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Executives

Hong Zhu – VP, IR

Tony Liu – Chairman and CEO

Lily Li – CFO and COO

Wilfred Chow – SVP of Finance

Analysts

Katherine Lu – Oppenheimer

Gene Mack – Lazard

Julie Chen – CRT Capital

Hongbo Lu – Piper Jaffray

American Oriental Bioengineering, Inc. (AOB) Q3 2008 Earnings Call Transcript November 10, 2008 8:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 American Oriental Bioengineering Inc. earnings conference call. My name is Francis and I will be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator instructions) As I reminder at this conference is being recorded for reply purpose.

I would now like to turn the call over to Hong Zhu, Vice President of Investor Relations. Please proceed.

Hong Zhu

Good morning everyone, and welcome to the American Oriental Bioengineering’s third quarter 2008 conference call. On our call today is Tony Liu, Chairman and CEO; Lily Li, Chief Financial Officer and Chief Operating Officer; Wilfred Chow, SVP of Finance.

Before we begin, I would like to mention that this conference call may contain forward-looking statements within the meaning of the Federal Securities Laws. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events, our performance and underlying assumptions and other statements that are not historical in nature.

These forward-looking statements are based on management’s current expectations and are subject to risks and uncertainties that may result in expectations not being realized and may cause actual outcomes to differ materially from the expectations reflected in these forward-looking statements.

Potential risks and uncertainties include products, service, demand and acceptance, changes in technology or economic conditions, the impact of competition on pricing and the impact of governmental regulation and other risks contained in the periodic reports filed by the company with the SEC. For more information on this matter, we encourage you to review the company’s most recent 10-Q filing and in its annual report on Form 10-K for 2007 filed with the SEC.

With that said, I would like now to turn the call over to Tony Liu. Go ahead Tony.

Tony Liu

(Interpreted) Good morning and welcome to our third quarter 2008 conference call. During today’s call, I will give you an update on the progress we are making toward achieving our strategic goal of becoming one of the China’s top pharmaceutical companies. Wilfred will provide you with an overview of our financial performance for the third quarter. Lily will also discuss our outlook for the remainder of the year of 2008. Thereafter, we will open the call for your questions.

I am pleased to report to you that we ended the third the third quarter of 2008 long financial performance in which all of our products performed ahead of our expectations. Our third quarter financial results reflect in particular the continued increasing demand for our prescription and OTC pharmaceutical products. Our brand recognition continues to improve and our distribution capabilities continue to expand into untapped rural areas throughout China.

We continue to realize synergies from our acquisitions and we are particularly excited about Nuo Hua and GHK, which help us further vertically integrate to expand our distribution reach and capitalized on a variety of new product opportunities in the future.

The results of this quarter indicate solid progress toward fulfilling our goal of becoming one of the China’s major pharmaceutical companies. In order to be successful we are convinced, we must build a company that can maintain with flexibility in the constantly changing and evolving healthcare market in China. In this regard, we are focused on vertically integrating our operations to ensure the self sufficiency required to maintain such flexibility in this changing environment.

We have a very strong fundamental financial position and we intent to selectively put our capital to use, whether it is through acquisitions, our stock buyback or investing in our manufacturing facilities, our productivity, and our product development.

We find acquisition landscape continue to be very compelling in China’s health care sector. In a while, we do intent to continue our acquisition effort. We do not intent to approach the capital markets in the next 12 months, between the cash on our balance sheet and our consistent cash flow generation. We are in the enviable position of strength at a time when smaller companies need excess to capital to gain scale. In this sense, we are stronger than ever before versus our competitors.

We thank all of you for your continued support. I will now turn the call over to Wilfred.

Wilfred Chow

Thank you, Tony. I will now review our financial results and then Lily will review our recent acquisitions and some key initiatives we are working on here at AOBO.

We generate net sales up $70.6 million with a 62% year over year increase. Net income increased to 38% to $16.5 million and our diluted earnings per share was $0.21 for the third quarter, even while the number of weighted average share outstanding increased by approximately $10 million during the period accounting for our convertible debt.

The strong revenue growth continues to reflect the expansion and diversification of our portfolio products and distribution capability as well as our acquisition. In particular, our organic growth was 23% during the third quarter, primarily driven by our leading over the counter pharmaceutical brands including, our Jinji series and the Jinji Yimucao product line that were launched in early 2007.

