Summary

Tianyin Pharmaceuticals Co Inc (TPI: AMEX) is a small but rapidly growing, high quality Chinese pharmaceutical company.  The company is run by an impressive management team that is intently focused on increasing shareholder value.   Despite the company’s impressive track record the stock remains under-followed and trades at an extremely cheap valuation.  With a broad portfolio of 52 traditional Chinese medicine (TCM) and western generic products, as well as a pipeline of 12 new products, Tianyin operates in an attractive Chinese pharmaceutical market.  Since taking over the company in 2003 the current management has grown revenues from $1M per year to $57.6M in the most recent 12 months.  In 2009 the company announced a JV to develop a new antibiotics ingredient business which we expect to be a major contributor to our estimated 70%+ top and bottom line growth in the next fiscal year ending June 2011.  Tianyin stock currently trades at a mere 8.2x and 4.7x management’s earnings guidance for fiscal years ending 6/30/10 and 6/30/11.  On an EV/EBITDA basis, the stock trades at 4.7x and 2.7x multiple of our EBITDA estimates.  While the stock has sold off in the market correction, the company’s fundamentals have absolutely no correlation to any of the macro-economic events in North America or Europe.  Our conservative price target is $5.10 which based upon a 10x multiple of fully diluted FY11 earnings, which accounts for the dilution from outstanding warrants and would give investors 73% upside from current price of $2.95.

Industry and market background

The Chinese pharmaceutical market presents an attractive and rapidly growing opportunity which is driven by a number of positive economic and demographic trends including strong per-capita GDP growth, the country’s aging population and the expansion of a government-backed healthcare reimbursement system.  These trends along with rising household income have resulted in increasing spending on prescription and OTC medicines in recent years, yet per capita spending on drugs in China is still less than 1/8th of the level it is in the US, providing a lot of room for growth.  Business Monitor International estimates the total size of the Chinese pharmaceutical market has reached $52.5B, up from the $28B in 2002.  IMS projects that the drug industry in China will continue its double-digit growth and expects China to become the 5^th largest drug market in the world by 2011.  Traditional Chinese herbal medicine, or TCM, has been used in China for thousands of years and they are therefore deeply ingrained in Chinese culture.  TCM accounts for 30-40% of the total pharmaceuticals sales and about two-thirds of the unit sales volume.

The Chinese government introduced the National Medical Insurance Program in 1999. The number of participants enrolled in this program is expected to grow to 300 million by the end of 2010, according to the PRC Ministry of Labor and Social Security.  The program maintains a national medicine catalog of a 2,151 drugs which are eligible for government reimbursement to program participants.  In 2009 the Chinese government, through the State Council, announced a comprehensive healthcare reform plan in which a total of $126B is going to be deployed into four areas of the healthcare system.  One of the areas of focus is to expand the coverage of the medical insurance program from 2009 to 2011.  The goal is to ensure that 90% of the country’s 1.3 billion population will be covered by the end of 2011.  Pharmaceutical manufacturers with products included in the insurance catalog have seen tremendous increases of the sales of such drugs, as the expansion of coverage and eligibility of a drug for reimbursement makes it more affordable to patients.

Company overview:

Tianyin was founded in 1994 in Chengdu, China and was acquired by the current management team, led by Chairman/CEO Mr. Guoqing Jiang in 2003.  The company went public through a reverse merger in January 2008 and closed a financing of $13.8M at the same time.  The proceeds were mainly used to build a second manufacturing facility to expand its production capacity in order to accommodate its fast growth. 

As of March 2010, Tianyin had 52 products treating a broad range of therapeutic areas including internal medicines, gynecology, hepatology, otolaryngology, urology, neurology, gastroenterology, orthopedics, dermatology, pediatrics, etc.  23 of its products are listed in the National Medicine Catalog of the National Medical Insurance program, including the patent protected flagship product Ginkgo Mihuan Oral Liquid.  These 23 products together generated 70% of the company’s revenue in FY 2009.  7 of the company’s products are included in the national Essential Drug List.  Over the past several years, organic revenue and earnings growth have been stellar to say the least (see below).  It is worth noting that the slight slow down in growth rate in FY 2009 was due to the fact that company was constrained by its manufacturing capacity.  With the new facility fully operational, management expects current production capacity will be enough to accommodate growth for the next 5 years without incurring significant capex for expansion.

* Mgmt guidance.

Competition in the Chinese pharmaceutical industry is much more fragmented than the US.  The main competitive advantages of Tianyin includes:

1. 23 products included in the highly selectively national medical insurance catalog.
2. Sole manufacturer of four proprietary products with substantial market potential.
3. A well-established national distribution network comprised of a 720 person sales force targeting different markets and product segments, with geographic coverage of all provinces in China.
4. A proven cooperative partnership based R&D model, with leading academic institutions, that is cost effective, less risky and has shorter development cycles.
5. An A-plus management team consisting of industry veterans with proven track records of past success.

