*****MUST READ SUMMARY*****
Posted by: ckuratz Date: Wednesday, December 23, 2009 1:44:19 AM
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CHME – A Company in Transition
Nearly a month ago, I composed this investment analysis due to the various facets at hand. Writing down my thoughts helped me get my arms around this company and its stock. It led me to making an investment. I reread this recently to remind myself why I got into it and thought that this might assist others at this time. Where appropriate, I’ve abridged it to make it more current, but for the most part it is the same as when it was first composed. Warning: I am an amateur investor and the ideas contained should be read with this in mind.
The Financial Foundation
For at least the past 3+ years Chinese Medicine Corporation has principally been a distributor of pharmaceutical products. During this time, it has grown its net income (NI) from $4,788M in 2006 to $9,126M by the end of 2008, a growth of 91%. The first 6 months for 2009 were substantially lower than the comparable period for 2008 due to many reasons. Because of a very strong Q3, the 9 month comparison between 2009 vs. 2008 is similar if non-GAAP auditing is applied. Should Q4 resemble Q3, 2009 should outpace 2008 but likely less than the growth rate previously recorded. Nevertheless, CMC management has proven that it can adeptly make money as a pharmaceutical distributor and this provides a sound financial base going forward. This thought should not be lost as the company changes its focus in becoming more of a producer of pharmaceuticals. Management’s announced vision is that its revenue stream will be 30% as a distributor for products manufactured elsewhere and 70% as a manufacturer/distributor of its own products in the future.
The New Direction
CMC is morphing into a different business model. Transformation is being accomplished along several major themes.
First, on October 26, 2009 CMC purchased Life Tech for $8.3M in cash and assumption of $13.2M debt. In my view this was a good deal for at least 3 reasons. (1) Total cost = $21.5M for $25.5M in appraised assets. Therefore, purchase price was at about a 16% discount. (2) “…the Company expects the acquisition to be accretive to earnings, generating revenues of between $ 10.0 million and $ 12.0 million and net profit margin of at least 40% in 2010.” If revenues of $11M are presumed which should generate a net profit of at least $4.4M, net income should generate $3.3M per annum with a 25% tax liability. Hence, Life Tech was purchased at a PE of 6.5, which seems quite reasonable to me. (3) Most importantly, there is a natural synergism that emerges between CMC and Life Tech. Not only are Life Tech’s drug formulary exposed to the well-established distribution system that CMC has in place, but many of the drugs that CMC distributes, particularly those for which it has exclusive nationwide distribution rights, will be able to be manufactured by Life Tech enabling substantially higher margins. This especially fits well with the recent Pakistan deal for Levocarnitine where as many as 2 million vials could be sent annually.
Second, the successful trial distribution of recombinant Aflatoxin Detoxifizyme (rADTZ), demonstrate that this program is now ready to take off after more than 10 years of scientific development. The emergence of this product has been a Chinese government priority. It is among the 863 projects that are considered to be key science projects of China, which explains why it has been fully funded by the National Science Foundation. rADTZ has been developed by Jinan University and Co-Win Bioengineering, a 70% owned subsidiary of CMC. Before year end CMC expects a permit from the Chinese government allowing nationwide distribution for rADTZ. The potential domestic market identified by CMC is immense - believe it or not, it is estimated to be about $200B when the feed, food, health and detection sectors are added together. CMC expects to ship 1,200 tons of rADTZ by 2010 and 4,200 tons by 2011. At a price of $9,500/ton sales for these 2 years should be $11.4M and $39.9M, respectively. Using a speculated gross margin of 80% [the company has recently reported that its gross margin has improved from 65% to 78%], gross profits for these 2 years should create $9.1M and $31.9M, respectively. If operational expenses are at a rate of about 33%, operational income should be approximately $6.1M and $21.4M respectively. Assuming a 25% tax liability, rADTZ net income for 2010 and 2011 is projected to be $4.6M and $16M, respectively.
An offshoot to CMC’s marketing strategy of rADTZ is the potential revenue for licensing. This is its reason for acquiring Chinese and international patents. To date it has collected 3 Chinese patents and patents for Australia, South Korea and South Africa. Patent applications have been registered in 9 other countries. It is conceivable that international licensure rights will substantially grow the bottom line.
Third, earlier in November CMC signed a non-binding term sheet with a private equity firm for up to $59.5M that we will be allocated in 3 tranches. The first stage is for $7.5M @ $3.50/sh which will create 2.14M shares. The second stage is for $24.2M at $2.60/sh creating another 9.3M shares. The average price per share for these 2 stages is $2.77. It appears to be a relative certainty that they will be executed since the company needs the money to buy Life Tech and for working capital to finance its continuing and new growth enterprises. Hence, add another 11.44M shares to the current outstanding count and the new OS becomes 26.8M. The third stage will be implemented if newly identified pharmaceutical companies become acquisition targets, so it will be dismissed for now in my calculations.
