Tongjitang Chinese Medicines Company (TCM) received a buyout offer from its Chairman and CEO, Mr. Xiaochun Wang, for $10.20 per ADS on March 10, 2008, a 55% premium to its closing price on March 7 of $6.60 per ADS.

In late March, the special committee of the Board of Directors of Tongjitang Chinese Medicines Company announced that Morgan Stanley Asia Limited has been appointed as its financial advisor. Morgan Stanley will assist the Special Committee in its evaluation of the proposal by Mr. Xiaochun Wang and Mr. Yongcun Chen to acquire all of the outstanding ordinary shares of the Company (including ordinary shares outstanding in the form of American Depositary Shares) not owned by Mr. Xiaochun Wang, Mr. Yongcun Chen or their affiliates in a scheme of arrangement transaction under Cayman Islands law that would result in the Company becoming a privately-held company.

Tongjitang made its IPO at NYSE one year ago in March of 2007 at $10 per ADS. It has traded as high as $12.88, but the recent downtrend in stock markets took the stock price to new lows. Tongjitang makes modernized forms of traditional Chinese medicines.

The company floated 9.9 million ADSs in the IPO, so its cash reserves of $108 million will just about pay for the entire go-private move. Nevertheless, the offer is contingent upon obtaining financing.

Of the 33.4 million ADSs outstanding, Mr. Wang holds about one-third. One of the directors is participating with him on the buy-out, which is being considered by the remainder of the board.

One of the upshots of the buy-out would be that the company would no longer have a publicly traded stock to use as currency to make acquisitions. However, that could be seen as a bonus, because the stock had fallen to a point where it was trading at just 7.3 times trailing 12 month earnings. At that point, a privately held stock may be more valuable. For a profitable company like Tongjitang, an IPO is often a means to make acquisitions, but Tongjitang has not announced any during the past 12 months.

Tongjitang Chinese Medicine’s ADSs responded to the announcement, rising $2.23 to $8.83, a 34% jump. The fact that the ADS price remains a long way from the $10.25 buy-out offer indicates investors have considerable doubt the deal will go through.

Performance

Tongjitang is a solidly profitable company. In the most recently announced 12 months (ending September 2007), it earned $26 million on revenues of $80 million. While profitable and well-stocked with cash, Tongjitang reported in Q3 that its main source of revenue, the osteoporosis drug Xianling Gubao, increased its sales just 2% over the year-earlier quarter.

Tongjitang Chinese Medicines Company said recently that share-based compensation costs took its net operating income down to almost zero in the fourth quarter. Without special charges, which include share-based compensation and other public company-related charges, Tongjitang would have reported net operating income of 55.2 million RMB ($7.6 million), a 55% improvement over the 35.5 million RMB ($4.9 million) the company earned in Q4 of 2006.

The decline is net operating income occurred despite an 18% increase in revenues, which were 180 million RMB ($24.6 million). Sales of the company’s main revenue driver, the osteoporosis treatment Xianling Gubao, were up 14% to 135 million RMB ($18.5 million) while other products increased their sales by 67%.

Following its IPO last March, Tongjitang has had a large cash position of $110 million. The cash earned interest, which took its null income from operations to a profit of $2.5 million.

For the 2007 full-year, Tongjitang recorded a 23% increase in revenues, which came in at 596 million RMB ($81.7 million). Profits from operations were down 19% at 121 million RMB ($16.6 million), largely because of the Q4 disappointment. Nevertheless, net income, with the interest income added in, moved up 27% to 171 million RMB ($23.5 million). 2007 net income was 76 cents per ADS.

Potential Risks

Although Tongjitang is a profitable, well-funded company, it is not growing as fast as its peers. It also has the problem of being heavily dependent upon its main product, Xianling Gubao. The company is developing new products, and it spends money on marketing, but its efforts have not provided big revenue and profit increases so far.

Any change in Government policies could materially affect Tongjitang. Exclusion of its products from the National Insurance Program, a price control decrease in its selling price or a change in it favorable tax rate could change the high net margins in currently obtains.

Tongjitang’s competitive protection relies on proprietary manufacturing processes, brand name and trade secrets rather than patents. It is therefore subject to some copycat competitors, who try to knock off its main products. However, Tongjitang is a reputable manufacturer of traditional medicines and that is not easy for an inexpensive knock off to compete against. Tongjitang’s products are included in a catalog of medicines that are covered by a national insurance program and have been proven through a clinical trial process.

During the IPO process, Tongjitang identified some accounting weaknesses. This is primarily related to its ability to report in US GAAP. Management has stated that they are correcting the situation but it is something to keep an eye on.

Future Prospects

Despite some risks above, Tongjitang’s business has been growing well in the last few years with excellent fundamentals. The aging population and growing middle class are two strong macro trends that are not going to diminish. Also, with a pure China play like Tongjitang, a North American investor will benefit from the expected appreciation of the Chinese Yuan. On top of all this, the Chinese government is making life easy for Tongjitang by including its medicines in the National Insurance program and lowering its tax rate. 

Tongjitang’s management has stated that it wants to be a leading consolidator in a highly fragmented industry, possibly using its shares as currency. Management therefore is highly motivated to unlock value in their shares. This could come in the form of share buy backs.

The recent buyout offer of $10.20 from two insiders highlights a couple of main points for investors. First, several insiders feel that the current share price is deeply undervalued, which is always encouraging. Second, the offer is contingent on financing, there is no guarantee that the buyout will occur and Tongjitang’s share price could be subject to increased volatility in the next few months.