Weikang Bio-Tech Group (OTC BB:WKBT)

The GeoTeam®­ listened to the WKBT 2010 second quarter conference call to determine if the company could meet its full year $17 million make good target despite a weak quarterly performance, resulting from

"harsh weather, which disrupted business operations and impacted our sales."

• Operations are back to normal and normal rate of growth is intact.
  
• Weather disruption should not result in a loss of customers.
  
• Acquisition strategy will be employed as part of overall growth strategy.
  
• Sufficient capacity to fund growth. We hope this means that an equity offering is not in the cards, unless for the purpose of an accretive acquisition.
  
• Upbeat for rest of 2010.
  
• 2010 results will exceed $17.0 million make good target.
  
• Will update outlook soon.

Second Quarter Highlights

• Revenue for the second quarter of 2010 was $10.5 million, down 20.5% from revenue of $13.2 million.
  
• Gross profit was $6.1 million with gross margin of 58.3%.
  
• Net income was $1.9 million in the second quarter of 2010, down 42.5% from $3.3 million, with fully diluted earnings per share of $0.07 vs $0.13.
  
• Non- GAAP net income was $2.8 million and non-GAAP fully diluted earnings per share was $0.10.

"During the second quarter we experienced severely harsh weather which disrupted business operations and impacted our sales. In early May, 2010, the southern and central region of China experienced an unusual amount of heavy rainfall resulting in extreme flooding and high humidity. This extreme weather caused disruption to transportation in the region which in turn prompted a portion of our sales to be postponed," commented Dr. Ying Wang, Chairman & CEO of Weikang Bio-Technology Group Co., Inc. "However, we are pleased to note that the majority of the problems caused by the extreme weather have been resolved and with our strong product offering as well as new therapeutics to be launched this year, we are looking forward to return to healthy revenue and net income growth for the rest of 2010."

Business Outlook

Weikang Bio-Technology intends to increase its sales by expanding its product offering as well as offering consumers value packages by bundling its therapeutics. At the end of August, 2010, the Company intends to launch a new value-add bundled package of its Rongrun Kidney Boost Tonic combined with newly launched therapeutics: Perilla Seed Soft Capsule, Forest Frog Oil Soft Capsule and Yangshen Pill. In the fourth quarter of 2010, Weikang Bio-Technology plans to launch two additional therapeutics, Sha Bai Shuanghuai Soft Capsules and Gouqi Xi Pu Soft Capsules which have the potential to add up to approximately $5.7 million in revenue and up to approximately $2.2 million in net income combined on an annual basis when it reaches full production.

"While the second quarter of 2010 was off due to events outside of managements' control, we are very positive about our outlook for the rest of 2010 as we have several exciting new products that we plan to launch by the end of the year," Mr. Wang continued. "Moreover, we believe our long-term growth opportunities are strong as we remain committed to expanding our distribution network and developing new high quality therapeutics. For example, a project that we believe has an exciting commercial potential is the development of licorice flavonoids for use in therapeutics which we anticipate has the possibility to contribute to over $13 million in annual sales when it reaches full production."

Recall from our recent WKBT article:

Second, we cannot rule out a capital raise as the company has yet to complete a major raise as a public company. Regardless, with the low capital requirement needs of WKBT's model, we are speculating that a raise would only be required to make an accretive acquisition and hopefully at higher valuations. With $18 million in cash and an extremely low valuation, we believe a raise at current price levels would not be a great show of faith to WKBT shareholders. Then again, we must be mindful that the ChinaHybrid space has been known to blind side us with irrational equity raises.

Third and most importantly, there are minimal funding requirements that have to be met to satisfy the original conditions of the reverse merger. As part of the original reverse merger agreement on July 22, 2008 Sinary, the public shell that Weikang merged into and 98% owner of WKBT, was obligated to pay Weikang $7.6 million (RMB 57 million). So far no money has been applied to this liability.

