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China Automotive Systems, Inc., (NASDAQ:CAAS)

Q3 2008 Earnings Call

November 12, 2008 8:00 am ET

Executives

Qizhou Wu - Chief Executive Officer

Li Jie - Chief Financial Officer

Daming Hu - Chief Accounting Officer

Kevin Theiss - Investor Relations, Grayling Global

Analysts

Ke Chen - Shah Capital Management

Ping Luo - Global Hunter Securities

Operator

Greetings and welcome to the China Automotive Systems Incorporated third quarter 2008 results conference. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) It is now my pleasure to introduce your host, Mr. Kevin Theiss. Thank you, Mr. Theiss, you may begin.

Kevin Theiss

Thank you for joining us today and welcome to China Automotive Systems 2008 third quarter conference call. My name is Kevin and I am with Grayling Global, China Automotives U.S. Investor Relations agency.

Joining us today are Mr. Qizhou Wu, Chief Executive Officer; Mr. Jie Li, Chief Financial Officer and Mr. Daming Hu, the Chief Accounting Officer of China Automotive Systems. They will be available to answer questions later in the conference call with Mr. Dixon Chen, also with Grayling Global, who helps with translation.

Before we begin, I will remind all listeners that throughout this call we may make statements that may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations or beliefs, including but not limited to statements concerning the company’s operations, financial performance and conditions and the impact of acquisitions on its financial performance. For this purpose, statements that are not historical fact may be deemed to be forward-looking statements.

The company cautions that these statements by their nature involve risk and uncertainties and actual results may differ materially depending on a variety of important factors, including among others the impact of the competitive products, pricing and new technology, changes in demand for the company’s products, changes in consumer preferences and tastes and effectiveness of marketing, changes in law of and regulations, fluctuations in the cost of production, delays and cost overruns related to developing and opening new product facilities and other factors as those discussed in the company’s reports filed with the Securities and Exchange Commission from time-to-time.

Undue reliance should not be placed on these forward-looking statements. The company’s expectations are as of this date and the company does not intended to update any of the forward-looking statements after this date except as required by law. I will provide a brief overview then I will return to Mr. Chen to conduct the question-and-answer session.

For our call today, I will review the financial results in U.S. dollars. The Chinese automotive market experienced a slowdown in the third quarter of 2008 following the Olympics. Truck sales were robust in the first half of 2008, as trucks were purchases before the implementation of the most stringent national three environmental emission standards in July 2008. Since then heavy and medium duty truck sales have been lackluster although light truck sales continue to sell.

Car sales have not grown as fast as in the past. The central government’s policies to combat inflation have slowed overall economic growth in China as being impacted by the international market uncertainty. The central government is now proposing new policies to reignite China’s growth including the easier credit and low interest for consumers for auto loans.

Yesterday China Automotive Systems announced its first purchase order from a Global Automotive OEM headquartered in North America. The order is for one vehicle model and CAAS sales are expected to build. We believe this first order reflects the progress we have made to meet the stringent demands of North American OEMs, among the most demand in the world and encourages us to continue our plans to penetrate the global OEM market. In addition to producing high quality advanced power steering systems, China auto offers a very competitive price for OEMs that are under cost and marketing pressure.

As China auto is the largest independent supplier of power steering systems and components in China, it has the capability to supply a wide variety of customers. It offers a broad line of steering systems and components and quickly designs new products. Additionally it has initially focused on the leading brands in the domestic China market.

Over the past two years it has now penetrated foreign joint ventures formed by both Volkswagen and Peugeot where it can offer a high quality product at a competitive price to replace power steering units currently being imported. With our last contract we improved the capability and quality of our products and we now moved into the international arena for power steering systems and components.

We will now begin a review of the third quarter results. The 2008 third quarter results reflect our planned expansion of our production capacity and R&D capabilities. China Automotive continues to invest in property plant and equipment as they spent over $9.4 million on new facilities and equipment in the last nine months.

These actions were made to further position China Automotive Systems for growth in the Chinese automotive market and especially to meet the requirements of the global market for steering systems; however, we don’t expect a significant increase in CapEx for the fourth quarter and even in 2009.

Total net sales increased by $5.7 million representing an 18.4% increase in sales to $36.9 million compared with $31.2 million for the third quarter in 2007 and $46.5 million for the 2008 second quarter. For the nine months we generated positive cash flow from operations up $4.4 million.

