raw materials
  2. additional R&D expense
  3. higher marketing expense
  4. pricing pressure (competitive and government)
  5. deliberately lower distribution business (as regulatory environment evolves).
We are disappointed by the higher expenses and lower guidance, which highlight key risks and the challenges of forecasting forward results for the company. The changing regulatory environment in China also complicates the near-term operating environment and visibility, but this is not new news. Fortunately, AOB generated meaningful free cash flow during the quarter, increasing the company's cash position to approximately $101 million from $74 million at 3/30/09.

Also today, the company also announced a new product launch for the rhinitis and allergy market to compete primarily against Schering Plough's Claritin. AOB estimates that Claritin currently generates annual sales of one billion RMB. We expect to see additional product launches in 2H09 and 2010, although exact timing remains unclear and initial contribution will likely be small.

Finally, AOB responded to a report from Manuel Asensio, who runs a research Web site and is (was?) short the stock (see his Seeking Alpha post for disclosure). We won't recount all of the details here, but suffice to say that Mr. Asensio's report raised all types of questions that investors fear most about investing in emerging market companies, especially: potential related party transactions where management has hands in many pockets. No matter how much research one performs on foreign companies, this type of risk is often difficult to uncover given language and legal-regulatory differences. However, AOB responded strongly today to his accusations and, in our view, provides comfort that there were no untoward actions by CEO Tony Liu or other members of management or the board. AOB's leading point:
  • "This statement is a clarification of the facts and circumstances surrounding the purchase of two properties that AOB purchased in 2008 - the Beijing Yizhuang Project (the "J Property") and an eight-building complex located in the Beijing Economic and Technology Development District (the "L Property"). We reiterate our prior disclosure - these acquisitions do not constitute related party transactions.None of our directors or officers have or had any direct or indirect interest in the seller of these properties and none of our directors or officers personally profited from these transactions."
Even with lower guidance, AOB is trading at only eight times our 2009 earnings estimate (13% yield) and we don't think our core thesis has really changed: we believe AOB has established a business that is difficult to replicate and should generate large, consistent, growing free cash flow. The one caveat is that lower net income guidance also reduces the FCF outlook for 2009, which is now clearly a transition year given increased R&D/marketing investment and regulatory changes. Our hope is that bottom-line growth can resume in 2010, although we see some risk that competitive pricing pressures and marketing expense related to new products further crimp margins.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
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