We believed that our effective marketing campaign, continued to improve the brand recognition of these products. In addition, the revenue performance of CCXA and Boke was significant. CCXA contributed $7.1 million for the quarter, while Boke revenue was $10 million. On the combined base of the nine period Boke and CCXA reached $40.5 million in revenue, and this gets us very close to our goal to double year-over-year revenue performance of those brands in 2008.

Note that Boke was not our subsidiary during the third quarter of 2007 and CCXA was only integrated from September of last year. Our three main businesses were as expected. We were pleased with our prescription pharmaceutical products revenues which increased 55% year-over-year to $24.3 million in the third quarter, reflects our product portfolio increasing recently reached CCXA prescription products in addition to the sales of existing products.

Extending rural market coverage also grew prescription pharmaceutical performance during the third quarter of 2008. Our over-the-counter pharmaceutical product revenue continues to be very strong and increased to 91% to $37.8 million during the period comparing to last year.

This was attributed to the increase in sales of our Jinji series and Yimucao product supported by our continuous marketing campaign to enhance recognition of these products. Our Nutraceutical revenue exhibit modest growth in this quarter inline with our goal for this division increased to $8.5 million for this quarter as compared $8 million in the third quarter last year. This is mainly attributed to the increase in sales of peptide tablets and peptide powder.

Our third quarter gross margin was 66.8% as compared to the prior year quarter, at 70.5% mainly reflecting the integration of CCXA which has lower margins. Operating margins decline to 31% in the third quarter 2008 from 32.1% in the same quarter 2007 and decreased slightly from 31.7% in the second quarter of 2008. This decrease mainly reflects our increased promotional activities in the third quarter as well as to Boke and CCXA integrations.

Net income, for the third quarter of 2008 increased to 38% to $16.5 million or $0.21 per diluted shares, compared $11.9 million or $0.16 diluted share in the prior year’s periods. We closed our third quarter of 2008 with $220 million in cash. We previously mentioned that we centralized our infrastructure and facility in Beijing and this is recorded in our cash flow statement this quarter.

We also place a deposit, for long-term deposit of $22 million which reflects our investment in facility to boost our production capacity. We also have a $27 million share buyback in place, of which we utilized $30 million in July and we have $45 million remaining, while we haven’t utilized this remainder yet we intended to do so from time-to-time depends on the market condition and other investment opportunity for good use of cash.

I would like to hand the call over to Lily.

Lily Li

Thank you, Wilfred. This was a great quarter for AOBO and I would like to give everyone an update of our company key initiative, the competitive and the regulatory landscape and our outlook for the future. One of our greatest recently initiative with integration of Nuo Hua and GHK, Nuo Hua provides us with a diverse range of incremental wholesale and retail distribution opportunities. Especially, major top-tier hospital in Northern China, additional provincial and municipal hospital, lower level distributors and retail chain pharmacies throughout the country.

Nuo Hua is also one of very few distributors with approval to distribute narcotic drug in China and we are excited about opportunities in this small, but growing market. GHK lends innovation we need to bring new products to market quickly and effectively, we also gain several exciting patents, a fantastic team of product specialists and industry know-how in China’s complex pharmaceutical registration process.

The Nuo Hua and GHK acquisitions, our strategic move to ensure that we are better positioned with this competitor in the context of regulatory changes. We are closely monitoring development of healthcare report and we are more focusing our innovation, diversification than ever in this changing regulatory environment, which include the hunting of product diversity, focusing on new product development and broadening our distribution platform.

We also expect to continue industry consolidation and at very well capitalized cash, cash flow positive business, we have confident in our ability to do this. Especially, with the top-tiers who may need to approach the capital market in this environment.

Let me take a minute now and review our guidance for the remainder of the year. Today we increased our revenue expectations to at least $250 million for the year 2008, up from prior guidance of $245 million. We are reiterating our full-year 2008 net income expectations of $62 million. We are being conservative in our net income expectation due to operating expenses in the fourth quarter such as sale and the marketing initiatives as well as some additional expenses related to integrating Nuo Hua and the GHK. Also note, we have excluded any net income benefit from Nuo Hua and GHK in the fourth quarter.

