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Executives

Xiaodong Wu - Chairman & Chief Executive Officer

Sam Tsang - Chief Financial Officer

Dr. Zhong Chen - Chief Technology Officer

Charles Zhu - Vice President

Winnie Yan - Investor Relations

Analysts

Bin Li - Morgan Stanley

Jinsong Du - Credit Suisse

Ho Ki Luc - Citigroup

Hao Hong - Brean Murray

China Medical Technologies Inc. (CMED) F3Q08 Earnings Call March 3, 2009 8:00 AM ET

Operator

Good day ladies and gentlemen and welcome to China Medical Technologies Incorporated, third quarter 2008 earnings conference call. My name is Mary and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the presentation over to your host for today’s call, Ms. Winnie Yan; please proceed.

Winnie Yan

Hello everyone. I’m pleased to welcome you to China Medical’s third fiscal quarter earnings conference call. China Medical already announced its third fiscal quarter results. A copy of the press releases is also available on the company’s website at www.chinameditech.com.

Today your speakers will be Mr. Xiaodong Wu, CEO; Mr. Sam Tsang, CFO; Dr. Zhong Chen, CTO; and Mr. Charles Zhu, VP. After they finish with their remarks, they will be available to answer your questions.

Before we continue, please bear with me as I take you through the company’s Safe Harbor policy. The discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risk and uncertainties. As such, the results may be materially different from the views expressed today.

A number of the potential risks and uncertainties are outlined in the company’s public filings with the U.S. Securities and Exchange Commission. China Medical does not undertake any obligation to update any forward-looking statements, except as required by applicable law. As a reminder, this conference call is being recorded. A replay of this conference call will be available via webcast on China Medical’s website.

Now, allow me to turn the call over to Charles, who will give remarks on behalf of Mr. Wu. Charles.

Charles Zhu

Thank you, Winnie. Ladies and gentlemen, welcome to our earnings call. We’re pleased to report another strong quarter ended December 2008. As for the economy, it’s experiencing significant challenges; China economy was the impacted as well, but at a lesser Degree. Additionally China healthcare as become one of the best defensive areas during this downturn, mainly because of ongoing government medical requirement.

In China’s recent [Inaudible] and stimulus plan, healthcare was one of the priorities and we anticipate positive impact in the near and long term. We believe the IVD market in China is still at the national stage and tremendous opportunities. Our company has transformed into a share IVD company after recent restructuring. We have the largest footprint in China IVD market as we are penetrating and approaching 200 Tier-1 hospitals.

While we are proud of our operational achievements, management is actively monitoring potential impact from the current economic downturn. So far we have see minimum or no impact. While visibility for business outlook remain challenging for many companies, the management made the decision to increase the visibility into our business.

Regarding the performance of our third fiscal quarter ended December 2008, we achieved in currency and growth, in both ECLIA and FISH businesses, given this economic downturn. Our business is less impacted compared to other healthcare companies for several reasons, which I will explain later accordingly when I go through each business.

For the ECLIA business, it continues to generate recurring revenue on the sales operation kit. Most of the ECLIA tests are reimbursed by government insurance policy and government has committed to make substantial additional investment to improve the coverage. We have recently received SFDA approval for our SIV reagent kit and expect to receive approval for our other reagent kits in the first half of 2009.

For the FISH business, it is less impacted by the economic downturn, because the technology is still in its early growth stage. It addresses very critical clinical needs, such as in prenatal and oncology related applications, often providing therapy guidance. Our FISH uses are mainly high-end customers and are largely immune to economic downturn.

We have received three SFDA approvals for our HER-2 Breast Cancer probe, prenatal probe and cervical cancer probe. Based upon this experience we’re confident in getting SFDA approvals for the rest of our FISH probes and SPR, HPV-DNA Chip product on a timely basis.

We have increased our efforts in promoting FISH applications in different clinical developments in each hospital, to build on public awareness of this clinical benefit for the FISH probes, which will result in long term sustainable growth of our recurring revenues from setting our FISH probes.

Recently, we have announced the successful development of a new FISH probe for detection of epidermal growth factor receptor, EGFR abnormalities in patients with non-small cell lung cancer and have offered the probe to the hospital customers in January 2009.

