China Medical: A Cure For My Portfolio?

I recently watched a CNN special investigative report, Planet in Peril, Pollution in China, on how a small village, Lianggiao, now known as 'cancer village', has become overridden with cancer as a result of an iron ore mine upstream. The report said that the Chinese ministry of health reported that increased pollution has made cancer the leading cause of death in the country causing nearly 1.5M annual deaths. This report, combined with the Chinese Communist most recent five year plan, which pledges to increase healthcare for more citizens, got the gears turning, "How will the market serve this issue and who will do it?" I asked myself. A myriad of companies materialized, but only a few, including China Medical Technologies (CMED), sparked my interest.

The following are highlights of China Medical Technologies' business:

• Average 72% revenue growth over the last four years
• FY08 Guidance: $118M in revenue a 64% increase and $55M in earnings a 45% increase
• Their HIFU (High Intensity Focused Ultrasound) has been used to treat various types of cancer for over 40,000 patients in China since 1999
• The Korean Food and Drug Administration recently granted approval for China Medical Technologies HIFU procedures.
• The United States Food and Drug Administration is currently administering clinical trials of the technology
• Their ECLIA business, which is a diagnostic tool, is just ramping up and growth has hardly been recognized.
• The chairman, the CEO, and the founder is Mr. Xiaodong Wu owns 26% of the company and has been with the company since it was only an idea in the early 90s

The Business

China Medical Technologies develops, manufactures and markets medical devices used for the treatment of cancer, diagnosing diseases, and detection of genetic information. The technology that would become China Medical Technologies was conceived in the early 1990s by PUPH, a leading medical research institution and hospital in China affiliated with Peking University. The initial research was funded by Beijing Chengxuan, a company controlled by Mr. Xiaodong Wu who is now the chairman of the board of directors, chief executive officer and a significant shareholder. After incubating the technologies through 90s, the initial concepts would eventually become YDME Beijing, which was incorporated in China and commenced business operations in July 1999 along with its first sale. As the approval of its treatments gained traction world-wide the company had an initial public offering in August of 2005 and became known as China Medical Technologies, listed on the NASDAQ exchange with an American Depository Shares [ADS].

The company has three areas of expertise: High Intensity Focused Ultrasound [HIFU], Enhanced Chemiluminescence Immunoassay Technology [ECLIA], and Flourescent In Situ Hybridization [FISH].

HIFU – HIFU is a procedure using high-intensity focused ultrasound to heat and destroy cancerous tissues or tumors. Much like your household microwave heats water molecules only the HIFU system will heat cancerous tissue only and not neighboring areas. The company’s HIFU therapy system is approved by the SFDA (China equivalency to the US Food and Drug Administration) to treat liver, breast and kidney tumors, solid tumors in the pelvic cavity or on bone and tumors in the four limbs or superficial tissues. The company’s main customer for this device has been the Chinese government owned hospitals, but the device has recently been approved by the Korean Food and Drug Administration [KFDA] and the device is currently undergoing human clinical trials in the US.

ECLIA – ECLIA is similar, but slightly more advanced than a better known procedure known as Enzyme-Linked ImmunoSorbent Assay (ELISA). The ECLIA system is a process used to diagnose various thyroid disorders, diabetes, SARS, hepatitis, Down syndrome, liver fibrosis, tumors, as well as to assess the effect of digoxin, a widely used drug for the treatment of heart failure. This process consists of reagents that will react with a sample and an analyzer which analyzes results. As you could imagine the analyzers are sold at the lower margins while the reagents are much higher, reminds me of the printer and printer cartridge scheme.

FISH – The FISH imaging analysis, like ECLIA is a diagnostic technology that analyzes DNA for deviations. FISH technology has been used in western hospitals for decades and is now becoming more common in China. The technology can be used for prenatal and postnatal diagnosis, and early detection and prognosis of various cancers. The FISH technology currently offered is used to detect various genetic syndromes and cancers including breast cancer, bladder cancer, cervical cancer, leukemia and multiple myeloma.

