Chinese Pharma Firm Ramps Up Production

China-Biotics is well positioned to serve a large, underserved probiotics market in China.
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Editor's note: This article was updated to reflect comments from the company's CFO, who clarified some information in the story.

I recently met with Travis Cai, the chief financial officer of

China-Biotics

(CHBT)

in Shanghai. The company is the largest provider of probiotic bacteria in China -- a segment of biopharmaceutical research that's often misunderstood and under-recognized by investors.

Travis, a well-spoken CFO, just joined the company in February. It's clear he's here to help the company cultivate its image in front of Western investors. He did his undergraduate work at Tsinghua University in Beijing and has a master's degree from the Stern School at New York University.

So, what are probiotics? You might have seen them mentioned in Activia commercials with actress Jaime Lee Curtis. They are live micro-organisms which, when administered in adequate amounts, confer a health benefit on the host (user). They can play an important role in immunological, digestive and respiratory functions.

Some of the uses for probiotics include improving the health of your gastrointestinal tract, stimulating your immune system, helping to break down nutrients properly, reducing the creation of toxins, and reducing symptoms of lactose intolerance. They get added to nutritional products (supplements/powders), dairy products, food additives, animal feed additives, and pharmaceuticals.

The key thing for investors to understand about probiotics is that the market is large and underserved in China. The Asian market for probiotics is expected to reach $9 billion by 2014. Asians, especially women, have a higher need for this type of bacteria to help their digestive systems.

The biggest area in the Chinese market is dairy, which isn't fully served by Chinese producers and still relies on European suppliers. China-Biotics hopes to exploit its current position as the largest Chinese producer of probiotics.

China-Biotics, founded in 1999, has its headquarters in Shanghai. It has been growing like a weed. Its top-line revenues have a CAGR of 35% for the last three years. The company, which had a trailing 12 months revenue of $71 million, recently guided a 50% increase in its top line for this year.

It sells its supplements and powder to retail customers through over 100 outlets in 13 cities (mostly in or near Shanghai) under the "Shining" brand. It certainly has an expansion opportunity in retail to the rest of the country. However, China-Biotics biggest opportunities are in dairy and animal feed, not retail. It wants to provide the additives to yogurt-based drinks and infant formula sold in China, as well as to the $58 billion Chinese animal feed market.

CHBT's gross margins have been an eye-popping 71% for the last two years. It also has $151 million in cash on its balance sheet. This will give it the flexibility to add further production capability. Let's talk about the importance of production for this company and its forward valuation.

In February, it opened a new 150 metric ton (MT) manufacturing facility for supplying the bulk market users of probiotics. At the moment, that facility is not yet fully operational. It expects it to be up to 75 MT production capability by this fall and 225 MT by 2011.

Why is that production capability important? China will use 10,600 MT of probiotics this year. That means, by next year, when China-Biotics is up to 150 MT capability, which allows it only address 1.4% of the current market. When you have gross margins over 70%, every new dollar of sales to a domestic market that is still importing to meet its needs goes almost entirely to the bottom line. More production capability means more EBITDA.

The Chinese market for probiotics, which has tripled in four years, will likely increase its growth, and CHBT is the largest producer today.

Production directly leads to sales and earnings. So, what the market is failing to understand is that China-Biotics should be able to effectively sextuple its sales by the end of the year (at least on a run-rate basis). The company confirmed its old facility had capacity to produce 12 MT, which produced the reported results in the most quarter.

Then, it can double it again by 2011 if it expands the existing plant as is its stated plan. Then, it can probably at least double it again by building a new facility with cash on hand. Even if it did all that, it would only be able to supply 5.6% of the existing market today (and realistically only 4% of the enlarged probiotic market by 2012 or 2013).

But what does producing 600 MT of probiotics in 2012 (if it built a second plan, which it hasn't commited to) versus 75 MT at its year-end run-rate translate into from a revenue perspective? Considering a doubling in its production capacity, a full 75 MT production quarter should produce EBITDA of $20 million compared to $10 million in the December quarter. Annualizing that number, CHBT trades currently at an enterprise value to EBITDA ratio of 5.8 times.

If it is really able to get up to 300 MT of production next year (from over 75 MT currently - and it hasn't comitted to that number by then), CHBT should be able to produce $160 million of EBITDA. That means CHBT has a forward enterprise value to EBITDA ratio of just 1.46x.

In its last reported quarter (ending Dec. 31), we estimate that China-Biotics were still only producing half (and it's probably more realistic one sixth) of what its production capability of probiotics will be at the end of the year. Its new facility went live mid-February (or midway through the current quarter). That means its quarter to be reported next month should demonstrate some upside compared to historical comparisons. I expect these reported results (which will come out by mid-June) to be a catalyst for the stock.

Assuming China-Biotics tracks to its 300 MT production capability to be operational by 2011, or slightly after, it's not unreasonable to expect the stock to finish this year at $50.

At the time of publication, Jackson was long position China-Biotics

.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider China-Biotics 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.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson