American Oriental Bioengineering: Prescription for Success?

The following is excerpted from a recent edition of Value Investor Insight.

With its 32% operating margins, 36% return on equity and annual earnings per share growth of 40% over the past five years, American Oriental Bioengineering (AOB) might be expected to be riding a wave of investor enthusiasm. Instead, at a recent $9.70, its shares (net of cash) trade at only 10x this year’s estimated earnings. That’s less than half the multiple of the typical Nasdaq stock.

AOB, not surprisingly, is far from a typical stock. While traded in the U.S., the company operates only in China, where it is a leading seller of plant-based pharmaceuticals and nutritional supplements. The majority of its products are branded and sold over-the-counter for such everyday problems as nasal congestion, gingivitis and menstrual cramps.

“Think Tylenol, not Zocor,” says Shaumo Sadhukhan of hedge fund Lotus Partners. Since going public through a reverse merger in late 2001, the company has pursued a straightforward business plan: using capital raised in the West, acquire cheap branded healthcare franchises in China and then upgrade marketing, distribution and technology to dramatically improve sales and operations. For example, anti-viral product manufacturer HSPL, bought by AOB in 2004 for $7 million, is expected to earn about $10 million in operating profit this year, says Sadhukhan. GLP, a women’s health company acquired for $24 million in 2006, should have pretax earnings this year of at least $15 million. “Will every deal end up being for 1-2x operating income after AOB has had a chance to improve operations? No. But they bring unique assets and expertise to any deal they decide to do,” says Sadhukhan.

The list of potential risks is long, of course. There is considerable uncertainty about longer-term regulatory impacts on drug pricing and distribution as the Chinese health care system rapidly modernizes and consolidates. For the time being, says Sadhukhan, AOB has been a beneficiary rather than victim of regulatory fiat, as its reputation as a strong operator positions it well to capitalize on the state’s push to consolidate the country’s thousands of small, profitless pharmaceutical companies. He also doesn’t see Western-style pharmaceuticals pushing aside the traditional remedies sold by AOB anytime soon. “They’ve been taking traditional Chinese medicines for thousands of years – it’s part of Chinese culture,” he says.

The company has also been subject to a wide variety of negative comment about its public listing through a reverse merger, allegations of impropriety on the part of certain of its board members, and charges that it at times has made overly aggressive claims about the effectiveness of its products. Its record of raising capital for acquisitions through dilutive financings has also been a concern, says Sadhukhan.

While many U.S. investors would consider investing in any purely domestic Chinese company to be a leap of faith they aren’t prepared to make, AOB makes a concerted effort to allay such fears. Chief Operating Officer Lily Li speaks fluent English and makes frequent trips to the company’s Madison Avenue office in New York City. Both the Director of Finance and newly hired Chief Strategy Officer are based in New York. None of that, however, is a replacement for on-the-ground research in China, says Sadhukhan: “You have to be there to get truly comfortable that the company is real, the products are real and that the story they’re telling American investors checks out,” he says. “That can only come from visiting distributors, pharmacies, hospitals and their manufacturing plants.”

In some ways, AOB’s risk profile is lower than that of its U.S. pharmaceutical counterparts. Its over-the-counter products rely not on patents, but on strong brands, an extensive distribution system and, in many cases, government controls on competitive entry to maintain leading market positions. In addition, instead of spending heavily on research and development with highly uncertain outcomes, AOB's business model involves selling established branded products with recurring sales demand.

AOB’s growth prospects remain impressive. Per capita healthcare spending in China is now about $110 per year and is poised to grow rapidly as disposable incomes increase and access to affordable healthcare products and services expands. Even assuming modest decreases in operating margins as its markets become more competitive, Sadhukhan expects the company’s earnings to continue growing at least 30% per year through organic growth, continued market-share gains and timely acquisitions.

On estimated revenues of $240 million this year, Sadhukhan expects AOB to earn net profits of $62 million, or 79 cents per share. The company has excess cash on its balance sheet of nearly $150 million, or $1.88 per share, after subtracting a small amount of debt and an announced, but still to be made, joint-venture investment.

“At today’s share price, excluding net cash, you’re paying 10x earnings for a company growing its bottom line at 30% per year and which requires little capital to grow,” says Sadhukhan. “If this were a U.S. company, it would trade for 30x earnings. Whatever reasonable discount we apply because it’s a Chinese company, the fair value here is significantly more than $10 per share.”