The following passages from the most recent 10Q sums up where WKBT currently stands on this issue:

"Sinary was incorporated under the laws of the State of Nevada on August 31, 2007. On October 25, 2007, Sinary entered into an equity interests transfer agreement with the stockholders of Heilongjiang Weikang, a limited liability company in the PRC, to acquire 100% of the equity interests of Heilongjiang Weikang for 57 million Renminbi (“RMB”), or approximately $7.6 million."

"Under applicable PRC regulations, the acquisition is deemed completed as of November 9, 2007. Pursuant to the terms of the equity interest transfer agreement and the requirements of applicable PRC laws and regulations, Sinary had a grace period to remit the Acquisition Price of RMB 57 million by August 6, 2009, which was extended to June 30, 2010 pursuant to an approval letter issued by PRC government on August 7, 2009. In the event that we are unable to timely remit the Acquisition Price by June 30, 2010, the Heilongjiang Provincial Government and Heilongjiang Office of the State Administration for Industry and Commerce may revoke the approval and license of Weikang as a foreign invested enterprise, and Sinary as the 100% owner of Weikang, thereby unwinding the acquisition. In the event that the acquisition is unwound, we will not be the owner of any equity interest in Weikang, and as a result, Weikang will no longer be our operating business. Should this occur, it would have an absolutely detrimental effect on our business; the Company would most likely fail and YOUR INVESTMENT IN OUR STOCK WOULD BECOME WORTHLESS. If we are unable to timely remit the purchase price for the acquisition of Weikang, the approval and designation of Weikang as a foreign investment enterprise and Sinary as the 100% owner of Weikang may be revoked, and the acquisition of Weikang may be deemed void. Although we may seek to acquire the equity interest of Weikang through other means , we cannot guarantee that we will do so, nor can we guarantee that we will be successful if we do."

The issue that exists here is that, unfortunately, this liability cannot be legally funded via operations.. To rectify this situation, we would suggest that the company utilize debt or a combination of debt and stock, as well as urge management to buy back stock if it completes a raise. This would show a strong commitment to its shareholders.

We have asked the company to respond to this matter as it leads to the perception of a threat to the company's survival.

We also indicated in our report that we were relatively confident that WKBT would rectify this issue.

On August 10, 2010, the company issued a press release announcing that it has indeed put this issue to rest. Even more positive is that due to the structure of the agreement, no stock will be issued to meet capital formation obligations.

Our intent over the short-term is to build a check list to assess the risk position of firms in the ChinaHybrid space. For the time being this will consist of the following: (this list is likely to grow substantially)

Began actively tracking on August 19, 2009 when stock was below $1.00 and traded virtually no volume.

Added to the GeoSpecial list on November 20, 2009 @ $2.90

Catalyst: Solved liquidity issues; Increased capacity; Attained several quarters of respectable EPS growth.
Peak performance: Reached a high of $6.99 on April 5, 2010
Current Price: $3.25

Current road block: Lack of investor awareness; Shares are quite illiquid; Make good net income target of $17.0 million implies growth of just 12.2%; Could not find verbiage in the 2010 first quarter regarding liquidity needs; Funding requirements surrounding original reverse merger transaction still exist.

Remains on the GeoSpecial list. Adjusted EPS for the 2010 first quarter increased 33.3% to $0.20, which would normally qualify a stock as a GeoBargain. However, the weak 2010 growth implied by existing net income targets creates a dilemma for us. The positive news is that the first quarter net income annual run rate is tracking at $22.0 million, which would imply a growth rate of 41.1%. Combine this observation with the company's typically weak first quarter in terms of sales and earnings and we have reason to postulate that the company can handily exceed its target. If we apply the first quarter outstanding share count of 27.4 million and $22.0 in net income, 2010 EPS translates to $0.80, implying EPS growth of 29.0%. Still, investors need to be aware that WKBT may have to deal with some sub par EPS comparisons in the third and fourth quarter depending on how net income is spread out.

Also consider

1. Comments from the 2010 first quarter press release:
   
    "The market opportunity for Traditional Chinese Medicine and Western medicine continues to expand in China as consumers' medical expenditure is estimated to double annually over the next two decades."
   
