Financial research is never a simple task. It requires a substantial time commitment to read over a company's recent filings and listen to its investor presentation, as well as to get a feel for the industry and sector as a whole. But, even the most bullish research should be viewed with a cautious eye.

One name to be leery of here is China Medical (CMED), which currently has 27 million shares outstanding. Based in Beijing, China, the medical device company manufactures and markets products using high-intensity focused ultrasound, or HIFU, for the treatment of solid cancers and benign tumors.

The largest owners in China Medical include Chengxuan International, the investment firm owned by CEO Wu, which still owns 54.9% of the company. Obviously, Wu has a huge economic tie to the company's performance. In addition, Golden Meditech owns 24.95%. General Electric (GE) used to own 19.95%, but various GE filings indicate that it's totally sold out of its position. Monster hedge fund Lone Pine Capital owned a large chunk of China Medical in mid-march. Recent filings show that it is now totally out of the stock.

On top of China's recently issued 4 trillion yuan ($586 billion) stimulus package, China also has an additional five-year plan, begun in 2006, in which the government will invest $3 billion in health care, of which $1 billion will be for medical equipment It is widely expected that smaller hospitals will receive a sizable chunk, as Beijing hopes to improve health care in more rural areas. China Medical is widely regarded to be one of the main beneficiaries of the government's spending.

Additional positives include China Medical's 2007 approval to market its HIFU tumor therapy system in South Korea. The system was approved for the indications of liver cancer, pancreatic cancer and uterine fibroids. Furthermore, China Medical now is represented by a limited medical distributor in South Korea, which has more than 2,000 hospitals overall.

On March 25, 2008, China Medical was awarded the CE mark for its ECLIA analyzers and 15 reagents, including reagents for thyroid disorders, diabetes and tumor markers. In a statement, Mr. Xiaodong Wu, chairman and CEO of the company, said that "the approval would give China Medical access to new markets and give it added prestige in China."

Here is where things get dicey for China Medial: A few months ago, it paid $345 million to purchase the rights for a human papillomavirus test from Molecular Diagnostics Technologies. China Medical will buy the HPV-DNA Biosensor Chip and Surface Plasmon Resonance-based Analysis System (the SPR System), which can detect the virus that causes cervical cancer and sexually transmitted disorders.

According to China Medical, there are 50 million cervical cancer gynecological tests performed in China every year, but the company estimates that 400 million women in China are of the age at which they should receive regular checkups. The market for the test could reach as much as $700 million if these women become aware of the importance of testing as a preventative measure for cervical cancer.

Sounds nice, right? What China Medical forgot to add is how it expects only $35 million in sales from the HPV test this year and how it is now finding it extremely difficult to mark HPV's assets to standard generally accepted accounting principles (or GAAP), which is why the company just pushed its earnings back a month.

Additionally, to help fund this purchase, China Medical announced the pricing of a $240 million convertible senior debt offering. Not only does this offering massively dilute current shareholders, there is a nasty reset clause for the buyers. According to China Medical's prospectus, "Holders of the notes may require the Company to repurchase the notes upon certain fundamental changes. In the event of certain types of fundamental changes, the Company will increase the conversion rate by a number of additional ADSs for holders who convert their notes in connection with such fundamental change."

Generally speaking, to hedge a convertible bond offering, the buyer will short the underlying stock. This leaves the convertible bond holder with a synthetic call option on the underlying stock, while still offering upside appreciation from the bond's yield to maturity, thus putting additional pressure on equity shares.

While China Medical does have solid long-term prospects, the near-term factor of additional debt and convertible arbitrageurs now shorting their shares, outweigh the company's bullish prospects going forward.

Know What You Own: China Medical operates in the medical instruments and supplies space. Some of the other stocks in this space include Abbott Laboratories (ABT), Boston Scientific (BSX), St. Jude Medical (STJ), Medtronic (MDT) and Johnson & Johnson (JNJ). These stocks recently were trading at, respectively, $52.78, down 3.2%; $5.98, down 8.7%; $27.07, down 2.6%; $30.84, down 1.2%; and $57.90, down 0.3%. For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

Posted on Nov. 20, 2008