IN CHINA'S FAST

modernizing economy,

American Oriental Bioengineering

Based in the city of Shenzhen, American Oriental makes medicine and supplements based on traditional Chinese medicine practices that use plants and minerals to alleviate ailments. While different from fare found in the average U.S. pharmacy, these products are part of a robust industry in China, where traditional medicines remain a popular choice over pricier Western drugs.

For investors looking to take advantage of China's growth, American Oriental is poised to benefit from the perfect storm of broader economic trends. The country's population is large and aging, while incomes are rising and the middle class burgeoning. What sets the company apart from its fellow U.S.-listed peers Tongjitang Chinese Medicines and China Shenghuo Pharmaceutical Holdings is that, thanks in part to an aggressive acquisition strategy, American Oriental has multiple brand-name products, national reach and a good-sized foot in both the over-the-counter and prescription markets.

While Chinese Internet stocks such as Sohu.com and Sina have enjoyed more of the Wall Street limelight, China's pharmaceutical industry is starting to catch up. A recent report out of PricewaterhouseCoopers says that a solid majority of multinational and U.S. companies believe Asia is quickly becoming the center of gravity in the pharmaceutical market.

"The Chinese pharmaceuticals industry is modernizing," William Lyons, director of equity research at Westminster Securities, said in an Aug. 21 note.

Traditional Chinese medicine is a more than $6 billion industry in China and accounts for 21% of all pharmaceutical spending in the country, according to Piper Jaffray analyst Gur Roshwalb.

American Oriental is easily one of the stronger contenders in the sector. Since the company listed its shares in the U.S. in July 2005, its profits and revenue have nearly tripled. In the second quarter, revenue grew 49% to $33.9 million and earnings rose 66% to $9.7 million, not including foreign-currency translation. The company's products include a soft gel formulated from the shinyleaf yellowhorn plant that's designed to alleviate bed-wetting, and an antiviral powder derived from weeping forsythia and other flowering plants.

Despite convincing financial results, American Oriental shares have been under the weather of late. Year to date, the stock is down nearly 4% at $11.70 as of Tuesday's close.

Julie Chen, an analyst at Brean Murray Carret & Co., views the weakness as a buying opportunity and rates American Oriental as a top pick for this year. "It really is capitalism at its best in China," Chen says.

In addition to the company's business prowess, Chen is impressed with its disciplined, no-frills corporate culture. Employees fly coach, for instance, and airfares are purchased at the lowest possible discounts. (We caught a whiff of this culture while requesting an interview from the company. A spokesman told us, "We have too many interview requests, and the company must not do too many interviews because it is a distraction from providing value to shareholders.")

It isn't clear exactly why American Oriental's stock has been suffering, but scandals in China's pharmaceutical industry might be scaring off investors. In May, the former head of China's drug administration was sentenced to death for allegedly taking bribes to approve faulty medicines, including a batch of antibiotics that killed six patients. None of American Oriental's products was swept up in the mess.

Piper Jaffray's Roshwalb said in a July note that suspicion of prescription drugs in the country would benefit American Oriental's strong over-the-counter business. "We believe that AOB's reputation for quality...will provide it with a competitive advantage," Roshwalb said.

Another factor possibly dragging down the stock is impatient investors, who are eager to see the company acquire more businesses, says Lyons, of Westminster Securities.

American Oriental owes a good amount of its growth to acquisitions. In November 2004, the company bought a state-owned drug company that developed what is now its prescription antiviral powder. Last year, American Oriental grew sales of that product by 69% to $27.5 million. Other key acquisitions include a pharmaceutical company specializing in gynecological medicine and a private health-care company that has over-the-counter products that sell throughout the country, including products for nasal congestion, dandruff and sore throats.

"The company does not depend on a single product as its primary source of revenue," Chen says.

In comparison, Tongjitang primarily depends on its flagship osteoporosis capsule and tablet for its revenue and has historically been stronger in selling prescription drugs to hospital pharmacies, vs. over-the-counter, Chen says. Similarly, China Shenghuo's flagship product, which treats symptoms related to cardiovascular diseases, accounts for more than 80% of its sales. Other strikes against China Shenghuo: One analyst noted that its stock is very illiquid, which can cause wild price swings. The company also sports a balance sheet that's strikingly light on cash.

American Oriental, with a market cap of $871 million, is trading at about 18 times expected earnings, putting it at a 16% premium to the S&P 500, according to Thomson Financial. Take into account long-term growth expectations, however, and American Oriental is trading at a healthy 71% discount to the broader index.

Westminster Securities' Lyons cautions that American Oriental shares "are not an appropriate investment for impatient investors." He believes the company will take at least 18 to 24 months to fully exploit all of its growth prospects.

Chen also reminds clients that "this is still China," where regulatory upheaval can be on the unpredictable side. "Investing in China has a risk of its own."