China Medical Tech: Fishing for Growth

Mar.30.07 | About: China Medical (CMEDQ)

Since I wrote about China Medical Tech's (CMED) growth strategies more than three months ago, several developments have been announced. The following is what I find particularly noteworthy.

1. The company's recent acquisition of FISH (Fluorescent in situ Hybridization) technology enables it to enter a huge and virtually untapped Chinese market.

The potential market for prenatal genetic defects diagnostics alone is 1.6 million patients. And that for cervical cancer diagnostics could be as many as 5.76 million patients (120,000 in Shanghai city alone). Were affordability not a hurdle, there would be as many as 19.2 million women that need cervical cancer diagnostics.

Besides, FISH can also be used in the diagnostics of postnatal disorders, breast cancer, bladder cancer, and leukemia. It can even be used for guiding therapy of certain cancers (e.g., it can help to determine if a breast cancer patient is suitable for Herceptin therapy).

The market is virtually untapped because the FISH technolgy is currently out of reach of ordinary Chinese citizens. For example, a typical imported FISH-based prenatal test can cost a patient north of $2400. This compares to the annual average disposable income per capita (for 2006) of about $1522 (RMB Yuan 11759) in urban areas and about $464 (RMB 3587) in rural areas. (Note: Per capita RMB data was from National Bureau of Statistics of China. US$ amount was calculated based on exchange rate as of 3/30/07)

CMED expects the acquired FISH business to generate at least $20M revenue in FY 2007 (ending March 31, 2008). This might not sound much; but for a small company CMED's size this represents 29 or 30% of projected FY 2006 (ending March 31, 2007) revenue of $67.4-69.0M (RMB 521-533 million). If CMED manages to make its goal, its revenue should surpass the $100M mark (45-48% increase YoY) solidly in FY 2007.

CMED also expects the FISH business to be accretive to earnings in FY 2008. And CEO Mr. Xiaodong Wu is optimistic its FISH business can grow from $20M to $200M in four years.

2. CMED's FISH and ECLIA (Enhanced Chemiluminescence Immunoassay) business complement each other, with ECLIA more suited for screening purposes while FISH providing more accurate or definitive result
. FISH and ECLIA together will define CMED as a major IVD (In-vitro Diagnostics) solution provider to large and medium-sized Chinese hospitals.

Up till now, the ECLIA market in the large-hospital space has been dominated by major multinational giants. And CMED's ECLIA analyzers and reagent kits have been mainly sold to medium and small hospitals. The situation is about to change with the help of three driving factors.

(1) CMED's FISH technology will be initially sold to large hospitals, making ECLIA an ideal cross-selling product line. In a sense, FISH is leading ECLIA into major hospitals.
(2) The company's fully automatic ECLIA analyzer is slated to be approved and launched late this year.
(3) The company will have 70 ECLIA reagents within the year.

With the market for all three business segments (FISH/ECLIA/HIFU) now converging on major hospitals, the synergy will not be confined to just IVD (FISH and ECLIA). FISH and ECLIA do make a natrual fit and perfect cross-selling targets. And cross selling HIFU (High Intensity Focused Ultrasound) and FISH/ECLIA products might not appear as straightforward. But if a hospital buys cancer diagnostic products (FISH/ECLIA), would you be surprised to hear it also need a cancer-treating machine (HIFU)? And vice versa.

3. Management's strategy to sacrifice profit on ECLIA analyzers is a particularly intelligent one.
In a competitive environment, the ability to secure market share can make a distinction between success and failure. Giving up profit on ECLIA analyzers secures a larger install base which leads to recurring revenues from the consumed ECLIA reagents. Therefore, this is a classical example of sacrificing short-term interest for long-term gains.

So, when the company rolled out its new semi-automatic ECLIA analyzer last October, it kept the sales price unchanged even though the new analyzer's material cost was significantly higher than the old semi-automatic analyzer.

The company also resumed the production and sales of old semi in late January. The old semi was priced at about half the original price. This could be a smart way to expand ECLIA install base in small hospitals and generate recurring revenues. Moreover, in the more distant future some of these small hospitals could well become customers of the higher-end products as they gain financial strength or as the price of the higher-end products come down due to economy of scale, technological advances, etc.

For the new FISH business, the company is committed to a similar philosophy of giving up profit on FISH microscopes in return for recurring revenues from probes.

4. The validity of the company's strategy and its ability to execute is visible in its financial performance.
Besides continued growth, the company has also succeeded in maintaining high gross margin and in reducing Days Sales Outstanding (DSO).

The net revenue for Q3 2006 (ending December 31) increased 46.1% year over year and 22.9% sequential to RMB 161.5M or US $20.7M. Net income (before convertible notes cost amortization and interest expense) increased 55.4% year over year and 23.4% sequential to RMB 88.4M, or US$11.3M.

As mentioned above, the company's strategy is to sacrifice profit from ELCIA analyzer in return for sustained recurring reveneue from reagents. But in Q3, the lowered gross margin from the new semi-automatic ECLIA analyzer turned out to be more than offset by the higher gross margin from ECLIA reagents and the new third generation HIFU equipment. So the overall gross margin in Q3 increased to 72.6%, compared to 70.4% in Q3 '05 and 71.9% in Q2 '06.

Because the company relaunched the old semi (at about half original price) in late January, going forward it will be experiencing double margin squeeze from both the old semi and the new semi. But the company believes the overall gross margin in Q4 (ending March 31) will remain above 70%, again thanks to the higher margins from ECLIA reagents and HIFU machine.

The increasing revenue contribution from IVD business has also embodied itself in the form of steadily decreasing DSO in the past three quarters. From end of Q1 (June 30) through end of Q3 (December 31) DSO declined from 153, to 148, and then to 140 days. An this was because the credit term of ECLIA reagents is 90 days versus HIFU's 150 days. The company expects the DSO to go down further to about 130 days going forward.

5. Although IVD revenue will top HIFU revenue in just two years, the company certainly has not forgot HIFU.
On the contrary, it is intensifying its sales and educational efforts in China. The company is collaborating with Ministry of Health and some twenty major hospitals on a large-scale clinical study on HIFU. The clinical study aims to increase HIFU's visibility and convert hospitals with radiotherapy and chemotherapy capabilities into HIFU customers. CMED's HIFU system captures about 70% of market share in China. The company thinks its HIFU system differentiates from competing products in its dual-transducers and real-time temperature monitoring capability.

6. The company is inching into international markets. HIFU machines will begin to be sold in Japan and Korea this year. The IDE application (for clinical trial of pancreatic cancer in U.S.) will be submitted to FDA this year. And clinical trial will commence in Europe, also this year.

CMED will also begin selling its new semi-automatic ECLIA analyzer internationally. Initial target will be developing markets like Southeast Asia, Eastern Europe and Middle East. The company will begin CE marking its ECLIA system in the next quarter (Q1, FY 2007).

7. To ensure long-term growth, the company has entered into two separate 10-year R&D collaboration agreements with Peking University's Biomed-X center, and China Academy of Sciences Institute of Acoustics, respectively.

Here is a company that can build business from ground up, one step at a time. Just look at how they started their ECLIA business with 27 reagents, grew it to 56 reagents in two years, have now developed 6 more, and are heading for 70 reagents late this year. With a lot of growth potential in the Chinese market, this company is now also going global cautiously with its cost advantage. For investors with a long-term horizon, I have no doubt the current weakness in the stock represents a great buying opportunity.

Disclosure: the author owns CMED shares as of this writing.

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