In addition, we’re also conducting research on [Kros] notation detection related to the treatment of lung and colon cancer. We have also laid out our long term R&D plan to develop other probes under the FISH technology platform, to address more clinical and market requirements.

As you know, we announced the acquisition of the HPV-DNA Biosensor Chip and SPR-based Analysis System in October 2008 and completed the acquisition in December 2008. We have outlined the potential benefits from the acquisitions in the related press release. We will leverage our FISH direct sales coverage to bring this new molecular diagnostic technology platform to the market and create a new source of recurring and growing revenue for us, starting from the next fiscal year.

We on the right track to capture the dominant shift in the targeted molecular pathology market in China. By the end of March 2009, we will penetrate over 400 Tier-1 hospitals in China. It puts us as one of the largest healthcare companies in China, in terms of the number of Tier-1 hospital customers. In next fiscal year, we will become truly the largest healthier company with the largest Tier-1 hospital customer based.

Based upon public data, we estimate that the 1000 Tier-1 hospitals in China, generating RMB500 million revenues each on average. Usually, 10% of the hospital revenue is coming from IVD related tests and among which, molecular pathology tests is growing at a faster rate and could reach over 10% of IVD revenue. Assuming related reagents and consumables costs accounted for about 50% of the test revenue, the whole molecular pathology market potential will reached over RMB2.5 billion in China.

FISH technology will play a dominant role in China’s molecular pathology, because the traditional pathology test methods like chromosome analysis are not as widely used and established as they are in U.S. and European market, due to lack of qualified technicians. This makes it possible for FISH to become first line pathology test method quicker in many obvious applications in China.

I have now finished Mr. Wu’s remarks and I’d like to turn the call over to Sam and he will give you an overview about our third quarter results. Sam, please.

Sam Tsang

Thank you, Charles and welcome everyone. Let us have a recap first. Our 3Q revenues from continuing operation were up 50.7% year-over-year to RMB225.3 million or US$33 million. Our 3Q loss from continuing operation was RMB171.5 million or US$75.1 million, including a onetime charge of RMB244.9 million or US$35.9 million to acquire IPR&D.

Our 3Q net income was up 10.5% year-over-year to RMB108.1 million or US$15.8 million. Our 3Q non-GAAP adjusted income from continuing operation was up 94.5% year-over-year to RMB119.4 million or US$17.5 million.

Our 3Q diluted loss from continuing operation per ADS was RMB6.54 or US$0.96. Our 3Q non-GAAP adjusted diluted earnings from continuing operation per ADS, was RMB$4.55 or US$0.67 for this quarter.

Let us highlight certain financial numbers in this quarter. First, the loss from continuing operation was RMB171.5 million or US$75.1 million. This loss was due to the one-time charge of in-process research and development acquired from the SPR acquisition. The fair value of the R&D projects was charged through the income statement in this quarter according to U.S. GAAP. In fact these projects are still ongoing and new products maybe develop if completed.

We did not incur additional cash payment from this charge, other than the agreed purchase consideration for the SPR acquisition. If we exclude this charge from the loss from continuing operation, we would have income of RMB73.4 million or US$10.8 million from continuing operation.

Second, the gross margin was 75.2%. This gross margin was up from 73.2% last quarter. This was driven by the increased revenue contribution from FISH probe sales, which generated a gross margin of over 80%. We expect 1% margin improvement, when FISH growth will be higher than ECLIA growth in the next quarter.

Third, SG&A was RMB52.7 million or US$7.7 million, accounting for 23.4% of revenue. SG&A included a non-cash stock compensation of RMB12.3 million or US$1.8 million and amortization of acquired intangible assets related to SPR acquisition of RMB9.1 million or US$1.3 million. If we exclude these expenses from SG&A, the number would be RMB31.3 million or US$4.6 million, accounting for about 13.9% of revenue.

As we continue to grow our direct sales force to expand our direct sales coverage, we expect an increase in selling expenses, faster than the growing revenue, while we will be take leverage on our G&A expenses. Therefore we expect the percentage to remain at the current AFO or slightly higher in the next quarter.

Next, income from discontinued operation was RMB279.6 million or US$41 million. The income from discontinued operation include the income from HIFU business of RMB36.3 million or US$5.3 million, as well as a gain from the sale of the HIFU business of RMB243.3 million or US$35.7 million.