Contrary to the prevailing beliefs that Chinese regulations are weak in the areas of protecting intellectual properties, pharmaceutical products in China actually enjoy stronger protection than they do in the US, given various administrative protections granted by the State Food and Drug Administration (SFDA).  For instance, the new SFDA product filing and registration policy provides an infinite period of administrative protection to approved products by prohibiting the production and marketing of similar products without the SFDA’s approval, unless a new medicine is clinically proven to have achieved major product breakthroughs.  Also, once a new medicine or an improvement to an existing medicine is approved by the SFDA, there is a monitoring period of as long as 5 years during which SFDA will closely monitor the safety of the new medicine.  The manufacturer is granted a provisional production standard to produce the new drug for 2 years, after which the standard is converted to a final one.  The conversion, in practice, could take a number of years to be reviewed and completed by the SFDA.  However, prior to the expiration of the monitoring period or the conversion of a provisional to final production standard, SFDA will not accept applications for an identical medicine by another pharmaceutical company, giving the current manufacturer exclusive production rights during such a period.  Such administrative protections essentially protect an existing manufacturer’s products from being knocked off or give exclusive production rights of certain drugs to a small group of manufacturers over a period of time, greatly strengthening the competitive positions for companies like Tianyin.

Unlike a chemical drug, which typically has one defined active pharmaceutical ingredient, TCMs typically consist of multiple ingredients extracted from natural herbs with undisclosed, unique formulations.  So even if the administrative or patent protections expire, consumers may still choose a TCM by its brand name, because there will be no generic/chemical name available for the products due to its complex ingredients.  On the other hand, when a chemical drug loses patent protection, many generic versions of the drug with the exact or similar formulation come to market.  Therefore, competition faced by TCMs with an established brand name is much less intense compared to that among generic chemical drugs.

Growth drivers and initiatives

Tianyin’s flagship product, Gingko Mihuan Oral Liquid, accounted for 27% of the 2009 sales and generated gross margin in the 73%-75% range.  Tianyin has two patents covering the formulation and design, lasting 17 more years.  The potential addressable market size for its area of focus, cardiovascular disease, is estimated to be $4.3B in China and growing at a 26% rate, according to a research report from Southern Institute of Medical Economy of the SFDA.  Since 2008, the company has won centralized government purchase tenders for Gingko Mihuan in four new provinces and signed distribution agreements with 15 regional distributors.  Revenue from this product grew 88% in FY08, 51% in FY09 and is expected to grow 89% to $22M in FY10.

In an effort to diversify its revenue and further grow its business, Tianyin announced in October 2009, through an 87% owned JV, to build a new plant to produce the Active Pharmaceutical Ingredients (API) for macrolide antibiotics.  Popular drugs under this category include Azithromycin, Clarithromycin and Roxithromycin etc.  The 1^st phase of the project will be producing oral and injectable grade API for Azithromycin.  Worldwide sales of Azithromycin has experienced steady, 30%+ CAGR since it was introduced in 1996, taking share from other antibiotics categories.  It is estimated that sales of Azithromycin in China and worldwide amounted $350M and $2.01B in 2007 respectively.  Both the Chinese and international markets for its API are currently experiencing supply shortages, which is unlikely to change any time soon due to several barriers to enter the business.  Within China, in addition to the fair amount of capital and technical requirements, the necessary product approval is extremely hard to obtain from thr SFDA due to environmental issues associated with the production process.  Worldwide, there has been a trend of Macrolide API production being outsourced to low-labor cost countries as well.  Tianyin has secured a piece of land suitable for construction of such a plant in a specialized industrial chemical park in a nearby county.  The JV partner contributed the product approval from SFDA.  The whole project, consisting of two phases, is expected to cost $20M in total with a fast payback period and a healthy ROI.  The API sales generate a gross margin in the 25-30% range and Tianyin can produce a 17-18% net margin with little incremental spending on sales and marketing.  Management expects the first phase (accounting for the majority of the capex) to produce about $43.9M of revenue and $7.3M net income in its first full year of operation.  The expected contribution to after-tax earnings will be $12M when both phases are operational and reach full capacity.  With market shortages, buyers usually have to pre-pay for the API, eliminating A/R and any significant working capital needs.  Phase I of the project is expected to be operational by the second quarter of FY11 and the $14M investment will be fully paid back within less than 2 years on a cash basis.

With its biggest strength being its extensive distribution network with national coverage, Tianyin can increase the sales of its approved new products by leveraging the existing sales force.  Our conservative view is the company can grow at least at the same 15-20% growth rate of the industry.  Given the fragmentation of the Chinese pharmaceutical industry and opportunities presented by the healthcare reform, management also believes there is an opportunity to capture more market share by acquisitions of manufacturers with promising products/pipelines but less effective sales and marketing capabilities.  The antibiotics JV mentioned above was originally planned as an acquisition, but management intelligently structured it as a new JV due to some complex requirements of buying formerly state-owned assets.

Management

Led by Chairman/CEO Guoqing Jiang, Tianyin has one of best management teams we have seen in the Chinese pharmaceutical space.  Prior to acquiring Tianyin, Mr. Jiang was the CEO of Kelun Pharmaceutical Group in China and had a track record of building that company into the world’s largest provider of intravenous solutions with $1B sales.  The rest of the management team consists of industry veterans with 15-20+ years of experience in sales and operations in the Chinese pharmaceutical industry.  The depth and capability of management is demonstrated through the history of consistent revenue/earnings growth achieved since they acquired Tianyin in 2003.  Over the last 5 years, they have achieved a revenue CAGR of 30%+ almost all organically.

