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China Nepstar Chain Drugstore Ltd. (NYSE:NPD)

Q3 2008 Earnings Call

November 26, 2008 8:00 am ET

Executives

Rachel Levine - Grayling Global

Simin Zhang - Chairman of the Board

Jiannong Qian - CEO

ZiXin Shao - Interim CFO

Lucia Qian - Marketing and IR Director

Analysts

Bin Li - Morgan Stanley

James Tom - Roth Capital

Chunan Ho - Goldman Sachs

Shaojing Tong - Merrill Lynch

Operator

Greetings and welcome to the China Nepstar third quarter 2008 earnings call. At this time, all participants are in a listen-only mode. The 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 Ms. Rachel Levine of Grayling Global. Thank you, you may begin.

Rachel Levine

Thank you. If you have not received the copy of Nepstar third quarter 2008 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 website under the Investor Relation section.

Before we begin, 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 Dr. Simin Zhang, Chairman of the Board, Mr. Jiannong Qian, Chief Executive Officer, Mr. ZiXin Shao, Interim Chief Financial Officer and Ms. Lucia Qian, Marketing and IR Director. 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 Ms. Qian. Please go ahead, Lucia.

Lucia Qian

Thank you, Rachel. Good morning and good evening. I would like to welcome you all to China Nepstar Chain Drugstore third quarter 2008 financial results conference call. Let me start by emphasizing a few accomplishment made in the challenging quarter.

We delivered revenue of RMB613 million in the third quarter, a significant increase over both last year’s quarter, as well as our own projection. More importantly, we successfully regained positive same-store sales growth of 0.5%. These achievements are even more notable, given the substantial decrease in customer traffic in our stores, for much of the quarter due to the Olympic Games and Para-Olympic Games that took place in China in August and September.

We believe the sales growth were partially attributable to the effectiveness of our training staff initiative, implemented in late July. By strengthening our store staff knowledge, of both pharmaceutical and non-pharmaceutical products, we were able to enhance our stores overall shopping experience, increasing customer’s average purchase value per store visit and increase repeat customer visits. We believe this initiative will continue to pay off in the future, and help us restore a positive trend in same-store sales.

Now, let me provide a detailed breakdown of the quarter’s financials. Revenue for the third quarter increased 26.6% to RMB613 million, compared to RMB484 million for the same period in 2007. Revenue contribution from prescription drugs were 21%. Over-the-counter drugs, was 34.7%; nutritional supplements were 22.4%; traditional Chinese herbal products was 3.1%; and other products was 18.7%.

The increased contribution by nutritional supplements from 20% in the second quarter of 2008, was partially attributable to the effectiveness of our sale staff training initiative implemented in late July, which increased our store staff knowledge and selling skills, for nutritional supplement.

Same-store sales for stores opened before December 31, 2006, for the third quarter of 2008, increased by 0.5% from the third quarter in 2007. Same-store sales were calculated based on 1,399 stores opened as of December 31, 2006.

Gross profit in the third quarter increased to 30.5% to RMB298 million from RMB228 million for the same period in 2007. Gross margin for the third quarter of 2008 increased to 48.6% from 47.1% for the same period in 2007. The increase in gross margin was largely driven by changes in product mix, including increased contributions from private label products and centrally procured products.

We further increased sales of private label products in the third quarter. Nepstar's portfolio of private label product included 1,341 products as of December 30th. Sales of private label products represented approximately 26.1% of revenue and 38.7% of gross profit of the company for the third quarter.

Sales, marketing and other operating expenses, as a percentage of revenue, for the third quarter of 2008, increased 41.1% from 31.8% for the same period in 2007. The increase was primarily due an increase in the proportion of newly opened stores in the company store base.

As of December 30th, the company had a total of 1,268 stores opened after January 1, 2007, which accounted for 47.5% of the company's total store base. Compared to stores that had been in operation for two years or above, younger stores generally generate lower revenue, but incur similar or even higher rental and labor costs. The high expense ratio was also partially due to increased salary and rental costs of older stores, which mainly reflected the overall high inflation rate in China.

General and administrative expenses as a percentage of revenue for the third quarter of 2008 increased to 4.4% compared to 3.3% for the same period in 2007. The increase was primarily due to additional administrative and compliance costs related to being a publicly listed company.

