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Executives

Dixon Chen - IR, Grayling

Lucia Qian - VP, IR

Fuxiang Zhang - CEO

ZiXin Shao - CFO

Analysts

Serena Shao - Bank of America

Chris Lui - Morgan Stanley

Wei Du - Goldman Sachs

China Nepstar Chain Drugstore Ltd. (NPD) Q3 2012 Earnings Call November 28, 2012 8:00 AM ET

Operator

Greetings and welcome to the China Nepstar Fiscal Year 2012 Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions)

As a reminder this conference is being recorded. It is now my pleasure to introduce your host Mr. Dixon Chen. Thank you, you may begin.

Dixon Chen - IR, Grayling

Thank you. If you have not received a copy of Nepstar’s third quarter 2012 earnings press release, it is currently available on the company's website at www.nepstar.cn. A presentation to accompany today's call and live webcast is also available on the company's website under the Investor Relation section.

Before we start, I would like to remind you that certain statements are not of historical facts made during the course of this conference call about future events and financial results, constitute forward-looking statements that are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995.

You should note that the company's actual results may differ materially from those projected in these statements due to a variety of factors affecting the business. Forward-looking statements are subject to risks and uncertainties. Discussions of factors that may affect future results are contained in our filings with the Securities and Exchange Commission. We undertake no obligation to correct or update any forward-looking statements provided as a result of new information, future events or even changes in expectations.

Joining us on today's call are Mr. Fuxiang Zhang, Chief Executive Officer, Mr. ZiXin Shao, Chief Financial Officer and Ms. Lucia Qian, VP, Investor Relations. Ms. Qian will also be our translator during the question-and-answer session. We will be translating questions and answers and ask your patience at that time.

With that I would like to turn the call over to Lucia Qian. Please go ahead Lucia.

Lucia Qian

We are pleased to report that our ongoing focus on product optimization and proactive sales and marketing campaigns continue to drive sales growth in both total revenue and same store sales during the third quarter, despite a reduction in a number of stores operating during the period. Following modest growth of 10% in the second quarter, our pharmaceutical categories including both prescription and over-the-counter drugs grew over 19% during the third quarter on a same store basis year-over-year. Store productivity and profitability remain our top priorities, as we strive to strengthen our competitiveness and maintain our leadership position in the market.

During the third quarter, we attempted to expand market share in certain regions through more intense sales promotions, which temporarily adversely affected our growth margin. We believe that our strategy will pay off in the long run; however, as we have already experienced a modest increase in traffic to our stores for two consecutive quarters on same store basis year-over-year.

In the third quarter, revenue increased 4.3% to RMB634.6 million compared to RMB608.6 million for the same quarter last year. For the 2088 stores opened before the December 31, 2010 same store sales increased by 12.8% compared to the same period in 2011. This growth was mainly attributable to the more than [19%] increase in sales of pharmaceutical products on a same store basis year-over-year as a result of our [successful] marketing campaigns and the closure of under performing stores.

We opened 11 new stores and closed 77 under performing stores during the quarter. As of September the 30, Nepstar had a total of 2191 stores in operation. Third quarter revenue contribution from prescription drugs was 18.9%. OTC Drugs was 39.6%, a nutritional supplement was 15.9%, traditional Chinese herbal product was 3.5%; and convenience of other products was 22.1%.

Now the portfolio of private label products included 1977 products as of September the 30, 2012. Sales of private label products which is aggregate approximately 27.7% of revenue and contributed 38.2% of the growth profit for the third quarter. This compares to approximately 30.9% of revenue contribution and 43.2% of gross profit contribution by private label products during the same period of 2011.

The decrease in contributions to revenue and gross profit from private label products was mainly due to the introduction of more locally procured pharmaceutical products in response to local customers demand.

Gross profit was RMB293 million, compared to RMB289.3 million. Gross profit margin in the third quarter of 2012 was 46.2%, compared to 47.5% for the same period of 2011. The decrease in gross profit margin was mainly due to active sales promotions across all product categories during the quarter.

Sales, marketing and other operating expenses as a percentage of revenue in the third quarter decreased 40.1% from 42.6% in the same period of 2011. The decrease was primarily due to the growth in same-store sales and closure of other underperforming stores.

General and administrative expenses as a percentage of revenue in the third quarter were 5% compared to 4.2% for the same period of 2011. This increase was mainly a result of higher labor costs reflecting the inflationary economic environment in China.

Impairment loss of RMB3 million was recognized in the third quarter of 2012 compared to RMB1 million in the same period of 2011. The impairment loss represented the reduction to the carrying amount of the property and equipment of certain underperforming stores, some of which will be closed in the fourth quarter of 2012.

As a result of the factors discussed above, income from operations in the third quarter of 2012 was RMB4.2 million compared to RMB3 million in the same period of 2011.

Interest income for the third quarter was RMB3.6 million compared to RMB6.1 million for the same period of 2011. Interest income decreased as a result of reduction in the company’s cash balance following distribution of a special dividend in the second quarter of 2012.

Diluted income from cost method investments was nil for the third quarter of 2012 compared to RMB0.7 million for the same period of 2011. Equity income of an equity method investee was a gain of RMB0.3 million for the third quarter compared to a loss of RMB0.6 million for the same period of 2011.

Nepstar's effective tax rate was 77.2% for the third quarter of 2012, compared to 87% for the same period in 2011. Compared to the PRC statutory tax rate of 25% applicable to our major operating subsidiaries, the difference in effective income tax rates was primarily due to non-deductible expenses and a relatively high amount of operating losses from loss-making subsidiaries for which full valuation allowances were made on their deferred tax assets, as compared to the overall results of the company.

Net income in the third quarter of 2012 was RMB1.9 million which represented RMB0.02 basic and diluted earnings per American Depositary Share. This compares to a net income of RMB1.2 million, which represented RMB0.01 basic and diluted earnings per ADS for the same period of 2011.

Outstanding ordinary shares of the company as of September 30, 2012 was 197.4 million. The weighted average number of ordinary shares in the third quarter of 2012 was 197.6 million. Each ADS represents two ordinary shares of the company.

As of September 30, 2012, Nepstar’s total cash, cash equivalents and bank deposits were RMB570.4 million and its shareholders’ equity was RMB947.7 million.

Net cash flow from operations in the third quarter was RMB50,000 as compared to RMB34.1 million in the same period of 2011. The lower net cash-flow from operations, compared to the same period of last year, was partially caused by the increases in inventory of the non-pharmaceutical categories due to the optimization of the company’s product portfolio. It was also partially caused by stocking of certain best selling pharmaceutical products, for which the company has relatively shorter credit terms than the other merchandise items for the peak sales season of the coming quarter.

And also a few words on the outlook for the remainder of the year. The fourth quarter is traditionally strong for drugstores due to the flu season and increased consumption of nutritional products towards the year-end. The same-store network has already undergone a series of operational optimizations over the course of the year. We expect our same-store productivity to keep the momentum of robust sales in the fourth quarter. We will continue to broaden our product portfolio and strengthen our marketing programs to encourage customers to visit our stores more frequently and buy more products across categories each visit. At the same time, we will also focus on maintaining our high quality customer services and building customers’ trust in our stores.

With that, Mr. Zhang, Mr. Shao and I will address your questions. Operator, please begin the Q&A.

Question-and-Answer Session

Operator

Thank you. We will now be conducting the question and answer session. (Operator Instructions) Our first question is from the line of Serena Shao of Bank of America. Please proceed with your question.

Serena Shao - Bank of America

I have two questions here, the first one is about your strategy, it seems like you continued your strategy in the last quarter to continue close those underperformance stores. So I would like to know your future plans, so if you are going to close more stores and then how this is going to show impact in your bottom line? And then my second question is on your cash flow, it seems like this quarter your cash flow it’s decreased a lot, so I would like to know the reason behind that? Thank you so much.

