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Seeking Clarity on Lotus Pharma

This company's shares should rise if it can do a better job of telling its story to investors.

Lotus Pharmaceuticals

(LTUS.OB)

is a low-priced China stock that may offer an attractive risk/reward opportunity.

We identified this stock as a special-situation play on Sept. 30, when shares were fetching 84 cents. They recently traded at $1.09.

In an

Oct. 14 article

we pointed that Lotus Pharmaceuticals was among the China penny stocks that were trading for less than book value. We also noted that although we initially had concerns about the company's liquidity situation, they appeared to be unfounded.

Today we'd like to provide more detail about those initial worries, which stemmed from our reading of

Securities and Exchange Commission

filings, and what we later learned in discussions with company management.

One concern was the company's ownership structure. According to the filings, Lotus Pharmaceuticals is a U.S. holding company that provides guidance and instructions to Lotus East, the Beijing-based operating entity. In return, Lotus Pharmaceuticals received a contracted fee, but it was several million dollars past due, according the filings.

Management had the following reply:

"The Company's structure is commonly used to allow foreign investors to invest in operating businesses in China. A set of contractual agreements provides the holding company with effective voting and management control over Lotus East in Beijing. In fact, the management of the holding entity is the same as the management in Lotus East."

The company went on to say that the ownership structure does not contractually obligate Lotus East to pay the U.S. holding company and that the statements about the past-due payments were thus made in error.

Second, we asked the company to explain why its current ratio in less than one. Management explained that "capital expenditures are being spent on preparing for the construction of a new office in Beijing, completing the foundation of the Inner Mongolia facility."

Third, we asked Lotus to give us insight into its accounts receivable policies. Management responded that "days outstanding in accounts receivable for the company's hospital customers are around 30 days. Its distributor customers pay on a cash basis."

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Lastly, we asked Lotus how it could grow earnings in the pricing-pressure environment it is currently facing. The company addressed this concern by briefly outlining its 2010 two-pronged growth strategy.

As part of the strategy, Lotus plans on adding five additional product offerings through its own retail locations as well as through third-party distribution channels.

The company also intends to add 15 to 20 third-party distributors to its existing network of 200.

Lotus has expectations that its growth plan will more than offset a soft pricing environment. The company is also comfortable with maintaining net margins of at least 30%. We were not able to pin down a concrete revenue and EPS growth scenario. However, based purely on new product offerings, it seems safe to assume that the company should be able to grow sales by at least 20% in 2010 from our own 2009 revenue estimates of $50 million to $60 million. Furthermore, the Company is on track to hit its net income target of $16.8 million.

In 2007 and 2008, Lotus was able to achieve quarterly revenue growth of more than 25%, with one exception. It also has maintained profitability in every quarter since 2006. However, we would still prefer to see more consistency in the company's quarterly earnings-per-share growth.

We are impressed that the company has been able to dramatically increase profitability in a declining sales environment

We asked the company about its need to raise equity capital, an event that could possibly lead to dilution for existing equity holders. Management indicated that it is not a consideration at the stock's current price. However, the company said it will keep in mind shareholder value if and when it decides to raise more capital.

Ongoing clarifications of the company's improved liquidity would temper our fear of the immediate need to raise capital at unfavorable prices and terms. It is our opinion that the confusing verbiage in the SEC filing was a major factor contributing to the stock selling below its fully diluted book value per share of 98 cents ($1.23 nondiluted) with a price-to-earnings ratio of around 2. Getting substantially above book will partly depend on future EPS growth. Keep in mind that the company has 5 million shares of potentially exercisable warrants.

We are comfortable with the company's liquidity situation, but Lotus Pharmaceuticals needs to do a better job of explaining it to the investing public. If it can do that, and if it can successfully implement its growth plan, its shares should rise.

-- Written by Maj Soueidan in Collegeville, Pa

.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider LTUS.OB to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Soueidan was long Lotus Pharmaceuticals.

Maj Soueidan founded The Market's Edge, Ltd. in 1994, The Markets Edge Hedge Fund in 2006 and GeoInvesting, LLC in 2007. Through his involvement with the equity markets, he developed the strategies that are now at the core of the hedge fund and

geoinvesting.com

. He currently leads a team of researchers and analysts (the GeoTeam) that help investors identify opportunities in today's volatile stock market. The team uses fundamental criteria to analyze stocks in the micro-cap to small-cap arena.