That concludes our prepared remarks for today. Operator, we are ready to take some questions.

Question-and-Answer Session

Operator

(Operator instructions) The first question comes from the line of Katherine Lu with Oppenheimer; please proceed.

Katherine Lu – Oppenheimer

Hi, good morning and good evening Tony, Lily, Wilfred and Hong. Thank you for taking my questions. Congratulations on the strong quarter. I have actually three questions; first is, on some P&L line items. It looks like the margin came in a bit lower than expected, I understand the product mix and increased SG&A led to this margin decline, but I’m just wondering do you see anything related to product pricing change, and also is this quarter's SG&A as a percentage of sales a good run rate for us to model forward?

(Spoken in Chinese)

Wilfred Chow

Hi Katherine, this is Wilfred. I would like to answer your question here. So as you can see the gross margin is little bit lower than the precious one. As you also noticed that as we explained this is mainly because of the (inaudible) which has a record low margin because of the nature and at the same time we have also invested a lot in the selling and marketing, also advertising and building our brand. So all this come together we have a net margin of approximately 23% or 24% in this quarter.

I think this is a completion of the factor of the product mix as well as our investment in the brand, but as you can see as the company continue to grow, each of the of our top line revenue mainly is concentrated on the over-to-counter product right now. We think that we will continue to invest in these line items. The line item currently that you see in the operating expenses line is fairly reasonable.

Katherine Lu – Oppenheimer & Co.

Okay, and there seems to be a deposit for long-term assets of roughly $23.6 million on your balance sheet, so I just curious what is that item for?

(Spoken in Chinese)

Lily Li

Hi, I am Lilly. Actually the deposit for long-term asset you mentioned are mainly the fall in two purposes, the first one is for the HSPL, in the harboring of our manufacturing facilities and the second purpose is for the GLP extraction facility and new deposit – actually for the land reserved for these two purposes..

Katherine Lu – Oppenheimer

Okay. Then my final question is for you Lily, Chinese NDRC put out a healthcare reform draft in last month and yesterday we also saw government put out $586 billion economic stimulus package. Again this package put healthcare reform in the 10 key investment areas. So, I am just wondering what types impact do you see this reform to China’s healthcare industry and maybe more specifically to AOBO’s performance outlook and also your exhibition strategy going forward.

(Spoken in Chinese)

Wilfred Chow

Yes, as you all know that’s actually the healthcare reform is now in discussion and the preliminary discussion will close on 15th of this month. I believe that this is indeed very positive news for us, especially for AOBO. Actually we are closely monitoring the comment of the healthcare reform and we are focused on the future trends of their reform in order to get us more and well prepared for this reform. So from the perspective of production and knowledge’s as well as distribution that, we are well prepared and also believe that suggests indeed a very good opportunity for AOBO.

Katherine Lu – Oppenheimer

Okay, great. Thank you very much.

(Spoken in Chinese)

Operator

Your next question is from the line of Gene Mack from Lazard. Please proceed.

Gene Mack – Lazard

Thank you for taking my question. I am just wondering. When are you planning on issuing 2009 guidance and as part of that would impact on gross in that margins Nuo Hua and GHK might have on the business in 2009, and do you see any prudence across 2009, Thanks.

(Spoken in Chinese)

Wilfred Chow

Hey, Gene this is Wilfred. We are planning to update a financial guidance for 2009 at the time where we report our fourth quarter earnings. This is mainly because of lot of moving pieces right now especially of the integration of Nuo Hua and GHK and as you asked us about what area will the integration will impact the margin performance.

Because Nuo Hua and GHK thereof very separate, different businesses, they are intermediary in distributions, what we were planning to do is to have a segment to reporting to report those numbers separate from our existing manufacturing business going forward.

So you will able to see each of these business segment contribution to the overall company going forward and in terms of the margin impact, as you also noticed the distribution business usually have a lower than manufacturing margins, but this doesn’t mean that the existing business is going to get a negative impact by the distribution margins.

So, the overall margin you may see a slower decline because of the combination, but those number will be separately reported and will be clearly shown to the investors on how we track those thing and track those and we currently do believe the distribution business will have very positive impact to the existing business network.