The company has recently hired a new English speaking CFO, James Tong, who not only had an academic/professional background in the healthcare space but also worked as a research analyst and an investment banker.  We believe his previous experience with Wall Street can be a very valuable addition to Tianyin’s operation focused management team.

As a group, management owns about 37% of the company on a fully diluted basis and has not sold a single share since the company went public in January 2008.

Valuation and risks

Despite the strong fundamentals, Tianyin stock trades at an extremely cheap valuation of 8.2x and 4.7x of FY 10 and 11 EPS, 4.6x and 2.6 of FY 10 and 11 EBITDA estimates.  The company has a strong balance sheet with $21M net cash, representing 23% of Tianyin’s market cap, although most of this cash will be invested in the antibiotics JV to produce the projected growth. 

In addition to selling off along with the overall market, the following issues are probably behind such a low valuation for the stock: 

1. Bad comparables.  Most other publicly traded Traditional Chinese Medicine stocks in the US are perceived by investors as poorly run companies with bad prospects, therefore trading at very low valuations.  Those comps have either very poor or questionable histories of investing the capital they raised, creating little value for shareholders.  With its traditional business in TCM, Tianyin is still being associated with the low quality TCM comps.  We not only view Tianyin as a much better run company, but also view it as being in the process of transforming itself from a pure TCM manufacturer to a biopharmaceutical company with a more comprehensive product portfolio.  The new antibiotics ingredient business is a great example, which will diversify about 1/3 of Tianyin’s profits into western medicine.  Moreover, management has hinted the new acquisitions they’ve been looking at or working on are outside of the TCM area.  The company has also been very careful with the investment decisions of the funds raised.  Two major investments pulled off so far have been very impressive to say the least.

2. A relatively complex capital structure.  As a result of prior two rounds of private placement financings, the company ended with up a current capital structure of 26.6M common stocks, 2.1M convertible preferred stocks and 8 million warrants with strike prices ranging from $2.50 to $4.50.  This was due to the company’s inexperience with US capital market, as well as the weak market condition when they closed the financings in 2008.  The warrants represented an overhang on the stock price.  In our conservative and worst case scenario valuation, FYE 6/30/11 EPS will end up being $0.51 per share on 38.5M shares accounting for the dilution from warrants conversion.  The reported EPS under US GAAP will almost certainly to be better, as our calculation does not assume proceeds from warrants exercise are used to buyback shares (the treasury method).  This number still implies only a 5.5x multiple.  With the $29.4 million cash that would be raised upon warrants exercises, EV/EBITDA multiple based on our $25M estimate for FYE 6/30/11 would be only 2.1x.

3. Risks associated with Chinese pharmaceutical industry.  There are concerns that the Chinese government will be constantly trying to squeeze the profits of the drug manufacturers given the rising cost of healthcare.  The length of the period for a new drug to obtain approval is also getting longer.  We view these types of the concerns as the risks one has to live with when investing in Chinese pharmaceutical companies, although we view the attempt by the government to control rising drug cost as primarily focused on controlling the profit margins of distributors and under-the-table payments to the doctors.  Our channel checks reveal that manufacturers’ ex-factory price typically represents 15-20% of the final sales price of a drug in China.  In summary, even mandatory pricing cut policies in the past have failed to have a significant impact on drug prices, as players in the drug supply chain in China always find a way to cope with such cuts.  The National Bureau of Statistics’ drug price index has shown a modestly 2.8% decline since 1996, despite 24 mandatory price cuts implemented by the government. The recent new government tender system to purchase drugs initiated by most provincial governments has proven to be neutral, or even modestly positive, for manufacturers in terms of pricing.  The new healthcare reform, in fact, encouraged preferential pricing treatment for innovative drugs and talked about measures to limit the margins of drug distributors.

4. Risk of further downside from market weakness.  Chinese small-caps are still deemed to be a risky asset class, judging by the magnitude of their movement along with market fluctuation.  For long-term investors (greater than 12 months investment horizon) we view the downside as quite limited with the current of valuation. Management believes that their shares are undervalued and is taking steps to improve the valuation.   The company has a history of opportunistic share buybacks at low prices during the financial crisis.  Given the strong cash position and the frustration management had with the stock price, we do not rule out the possibility of another buyback announcement if the price drops lower from here.

Target price:

We believe such a well-run company with strong growth prospects and shareholder friendly management should deserve at least a 10x PE multiple, equating a price of $5.20 based on our conservative estimates.  This price target represents 74% upside from the current stock price of $2.95.  In a pessimistic scenario where Tianyin’s actual earnings fall 20% short of their FY11 guidance, the target price from appying the current 8x trailing multiple gets us a $3.32 stock, still a 13% upside from current level.  Considering management’s history of exceeding their guidance, we consider such shortfall highly unlikely.