Lotus Pharmaceuticals (OTC BB:LTUS)

Re-pricing of risk premium

Seeking Clarity with Lotus Pharmaceuticals

On August 27, 2009, we published an update on Lotus Pharmaceuticals (OTCBB:LTUS), a China-based manufacturer and distributor of pharmaceutical products. The update echoed similar thoughts shared in prior notes about liquidity constraints. We derived our conclusions from verbiage contained in SEC filings.  

After speaking with Lotus management, we believe the stock offers an attractive risk/reward opportunity and is in part the reason why we identified the stock as a special situation play on September 30, 2009 at $0.84.

At first glance, we identified four issues that were cause for concern:

Issue 1 - Ownership Structure

The ownership structure is addressed in the Company’s most recent filings, after which the text indicates a past due payment of several million dollars accompanied by the following verbiage:

Lotus East is comprised of two pharmaceutical companies in the PRC, both of which have contractual obligations to Lotus Pharmaceuticals (USA). Lotus provides guidance and instructions on Lotus East's daily operations, financial management and employment issues. As a result of these contractual arrangements, which enable Lotus International to control Lotus East, Lotus International is considered the primary beneficiary of Lotus East.

The filing goes on to infer that this ownership structure obligates Lotus East to pay Lotus (USA) management fees.

Question Posed to LTUS Management

Please explain in simple terms what the ownership structure really is and why it had to be structured in such a manner?

Answer

The Company’s structure is commonly used to allow foreign investors to invest in operating businesses in China.   Our holding company Lotus Pharmaceuticals and its subsidiary in the US have no operations. All of our operations are conducted through our two controlled entities (called “Lotus East”) in China. A set of contractual agreements provide the holding company with effective voting and management control over Lotus East in Beijing.  In fact, the management of the holding entity is the same as the management in Lotus East. The board of Lotus Pharmaceuticals has decided that incomes generated by the operating entities are retained within China for operating purposes.

The Company spoke with us about these and other statements made in the filings, explaining that some commentary was made in error and that there is no money owed to Lotus (USA). The ownership structure does not contractually obligate Lotus East to pay Lotus (USA).

Issue 2 – Lotus Pharmaceutical’s Current Ratio

Question Posed to LTUS Management

In simple terms, please explain why LTUS current ratio in less than one?

Answer

Current ratio is less than on, because the Company’s capital expenditures are being spent on preparing a new office in Beijing to be built, completing the foundation of the Inner Mongolia facility.

Issue 3 - Accounts Receivable Issue

Question

In simple terms, please explain your AR situation?

Answer

Days outstanding in accounts receivable for the company’s hospital customers are around 30 days. Its distributor customers pay on a cash basis.

Issue 4 - Pricing Pressure

Lotus has been experiencing pricing pressure on its products, resulting in lower sales for the first six months of 2009. The Company addressed this concern to us by briefly outlining its 2010 two pronged growth strategy.

First, Lotus plans on increasing its product offerings. The Company currently sells its products through its own retail locations as well as through third party distribution channels. Lotus plans to offer an additional 5 drugs through these channels.

Second, Lotus intends to increase its third party distribution network.  The Company currently has about 200 third party distributors and sees additional 15 to 20 in 2010. The company was not able to provide an “average revenue per distributor” figure.

Lotus has expectations that its increased product offerings and distribution channels will more than offset a soft pricing environment. The Company is also comfortable with maintaining net-margins of at least 30%. We were not able to pin down a concrete revenue and EPS growth scenario. However, based purely on new product offerings, it seems safe to assume that the company should be able to grow sales by at least 20% in 2010.  This year, we feel that Lotus sales will achieve $50 to $60 million in revenue. Furthermore, the Company is on track to hit its make good net income target of $16.8 million.

It is important to note that apart from this year, Lotus has been able to achieve over 25% quarterly revenue growth in 2007 & 2008, missing this mark only once. Although the Company has maintained profitability in every quarter since 2006 and had consistently posted year over year growth, we would like to see a little more consistency in quarterly EPS growth.

Finally, we asked the company about its need to raise equity capital, an event that could possibly lead to dilution. Management indicated that it is not a consideration at the stock’s current price.   However, the Company is mindful of shareholder value if and when it decides what capital raising methods to employ.

Ongoing clarifications of the Company’s improved liquidity standings would temper our fear of the Company’s immediate need to raise capital at unfavorable prices and terms.  It is the GeoTeam’s opinion that the confusing verbiage in SEC filing has been a major factor in the stock was selling below its fully diluted book value per share of $0.98 ($1.23 non-diluted) with a PE of around 2. Getting substantially above book will depend on the future EPS growth, keeping in mind that the company has 5 million shares of potentially exercisable warrants. 

If the company continues to shed light on its liquidity standings and successfully implements its growth strategy, the stock may reflect a better valuation.

We are impressed that the Company has been able to dramatically increase profitability in a declining sales environment. Investors have been taking notice of the stock since our earlier article that identified stocks trading below book value. As of yesterday’s close, LTUS is actually up 123% since July 1. We have urged the company to immediately clarify its story and retain qualified investor relations representation.