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American Oriental Bioengineering (AOB), a manufacturer and distributor of Traditional Chinese Medicines (TCM) and Nutraceutical products in China, has seen its business model suffer from a combination of factors.

First, through the Chinese Government health reforms and the creation of an Essential Drug List (EDL), a list of drugs "deemed essential for good health" and a National Insurance Catalog (NIC) of drugs that would be subsidized by the Government. Also, the Government would set price caps on what manufacturers could charge for these drugs. AOB manufactures some of these drugs that in either the EDL or NIC. See pg. 7 of the most recent 10-K.

Second, as we have seen the price of gas and silver soar since the start of QE2, China has also been experiencing high inflation, but much more so in the raw materials that go into making TCM. This price surge was especially pronounced in the 4th Quarter of 2010 and throughout the 1st Quarter of 2011. See here, here and here.

These factors, in and of themselves, give reason for a downgrade in the enterprise value of AOB.
The increases in raw material prices have caused AOB's management to shift production from drugs whose material cost surged to drugs they could manufacture and still profit. The net result of this has been a decline in year over year sales in Q4 of 2010, down 16.7% y/y, and a slight decline in sales in year over year for Q1 of 2011, down from $53.7 million to $52.0 million. Earnings have also suffered year over year.

Despite these challenges facing AOB, the company has remained profitable, earning $924,146 in Q1 while also spending $2.7 million on Research and Development.

So where is the value in a company that is seeing its profit margins collapse, its sales revenue growth non existent, and is faced with tremendous uncertainty regarding raw material prices and Government reforms?

Price is what you pay and value is what you get.

The current price of AOB is 1.36 per share, making the market cap $106.68 million based on 78.6 million shares outstanding as of March 31st, 2011.

*AOB announced that it bought back 420,218 shares at an average price of $1.79 in the month of April 2011 as part of a $20 million share buyback program announced in March 2011 .


Throughout the life of AOB as a public company, through cash flows generated from operations, the total amount of earnings retained in the enterprise as of March 31st, 2011, was $208,439,256. Total Paid In Capital, mostly money raised from previous public share offerings, totals $204,063,263. Total accumulated other comprehensive income, income from currency adjustments due to the strengthening of the Chinese RMB vs. the U.S.$ total is $52,257,717. Subtract out a prepaid forward repurchase contract of $29,998,616 and including a few other smaller items, the total equity of AOB is $435,779,441-- or $5.54 per share-- as of March 31sth, 2011.

The rule of thumb to value investors is that the value of an asset is worth what you can get out over the life of the asset discounted at at least the rate of inflation.

AOB is selling at a discount of 75% of book value or equity. There is your first identification of value.

The next question that must be answered is: Where will future increases in equity come from to increase the value of the asset over its life?

Don't count on retained earnings to grow too much in 2011. Investors should have low expectations for earnings due to the previously mentioned factors, raw material prices surging and Government reforms. Investors would need to be patient for AOB management to shift gears in this process. Management will certainly be tested in their ability to both remain profitable-- even just barely-- while still managing to pour 5% of the company's revenues into research and development.

Investors should look to the currency adjustment income in order to make up for the lost income from operations to enable AOB to continue to build equity in 2011.

In January of 2011, Li Daokui, an advisor to China's Central Bank, was quoted as saying that China would appreciate the RMB 5%-6% in 2011. For whatever reason, I took this seriously, and thus far it has proven to be the case.

On December 31st, 2010, 1 U.S.$ bought your 6.60 Chinese RMB. A 5% appreciation would bring the RMB to getting 6.27 to 1 U.S.$ by the end of the year. So as Americans want to buy Chinese goods, or even real estate, even if the price remains the same in RMB, it will go up 5% in U.S.$.

AOB shareholders need not worry, as nearly all the assets at AOB are in China and valued in RMB. So every quarter, because the RMB gets stronger vs. the dollar, AOB has to account for this and make an adjustment. This is indicated in the income statement as "Other Comprehensive Income."

Here is a chart of the RMB vs. the U.S.$ since the beginning of the year.



If the RMB was to appreciate 5%, as the advisor stated in January, the pace would put the ratio at 6.435 RMB to 1 U.S.$ by June 30th. So far, they look to be very on target.

AOB has $614 million in total assets and $179 million in total Liabilities. The $115 million note that is due in 2015 is not denominated in RMB. So AOB will be paying the note back to depreciated U.S. $!

The total liabilities in RMB would be $179 million - $115 million, and equal approximately $64 million.

The total amount of equity that would benefit from the adjustment in RMB of 5% for 2011 would be $614 - $64 million or about $550 million.

Five percent of $550 million is $27.5 million. So my estimate for "Other Comprehensive Income" for 2011 will be $27.5 million and based on there being 78.6 million shares outstanding, but knowingly there will be less due to the buyback program, this would yield an additional 35 cents per share in equity.

Even if AOB earns 5 cents per share for the fiscal year 2011, the earnings from currency adjustment will make total income 40 cents per share.

Now you have a stock with a price to book value of .25 and a forward estimated P/E of 3.4.


So far, Q1 has given AOB $924,152 in earnings from operations and $3,132,466 in the currency adjustment (based on average RMB 6.59 exchange in Q1) making total comprehensive income $4,056,618, which comes out to be 5 cents per share.

Looking out to 2012 and beyond, investors would be wise to keep an eye on developments of Aoxing Pharmaceutical Company (NYSEMKT:AXN) and its partnership with Macfarlan Smith. AOB owns 36.1% or 16,789,203 shares in AXN.
*AOB carries its investment in AXN at cost of $18,380,562 but the share price as of this writing is $1.89 per share, making the market value $31,731,593. This would be an additional 17 cents per share in equity.

Beyond that, as long as management navigates through the Government reforms successfully while new drugs from its R&D begin to add more meaningfully to growth, the future could look bright again for AOB. However, if the margin pressures continue and it doesn't look like the R&D is paying off enough, AOB could find itself in a position where the business enterprise itself no longer warrents investment capital and the stock becomes a cigar butt pay. (Cigar Butt where investors buy the stock for one puff or jump in share price and then sell.) However, the puff price should still be closer to book value.
By the end of the year, I project that AOB sees its book value come close to 6.00 per share-- if not higher-- depending on how many shares are bought back this year.
The long term quarterly stock chart, with slow and fast stochastics as well as RSI, indicate that AOB may well be bottoming in the current range.
AOB should be considered a speculative value play. Speculative because the share price is extremely volatile and because there is still uncertainty about the TCM industry in China as a whole, due to Government reforms and raw material prices. Value because of the tremendous discount to equity that should still grow in the year ahead.



Disclosure: I am long AOB.

Source: Identifying the Value in American Oriental Bioengineering