China Sky's Reported First Quarter Earnings Raise More Questions

China Sky One Medical, Inc. (CSKI) released first quarter earnings on May 14. The disclosures made in China Sky's earnings announcement and Form 10-Q for the first quarter continue to underscore the issues raised previously by asensio.com, concerning margins and inventory levels. China Sky's disclosures also raise new questions.

China Sky competes in a mature and highly competitive industry. China Sky's claimed results are not comparable with those of the established industry leaders, which do not have China Sky's serious governance and accounting issues.

China Sky continues reporting questionable margins. Gross margin for the first quarter was 76%, compared to gross margin of 77% in the first quarter of last year. However, China Sky claimed to discontinue its "contract sales" entirely, meaning sales of products manufactured by other companies. These contract sales should have lower margins than products manufactured by China Sky directly. According to China Sky's Form 10-Q, contract sales decreased from 24% of sales in the first quarter of 2008 to 0% in the first quarter of 2009. Despite the sharp change in contract sales, gross margins remained remarkably constant, decreasing only 1%. An asensio.com report issued on April 20 analyzes CSKI's margin reporting.

A report issued by asensio.com on May 5 questioned the low level of China Sky's reported inventory relative to sales. At year-end 2008, China Sky reported having only $55,614 in finished goods inventory, representing less than one day's worth of sales. At the end of the first quarter, reported finished goods inventory was $498,095. This represents only 7.5 days of sales. By comparison, American Oriental Bioengineering, Inc. (AOB), a company very similar to CSKI, reported having more than $8 million in finished goods inventory at the end of the first quarter, representing more than 43 days of sales.

China Sky continues reporting unexplained growth, which is the subject of an ongoing asensio.com review. In the first quarter, China Sky’s revenues increased 100% from prior-year period, going from $12.4 million in 2008 to $24.8 million in 2009. According to disclosures made in China Sky’s SEC filings, this purported growth must be organic. China Sky did complete three acquisitions in 2008, but none of these could have been a major source of revenue growth. One of the acquired companies, Peng Lai Jin Chuang, had "dormant operations" until after the acquisition, according to CSKI's 10-Q. Another, Haina Pharmaceutical, was only acquired for a distribution license for $437,375. CSKI's 10-Q actually discloses that the acquired company "does not have an established sales network." The third acquired company only had $2 million in sales the prior year. Therefore, none of these acquisitions could be driving the more than $37 million, or 40%, increase in revenues China Sky is projecting for 2009.

Investors should carefully question how a company can increase its sales without substantial increases in working capital and property, plant, and equipment. China Sky states that it only has $20.9 million in net property and equipment, which reportedly generated $24.8 million in revenue in the first quarter. In contrast, AOB had $245.5 million in property, plant, equipment, and land-use rights to generate $46.1 million of revenue in the first quarter. That is, China Sky in one quarter generated revenue comprising 118% of its total PP&E, while AOB generated revenue representing only 19% of its PP&E.

Disclosure: Short CSKI.

Comments

[China Expert:]

Manuel, I know you've done good work in the past, but this one will be a tough one. You're going to have to sit and wait this one out for a long time. There is no Chinese company that you can't pick apart and find a few things that don't add up. CSKI is one of many. I suggest you short a portfolio of them. If the $48.8 million in cash is "really" in the bank and this company is debt free and generating real "free cash" than I don't see a bullett that will "finish" this company. I really don't care whether the products work or not, to be honest, I've spend thousands of dollars at my local CVS on medications that seem worthless. Check out the most recent "Consumers Report" on all those infomercials gimmicks being sold in our country. About 90% are worthless. Is China any different than the U.S. in selling worthless things to their consumers ? NOT !...... I predict you will be short this one for a long time, splitting hairs when your voicing concerns ! I personally like more "substance" in a good "short". Like a broken clock which is right twice a day, you may be right eventually. For now, the "red flags" of caution are simply not as glaring as you make it out to be. There is another small Chinese pharma company out there that is actually now paying a cash dividend and actually buying back their own shares. If CSKI does this, your going to be in a heap of trouble with your position. ......Postion: None

May 16 10:19 AM

[Homer II:]

Hmm, since my DW has a position in this, I wonder who is right here. Sure hate to see anyone get hurt.

May 16 04:49 PM

[stocklad:]

I like the fact that the company took extra time during the Q1 2009 conference call to address all questions from shareholders, including those issues raised over time by the author of the above article.

I thought the company’s answers were clear and thorough. For example, the company’s answer on the inventory issue showed that they judiciously manage inventories via their contracts with suppliers, distributors and sales agents. Their answer on the gross margin question showed that margins on (previous) third party sales were only 2% less than those for its own products. In terms of growth, it came from acquisitions and the numerous product approvals/expansions clearly identified by the company in its many press releases over many, many months. The governance issue is really not an issue and, to the best of my knowledge, there actually aren’t any accounting issues at all. The auditors are well respected and were accepted by major investors some time ago.

