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Executives

Leslie Richardson – IR, Elite IR

Dan Carlson – Non-Executive Director

Leada Li – CFO, Secretary and Treasurer

Analysts

Kun Tao – Roth Capital Partners

China Precision Steel, Inc. (CPSL) F2Q09 (Qtr End 12/31/08) Earnings Call Transcript February 10, 2009 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the China Precision Steel second quarter earning conference call. My name is Josh and I’ll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. (Operator instructions) I would now like to turn the presentation over to your host for today’s call, Ms. Leslie Richardson from Elite IR. You may proceed.

Leslie Richardson

Good morning, ladies and gentlemen. My name is Leslie Richardson from Elite Investor Relations, and I’d like to welcome you to China Precision Steel’s second quarter fiscal 2009 conference call. Joining us today is China Precision Steel’s Chief Financial Officer, Ms. Leada Li, and Dan Carlson, Non-Executive Director of China Precision Steel.

I would like to remind our listeners that management’s prepared remarks during this call contain forward-looking statements, which are subject to risks and uncertainties faced by the company, and management may make additional forward-looking statements in response to your questions. Therefore the company claims the protection of the Safe Harbor for forward-looking statements that is contained in the Private Securities Litigation Reform Act of 1995.

Due to such risks, actual results may differ from those discussed today including, but not limited to, business conditions in China, legislation or regulatory environment, requirements or changes adversely affecting the business in which China Precision Steel is engaged, cyclicality of the steel consumption including overcapacity and decline in steel prices, limited availability of raw materials and energy may constrain operating levels and reduce profit margins, environmental compliance or remediation, and other risk factors detailed from time to time in the company’s filing and future filings with the United States Securities and Exchange Commission.

Accordingly, although the company believes that the expectations reflected in such forward-looking statements are reasonable, there can be no assurance that such expectations will prove to be correct. In addition, any projections as to the company’s future performance represent management’s estimates as of today, February 10, 2009. China Precision Steel assumes no obligation to update these projections in the future as market conditions change.

For those of you unable to listen to the entire call at this time, a recording will be available via webcast for 90 days. The web link is available at the company's corporate website. And with that, Dan Carlson will now present management discussion on behalf of Dr. Wo Hing Li, China Precision Steel’s Chairman and CEO.

Dan Carlson

Thank you, Leslie. Good morning, everybody, and thank you for joining China Precision Steel’s second quarter fiscal 2009 earnings conference call. Our revenues for the second quarter increased to $17.5 million, up 32.9% over revenues in the second quarter of fiscal 2008. Our high carbon and low carbon products accounted for 6.1% and 87.3% of sales respectively compared to 38.5% and 47.6% respectively from the prior year period. Exports contributed to 75.3% of total revenue compared to 26.5% in the second quarter of fiscal 2008.

Gross profit was $3.5 million, down 26.6% from the same quarter a year ago with gross margin at 19.6%. For the second quarter of fiscal 2009, we recorded a net loss of $2 million from a fully diluted loss of $0.04 a share. Contributing to the net loss for the quarter was a non-cash charge in the amount of $3.8 million due to a dispute over services rendered by the company. Revenue growth for the quarter was attributable to strong sales of our low carbon products, which increased 143% over sales of our low carbon products in the second quarter of last year.

During the quarter we fulfilled an order worth over $11 million for Salzgitter Mannesmann International, which represented 64% of our total sales. Salzgitter is a German global steel trading company who in turn sold the cold-rolled steel to Western Metal Products Company or WEMPCO. WEMPCO is a leading importer of cold-rolled steel strips for the production of roofing sheets in Nigeria. Last year we were approached by WEMPCO to begin supplying them with the steel strips to import into Nigeria. And from August to December 2008 we delivered to them a total of 12,000 tons of low-carbon precision steel through Salzgitter. We are very happy to be working with both Salzgitter and WEMPCO, and look forward to building a long-term relationship with both of them.

Sales of our high carbon products declined 79% during the second quarter compared to the same quarter a year ago. The significant decline in high carbon products was primarily due to the majority of our high carbon customers lowering their inventory level in the wake of the slowdown in end market demand for their products. Approximately 50% plus of our high carbon products are clutch discs used in heavy trucks.

In general, the manufacturing of clutch discs is a very attractive business with gross margin in the high 30% and a high replacement demand as they typically need to be replaced approximately every two months. While the global economic slowdown contributed to the drop-off in demand for high carbon products this quarter, we are hopeful that the Chinese government stimulus package and steel rejuvenation plan will help revive the construction industry and related industries, as well as stabilize steel prices, which will help reinvigorate demand for high carbon steel products.

