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Tongjitang Chinese Medicines Company (NYSE:TCM)

Q3 2008 Earnings Call Transcript

November 25, 2008, 8:00 am ET

Executives

Justin Chen – COO

Xiaochun Wang – Chairman and CEO

Eric Chan – Interim CFO and Financial Controller

Analysts

Katherine Lu – Oppenheimer & Company

Mel Drucker [ph]

Jee Hang [ph] – Jacobs Investment

Operator

Good day everyone and welcome to the Tongjitang Chinese Medicines Company third quarter 2008 financial results conference call. Today’s call is being recorded. I would now like to turn the meeting over to your host for today’s conference Justin Chen, Chief Operating Office. Please proceed.

Justin Chen

Good morning. By now, everyone should have access to the earnings release in which we detailed our financial performance in the third quarter. Before we continue, please bear with me as I take you through the company’s Safe Harbor policy. The statements contained in this conference call which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company’s filing with the SEC. Tongjitang does not undertake any obligation to update forward-looking statements except as required by applicable law.

I’m joined today by Xiaochun Wang, our Chief Executive Officer; and Eric Chan, our Interim CFO and Financial Controller.

Now allow me to turn the call over to Xiaochun Wang, Chief Executive Officer. Mr. Wang.

Xiaochun Wang

(Interpreted) Ladies and gentlemen, thank you for participating in the Tongjitang Chinese Medicine’s third quarter 2008 conference call. I would like to take a moment to thank all of our associates for their hard work and commitment during 2008. I would also like to thank our advisors and investors for their ongoing loyalty, enthusiasm and support. In the interest of time, we will now have our translator Linda speak on my behalf and then we will open the call to questions.

Third quarter 2008 revenue was RMB110.4 million or $16.3 million, down 13% or down RMB16.5 million from RMB126.9 million in the same period of 2007, and down 7.7% from the second quarter of 2008. This reflects a 3.8% year-over-year decrease in Xianling Gubao sales as well as reduced sales of other core product such as Moisturizing and Anti-itching Capsules, Zaoren and Dianbaizhu, which decreased to RMB12.6 million or $1.8 million from RMB25.5 million in the prior year period.

Revenue contribution from Guizhou LLF decreased 50% to RMB5.1 million from RMB10.2 million in the second quarter. The decrease in Xianling Gubao OTC and other core products reflects three main issues: Our drug store commission rates are relatively low; we downsized our OTC sales force; and we were impacted by the counterfeit efforts we previously announced. In order to address these issues, we did several things.

During the quarter, we changed our marketing strategy for Xianling Gubao OTC, including increasing our marketing efforts and launching a new advertising campaign. We set up standalone counters with company employees in some pharmacies to promote our products and we believe the new strategy will benefit future sales.

We also restructured our Xianling Gubao OTC sales force to effectively incentivize sales people to promote our products more effectively in drug stores. Regarding the counterfeit problem and as we have previously discussed, Jilin [ph] drug manufacturer in China used our trademark to produce Xianling Gubao Granules and used lowest price strategy to market the product which disturbed the market.

We took swift legal action to address the issue and in mid-November, the court issued a verdict that banned Yulongyadong or any of its distributors from producing or selling Xianling Gubao Granules. Unless, Yulongyadong appeals to a higher court, the matter has been settled.

Although we are affected by these infractions, we are pleased that the court has ruled in our favor and expect that the sales of Xianling Gubao would have been much helped by the execution of the verdict. Xianling Gubao sales were also impacted by our pricing strategy in hospitals. We have strategically stepped back from some low priced local markets to maintain our uniformed pricing system nationwide.

We believe that this strategy is best for our financial performance for the long-term, even though we have some volume weakness in the near-term. Sales of the high margin products from Guizhou LLF were slowed down because of the government policy change on medicine promotion in hospitals in some cities in mid 2008. Correspondingly, we adjusted the business model for LLF products and expect that sales will resume gradually.

In the third quarter, our operating cost increased year-over-year, but decreased compared to the second quarter of 2008. The year-over-year increase reflects increased compensation to employees as required by the new labor law in 2008. Spending on advertising, selling and marketing expenditure increased as we promoted newly acquired products such as the high margin products of Guizhou LLF.

I would like to add some additional color about our business and our outlook. I continue to believe that Xianling Gubao will remain a dominant healthcare product in the traditional Chinese medicine therapy market in China. As we complete the restructure of our OTC sales team and settle the counterfeit issue, we expect sales of those products to increase in addition to growth from Xianling Gubao sales. We expect to move revenue diversification, especially from growing contributions of higher margin products from Guizhou LLF.

We believe the recently acquired Pulante transaction will further diversify our product portfolio, particularly in our OTC operating segment and further increase our margin in the future when we complete the integration process of Pulante. Just as in the past, we are working diligently to identify more acquisition targets, as we see fit.

We will continue to update the investors with our progress. Also note that our ADS repurchase was approved recently and we are pleased that we now have the flexibility to buy back ADS as we see fit. We are confident in our ability to successfully execute our business plan and generate shareholder value over time, and we believe this repurchase program is in the best interest of Tongjitang and our shareholders.