Gene Mack – Lazard

Okay, thanks. Just one other question, in terms of the internal legislation and healthcare, from in your perspective and I know that broadly it will all impact your business and probably most likely positively, but I’m just wondering with these legislation, do you think singularly will impact the business most immediately, is there one piece legislation that AOBO is watching more closely because it has a direct impact on your business in the shorter and how can you help us there? Thanks.

(Spoken in Chinese)

Lily Li

Thank you, Gene for your question. Actually I think for the reform plan of the healthcare sector, we assuring the stage of submissions to listing and we are discussing about the reform plan, but the whole general framework is indeed pretty definite. So what is pretty definite is that the government was certainly enhanced the input in the rural healthcare market and this is indeed a very positive news for us, because AOBO will have been focusing on the rural healthcare market and in this news was certainly, positively impact the AOBO performance, but we cannot be very sure about any single or any one legislation of the new regulatory reform will have on the company, but we are actually closely monitoring and watching the reform plan.

Gene Mack – Lazard

Great thanks very much.

Wilfred Chow

Okay, thank you.

Lily Li

Thank you.

Operator

Your next question comes from the line of Julie Chen with CRT Capital; please proceed.

Julie Chen – CRT Capital

Yes, good morning Tony and Lily. Congratulations.

Lily Li

Good morning Julie

Julie Chen – CRT Capital

Thank you, good quarter. I have actually two key focuses in terms of our question. One is in terms of your marketing effort moving forward. If we look back quarter-over-quarter change, sales and distribution including advertising of per quarter changes 29.3% for advertising 33% increase.

As I understand from the press release, and your explanation that increase primarily is due to sales and marketing expenses as well as additional depreciation and amortization, is that possible for you to give us some color into what sales and marketing effort and advertising effort that AOB is doing in terms of brand new product in terms of helping increase this volume?

(Spoken in Chinese)

Lily Li

So, in the third quarter actually we have been in the pharmaceutical as well as Nutraceutical brand designation. Especially after the Olympic Games we have been enhancing in the market efforts in Vocus Nasal products as well as the Jinji and peptide product and as you may now that China had successfully launched its Air Spacecraft Shenzhou #7 and the peptide product has been designated as the official product for the national sales administration.

Julie Chen – CRT Capital

Great, so if I may move onto my next category of question which has to do with overall macro economic environment in China. Despite the stimulus, if we notice stimulus temporarily for a minute the overall environment is a little bit weaker this movement, per watt in terms of electricity went up about certain percentage, gas prices has sustained in the same area despite per barrels as went down.

So, in terms of operating expenses, will that be a factor we should be thinking about moving forward in terms of the inflation potentially from that standpoint? Or should we think about there are certain changes coming in that would potentially lower certain factors within the operating, or certain parameters within the operating expenses?

(Spoken in Chinese)

Lily Li

Thank you for the question. Yes indeed we are facing pretty serious global, as well as domestic economic environment. The profitability I think is indeed as very serious issue for any corporation to think about. I believe that we are facing, not only the healthcare reform, but also the enhanced regulatory environment in China, as well the inflation as you mentioned just now.

We are closely monitoring and watching the changes in the macroeconomic environment. We have also put efforts in order to coupe with such changes, mainly focusing on the opponent two areas. The first one is the divesting; the second one is innovation capability. We are focusing on the corporate structure evolution as well as the marketing efforts and R&D efforts. So, we are focusing on the whole general efforts in order to cope with the market changes. However, we are pretty confident about the future.

Wilfred Chow

Acutely, I want to add some point in this area. As Lily has given the very overall view on how we look at our company going forward and in the cost control prospect you can see all the resources are very valuable to us, especially cash and we are spending our money in the most important area like; advertising, sales and marketing.

The percentage of expenses in revenue as you can see increased a little bit, but I would also like to draw your attention to our general and administrative line. The percentage to our revenue is actually reduced quite a bit this quarter. This is our continuous effort to cost in this kind of market and I think the company has a coverage has to respond very diligently on this and this is the way cope with this fact that is faced by all the company in China.

Julie Chen – CRT Capital

Thank you very much. That is very helpful.

Lily Li

Thank you.

Operator

Your next question comes from the line of Hongbo Lu with Piper Jaffray; please proceed.

