As China emerges into a modern economy, demand for services that most Westerners would consider basic is on the rise. China Medical (CMED) is hard at work filling the healthcare needs from both the treatment side as well as through its diagnostic products. Last year the company received 60% of its revenues from its High Intensity Focused Ultrasound (HIFU) line whose primary function is treating tumors. The ultrasound waves are focused directly on the offending tissue and essentially breaks down the tumor.

While HIFU has been the primary bread winner the past few years, a new acquisition in March paves the way for the company to expand its diagnostic line of products. The system that was purchased is called the Fluorescent In Situ Hybridization or (FISH). The acquisition is part of the company’s strategy to transform itself into an advanced in-vitro diagnostic (IVD) business. The specialized technology allows physicians to spot prenatal disorders as well as cancer occurrences in adults. While the FISH system is currently only approved for distribution in China, CMED hopes to soon be able to sell the units in Korea and Japan.

While the main product line sold to physicians is capital intensive and sales of this magnitude can take time to complete, CMED enjoys a predictable revenue flow from the reagents or consumable inputs needed to run many of its diagnostic tests. This reagent business helps smooth out the peaks and valleys in between the less predictable sales of large equipment. As the company is successful in placing more and more diagnostic products, its base of consumable reagents will create a stronger recurring revenue source.

Fiscally, the company operates on a 3/31 year end. The most recent quarter for which earnings data is available is Q1 (ending 6/30). The company reported earnings of $0.34 on revenues of $19.9m which beat street estimates. During the conference call, management stated that they are “re-evaluating their current outlook for FY 2007″ due to better than expected reagent business and smooth implementation of the FISH acquisition. After the call, Merrill Lynch analyst Bin Li noted that estimates for the HIFU system were slowing down a bit, but the reagent business was picking up enough to make up the difference.

Earlier this month, CMED issued a press release stating that the Korean version of the FDA had approved the HIFU system for treatment of liver cancer, pancreatic cancer and uterine fibroids. This is a positive first step towards the broader global footprint the company is aiming for. Expanding into Korea, Japan and eventually Europe and the US will cause investors to view the stock as a better global expansion play instead of pushing it higher or lower in sync with the China market. The company has partnered with France’s EDAP to sell the HIFU system in Europe and Russia pending approvals. Chinamed is pursuing FDA approval for tumor therapy with its HIFU system in the US which would further diversify its revenue base.

While China continues to grow and CMED has been successful in penetrating the largest provinces with its systems, active diversification should help the company survive and even thrive in spite of the potential for a decline in China growth. Research and Development is a priority for the company which should keep it competitive in the midst of technological breakthroughs. The stock recently cleared the high from 2006 shortly after the IPO which may have offered resistance. As long as the fundamental story remains the same, I would want to hold the stock for long-term gains.

CMED Notes

FD: Author has a long position in CMED