The Short Story
China Medical Technologies (CMED) is a fast growing Chinese in-vitro diagnostic [IVD] company that possesses a compelling business model and low cost operations to take advantage of China’s continuing urbanization and rising incomes.
This company has adept management and strong ties to various research institutions in China that allowed it to develop a high margin and recurring revenue product base that bodes well for growth not only in China but also in other areas throughout Southeast Asia, Europe and the United States. In its young history China Medical exhibited devotion to shareholders by paying an increasing annual dividend. This notion is buttressed by the fact that chairman, CEO and founder Xiaodong Wu owns over 25 percent of the company. Any investment in this company is not without risks as China’s economy may be overheating and inflation may diminish future economic growth.
In Depth Analysis
The Business:
Investing in China has almost become cliché, but China Medical is an interesting company with excellent prospects that has undergone an exciting transition since the company went public in 2005. Take a quick look at the chart to see the dramatic swings the company’s stock:
*chart from nytimes.com
After the IPO, CMED’s stock price tripled but investors quickly lost enthusiasm. The process repeated in late 2007 until the run was hampered by an earnings release that disappointed investors. Throughout these dramatic stock swings, the Beijing based company made drastic changes to their business plan. To give you an idea what exactly what changes went on at headquarters, it would first be useful to examine the different sectors of the business.
HIFU:
HIFU might sound like something Kung Fu Panda’s lead character Po would eat with fried rice and tofu but it’s actually an advanced tumor treatment therapy system. Tumor tissues can only survive up to 109.4 degrees Fahrenheit (43 degrees Celsius for all you scientists and international readers out there; in this regard I apologize for my ignorance). Basically what the HIFU system uses intense ultrasound waves to the heat the tumor tissue to 140 – 158 degrees Fahrenheit (sorry Celsius users, but I don’t have a conversion for you on this one). At 140 degrees Fahrenheit the tumor cells are destroyed in one second. The HIFU system is non-invasive, and only a limited temperature increase occurs on body tissue surrounding the focal point. It’s also a cost-effective treatment for a wide range of tumors. This treatment system competes with traditional tumor treatments such as surgery, radiotherapy and chemotherapy. The system has been approved in China since 1999 and is undergoing approval in the United States with clinical trials conducted at the University of Washington. The system is currently under review with the American FDA. In FY 2006 HIFU sales accounted for 61 percent of revenue and in FY 2007 that number dropped to about 40 percent.
Currently, CMED is working with other research institutions in China to determine if the HIFU system increases the effectiveness of other tumor treatments. Even though there are other HIFU systems on the market, CMED’s system treats a wider range of tumors than those of competitors and is more attractively priced. If you’re thinking that HIFU is a promising product with potential, you’re right. However, thus far I have neglected to mention one little caveat: each hospital really only needs one HIFU system and once the purchase is made there are no other profits to be won. This is a huge problem for both investors and management. Products that do not possess re-occurring revenue possibilities are extremely limited in their growth potential. That’s exactly the position that CMED was in until it made changes to the company.
ECLIA:
CMED purchased ECLIA technology in 2004 and started marketing the system that September. ECLIA is an in-vitro diagnostics (IVD – basically means the detection and monitoring of disease through use of bodily fluid/tissue and analysis) system that includes an ECLIA analyzer and reagents (I’m not going to share the complicated scientific name for ECLIA, but just the fifth grade version that I easily understand). The ECLIA analyzer detects minute levels of light created by combining the reagent with bodily fluid to produce diagnostic results. The reagents are chemically active and are formulated to create different reactions with blood or other bodily samples depending the whether or not a certain condition is absent or present.
That might sound quite complicated due to some technical terms but the idea is rather simple: Reagents are mixed in a microplate with the bodily sample and a chemical reaction occurs that emits light. The ECLIA analyzer then determines based on the results of the reaction, if the patient has the condition for which they were tested. A different reagent is needed to test for a different disease. The ECLIA system is used to test for infectious diseases such as Hepatitis B, cardiac diseases, infertility, growth disorder, liver fibrosis, thyroid disorders and various types of tumors. Overall the company currently has 70 different reagent kits and expects to have 90 by the end of fiscal year 2008. For FY 2007 the reagent kits made up 90 percent of the revenue for CMED’s ECLIA division. FY 2007 revenue for ECLIA was RMB289.9 million, a 76.5 percent year-over year increase. In the last fiscal year ECLIA accounted for 42 percent of CMED’s total revenue.
The reagent kits present a sweet re-occurring revenue high margin opportunity as a new kit is needed every time a test is performed. The ECLIA system was the start of CMED’s transition away from a manufacturer of medical systems to a higher margin in-vitro diagnostic company.
