Description

Overview

Skystar Bio-Pharmaceutical (SKBI) is an unknown, rapidly growing U.S. listed Chinese manufacturer of veterinary medicine which, due to some GAAP accounting quirks, is significantly cheaper than its reported  financials.  According to Bloomberg and many other data services, the company is trading at approximately 5.2x LTM EBITDA, which I would argue is still cheap given the company's growth prospects discussed below.  However, due to an unusual accounting rule, this calculation does not give the company credit for $19mm of net cash proceeds that the company raised via a secondary offering from the sale of 1.6 mm shares at the end of last quarter.  The latest 10Q's balance sheet reflects the additional 1.6 million shares issued in the offering (at $12.98) but the cash proceeds from the offering are not reflected as cash and instead are listed as a Contribution Receivable in Shareholders Equity.  This odd treatment was simply a timing issue and on the next quarterly report, the Contribution Receivable will go away and the cash line item will go up by $19mm.  Consequently, the company's Enterprise value is really $19mm less than it appears on Bloomberg or if one were to quickly look at SKBI's balance sheet.  Thus its LTM EBITDA multiple is 3.2x not the 5.2x as reported on Bloomberg. And EBITDA (up 30% YTD) will be up in 2009 and up even more in 2010.   The company's reported EPS is also distorted by non-cash charges related to a small number of outstanding warrants.  As a result, reported earnings look terrible but one must add back these charges to understand the true operating results.  For example, last quarter's reported EPS was $(0.06) but $0.73 if you exclude warrant charges.  There are some near term catalysts for the stock including (i) the company's presentation at Rodman's conference on September 9, at which point we expect the company to educate the investors regarding the true cash balance after failing to do so on the latest earnings call and (ii) initiation of sell-side research coverage.  SKBI currently has no analysts covering the stock (which is one of the reasons its valuation is misunderstood) but we expect that will change in the near future.  Several firms who cover this space have indicated they are "talking" to management and we note that Rodman underwrote the recent equity deal and invited them to present at their upcoming conference.

Description

This will be brief since the company's SEC filings give a good business description and the company filed an 8k on July 31st with its latest presentation.  SKBI is a leading China based producer and distributor of veterinary medicines, vaccines, microorganisms and feed additives.  It has 4 segments, but as discussed below it is significantly expanding capacity of its highest margin segments. 

• - Veterinary Medications(70% of revenue): 140 products for poultry and livestock. Generating gross margins of 42%.
• - Micro organisms (23% of revenue): 13 products which are fed to animals and result in healthier livestock and reduced feed requirements, generating 70% gross margins.
• - Feed additives ( 5% of revenue): 10 products which increase yield and health of livestock. 57% gross margins.
• - Vaccines (4% of revenue): 10 products; 85% gross margin.

The company is introducing new products in virtually all its segments which will continue to drive profitability.  In addition, with $4mm from the recent equity offering, the company intends to make 2 significant capacity expansions in their highest margins segments:

• 1) $2.5mm to finish a new vaccine facility. This is critical because the company's current operation is running at full capacity. This new facility will increase capacity by 2,300%. SBKI expects this new facility will initiate production in Q4 of CY 2009 and generate in $9.1mm of additional gross profit in 2010;
• 2) $1.5mm to build a new micro-organism facility which will increase capacity by 49%. SBKI expects this new facility will initiate production in Q4 of CY 2009 and generate in $1.9mm of additional gross profit in 2010.

Thus, with a relatively small capital investment, the company expects to increase gross profit next year by over $10mm, which is significant considering LTM gross profit was only $14mm.  So, if you didn't think the stock was undervalued at 3.5x LTM EBITDA, image what 2010 EBITDA might look like.  Obviously not all of that incremental gross profit will fall to the bottom line due to increased selling expenses.

The company sells its products through a distribution channel covering 29 provinces in China. It has over 1,128 distributors and 403 direct customers. SKBI intends to establish more representative offices and engage additional distribution agents in order to strengthen its distribution network.  The company has no significant customer concentration.

Valuation

Stock Price                            $14.00

Shares                                   3.6 (pf recent offering and includes warrants)

Equity Cap                            $50.9

Cash on b/s                           0.7

Contribution Receivable        19.2

Warrant proceeds                    1.7

Total cash                             21.6

Debt                                       1.1

Adj Enterprise Value           $30.3

LTM EBITDA                       $9.5

Adj EV/EBITDA                   3.2x

Non-adj Ev/EBITDA           5.2x         (incorrectly excludes 19.2mm of cash)

We are still working on our 2009 full year and 2010 estimates.  However, given this company's growth YTD and their planned expansion for 2010, you don't have to be a rocket scientist to realize 2009 (YTD EBITDA is up 30%, and we are going into their seasonally stronger periods) and 2010 EBITDA will be significantly higher than LTM.  However, for purposes of this write up we have looked at valuations based on various multiples of LTM EBITDA.

Given the company's tremendous growth opportunities, its not long before the company will be generating $20mm of EBITDA, so we've run the same analysis using a $20mm EBITDA figure.  Considering the increased profitability next year from the new plants, it really wont take much "organic" growth for the company to achieve the $20mm figure.  Note that we haven't reduced the EV in the below calculation for the $4mm they will spend on these plants because they will also be generating cash in the interim and frankly $4mm doesn't really change the analysis.

Summary Financials ($MM)

Industry Trends

• - China is the world's largest producer of poultry and livestock
• - Gov't supports rapid development & modernization of farming industry (wants more effective and safer methods)
• - Higher standard of living increasing demand for animal-based food sources among chinese
• - High barriers to entry given certification requirements
• - SKBI's largest competitors are state owned enterprises, which often are not the most efficient competitors

Management

Insiders own over 25% of the company's stock so they are incentivized to create shareholder value.  Unlike many US listed Chinese companies, SKBI has a very experienced and American CFO, Bennet Tchaikovsky, who is very responsive to investors. 

Warrant Charge

The non-cash warrant charges mentioned above were quite big this quarter as the company's stock price increased dramatically from $9.80 to $17.94.  Unless you can predict where the stock price is going , its hard to predict the extent of such subsequent charges.  65% of the warrants expire in February 2010 and the rest in 2013. 

 Seasonality

Like many industry participants, the company does have seasonality with strongest to weakest quarters being q3,q4,q2,q1..In other words, q3 and q4 are seasonally strongest quarters.

 Stock Split

On May 12, 2009 the company did a 10:1 reverse stock split.

Equity offering use of proceeds

The following is an estimated breakdown of use of net proceeds from the recent equity offering.  The biggest use of proceeds is for acquisitions.  Although we do not believe any acquisitions are imminent, this is a highly fragmented industry and we expect that SKBI's highly experienced management will prudently deploy this capital.  Management has indicated they hope to do an acquisition by year end.

Catalyst

1) Presentation at Rodman conference

2) Increased investor awareness regarding true cash balance

3) improved operating results

3) initiation of sell side analyst coverage