Analyzing American Oriental Bioengineering's Profit Margin Decline

| About: American Oriental (AOBI)

Shares of American Oriental Bioengineering (AOB) have fallen victim to a multi year decline in price that is largely due to a somewhat equal decline in profit margins. In October of 2007, AOB reached a high of $14.48 per shares. Since then, shares have traded as low as 2.17 in recent days. That's a decline of 85%. Meanwhile, net profit margins during the same period have declined from nearly 27% to about 6% today. That's a 78% decline in profit margins.

Here is a 5 year stock chart (click to enlarge images):

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Let's look at what AOBs income statement for fiscal year 2007:

Sources for all data include: SEC filings, Google Finance and Yahoo Finance

By the end of 2007, AOB is a very profitable business operation with a very healthy net profit margin.

What happened since then?

Over the following years, 2008, 2009 and even into 2010, AOB experienced margin compression, most notably from cost of sales.

Here's the data for 2008 and 2009:

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Revenue growth from 2007 to 2008 was up 64.9%

Revenue growth from 2008 to 2009 was up 11.91%

What needs to be analyzed here is the net income margin going from 26.98% in 2007 to 18.06% in 2008 to 13.99% in 2009 for a drop of about 13%.

The cost of sales as a % of revenue had gone from 30.76% in 2007 to 43.68% in 2009. That's an increase of 13%.

That's where your net profits went and what most likely, investors in 2007 who were eager to buy this highly profitable high growth Chinese TCM company as high as 14.48 per share were not anticipating.

What contributed to this increase in cost of sales?

Product mix played a role as lower margin products took up a larger share of sales. Also, and more important, are the effects of the Chinese Health Reforms that have occurred. Price caps put on some of their drugs by the Gov't. to help make them more affordable to the Chinese people, also, subsidized by the Gov't. have contributed to lower revenue growth, even though volume of drugs sold may be experiencing far higher rates.

Lastly, general price inflation of raw materials has played a role, according to management discussion and analysis found in the fiscal 2009 annual 10-K.

Profit margin erosion didn't end there, but it has finally eased up.

Let's now look at the first 3 quarters of 2010.

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The first thing that should strike you is the leveling off of cost of sales % in and around the 48% range. Take note, it is up from 43.68% in 2009.

Also striking is the net income margin down to the 6% range. It was 13.99% in 2009. Net profit margins are down an additional 8% in 2010 thus far. 4% of that 8% has come from the increase in cost of sales as a % of revenue.

SG&A was 31.76% in 2009 and has been creeping up to nearly 35% in the 3rd qtr, but averaging around 33.8% for the first 9 months. There is another 2% of the profit margin.

R&D has increased from 2.67% in 2009 as a % of sales and that is now around 5% and will likely continue to be around 5% according to AOB's managements strategy. There is your final 2% of the 8% drop in net profit margin from 2009.

So there you have it. AOB's net profit margin has declined from 27% in 2007 to 6.1% give or take today and its share price has fallen from its intra-day high of 14.48 to 2.29 as I write now.

This now begs the question, just how profitable as an enterprise is AOB and is its current business model both sustainable and worthy of owning at the current price with current margins as they are?

That question I will attempt to answer objectively in a follow up article. Stay tuned.

Disclosure: I am long AOB.