The market is a voting machine in the short run and a weighing machine in the long run. That was how Benjamin Graham, the Father of modern security analysis, characterized it. On Wednesday, shareholders of Tongjitang Chinese Medicines (TCM) overwhelmingly voted “no confidence” on TCM’s management team. Shares of TCM closed down 25.87% on heavy volume.
Before the market opened, CIBC World Markets analyst Elliot Wilbur downgraded Tongjitang to "Sector Perform" from "Sector Outperform”, citing disappointing revenue growth from the company’s flagship product XLGB (Xianling Gubao). Following her lead, investors run for exit in great panic, in a day when S&P 500 lost 2.94% and FXI lost 4.77%.
In the third quarter XLGB sales grew only a paltry 2% year over year. The management attributed the slow growth to a combination of three factors. First, TCM obtained the national trade secret status for XLGB which provided for manufacturing exclusivity and pricing protection. As a result, the company was ready to raise its selling price and accordingly scaled back sales and marketing effort. Second, unusually warm weather in certain regions has served to reduce its sales since warmer temperature tends to lessen symptom of osteoporosis, particularly among senior patients. Third, flooding in certain areas served to reduce the number of trips patients made to hospitals and retail pharmacies.
Apparently shareholders did not want to listen to excuses. But is this (paltry XLGB growth) the sole factor behind CIBC’s downgrade and investors’ panic exodus? It does not appear so simple to me. The 26% single-day drop is essentially a loud “no confidence” vote on TCM’s management. And it is not all about XLGB.
If you are like me, what appears the most worrisome is actually the management’s asset management strategy. Since Q2 (although I just found out from Q3 conference call) the company has invested a fraction of its cash reserve in Chinese IPOs listed in Hong Kong or mainland exchanges. In Q3, TCM recorded a RMB 4M gain from these short-term investments. As of end of Q3, the company has RMB 41.4M (about 5.1% of company’s total cash reserve) invested in these junior Chinese securities.
In the Q&A session of the Q3 conference call, management revealed the IPO investment program will continue through at least the end of Q4. Whether they will continue this program into 2008 depends on cash reserve available and market condition ("extent of market activity," to use the management's original words) then. The management intends to allocate 10-15% of cash for investment in Chinese IPOs.
Moreover, the company’s IPO proceeds were still mostly deposited in US$. Management explained that this was due to the stringent foreign currency regulation in China that limits conversion into RMB. It also partly justified its IPO investment program as a way to hedge the loss incurred by the depreciation of US$ against RMB.
From management’s remarks, it appears the IPO investments are mostly short-term oriented. There was no mentioning of valuation considerations, only market condition. It seems the hotter the market is, the more likely the company is going to stay in this game. Given today’s frothy Chinese stock market, it makes me wonder if the management’s vocabulary contains the word “risk” at all.
Secondary to the cash management, analysts were concerned about the rise of accounts receivables (A/R). Based on my calculation, A/R turnover increased to about 131 days at end of Q3 compared to 118.5 days as of end of 2006. Management indicated they are aware of this problem and is working to improve it significantly in Q4. Let’s follow up on how well they keep their words three months later.
Obviously, these are more than enough for investors to scream “enough is enough.”
I also noted a significant increase in inventories. Inventories turnover increased to about 134 days from 78.5 days as of end of 2006. I do not know if this inventories build up was on finished goods or on raw materials (I intended to ask about this during the conference call; but operator cut me off). If it was due to stock-up of barrenwort or other raw materials this would be a non-issue, since it could be a great strategy to lock down raw materials cost in an inflationary environment. The price of barrenwort has skyrocketed in the past couple of years until recently.
Then, wasn’t there anything encouraging out of the quarter? Sure yes.
Sales of other core products excluding XLGB (Moisturizing and anti-itching capsules, Zaoren Anshen capsules, and Daibaizhu Syrup) increased 723% to RMB 25.5M. The company’s OTC strategy seems to have worked pretty well, particularly the Moisturizing and anti-itching capsules which have registered more sales to the OTC market (retail pharmacies) than to the prescription market (hospitals). To understand why OTC strategy is important, please read my previous post.
