Description

 GNPH (Genesis Pharmaceuticals) is a growing and leading provider of drugs in China.  GNPH trades at 1.1x LTM (and growing)EBIT, has 35% of its market cap in net cash, a portfolio of well established drugs, will benefit from favorable industry trends, new drug introductions, a recent acquisition and operating leverage at its state of the art manufacturing facility that is currently running at only 70% capacity. GNPH will be doing investor relations for the first time in ages in May, and recently reaffirmed guidance.  Insiders own 45% of the company's stock, so they are highly incentivized to create shareholder value.   Reported EPS is very deceiving (as discussed below) so those screening on EPS may miss this stock.  This is an illiquid stock; however, we understand there is stock available for sale (not by us or insiders) and we also believe liquidity will improve as people learn about the stock, as the company presents at the May conference and as the company continues to generate strong operating results.

 GNPH is primarily a manufacturer of Western drugs, although it recently expanded its Traditional Chinese Medicine portfolio with the acquisition of Hongrui, discussed below.  The company sells its products under the well known Jiangbo brand name.  Products are sold primarily to hospitals and to a less extent to pharmacies, although the Hongrui acquisition will increase the products sold via pharmacies. GNPH sells products through 28 first tier distributors and their 1,000+ salespeople.  Products are sold in 30 provinces and regions throughout China.  The company's main manufacturing facility is state of the art, but only operating at 70% of capacity, which will enable the company to grow without having to spend significant capex.  The company's 5 largest customers represent only 17% of sales.

 Recent Hongrui Acquisition

In late January 2009, the company announced the acquisition of Hongrui for $12.2 mm ($9.6mm in cash and $2.6 mm in stock).  This 3.5x P/E acquisition is not reflected in the balance sheet information below nor is it included in the company's FY 2009 guidance.  Hongrui is a quasi-state owned entity that produces traditional Chinese medicines which are widely used to cure gynecologic diseases, fevers, colds and coughs, pediatric diseases, and for daily health care.  GNPH expects to relabel these products under its existing and well-know Jiangbo name and sell the products thru GNPH's established sales network.

 The acquisition is strategically important as it will increase Genesis' product portfolio from 6 to 28 products during a time when the Chinese SFDA is tightening its standards and slowing down its approval process for new drugs. A larger number of Traditional Chinese Medicine will help increase the Company's presence in the OTC drug market and help balance Genesis' OTC sales with its sales of prescription drugs.

 The company has stated that in the first 12 months after closing, this acquisition will generate approximately $22.1 mm in revenue and $3.5 mm of net income (implying a 3.5x acquisition price of net income).  We note that this figure is a "next 12 months" figure and does not reflect the full "runrate" of the acquired operations since it will take some time for GNPH to relabel and begin marketing all of the acquired products.  Furthermore, our conversations with management has lead us to believe that based on initial sales, they will be increasing the $3.5mm guidance.  To help you better understand the growth opportunities from these acquired drugs, look at the April 22, 2009 press release which states that three of the acquired drugs are projected to generate $1.5mm of revenue in FY 2009 (ending June) and $7.3mm in FY 2010.

 We would also note that GNPH is initially only promoting 11 of Hongrui's 22 products (although they are the highest volume and highest margin products) and that eventually it will roll out the remaining 11 products.   Finally, we note that Hongrui was a quasi-state owned enterprises and thus was not fully maximizing its profitability.

 Capitalization

 Below is the company's capitalization.  The company has $35mm of debt convertible at $8/share) which, for accounting reasons discussed below is on the balance sheet for only $4mm.  We have shown the full $35mm.  Also, we have assumed the company will have to pay all $14mm of VAT tax payable (although it may not have to pay all of it) and we have also included $1.7 for legal/reorg expenses that the company will pay.

 Current Price                            $6.80

 Shares Outstanding                     9.8

Shares from convert                   0.0     . 

Total shares                                9.8

 Equity cap                                66.6

Cash                                        76.4

Restricted cash                         6.6     Security for debt

Total cash                                 83.0

Short term debt                          8.8

Reorg liabilities                          1.7

Converts                                  35.0

Taxes payable                          14.0    Unclear if company will need to pay all of it

Total   Debt                              59.5

Enterprise value                     $43.1

EV/LTM EBIT                         1.1x    

EV/FYE June '09 EBIT             1.0x     High end of co guidance           

EV/ FYE June '10 EBIT             0.8x     As per Brean Murray

Brean Murray, the only firm covering the stock, is projecting EBIT of $54.8mm for FY 2010 (up 33% y/y). This figure does not include any other acquisitions besides Hongrui.

Recent Regulation

On January 21, 2009 the Proposal of China Healthcare Reform was released by the Chinese government.  According to Susquehanna Financial Group, " The Chinese government will increase its spending on healthcare by 44% annually (vs FY 2007) to ~$42 billion for 2009- 2011, up from 15% growth of government healthcare spending over the past five years.  Part of the new budget will be used to increase the government subsidy for 84% of the Chinese population by 20%-50% each year, starting in 2010.  The new guidelines also established a more aggressive timeline on providing basic national insurance coverage by 2011, instead of 2020.  Based on these new details, we estimate a potential $31 billion annual increase of drug sales (domestic drug sales in China reached ~$67 billion in 2008) benefiting directly from the healthcare reform."

