China Medical Technologies, Inc. (ADR) (CMED) and its often cited cousin Mindray Medical International Limited (MR) have both had more than their share of volatility this year. But on a relative basis, China Medical appears to be a better value with a more optimistic future. That may help to explain why China Medical is holding onto a small gain for the year while Mindray is down about 15%. To understand the dynamics helping to lift CMED, it is helpful to dissect a recent report issued by Morgan Stanley on the company.

In the report, Bin Li places much of the credit on CMED management’s decision to concentrate on its InVitro Diagnostic (IVD) business. This portion of the company’s sales is strategically important because the division sells not only basic equipment, but also consumable products that are used throughout the useful life of the equipment. This creates a recurring revenue stream that is predictable. The virtually guaranteed sales can then be modeled to allow management to grow the business with a well known cash flow model. Morgan estimates that this business could reach 80% of the company’s sales by 2010.

While the company continues to operate profitably as a stand-alone business, management has indicated that it is on the lookout for an acquisition target that would create synergistic growth. In order for a company to qualify as a takeover candidate it must meet four rigorous criteria:

• The acquisition target must complement the existing portfolio of products already offered by CMED. This is important because the sales-force which already has relationships with many of the healthcare facilities must be able to quickly learn about the new products and it must be applicable to their current sales channels.
• The new product(s) acquired must have huge market potential. Management is looking for a solution to a disease that has a large patient population. While some companies concentrate on niche offerings and do it well, CMED wants to reach out to a large population and give its sales force opportunity to place products with many facilities.
• Any new acquisition must have a significantly advanced technology which creates barriers to entry. It would be a tragedy for the company to spend capital to purchase a business that ended up becoming obsolete within a few years.
• Finally, any company purchased should already be experiencing strong margins. This not only places more profit in the hands of shareholders, but it also gives management a bit of cushion as they integrate the new business. If things do not go exactly as planned there should still be some room for error with a high margin business.

In order to get all of these criteria met, it is likely the company will have to pay a high price for the acquisition. Still, in the hands of CMED’s skilled management team, an acquisition could quickly become accretive simply due to the proper allocation of the full company’s resources.

Aside from a potential acquisition, there are additional data points which could lead to surprise increases in the stock. At this point there are several applications pending with the State Food and Drug Administration (SFDA). Currently the SFDA has a backlog of applications and it is unlikely CMED will see their applications passed within the next few months. However, management has stated that the company will be able to reach projected sales targets even without approval for these new applications. That implies that if the approvals come on time or ahead of schedule, it would mean additional revenue for the 2008 calendar year.

The company is not scheduled to release earnings until the end of August. But even without this earnings announcement, the stock could move quickly based on announcements relating to acquisitions, SFDA decisions, or broad market movements. The stock is well off the $50 high it made last month. However, the pullback appears to be a buying opportunity and I would suggest beginning to build positions with proper risk controls.

CMED Notes

FD: Author does not have a position in CMED