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American Oriental Stands at Neutral

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We reiterate our Neutral recommendation on American Oriental Bioengineering, Inc. with a target price of $1.00.

The company recently reported its financial results for the second quarter of 2011. Earnings per share during the quarter came in at 5 cents per share, 2 cents short of both the Zacks Consensus Estimate and the year-ago earnings. Earnings were hurt by lower revenues, which declined 30% year over year to $54.1 million. Weakness in the manufacturing segment (down 31.8%) was responsible for the slide in revenues. Revenues were well below the Zacks Consensus Estimate of $82 million.

American Oriental earns revenues from two operating segments – manufacturing and distribution. While the manufacturing business accounted for approximately 93.6% (50.3 million) of the company’s total revenue, the distribution business – Nuo Hua generated the remaining revenues of $3.8 million. (Read our full coverage on the earnings at: American Oriental Misses)

We note that the company operates in a highly competitive environment. American Oriental’s SHL injection powder primarily competes with Harbin Pharmaceutical Group, which produces a very similar injection powder product. Another product, Cease Enuresis Soft Gel competes with Jianpizhiyi Tablet (produced by Shangdong Zhiling), Yeniaoying (produced by Tianjin Zhongxin), Shengjiyiniaokang (produced by Shanxi Dingxing) and Suoquan Pill produced by (Jilin Tianguang). Additionally, products such as Jinji Capsule and Jinji Pill compete with Huahong Pill produced by Huahong Pharmaceutical Group and Qianjin Pill produced by Qianjin Pharmaceutical Group. Soy Peptide products compete with Leneng Peptide Powder, produced by Leneng Bioengineering and Soybean Protein Peptide produced by Harbin High-Tech. The excessive competition confronting the company’s products concern us.

Moreover, over the last few years, American Oriental’s operating margin has declined steadily. From 32% in 2007, 24% in 2008, 20% in 2009, the margin hit a low of approximately 10% in 2010. If this declining trend continues, the company’s bottom-line will be severely affected.

However, we note that the pharmaceutical industry in China is growing rapidly. The growth is attributable to the government’s efforts to improve the healthcare infrastructure coupled with its goal to achieve near-universal health coverage. We believe prescription drug sales will continue their growth trajectory as China aims to reform its health care sector to incorporate unaddressed rural markets.  Management believes that by 2020 the entire Chinese population will have access to safe, effective and affordable healthcare services. The rapidly growing Chinese pharma market provides a lucrative opportunity to American Oriental to increase its revenue.

Further, American Oriental believes in the strategy of growth by acquisitions. The company has completed multiple acquisitions in the past few years which have expanded its product portfolio and contributed to growth. For example, with the acquisition of Nuo Hua Investment Company Ltd. in 2008, the distribution of pharmaceutical products became a part of the company’s operations. American Oriental currently distributes more than 13,000 pharmaceutical products. We believe that such profitable acquisitions in future will aid the company’s growth.

We prefer to remain on the sidelines till further visibility is obtained on the growth of the Chinese pharmaceutical industry and its impact on American Oriental. Consequently, we remain Neutral on the stock, which carries a Zacks #3 Rank (Hold rating) in the short-run.

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