FISH:
The company continued their transition into an IVD firm with the acquisition of FISH technology in June 2007. The FISH program uses a FISH probe (DNA Probe) which is mixed a patient’s bodily fluid to allow medical practitioners to detect an absence of a DNA sequence in a specific chromosome with the use of a fluorescent microscope (again, it may sound complicated but it’s really quite intuitive: the test simply just checks if DNA is abnormal). Currently, China Medical uses the FISH probes to test for bladder cancer, breast cancer, cervical cancer, leukemia and pre-natal conditions. CMED manufactures and sells the FISH probes which, like the ECLIA reagents, are a re-occurring high margin product. Previously, CMED also sold the fluorescent microscope required for FISH analysis even though they did not manufacture it. They have reversed this strategy and allowed hospitals to purchase the microscopes directly from the manufacturers which CMED anticipates will allow for greater penetration of the microscopes and wider opportunities for FISH probe sales.
Sales & Marketing; The Industry and the Competition:
Previously for the HIFU and ECLIA system, China Medical sold their products directly to distributors and did not have a direct sales force. The company did create a direct sales force for its FISH products. The company’s first direct sales force encompasses 200 hospitals and CMED has plans to increase the number to 500 by the end of fiscal year 2008. A worthwhile sales organization is vital to a firm’s success, but it is often overlooked by investors. After all, without a solid sales team even a great product will sit on the shelf and collect dust for years. The creation of a sales force will not only create opportunities in the FISH business, but in other businesses as well. For example, previously CMED only marketed their ECLIA system to middle-sized hospitals, but now they plan on leveraging the FISH salesman to sell the ECLIA reagents to large tier one Chinese hospitals. Also, CMED just introduced a rental-agreement for small hospitals where the firm gives the hospital the ECLIA analyzer for free but requires them to purchase the reagents exclusively from China Medical. If you are having business class flashbacks, this is the same time-tested model used by Gillette to sell their razor blades and HP with their printers and ink cartridges. At last count there were over 18,000 small hospitals so the market for CMED is extensive. CMED also has expects growth opportunities for HIFU through the direct sales.
The fields that CMED competes in are highly competitive with many of the other firms being based outside of China. The HIFU system competes with such companies as EDAP and Focus Surgery while ECLIA’s rivals include Abbott Diagnostics, Bayer AG, Beckman Coulter, Johnson & Johnson and Roche. Additionally, the FISH line also competes with Abbott and Roche. These are very well run companies that likely understand the huge urbanization taking place in China and the large amount of money the Chinese people are going to spend on healthcare in the near and long-term future.
China Medical does possess many competitive advantages that may make them better suited for success than their competitors in the Chinese market. The first and most important is the cost of manufacturing. CMED has substantially lower input costs (read wages and raw materials) than most of their competitors. This allows the company to price their products lower than that of other firms. This is evinced by their pre-tax margins: China Medical has a pre-tax margin of 44 percent compared to 33 percent for Roche, 17.9 percent for Abbott and just 15.4 percent for the S&P 500. Recall that the company with the highest pre-tax margin in an industry is by definition the low cost producer. Additionally, CMED is using research and development to expand their ECLIA reagent and FISH product lines which should further add differentiation between themselves and their competitors.
Research & Development and Growth:
Above I touched on how necessary an important sales organization is to a firm’s prosperity, but equally important for a medical company are research and development capabilities. In this regard China Medical has successfully leveraged their close connections with Chinese national research institutions (with more than a billion people and growing academic community this is clearly a powerful ally to have). In particular, CMED continues to work with PUPH, a leading medical research institution and hospital associated with Peking University. In fact, China Medical purchased the HIFU and ECLIA technologies from PUPH and many of the leading PUPH scientists who worked on those specific projects are now CMED employees. Additionally, China Medical is collaborating with the Chinese Academy of Sciences Institute of Acoustics on new product development.
The company also is swiftly developing its own research efforts. Since 2003 the CMED’s annual R&D spending has increased almost 30 times! In FY 2007 research and development spending increased 29.9 percent year-over-year.
As the company continues to develop into an in-vitro diagnostics enterprise new research and development will largely be focused on creating new reagents for ECLIA and FISH probes. For example, China Medical hopes to launch a new FISH probe to test for prostate cancer next month. This will expand CMED’s products line adding to future growth.
Some evidence of management’s effectiveness with regard to the growth by acquisition strategy is return on equity, return on assets and return on capital which are all well above the industry averages and those for the S&P 500.
CMED has delivered robust growth in the past with FY 2007 revenue increasing 67.4 percent. Obviously this type of growth is not sustainable, but management does expect FY 2008 revenue to jump between 30 and 34 percent.
To achieve such high growth goals management hopes for increasing penetration of their ECLIA franchise as well as rapid expansion of the FISH product line.