Unidentified Company Speaker

[Foreign Language]

Lucia Qian

Well, you are actually quite right that in the third quarter we had closed 77 stores, and we plan to close altogether roughly 300 stores for 2012. You will see that this is actually quite a historical number in terms of store closures for Nepstar in its past decade of operations. We have to stress that we are actually proactively adjusting the store composition in an attempt to focus our resources on stores with higher productivity.

In 2013, we expect to reduce the store closures and we hope that overall we will close roughly 180 stores in the coming year, so that in the end our total store number will be maintained above the figure of 2000. And we believe that closing those under performing stores will make a positive contribution to the bottom line, because in the end we will have to focus on stores with better performance and to invest our resources in those higher productivity stores.

Unidentified Company Speaker

[Foreign Language]

Lucia Qian

For the third quarter compared to the same period of last year, cash flow from operations went down by RMB30 million. This is mainly due to two reasons; first of all, this is a reflection of the increase of inventory and secondly, it also reflects some of our procurement actions to certain products that are commanding less favorable credit terms, hence a reduction in our payable days.

For the reduction in payable days, this is mainly because historically in the fourth quarter the suppliers of certain best selling items tend to charge higher procurement price on us and we believe that by stocking on those best selling products in third quarter, we might be able to win a better margin for those pressuring products. That's why we took certain actions in procuring more of those best selling products hence there is an increase in the stock.

And at the same time, as you aware, we have been expanding our product portfolio especially into the non-pharma categories, and such a shift of our merchandize structure also lead to more inventories because quite a bit of those non-pharmaceutical products are procured in the private label way and that has led to shorter credit turns on those products.

If we go deeper into the figures on key inventory and payable ratios, we will see that our inventory days for the third quarter of this year is 119 days compared a 117 days for the third quarter of last year, and our payable days of this quarter is 82 days compared to 89 days of the same quarter of last year. So nothing and out we had equivalent to 9 days of customer goods sold reflected into the lower operating cash flow. I believe that explains why we had a reduction of RMB30 million of operating cash flow in the third quarter of this year.

Operator

Our next question is from the line of Chris Lui of Morgan Stanley. Please proceed with your question.

Chris Lui - Morgan Stanley

When I see 19% same-store sales growth for pharmaceutical products this quarter, does that mean other products such as nutritional products decline in same-store sales growth? This is my first question. My second question is on the gross margin decline from last quarter, can you give us a breakdown on how much was from ASP, how much was from product mix and how much was from promotional events?

[Foreign Language]

Unidentified Company Speaker

[Foreign Language]

Lucia Qian

Basically, we achieved a quite remarkable growth in pharmaceuticals in the third quarter. We believe that this is attributable to our effort in constantly introducing pharmaceutical products that attain the local demand. And those newly introduced pharmaceuticals include lots of the products that have covered by healthcare insurance and they are locally procured.

We also have been working very proactively with major pharmaceutical suppliers and those suppliers invested in joint promotion with us and that effectively helped us to snatch market shares from our competitors. I think these two efforts have more or less helped us realized a very robust same-store sales pharmaceutical growth.

We did experience a quite slow growth in the non-pharmaceutical categories compared to pharma, it’s not that they are declining it’s just they are growth compared to pharmaceutical it has being a lot more modest. This is basically because we have been constantly encountering local policies that are restricting drugstores to conduct non-pharmaceutical products promotions in pharmacies or even restricting the listing of non-pharmaceutical products in pharmacies.

Hence, we think we don’t have to just go heading against the policy unfavorable conditions and instead we put more of our efforts and emphasis in building the pharmaceutical sector stronger for the third quarter. I think that explains why we see a much stronger pharmaceutical same-store growth versus a lot more humble growth in the non-pharmaceutical sectors.

[Foreign Language]

Unidentified Company Representative

[Foreign Language]

Lucia Qian

Well, basically we leave the margin reduction year-over-year for the third quarter was closed mainly because of our promotional activities. One of the key promotion actions we took in quite a few areas is to make the price of our pharmaceuticals really competitive, compared to our competition and we believe that on the one hand enlarged our market share in pharmaceuticals in those regions but on the same time adversely impacted our gross margin and we believe that's the great majority reasons for the reduction of gross margin for the third quarter.

