Can Eu Yan Sang International Ltd. Continue to Nourish its Profits?

Welcome to the second part of the article on traditional medicine retailer, Eu Yan Sang International Ltd. (SGX: E02). In my previous article, I covered the sources of revenue growth for Eu Yan Sang. Now we look at the cash flow and balance sheet for the company.

As a recap: Eu Yan Sang recorded capital returns of about 169% from 1 July 2009 to its closing price on 20 November 2014. By comparison, the capital gain returns of the SPDR STI ETF (SGX: ES3),a proxy for the Straits Times Index (SGX: ^STI), was 41% for the same duration. During the same timeframe, the company also distributed a total of about 10 cents per share in dividends.

A closer look at profits

From our previous article, we have observed that Eu Yan Sang has grown its revenue by a compounded annual rate of 8.3% over the past five financial years. We take a look at the operating cash-flows and capital expenditure to see if the topline trickles down to the bottom line.

 Eu Yan Sang - 1

Source: Company Earnings Report

From the graph above, we can see Eu Yan Sang’s operating cash-flow starting to stumble in FY2012. The drop on a year on year comparison was caused by higher retail operating costs, inventory build up, and working capital effects from the acquisition of Health Life Pty Ltd (HLG) in Australia. Due to its Australian business mix in retail and distribution, the gross profit margin is lower as well.

Unfortunately, this also meant that the TCM company was free cash-flow negative (operating cash-flow minus capital expenditure) starting from FY2012. Further build-up of inventory in anticipation of higher demand has caused operating cash-flow to dip further $6.3 million for FY2014.

Further more, capital expenditure has been moving up strongly. I mentioned in my previous article that Eu Yan Sang plans to at least double the production capacity if its plant in Hong Kong. Phase 1 of the construction is expected to be completed in 2016, while operations for the plan will commerce from early 2017. The cost of Phase 1 is budgeted at around HK$ 500 million (around S$80 million). On top of that, the company plans to spend RMB 40 million (around S$8 million) on the setup of a GMP plant in Chengdu Hi-Tech Zone.

With the high capital expenditure, and tepid operating cash-flow, this might mean a couple more years of negative free cash-flow.

Eu Yan Sang - 1

Source: Company Earnings Report

With the negative free cash-flow, it would not be surprising to see additional funding needed by the company. To this, we can the level of borrowings for Eu Yan Sang starting to spike up from FY2012 onwards. During FY2012, the TCM company also issued 22 million in convertible warrants worth $25 million which could dilute earnings in the years ahead.

Foolish summary

Negative free cash-flow, and having more debt than cash might not be an appetising scenario for some Foolish investors. Investors in Eu Yan Sang will have to believe strongly that it can pull of its Hong Kong plant expansion, and secure its growth over the next decade. This effort would involve continuing to grow in its core markets, and rationalising its operations in Australia to recover its operating cash-flow.

The plan is not without potholes along the way, as my fellow Fool Sudhan has noted the expected slower pace of growth in Hong Kong and China, as well as a safety warning from the US FDA for its Bo Ying Compound. The company has officially responded to the safety warning and has engaged an US-based legal counsel to manage this.

Overall, individual investors would have to decide it the upside potential is sufficient to compensate for the risks in its balance sheet and negative free cash-flow.

As of the closing price on 20th November 2014 of $0.725, Eu Yan Sang traded at a trailing earnings ratio of about 22.7, and has a dividend yield of around 3%.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn't own shares in any companies mentioned.