Fourth, signs to uplist to a major exchange are underway. The CEO responded to a question during the recent conference call as to what the company is planning with respect to uplisting. He briefly said that CMC expects to uplist to a senior exchange when CHME escalates to $4.
Investment Metrics
Price for CHME on 12/21/09 was $3.30
Using non-GAAP accounting which dismisses the confusing warrant input to the bottom line, the TTM eps = $0.62 (first 9 mo for 2009 + Q4 from 2008), yielding a ttm PE of 4.6.
Forward projections are hazardous since so many assumptions arise. I will use what I consider to be very conservative guesses to drive the results. Some of them have been described in the foregoing text. Assumptions: a) NI from Life Tech = $3.3M; b) NI from rADTZ = $4.1M; c) ignore the 91% growth that CMC has recorded between 2006-2008; d) ignore synergism between Life Tech and CMC to produce and distribute products more efficiently with higher margins; e) ignore increased sales/profits from Pakistan-Levocarnitine deal; f) assume 2009 OS = 26.8M.
With the foregoing conservative assumptions in the previous paragraph, 2010 NI = $3.3 (Life Tech) + $4.6M (rADTZ) + $9.4M (CMC core business without growth between 2009-2010) = $17.3M. EPS = $17.9/26.8sh = $0.65. Obviously, this is very close to my projected EPS for 2009 because the increased earnings were balanced by the increased OS, but I can live with this since very conservative assumptions were applied. This is another way of saying that the downside risk for this investment at this time is low. If the company uplists and the PE doubles to 9.2, stock value = $6, almost double the price on 12/21. Continuing with this conservative look, if all the same input is used for 2011 except for the expected growing revenues for rADTZ, the 2011 NI = $28.7M, EPS = $28.7/26.8sh = $1.07 and pps with PE of 9.2 = $9.8.
However, I am not investing into Chinese small cap stocks for small gains. Having a small downside risk is comforting, but I am obviously searching for stocks that have high potential. To this end make the following assumptions that are more aggressive but still quite reasonable: a) NI from Life Tech = $3.6M (high end of the CEO’s est.); b) NI from rADTZ = $4.9M (using an 85% gross margin); c) presume 50% growth in NI for CMC core operations (the average growth per year from 2006-2008 was 35%, so to grow 50% with the synergism between Life Tech and CMC is very reasonable) = 1.5 x $9.4 = $14.1M; d) without guidance from CMC other than the size of the market at 2M vials/yr for Levocarnitine, I will simply guess that the value for this is NI = $1M; e) increasing the OS and increasing the EPS of $0.05 by using part or all of the remaining $27.8M for the third stage from the Investor. These are obviously more aggressive, but I think very reasonable, assumptions. Applying these metrics will yield and EPS of $0.93 for 2010, 50% YoY growth. Use similar assumptions for 2011 which will yield: a) $3.6M, b) $17.9M, c) $21.2M; d) add another $1M for Pakistan and e) another $.05/sh for use of capital to purchase accretive pharmaceutical businesses. Following these guidelines will yield an EPS of $1.68, a 170% growth in 2 years. I believe that even a conservative analyst would project a PE of at least 15 for a company growing at more than 50% annually for 2 years. If true, value in 2010 = $14 and 2011 = $25.
Although the foregoing analysis shows that there are multiple revenue producers for CHME, anyone interested in this company will be focused on the potential for rADTZ. Although I could be wrong, my assumption is that the company has given guidance that is conservative for rADTZ revenues, particularly when it proclaims that the domestic market size in about $200B…yes, $ billions, not $ millions.
Delving into the rADTZ revenue potential more, the valuation scenarios that I have written about don’t include licensing fees for rADTZ in China and internationally. CMC is proud of its patent portfolio and it obviously intends to gain sales through licensing fees from rADTZ. If the China market is close to $200B, I am imagining a combined China + international market size of perhaps $800B for rADTZ. Just for the fun of it, presume that CMC could capture 1% of this market, or $8B, and that it charges a licensing fee of 1% for the use of rADTZ. This would create $80M in revenues of which CMC would claim 70% [with the other 30% going to minority interest], or $56M. Of course for every per cent increase for either market share or licensing fee, the total revenue multiplies by this factor – e.g. at 5% for either market share or licensing fee, the number grows to $280M. Yes, this is fanciful, but investors like me should be able to dream about this.
I didn't like the recent announcement about the CFO leaving, particularly since he has recently come on board and it appeared to me as if he were readying the company to list on the NASDAQ. Of course it could mean nothing to the investors, but it briefly worried me nonetheless. However, after a moment of contemplation, I bought a few more shares @ $3.4 since it appeared to me as if the stock was resting at this level from its recent rise.