So, what are we left with to dislike about the company? Not much, apparently. It would seem that all this short selling analyst has left in his arsenal is that he has cast aspersions on China Sky One without having actually contacted the company or visited its operations.

Personally, it wouldn’t surprise me to see the short attacks stop in the near future. They’ve run their course. The arguments have been made and refuted. Any further accusations in the face of the evidence might turn out in the end to be libellous.

Of course, the biggest single weapon in a short selling analyst’s arsenal is the psychology of attaching the stigma of an “irregularity” or “investigation” to a company so that investors will shy away from its stock by either not buying it, by liquidating their existing positions or by shorting it themselves. I would think we’ve seen enough results and explanations to show convincingly that the company has real products, real growth, magnificent earnings, no debt and a lot of real cash on hand.

Callers on the conference call complimented the company on its results, commended the company for its openness and stated that they would be adding to their positions. I think these callers have got it right.

The current market price in my opinion is dirt cheap and hasn’t factored anything in for the company’s pipeline or the potential from the upcoming stem cell bank. One of the conference callers pointed out that a couple of Chinese stem cell related companies sell for a multiple of 70x earnings. Of course, CSKI will never be a pure stem cell storage company, but at some point the potential of this aspect of its operations should get recognized.

Based on Q1 results and conference call details, I’ve updated my reasons for liking the company. Here they are…

Product Related
- Large and diversified portfolio of approximately 100 products including:
… Patches, the main one being the slim patch which has been shown to be 76.9% effective in clinical trials
… Creams, ointments, drops and sprays
… Diagnostic kits
… Injectibles
… Tablets and suppositories
- Nine drugs in for SFDA approval
- Company-controlled sales force of 1,300 people as well as third party distribution
- Three acquisitions in 2008
- Expansion into prescription drugs (greater than 15% of products now)
- Expansion into Western medicines and biotech products (about 10% of products at this time)
- Large commitment to R&D spending
- Strong and expanding drug pipeline including 9 in early stage development and 12 in clinical trials. A couple of them with big potential are:
… Sudden cardiac death early exam kit (revenue potential of $20+ Million)
… Breast Lesion drug (revenue potential of $146.2 Million)
- Management that is pleased to open its facilities to shareholders

Financial
- Annual revenue growth from $8M to $92M since 2005 and 100% year-over-year growth in Q1 2009. More importantly, Q1 2009 sales from the company’s own products rose 162% over Q1 2008 (third party sales were discontinued at the beginning of Q1 2009), which means that the company’s core business is soaring
- High gross margin of 76%
- Reasonably controlled expenses
- Annual earnings growth from $2M to $29M since 2005 and year-over-year growth of 87% in Q1 2009.
- Annual earnings per share growth from $.19 to $1.87 since 2005 and year-over-year growth of 67% in Q1 2009 notwithstanding a large R&D investment.
- Cash on hand of $49M, or $2.97 per basic share.
- Working capital of $66M, or $4.01 per basic share
- No debt
- Judicious inventory management
- Reasonable level of accounts receivable
- Strong cash flow which should be able to fund 2009 CAPEX

Future
- Strong 2009 guidance of $128M-$130M revenue and $38M-$39M net income
- Guidance doesn’t include acquisitions
- Management is predicting continued growth over the next five year period
- The company can easily afford to commence payment of a dividend, if it so chooses

Let me close off this listing of positives for CSKI by stating that the company appears to be driven to be successful, as is obvious from their press releases. Over the last year (by my count on 10 May 2009), they issued 17 drug/pipe related releases, plus 4 related to distribution agreements/export arrangements, 1 for an acquisition, 1 for a guidance increase, 2 for a change of market for the stock (OTC to AMEX to Nasdaq) and 2 for scientific recognition. That’s about one positive news release every 2 weeks.

Disclosure: I am long on CSKI and I don’t concern myself with the day to day stock price movements. This is such a lovely long term growth story.

May 16 06:35 PM

[balabanovj:]

I've read your articles on CSKI before and this one is especially groundless, so I 'm not going to spend any time addressing your points. I've done in-depth DD on this company and they are my top holding and are likely to remain in that position. Management is not perfect when it comes to following Wall Street rules, but they are learning fast. As for managing the day to day business, no Chinese pharma does it better! They're aggressive in persuing their market, conservative in their capex and other expenditures and the most shareholder friendly company I've come across.

James Balaban

May 17 06:46 AM

[Lookatvalue:]

www.finra.org/Newsroom...

This is coming from a guy who is a confirmed criminal....

May 19 09:05 PM