 Industry Overview

 The Chinese pharmaceutical industry is highly fragmented and is rapidly consolidating.  There are currently over 3,000 pharmaceutical companies, with the top 10 accounting for only 15% of total industry sales.  The consolidation is being driven by the usual forces (i.e. economies of scale) and equally important, the increasingly stringent governmental regulations.  Anyone who has followed the tainted milk scandal in China understands the government's increased emphasis on quality control for many products.  Given its high profile nature, the pharmaceutical industry is of particular interest to the government, so it reacts quickly if it determines a company's products or manufacturing may be deficient.  As a result, smaller industry players with less sophisticated manufacturing capabilities are being forced out of business or into a competitor's arms as a result of the tighter and more expensive government regulation.  This consolidation trends benefits GNPH is several ways.  First, it will gain market share as many smaller players leave the industry.  Second, it can acquire other smaller competitors at very attractive valuations.  Thirdly, GNPH may be an acquisition target for a larger domestic or foreign player.  Considering many larger drug companies trade at significantly higher multiples than does GNPH, these companies could pay a huge premium for GNPH and still have the acquisition be accretive.

 Why Reported Net Income is deceiving

 The company has several non-cash items that significantly distort reported net income.  GNPH reports GAAP and NON-GAAP eps.  Non-Gaap adds back the first two items discussed below but does not add back the final item which I think should also be added back so I have calculated PF Net Income.  Some analysts and data sources are using GAAP EPS which are completely deceiving.

 1) Due to accounting rules, the two converts that are outstanding are rather deceiving. The company has $35mm of face converts outstanding (2 separate issues), but they are recorded on the balance sheet at only $4mm. Every quarter the company takes a significant non-cash charge to amortize the issuance discount.

2) When the company became public through a reverse merger, it "inherited" positions in 2 publicly traded stocks. The positions aren't worth much, have not been included in cash in this analysis, and are included in Other Assets at the Dec 2008 fmv of $0.6mm. However, the company has to mark to market its positions in these stocks and record non-cash gains/losses on these positions. The two positions are 7.2mm shares in Gold Horse international and 2.4 million shares in Lotus Pharmecutical. The company expects overtime to liquidate its position in these stocks.

3) The company recorded some losses for discontinued operations. They were recorded above the line and not "excluded" from reported net income, although it was broken out in a separate line item.

                                                                        6 mnths            6 mnths            FY

                                                                        12/07               12/08               2008       LTM

Reported Net income                                       $8.4                 8.5                   22.4       22.5

Non cash debt amort                                         0.3                 2.0                   2.6           4.3

Non cash unrealized loss on securities                0.0                 1.5                   0.7           2.2

Adjusted Net income                                        $8.7                 12.0                 25.7       29.0

Plus : Loss on Disc ops                                       0.1                   1.6                   0.4          1.9

 PF Net Income                                                  8.8                   13.6                 26.1       30.9

 Some analysts and data sources are not backing out these items, all of which are non-cash, none of which impact the company's "operations."  The debt charge will continue but the loss on discontinue operations is non-recurring.  The unrealized gain/loss will continue, but considering the investments are now written down to $0.6mm and their stock prices have stabilized, it is unlikely that the company will incur charges of such a large magnitude going forward.

Buyback

In late November 2008, the company announced a $2mm stock buyback.  The Board is eager to begin the buyback.  We suspect the delay is a result of the difficulty some Chinese companies have in getting cash out China.  However, there are several legal developments which we think will make it easier for GNPH and others companies to expatriate cash and  repurchase their stock in the . 

The Company had a 40-to-1 reverse stock split effective September 4, 2008.

Lawsuit

The company has had a few lawsuits (mostly resulting from the reverse merger which the company did to become public).  All of the suits have been effectively resolved.  The biggest of these suits was by CRG, a former consultant to the company, who had been seeking $13.8mm.  In February 2009, an arbitration panel awarded CRG $0.9 mm (not the $13.8mm it had been seeking). Once the award is satisfied, CRG would have no further claims against the Company's common stock or other property that were the subject of the arbitration. The amount is included in reorg liabilities that I have treated as debt above. You will find some interesting information about CRG on google.  Despite the victory in the recent arbitration, the company is considering not paying the $0.9 million because they believe CRG is saying unflattering things about the company.  As a result, GNPH is considering taking the case to federal court to resolve the lawsuit and to get an order preventing CRG from saying unflattering things about the company.  While this issue remains an annoyance and a use of the CFO's time, it has relatively little impact on the company's operations, cash flow or inherent value.

 Investor Relations

The company historically has not done much investor relations.  While they are very receptive to investors' questions, they don't roadshow often.  However, the company is presenting at a NYC conference in May and will likely do a non-deal roadshow around the conference.   The company's CFO is located in Florida and is very user friendly.    The company also has CCGIR as its i.r. firm.