   "Weikang intends to continue developing new products and expanding its distribution network throughout 2010. The Company has 10 therapeutics in various stages of the SFDA approval process and expects to launch its 10-HDA in the third quarter of 2010 and ShuangBaoGu by the end of 2010."
   
2. The company has openly stated goals to enhance shareholder value.
   
3. Solved liquidity problems we highlighted in our original note.

One stock on our list that may fit this bill is Weikang Bio-Tech Group.

1. Liquidity standing has improved. We have followed Weikang since April 26, 2009 when it had a negative working capital of $8.0 million. Over the past year the company has consistently improved its working capital position, which now stands at positive $1.15 million.
   
2. Need for expansion capital may not be a number one priority. Combined with its $18.1 million cash position and ample production capacity, the company should be able to grow EPS without having to dilute it shares. During a brief conversation with company management, it indicated that tapping the equity markets would mainly occur to take advantage of an accretive acquisition. (As we will discuss later, we would not be in total agreement with such a move at current prices).
   
3. Acquisition opportunities are abound. China's health and nutritional supplements industry is fragmented and characterized by many small players. Weikang believes that it can gobble up a few companies with complimentary product lines that need access to capital, technology and distribution channels that WKBT possesses.
   
4. Impressive growth track record. With healthy pre-tax margins of over 50%, the company has been able to grow EPS for five straight quarters in which only one quarter was below 30%.  Still, at its current price of $3.05 WKBT sports a meager P/E of 4.6
   
   

   Mar Rev (t) EPS	2010 13,959 0.20	Chg 38.1% 33.3%	2009 10,111 0.15	Chg 782% 650%	2008 1,146 0.02
   Jun Rev (t) EPS	- -	- -	13,196 0.13	543% 225%	2,051 0.04
   Sep Rev (t) EPS	- -	- -	11,227 0.16	225% 129%	3,452 0.07
   Dec Rev (t) EPS	- -	-  -	12,950 0.17	109% 6.30%	6,204 0.16
   Totals Rev (t) EPS	- -	- -	47,484 0.62	269% 114%	12,853 0.29

   
   
5. Healthy Product Pipeline. WKBT has a more robust line than usual. Typically the company would like to introduce about 2 to 4 products a year. Currently, WKBT has nine more products that could see preliminary launches during the 2010 third and fourth quarters.

Lack of investor awareness and a small float could make for a limited trading market in WKBT shares. However, the company has recently hired an IR firm and other than price qualifies for NASDAQ listing; two factors that should eventually help increase awareness. Also, the company has aggressively communicated its goal to maximize shareholder value. The validity of this goal is reinforced by the fact that insiders own 88.0% of the stock.

Another potential "psychological" road block is the existence of a 2010 Make good net income target of $17.0 million, associated with a recent private placement, that implies growth of just 12.2%. This creates a dilemma for us, as we normally seek EPS growth rates of at least 30%.

The positive news is that the first quarter's adjusted net income of $5.5 million translates into an annual run rate of $22.0 million which would imply a growth rate of 41.1%. Adjusted EPS for the 2010 first quarter rose 33.3% to $0.20. Combine these observations with the fact that the first quarter has historically been WKBT's low quarter in terms of sales and earnings, gives us added reason to postulate that the company can handily exceed its target. If we apply the first quarter outstanding share count of 27.4 million and $22.0 million in net income, 2010 EPS would come in at $0.80 implying a growth of 29.0%.

Still, investors need to be aware that WKBT may have to deal with some less desirable EPS growth rates in the third and fourth quarters, when comparisons become more challenging, depending on how net income falls.

Dilution:

Investors need to be aware of three issues with respect to dilution.

First, 772,000 in the money warrants exist which translates into only about 3% dilution.

Second, we cannot rule out a capital raise as the company has yet to complete a major raise as a public company. Regardless, with the low capital requirement needs of WKBT's model, we are speculating that a raise would only be required to make an accretive acquisition and hopefully at higher valuations. With $18 million in cash and an extremely low valuation, we believe a raise at current price levels would not be a great show of faith to WKBT shareholders. Then again, we must be mindful that the ChinaHybrid space has been known to blind side us with irrational equity raises.

