China Kangtai Cactus Bio (PINK:CKGT)

China Kangtai Cactus Biotech Announces Acquisition of Tobacco Manufacturer

 Expanding and Broadening Cigarette Markets to Southeast Asia

Harbin, China – July 6, 2010 -- China Kangtai Cactus Biotech Inc. (OTCBB: CKGT), a vertically integrated grower, developer, manufacturer and marketer of a variety of cactus-based products in China, announced today that it has entered into a definitive assets purchase agreement to acquire the assets of Raoping County Dadi Tobacco Trade Center. (Hereinafter referred to as Dadi).

Pursuant to a definitive equity transfer agreement signed on June 28, 2010, the RMB 35 million (approximately $5.1 million) acquisition includes a building, equipment, a warehouse and established brands in Guangdong province and Macao.

Dadi is a tobacco product manufacturer and wholesaler of commodity, hardware and electric equipment. Dadi manufactures tobacco cigarettes in Guangdong province and Macao and sells them under its own brand name mainly throughout Southeast Asia including The Philippines, Taiwan and Myanmar; part of them are also sold to China.

Mr. JianDe Lin, CEO of Dadi, said: "China Kangtai Cactus is a great company that has shown remarkable growth with its line of excellent cactus-based products. We are confident this transaction provides a solid foundation for China Kangtai Cactus to continue building a strong cigarette business.”

China Kangtai Cactus currently outsources cactus-based cigarette production to a manufacturer approved by China’s State Administration for Industry & Commerce and China's State Tobacco Monopoly Bureau.

China Kangtai CEO Jinjiang Wang said, “This acquisition enables us to produce cactus-based cigarettes in our own facilities, which will provide us with stronger cost control and production flexibility. By leveraging Dadi’s brand name and sale channels in The Philippines, Taiwan and Myanmar, we can expand our cactus-based cigarette market sales to Southeast Asia, which we expect to help us significantly broaden future sales. We also expect this acquisition to be accretive to earnings and to significantly increase shareholder value in the long run.”

Investors require more details on this transaction:

1. Will it be accretive in the short-run?

2. More information on the payment terms. (Shares issued)?

On June 28, 2010, China Kangtai Cactus Bio-Tech, Inc., through its wholly-owned subsidiary, Harbin Hainan Kangda Cacti Hygienical Foods Co., Ltd. entered into an Asset Purchase Agreement  with Dadi Tobacco Trade Center of Raoping County in Guangdong Province of China. The Company has agreed to purchase from Seller certain real property and all improvements thereon, and all equipment, fixtures used in connection with the Seller’s operations for RMB (“Renminbi”) 3,500,000 (approximately US$5,147,000) in cash. The real property consists of the land use right to 4,784 square meters of land located in Raoping County of Guangdong Province of China for a period of 50 years.
 
Pursuant to the Agreement, the Company will make payments to the Seller in three installments:

• First installment will consist of 30% of the total purchase price to be paid within 10 days from the date of the execution of the Agreement.
  
• Second installment of 30% of the total purchase price will be paid at the commencement of the title transfer for the assets to be purchased under the Agreement with the applicable regulatory agencies.
  
• The third installment of 40% of the total purchase price will be paid within 5 days following the completion of the title transfer of all assets purchased.

If the Seller does not complete all transfer of title of the assets required by law within 4 months from the date of the Agreement, the Seller will be subject to a penalty equal to 10% of the aggregate purchase price. If the Company does not make payment of the purchased price as set forth in the Agreement, the Company will be subject to a penalty payment equal to 10% of the amount of the installment payment not made at the time set out in the Agreement.
 
The Company currently outsources its cactus cigarettes. This acquisition will provide the Company with cigarette manufacturing capabilities to produce its own cactus cigarettes.

On May 17, 2010 CKGT reported first quarter results.