And although Q3 is the seasonally weakest quarter, it also has grown significantly faster than the other quarters so far this year. Net revenue has grown 28.7% YoY in the quarter compared to growth YoY of 24.9% for the first nine months of the year. Gross profit has grown 34.1% in the quarter compared to growth of 22.5% for the first nine months. Operating income has grown 147.1% in the quarter vs. growth of 15.6% for the first nine months. Net income has grown 464.7% in the quarter vs. 52% for the first nine months. Net income in the quarter was greatly helped (and skewed) by interest income (mainly from the IPO proceeds), investment gain, government grant and a gain associated with disposal of Guizhou LLF’s liabilities. Acquisition of Guizhou LLF is expected to complete by the end of year. LLF will contribute an estimated RMB 10M of revenue in Q4.
By my calculation, ROE and ROC for the past twelve months were roughly 23.7% and 19.8%, respectively. Admittedly these numbers were helped by the tax exemption status, and also slightly by the unusual gains mentioned above. But they were also diluted by a greatly expanded equity and capital base associated with the huge and non-productive cash reserve generated from the IPO earlier this year.
Another encouraging piece of news is that the company has obtained a legal “nationally well-known brand” for its Tongjitang name. This marked an important victory for the company in its brand protection endeavors. It allows the company to weigh its legal options against Hubei Tongjitang, Sanjin Group’s Tongjitang subsidiaries, and any other company that attempts to steal the Tongjitang brand. You can read more about this in this post. As a follow up and clarification to that post, company CEO Mr. Wu Xiaochun is a major shareholder in Shanghai Tongjitang and use of the word Tongjitang there was by an agreement with Guizhou Tongjitang, TCM’s major operating company.
On top of these, you can also add the 11 potential new products on company's pipeline, encouraging clinical result from Synarc, and the active acquisition efforts being undertaken. Not counting Guizhou LLF, the company's current products include 15 modernized traditional Chinese medicines, 38 western medicines, and 4 nutritional products.
Coming back to XLGB, management expects its normalized growth rate to be in the vicinity of 20%. On a TTM basis, XLGB has generated a net revenue of RMB 437.3M as of end of Q3, compared to RMB 374.6M for FY 2006. This means that if XLGB proves to bring in zero growth in Q4, we will be looking at 16.7% growth for XLGB in FY 07. For XLGB sales to reach the 20% ball mark in FY 07, Q4 growth on XLGB has to be about 9.5%. This looks an achievable target for Q4.
In fact if you assume XLGB grows 20% and non-XLGB products grow 40.8% in FY 07, you would arrive at RMB 605M total revenue for the year. And this is precisely the midpoint of the managment's projection (RMB 590-620M) for the year. What's to be ashamed of these growth numbers (20% flagship product and double that rate for other products)?
To the management, XLGB’s long-term potential can be seen from its room to grow in China. At this stage, XLGB is only carried in 2400+ out of more than 20,000 hospitals and 34,000+ out of 250,000 retail pharmacies.
All in all, management’s execution does not look all that bad so far this year. Management has demonstrated ability to execute in OTC market, product diversification (non-XLGB and new products), brand protection, acquisition initiatives, and more. (Investors might like to see a faster pace of acquisition than is already achieved though.) Long-term investors will look beyond the quarter and the year to get at the whole picture. They will not be part of the voting machine.
However, I’m very concerned about management’s cash management strategy going forward. The Wall Street has voted out loud in protest against the management’s reckless way of asset management. This is a critical test on the management’s willingness to listen to shareholder voices, sincerity in enhancing shareholder value, and overall wisdom and intelligence. Unless the company has a long-term plan to Chinese equity investment and imparts adequate valuation considerations, the obvious smart choice is to stop this reckless practice before it is too late. Meanwhile I urge my fellow investors to open dialog with the management to find out more about this.
How the market will weigh TCM in the long run rests completely on the management.
Disclosure: The author owns TCM as of this writing.