Revenue from HIFU business declined 76% year-over-year and 11.6% quarter-over-quarter to RMB85.4 million or US$7.5 million. The income from HIFU business declined 42.7% year-over-year and 30.8% quarter-over-quarter. We have seen the revenue from HIFU business to continue to decline after our sale of the business.

Next, non-GAAP adjusted income from continued operation was RMB119.4 million or US$17.5 million. We exclude stock compensation expense, amortization of acquired intangible assets and acquired IPR&D charge at the non-GAAP adjusted income from continuing operation. We believe this number provides a good reference to investors to assess our performance on a continuous basis.

Non-GAAP adjusted diluted EPS from continuing operation was RMB4.55 or US$0.67. We used $26.2 million ADS for the calculation of EPS, rather than $36.2 million ADS, because the convertible notes are anti-dilutive for the competition of diluted loss from continuing operation through ADS and excluded from the combination of EPS, which is applicable to other EPS computation.

If we add that RMB27.9 million convertible notes interest expense and RMB4.7 million convertible notes issuance costs, to the non-GAAP adjusted income from continuing operation of RMB119.4 million and divide it by 36.2 million ADS, the adjusted EPS from continuing operation would be RMB4.20 or US$0.62.

Next, cash balance was RMB1.9 billion or US$248.9 million. We had unpaid balance of about US$118 million for acquisitions and receivables of US$30 million from the sale of HIFU business; here the net balances is above US$130 million. We have generated cash of RMB121 million or US$17.7 million from operations in this quarter. Our current cash position is healthy and we will maintain our dividend policy.

Last, outlook for financial year 2008; we estimate the non-GAAP adjusted income from continuing operation to range from RMB410 million or US$60.1 million to RMB420 or US$61.6 million for the financial year 2008. Based on this estimate, the non-GAAP diluted EPS range from RMB14.84 or US$2.18 to RMB15.13 or US$2.22.

Our revenues for financial year 2009 will come from the recurring sales of consumables, including ECLIA reagent kits, FISH probes and HPV chips, where a majority of the sales will be made through our direct sales force to our Tier-1 hospital sales coverage. We will provide outlook for financial year 2009 when we report our next quarter results in June.

This concludes our remarks. Now, we will be happy to take your questions. Operator, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bin Li - Morgan Stanley.

Bin Li - Morgan Stanley

First is on the FISH performance for the quarter. Can you tell us what was the true run rate for the number of new hospitals you have penetrated during the last quarter?

Sam Tsang

Hi, Bin. This is Sam. We have had about another 50 new hospital customers during the quarter and also we have our dollar sales force, in addition to adding new hospitals is progressing on actually increasing the FISH probe consumptions by promoting the benefits of the FISH probes to many chemical departments in the hospitals, which drive the news of FISH probes in various test application, especially you know we have received the SFDA approval on fee of our FISH probe types.

Bin Li - Morgan Stanley

My follow-up question is, I remember earlier, I think you have forecast for the number of hospitals you want to penetrate in year one, year two and year three. Can you remind us and has that change because of new dynamics?

Sam Tsang

Previously, we expect to penetrate I think by the end of March, about 500 Tier-1 hospitals for the use of FISH and also we would expect that ECLIA, we’ll able to penetrate to not only to mid Tier-2 hospitals, but also Tier-1 as well as Tier-2 hospitals and so that’s why we launched the ECLIA system rental arrangement to our customers.

We do not change the plan and the number of Teir-1 hospital for the FISH, you may see that as we mentioned we expect to have more than 400 Tier-1 hospitals and at the same time we actually focused more on increasing the utilization or consumptions of the FISH probe by the existing Teir-1 hospitals and also the new Tier-1 hospital customers by our direct sales.

Bin Li - Morgan Stanley

Okay and just one more question on the FISH. Now, in terms of Tier-1 versus Tier-2 hospitals, can you tell us the utilization in Tier-1 hospitals versus Tier-2 hospitals and what kind of GAAP we’re seeing in terms of utilization within Tier-1 and Tier-2?