Several factors helped to generate our sales growth, including the continuing growth of the Chinese economy although at a slower pace and increasing personal incomes continues to result in higher passenger car production, but at a slower rate. Continuing investment in infrastructure building by the central government and commercial business activity continues to generate commercial vehicle sales.

Sales of passenger vehicle steering gears grew by $4.5 million, a 22% increase to $24.6 million compared with $20.2 million in the year ago third quarter. Passenger vehicle top sales rose by 18.1% to $3.4 million in the 2008 third quarter from the same quarter last year. For the 2008 third quarter, sales of steering gears and accessories for commercial vehicles increased by over $700,000 or 8.8% to $8.8 million from $8.1 million in the third quarter of last year.

China Automotive experienced slower growth partially due to the Olympics, which impacted new sales orders and production, but also due to normal seasonality during the third quarter. The company continued to improve our production technology to enhance efficiency, while also adding technology to its products. The result is relatively lower cost in places to generate greater sales volumes.

The 2008, third quarter gross profit was $9.9 million compared with $11.4 million in the third quarter of 2007. Higher sales volume, but higher selling prices in the commercial vehicle market were offset by higher unit cost due to a higher raw material cost, especially for the high steel content for the commercial vehicle market.

The 2008 third quarter gross margin was 26.7%, compared with 31.1% in the second quarter. The dramatic decline in Chinese steel prices that began late in the third quarter combined with higher selling prices in the commercial market should positively affect gross profits and margins going forward.

To move the gross margin back towards the 30% gross margin target, management is taking the following steps to improve manufacture. We reduced material rate, especially for steel to product design and better production techniques and maintain the higher selling prices accepted by many of our commercial customers.

2008 third quarter net income increased by 7.2% to $2.8 million. Earnings per share on a fully diluted basis in the third quarter of 2008 were $0.09 as compared to $0.11 in the same period of 2007. Total shares outstanding on a fully diluted basis were $31.4 million shares as compared to $24 million shares in the third quarter of 2007.

The share count increase was mainly related to the $35 million convertible note financing and the Henglong acquisition in early 2008. The conversion price of the convertible notes which was initially $8.8527, was reset to a bottom of $7.0822 on August 15, 2008. There will be no more conversion to price resets hereafter.

We will now comment on some line items to provide more insight. Operating expenses in the 2008 third quarter grew 13.5% to $6.5 million from $4.8 million a year ago. Operating expenses were 17.7% of sales in the 2008 third quarter compared with 15.5% in the year ago same quarter.

Selling expenses of $2.3 million were 10.3% above last year’s third quarter and as a percent of sales declined to 6.3% from 6.7% in the third quarter of 2007. The main expenses in this category were increased transportation, wage and salary expenses and warranty reserves reflecting the sales growth achieved compared with the year ago quarter.

General and administrative expenses were $2.1 million, a $377,485 increase compared with $1.7 million in the 2007 third quarter. G&A expenses as a percent of sale were 5.6% in the 2008 third quarter compared to 5.4% in the same period last year. Additional labor insurance expenses due to housing of two subsidiaries, construction of a new joint venture company requiring a higher supplies and an increase in bad debt provision for certain advance payments for equipment and other receivables were responsible for the increase.

During the third quarter 2008, China Automotives depreciation and amortization, excluding those expenses recorded in cost of sales, rose to almost $1.5 million reflecting the company’s investment in new plant and equipment as the company is planning its future growth.

Research and development expenses grew 107% to $665,552 compared with the $321,533 in the same quarter of 2007. R&D continues to expand with more personnel and support in new product research and development programs. R&D expenses were 1.8% of sales in the 2008 third quarter, compared with 1% in the same quarter last year.

Income from operations was $3.7 million for the three months ended September 30, 2008 compared to $6.6 million in the third quarter of 2007. The lower income from operations in the 2008 third quarter reflected reduced gross profits and increased operating expenses related to higher sales and the company’s investments in R&D and property, plant and equipment including much higher depreciation expenses.

For the third quarter, China Automotive had a financial expense of $446,261 compared with financial expenses last year of $215,400. The increase of $230,861 is related primarily to higher interest expense and an increase in convertible notes discount amortization.

In the 2008 third quarter, the minority interest expense decreased to $983,480 compared to almost $3.5 million in the year ago quarter. This change was mainly due to the company’s acquisition of the additional 35.5% equity interest in head loan.

As of September 30, 2008, the company had cash and cash equivalents of $36.4 million including $9.2 million of pledged cash deposits, compared to $24.1 million at December 31, 2007. The company had a working capital of $75 million, compared with $35 million at December 31, 2007.