Moreover, because auto sales in China along with the rest of the world have been under pressure recently as global demand declined, the Chinese government has implemented its own auto bailout program to revive the world’s second largest auto market, which includes support for production in spare parts. Despite the economic slowdown, we do continue to receive interests from potential new customers, motivated to reduce their production cost by switching from higher cost imported precision steel. Although I would like to stress a critical consideration in deciding to work with a new customer is that the customer must prove a high degree of creditworthiness. Therefore we are extremely selective in which orders we accept so that we limit our payment risks.

Furthermore, the lead time for developing new customers products can range from six months to over a year depending upon the complexity of the products and the customer’s testing procedures. While today’s economic environment does remain challenging, we believe that the mid to long-term opportunities remain attractive and therefore have stayed on schedule with the construction of our third cold-rolling mill, which is expected to be in production by this coming June.

The mill is a 4-high tandem mill designed for products with a width up to 1,450 millimeters and will be capable of consistently producing cold-rolled steel of the highest quality for both exposed and unexposed products. The tandem mill will enable us to add an additional value-added process to improve the surface quality of end products. We believe the new mill will increase our production capacity by 33% once fully operational and expand our product line offerings creating new opportunities for the company’s growth.

Before I turn the call over to Leada, I would also like to point out that during the quarter we have strengthened our balance sheet by reducing our accounts receivables and current liabilities while generating over $8 million in operating cash over the past six months.

And with that, I will now turn the call over to our CFO, Ms. Leada Li, who will discuss our financial results for the quarter in greater detail.

Leada Li

Thank you, Dan. Our revenue for the second quarter of fiscal 2009 increased to $17.6 million, up 32.9% from $13.2 million in the second quarter of fiscal 2008. The growth in revenue was mainly attributable to the increase in sales volume of 852 tons to 14,862 tons during the second quarter of fiscal 2009 from 14,010 tons in the same period a year ago, combined with a 25.3% increase in the average selling price.

Gross profit in the second quarter was $3.5 million, down 26.6% from gross profit in the second quarter of fiscal 2008 of $4.6 million. Gross margin was 19.6% compared to 35.5% in the same period a year ago. The decline in gross margin was mainly due to the exceptionally high gross margin in the second quarter of fiscal 2008 as a result of strong sales of the company's high margin products for both high carbon and low carbon steel in addition to the inability to pass on all of the higher raw material cost to customers and lower sales of the higher margin products during the second quarter of fiscal 2009. While we always strive to maximize our gross margin, we believe a healthy and achievable gross margin target for the current economic environment is in the low 20%.

Selling expenses for the second quarter of fiscal 2009 were $1.1 million, or 6.4% of revenue, compared to $181,000, or 1.4% of revenue, in the second fiscal quarter of 2008. The increase in selling expenses was primarily attributable to an increase in agent commission associated with the order from Salzgitter Mannesmann International as well as an increase in transportation costs and custom clearing charges in relation to the increase in exports. Administrative expenses were $587,000, or 3.3% of revenue, compared to $846,000, or 6.4% of revenue. The decline in administrative expenses was mainly due to the lower SEC compliance costs and professional fees as there was no financing activity during the quarter.

Our operating loss for the second quarter was $2.1 million compared to operating income of $3.6 million in the same period a year ago. As Dan mentioned earlier in the call, we incurred an allowance for bad debt in the amount of $3.8 million due to a dispute with a customer over services we rendered, which contributed to our operating loss for the quarter.

Net loss for the second quarter of fiscal 2009 was $2.0 million compared to net income of $3.5 million in the prior year period. Fully diluted earnings per share were a negative $0.04 compared to fully diluted earnings per share of $0.08 in the comparable period a year ago. Weighted average diluted shares outstanding for the quarter increased to 46.6 million from 43.6 million in prior year period.

And now turning on to our balance sheet. As of December 31, 2008, we had $14.8 million in cash and cash equivalents, no long-term debt, total liabilities of $41.2 million, and a working capital of $53.4 million. Our shareholders' equity was $122.2 million compared to $120.3 million as of June 30, 2008. Days sales outstanding were 122 days, down from 138 days in the second quarter of fiscal 2008 and down from 133 days in the first quarter of fiscal 2009.