Sam Tsang

Bin, I just want to clarify, you thought that FISH is used in Tier-2 hospitals, is that correct?

Bin Li - Morgan Stanley

Yes, because I think you have also sold something in Tier-2 hospitals?

Sam Tsang

I think you maybe mixed up with our ECLIA operation, because currently all our sales folks are selling to Tier-1 hospitals. We mentioned that we expect to penetrate more than 400 by the end of March this year, and there are about 1000 Tier-1 hospitals and our focus is to continue to penetrate to other Tier-1 hospitals for our direct sales to expand the direct sales coverage and so more and more Tier-1 hospitals can use our FISH probes.

Bin Li - Morgan Stanley

So, you have not sold anything to Tier-2 yet?

Sam Tsang

Yes. We are selling our ECLIA reagents mainly to Tier-2 hospitals through our distributors led by direct sales.

Bin Li - Morgan Stanley

Sure. If I can ask a question on HPV; in terms of early feedback you have recurring in the past few months since you acquired the franchise, can you tell us what are the early feedbacks from the fields, when you talk to the doctors and you are going to the hospitals?

Sam Tsang

Let Mr. Wu answer this question and Charles will translate, therefore Mr. Wu will answer your question.

Xiaodong Wu - [Interpreted]

I’d like to address this question in several points. The first one is, since the closing of the acquisition, we have been quickly integrating this business and by end of March the first batch of the FCI analysis system will be assembled and ready to launch in markets in April this year.

The feedback we got from the physicians in the hospitals, we got the feeling that the awareness of HPV tests has been increased in the past several months because first perhaps related test, cytology tests has been adopted widely and also more and more hospitals are performing HPV related tests as well.

So in general speaking, we see the demand for the HPV test from the hospitals, from the patients or from the physicians has been increasing there fast and this is inline with our assumptions earlier. The feedback from the physicians and many of them are the expert in the industry, is by combining our FISH probes to detect the TERC gene with our HPV tests, those two technologies are complementary to each other and make a very good package for the early diagnosis for the cervical cancer.

So, we see great synergy potential between our FISH products and the HPV products. So, we are very confident about the prospect of this HPV product as we are increasing the FISH probe coverage by our direct sales force.

Bin Li - Morgan Stanley

Thanks. Just a follow-up question if I could on the HPV. Mr. Wu I don’t know whether you can remind us the cost of competitors price for HPV test and I know you might not be able to comment on the current thinking of your price, but are we going to see substantial price discounts to competitor’s price?

Xiaodong Wu - [Interpreted]

Based on the feedback from the market, the product is provided by Beijing as well as provided by some domestic players. The price they sell to the hospitals is over RMB200. We are determining our pricing based on the market feedback as well as our cost analysis. We will price our product lower than our competitor’s price, but still we can achieve around 80% gross margin.

Bin Li - Morgan Stanley

Okay, thanks. Just one last question, housekeeping items if I could. I think Sam you just reviewed the latest balance sheet information; can you tell us how much you’re paid regarding the HPV proceeds and what we should expect for the cash flow going forward. Now you don’t have the HIFU business and also I think you touched on the dividend policy; am I right on that you said you would not cut the dividends? Also on CapEx, I don’t know whether you can provide more color on the CapEx plan?

Sam Tsang

Well, your last question consists of many questions. The cash balance we have, about US$285 million by the end of December, which I mentioned that we have unpaid acquisition balance of about US$180 million; so if US$285 million minus US$180 million is above US$105 million, but at the same time we still have about $30 million to be received from the sale of HIFU business.

So if we let of these acquisition and disposal, we will have about US$113 million and also we talked about we have about US$17.7 million operating cash flow generated from the operation and so we used this number to annualize, it will be about US$74 million to US$75 million a year and in fact as we still have growing business in our ECLIA and as well FISH, the HER-2 cash inflow from operations will be higher.

Also we do not have any construction or trends building facility; we have a new facility for the SPR production, as well as HPV chip production, as well as for the expansion of FISH probe production, but we just leased this building and we expect to spend about US$4 million to US$5 million for the renovation and the renovation is almost compete.

So, you can see that we do not have a large amount of CapEx in 2009. The longer level of capacity is also about US$4 million to US$5 million. Also you talked about a dividend policy and also as we previously mentioned I believe we can maintain an ongoing dividend; that is, the dividend should not be lower than loss in this level.

