Thoughts on CMED’s Debt and Equity

On China Medical Technologies’ recent $150M convertible bond offering, I wrote that it was a way to improve the company’s ROE. But I also think as important to strike a correct balance. As of Q2 (ending September 2006) the shareholders’ equity is $171.7M. Even factoring in possible increase of this number going forward, the debt/equity ratio is likely to remain close to 0.8 for quite a few quarters. I consider this a roughly healthy ratio for a fast growing young Chinese medical tech company.

However, the company should strive to maintain a high cash position to ensure good liquidity, particularly for it to be able to weather any possible hard landing or bubble bursting of the Chinese economy. I prefer them to maintain a current ratio of above 4 all the time. And I would not mind if the company still keeps it at 7+ as of now.

With regards to the use of the bond proceeds, an ideal acquisition target would be one that is immediately accretive to CMED’s earnings, and one that is easily integrated. If the acquisition is highly accretive to the earnings, the company might even be able to go after other targets and kick on a rapid and healthy (meaning not having to increase the debt/equity ratio significantly above the 0.8 level) self-sustaining expansion process. But, obviously, that sounds too good to be true at least for now. We just have to wait and see.

The $150M convertible bond offering allows the company to sell up to 5,345,230 ADSs; see the company’s recent F-3 filing. As of Q2 end, total ADSs outstanding was 27,381,116. The following formula can be used to calculate dilution effect:

1 – Original Shares / (Original Shares + Additional Shares)

OR

Additional Shares/(Original Shares + Additional Shares)

However note that the maximum number of ADSs issuable will be offset by the $30M repurchased by the company in association with the debt offering. Assuming the $30M ADSs repurchase occurred at an average ADS price of $26, the net maximum number of additional shares would be 4,191,384. And the maximum potential dilutive effect would be 13.3%. This potential dilution has pressured the stock for the past month and half or so. But since investing in this stock is about investing in China’s growing healthcare need, a long-term horizon is required.

CMED: a Company with a Clear Growth Path

China Medical Technologies (CMED) delivered a blowout quarter once again when it announced financial result for its fiscal second quarter (ending September 30) in mid November. Top line and bottom line grew at 49.2% and 67.0% on gross and net margins of 71.9% and 54.5%, respectively.

This young Chinese company has a track record of excellent financial performance. For the past five quarters since its IPO, CMED has reported revenue growth that ranged between 48.0% and 81.8% and net income growth that ranged between 41.7% and 75.0%. For the past nine quarters (including four before IPO) since it first made a profit, it has recorded a gross margin from 69.8% to 71.9% and net margin from 48.7% to 61.8%. Seven out of the nine quarters had a gross margin of above 70%.

CMED also has a very solid balance sheet. As of Q2, the current ratio and quick ratio stood at 7.29 and 7.18, respectively. The company carried no long-term debt, and the cash to equity ratio stood at 69.1% making it a highly liquid company. However, the same good cash-rich virtue has also made its ROE (Return on Equity) mediocre, which stood at 19.6% (trailing annual figure) as of end of Q2.

To fuel further growth, the company has just closed an offering of $150M worth of convertible bond. $30M of the net proceeds was used to buy back the company’s shares. The bulk of what remains, potentially along with part of the cash reserve, will be used to acquire advanced IVD businesses and technologies. Obviously this will increase the debt/equity ratio (from 0 now) significantly going forward. However, investment return from both the debt and the higher utilization of equity should serve to increase ROE and total return over the long term.

Based on the company’s Q2 earnings conference call, recent press releases, and my own communication with the company, it is clear to me that CMED is positioning itself to be a global player in the Medical Devices arena through the implementation of a coherent set of short, intermediate, and long-term growth strategies. The following is a run down of the strategies being implemented by the company.

A few acronyms used in this article:
HIFU: High Intensity Focused Ultrasound
ECLIA: Enhanced Chemiluminescence Immunoassay
IVD: In-vitro Diagnostics
GMP: Good Manufacturing Practice
IDE: Investigational Device Exemption

Short-Term Strategies

I define short-term strategies as measures that produce result immediately, but might also have a positive impact longer term as well.

• The company recently phased out their second generation (2G) HIFU system and replaced it with a new third generation (3G) system. The new 3G HIFU system is capable of real time tissue temperature monitoring and respiration control. According to the company, the real time temperature monitoring is a first in the world. With this new capability, CMED raised the selling price of HIFU system by 6% starting September.
• They rolled out a new version of semi-automatic ECLIA system. This will enable them to penetrate medium-sized hospitals, which has a higher buying volume and utilization rate for the ECLIA reagent kits they are also selling, thus increasing recurring revenue at higher margin (reagents have a higher gross margin).

