China Medicine: Expect a Big Quarter

Aug.11.09 | About: China Medicine (CHME)

China Medicine (OTCPK:CHME) is scheduled to report 2Q’09 earnings this Thursday morning, August 13. While there is no consensus estimates or management guidance for investors to base expectations on, we believe the company’s balance sheet offers some important clues as it pertains to ball-parking China Medicine’s results. And these clues lead us to believe that China Medicine is going to report a remarkably and unexpectedly strong quarter.

Our logic is as follows: in order to meet customer demand China Medicine carries inventory and also makes advanced payments to its suppliers in order to secure product. Both of these are recorded as current assets on its balance sheet and are indicative of the next quarter’s sales. The exhibit below captures the relationship between the balance sheet amounts it records as inventory plus advances to suppliers and the company’s next quarter’s sales.

To make the comparison easier we have simply lagged by one quarter the aggregate of these balance sheet items and compare them to the next quarter’s sales. As the chart shows, using these balance sheet accounts to forecast China Medicine’s quarterly sales would have enabled us to make fairly accurate directional forecasts about quarterly revenue as the blue and red lines in the chart generally rise and fall together.

Using the Balance Sheet to Forecast Sales

CHME: USING THE BALANCE SHEET TO FORECAST SALESClick to enlarge

While the history available to us is far too limited to make any statistically verifiable claims about the correlation between these balance sheet accounts and next quarter’s sales, the data does offer some observations that are worth mentioning.

First, by simply eye-balling the chart it appears that the largest “forecasting error” between our leading indicators (blue bars: inventory plus advances to suppliers) and the next quarter’s sales (red bars) occurs in the fourth quarter; in the other quarters the relationship between these balance sheet accounts and one-quarter forward sales seems to be pretty tight. To wit: the drop in the inventory accounts at the end of the fourth quarter (shown as the blue bar on 1Q data plots) has presaged the seasonal drop in sales in the first quarter (shown as the red bar on 1Q data plots). At the same time, the increase in those balance sheet accounts at the end of the first quarter (shown as the blue bar on 2Q data plots) seems to be a pretty good leading indicator for the spike in second quarter sales. In fact, the relationship between the 1Q balance sheet accounts and 2Q sales seems to be the tightest in terms of forecasting sales results. Specifically, inventory plus advances to suppliers heading into 2Q’07 was $7.9 million which compared closely to actual sales in 2Q’07 of $8.2 million. Similarly, inventories plus advances to suppliers leading into 2Q’08 totaled $11.8 million which was close to actual sales for the quarter of approximately $11.6 million.

So where are we today? At the end of 1Q’09 heading into 2Q’09, as evidenced by the far right blue bar on the chart, inventories plus advances to suppliers were a record high $17.3 million. Prior to the current 1Q’09 balance sheet, the largest amount of inventory plus advances to suppliers the company carried on its balance sheet was $15.2 million in the quarter preceding fourth quarter 2008’s record sales of $24.4 million. If the relationship between inventories plus advances to suppliers and next quarter sales holds—and we have no reason to think it won’t—the current record balance suggests that we should expect very strong revenue for the second quarter when it is reported on Thursday. While it is tempting to assume a record level of inventory plus advances will translate into a record level of sales this quarter (which would suggest sales greater than $24 million!) this assumption would be inconsistent with China Medicine’s past seasonal patterns where 2Q results recover from 1Q’s seasonal dip but are below 4Q’s high.

So, in order to be consistent with seasonal patterns and given the fairly tight past relationship between 1Q inventories plus advances to suppliers and 2Q sales, we are pegging our second quarter 2009 revenue estimate at $17 million but would not be surprised to see upside to this estimate. As shown in our financial model/forecast for CHME (available at www.dominoanalytics.com), this translates into 46.1 percent year over year growth and 68.3 percent sequential growth over the first quarter.

This forecast and our methodology for deriving it are lent added legitimacy by management’s statement in its recently filed 10Q: “From December 31, 2008 to March 31, 2009, our inventories increased 66.75% as we anticipate a significant increase in goods order for the upcoming quarter.” As part of this significant increase in sales, we expect the company to book initial sales of rADTZ which is used for treating aflatoxin in animal feed and food storage. Given the very recent revenue mix-shift in third-party distribution sales toward the higher margin products for which the company maintains national and exclusive distribution rights, coupled with the inclusion of initial rADTZ sales (which garner 90 percent gross margins), we are expecting strong 2Q results to generate higher profitability as well. On a non-GAAP basis we expect China Medicine to earn $0.20 for the second quarter which translates into annualized EPS of $0.80. With the company growing like a weed and its proprietary drug rADTZ just entering production, at $2.10 per share the valuation on CHME is pretty compelling.