Natural Healing Pays Off

08/26/2008 12:00 am EST

Focus: GLOBAL

Vahan Janjigian

Editor, Bottom Line's Money Masters Stock Report

Vahan Janjigian, editor of Forbes Growth Investor, says a rising standard of living in China boosts one company's earnings power.

American Oriental Bioengineering (NYSE: AOB) is a pharmaceutical company specializing in manufacturing and marketing plant-based traditional Chinese medicines (TCM) in China. Plant-based pharmaceuticals (PBP), medicinal compounds derived from the leaves and roots of plants, generated 82% of first quarter sales.

Approved by the Chinese State Food and Drug Administration (SFDA), PBPs are sold over-the counter and by prescription. Examples include products effective against respiratory disease and others that treat urinary disorders such as bedwetting and incontinence.

Plant-based nutraceuticals (PBN), dietary supplements designed to prevent illness rather than treat it, generated 18% of first quarter sales. AOB sells tablets, powders, an instant coffee containing soy peptides, and nutritional drinks.
 
The Chinese pharmaceutical market has enjoyed significant growth over the past several years as a booming economy has increased disposable incomes and raised living standards. Demand for pharmaceutical products has risen as Chinese people have climbed up the economic ladder. These trends have been accompanied by greater participation in the State Basic Medical Insurance System and increased government spending on health care. AOB has benefited from a general preference in China for TCMs over synthetically manufactured alternatives.

Complementary acquisitions have also contributed to the company's growth. Total revenues over the past three years climbed fivefold to $160 million, while net income hit $43.3 million in 2007. First quarter 2008 net revenues jumped 50.7% from a year ago. Strong OTC sales more than offset slower growth in the prescription business and falling PBN sales.

The gross profit margin contracted 101 basis points to 67.82% due to a shift in the sales mix and higher expenses associated with the integration of an acquisition. However, the operating profit margin improved 12 basis points to 30.89% and net income jumped 46.2% in the quarter.

However, we are focused more on potential growth. Organic sales should rise 30% in 2008, while total sales growth should exceed 50%. Net income is expected to climb by at least 43%.

The company has set aside $16.4 million to fund acquisitions that are already in the pipeline. These should help AOB build scale and expand market share in China's fragmented pharmaceutical and nutraceutical markets.

Greater scale should help AOB build its relationship with foreign pharmaceutical companies, which prefer working with larger companies when signing marketing agreements in new markets. Additionally, revenues could receive a boost from a strategic alliance with Aoxing Pharmaceutical, a China-based narcotics and pain-management pharmaceuticals maker.

Investment risks include the planned issuance of $115 million of convertible bonds, which could dilute future earnings; and the sometimes capricious nature of Chinese laws and regulations.

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