As of September 30, net accounts and notes receivable rose to $100.9 million from $82 million in December 2007 due to the continued sales growth of the company’s products. Accounts receivable increased by $14.4 million and notes receivable expanded by $4.3 million from December 2007.

Inventories rose by $9.7 million to almost $30 million. Allowance for doubtful accounts declined to $3.6 million from $3.8 million at December 31, 2007. Short-terms bank loans declined to $5.9 million from almost $14 million at December 31, 2007, as the company strengthened its balance sheet.

Accounts and notes payable increased by $12.2 million, the $35 million convertible note payable was valued at $32.8 million on the balance sheet as of September 30, 2008. A long-term derivative was established and valued at $821,583 related to the convertible debt. Total shareholders equity rose to $80.8 million at September 30 from $67.2 million at December 31, 2007.

In 2007, China Automotive announced a supply contract with Volkswagen, an important foreign joint venture in China. In 2008 the company continued to win new accounts as it signed supply agreements with the second Sino joint venture, Dongfeng Peugeot Citroen Automobile Company. The company passed all the stringent test of this OEM. China auto began by supplying the Dongfeng Peugeots 206 model and subsequently is now supplying Dongfeng Elysee R23 model. We are still working on commercializing the third contract for the Dongfeng Picasso N68 model.

Additionally in the third quarter of 2008 China Automotive signed a supply agreement with ChangAn Auto Company, which has been a tough automaker in China for years. The Chinese Auto industry will remain stable for the rest of 2008. We expect Chinese Governments $586 billion stimulus package to relight the auto industry.

China Automotive continues to invest in R&D. We are carefully planning production capacity expansion. Production methods are being improved to eliminate waste and to optimize design to improve manufacturing efficiency, but the challenges is in the international auto market and capital markets, we believe is prudent to take a conservative approach to managing our assets. We are managing our cash and current assets to keep them inline with our sales expectation and to generate positive cash flow.

Capital expenditure are being balanced to match the company’s immediate and near-term needs. Overall we remain confident that our products enjoy a high barrier to entry, our quality reached global standards and our financial and production capacity are strong. We also continue to expand our market share by winning new customers.

Management believes, the current stock price does not match the fundamental results of the company’s performance, so several members of the management have decided to purchase shares individually. In addition to getting what they believe is a favorable price management believes in the company’s future.

With that I will turn the call to Dixon Chen, who will provide English translation for the Q-and-A session. Operator, we are ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ping Luo - Global Hunter Securities.

Ping Luo - Global Hunter Securities

For this quarter essentially we are seeing lower gross margin and higher operating expenses. I want to know if going forward are we seeing this margin to continue or is there any operating expenses that is only Korean this quarter that will not be recurring in the coming quarters. My question is that, whether you will continue to be at such a margin going forward?

Li Jie [Interpreted]

Okay, there’s a few things here; first is the gross margin. In the third quarter, we continue to experience the high raw material price, followed by the second quarter, given somewhat our raw material inventory we purchased. Actually it was purchased in the second quarter, but now we are coming towards the end of those material and entering fourth quarter generally the steel price has been coming down. So, it’s benefiting us going forward. So, fourth quarter our cost of goods sold should be lower and gross margin will be higher than the third quarter.

On the expense side, in response to the market, we increased our marketing effort in the third quarter, so that increased our overall selling expenses in the third quarter. Also we don’t believe we will continue to have such high marketing expenses in the fourth quarter, so in terms of marketing and selling expenses we should start coming down as well.

Also in the third quarter, we have higher account receivables. According to the U.S. GAAP, we incurred some of the bad debt provisions that also go into our G&A. We are looking forward to collect those receivables in the fourth quarter and we are confident we will be able to collect that and with that we should be able to lower our operating expenses. So, operating margin will be improved in the fourth quarter as well.

Also in terms of steel price, to just gives you a more color on the apple-to-apple comparison, in the third quarter 2008 compared with the third quarter of 2007, the steel price has gone up more than 50%. Also steel is one of the key raw materials of our products, which account for 20% of our cost of goods sold, so you can do the math with such a high steel price. Our cost has gone up more than 10%, so the recent price decline on the steel price is definitely benefiting us. Coming into the fourth quarter, we should see a better gross margin.

In terms of SG&A as a percentage of sales, we actually were pretty much inline with last year. We actually are slightly down from the same quarter 2007. We do see a higher depreciation as we’re expanding our production capacity adding facility capacity and so actually we have a higher depreciation.

