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Monday, November 16, 2009

Risk Factors Weigh on AOB's 3Q09 Results

We regret to relay that American Oriental Bioengineering's (AOB, $4.18) 3Q09 results missed expectations and prior guidance as key risk factors came to bear. The company also announced a relatively small restatement to prior results following the engagement of Ernst & Young as its auditor (some minor housekeeping is okay, in our view). We noted in our post last week that short interest was elevated, but we hoped the shorts would be wrong this time.

Key figures:
  • 3Q09 revenue increased 11.7% Y/Y to $78.8 million, well below a Wall Street consensus expectation of $89 million and full-year revenue guidance for +30% Y/Y implying 2H09 revenue of $228 million (+95% H/H). Last year's 2H revenue was up 70% H/H and 2H is typically stronger with normal seasonality.
  • Gross profit was $44.1 million (56.0% gross margin) compared to $47.2 million (66.8%) in 3Q08, "reflecting continued revenue mix shift to CCXA's generic product sales, increasing raw material prices and lower margin distribution business from Nuo Hua."
  • Operating income was $15.0 million (19.0% operating margin) compared to $21.6 million in 3Q08 (30.6%).
  • Net income attributable to controlling interest for the third quarter of 2009 was $10.0 million, compared to $16.3 million in the prior year period. Adjusted for certain items, EPS was $0.13 per diluted share versus a consensus expectation for $0.17 and $0.21 in 3Q08.
Revenue mix:
  • Revenue from pharmaceutical products increased 6.3% to $66.0 million.
  • Revenue from prescription pharmaceutical products increased 22.7% Y/Y to $29.8 million.
  • OTC pharmaceutical products decreased 4% Y/Y to $36.2 million.
  • Nutraceutical products increased 8.7% Y/Y to $9.2 million.
Management attributed the top-line weakness to the following: "we are witnessing uncertainty around product pricing related to healthcare reform, and this has caused select disruption in purchasing patterns."

However, we wonder whether necessary price reductions (forced or otherwise) are also eroding revenue and margins. Further, we expected management to have a better handle on revenue performance, especially after reiterating guidance at the recent investor conference in mid-September. Or, even better, given market uncertainty, management should have pulled guidance earlier this year as it had a "free pass" to do so with the stock already under pressure. We think the institutional investor base was then churning to "value" from "growth".

There is some good news: at 9/30/09, AOB had $115.9 million in cash and generated $44.3 million of operating cash flow during the first nine months of 2009 (per 10-Q filed today, down 9% Y/Y). Capital expenditures YTD are small (AOB prepaid some funds in 2008 for certain expenditures this year). As a result, the company's net debt position declined $42.3 million during 9M09 to $13.6 million at 9/30/09 from $55.9 million at 12/31/09. So, the business continues to generate meaningful, consistent free cash flow.

We'll need to see what management says on the conference call tomorrow morning, yet the large revenue miss calls into question our (and management's) ability to understand and forecast the business. Needless to say, we don't like this uncertainty and nor does the Market. Granted, 2009 is a year in transition as China is pushing through sweeping regulatory changes.

Post results today, a friend who is also long AOB aptly raised the paramount question: what is the true earnings power of the business? In this regard, perhaps we made a mistake as we prefer to own businesses with high visibility into operating results and primary drivers. We would like to believe that our initial parallel between buying AOB and Berkshire Hathaway's long-standing investment in Sanofi-Aventis (SNY) holds true: 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. Yet, results today indicate that risk factors in a rapidly emerging market such as China are difficult to assess, particularly when regulatory changes are involved.

Fortunately, negative Market sentiment toward AOB in recent weeks appears to have already priced in an earnings miss and the company's cash generation should provide a backstop. Shares are already inexpensive on a price to free cash flow basis (even with reduced FCF):
  • Market Capitalization (MC): $320 million ($4.29 times diluted shares of 74.5 million, excluding out-of-the money convertible notes of $115 million convertible at $8.08 per share, or 14.2 million shares)
  • Plus Net Debt as of 9/30/09: $14 million
  • Equals Enterprise Value (EV): $334 million
  • Reduced, conservative 2009E Free Cash Flow: $50 million (divided by MC = FCF yield of 16%, or only 6 times FCF)
We find some comfort in the low FCF multiple and expect cash to keep piling up on the balance sheet even if growth is lower than anticipated. On a relative basis, other Chinese pharmaceutical companies (e.g. Simcere Pharmaceutical Group - SCR) trade at higher multiples but have lower growth and margins than AOB. We think management credibility remains the key issue. How will it manage the business and use excess cash to enhance shareholder value?

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
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