Many investors have found that in this turbulent market, gains often come in the “two steps forward, one step back” variety. Such is the case with China Medical Technologies, Inc. (ADR), (CMED) over the past two weeks. The company announced earnings August 4th after the close which sent the stock sprinting higher. But a week later on the 12th, management announced they would be issuing $150 million worth of convertible senior notes along with additional stock (or American Depository Receipts – ADS). The news sent the stock tumbling back down and after the deal was priced at $48.00 the stock continued to trade lower Wednesday.

Leafing through the earnings report it is easy to see why the stock reacted positively. Revenues were $33.1 million which represented a 49.7% increase over last year. Net income came in at $16.1 million or 57 cents per ADS which was good for a 61.2% increase. In addition to stronger sales numbers, the company saw sharply higher margins as a result of transition in revenue mix. Previously the company had concentrated on selling medical equipment. But now that the installed base of equipment is largely in place, management has intentionally transitioned to focusing on sales of consumable reagents used in this equipment. The result is higher margin products and a more predictable revenue stream.

Zachstocks has already mentioned how the acquisition of the FISH (Fluorescent In Situ Hybridization) product line drove sales higher in previous quarters. Management now notes that the direct sales force employed to market the FISH products is now becoming more adept at cross-selling other product lines. While cross selling is only a secondary reason for the FISH acquisition, it is clear that management is effectively integrating this acquisition and has proven their ability to pick out attractive investments within their field of expertise.

This talented management team may have the opportunity to make additional investments in the near future. When reading through the press release describing the most recent security offering, it is clear that the funds raised are likely to be used in future acquisitions. If the company is able to bolt on additional product lines and then sell then to current clients, the synergies could quickly add to profitability and beef up the total value of the company. With a presence in 200 large Chinese hospitals, and international expansion on the rise, it would not be surprising to see CMED leverage its infrastructure with a complementary acquisition.

Some analysts appeared to be a bit disappointed that the company did not raise guidance for upcoming quarters. At this point, management is targeting revenues of $173.5 to179.3 million with EPS expected between 2.93 to 3.02. This is for the fiscal year ending in March of 2009. It appears management is being conservative in their guidance which should give them a chance to increase expectations in following quarters as trends become more apparent. While many Chinese manufacturers are seeing cost inflation, management has done a good job of controlling expenses thus adding to margin strength.

The Chinese medical device market should continue to show strong growth (according to Morningstar) as the population rapidly ages, and expectations of a higher standard of living prevail. Since management owns 27% of the company, they appear properly incentivized to drive performance. Unresolved issues such as the proper tax rate for the company, and rising marketing expenses still weigh on investors minds, but the picture is becoming clearer and I anticipate that with more visibility, the stock will receive a higher multiple in the coming weeks and months.

CMED Notes

FD: Author has a long position in CMED

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Trader Mark covers the security offering