Also we substantially increased our R&D capability, also expenditures in the third quarter 2008. That’s part of our plan to prepare ourselves to a global expansion. So, we were working hard on the quality improvement in R&D.

Ping Luo - Global Hunter Securities

My second question is, we all know that domestic automotive market is slowing down. The industry association, they are projecting just roughly 10% gross for this year and for next year. I would like to ask, what’s your gross expectation on your business; just obviously that gross should be slowing down?

So I want to know, just basically if that’s the case, if you are seeing smaller orders from existing customers or having difficulty expanding to new customer base or maybe on the pricing side you are seeing a slower pricing or specifically pricing decrease? So I want to know, what’s your gross expectation on your business and basically that’s my question? Thank you.

Qizhou Wu [Interpreted]

Okay, we like to break the answer down to different section of our business. Firstly, on the commercial vehicle sector, we see six items is going to be very favorable for our business in 2009 and firstly is aftermarket. In the past we never really focused on aftermarket sales. All our efforts has been focusing on OEM and the main reason we’ve been focusing on OEM was our capacity constraint and now as we are expending our capacity we do have those down ways to handover the aftermarket. So, we are going to vigorously pursue business in the aftermarket space in 2009.

Secondly, we see this stimulus package, $586 billion stimulus package are going to the infrastructure build-out and that’s definitely going to boost the commercial vehicle sales, especially the truck sales; so that will benefit our OEM business.

Thirdly, the exports; in a past we haven’t a much exports, but this 2009, we already received 80,000 to 90,000 units of power steering order for the commercial vehicle OEMs overseas.

Fourthly, is our capacity bottleneck in 2007. Now, we de-bottlenecked our capacity in 2008. Now we can definitely increase our sales into some of the markets we haven’t really focused on. So, there are areas in China we’re not strong in and we have been holding back because of our capacity constrain. Now, we can aggressively expand in through these areas.

Fifth, we want to continue to increase our shares in our existing customers. I will give you a good example; Shanxi Automobile, they are the one of the of the largest heavy-duty truck producer in China and their capacity a year, production capacity on an annual basis is between 80,000 to 90,000 trucks per year. Currently about 40% of their power steering was supplied by China Automotive Systems. Now, this year, 2009 we want to increase to 80% of the Shanxi’s Power Steering.

Lastly, we are very proud to share with our investors; we now have the best commercial vehicle in the power steering production line in China. With that we’ll definitely win a lot of contracts in China. So with that, the commercial vehicle market next year will only increase by 10% for us. We are confident that we can grow 20% to 30% next year.

On the past year vehicle side, also we see in 2009 we will have more orders in aftermarket space with our production capacity expansion and also we won a number of new contract in 2008 that include Dongfeng Peugeot Citroen, ChangAn Automotive and HengLong Auto. So, with those new contracts, they’re all going to announce their new auto rollout models in 2009 and we definitely will increase our sales from those customers.

Lastly is our exports; we expect we will have a good export in 2009 as well.

So, as a result the overall China market for the passenger vehicle increased by 10%; next year we are confident we can grow at least 20% for passenger vehicle.

Lastly, is our product line for the pump sales. We also have the capacity constrain in 2007, we expanded in 2008 and with that we’re looking to increase our sales in 2009 for the pump sales and also our end-market split. In 2008 we have more passenger vehicle sales for the pumps. We have about 85% sales to the passenger vehicle, 15% sales to the commercial vehicle, but now in 2009 with our new additional capacity we want to increase our share in the commercial vehicle pump sales. So with that, I think our pump sales in 2009 can increase over 30%.

In terms of your question of raw material and gross margin, we see that raw material will continue to drop, especially the steel price. If the steel price dropped by 20%, our gross margin definitely increase. Even if we give some price discount to our good customers, a few percentage price discounts, we still can increase our gross margin from here. So, that the overall trend of lower raw material price is definitely benefiting our gross margin.

Also in terms of new product, we are in new sales territory. 2009 will be an exciting year for us because we are finally rolling our electric power steering products in the China market and also we are now having more export contract for late 2008 and early 2009. So, we are looking to increase our exports.

In the past few years, we’ve been working hard on those new products and new sales territory, but finally coming to the point those hard work will payoff and start to reflect in our income statement, especially the revenue side. So, is that good?

Operator

(Operator Instructions) Your next comes from Ke Chen - Shah Capital Management.