HIFU represented 81%, 66% and 61% of total revenue over 2005, 2006, and 2007. Last quarter HIFU related revenue was only 43% while the ECLIA contributed 43% and the FISH technology added another 12%.

The Financials

At first glance it is easy to see you would not buy this company for the balance sheet, but you might for its fast growing income statement and upcoming new market opportunities.

• Market Capitalization: 1.15B
• Price to Earnings: 28
• Book Value: < 0
• 52 week High: $48.25
• 52 week low: $21.65
• Long term debt: $161M
• Current price: $42.07

Management

The chairman, the CEO, and the founder is Mr. Xiaodong Wu who has been with the company since before it was a company and just an idea in 1989 and at the ripe young age of 51 may have many more years left at the helm. Mr. Xiaodong Wu’s 26% shareholder status is an important reason for my position with the company otherwise the ‘skin’ in the game factor may be lacking. Mr. Xiaodong Wu has surrounded himself with a capable management team that includes the Chief Financial Officer is Mr. Takyung (Sam) Tsang a former KPMG and Ernst & Young manager who is a Certified Public Accountant in both the US and Hong Kong. The Chief Operating Officer is Mr. Minshi Shen, a sales man with industry relationships, who rose through the ranks of Shell (China) Co. and then General Electric Healthcare division. The most recent addition Dr. Chen Zhong is the Chief Technology officer who received his medical degree in China and then postdoctoral work in the US where he held several university and private positions in cytogenetics, pathology, and biotechnology. The stewardship that the leader has provided through the years combined with the well connected and US influenced management team is the right combination to excel the company to fill out the potentially all inclusive company name - China Medical Technologies.

Risks

Taxes – The Chinese government, in an effort to promote ‘hi-tech’ industry, provides a tax rate of 15% to those duly noted companies, otherwise its 25% or higher. The company believes it will continue to maintain the designation as ‘hi-tech’ otherwise the tax rate will increase and earnings will be adversely affected.

Competitors – In a new and growing market such as HIFU, competition may not always be bad because it contributes awareness, acceptance, and further testing to verify results. In Europe the most well founded competitor is EDAP-TMS who received European CE in 2000. However, it s noteworthy that EDAP-TMS may be more of a partner than a competitor after they signed a 4 year exclusive deal with China Medical Technologies to market and distribute their devices after European CE approval. Other European competitors include Focus Surgery who has European CE approval and like China Medical Technologies is in US investigational clinical trials. InSightec is another US and European competitor who has received FDA approval for the usage of the technology to treat fibroids and is also undergoing clinical trials to treat cancer. Chinese based competitors include Chongqing Haifu Technology Co., Ltd.; and Shanghai A&S Science Technology Development Co., Ltd.

On the ECLIA side of the business where the technology is widely accepted the competitors are more typical medical device companies that include Abbott Diagnostics, Bayer AG, Beckman Coulter, Diagnostic Products Corporation, PerkinElmer, Inc., Johnson & Johnson and Roche Group.

Slowing revenue/income growth and profit margin erosion Revenue and net income growth has slowed since 2004 and without further advances in HIFU approvals or if the potential of the diagnostics side of the business is not realized I am concerned the trend may continue and the lofty share price unsupported.

China boom goes bust – China has experienced undeniable growth and the concern is that regardless of the success of this company, or even more so if it fails, a busted fortune cookie would result in an across the board hair cut of valuation ratios.

Opportunities

Market Growth (China) – As China makes strides to modernize its healthcare the opportunity for growth from within its own country is staggering given the large population. In a KPMG report, "China, Land of Opportunity for Medical Equipment Suppliers" it is noted that the market has grown from $9bn to $17bn from 2003 to 2008 and is set to continue growth at this double digit pace. To date, over 40,000 tumor patients, including patients with pancreatic, liver, breast, kidney and other solid tumors in pelvic cavity, received treatments by using the Company's HIFU tumor therapy system in China.