Third and most importantly, there are minimal funding requirements that have to be met to satisfy the original conditions of the reverse merger. As part of the original reverse merger agreement on July 22, 2008 Sinary, the public shell that Weikang merged into and 98% owner of WKBT, was obligated to pay Weikang $7.6 million (RMB 57 million). So far no money has been applied to this liability.

The following passages from the most recent 10Q sums up where WKBT currently stands on this issue:

"Sinary was incorporated under the laws of the State of Nevada on August 31, 2007. On October 25, 2007, Sinary entered into an equity interests transfer agreement with the stockholders of Heilongjiang Weikang, a limited liability company in the PRC, to acquire 100% of the equity interests of Heilongjiang Weikang for 57 million Renminbi (“RMB”), or approximately $7.6 million."

"Under applicable PRC regulations, the acquisition is deemed completed as of November 9, 2007. Pursuant to the terms of the equity interest transfer agreement and the requirements of applicable PRC laws and regulations, Sinary had a grace period to remit the Acquisition Price of RMB 57 million by August 6, 2009, which was extended to June 30, 2010 pursuant to an approval letter issued by PRC government on August 7, 2009. In the event that we are unable to timely remit the Acquisition Price by June 30, 2010, the Heilongjiang Provincial Government and Heilongjiang Office of the State Administration for Industry and Commerce may revoke the approval and license of Weikang as a foreign invested enterprise, and Sinary as the 100% owner of Weikang, thereby unwinding the acquisition. In the event that the acquisition is unwound, we will not be the owner of any equity interest in Weikang, and as a result, Weikang will no longer be our operating business. Should this occur, it would have an absolutely detrimental effect on our business; the Company would most likely fail and YOUR INVESTMENT IN OUR STOCK WOULD BECOME WORTHLESS. If we are unable to timely remit the purchase price for the acquisition of Weikang, the approval and designation of Weikang as a foreign investment enterprise and Sinary as the 100% owner of Weikang may be revoked, and the acquisition of Weikang may be deemed void. Although we may seek to acquire the equity interest of Weikang through other means , we cannot guarantee that we will do so, nor can we guarantee that we will be successful if we do."

The issue that exists here is that, unfortunately, this liability cannot be legally funded via operations.. To rectify this situation, we would suggest that the company utilize debt or a combination of debt and stock, as well as urge management to buy back stock if it completes a raise. This would show a strong commitment to its shareholders.

We have asked the company to respond to this matter as it leads to the perception of a threat to the company's survival.

Overall we are impressed with WKBT's accomplishments. If the company can put to rest its capital formation issues, which we believe it will, and confirm that the 2010 net income target is conservative, which is often the case with make good targets, we are speculating that its shares can achieve P/E expansion.

Important Note: The financial table and verbiage included in the 2010 first quarter press release seems to contain errors.

The following statement appears incorrect:

Operating income for the first quarter was $6.4 million, up 27.1% from $5.0 million in the first quarter of 2009. Operating margin was 45.6% compared to 49.6% in the same period a year ago. Adjusting for the previously mentioned non-cash, stock-based compensation charge of $912 thousand, non-GAAP operating income was $5.5 million in the first quarter of 2010. Obviously non-GAAP should be higher than GAAP.

The 2010 Non-GAAP pre-tax number should be $7.3 million. Instead of adding back the compensation charge WKBT subtracted it. This is likely no big deal, but right now Chinese firms have to make sure they are impeccable with respect to financial reporting.

The non-GAAP adjusted net income figure of $5.5 million is correct.

"We are pleased to have achieved a record quarter in terms of revenue and net income. Moreover, we believe the strong quarter demonstrates our solid competitive position with our portfolio of proprietary therapeutics and ability to consistently expand our market penetration," commented Mr. Yin Wang, Chairman & CEO of Weikang Bio-Technology Group Co., Inc. "Both Tianfang and Weikang had strong sales growth as a result of our increased distribution network and market coverage."

