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Monday, December 14, 2009

AOB: Management or Cash Generation More Important?

Shares of American Oriental Bioengineering (AOB, $4.04) have held up well since missing our and consensus 3Q09 expectations in mid-November. We were disappointed by the results and stated that we may have made a mistake, yet we still hold shares with a view that intrinsic value is closer to $7 - $8 per share than $4. Here is AOB's one-year stock chart:

We noted at the time that "negative Market sentiment toward AOB [appeared] to have already priced in an earnings miss and the company's cash generation should provide a backstop." Further, at this point, we surmise that the short story for AOB (e.g. potential 3Q miss, regulatory changes, competition, margin compression, management credibility, etc.) has run its course given the large expectation "reset" in November. Based on recent short interest data, "S/I" did tick lower in the most recent period:

Following the same approach applied in our prior post (excluding out-of-the-money convertible shares), we estimate AOB is trading at six times (16% yield) estimated 2009E free cash flow of $50 million (conservative). We continue to find comfort in the low FCF multiple and expect cash to keep accumulating on AOB's balance sheet even if 2010 growth is lower than anticipated. Moreover, we still believe that AOB's products and growing franchise are difficult to replicate -- we sure couldn't do it and also think Western pharma/biotech companies would find the task challenging because of cultural and language barriers.

Thus, even with risk factors (e.g. regulatory, execution, competition), we find the 16% FCF yield very compelling. As with our Weight Watcher's (WTW) post on Friday, we ask ourselves a Warren Buffett-like question, if we could, would we purchase the entire business at the current price offered by the Market? Our answer: YES. Imagine owning the whole company and reinvesting one half of free cash flow to grow the business and paying yourself the other half (8%) as a perpetual dividend -- we'd take that any day.

We also note that other Chinese pharmaceutical companies (e.g. Simcere Pharmaceutical Group - SCR) trade at higher multiples but have lower growth and margins than AOB. Simcere is trading at 21 times consensus 2010 earnings estimate of $0.40 while AOB trades at only 6.5 times a reduced 2010 estimate of $0.62 (only slightly higher than 2009E's $0.58). Our intrinsic value estimates are always based on absolute measures. However, if AOB garnered SCR's 21 times forward multiple, the stock would trade at $13.00 today.

Finally, with regard to management credibility let's share a quote from the Fairholme Fund's Bruce Berkowitz featured in the Winter 2009 issue of Graham & Doddsville:
  • "The management factor is important. But, the ability of a company to intrinsically generate cash is probably more important."
We think Mr. Berkowitz makes a good point, which is somewhat related to a point made by other well-known investors -- something to the effect, "it's best to own a business any fool can run because someday a fool may well be running it" (tongue in cheek as clearly management stewardship of shareholder capital is important).

We'll continue to watch how AOB's management deploys excess cash flow to enhance shareholder value. As noted in our pre-3Q09 results post, only "modest improvement in the Market's perception of management credibility should lead to multiple expansion". We still think this is true.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB, WTW.

© 2009 Jeffrey Walkenhorst
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