Sino Biopharmaceutical (HK1177) manufactures and distributes pharmaceutical drugs that combat cardio-cerebral diseases and hepatitis. The company operates in China. Historically, it has been difficult to find any of the following metrics in a company: 1) Selling at a discount to cash, 2) 11% dividend yield for a well capitalized company, 3) 50%+ earnings growth for a P/E of 6. Surprisingly, Sino provides an investor all three metrics and has gross margins in excess of 80%, net profit margins in excess of 20%, and a diversified set of patented products with accelerating growth.
Chinese Pharmaceutical Market
The company is well positioned to benefit from the continued increase in healthcare spending in China. There are several characteristics that make the Chinese drug industry attractive from an investor perspective including:
- Growing Significantly Faster than GDP - Over the past 10 years the Chinese Pharmaceutical industry has grown revenues at a compounded annual growth rate of 17% and profits at 22%. Thus revenues grew at 1.7x GDP and profits grew at 2.2x GDP according to DBS Vickers.
- Strong Underlying Demographics – China has the world’s largest population with 1.3 billion people. The percentage of the population over 65 has increased from 7% in 2000 to 9% in 2006 and is equal to Japan’s population.
Fragmented but Consolidating – There are currently 4,000 domestic drug manufacturers and 6,000 drug distributors. It is estimated that the top 100 firms account for just 34% of total revenue. There government is leading a drive towards improving quality and raising standards which should lead to significant consolidation. This can be seen by both the implementation of the GMP manufacturing standards as well as the execution of the head of the Chinese equivalent of the FDA (SFDA) for the fraudulent approval of ineffective drugs.
- Enormous Potential from Small Base – China’s spending on all levels of healthcare is very low by Western standards on both a relative and absolute basis. According to the World Health Organization China spends less than 4% of GDP on healthcare vs. 6% for Mexico, 10% for Germany and 15% for the US. On a per capita basis, drug spending is roughly $10 per person per year. The Chinese drug market is approximately 2% of the size of the US drug market at $13B annually. As the Chinese economy matures and the country builds out its social safety net, healthcare is likely to be a large beneficiary. In addition, as incomes rise, healthcare is one of the first uses of discretionary income and is very defensive in nature.
Policy Changes Helping to Drive Growth - China uses two basic insurance schemes. The NCMS for rural areas covers roughly 50% of the rural population. The urban population is covered by BMIS which covers 70% of the urban population. The government has announced the intention to cover 100% of the country by 2010. Both insurance schemes have significant copayment and burdens on the individual. In fact, according to the Ministry of Health, the government currently represents 18% of healthcare funding, employers represent 30% of healthcare spending and individuals represent 52%. Given the large uncovered population and the percentage funded by individual, healthcare in China is not being propped up by the government at unsustainably high levels.
Management Team
Sino Biopharmaceutical is lead by President and Chairman Tse Ping. According to the Prospectus issued in 2000, he has been involved in the Pharmaceutical industry since 1991 as an investor. He has been CEO of another publicly traded Chinese drug company. He controls and is involved with at least three other smaller private pharmaceutical companies. Sino Biopharmaceutical is the only public company and is the largest. Mr. Ping currently controls in excess of 47% of Sino Biopharmaceutical stock.
Overview of Products - Chinese drugs are generally segmented into “Traditional Chinese Medicine” (TCM) which are based on natural herbs and tradition, and the pharmaceutical industry which has SFDA approvals and patents. Sino Biopharmaceutical participates in the intellectual property intensive pharmaceutical industry. Their breakdown of products is as follows:
Hepatitis is the highest revenue drug segment. Hepatitis drugs currently generate 48% of sales with 20% of sales coming from a single capsule product called Mingzheng.
Cardio Cerebral is the second strongest revenue generating segment at 19% of 2008 H1 revenue.
Oncology, Diabietes and Other constitute the balance of the drugs produced.
There is also a strong pipeline of new drugs including 5-6 drugs to be released in the next two years, each of which could contribute in excess of 10% of incremental revenue. The pipeline is difficult to value. Fortunately, at current valuations and growth of existing products, a strong pipeline is not necessary for an attractive investment return.
Recent Performance and Historical Growth
In the first half of 2008, Sino Biopharmaceutical increased sales 109% y/y and profits 56%. Profit growth trailed revenue growth primarily because of an increased tax rate. Interfax China, an independent Chinese research firm, reported that in the first half of 2008 Chinese hospitals increased prescriptions by 10% y/y and drug expenditures by 32%. This is not a perfect comparison since not all of Sino Biopharmaceutical products are distributed in hospitals, however, it is illustrative that the drug industry’s growth has remained strong and that Sino Biopharmaceutical has significantly outpaced its growth. Below are charts showing consistent five year sales growth CAGR of 21% and profit from continuing operations five year CAGR of 34%. By all metrics, this is a healthy business that should command higher multiples.