Operator

Your next question comes from Jinsong Du - Credit Suisse.

Jinsong Du - Credit Suisse

I’d just like to understand, after the sales of HIFU, what is the impact or the changes on the balance sheet such as account receivables? I noticed that the account receivable day is actually around the same as before. Could you help us understand more on that; of the impact on HIFU and also going forward in terms of cash flow, with the sales of HIFU to ongoing operating cash flow, if you could elaborate, whether there’ll be any changes comparing to the situation before the sale of HIFU?

Sam Tsang

The balance sheet we show in the press release actually by the end of December ’08 we fit the sale of HIFU; that means the related asset of HIFU and the related liabilities of HIFU were excluded because of the sale and the only item you can see from the balance sheet related to HIFU business disposal, is the receivable of US$30. This is the balance payment of the month to be received for the HIFU disposal.

You can say for example, trade accounts receivable with this particular asset. You can see the balance of RMB284.3 million, which is lower than September balance of RMB325.6 million. The reason is because, even though we have going, our business of revenue in over 50% in continuing operation, but we have a lower accounts receivable because we exclude of this sold accounts receivable related to HIFU.

The current accounts receivable day is roughly about 115 days, which is very comparable to the accounts receivable day of the last quarter. The reason for that is because the collection from large hospitals takes in fact longer time, because these large hospitals they have their internal processing.

Even though we give them 90 credit, but normally they start to arrange the payment after 90 days and so normally we receive the payments in about say 150 days, about one to five months, but this is very normal for large hospitals to pay their payment in this time, not only to us, but all the suppliers, including many international medical companies.

So, we do not any problems of collection from these Tier-1 large hospitals. As we mentioned previously in each of these Tier-1 hospitals they have annual revenue on the average of RMB500 million a year and they have a very strong cash flow position and so we don’t believe there is any and we don’t see any problem of collecting payments from large Tier-1 hospital, although the production days are a little bit longer.

Jinsong Du - Credit Suisse

Right. Then, will be any changes in terms of the ongoing operating cash flow? I understand that this quarter the operating cash flow amount by the same as the non-GAAP net income; would that be about the same going forward, just inline of the…?

Sam Tsang

I would think that operating cash flow for example this quarter is US$17.7 million. I was think the next quarters or following quarter the number should be higher.

Jinsong Du - Credit Suisse

Just going back to HIFU, I understand although this is a discontinued business, I noticed that the sales number and the profit number of HIFU in this quarter have shown very share decline quarter-over-quarter and year-over-year. Could Mr. Wu comment on what is the reason for that and also going forward, what is the direction of HIFU?

Xiaodong Wu - [Interpreted]

Yes, you’re right. You can see the decline of HIFU sales compared to the last quarter OEM, manly because of the economic downturn. We see the hospitals; they are getting more cautious to purchase large capital equipment. This is not only when they are buying our HIFU system, its true for the other large medical devices suppliers, multinational companies, it’s the same case.

The second reason is, some of our dealers, they used to get the credit from the bank and buy our HIFU and invest the HIFU in the hospitals on a profit sharing basis and early at the economic downturn, there is the tightening of the credit in the China market and it’s getting hard for those dealers to get the bank facilities to finance this kind of business model. So we see slowing down for the orders from this kind of distributor.

So, we actually predict this kind of slowdown and its part of the reasons we decide to sell HIFU business, but it’s not the whole reason and another reason is of course the HIFU, this is not in line with our company’s future direction. We have claimed that our company’s strategic direction for the long term is to become the high end IVD Company in China. Of course HIFU does not fit very well in our long term business strategy. So, we decided to sell our HIFU business.

For your question about the future direction for HIFU business, I like to add one comment. Chinese FDA is getting more shipped, proving this kind of therapeutic equipment and they are putting more shipped regulations when they approve this kind of therapeutic equipments. So, this also affects the prospect of the HIFU business.

The Chinese FDA has officially notice us that when we renew our HIFU license, they need approve in each indication one-by-one. We have been negotiating with the Chinese FDA on how we can get the renewal of the HIFU approval and the SFDA noticed us that to renew the approval we need to submit 130 clinical study cases for each indications.