Before we open the call to questions and answers, I would like to point out some key highlights in terms of financial guidance. Today, we adjusted expectations for the full year 2008. We currently expect revenue to be at the level of RMB450 million and gross margins to be sustainable at levels in the mid 60%.

This adjusted revenue guidance reflects our third quarter performance and assumes that our recent operational changes such as the changes to our OTC sales force, our longer-term solution. We expect our initiative steps could bring some positive results next year, and we intend to update you on our expectations for 2009, when we report the full year 2008.

That concludes our financial performance overview. Thank you for participating on the call today. Operator, we are ready to take questions.

Question-and-Answer Session

Operator

Thank you so much. (Operator instructions) We’ll take our first question from Katherine Lu with Oppenheimer & Company.

Katherine Lu – Oppenheimer & Company

Hi, good morning. Thank you for taking my question. The Xianling Gubao sales again came in lighter than expected, especially given you had a new advertisement for Xianling Gubao. I’m just wondering if you can comment on the cause of the weakness and maybe specifically talking about the price and volume trend for Xianling Gubao. In addition, could you also give some comments on Xianling Gubao’s raw material pricing as the gross margin was also lower than expected?

Eric Chan

(Interpreted) The cost of raw material for Xianling Gubao is barrenwort and the price of barrenwort has gone up by 3% over its price at the beginning of the year. So the slight increase in the price of barrenwort has affected our gross margin of Xianling Gubao.

Xiaochun Wang

(Interpreted) The new advertising campaign has had little impact in promoting the sales of Xianling Gubao. Primarily that is because we have found Chinese consumers do not respond very sensitively to TV or newspaper advertising. Also osteoporosis patients are not in an urgent need to cure and treat their illness and even if they see an advertisement on TV or in the newspaper, they won’t immediately go and buy our Xianling Gubao products.

The symptoms of osteoporosis are always hidden unlike the symptoms of cold. For a cold patient, they would immediately find they are ill. So right now, we are reviewing our marketing strategy for next year.

Katherine Lu – Oppenheimer & Company

Okay, thank you. I just want to follow-up with Mr. Wang on Xianling Gubao sales. I’m just wondering, when you would expect the turnaround of this trend type to come in six months, or in 12 months. The turnaround which means we should see a year-over-year increase on Xianling Gubao.

Xiaochun Wang

(Interpreted) During the second quarter and also in the beginning of the third quarter of this year, we have made a lot of changes to the OTC sales of Xianling Gubao. First, we restructured the OTC sales team and secondly, we have made changes to the sales model of Xianling Gubao. For example, we have set up dedicated counters for the sales of Xianling Gubao at number of pharmacies.

However, we have found that setting up such dedicated counter sales to stimulate the sales of Xianling Gubao and also right now in China a lot of the chain store, the retail chain stores require very high gross margins for our products and at the same time given that we are doing a new advertising campaign for Xianling Gubao and we also sell this product through other channels, we cannot guarantee a higher margins than what it is now to the retail channel.

That is why the retail channel is not prioritizing the sales of Xianling Gubao and they’re not putting a lot of effort in aggressively selling Xianling Gubao for us. Right now, we are researching new ways and new methodologies for promoting the sales of Xianling Gubao, but we haven’t arrived at a final conclusion yet.

In addition, the sales of Xianling Gubao through the prescription channel is going on very well. However, in some Chinese cities, we are seeing a falling trend of Xianling Gubao sales through the hospitals channel. That is why we have decided to give up the sales of Xianling Gubao in those low priced cities. For example, (inaudible) and some cities in Sichuan Province.

We do that in order to contain the falling trend in the price of Xianling Gubao and we want to maintain a high price for Xianling Gubao across the country. Thank you.

In addition, ever since we launched Xianling Gubao OTC sales in 2005, through all these years of operation, we have come to a clear conclusion that is, over the all these years we have over emphasized the promotion of one fact that is Xianling Gubao could be used to treat only osteoporosis. But for the ordinary Chinese patients, they are more familiar with the neck pain, back pain, shoulder pain and rheumatic knees.

So, even if we are putting a lot of advertising effort in promoting the fact that our Xianling Gubao can treat osteoporosis, patients and doctors do not really care about that. So in the future, when we consider and review our marketing strategy for the sales of Xianling Gubao through the clinical channel, we will definitely make substantial changes to our marketing strategy. On one front, we will still continue to promote the fact that Xianling Gubao can effectively treat osteoporosis and at the same time, we want to make sure that everybody understands the fact that Xianling Gubao can also be used to treat the ordinary neck pain, back pain, shoulder pain and knee pain that ordinary Chinese people are so familiar with.

I believe that kind of a marketing strategy would help us stimulate the sales of Xianling Gubao significantly. Thank you.

Katherine Lu – Oppenheimer & Company

Okay. I have one more question before I get back to the queue. So, you talked about the integration of acquisition as a way to diversify your revenue and as a growth driver. So, I am just wondering how the integration of LLF and Pulante is going? Is there any timeline or quantitative objectives that we should be thinking about?

