On December 6, 2012, Glaucus issued a negative “research” report on China Medical Technologies (CMED). They are admittedly short the stock. My fund engages in short selling and I appreciate investigative research as much as anyone. The report that Glaucus wrote falls short in two primary ways. First, most of what is mentioned in the report is a number of years old and widely known among institutional investors, hence the already low valuation. Second, there are a good deal of factual mistakes in the report.
The report starts with the accusation that the Chairman and CEO of CMED secretly owned Beijing Bio-Ekon “BBE” when the company purchased it in 2007 for $28 million. Additionally, the author claims that CMED overpaid for BBE to the tune of $20 million. In approximately 6 pages, the author attempts to link the company that owned BBE to Wu Xiaodong, China Medical’s CEO and Chairman. Unqualified words and phrases including “it appears”, “we believe”, “we suspect” and “inferred beneficiary” were mentioned throughout this section of the report. The report states that since BBE’s inception, the largest shareholder has been a company operated by one of Wu’s former employees. Before, being purchased by China Medical, the report states that the entity controlled by the former employee purchased the shares it did not already own in BBE, resulting in an implied valuation of $8 million. When China Medical purchased BBE for $28 million at the end of 2008, the completion of the Chairman’s purported laundering of China Medical for $20 million in profit was complete.
There are a few items that the report leaves out in this example. First, aside from the officer of the controlling company of BBE having worked for Mr. Xiaodong, the author fails to make any material connection between the China Medical Chairman and BBE. Second, according to the press release associated with the acquisition on November 26, 2007, BBE has been selling IVD products in China since 1999. Is Glaucus inferring that this elaborate scheme was thought up back in 1999? In August of 2005, China Medical, of which Mr. Xiaodong owns more than 20% of, went public in the United States and raised nearly $100 million. Why would Wu risk involving a former employee in a scheme with a net benefit which is significantly less than what he could make on China Medical’s success? Additionally, the company has $200 million in cash on the balance sheet. If a fraud was actually committed, and there was some type of fine, it appears that the company would be able to manage.
The next topic that the author brings up is the company’s sale of its HIFU business to its chairman in December of 2008 for $53.5 million, or approximately 1x sales. At the time, most investors did throw up a red flag over the transaction. It was well documented that this non-arms length transaction did not sit well with investors as reflected in the significant drop in the company’s shares. However, in hindsight, its quite possible that the sale price was at least fair. HIFU is far from a standard of care in the markets that it serves. Its clinical data is limited. A public company that provides cancer treatment in China, Concord Medical (NYSE:CCM), doesn’t mention HIFU technology once in its most recent annual filing, indicating that they do not ascribe to it as a primary treatment offering.
Additionally, the author tried to make the case that management using a weak economy as a reason to sell the HIFU business did not make sense because the company’s customers were the same in its other business lines. While hospitals purchase both diagnostic products and HIFU equipment, the types of purchases are completely different. In the company’s diagnostic segment, the company gives the equipment to its customers and primarily raises revenue through the sale of disposable reagents. In its HIFU business, a capital purchase is required. Most healthcare investors recognize that companies including Hologic and General Electric (NYSE:GE), who sell expensive medical equipment throughout the world, struggled when the credit crisis hit and continue to have difficulty making considerable strides in organic revenue growth.
At the completion of the sale agreement the company states its intention to focus on its IVD business, a move which in my opinion makes complete sense. A unified sales force can sell diagnostic products to hospitals and labs, while a different sales force and research team would be needed if the company still had the HIFU business.
The author’s argument is somewhat conflicting. On one hand, he states that the HIFU business was in such disarray that the company wanted to get it off the books so investors would not notice. On the other hand, he states that the purchase price was excessively low. Which one is it?