Sales Growth of Continuing Operations Growth of Profit from Continuing Operations







Risk
Given the valuation at net cash and reported sales growth in excess of 100%, questioning if this company is simply a fraud is fair and prudent. A couple of facts limit the likelihood. Ernest and Young is company’s auditor. This is not the norm for Chinese companies, many have smaller and far less reputable auditors. In addition, the company pays a significant dividend. A fraud would typically not pay a dividend, and would generally issue additional shares on a frequent basis, which has also not happened since 2002. Lastly, in addition to strong insider ownership, Goldman Sachs has a 9% ownership stake. There are several tangible risks to a Sino Biopharmaceutical investment including:
Policy Changes – Current policies driving increased access to healthcare as well as consolidation around drug companies are helpful to Sino Biopharmaceutical. The government has a “Nationally Essential Drug List” (NELP). This is a list of approved drugs. There is a restructuring of the healthcare industry being debated in China. To the extent that there are large cuts in prices the government will pay for drugs could significantly hurt Sino Biopharmaceuticals profitability. The government is actively encouraging domestic R&D and the development of its pharmaceutical industry, so draconian cuts are not expected, however, there is a risk.
Poor Intellectual Protection – Sino Biopharmaceutical owns a total of 132 invention patents. China has a poor history of protecting intellectual property. There is a risk of unenforced patent infringement. With the focus on improving the quality of manufacturing and supporting the pharmaceutical industry, infringement is less rampant, however it remains a risk.

Use of Cash - The company currently trades for less than the value of the net cash on the books. There are three potential risks. The first is that management invests the money poorly. There is some evidence of this. The company has proposed using up to 1/3 of the cash balance on a project turning coal into methane gas. Given the governments current reluctance to approve these types of projects and the decline in oil prices it is unlikely that the project is funded. However, it is indicative of a willingness to explore the use of cash on unrelated activities. The second risk is that the cash figure could be overstated because a large portion belongs to their minority interest holders. The leading sell side analyst which has covered the company for several years claims the cash is attributable to Sino and not the minority interests because the vast majority of it came from the sale of a subsidiary to Bausch and Lomb and cash generated from earnings is generally paid out in the form of dividends (60% payout). The company issued financials are not transparent enough on this issue and the company has not responded to two separate inquiries. To be conservative, one could discount the cash by 15%, which is in proportion to the minority interests equity on the balance sheet. This still yields $.70 per share. The third risk is that management takes the company private. Insiders own or beneficially control just over 50% of the outstanding shares and could take the company private at the currently depressed valuation using the strong balance sheet and only a very modest amount of leverage. This scenario limits the upside of any investment.
Governance – The company’s chairman controls two companies which have drug research and development deals with Sino Biopharmaceutical. In addition, the chairman’s wife is on the board of directors. Both of which are indicative to potential self dealing. In addition, minority interests share of profits are increasing and there is almost no transparency into how or why this is happening.
Liquidity/Hong Kong Discount – Sino Biopharmaceutical is listed on the Hong Kong stock exchange. Trading volumes on a US dollar basis are quite low. Ranging from $250K to $1M USD. This creates barriers to establishing a large position and can increase volatility.
Valuation
Shares of Sino Biopharmaceutical have sold off significantly since September 1st along with the Hong Kong markets. Sino is down 42% vs. 32% for the Hang Seng Index, despite reporting strong earnings and beginning with multiples far below the index.
PEG - Using the historical sales growth rates from continuing operations of 21% implies a current year PEG ratio of .31. This is conservative given the 109% growth in the first half of 2008.
Dividend Yield – The company typically pays out 50-60% of earnings in the form of dividends. The current estimated dividend yield is 11%. In June, the implied dividend yield was 5% and in the past year it has traded below 3%.
Price to LTM Normalized Earnings – The company currently trades at 6X trailing normalized earnings. According to Capital IQ, the company reached its lowest point on October 27th at 5.5. In the past four years the high has been 48 and the average has been 20.
Discount to Tangible Book Value – The company has $.87 cents per share of tangible book value, implying a 10% discount to book value – historically shares trades at 1.5 to 2.0 tangible book value.
Intrinsic Value - Given the high gross and net margins, strong balance sheet, and rapid revenue growth, even in a depressed multiple market, a valuation of 6X forward earnings + cash (discounted by 30%) would be a very reasonable valuation. This would imply a price of $1.74 or a 120% return. A more aggressive valuation of 15X earnings + cash (discounted by 30%) would imply a price of $3.36 and a return of 325%. For an investor with a longer time horizon, if the company continues to compound earnings growth at 34% (5 yr CAGR of profits from continuing operations) and the company and gets a 20 multiple on earnings Sino Biopharmaceutical has the opportunity to be an 8 bagger in three years for a company with limited downside selling below cash on the books.
Catalysts• Cancelling of the cash intensive non-core coal project
• Continued strong earnings growth