As the result of the above, operating income for third quarter of 2008 was RMB19 million compared to RMB58 million for the same period in 2007. The company's effective tax rate was 27% for third quarter of 2008, compared to the effective tax rate of 16.7% for the same period of 2007. The increase in effective tax rate was primarily due to higher tax rates that certain of the company's subsidiaries becoming subject to under the new PRC corporate income tax law, the recognition of withholding taxes related to profit distribution from the company's PRC subsidiaries to the Cayman Islands holding company, and an increase in the impairment provision for the deferred tax assets.

Net income in the third quarter of 2008 was RMB36 million or RMB0.17 basic earnings per share, or RMB0.34 basic earnings per American depositary share and RMB0.16 diluted earnings per share, or RMB0.32 diluted earnings per ADS. This compares to the net income of RMB46 million, or RMB0.25 diluted earnings per share for the same quarter in 2007. The weighted average number of ADS for the third quarter of 2008 was $110 million. One ADS represents two ordinary shares.

As of September 30, 2008, the company's total cash and cash equivalents was RMB1,348 million, held-to-maturity investment securities in total were RMB1,148 million and total shareholders' equity was RMB2,978 million.

On August 27, 2008, we announced that our Board of Directors authorized a US$40 million share repurchase program. The duration of the share buyback will be over the next 16 months. Based on market conditions, Nepstar’ share cash status, general economic conditions and trading prices, the repurchases will be made in open market at prevailing market prices, or in block trades, which are subject to restrictions relating to volume, price and timing.

As of November 24, 2008, the company had repurchased approximately 3.8 million ADSs and spent approximately US$16 million on the repurchase program. We opened 150 new stores organically during the quarter, acquired 40 stores and closed 6 stores. As of the September the 30th, Nepstar had a total of 2,667 stores in operation.

In early August 2008, the company entered into a definitive acquisition agreement with Qingdao Kangjie Chain Drugstore to acquire all of Kangjie's 42 drugstores in Qingdao, Shandong Province for an aggregate cash consideration of RMB16.8 million.

Qingdao Kangjie Chain Drugstore was the second largest chain drugstore in Qingdao based on a number of directly operated drug stores in 2007. All of the 42 Kangjie stores are designated national healthcare insurance reimbursement store. At the end of the third quarter, 40 of the acquired stores had been transferred to and operated by Nepstar. The remaining two stores are expected to be transferred in the fourth quarter.

At this point, I would like to turn to the call to Mr. Jiannong Qian who is going to discuss about strategic outlook.

Jiannong Qian

Thank you, Lucia. As we enter the fourth quarter, our focus is not only on growing revenue and gross margin, but also on cost reduction by streamlining our operations to eliminate redundancies, and maximize our competitive edge in these challenging economic times. We expect to continue to generate positive cash-flow and aim to utilize our ample cash reserve effectively for future growth.

Although economic growth in China is expected to slow down overall, the economic stimulus plan recently announced by the PRC government may serve as a catalyst to bolster China's economy and benefit consumers in general, as well as Nepstar.

Nepstar continues to remain financially well-equipped and operationally sound. And we are working hard to maintain our position in the challenging economic environment, as well as continue to extend our leadership in the marketplace.

With that let me join Mr. Shao and Lucia to take 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 comes from Bin Li with Morgan Stanley. Please state your question.

Bin Li - Morgan Stanley

Thanks for taking my question. Looks like you didn’t mention guidance for the first quarter or for the full year. Can you explain that?

(Foreign Language)

Lucia Qian

(Interpreted) You’ll recall in August, the company has provided the annual guidance for the third quarter’s performance, we have met all the guidances that we provided for the third quarter. At the moment, we are carefully monitoring the domestic consumption market, which is quite subject to rapid changes. And at the same time, starting from the second half of the third quarter, we have been launching various initiatives internally to improve the sales revenues as well as to reduce the redundancies and cut costs.

All those measures were launched in the second half of September and is gradually showing their good results. The Board of Directors are keeping very careful consideration of guidance provision and because we have been seeing the rapid changes domestically in terms of the consumption market and also the company is also seeing lot of the positive changes driven by our revenue driving and cost cutting measures.