• First quarter ended March 31, 2010 increased 66% to $5.5 Million
• GAAP net income was $2.4 Million versus $956,673
• Adjusted net income (absent revaluation of Series A preferred Stock and A, B, C and D warrants) rose 20.5% to $836,723 of $0.04 per diluted share versus $693,948 or $0.04 per diluted share in Q1 2009
• Gross profit margin was 27% compared with 37% in the first quarter of 2009.
• Income from operations increased 34% to $1.2 Million from $880,530 in 2009.
• Weighted average number of diluted shares outstanding was 21.7 Million as of March 31, 2010 compared with 19 Million as of March 31, 2009

The stock has since sold off on this report. We suspect that even though the first quarter is historically the weakest quarter for CKGT, investors were likely expecting some EPS growth. Even though sales were robust and more than we had anticipated, lower margins did not allow operating earnings to keep pace.

Ideally, as a company expands, growth is also preferred in the slowest quarter even though the EPS is less then each of the remaining three quarters. It is unfortunate that U.S. investors analyze stocks on a quarterly basis. But we can't ignore the typical investor’s point of view.

We believe that the decline in CKGT shares could have been averted if the company did a better job of educating investors in its press release.

1. Recall from our Rodman conference interview, the company maintained that in order to accelerate its EPS grow rate it would require financing. Although the company's growth assumption may have been conservative, this issue could still lead to investor trepidation. The company did receive funds from a land deal which happened last year between China Kangtai and Government of Qitaihe Cityand and also canceled a pending private placement deal involving 2,100,000 shares. These events may ease the concern of possible dilution. CKGT needs to put this issue to rest.

2. The company did not reiterate guidance or explicitly mention that the first quarter is typically the weakest. Investors need clarity, so the fact that CKGT won't give net income guidance could be causing a perception problem as it pertains to margin uncertainties.

3. Operating income grew at a lesser rate than sales

Product mix played led to decreased margins:

"Sales of raw and intermediate materials were up 170% to $1.6 Million. This had a negative impact on our gross margin because the gross profit rate for raw and intermediate materials is about 11%, compared with substantially higher margins in the other two categories."

Management did not indicate if this situation would change. We can make the assumption that it will, but we need to hear it from the company. Maybe this is a clue to management's own margin uncertainties and lack of net income guidance?

4. We also have to remember that many novice investors are most likely applying a trailing GAAP EPS of $0.08 as opposed to non-GAAP EPS of $0.39 to value CKGT shares.

The GeoTeam has attempted to roughly calculate what the 2010 future quarters will look like.

Revenue estimates using:

• 2010 company revenue guidance of about $35.0 Million
• Past trends (Revenue per Qtr/total sales). This relationship has been remarkably consistent and can provide us with a conservative starting point.

Aggressive Revenue estimate using:

• First quarter sales
• Past trends (Revenue per Qtr/total sales).

Please note that past Revenue per Qtr/total sales relationships may not hold as new products are now in the mix.

The fact that no net income guidance was provided and that no color on margins was provided in the press release will keep investors in limbo regarding EPS. Using our low end EPS estimate from our April 20, 2010 research note of around $0.50 yields the following:

The EPS calculation assumes that non-GAAP net margins will come in around 30%. Of course, if first quarter margins do not improve, EPS could come in lower, unless revenue growth is more robust than company expectations.

Using our more aggressive revenue assumption would yield higher results.

Investors have taken CKGT shares down to its book value per share and an adjusted P/E of 3.3. This low valuation will prompt us to keep CKGT coded as a GeoSpecial until the second quarter is reported or more information becomes available. We will be speaking with CKGT's IR firm on the issues in this research note.

Some good news that may help quell dilution fears:

On April 30, 2010, China Kangtai Cactus bio-Tech, Inc. entered into a termination agreement with Seaside 88, LP pursuant to which the parties agreed to mutually terminate the Common Stock Purchase Agreement, dated November 5, 2009, between the Company and Seaside 88, LP with no further obligations. The parties agreed to enter into the Termination Agreement because the Company believes the financing terms as contemplated by the Purchase Agreement is not in the best interest of the Company at the current time.