Guidance

On April 2, 2009 the company affirmed its previously announced operating income guidance of $40 to $43 million for its fiscal year ending June 30, 2009. The Company also adjusted its revenue guidance for its fiscal year ending June 30, 2009 from a range of $122 to $130 million to a range of $111 to $116 million as a result of restructuring how it distributes and sells its products, not because of a slow down in sales.  Considering its growth rates and its LTM thru December figures, it is highly unlikely the company will miss this guidance.  The Company restructured its distribution and sales system to sell its Clarithromycin sustained-release tablets, Itopride Hydrochloride granules and Baobaole chewable tablets to hospitals and pharmacies through 28 large independent regional distributors. Each of these primary regional distributors works closely with sub-distributors and Genesis' internal marketing and sales network.  In connection with its sales restructuring, the Company lowered the per unit prices of certain products that the Company charges to regional distributors in cases where such regional distributors became responsible for some of the costs associated with these products that previously were direct marketing expenses of the Company. The Company adjusted its revenue guidance to reflect these adjusted prices.  The Company's new products, including Radix Isatidis dispersible tablets and products, acquired from its recent purchase of Hongrui Pharmaceuticals Company, will be sold through this new sales structure. However, the Company will not change its marketing method or sales structure with respect to the sale of its low margin Ciprofloxacin Hydrochloride tablets and Paracetamol tablets.

Valuation

We used very conservative assumptions for our valuation, including assuming debt converts at $8, all taxes payable are actually paid, and all 2.3mm warrants are exercised at $9.60.  We have looked at the valuation both based on LTM EBIT and 6/2010 estimate of $51.6 (we very scientifically took high end of FY 09 guidance and grew it by 20% or $8mm.  Remember the company expects the Hongrui acquisition to generate atleast $5.4mm of EBIT (assuming 35% tax rate) over the next 12 months, so to hit our target, organic ebit would only have to increase $3mm.)

Products

Prior to the Hongrui acquisition, the company had 3 primary products that made up 90%+ of its revenue for the FY ended June 2008.  A brief summary of the 3 products is below.  However, the company has reduced its revenue concentration  with (i) the  Hongrui acquisition (22 drugs with total revenue equal to GNPH's standalone),(ii) the recent introduction of new products such as Radix in Sept 2008, and (iii) potentially with 3 products that are awaiting final government approval, which is expected this calender year.

1) Clarithromycin sustained-release tabletsClarithromycin

sustained-release tablets, are semi-synthetic antibiotics for curing Clarithromycin sensitive microorganism infections including pneumonia, bronchitis and infections of the ears, sinuses, skin and throat.  The company has a 50% market share and is one of only two domestic Chinese pharmaceutical companies that has the technology to manufacture and actively produce and sell this drug.

Clarithromycin is the second generation of macrolide antibiotic and replaces the older generation of Erythromycin. Clarithromycin first entered the pharmaceutical market in Ireland in 1989, and as of 2007, it is one of thirty medicines which generate the greatest sales revenue all over the world. Chemically, Clarithromycin has a wider antimicrobial spectrum and longer duration of acid resistance. Its activity is 2 to 4 times better than Erythromycin, but the toxicity is 2-12 times lower.

Clarithromycin sustained-release tablets utilize sustained-release technology, which requires a high degree of production technology. Because of the high degree of technology required to produce this product, PRC production requirements are very strict and there are very few manufacturers who gain permission to produce this product. Therefore, there is a significant barrier to entry in the PRC market. Currently, our Clarithromycin sustained-release tablets are the leading product in the PRC domestic antibiotic sustained-release tablets market.

2) Itopride Hydrochloride granules

Itopride Hydrochloride granules used for curing digestive system-related diseases. The Company has approximately 10-12% of the market share in China for this type of drug. This product is widely regarded for its pharmacological properties, i.e., rapid absorption, positive clinical effects, and few side effects. Based on clinical observation, it has been shown that Itopride Hydrochloride granules can improve 95.1% of gastrointestinal indigestion symptoms.

 Itopride Hydrochloride granules are the fourth generation of gastrointestinal double dynamic medicines, which are used for curing most symptoms due to functional indigestion. The older generations are Metoclopramide Paspertin, Domperidone and Cisapride

    3)Baobaole Chewable tablets

Launched in November 2007, are nonprescription over-the counter drugs for gastric cavity aches. This Traditional Chinese Medicine stimulates the appetite and promotes digestion. Baobaole is used to cure deficiencies in the spleen and stomach, abdomen aches, loss of appetite, and loose bowels. Its effects are mild and lasting. The drug has quickly gained its popularity in the market and the sales for this drug has grown at a fast pace since its initial introduction.

Why is stock so cheap

 1) This is an unknown company. The company came public through a reverse merger so it never did a full blown roadshow which would have introduced the company to a the investment community.

2) The company has minimal sell-side coverage: Only Brean Murray

3) The EPS and balance sheet financials are deceiving

4) It is a Chinese company and thus hard to due dili

5) It is illiquid

6) Concerns over what company will do with excess cash

Catalyst

May 2009 NYC conference presentation

Increased guidance for Hongrui acquisition

Increased guidance for entire company

Stock buyback