Traditional Chinese Medicine has survived over 3000 years. Today’s stock analysis takes us deep into this culturally engrained market, deep into the heart of China. This stock isn’t institutionally owned. It’s a nano-cap. It’s Shandong Spring Pharmaceutical stock (CYIG).
The fundamentals filter says we can buy it for a fifth of what it’s physical assets are worth today, watch it debt-less-ly grow the top-line 15%, and have it pay us our money back in a couple of years. Wow! That’s anomaly-level good. Let’s try to disprove it!
Spring Pharmaceutical stock (CYIG) is sold over the counter, OTC. It passes enough regulation not to be a penny stock, and I think can be counted as one of the more successful, small growth companies trading over the counter. Still very risky though as you’ll see. Risk management remains at the epicentre of this analysis… has the market judged Spring’s risk properly at PE:2?
Spring Pharmaceutical (CYIG) Stock’s Industry
Traditional Chinese Medicine has modernised of course. This correlates with Spring becoming more pharmaceutical than biotechnological. Spring started as a biotech firm. That means its breakthroughs came in surges instead of through gradual development. Spring is also a farm, and that has removed much of the biotech risk from the stock.TCM has a 20% growth rate owing to –
- An aging population who are expected to suffer more chronic diseases
- A growing middle class
- And the whole industry being a Chinese national strategy.
How Spring Makes Money
So how does it make its money? Well, it has 3 business segments on the go. Heard of Omega, an Omega 9 fatty acid? That’s one of them! It’s beneficial in all these ways-
- Memory-related brain health
- Blood lip regulation
One Omega 9 fatty acid is nervonic acid. Put it into a medicine, and that’s the product. 20% of revenue.
Sources of Nervonic Acid
One is the seed oil of a maple tree. A maple tree found only in China. Shark brains have it as well, but the UN has sanctioned that. There’s also a plant called Malania Oleifera, but that’s a protected species. So Spring Pharmaceutical (CYIG) deem this maple tree to be the best commercial source of nervonic acid. And it’s sunk a lot into that belief: $50m for a maple tree farm, in fact!
Spring Pharma has 50% market share according to its own figures.
Vertically integrating with the farm gives them a competitive cost and pricing advantage. The company sees its future growth mainly from this nervonic acid segment.
Another third of its business comes from another traditional medicine, known as Huoliyuan. 35% of revenue. Spring has 27% share of a fragmented Huoliyuan market. It is the clear leader in the industry by market share, its 2 closest competitors enjoying around 10% each. Huoliyuan has been tested once to be a beneficial aid to –
- Cardiovascular issues
- Chronic hepatitis
- Memory loss
- Menopause syndrome
But the real benefit for Spring Pharma is it’s the only company to produce it in capsules, instead of tablets. Customers prefer it. It’s a prescription drug though, you can’t just walk in and buy it!
The growing TCM market is a runway for growing its top line 15%. It also its maple tree farm helping them to keep up with demand. Planting, irrigating, and fertilising its farm costs it 10% of earnings. That’s not capital intensive. Most free cash flows are left in-tact.
2018 cash flows were $16m. Closer inspection reveals some one-offs though; accounts receivables from previous years and selling parts of its inventory. It would have been $7 or 8 million in earnings but for these one-off factors.
There’s no dividend. The earnings are invested back into the business at a decent 10% return. No debt at all. Relatively cash rich.
But this all makes our price to normalized free cash flow; 2! So is this the worst quality business in the world that’s only going to be around for 2 more years? Because that’s what that ratio suggests. Or this an undiscovered steal? Let’s assume the former and see if we can’t stump ourselves for a reason not to invest.
Risks to How Spring Makes Money
When it comes to the nervonic acid wing of its business… it’s already sunk costs and made commitments. Efforts out there to contrive a better source of nervonic acid need to fail. Cultured Malania Oleifera and biosynthesis from chemicals are the threats. This recent study targeted the right genes to engineer nervonic acid. It’s studies like this where the penny drops.
If Spring is technologically leapfrogged, its gross margin becomes uncompetitive. Its cost commitments to maple trees would become competitively disadvantageous not advantageous. Biotech research is complicated stuff. No expert to inform you of bad news ahead of time? And the falling stock price will.
Second; Spring has no insurance. There are perils in farming. So it’s a gamble on there being no natural disasters before the company can diversify into more farms. Weak typhoons can hit Shandong as they move north. However, Spring is also on a tectonic plate. Munich Reinsurance sees danger over the next 10 years to that region and I reckon Spring could build 2 more farms in that time if maple tree farms are indeed still competitive as we’ve questioned.
The Maple tree is apparently heat and drought resistant. Oregon State reveal a direct relative in its species has these characteristics which is good support. Regardless, we’re playing chicken with the weather. Spring can’t easily go back to using old suppliers for seed pods, because time spent transitioning back would work against Spring’s market power with its direct sales network. Its direct-sales network would either leave, or be able to negotiate better terms against Spring.
It’s a prescription drug. Being in capsule form is its edge. As competitors catch up to capsules, it may lose its edge and stop winning prescriptions. Only province authorities could say. Spring’s competitors are all private companies, so whether they’re catching up is unknown. Unknowns are risks to us as investors.
Compounding that, 44% of raw materials for Huoliyuan come from just 1 supplier. That supplier is unnamed, too! But with management putting down fixed and large investments like the tree farm, they must have confidence in its financial health to continue supporting a third of its revenues.
And finally reselling, Spring Pharma distributes 95% percent of Yongchuntang’s products! So it has the bargaining power and it needs it, because it relies on a license belonging to Yongchuntang, to actually sell the products. Spring doesn’t have its own license!
In fact, that license isn’t just granted to them for reselling. It takes its Nervonic acid business to market as well! The Houliyuan capsules are handled by a third party, by law.
The relationship between Spring and Yongchuntang is absolutely important. If it disintegrates, 60% of our investment returns disintegrate.
So how is the relationship? Very, very close. I wouldn’t be surprised if both companies worked in the same office…
- Both are Shandong companies
- Many Spring executives & board members have worked at Yongchuntang. The CEO, CFO and Chairman prime examples
- Yongchuntang owns 3% of Spring
- And a few years ago the two traded a patent, and Spring paid 40% less than fair value. They both knew what fair value was!
So it’s an interesting dynamic. Personal, maybe informal, probably strong.
According to a deal, Spring has to pay $1.6m to Yongchuntang if it can’t grow reselling sales 20% over a year. Spring have never failed at this task, and it’s a common contract stipulation. $1.6m is covered handsomely by Springs $35m cash reserve anyway.
Systemic problems for Spring Pharmaceutical stock (CYIG) without possible solutions are;
→ Either being hit by a storm or being technologically vaulted. That would impair or destroy 20% of our earnings. → Losing its edge as the sole producer of Houliyuan capsules. That would impair or destroy 36% more of our earnings. → A breakdown in the informal relationship between Spring and Yongchuntang. That would impair or destroy the rest of our earnings (44%).
Is it all going to happen in 2 years? Risk is subjective: your call. My call is no. I disagree with the market. An annihilation of value at Spring is not on the horizon. The reselling business appears most likely to live long. I still want to see the array of risks resolved anyway. I want the business to become higher quality – so the multiple can rise.
If it could garner unquestionable competitive advantages and unquestionable long-term prospects (like its industry) that would complete a brilliant investment picture for Spring Pharmaceutical stock (CYIG). Because it’s financially all there otherwise. But oh well, onto the next one!