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A Lack of Logic Around China Sky One Medical (CSKI)

Imagine this scenario. A firm that has grown revenues at a 50% CAGR for the past 4 years, operating profits at 39%, and is projected to continue growth at levels above 20%. This firm has no debt and holds over $65 million in cash on the balance sheet. Operating margins have routinely come in above 35%. The company competes in the historically lucrative OTC and personal care product market, which is largely isolated from recessions and feature consumer branding and repeat purchases - a favorite industry of none other than Warren Buffett.

Now, what if I told you this company was selling at a P/E ratio of under 4? A forward P/E ratio of just above 3? An enterprise value to earnings (EV/E) ratio of 2.4? An EV/book value of 0.7, and 0.88 against tangible assets only. An EV/sales of 0.7. Basically, what you would expect to pay for a company about to go out of business. Sounds too good to be true, doesn't it?

But it is true - this company is China Sky One Medical (CSKI).

How did this happen? A lot of negative press, that's how. A few investors, all short the stock, have been extremely successful in creating a campaign of fear and doubt against whether this company is real and if their reported financials are accurate. If they are right, the valuation is indeed very rich. If they are wrong, the valuation is nothing short of absurd.

I am long the stock and have recommended it. However, if there is a more-than-reasonable doubt about the validity of the company's results, I do not want to be in it or recommend it. As the stock has gotten to unbelievably cheap levels, I dug into the main arguments of those against the company to decide whether to take losses or to hold on for what has to be a big upswing. So, here are the 4 main points I've seen brought against the company and the results of some research into them:

1) The company has no Chinese website and, as such, must be a shell company for U.S. investors only.

China Sky One itself has a website, and there is even a Chinese version of this site, although the latter does appear to be out of date.

This is not particularly concerning, though - Sky One itself is a U.S.-based holding company. The actual operating entities are based in China, the largest of which is Harbin Tian Di Ren Medical Science and Technology, or Harbin TDR. Doing a Google search for this pulls up a number of results, including this Alibaba company profile. From there, you can get to this English language page that sells CSKI's products. And finally, from there, you can reach a detailed Chinese language website for the firm, that appears to be their primary Chinese web presence. For that matter, there is a Russian language version of the site as well.

Bottom line: CSKI and its subsidiaries have a substantial Chinese and English language presence on the web. This criticism can be put to rest.

2) The company's reported gross and operating margins are far out of the norm for this business.

CSKI is in the business of selling over-the-counter health products. For the past 3 years, reported gross margins have been steady between 75-76%, and operating margins (EBIT) in the 35-38% range.

The simplest thing to do here is to compare these margins against similar public companies, preferably ones where we can trust the financial statements. A good analog would be Chattem, who makes similar OTC health products such as Gold Bond, Icy Hot, Dexatrim, and others. Chattem was purchased by Sanofi-Aventis (SNY) back in December for $1.9 billion dollars (almost 4x sales), so we can be reasonably sure their reported financials were properly vetted.

In 2009, the last full year Chattem reported, the company made $463 million in sales and charged $140 million in cost of sales, for a gross margin of about 70% (last 10-K here). The year before that was 71%. Chattem's operating margin (EBIT) was 27% in both 2009 and 2008.

CSKI's margins are higher, but not ridiculously so. For one, CSKI almost assuredly has access to lower cost labor, manufacturing, and materials. Also, the U.S. market, where Chattem makes over 90% of sales, is more competitive in OTC products (currently) than the Chinese market, with higher rates of consolidation, as Chattem derived 74% of sales from its ten largest customers such as Walmart (WMT) and Walgreens (WAG). This kind of consolidation leads to pricing power for its customers, driving down margins. For comparison, CSKI's largest customer does not account for more than 20% of sales.

Bottom line: CSKI does boast impressive margins, but they are not astronomically out of proportion with similar U.S. companies, and can be explained reasonably through several competitive and positional factors.

3) The company's reported SEC revenues and cash holdings are wildly out of sync with Harbin TDR's Chinese SAIC filings.

This has been the primary argument made by the most vocal shorts like John Bird ("Waldo Mushman") and This credit report for Harbin TDR has been supplied as the "smoking gun" evidence. In it, TDR's 2008 revenue is reported as 6.92 million CNY (about $1 million USD), and balance sheet cash as 7.27 million CNY ($1.1 million USD). On the other hand, CSKI's SEC filings for 2008 report $92 million in revenue and over $40 million in balance sheet cash. Asensio and Bird both maintain that this discrepancy casts doubt on the accuracy of the SEC filings and implies that CSKI's main operating subsidiary is significantly smaller than is being reported to U.S. investors.

Another point made is that CSKI's main customers and suppliers both showed similarly low levels of revenue in their credit reports and/or SAIC filings.