The Board of Directors finally decided we are not going to make any definitive promises for the delivery of the fourth quarter. However, we do see that, in the third quarter we have already made an improvement in our revenue side, the first time in this year same store sales has gained positive growth, and at the same time, some of our cost control measures starting to demonstrating contributions to our net income in the fourth quarter. So, we believe that we have been doing all the right things to improve the company's productivity and profitability.

Bin Li - Morgan Stanley

Yes, thanks for the color. I understand that the current environment is very uncertain; I was just wondering what your sense of the 4Q performance so far, seems you have about two months for the quarter already. Are you still comfortable with your previous top line, bottom line guidance?

I guess the reason I’m asking that is because based on my calculations, the sales in the first three quarters are about 75% to 76% of your previous top line guidance for the full year, and net income for the first three quarters about 70% of your previous bottom line guidance. So, should I think this previous guidance will be at risk or are you still comfortable with that?

ZiXin Shao

(Foreign Language)

Lucia Qian

(Interpreted) And for the quarter-to-date now, we seems to have been maintaining this momentum and for the October and so far November same store sales are keeping a very small positive growth. In the second half of November, we did see that there is a quite obvious sign of sales picking up that is very encouraging. And at the same time, we have fully realized that the cost pressure is one of the major threat to our company’s profitability.

So, in the second half of September, we started to take very strong measures in terms of cost control. You may well reckon that the largest cost item is the labor cost. At the moment, we have already reduced our per store head account from the high level of 6.7 people per store in the third quarter to 6 people per store by now. And we asked you to evaluate how much we can further reduce on the head accounts at the store level without sacrificing our service and at the same time on the rental side, the economy has slowed down in China, which has already brought some impact to the mentality of the landlords.

So, we have actively sent our store development team to revisit and trying to renegotiate some of the leases that are not compatible with the revenue generated on top of the premises and we have already gained certain results in terms of rental reduction.

Our target in terms of rental reduction for the fourth quarter should be 1 million saving for the same stores compared to that of the third quarter. So, you will see that company’s various measures cost cutting will show the results in the fourth quarter and on the other hand the company has been maintaining good gross margin. And for the first quarter of this year gross margins was 47.8, second quarter was 48.3 and third quarter is 48.6. It is on a steadily growing trend. We are keeping the gross margin very steadily. So, all in all with the lease various of our efforts has working cohesively improve in the profitability of the company.

Bin Li - Morgan Stanley

Thanks. And just want to follow-up on the same store sales growth. It’s good of course to see it in Q2 0.5% in a positive territory. And I think you said, the main reason is the average ticket item went up. Can you quantify that for us? Also can you tell us what was year-over-year decrease of the traffic volume for the stores given that, Olympic impact, given the Olympic impact?

(Foreign Language)

Lucia Qian

(Interpreted) We actually observed that the reduction in the traffic was mainly in July and August, and this is primarily due to the regulatory impact pre-Olympic games and during the Olympic Games. However, we do see that in September, the traffic came back quite significantly and in a way made up for the quarterly traffic per store.

And the same-store sales growth was mainly driven by, of course, the recovery of the store traffic in the second half of September and also the initial demonstration of our training initiative for our store staff to make [linked] sales and to enlarge our basket size.

(Foreign Language)

Lucia Qian

(Interpreted) The per visit ticket value in the third quarter compared to the second quarter is RMB37 in the third quarter versus RMB30 in the second quarter.

Bin Li - Morgan Stanley

What was it a year ago? What was the ticket price a year ago? Do you have that?

(Foreign Language)

Lucia Qian

(Interpreted) A year ago it was RMB26 per visit.

Bin Li - Morgan Stanley

Okay.

Operator

Any additional question Mr. Li

Bin Li - Morgan Stanley

It’s fine. I'll go back to the queue.

Operator

Our next question comes from the [James Tom with Roth Capital]. Please state your questions.

James Tom - Roth Capital

Hi. Congratulations for the quarter. So you have the guidance, $81 million, and then you actually beat the guidance handsomely by 9 million. It seems that the advantage actually got offset by this 5% increase -- a kind of 27% of tax rate. Is there any color on this whether in the future it will be around 25% or if there's any fluctuation on that?