For the first half of fiscal 2009, we generated $8.7 million in cash flow from operating activities. With $14.8 million in cash and cash equivalents, we have sufficient cash to meet our planned capital expenditure commitment of $900,000 for the completion of our third mill. Currently, we have about a month of backlog orders. We remain cautious for the foreseeable future as the current economic climate makes it difficult to provide any clear visibility.

And with that, I will turn the call back to Dan for concluding remarks before we open up the call to questions and answers.

Dan Carlson

Hi. I would like to conclude by saying that we continue to strengthen our reputation for providing high quality cold-rolled steel products at a competitive price in the Chinese and global markets, as well as continue to negotiate new contracts with customers who demonstrate a strong level of creditworthiness. Moreover, we believe that the growth drivers for the mid to long-term remain in place as we focus on expanding our market share through increasing exports and replacing higher priced imported precision steel.

While we anticipate that we will continue to feel the effects of the global economic slowdown for the foreseeable future, we believe that our industry is an early indicator of economic trends, and as such, expect to be one of the first to benefit from the global economic recovery. Furthermore, we expect the Chinese government stimulus plan to be a critical part in accelerating the recovery process and reinvigorating demand. With additional new capacities soon to be in production, we believe we are well positioned to expand our market penetration over the next several years.

I’d like to thank all of you for your interest in China Precision Steel and we look forward to updating you on China Precision Steel’s progress next quarter. We will now open up the call to any questions you may have for me and Ms. Leada Li. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from Kun Tao. Kun, you may proceed.

Kun Tao – Roth Capital Partners

Hi, good morning. My first question is your – can you give more details, your selling expenses up significantly this quarter. What’s your expectation on the following quarters?

Leada Li

I’m sorry. Can you repeat your question? What is our – sorry, the first part is to explain the selling expenses. And then?

Kun Tao – Roth Capital Partners

So can you explain why the selling expenses up so much this quarter? And what’s your expectation for the following quarters?

Leada Li

Right, okay. So first of all, the selling expenses – the increase of the selling expense is associated with the exports. So as we mentioned in the call earlier that 75% of sales this quarter was contributed by exports. And one of our major customers is Salzgitter Mannesmann International, which is a German company. So in agreement with Salzgitter Mannesmann, I’d say [ph] that they will introduce customers to us. So they are the (inaudible) for, I’d like to call, which is end customer. But in terms of that, we need to pay them 1% of by tonnage. So it’s how many dollars per ton by tonnage agency to Salzgitter Mannesmann. So the fee was actually already added to the selling price to our end customer that the fee that’s paid to Salzgitter is kind of in the selling expenses in dollar a ton. And that is why with this quarter’s increase in exports, the selling expenses went up.

Kun Tao – Roth Capital Partners

So, do you expect the same amount of – about the same amount of money going forward as long as your low carbon steel is maintained at the current level?

Leada Li

Yes. So – because this agency and selling expenses will be proportionate to the amount of export that we sell and deliver every quarter. So in a quarter with high export sales, we will expect the selling expenses to be high as well.

Kun Tao – Roth Capital Partners

Okay. Going to the low carbon sales export – exporting, we see – I have two questions on that. What’s your expectation on export of low carbon sales going forward given your high carbon steel is – the demand for high carbon steel is actually shrinking. So do you expect the same percentage of sales will come from low carbon steels in the next two quarters only this fiscal year? That’s question number one. And question number two is, what’s your expectation on the selling price given low carbon – your low carbon selling price actually increased in this quarter – in the December quarter?

Leada Li

Okay. So the first question is related to low and high carbon, that really depends on the orders we receive and the number of new customers we work with. So although for this quarter we’ve seen a great 60s in the high carbon sector because of the slowdown of the auto industry, we are also seeing that the government is helping the auto industry by increasing demand or giving incentives to buyers to motivate across the auto industry, including components manufacturers. So we are hoping to – the more detailed announcement regarding the package is still to be announced, we are waiting to see the full details, but at the same time we are receiving orders from our auto components customers this quarter. So that’s one related to the high carbon sales. As for low carbon, we have been working with Salzgitter and WEMPCO since last quarter, as we mentioned in the call. So we hope to build a strong relationship with them and at the same time have a stable – we hope to have a stable volume shipped to them every quarter. And at the same time, we are also working with a number of new customers in the international market, the other regions that we can potentially sell to. So our goal really is to maximize the tonnage, all the gross profit while we can achieve in every sector. So depending on our customer orders and the market trend in every quarter, we will try to strive to maximize the gross profit in each (inaudible) that we ship within each product category. So that’s number one. Number two, regarding prices, one of the reasons for the selling prices – for higher selling prices this quarter is because of higher steel price now compared to the same period last year. So part of the reason that the selling prices went up is because we have a high raw material cost. And we expect the coming quarter, which is the March quarter, steel prices to be relatively similar to this quarter as steel prices have been more or less stabilized as the government announced a steel package.