Market Growth (Korea) – In demonstration that the Company’s HIFU successes is not limited to the home court China advantage it was announced that the Company has received official approval from the Korean Food and Drug Administration [KFDA] to market its HIFU tumor therapy systems for the treatment of liver cancer, pancreatic cancer and uterine fibroids.

Market Growth (Europe and Russia) – In April of 2007 EDAP-TMS, A HIFU competitor, signed a deal with China Medical Deices to be is sole distributor of HIFU machines to Europe and Russia in anticipation of CE approval.

Market Growth (Japan) – As with EDAP and the European and Russian regions, China Medical Technologies has signed a similar deal with Century medical to distribute the HFU system in Japan. The company plans to use the data from the U.S. clinical trials to apply for "shonin" [a marketing authorization approval].

Market Growth [US] – As for the mother of all consumers, the U.S. Food and Drug Administration has given an Investigational Device Exemption application to the Company to use its HIFU tumor therapy system in patients with pancreatic cancer. The clinical trials at the University of Washington Medical Center in Seattle will be a stepping stone towards US FDA approval.

Research and Development – To ensure the future of the Company, and reassure this investor that we have long term prospects, they have signed a ten-year partnership agreement with Chinese Academy of Sciences Institute of Acoustics to build a medical research lab to develop new acoustic medical devices. The initiative can explore diagnostic and therapeutic applications in non-oncology areas. The new lab will serve as the Companies incubator for new commercial acoustic technologies.

Bottom Line

China Medical Technologies is a fast growing company in a newly forming market for cancer treatments and diagnostics. The leadership has the experience to steer clear of the risks and onwards to the boundless opportunities of new markets for their HIFU procedures and developing a diagnostics to compete with the major players. The biggest risk to the investor is the lofty stock price – Buying an initially small position or on jittery market related dips is the best hedge on this company to balance risks with potential market beating returns. Given China Medical Technologies world class cancer treating HIFU technology and their diagnostic capabilities the company is well positioned to benefit from the long term Chinese government led effort to reform health care.

Disclosure: none

Comments

[ehp246:]

Is PE 28 really that "lofty"? I guess you are not a fan of BIDU or RIMM.

2008 Jan 07 09:31 AM

[Matthew J. ...:]

I love RIMM and BIDU, but just not at these prices and that doesn't mean their business or their stock price won't continue to expand. Anecdotal stories of companies like these are far more common than the unknown stories of companies like these fading. There just isn’t enough room for errors in judgment or performance which inevitably happen.

2008 Jan 07 12:46 PM

[Feng:]

thanks for such a well written and informative article !

2008 Feb 25 11:47 PM

[ede:]

I’m currently researching this industry for my company, an investment firm, and to be clear, the cited KPMG report does not say, “the market has grown from $9bn to $17bn from 2003 to 2008.” It was published in 2005 based on data through 2004; $17bn in 2008 is a forecast. That data is from a 2005 report from Datamonitor, which has updated that report for 2007 (reports.manta.com/data...) Nonetheless, there’s no doubt that this market is growing fast and will continue to do so.

I found the most interesting part of that report to be China’s demographic shift, i.e. ageing population. According to the report, “By 2025, the number of people in China aged 65 or over is expected to top 198 million.” You can be sure quite a few of those are going to get cancer.

2008 Mar 04 02:29 AM

[Matthew J. ...:]

ede,

Thanks for the correction I should have said it as you said, "in 2003...forecast..."

Matt

2008 Mar 05 12:28 AM

[Carl S.:]

Why the recent sell off of CMED? They narrowly missed the Wall Street estimates, which IMO were overhyped, and still show room for growth. I have heard pessimistic views that HIFU is slowing in growth, but to me it seems that European and American market will all open up within 1-2 years time.

Not to mention that there aren't any real competitors to this company... they are at the top of their class. The downward trend has been nothing short of amazing and it is below the 200 SMA now.

2008 Mar 05 11:55 PM