(Foreign Language)

Lucia Qian

(Interpreted) The reason for a 27% of effective tax rate was mainly due to the impairment provision we made for our deferred tax asset in the third quarter. Let me briefly explain what deferred tax asset is. In the previous two years, there were substantial difference in terms of tax rate between Shenzen and our other branches. We tend to taxation organization; we tend to try to make more of our taxation happen in Shenzen to take advantage of tax haven. In the due course, most of our branches have been incurring losses.

According to the Chinese taxation law, basically if you made losses in year one, within the next five years if you can make profit you will not have to be fully tax on the profit make you can offset the profit with the tax losses that incurred in the past five years. So, in the due course we have accumulated certain level of deferred tax asset in the past two years and every quarter we need to make some valuation allowances and judgment as to if we will be able to realign our deferred tax asset.

In the third quarter, we have incurred a 2.5 million deferred tax and the RMB2.5 million was of deferred tax impairment provision. Next year we will try to organize our taxation to take advantage of the deferred tax asset better as starting from next year, there will be a migration of the tax rate of Shenzhen from low level of 18% to even a higher level. So, there is no point to have all of taxation happening in Shenzhen.

So, through careful tax spending we do not believe the next year the overall company’s tax rate is going to go beyond 25%.

James Tom - Roth Capital

Thanks.

Operator

Thank you. (Operator Instructions) Our next question comes from [Chunan Ho] with Goldman Sachs. Please state your question. Chunan Ho?

Chunan Ho - Goldman Sachs

Hello, yes. Can you hear me?

Operator

Yes, go ahead.

Chunan Ho - Goldman Sachs

Okay. Hi, thanks for taking my question. Just a few questions, could you give as a sense of your working cap per days, for the full year, that’s again in AI & AP?

ZiXin Shao

(Foreign Language)

Lucia Qian

(Interpreted) First of all, the company is in a very strong cash position. At the moment we have RMB1340 million of cash and cash equivalent and we also holding maturity securities, which is literally a wealth management program provided by various Chinese banks. And for those maturity securities, 748 million will be due within the next 12 months and RMB400 million was wealth management program participants will be due by January 2010.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) We are actually, very comfortable to say that for the maturity securities, it is very safe and quite liquid. And for companies AI and AP, actually, we would like to explain that for the accounts receivable is a rather small amount. Basically, the only party that is incurring AR for us is the stores that under the national healthcare reimbursement scheme.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) And that AR is RMB40 million.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) And the other item that is belonging to accounts receivable, a very small amount that some of our mass merchandisers where we open our stores within their stores owning to us. The total amount of that amount is RMB20 million.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) So all together, we are roughly having am AR of RMB79 million.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) And the accounts payable, total payable for the company is RMB246 million.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) The accounts payable major, the payment that we, that are due to pay to the suppliers.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) The company's overall inventory is RMB348 million and in terms of inventory, we have to explain because 40% of the inventory actually on a consignment basis. However because it is now in our warehouses, we are taking it as our inventory, but if we do not sell them, actually we can give it back to the suppliers. So 40% of those RMB348 million inventories are on consignment basis.

Therefore, we are having inventory days very close to our account payable days, and we are not really incurring much of the working capital for daily operation and you can see that we actually generate RMB59 million of cash from operating activities.

Chunan Ho - Goldman Sachs

Okay. Thank you. Could you also give us the guidance for your dividend payouts, both full year '08 as well as your CapEx?

Lucia Qian

(Interpreted) For '08 the CapEx is slightly lower RMB200 million and for the dividend, as we announced the dividend for 2007, we are saying the company's dividend policy is more than 50% of the annual net income as dividend to pay. We have not on the Board meeting discussed about dividends, how much of dividend that we'll pay for year 2008. Our estimation is, ratio-wise it should be more than what we paid-out last year.

Chunan Ho - Goldman Sachs

Okay. Thank you. And if I am not mistaken, it seems like your number of shares have increased slightly from your last reporting session. Why is that since you've [shelved] your share buyback program?

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) When we say our total share number, it is the weighted average total share number and it's actually a calculation mechanism. For the second quarter, you realized that there were certain number of employees stock options exercised approaching the end of the second quarter. So, by weighting them it will have a rather slighter impact to the share account of the second quarter compared to impact to the third quarter.