Ke Chen - Shah Capital Management

Just wondering if you could first comment on the capacity in the third quarter and the fourth quarter and also 2009 and also talking about the capacity utilization rate in the third quarter, fourth quarter and 2009 and also please talk about your CapEx guidance for the fourth quarter and 2009?

Li Jie [Interpreted]

Okay, right now we have a capacity about 1.4 million unit and by the end of this year we will reach to 1.45 million. So, now the utilization rate is about 90%. Next year, we’ll have a very moderate intervention plan to 200,000 more units for next year. So, the CapEx this year we already used $9.5 million cash to the expansion and by the end of this year we’ll have another 3 million to spend and next we will spend $5 million to $7 million to expand our capacity.

Operator

There are no questions at this time, I would like to turn the floor back over to Kevin Theiss.

Kevin Theiss

Ping, do you have any questions?

Operator

Your next question comes from Ping Lou – Global Hunter Securities.

Ping Luo - Global Hunter Securities

Just regarding the capacity, so you said you’re going to have $1.5 million units by year-end?

Jie Li

The year-end we’ll have $1.45 million.

Ping Luo - Global Hunter Securities

And then next year you’re basically expanding and you’ll have 200,000 units more next year.

Jie Li

Yes.

Ping Luo - Global Hunter Securities

Okay, so then in the CapEx you have $12.5 million for this year total and which means basically $3 million in the last quarter.

Jie Li

Yes

Ping Luo - Global Hunter Securities

So, in terms of the export you just announced your order with North American OEM. Can you tell a little bit more about the nature of that OEM contract? Is that a one-time contract or multi-year contract and also looking at North American automotive market condition right now, how does that effect your existing order and future orders to the North American market?

Jie Li

We have already worked with this OEM for more than two years, finally we get a formal order from this customer and this is a reward for our high quality products and a very reasonable price and I think from this order we have other customers, other international OEMs. This is a safety related product after a stringent verification process and we have a good access to past to this international market, so this is an asset to China Automotive. This is just a one mortar from this key customer and if [inaudible] so I think we’ll gradually expand our international business from that on.

Ping Luo - Global Hunter Securities

So, I just want to for the near-term look at the outlook for the fourth quarter. I understand the fourth quarter could be a seasonally better quarter than Q3, but the market is slowing down in the meantime. So, let see the revenue side? What level we can compare it to? Is that comparable to Q2, better than Q2 or just slightly better than the Q3? So, I basically want to know what is your kind of expectations for Q4 results?

Jie Li

Typically Q4 is the best season for the year, but this year is something different. For the first half of this year the China Auto industry still experienced a rough growth, for the third quarter suddenly down and as we don’t give a guidance to accurate results, I can give you just general information about what we focus. If the industrial benchmark is like 10% for the first quarter, we were 1.5 times of this growth rate compared with the same period of last year.

Ping Luo - Global Hunter Securities

Just maybe lastly, any new products on the development. Essentially applying to future vehicles, such as electric vehicles, any new development or new products targeting those markets?

Jie Li

We have a very key customer in BYD and this year it grew very fast and it almost ranked number one or number two for our sales with customers, almost ranked number one or number two and now we have contact with this customer and we are exploring further corporation and this BYD customer has planned to do some electric motor. So, we are just to at a early stage for kind of corporation talks, negotiations.

Operator

Your final question comes from Ke Chen – Shah Capital Management.

Ke Chen - Shah Capital Management

Yes, could you please comment on the gross margin for the oversea orders and also the last question will be, could you talk about your buyback and when do you plan to do that? That’s two quick questions.

Jie Li

Yes, overseas our gross margin is comparable with the domestic margins. It has been the basic customer and this customer had a very through research study of our cost structure. So, we give them the same margin comp as domestic products. As for the management buyback and the announcement, we feel the stock pressure now is far, far below it’s own fair values, so it’s trying to get buyback and then also on the single loan, the management is very, very confident in the company’s bright future.

Operator

There are no further questions at this time. I would like to turn the floor back over to Kevin Theiss for closing comments.

Kevin Theiss

2008 has been a difficult year for U.S. and European auto markets and a transition year for the Chinese auto industry. However, tons of millions of Chinese are not going to stop to dream of owning a car just because foreign auto makers are in trouble. With the Chinese Government support the Chinese auto market may likely recover in 2009. Also thank you for your time and your interest and we hope to speak to you again in the future. Thank you.

Operator

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

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