Weikang intends to continue developing new products and expanding its distribution network throughout 2010. The Company has 10 therapeutics in various stages of the SFDA approval process and expects to launch its 10-HDA in the third quarter of 2010 and ShuangBaoGu by the end of 2010.

"The market opportunity for Traditional Chinese Medicine and Western medicine continues to expand in China as consumers' medical expenditure is estimated to double annually over the next two decades. We remain focused on our long-term growth and expanding our distribution network by increasing our wholesale network and dedicated sales force," Mr. Wang continued. "We also welcome Mr. Hu to the Weikang Bio-Technology executive team who will assist us in increasing our visibility in the investment community and enhancing our shareholder value as we continue to expand our market penetration."

Mr. Wang concludes, "Looking ahead, we will continue our growth strategy of developing newer and higher margin pharmaceutical and nutriceutical products, while expanding our sales and distribution network in China. In 2010, we will also deploy more time and resources towards the U.S. capital markets by increasing our investor relations efforts and potentially uplifting to a senior stock exchange. The management team is fully committed to build long term value for all of our stakeholders."

Source: MarketWire (April 5,  2009)

Net income targets in connection with private placement on January 20, 2010:  

• Fiscal Year ending December 31, 2009: $13,000,000 
• Fiscal year ending December 31, 2010: $17,000,000 

Formula to be applied to issue shares to investors if targets are not attained:

• The percentage of variation of the Actual 2009 Net Income from the 2009 Targeted Net Income times the number of Purchased Shares acquired by such Subscriber pursuant to the private placement.
• The percentage of variation of the Actual 2010 Net Income from the 2010 Targeted Net Income times the number of Purchased Shares acquired by such Subscriber pursuant to the private placement.

Example..

if the Actual 2009 Net Income is $11,700,000, which is a variation of 10% of the 2009 Targeted Net Income, then the Company shall issue to each Subscriber, shares of the Company’s Common Stock, equal to a total of 10% of the Purchased Shares acquired by such Subscriber hereunder.

New Share Structure due to a private placement transaction on January 20, 2010:

Post Merger Share Calculation:

• 25,479,800: Pre transaction outstanding shares
•  1,470,588 : Newly issued shares of Common Stock 
•      180,000: Shares issued to investor relations firm
•      600,000: Shares issued consultant
•          7,000: Shares to legal firm 
•      312,500: Shares from series A warrants associated with private placement
•      312,500: Shares from series B warrants associated with private placement
•        73,528: Series A warrants to placement agents
•        73,528: Series B warrants to placement agents 

GeoTeam® best effort calculation of total post transaction fully diluted shares assuming full conversions:  28,509,444

WKBT reported 2009 net income of $15.6 million, which exceeded its 2009 net income target figure of $13.0 million. The 2010 net income target is $17.0 million.

More due diligence is required to determine if 2010 EPS can grow at least 30%, which seems like a tall task:

• The 2010 net income target is calling for 8.7% growth.
• Dilution from recent private placement.

However, the company did handily beat its 2009 target. Furthermore, with trailing EPS of $0.62 WKBT shares are trading at a meager P/E of 6.82. Combine this with:

Mr. Wang concludes, "Looking ahead, we will continue our growth strategy of developing newer and higher margin pharmaceutical and nutriceutical products, while expanding our sales and distribution network in China. In 2010, we will also deploy more time and resources towards the U.S. capital markets by increasing our investor relations efforts and potentially uplifting to a senior stock exchange. The management team is fully committed to build long term value for all of our stakeholders."

Gives us hope that investors will bid up WKBT shares to a more appropriate P/E multiple.

We have mentioned Weikang Bio-Tech twice over the past year and a half, indicating that it may qualify as a GeoSpecial if it could rectify some outstanding liquidity issues.

At eh outset of tracking Weikang, the Company had negative working capital of $8 million due to a rather large financial obligation of approximately $7.6 million that it was supposed to satisfy by October of 2009. A financing arrangement to remedy this situation has yet to occur.