Kun Tao – Roth Capital Partners

Okay. Can you tell – can you give more details on your $3.8 million write-off on related to credit quality issue with the customer? And do you expect additional write-off or do you expect any order from the same customer going forward?

Leada Li

Right. First of all, I would like to emphasize that this is an isolated case. So this is a one-time case. What happened was the customer provided us raw materials for us to process into end product. And there were some inadequacies in the raw materials, which has led to (inaudible) over the quality on various specifications over the end product. After rounds of discussions with the customers, both parties, that’s the customer and us, have agreed on the terms that they will be responsible for the raw material cost, and us, China Precision Steel will (inaudible) the processing cost. So during the quarter we’ve determined that the accounts receivable in relation to this processing fee is not recoverable. And that is why we have provided allowance for bad debt for this particular contract and that particular good amount of processing fees. And also we worked on other tax payables in relation to this particular contract and things [ph] as well. So one, I would like to emphasize that this is an isolated case. So we are still on agreeable term manners with this customer. So we will continue doing business with them. And second, the auto impact of this contract and this processing fees, the write-off had been fully reflective in our financials for the December quarter.

Kun Tao – Roth Capital Partners

Okay. So – is this the customer that you deal with subcontract business that you disclosed?

Leada Li

Yes.

Kun Tao – Roth Capital Partners

Okay. So do you expect a same amount – just last quarter you had almost $4.6 million in subcontract and last fiscal year you had $6.4 million. Do you expect the same amount of revenue will come from the same customer?

Leada Li

I cannot give you – we don’t have the amount of orders on hand right now, but we are working with – as I mentioned, we will continue our business with our trusted customers. So we certainly look forward to our future relationship and future sales with this customer as well.

Kun Tao – Roth Capital Partners

Okay. That’s – again, go back to the – my last question, go back to the selling expenses, joining a model on that, so do you – in terms of dollar amount, let’s say, you’re selling the same amount of – you have same amount of revenue this quarter, June quarter or next year. So you do expect an average of 5% to 6% in selling percentages overall if low carbon continued to maintain that 60% to 70% of the total revenue?

Leada Li

Yes, that will be the case.

Kun Tao – Roth Capital Partners

Okay. All right. Thank you.

Leada Li

I’m sorry. (inaudible) but this selling expenses, the higher selling expense because of that particular arrangement with Salzgitter, whereas they try those agent fees [ph]. So, say, if for example, we have another customer that is able to repay Salzgitter OEM, we can find more – ask for customers to also sell them (inaudible) amount of the export low carbon steel with our OEM [ph] manufacturer. And for that agreement, we don’t have the agent fees, and then the selling expenses wouldn’t be this high. So it really depends on the future agreements we sign with other customers. So it’s not necessary – at the moment, yes.

Kun Tao – Roth Capital Partners

Okay. I’m sorry, one more question. For your export, other than you’re selling from the agent, I remember on previous quarters you have – you export mainly for construction purposes like roofing for buildings. Do you see any slowdown – do you have any visibility on the next couple of quarters in terms of that exporting factor?

Leada Li

Currently, visibility is relatively low because of the economic environment, I have to say, and also because of the prices – because we sell to the Southeast Asian countries as well. And because of the credit crisis in both countries, we are being very careful with selling or shipping quantities to them, because once we make sure that order terms and they have agreed to pay, rather than leaving us a credit risk. So again, I have to say visibility is vastly low at this moment. But at the same time, we are continuing to work with a number of new customers and we are doing our best to expand for the sales and for the Southeast Asian regions as well.

Kun Tao – Roth Capital Partners

Okay. Thanks. That’s all for my question.

Leada Li

Thank you.

Operator

(Operator instructions) And at this time we are showing no more questions available. You may proceed.

Leada Li

I’d like to thank everybody for joining us on the second quarter 2009 fiscal conference call. And we look forward to talking to everybody again in our third quarter announcement. And perhaps you will meet – some people will meet with Dan at the Roth Conference this next week. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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Source: China Precision Steel, Inc. F2Q09 (Qtr End 12/31/08) Earnings Call Transcript
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