China-Biotics: An Undervalued Stock with a Growth Catalyst

China-Biotics Inc. (CHBT) may not be in the most glamorous business dealing with bacteria, but its stock appears quite appetizing for investors. The company is one of the few domestic producers of probiotics in a baby formula market that primarily relies on imports, while it is also rapidly expanding its retail probiotics segment to capture higher-margin sales down the road.

China-Biotics manufactures and distributes probiotics comprised of live bacteria produced with an advanced proprietary fermentation process. These bacteria, like those found in foods like yogurt, help to clean the human digestive system and improve health. They are particularly important for infants, who are more susceptible to complications.

China-Biotics Appears Undervalued

During the second quarter, China-Biotics saw its net income jump 78.2% to $5.76 million, or $0.34 per share, on revenues that increased 35.5% to $15.4 million. Meanwhile, the company’s balance sheet remains strong with $77.4 million in cash and equivalents and a current ratio of 2.66 with very little long-term liabilities relative to its enormous asset base.

The increase in revenues for the quarter was primarily attributed to increased sales volumes from new products, including its recently-launched bulk additives, along with an increase in the selling price of these products. However, gross margins dropped slightly from 71.34% to 70.81% due to the increased cost of packaging materials and higher electricity costs.

On a valuation basis, China-Biotics appears substantially undervalued given its growth rates. Currently, the stock trades for around 13x trailing earnings and 12x analyst estimates for this year’s fiscal 2010 earnings. Given conservative long-term growth rates of 20%, the stock should be trading closer to $23.40 per share on a price-earnings to growth basis.

Explosive Growth in Baby Formulas

The Nutritional Development Center of National Development and Reform in China mandated that probiotics be used in baby formulas in April of 2007. Since then, demand for probiotics as an additive has grown exponentially, but the majority of the products have been imported. China-Biotics provide limited bulk additives, but is limited by its production capacity right now.

China-Biotics plans to capitalize on this market by providing probiotics for baby formulas domestically. To this end, the company is constructing a new factory that is expected to complete its first trial run in the second quarter of F2010. Funded internally and with a December 2007 note, the factory will initially produce 150 tons per year with upgradability to 300 tons per year.

So far, China-Biotics has entered into 16 contracts with customers for this new business segment in preparation for the completion of the factory. This means that investors can expect a near-term jump in sales and a quick return on investment for the capital expenditure needed to build the factory. In the end, this could be the catalyst needed to send shares of this company higher!

Conclusions

In the end, China-Biotics appears to be an undervalued stock with a strong catalyst for future growth. The company appears to be at the beginning of its growth phase with a new factory under construction and a rapid expansion of its retail segment planned for the remainder of 2009.

Disclosure: No positions.

Comments

[China Expert:]

Some valid points here. To clarify, the company has increased its cash position over the last 12 consecutive quarters to $77.4 million. On the liability side it has a $25M convertible bond that matures 12/2010 and converts at $12 per share and a questionable tax liability of $26.1 million which has increased steadily for a few years. Value and free cash flow investors will like that the business generates consistant 40sh% EBITDA margins and except for plant construction/expansion costs, low maintenance capital expenditures could cause significant free cash flow generation. The fact that China is a net importer of probiotics bodes well for future demand. Once the new plant is running at full capacity in late 2010/early 2011, revenues should approach a $154 million a year run rate with an EBITDA run rate of $55-$65 million. Assuming 19.2 million FD shares and a 15% tax rate (started 1/1/09), EPS would be about $2.47 per share. I assume by that time, the cash position will be much higher and the $25 million of converts will have been converted. Hopefully talk of raising cash for future international expansion/acquisitions is delayed until the stock increases in response to earnngs increases or using organic generated free cash flow is carefully studied at a viable alternative.

Aug 26 07:02 AM