The good news is that the date to meet its financial obligation has been extended to June 30, 2010. Also, the negative working capital situation is much improved, having been reduced to $46,218 from $4.27 million in its 2009 second quarter. This coupled with Weikang's low valuation has prompted us to code WKBT as a low tier GeoSpecial. We must realize that the risk of a dilutive capital raising event still exists. We also need information on whether or not the Company is operating at full capacity, a factor that could impact near term growth as EPS comparisons will be more challenging.

Valuation Parameters:
Price as of November 20, 2009: $2.75
Trailing EPS: $0.59
Trailing P/E: 4.7
Nine months EPS growth rate: 238.5%
PEG Ratio (P/E divided by EPS growth rate): 0.02

Weikang Bio-Tech Group reported strong 2009 second quarter results after the close today.  Once again, the company was able to post solid growth in sales and earnings per share.

• Revenues increased 544% to $13.20 million.
• Earning per share increased 225% to $0.13.

Comments about future prospects were encouraging:

Our business will continue to accelerate as we enter the second half of 2009. We are seeing strong demand for our OTC pharmaceuticals and TCM products especially in the midst of China's new healthcare reform initiatives, which will secure our future growth.'

Unfortunately, as we highlighted on May 8, 2009, the company still has issues regarding its liquidity position.  Thus, an  investment decision here is a tough call.   On the flip side, the stock has a tax adjusted P/E of 7.3 and a peg ratio of 1.4.  Given the compelling valuation proposition the GeoTeam® will establish a position in WKBT realizing that there may be substantial dilution risk as management grapples with ways to cure the company's negative working capital position.   If not for the this issue WKBT would be a classic GeoBargain selection.

We have requested an interview with management.  The stock remains on the GeoBargain on the Radar list and is also an ideal candidate for consideration as a GeoSpecial.

As of September 30, 2009, the Company had cash and cash equivalents of $8.71 million, other current assets of $1.02 million, and current liabilities of $9.77 million. Negative working capital was $46,218 at September 30, 2009. The ratio of current assets to current liabilities was 0.99-to-1 as of September 30, 2009.
 
The negative working capital and the ratio of current assets to current liabilities are primarily due to other payables of $7.62 million that Sinary is obligated to pay to the prior owners of Heilongjiang Weikang within one year from the closing of the acquisition of Heilongjiang Weikang. This payable does not bear any interest, and has been renewed to June 30, 2010.

The following is a summary of cash provided by or used in each of the indicated types of activities during the nine months ended September 30, 2009 and 2008, respectively:
 
            
      2009       2008   
Cash provided by (used in):                
Operating Activities     $ 11,325,255       $ 3,698,792   
Investing Activities     $ (27,751 )     $ (78,638 )
Financing Activities     $ (2,614,430)       $ (2,633,277 ) 

 
    Net cash provided by operating activities was $11.33 million for the nine months ended September 30, 2009, compared to net cash provided by operating activities of $3.70 million for the comparable period of 2008. The increase in net cash inflow from operating activities was mainly due to an increase in our net income with faster collection on accounts receivable.
 
    Net cash used in investing activities was $27,751 for the nine months ended September 30, 2009, as compared to net cash used in investing activities of $78,638 for the nine months ended September 30, 2008.  The cash outflow during the nine months ended September 30, 2009 was mainly due to the acquisition of additional office equipment.
 
Net cash used in financing activities was $2.61 million for the nine months ended September 30, 2009 compared to net cash used in financing activities of $2.63 million for the nine months ended September 30, 2008. The net cash outflow in financing activities for the nine months ended September 30, 2009 mainly consisted of payment of $3.81 million for the remaining portion of the acquisition price of Tianfang, net of repayment of sales receipts of $1.20 million from the management that was previously deposited into a personal bankcard owned by the Company’s officer mainly for the purpose of convenience on payment collection.  While in the comparable period of 2008, we paid $4.87 million for the first and second installment for the acquisition price of Tianfang, net of $2.46 million repayment of Weikang’s management for the sales receipts that was originally received by Weikang’s management on behalf of Weikang; and a repayment of $0.23 million to a related party.
 
    We do not believe inflation had a significant negative impact on our results of operations during 2009