Earnings Quality Key for China Pharma Investors

Tongjitang Chinese Medicines (NYSE: TCM) has had a rough November. Following its earnings report on Nov. 7, investors hammered the stock. From a high of US$12.39 in late October, shares fell over 30% to a low of US$8.60. With revenues up 29% and net profits rising, why did investors show such a foul mood? One reason was:

Quality of Earnings

For the third quarter of 2007 the company reported a “disposal gain on listed shares” of US$536 thousand, accounting for 8% of total net income. The company’s balance sheet showed that “Deposits for acquisition of trading securities” reached US$5.5 million for the quarter, up from zero in December 2006 and roughly 10 times the amount spent by the company for R&D in the quarter. Company management reiterated their intention to continue investing in shares of public companies in the mainland and Hong Kong. The non-recurring nature and increased risks of putting trading securities on the balance sheet did not sit well with analysts or investors.

TCM’s securities investments are neither unusual nor abnormally large according to a report from Zhejiang PharmNet. As reported by Wei Wang Jia, Chinese pharma companies have become increasingly dependent on investment income to boost their bottom lines.

Based on research from market data provider WIND Information [WIND资讯], 40% of the net profit of publicly listed mainland Chinese pharma companies through the third quarter of 2007 was derived from investment income. The research shows that for 74 companies in China’s pharmaceutical and biological products industry, realized investment income was RMB4.2 billion (US$570 million) for 2007’s first nine months, up more than 570% from the same period in 2006. For the companies studied, investment income accounted for 36% of total profits and grew substantially faster than the 13.2% growth rate of operating profits.

The increased investment activity of Chinese pharma companies is not merely due to shortsightedness or speculation, according to Li Lei of the Chinese Medicine Competitive Research Center. “In recent years pharmaceutical industry profits were declining, innovation was expensive, and the main business income was not growing…[The investments] reflect a lack of confidence and lack of direction in the industry.”

“Pharmaceutical companies that over-rely on investment income have almost lost the essence of "medicine", becoming investment-oriented companies. Although presently the investment behavior of pharmaceutical enterprises helps earnings, from the mid-term and even long-term perspective this investment behavior is full of uncertainty. Development of Chinese medicine industry competitiveness will not be dependent on sideline investments.”

Pharmaceutical companies in China are certainly not alone in their willingness to speculate in the public markets. The multi-year bull market in Chinese stocks has lured in managers from many companies. For investors in these companies, due diligence is clearly required. While the bottom line EPS is important, investors need to keep a close eye on factors such as operating earnings, cash flow and the balance sheet. “Caveat Emptor” remains the theme for investors.

Disclosure: Author has no position in stocks mentioned