Xiaochun Wang

(Interpreted) Well, the integration of LLF is basically completed. Right now, LLF sales and marketing teams are all integrated into Tongjitang's existing sales and marketing teams. And regarding Pulante, a newly acquired company, we have just recently acquired Pulante. We are still in the process of integrating Pulante into our company and we estimate that by the first quarter of next year we will complete the integration process of Pulante.

Katherine Lu – Oppenheimer & Company

Just on the LLF; I came here a little bit late. Why was there a sequential decline in LLF revenue?

Xiaochun Wang

(Interpreted) The reason LLF revenue has slowed down is because we have made changes to its sales model. In the past, we partner with hospitals and our sales teams would go to the hospitals to sell LLF products. This model has proven very effective over the past few years.

However, starting from the middle of this year, the management team of a number of hospitals have refused to continue this sales model and they required to sell LLF products to the hospital pharmacies first, before the pharmacies sell the products to patients. And as a result, the pace of LLF sales has slowed down and we have actually comeback to the traditional way of sales that is we first sell LLF products to the distributor and the distributor would then sell the products to the pharmacy, and the pharmacy would sell the products to the patient.

Although we believe LLF products have very long-term sales growth potential, in the short-term, due to the changes to the sales model, the sales of LLF products have slowed down. Thank you.

Katherine Lu – Oppenheimer & Company

That’s very helpful. Thank you very much.

Operator

Thank you. (Operator instructions) And we will take our next question from private investor, Mel Drucker [ph]. Mr. Drucker, your line is open.

Mel Drucker

Hello. Are you speaking with me?

Operator

Yes.

Mel Drucker

I have a question, how about the progress of the FDA recognition for Xianling Gubao?

Xiaochun Wang

(Interpreted) Well, back in 2005, we were asked by the FDA to conduct Phase IV clinical trial for Xianling Gubao to prove the efficacy and safety of our Xianling Gubao products. We have already published the results of the Phase IV clinical trial and we have submitted the results to FDA. And to respond to your question whether we have started the work on the FDA’s recognition of Xianling Gubao, that piece of work has not started yet.

The Phase IV clinical trial is in accordance with FDA’s standards, however, we did not register the trial or the trial’s results with FDA. So strictly speaking, we have not started the process of registering our products with FDA.

Operator

Thank you very much again. We will move on to Jee Hang [ph] with Jacobs Investment. Please go ahead.

Jee Hang – Jacobs Investment

I have a question on the repurchase plan, do you have any – you had announced the repurchase plan about $20 million, do you have other or further repurchase plan of the stock in the future?

Xiaochun Wang

(Interpreted) Our announcement, we are allowed to complete the repurchase of up to $20 million worth of shares within 18 months and 18 months is a relatively long period of time. Since this repurchase plan has not been implemented yet, we are not considering other repurchase plans.

Operator

(Operator instructions) Next, we’ll move to Katherine Lu with Oppenheimer and Company.

Katherine Lu – Oppenheimer & Company

Hi, thanks for taking my follow-up. I’d like to ask a macro question. In the past few weeks, we’ve seen several changes on the macro level: First, is a draft for healthcare reform and then we saw central government stimulus package, and then this week we also noticed the MOH is going to invest the RMB4.8 billion in rural area. So I’m just wondering, Mr. Wang, do you see Tongjitang – what kind of impact do you see those macro policies will impact Tongjitang’s business?

Xiaochun Wang

(Interpreted) Yes. Indeed, we are also paying close attention to the latest round of healthcare reforms in China. We have read the principles of this new healthcare reform very carefully and we also noticed that the MOH is going to invest RMB4.8 million on the development of healthcare system in the rural areas of China. And according to the new healthcare reform program, China is going to reform its catalog of essential medicines and Tongjitang’s Xianling Gubao product is already listed on the original catalog of essential medicines.

If the government is going to carry through this new catalog of essential medicines just has it has promised that would greatly help stimulate the sales of Xianling Gubao in the future. However, there is also one risk, that is the government might have stricter or tighter price control over the price of Xianling Gubao.

Secondly, regarding the RMB4.8 billion of investment on rural areas, I believe that amount of money is going to be used for the renovation of rural clinics or the purchase of medical equipment and devices at those rural clinics and there are not any plans for the pharmaceutical investment or purchase for the rural clinic.

Katherine Lu – Oppenheimer & Company

Okay. Thank you. That’s very helpful. And finally, you have announced the share repurchase and we have seen increased interest from strategic investors in the past quarter and also the stock is trading below the cash value. So I am just wondering, sometimes on the road, would you ever consider strategic alternative for the company?

Justin Chen

(Interpreted) The alternative, right now, we have no latest news and if we have any further news or further update, we will definitely communicate with our investors in a timely way as required by the regulators.

Katherine Lu – Oppenheimer and company

Thank you very much.

Operator

Thank you so much and that does conclude our conference for today. We do ask that you have a wonderful day and thank you for your participation.

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