And at the same time, we see that structure wise the nutritional supplements which used to be a higher gross margin category didn't perform as well as the pharmaceutical category and its rather humble growth actually reduced its contribution in gross margin overall and that has also contributed to a lower gross margin year-over-year.

We also analyzed on the impact of price mandatory price ceilings, policies on our gross margin and we don't think that in this quarter that was the material issued to consider, that's a general explanation of the gross margin reduction across categories.

Operator

Thank you. Our next question is from the line of Wei Du of Goldman Sachs. Please proceed with your question.

Wei Du - Goldman Sachs

I have two questions. The first question is I would like to get a clear understanding of what you mentioned of in case of a price hike in the first quarter of next year. What do you mean by the price hike of suppliers that will be hiking their prices for products in startup of the next year, because that basically has made us to make more purchases than that resulting in the decreasing the operating cash flow.

And the second question is, if we take a look at the net margin, it looks like we have a industry leading gross margin level. But it seems like the profitability is lingering around 0%. So could you tell us what do you see as the industry trend that you see there are some inflection point that can turn north, that can improve for the retail pharmacies especially for industry leaders like Nepstar. Thank you.

Unidentified Company Speaker

[Foreign Language]

Lucia Qian

First of all to further clarify the explanation that we made in terms of stocking some of the top selling items; to give you an example we had a collection of OTC and nutritional supplements products that are produced by the manufacturer called (inaudible). That collected had always been the top selling items in the first quarter for the company, and we have observed that almost every year approaching year end the supplier has a tendency of raising their supply price sometimes up to 10%. So this year in the third quarter we had deliberately eased up the stock of this collection, for instance, for this single collection we have increased our inventory of that by RMB10 million that’s sort of a (inaudible) example to show some of the actions we took in the third quarter which helped the company in better margin in the fourth quarter but adversely affected the company’s cash-flow.

[Foreign Language]

Unidentified Company Speaker

[Foreign language]

Lucia Qian

Well, so the past year on our operating profits as well as bottom line have been quite significantly impacted by the increased in the operating expenses and basically its hiking of labor cost as well as an increase in the rental cost. And at the same time in 2011, we had a reduction in gross profit on pharmaceuticals due to the price ceiling policies and that has lingered into 2012. So that also limited the upside for gross margin as well.

However what we think, what is positive is through our efforts in improving our store profit productivity; we see despite the reduction of store numbers there is still growth in our overall revenue and quite encouraging same-store sales growth. I would believe those growth is the reflection of our increased market share and reflection of the effectiveness of improving the store performance.

For 2012, on the one hand we have been closing underperforming stores and on the other hand we have been constantly expanding our product offerings not only in the non-pharmaceutical products categories but also in the pharmaceutical categories.

At the same time, we have been even more active in competing head-to-head against our competitors and to be more proactive in conducting marketing campaigns. We believe that the phase that we have been overly focused on gross margin is behind us. In the foreseeable future, profitability will be our sole performance key indicators that management will focus on.

We think that in 2013 if the general economic environment does not change drastically, this coming year will be a crucial period for us to have an improvement in our profitability and we are quite hopeful to welcome the inflexion point that you have just mentioned in the next coming years.

Operator

Thank you. There are no further questions at this time. I would like to turn the floor back to management for closing comments.

Unidentified Company Representative

[Foreign Language]

Lucia Qian

Well, first of all, we would appreciate the questions raised by the analysts and also we thank investors for your constant attention on Nepstar. In the past quarter, we have been making efforts in not just closing our underperforming stores but also expanding our product offerings across all categories and adopting more proactive marketing campaigns and we believe all those measures will be or are already being reflected by the existing stores performance.

Unidentified Company Representative

[Foreign Language]

Lucia Qian

Well, the first quarter as we all know is the peak season for drugstore sector, and we believe that we will stick to our exiting strategies and at the same time we will also keep a close grip on our operating cash-flow. At the same time, we are actively preparing for the coming New Year. We hope that we could still have the trust and attention of all the investors. Thank you very much again.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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