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3 Plays on Health Care in China

By David Sterman

NEW YORK ( StreetAuthority) -- The health care industry has been on a steady growth path for nearly two decades. That's been good news for investors who have enjoyed almost non-stop gains from the sector. But now, cost pressures are putting heat on the sector and gains have been much harder to come by. In contrast, the party's just beginning for China.

Chinese health care is far earlier on the growth curve and appears to have a long growth path ahead. Chinese per-capita spending on health care is the lowest of any of the 20 largest global economies. Off that low base, key companies look set to grow at a double-digit clip for a number of years to come and offer investors the same consistent gains once offered by American health care stocks.

Here are three companies I've found that appear nicely positioned to capitalize on that trend.

American Oriental Bioengineering

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Growing through acquisitions can be winning strategy if it helps a company develop a broad and compelling set of products. That was the plan for American Oriental Bioengineering (AOB) , a purveyor of plant-based drugs and neutraceuticals. Chinese consumers greatly prefer traditional organic remedies, some of which go back more than a thousand years. AOB hoped to become the leading seller of these traditional remedies. Sales grew from just $32 million in 2004 to more than $250 million by 2008. That helped push shares above $10 a few years ago.

But as the company grew, a major flaw appeared: ABO's acquisition spree was taking it into ever-lower profit margin niches. Margins on earnings before interest, taxes, depreciation and amortization that had been around 35% likely fell down to 20% in 2010. Earnings look to have fallen by half in 2010 to around 26 cents a share. Roughly half of the company's deals have worked out well, and the other half have been disappointing. Sensing the company had been pursuing growth for growth's sake, investors have fled and shares now trade for around $2.40. The luster of this high-growth business model has surely dimmed, but shares now look quite oversold.

Chastened from its buying spree, management now plans to generate organic growth by expanding its national footprint and improving the productivity of its distribution network. Those efforts are starting to bear fruit. In the third quarter of 2010, sales rose 16%, the highest organic growth rate in several years. In fact, all three operating divisions (pharmaceuticals, nutraceuticals and distribution) saw sales rise at least 10% from a year earlier. But profit margins are lower than a year earlier, which explains the downturn in profits. Margins now appear to have stabilized, so EPS is expected to rise roughly 20% in 2011 (to 31 cents) on a projected 12% increase in sales.

Current research and development efforts are focusing on improving the efficacy of AOB's existing products, money likely better spent than on yet another acquisition.

Meanwhile, $92 million in cash holdings accounts for more than half of the company's market value, and shares trade at about 60% of tangible book value. Back out that cash, and shares trade for less than five times projected 2011 cash flow. Shares look capable of rising roughly 40% to the $3.50 to $4 range, assuming AOB can continue to generate the more stable results in posted in the third quarter of 2010. (Fourth-quarter results will likely be released in about a month).
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