Management acquired all of their current product lines through acquisition and will likely obtain further properties in a similar way. For acquisitions, CMED is targeting technologies that are high margin and have potentially large markets that fit into their current in-vitro diagnostics framework.
Management and Profitability:
CMED has an experienced management team led by Xiaodong Wu who is the company’s founder in CEO. Mr. Wu owns over 26 percent of the company which should ensure that shareholders and the firm’s executives share the same interests. Management has also done an excellent job of keeping costs down. For FY 2007 general and administrative (G&A) expenses were up 36.2 percent year-over-year. This seems like an exorbitant increase, but is rather quite reasonable when you consider that revenue jumped almost twice that amount. Furthermore, for the fourth quarter of FY 2007 G&A expense actually decreased by 10 percent. One of CMED’s greatest advantages is its low cost of operations. Going forward the change in G&A expenses with regard to revenue growth may tell us if the company is successfully keeping costs in check as the company expands.
One of the benefits of China Medical’s transformation into a re-occurring revenue in-vitro diagnostics company is the high profit margins. For FY 2007 the firm enjoyed gross margins of 62.2 percent. This number was down from the previous year’s 72.2 percent. Management blamed the drop off on the launch of their new FISH product line. On a brighter note, margins increased in the third and fourth quarters of the last fiscal year and management expects the trend to continue going forward. Also, a change in China Medical’s tax rate affected margins.
The Financials
The Income Statement:
The income statement shows CMED’s fantastic growth which I highlighted above. Going forward management expects adjusted net income growth of 35 to 40 percent. As you may recall I previously noted that management was guiding revenue to grow 30 to 34 percent. The difference arises since management expects margins to rise next year. It also may be important that management has beat estimates in the past in addition to revising them upward. It is my experience that companies that beat earnings consistently continue to do so in the future.
The Balance Sheet:
The first look at the balance shows the CMED’s 97.36 million dollars in cash and 150 million dollars in debt. Clearly, the large amount of debt relative to cash is not a positive sign, but most of the long term debt funded debt in the form of convertible notes. This allows China Medical some wiggle room in times of trouble (if all their debt was financed by banks, creditors would start calling at the first sign of trouble). Also, there has been an increase in the number of shares outstanding as the company increased its stock compensation plan.
The Cash Flow Statement:
Unfortunately CMED did not produce a complete cash flow statement with their latest annual filing with the SEC (CMED gets two thumbs down here), but looking at the FY 2006 complete annual report shows large increases in free cash flow from RMB140.962 million in 2005 to RMB324.716 in 2007. Compare this to net income of RMB118.443 in 2005 and RMB289.718 million in 2007. The ratio between net income and free cash flow shows the “strength” of China Medical’s earnings on the income statement. Since CMED’s earnings have shown strength in the past, I’m not worried about the current cash flow statement but I am anxiously waiting the firm’s latest report.
The Risks and Investing in China:
Besides the competitive nature of the industry and dangers of the growth by acquisition strategy that China Medical partially employs the biggest risk with this investment is the Chinese economic system. China is such a “hot” spot to invest that random people off the street tell me that’s where I should have my money, but there are many downsides to their economic system. First, China is not a democracy and the government has the right to seize an asset anytime they want. Granted the likelihood is small, but the probability of it happening is still greater than zero. Besides certain geopolitical concerns there are also issues with the Chinese economy. Even though the economy is growing quite rapidly, inflation is a major hitch for the developing state. Even according to the central government’s statistics inflation is running rampant and no one knows how accurate those statistics really are. One strategy that the government is likely to employ is letting the renminbi, the Chinese currency, appreciate against the US Dollar and the Euro. This may increase profits for China Medical (in terms of US Dollars) but will make it easier for foreign competitors to compete (as their products will become cheaper in China).
Valuation and Buying Point
China Medical’s valuation point is extremely attractive. With new reagents and probes coming onto the market and the new direct sales force CMED may see a surge of profits in the near future. International sales may also be a boon for revenue growth as well.
Since China runs large trade and budget surpluses, the Chinese currency will likely continue to increase against the dollar. This may add an extra benefit for American investors.
Also, the company trades at an appealing level according to traditional metrics. The company trades at just 25 times earnings and if you adjust for amortization and stock expense that metric drops to just 20 times earnings (as shown in the chart above). Given China Medical’s growth prospects and its newly proven success with ECLIA and FISH these are extremely attractive levels. At these prices it appears that CMED is trading below its true value.
Conclusion
Given the large growth prospects and sound management China Medical offers investors great growth at a reasonable price as it continues to take advantage of China’s flourishing middle class.
Disclosure: Chandler Lutz owns shares of China Medical Technology