Hongbo Lu – Piper Jaffray

Thank you so much. Thank you for taking my question Tony, Lily and Wilfred. I think, I am going to focus on the top line. So first of all, Wilfred, I’m not sure if I heard a right, you said for this quarter, the organic growth was 23%. Can you clarify that and are we still looking for 30% year-over-year growth for organic growth for 2008?

(Spoken in Chinese)

Wilfred Chow

Hi, Hongbo, I think I can refer to the number. As the organic growth for this quarter is 23%, which is right and the 30% organic growth year-over-year growth, I am looking at 2008 as a full-year. As CCXA and Boke, we have come to an end of this 12-month initial consolidation cycle and the fourth quarter contribution from CCXA and Boke, we will be considering organic. We are still confidence that in our overall growth for 2008, organically is going to be over 30%.

Hongbo Lu – Piper Jaffray

Okay, thank you that’s very helpful. Second question, I will go into the line item for the prescription drugs, I think if my calculation is right he quarter-over-quarter growth in this quarter is about 19% versus 90% in the last quarter. So is there a seasonality that you can help us to understand. How these channel talking level change in these two quarters?

(Spoken in Chinese)

Wilfred Chow

Our prescription product line actually increased quite a bit to during this quarter, and this is mainly attributable to the increase in product offering, especially from the CCXA and we also see considerable growth in SHL Injection Powder as well as Cease Enuresis Soft Gel. So, the overall growth is, I mean within our expectation and we will continue to monitor the growth in this area.

Hongbo Lu – Piper Jaffray

Okay, thank you. Then I want to squeeze in two more questions, if I may. For the guidance $200 million and then I think Lily said, you said that does not include Nuo Hua and GHK numbers. So, since the deals were closed at the end of October, your fourth quarter earnings probably would potentially included revenue contribution from these two new acquisitions. So, what is expectation for your fourth quarter, contribution from these two subsidiaries?

(Spoken in Chinese)

Wilfred Chow

Yes, first of all, I think we are being very conservative in our net income expectation, and you are right because we have close Nuo Hua and GHK, these two companies is actually under our control end of October. We will begin to consolidate their financial operating income as well as net income starting November.

As I said, we are still trying to integrate this company, and for Nuo Hua in particular we are more concentrated on their net income contribution and we are currently expecting a phenomenal contribution from Nuo Hua and I don’t want to distract the – I mean the cover the our existing business contribution. So that is why we are not giving the guidance right now.

Hongbo Lu – Piper Jaffray

How about the top line guidance for $250 million?

(Spoken in Chinese)

Wilfred Chow

The $250 million guidance is refracting the operation that we have right now, and we have confidence that in the fourth quarter there will be considerable contributions from all of the existing business that we have. We will continue to monitor the situation with Nuo Hua and update the investor at our fourth quarter earnings call.

Hongbo Lu – Piper Jaffray

Great, thank you. Just one last question, if I may. So, as we are approaching to the end of 2008, I want to look ahead in 2009 and 2010. So, probably Lily in your mind to what or which products are most important growth drivers in 2009, 2010?

(Spoken in Chinese)

Lily Li

Thank you for the question. Actually as we all looking-forward to year ‘09, ‘10 the view of the company will certainly focus on the existing growth of the existing product portfolio. What you need to look at for the new growth opponents, is actually the newer product launches. We certainly will have some very good new product launches as well as the growth for the existing OTC prescription products.

Hongbo Lu – Piper Jaffray

Thank you so much for taking my question.

Operator

Your next question is a follow-up from the line of Katherine Lu with Oppenheimer, please proceed.

Katherine Lu – Oppenheimer

Hi, thank you for taking my follow-up. Actually most of my follow ups had being answered. Actually Wilfred, could you just clarify on your top-line guidance for 2008. I didn’t catch, is that to an existing excludes the contribution from, Nuo Hua and NHA, I mean NH?

Wilfred Chow

Yes, $250 million is excluding contribution from Nuo Hua and GHK.

Katherine Lu – Oppenheimer

Okay, that’s helpful thank you.

Wilfred Chow

Okay.

Operator

There are no other questions at this time. Ladies and gentlemen, we would like to thank you for participation in today’s conference. This now concludes the presentation. You may now disconnect.

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