CSKI actually did respond to the argument, which was originally made last summer. The response can be read here. In it, CSKI admits that the filings do not match, but stresses that the purpose of SAIC filings is different than SEC filings and that their SEC filings followed US GAAP. The company also promised that future filings would not show material differences.

In the opinion of MagicDiligence, the SAIC filings and/or credit reports are probably wrong. The Alibaba profile (previously linked) has Harbin TDR as a TrustPass "Gold Supplier" and "A&V Checked Supplier", which uses a third-party credit agency (ACP) to verify the Alibaba listing statistics. On this profile, Harbin TDR has listed 5,000 square meters of manufacturing, with distributing capital of US $80 million a year, and a sales volume over > $100 million USD per year. It also says the firm has 2,500 employees and a capacity of 2 million patches a month. Finally, the profile lists Mr. Yanqing Liu as the owner, which agrees with CSKI's filings. You can also find Harbin TDR's dozens of products from that profile.

To be fair, there are conflicting statistics on this company. For example, this page lists TDR's sales as between $35-$40 million annually, with 200-250 employees. Alibaba is one of the more respected business-to-business trade sites in Asia, though, so I am inclined to trust them the most. In any case, as recently as 2007 $35-$40 million would have been about right for TDR.

Clearly, the company makes more than $1 million a year. TDR's products are available for ordering on any number of pages you can find in a simple search. This is a real business with significant distribution capacity. Products sell through some of China's largest pharmacy chains such as Nepstar (NPD, nearly 2,500 stores) and are being exported to several countries.

On the distributor side, similar problems with the short argument arise. Take Shaanxi Xintai Pharmaceutical, who distributes CSKI's Sumei Slim Patch, their top selling product over the past few years. John Bird's site lists a "credit report" that has Shaanxi's 2008 revenues at under $5 million and employee count at 50. However, Shaanxi's website information has employee count at over 500. It's the same company - the address on the website matches the credit report. However, it is difficult to prove or disprove the claim here, although I think it is more likely than not that a similar issue to CSKI's SAIC filings is showing up in the credit report. Could it be that Chinese companies routinely and massively understate financial information in these SAIC reports? Seems likely.

Also, we have to ask several more questions of the SAIC filings and credit reports based on them. First, how did CSKI complete its 2008 purchase of Heilongjiang Tianlong Pharmaceutical with an $8 million cash component if the firm barely had over $1 million in cash on the balance sheet (8-K filing)?

Secondly, how did the company manage to finance a two six-story building, $13 million headquarters complex which opened in January (press release)? This building should be very easy to verify. I looked up the address on Google Maps (No. 2158, North Xiang An Road, Song Bei District, Harbin, Heilongjiang Province, P. R. of China 150028), and clearly it is a large industrial park not far from Harbin TDR's address. Why didn't Bird or Asensio drive by and verify the construction? A $13 million dollar building is a pretty good indicator that business is good.

Finally, CSKI's 2009 revenues were about $130 million. To put it in perspective, that's about 1/3rd of what Chattem sold in the same year. Despite the fact that both companies had similar distribution (mainly pharmacies) and China is a larger, more untapped market. $130 million is not unfathomable by any stretch.

Bottom line: it is almost impossible to believe that Harbin TDR is doing just $1 million of revenue a year, and much more likely that CSKI's SEC filings are closer to the truth. There is no way the company could support acquisitions, capital spending, or product distribution, all of which are verifiable, on such a small revenue base. CSKI's reported revenues are not unreasonable given the company's distribution, product roster, and market size.

4) CSKI has a history of changing auditors and has a questionable auditing firm in place.

Certainly the company has gone through several auditors since going public, some of which were shady (Sherb & Co. comes to mind). However, since joining the NASDAQ in 2008, the company has used MSPC. Moore Stephens is a rather large firm that consists of a large number of independent auditors, one of which is MSPC.

The main complaint so far has been MSPC's alleged failure to verify $15 million in 7 patents claimed on CSKI's balance sheet. But wait... the 2010 10-K filing doesn't mention these 7 "missing" patents that talks about. There are a couple explanations here. One is just poor categorization of SFDA (think FDA) licenses:

Historically, we included our proprietary technologies and SFDA licenses for drug batch numbers within the category of patents. We now believe it is more accurate to categorize such intellectual property as SFDA licenses for drug batch numbers and other proprietary technologies.

The second is purchased patent rights, under names that may not have been searched for by Asensio's legal team:

We purchased the rights to the patents for Endostatin and Antroquinonol, which are registered under the names of Harbin Medical University and Taiwan Golden Biotechnology Corporation, respectively.

And finally are the packaging patents that the legal team actually verified:

As of the date of this filing, we own two registered patents for product packaging. As of December 31, 2009, these patents have nominal carrying values.

Bottom line: Other than mostly unrelated mud on Moore Stephens (a very large firm), there isn't much smoke here as best I can tell. That said, I would prefer CSKI to hire PriceWaterhouseCoopers or Deloitte to put accounting issues to rest.

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