And our share buy back program actually time execution in the last month of third quarter. So, by weight, the shares we bought back did not really make much of the impact to the overall share count in the third quarter. So, in the end, we seem to be increasing our share count in the third quarter, but again it is really a computation mechanism that is leading to this. In the third quarter, literally no employees sold any option during the third quarter.

Chunan Ho - Goldman Sachs

Okay, great. And just one last question, could you give us a sense of your sales per store per day by [storage]?

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) Into what detail the same stores?

Chunan Ho - Goldman Sachs

Yes and opened during this period and yes.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) Just a moment. For stores opened by year in 2006 there are 1,399 stores in total, and the per store to-date revenue is RMB3474. And for those stores, their performance is in the third quarter of year 2007, the number was RMB3456. And for stores that have been was opened in year 2007, their per store per day revenue in the third quarter is RMB1776. And that number in the previous year was like RMB1449 and for this new store that we opened in 2008, those stores has a revenue of RMB1580 per store per day.

Chunan Ho - Goldman Sachs

Okay, great. Thank you so much.

Operator

Our next question comes from Shaojing Tong with Merrill Lynch. Please state your question.

Shaojing Tong - Merrill Lynch

Hi, most of my questions have been answered. I just have one quick question on your minority interest line. It seems that this line is much less than previous quarters. I believe this line is mostly related to your Yunnan subsidiary. Can I read this as that subsidiary is much less profitable or is there some dramatic change in that subsidiary? If lower profitability is the case, does that is also part of reason you reported much lower operating margin for this quarter.

ZiXin Shao

(Foreign Language)

Lucia Qian

(Interpreted) For the minority interest, you are right. It was really a description of our Yunnan branch where we have 40% of the shares in that YunNan JianZhiJia, a chain drug store. Currently we are seeing that our Yunnan is turning up comparatively lower profits this quarter and this is primarily due to the worsened competition in that province and because Yunnan branch is – and profit-wise not a material part of the companies overall profitability. So we do not think Yunnan branch is making too much of an impact to our profitability of the overall company.

Shaojing Tong - Merrill Lynch

Okay, thanks. That’s helpful.

Operator

Thank you. Our next question comes from [James Tom with Roth Capital]. Please state your question.

James Tom - Roth Capital

It is just a quick general question, that in your future growth, are you going select for individual store openings, finding the locations or try to make the acquisition of the profitable existing chain.

ZiXin Shao

(Foreign Language)

Lucia Qian

(Interpreted) In the foreseeable future, organic growth and acquisition will always be two major drivers for our expansion. And we think that in the near future, the proportion of acquired stores shall be increased on top of this years level and we have been observing that some of them, the small and medium sized chains are struggling under the economic recession, particularly approaching year-end.

Our adjustments currently are that the acquisition opportunities in the next one to two years shall be more favorable to Nepstar compared to that of this year.

Operator

Thank you. Ladies and gentlemen, we only have time for one more question. Our final question comes from Bin Li with Morgan Stanley. Please state your question.

Bin Li - Morgan Stanley

Thanks for taking my follow-up question. I just have a house keeping item. I think you gave the private labels as a percentage of sales and also the gross margin for that? Can you also give us the centrally procured products and the regionally procured products, procurement figures?

ZiXin Shao

(Foreign Language)

Lucia Qian

(Interpreted) Currently we are having and in the third quarter, private label products account for 26.1% of the total revenue and the centrally procured non-private label products account for 40.7% of the total revenue. Regionally procured products were further reduced to 33.2% of the company's total revenue.

Simin Zhang

(Foreign Language)

Lucia Qian

(Interpreted) Private label products contributed 38.7% of the company's total gross profit. Centrally procured non-private label products contributed 49% of the total gross profit and regionally procured products contributed 12.3% of the company's total gross profit.

Operator

Thank you. Ladies and gentlemen there are no further questions at this time. I'll turn the conference back over to management for closing comments.

Lucia Qian

(Interpreted) Thank you all for joining us for the third quarter financial results conference call. We appreciate your support to the company during this very volatile market phase, and we wish all of us good luck. Thank you.

Operator

Thank you. This concludes today's teleconference. Thank you all for participating.

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