As previously disclosed in a Current Report on Form 8-K filed on November 9, 2009, the Purchase Agreement provides for the offer and sale of up to 2,100,000 shares of the Company’s common stock to Seaside.

CKGT reported 2009 results on April 15, 2010. The company posted 2009 adjusted annual EPS growth of around 30%.

But more importantly, after breaking down the numbers and reviewing amended filings it appears that the 2009 fourth quarter adjusted EPS grew 36.4% and experienced sequential quarterly EPS growth throughout 2009:

^aNon-GAAP EPS Figures exclude certain non-operating gains and losses as well as certain non-cash items. Non-GAAP information should not be viewed in isolation or as a substitute for reported, or GAAP information . For a more complete explanation of the company's definition of non-GAAP please refer to its financial press releases. The GeoTeam® non-GAAP figures may, from time to time, differ from company supplied figures.The GeoTeam® non-GAAP figures apply a 25% and 36% tax rate for Chinese and United States companies respectively.

Why the IR firm did not persuade CKGT provide fourth quarter information in the release baffles us. Investors are going to attempt the calculations anyway… Why make our life harder and results open to interpretation? At least in this case the fourth quarter results were positive.

On the bright side, CKGT reaffirmed its revenue guidance for 30% growth in 2010; but with no net income guidance we are still left somewhat in the dark. If we assume that adjusted 4^th quarter margins will hold, we are looking at 2010 EPS of $0.59 equating to a forward a P/E of 4.45. If we use adjusted year end margins, we are looking at 2010 EPS of $0.49 and a P/E of 5.36. Also, if seasonality is not an issue, then the next two quarters look like easy comps. The challenge for EPS growth begins in the 2010 third quarter where numbers become more challenging.

It is quite a frustrating situation in which a company that has a current ratio of 5.8, a growth rate of 30% and a P/E ratio of less than 10 to sell for less than two times its book value of $1.47.

At this point I can think of the following reasons for this conundrum:

1. Poor IR
2. Lack of clarity in quarterly press releases
3. Confusion over its Series A Preferred Stock/associated warrants and its effect on the income statement. The company needs to break down non-GAAP EPS on a quarterly basis, not just on an annually.
4. Dilution of about 10% from preferred stock and in money the warrants .
5. Investor speculation that the company will have to raise money? We think this would be egregious at these levels, but with ridiculous offerings terms that take place in the ChinaHybrid space, who knows anymore.

CKGT issued revenue guidance this morning.  The company did not provide any net income or EPS guidance. The stock did not react in a way that some may have hoped so we worked through the numbers to achieve a better grip of EPS implications. We came up with the following:

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So, even though the 2009 year will show growth in EPS,  it is possible that short-term investors were unimpressed due to the possibility of a weak fourth quarter. (Our  EPS calculation for the 2008 4th qtr. is much less than the $0.18 GAAP EPS that Reuters portrays). We look forward to the company’s year end release and the light it might shed on 2010 prospects. We particularly would like to understand what CKGT financing needs are. Until this time we we will keep CKGT coded as a GeoSpecial.

^a Non-GAAP EPS Figures exclude certain non-operating gains and losses as well as certain non-cash items. Non-GAAP information should not be viewed in isolation or as a substitute for reported, or GAAP information . For a more complete explanation of the company's definition of non-GAAP please refer to its financial press releases. The GeoTeam® non-GAAP figures may, from time to time, differ from company supplied figures.The GeoTeam® non-GAAP figures apply a 25% and 36% tax rate for Chinese and United States companies respectively.

^b China Kangtai Cactus Bio did not provide EPS guidance. The GeoTeam® calculated an implied EPS figure using the current outstanding share count, current margins and revenue guidance.  Using the current share count is likely an unrealistic assumption.