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Following comprehensive analysis of public information, on-the-ground due diligence and research, we conclude in our full length report (here) that China Sky One Medical’s shares (OTCPK:CSKI) is a stock to avoid for the time being.

China Sky One Medical’s shares have taken one of the most dramatic dives seen on the NASDAQ in the last year, losing about 75% of their value.

Its story is, unfortunately, becoming a familiar one: The Harbin-based company, which makes and sells traditional Chinese medicines and nutritional supplements, went public on the US over-the-counter market through a reverse merger with a Nevada corporation. It then took advantage of low requirements for transferring between the exchanges, moving to the American Stock Exchange in May 2008 and then to the NASDAQ Composite Index in September 2009.

The company has consistently reported fat margins and a head-spinning turnaround time for inventory. These impressive financial results, when combined with its long line-up of dubious auditors, have aroused the suspicion of short-sellers. Short positions have slashed the company’s share price and now account for around 20% of its public float.

China Sky One Medical operates in a promising market – total sales from TCM products grew 27% to US$33.1 billion in 2010. However, investors should continue to be cautious about this stock. For one thing, our research confirms that China Sky One Medical’s margins are suspiciously high. The company reported a gross margin of 72.9% in 2010; that compares to an average of 45.5% for 27 China-listed TCM companies, according to data from Qilu Securities.

Yanqing Liu, the CEO of China Sky One Medical, told China Economic Review that its hefty margins are the result of its in-house herb farm: The company can obtain raw materials from the planting area at a lower cost, as well as exchange the herbs with other TCM producers to acquire the materials it needs.

But a comparison with the company’s close competitors indicates this argument does not hold water. Tonghua Golden Horse and Guilin Sanjin, which have similar product lines to China Sky One Medical, both own large herb-planting bases. Tonghua Golden Horse’s average gross margins were 60.1% in the past three years, around 16.4 percentage points lower than those of China Sky One Medical.

Guilin Sanjin’s gross margins were almost as high as China Sky One Medical’s, but Guilin Sanjin spends far more on advertising – about 16% of sales revenue between 2008 and 2010 – and has better product recognition as a result. That brand was well known among the customers and pharmacy counter staff we interviewed, whereas few knew of China Sky One Medical’s brand.

Nothing special

Companies that record higher-than-average gross margins in the long run typically have unique products, according to a Changjiang Securities analyst surnamed Ye. This is often the result of access to a rare natural resource or undisclosed formula. For example, Tibet Cheezheng Tibetan Medicine had the highest gross margins of any listed company in 2010 (74.0%), partly due to its ownership of unique Tibetan medical compounds.

China Sky One Medical does not share this competitive advantage. None of the company’s main products – including camphor cream, patches for pain relief, weight loss and anti-hypertension, and eye drops – is unique in the market in terms of effect or material.

The company has also reported other suspect figures: In 2008, its figure for inventory turn-around, days inventory outstanding (DIO), bottomed out at 6.79 days per year, far below the average of supermarket and convenience stores chains. Its DIO has lengthened since then, but the company still reported turning over inventory nearly seven times as fast as domestic competitors, according to Ms Xu, an analyst at Dongwu Securities.

Custom research by China Economic Review also casts doubt onto China Sky One’s claim that its distribution network covers all of China’s major metropolitan areas and, consequently, its impressive annual revenue figures.

China Sky One Medical management needs to give investors a more detailed explanation of how it achieves such impressive operating results by spending little on advertising its brand and producing medicines that can be manufactured by many of its competitors. Until that day, we recommend investors avoid this stock.

Disclosure: We have no positions in any stocks mentioned, and no plans to initiate any positions. China Economic Review has no interest or investments in the stocks it covers, and has strict rules for staff with regard to holdings and trading to ensure their impartiality.

Source: China Sky One Medical: Impressive Results Are Suspect