- Why did AOB change its business model and start focusing on traditional "pharma" as opposed to enhancing its traditional Chinese medicine (TCM) offerings?
- We're not sure management changed the business model all that much or at all. Instead, we think the company grew so quickly via acquisition that management wanted to take several years (2008-2010) to integrate/streamline the portfolio of product offerings. In addition, regulatory change in China put the whole sector somewhat on hold as companies apparently waited for clarity on how new rules would impact the business. Finally, we suspect TCM offerings will remain the lion's share of revenue for a long time, but think diversification into pharma (where possible) is logical and part of AOB's plan to further diversify the company's portfolio from both a growth and risk control standpoint.
- Is CAXG a significant risk for AOB moving forward?
- We see CAXG as a call option for AOB in the narcotic pharma segment to, hopefully, further diversify the company's revenue streams -- note that AOB's risk is limited to the amount invested in CAXG, or approximately $22 million -- from the last 10Q:
The Company owns 37% equity interest in CAXG through an initial $18 million direct investment of its common stock in April 2008 and a subsequent conversion of approximately $4.5 million worth of promissory note into additional common stock in August 2009. The promissory note was an advance of RMB30 million to CAXG in May 2008. The note bears interest at a rate of 8% payable quarterly in arrears with an initial term of one year and was subsequently extended for an additional three months. The promissory note plus accrued interest was converted into CAXG’s common stock based on a predetermined conversion rate at maturity.
- Do you have any opinion regarding the tilidine trials and CAXG's status going forward?
- Not really. The challenge with AOB/CAXG is that it's extremely difficult for us to know what's happening in China and to understand regulatory/government pressures/risks. However, we gain comfort from our core thesis (despite lackluster 9M09 results):
Plus, we have contacts who have toured AOB's facilities and conducted channel checks in China. Their feedback is that AOB's products and presence are legitimate with well-established brand recognition.
As noted above, AOB's risk with CAXG is limited to the initial funding amount unless the company pours more capital into CAXG. Based on the latter's management commentary, CAXG should be better positioned in 2010 after 2009 events (including manufacturing facility consolidation).
- The completion of phase III clinical trials for tilidine seems to be positive news for both CAXG and AOB, correct?
- Yes, appears positive. Forward progress. Of course, CAXG has more than just Tilidine in the pipeline.
- While the Beijing real estate purchase might have improved business/political connections and brought tax credits, why didn't AOB purchase a smaller, cheaper facility?
- We think AOB is planning for the future with the large RE purchase. The company wants to be the J&J (JNJ) of China, somewhat to the chagrin of short-term oriented investors (and an often myopic Market).
- Why do you think the bears are wrong?
- It's easy for investors (or traders) here to criticize AOB, but China truly is a different world (culture, language, politics). As such, we'll never understand everything they do. We must acknowledge that Asian/Chinese companies sometimes do not put shareholders first. We know from our experience visiting companies that, in order of importance, employees and customers often rank ahead of shareholders. This is a risk factor, but also a FACT of investing in this geography (which is, no doubt, why some value investors stay out of China). Personally, we can't ignore the growth profile of this region and want to participate in Chinese style capitalism by owning attractively valued businesses poised for long-term growth such as AOB. We are aware of Chinese "bubble" fears and can envision potential troubles where demand does not match/meet excess supply -- for an insightful, if not scary read, please see this Forbes article.
- At some point, AOB's margin compression slows/stabilizes and earnings growth should accelerate as top-line continues to grow organically (general market growth and company specific). Plus, we're fairly certain AOB will use excess cash to resume acquisitions at some point, which will bolster the top-line and, presumably, the bottom-line.
- We believe barriers to entry are incredibly high for outsiders and even other Chinese firms without the right connections. We simply have a hard time NOT believing that AOB will be bigger, better, stronger in five years' time, with a much higher share price to boot.
- What about a protective put strategy to protect against a decline in the stock price?
- We've not explored options for AOB and are not sure such a strategy is necessary at the current low valuation. While anything is possible, we should have excellent downside support because of the company's very low multiple of earnings and cash flow. Aside from continued growth and margin stabilization, the key to regain and/or attract Wall Street interest is for management to announce something productive with all of the company's cash and additional free cash flow. Government pricing pressures remain a risk to margins and earnings, yet we're inclined to believe something good will happen at some point and push shares higher. We just don't know when.
Disclosure: long AOB.
© 2010 Jeffrey Walkenhorst
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