The author rebuffs that the reason to keep the stock price high would be to tap the capital markets for cash. When the deal was announced, the company’s market capitalization was approximately $500 million, implying the CEO’s position was worth approximately $100 million. Similar to the BBE situation, why would Wu spend $55 million to “prop up” a stock that had already declined 50% from its peak? In the BBE example, we are to believe that the company was paying off the CEO and in the HIFU example we are to believe that the CEO is paying off the company. On a net basis, it implies that the CEO paid the company $35 million to prop up its stock price, a practice, which even if true, clearly has not worked.
On page 17 of the report, the author lays out a simple cash flow statement from FY2006-FY2011. He argues that the chart indicates that the primary source of cash for the company is selling debt or equity instruments. The sum of the operating cash flow over the stated years is $284 million, the company spent $563 million on acquisitions and capital expenditures and generated $506 million from financing activities to finance the acquisitions. What is the mystery? His own numbers show the company having produced $340 million in cash flow since 2006, or approximately $56 million per year. Most companies have to issue debt or equity to finance large acquisitions, why would China Medical be an exception?
One point the author brings up that most investors including myself have been focused on of late is the company’s high level of accounts receivable and resulting DSOs. Management has stated on numerous conference calls that DSOs are high because tier-1 hospitals, who have become an increasingly large portion of the company’s sales, take 9-12 months to pay, versus distributors in its legacy ECLIA business, which pay quicker. The author uses Mindray (NYSE:MR), a company that sells heavy equipment in China and around the world as a comparable. I have also used the company as a metric for DSOs, however, the company sells different products and has a significant portion of its sales outside China. Still, its DSO’s are quite high. Another Chinese company, Concord Medical, who provides cancer treatments and radiology imaging services for hospitals, has also noticed a lengthening in receiving cash from tier-1 hospitals.
As I see it, only time will bare out if these companies are being honest about the collectability of their receivables. Chinamed’s DSOs are currently in the 9-12 month period the company mentions. If over the next two quarters the growth in receivables does not slow or goes beyond a year, investors should take serious note. Even though the company has been slow to collect on its receivables over the past year, excluding one time benefits, it has produced $16 million of free cash flow.
The author moves on to judge the company’s valuation of its intangible assets, claiming that unpatented technology does not warrant a significant level of goodwill. This item is a judgment call. If you remove all the noise out of the story, the company produces over $2 per share in EPS. If the company does begin to collect on its receivables, the argument would favor the idea that the company produces enough earnings to justify the intangibles. Additionally, the intangibles are non-cash and not material to the amount of money that the company has or does not have.
The next argument is that CMED’s margins are too high because the company sells “commoditized products”. While the company’s ECLIA business is not highly proprietary, which management readily admits, anyone familiar with the company’s other two technologies, FISH & SPR, are aware that these are in fact proprietary products. In China, the company has 90% market share in FISH, with the other 10% being primarily garnered by Abbott Laboratories. In SPR, and more specifically, the company’s HPV test, there are more competitors, but the test still commands a high price. GenProbe, a multi-billion American based diagnostic company, just received approval in the US for its HPV test and is looking to it for its next significant leg of growth. Another point regarding its margins is that the entire infrastructure of the company is China based, and as we all know, wages are considerably lower in China than the United States.
The thing about a ponzi scheme or a fraud is that the bad acts usually aren’t designed to hurt the perpetrator. In this case, the CEO owns more than 20% of the company and stated earlier this year that he was purchasing more shares. Additionally, other executives of the company have purchased shares as the stock price has declined.
There are reasons to be cautious when considering an investment in China Medical, one being the previously mentioned high level of accounts receivable. Another being the high price tag of its acquisition of the SPR technology in 2008 and the existing amount of debt it has left the company with. However, the Glaucus report attempts to connect many dots that don’t show the entire picture.
At its current share price of $2.65, the stock trades at 1.2x F2012 EPS expectations, 0.4x sales and 4x enterprise value to free cash flow. While I wouldn’t suggest putting your life savings into this name, I do own it and think it is a name worth investors' time to consider.
Disclosure: I am long CMED.