Note that these business actions also have positive, intermediate to long-term impacts. The 3G HIFU system might be able to generate sales for CMED for a few years. The new semi-automatic ECLIA system might continue to be sold to smaller hospitals with less capital resources, even after they roll out a fully automatic system mid this year (2007, more below).

The new semi-automatic ECLIA system increases material cost by 60%. However, CMED is selling them at similar price as the old (also semi-automatic) system. This will decrease gross margin on ECLIA systems. However, the company expects this to be offset by the increased margin from the 6% price increase in HIFU systems, which account for 60% of revenue now. By maintaining the price of the new ECLIA system, CMED is also maintaining the sales momentum of the ECLIA business. This can be a smart decision since increasing installation of ECLIA analyzers also increases the recurring revenue from the sales of ECLIA reagent kits. Particularly when you realize that CMED’s reagent revenue has now surpassed the system revenues. As of Q2, reagent sales account for 60% of the entire ECLIA revenue.

Intermediate and Long-Term Strategies

These are what will produce result in the intermediate term (a few months to one year or so) but also have a far-reaching effect over the long term.

• They have developed a fully automatic ECLIA system, to be rolled out pending approval by the Chinese FDA. They submitted application in Q2 and expect approval in mid 2007. With this system CMED is targeting large and medium sized hospitals. This space is currently dominated by major multinational giants such as Abbot, Bayer AG, Johnson & John, Roche, DPC, and so on. Entering this space means they will be competing head to head with these global giants. However CMED is optimistic it can win the competition with its cost advantages and strong distribution network that has been in place and expanding.
• They are expanding their ECLIA reagent portfolio. As of end of Q2 they were selling 56 reagents. But they were aiming to expand to 70 reagents in 12 months. New reagents would cover HIV, hepatitis related diseases, fertility, Down syndrome, etc. With this broad portfolio, they are well positioned to sell to major hospitals. At the end of Q3 (ending 12/31/2006) they already managed to add 6 more reagents. So at the time of this writing its reagent kit offering already stood at 62, only 8 short of their 12-month target set at the end of Q2. The 6 new reagents introduced in Q3 were for Down Syndrome (2) and liver fibrosis (4).
• CMED will complete the construction of a GMP facility in early 2007 to expand the production capacity for ECLIA reagents. Total capital outlay of this project is $6M. This is their strategy to profit from the growing reagent demand.
• As mentioned before, they have issued $150M worth of convertible bonds. The main purpose of this transaction is to finance the acquisition of advanced IVD technologies that have been proven in US and Europe but have no penetration in China yet. They have specific acquisition plan and target. But they will not disclose full details until time is right. One area they could have been looking at is molecular diagnostic techs. Their objective is to leverage their cost advantage and distribution network to bring these high growth, revenue-recurring techs into China.

Long-Term Strategies

These are what I see hard to set a time frame on at this point but will bring long-term benefit to the company.

• CMED is seeking FDA (U.S.) approval for HIFU treatment of pancreatic cancer. Animal test has been completed and an IDE application will be submitted in early Jan. 2007. They also have plan to pursue other indications in the future.
• They have struck an agreement with Century Medical to distribute HIFU systems in Japan. CMED plans to use the data from the U.S. clinical trials to apply for “shonin” (a marketing authorization approval).
• They have signed a ten-year partnership agreement with Chinese Academy of Sciences Institute of Acoustics to build a medical research lab to develop new acoustic medical devices. The initiative can explore diagnostic and therapeutic applications in non-oncology areas. The new lab will serve as CMED’s incubator for new commercial acoustic technologies.
  

Conclusion

IVD is the key focus of the company, from the current emphasis on ECLIA reagents to the longer-term pursuit of advanced IVD techs. This is because of the high growth, high margin, and recurring revenue characteristics of this business segment. The strategies laid out above reflect the company’s objectives to expand their IVD business into medium and large Chinese hospitals, expand IVD portfolio, improve HIFU technology, develop and commercialize new acoustic medical devices, and enter international markets. They have the potential to sustain the company’s growth while improving ROE, thus increasing shareholder values. As a shareholder, I feel encouraged by the company’s vision and clear growth path.

A slightly edited version of this post was published in SeekingAlpha on December 18th, 2006