In the past, when we get our original approval for HIFU system, the SFDA approved a very broad range of indication putting so that it can enable us to treat tumors in different parts of the body. Now the new regulations requires us to submit the clinical cases for each single indications it makes us very hard to get this broad approval as before, so that we have to narrow the treatment range and that results will push us, force us to either low of selling price of the HIFU system or postpone the sales of HIFU systems for hospitals, because it is been helpful as to provide so many clinical cases in short period of time.

So, we predict our HIFU business could decline as much as 50% and actually that’s also my personal prediction, when I decided to purchase HIFU and I actually prepare to have another fives years to break-even for the amount that I paid for purchase the HIFU business. So the economic downturn and the more has shifted SFDA regulation, the two major effect is that make us to decide to sell HIFU business as soon as possible.

What I can tell you is so far we haven’t got the final renewal approval from the SFDA. We still don’t know what kind of renewal to approve or we can get from SFDA.

Jinsong Du - Credit Suisse

Regarding the economic impacts, so would that affect the FISH and the upcoming launch of the HPV testing business as both of them, if I remember correctly, are currently not reimbursable under the current social healthcare insurance and also Sam could you comment on the effected tax rate going forward, because I understand that the non-cash charges are not going to be counted into taxable. It cannot be deducted in the taxable income. So, if that’s the case, should we assume a much higher effective tax rate going forward?

Xiaodong Wu - [Interpreted]

Let’s talk about FISH first. FISH probes are mainly targeting those patients with malignant tumor. It’s for the diagnosis or for adding the guidance for the therapy for the malignant tumor or hematology cancer and this type of patients is not affected by the economic downturn.

If you look at the revenue, profit results from those pharmaceutical companies in the past two quarters, you can see that those pharma companies who produced chronic drugs for the chronic diseases, they’ve been experiencing some decline in their numbers. However, those pharma companies who produced the drugs for treating malignant cancer, has not been affected by the economic downturn.

Also FISH technology in China is still in its early adoption stage and is still at the growing phase. I cannot predict the exact growth rate for FISH market in China, but I’m very sure the growth rate in the future will be positive.

For HPVs, it’s related to the cervical cancer and the cervical cancer ranks the second place in the female cancer. Also it is just like the FISH product in China, HPV, the screening diagnosis in China is still at the early stage experiencing a very high growth rate. So, we expect the prospect for both the HPV and FISH markets will be growing very fast.

Sam Tsang

Okay and so Jinsong, you ask about the tax rate. You know that we have received the high pass certification from the Chinese Government and so our PRC subsidiaries can enjoy the preferential, the special income tax rate of 15%, which is lower than the statutory income tax rate of 25%. In 2008 we used 18% as the way to recall our income tax expenses under the income tax transitional arrangement under the low PRC income tax law.

If we didn’t get a certification, we would lead to use 20% to accrual income tax in 2009 and so at least for 2009 and 2010, we will be able to use 15% as the income rate to pay our tax by the PRC subsidiaries. The high classification will be in the HIFU units, but we don’t expect any difficulties for the renewal process. Once, we pass the renewal process, we will be granted another three years of high tech status, which means that we can continue to enjoy the 15% income tax rate.

Operator

Your next question comes from Ho Ki Luc – Citigroup.

Ho Ki Luc – Citigroup

My questions focus more on the financials. Sam, if you could just give us some color on the expense trends and also margin trends for your products for next year, given that you will be launching HPV and there will be expected cost of free equipment. So, we just want to get a sense of how expense trends are going to look like and also the margin trends? Thank you.

Sam Tsang

Right, you have seen the gross margin of the company increase from 73.2% to 75.2% this quarter and we already expect another 1% margin improvement next quarter, because of expected higher proportion of FISH probe sales in the company’s total revenues, because credit FISH probes gross margin is high than the ECLIA and is above 50%. We have mentioned that the HPV chips, the gross margin should be above 50%. So, compared to the current level, there should be a margin improvement even when we launch our HPV chips.

In respect of expenses, we are still expanding our direct sales coverage, even though we already have been one of the largest direct sales coverage to Tier-1 large hospitals in China. We expect to continue to penetrate to the other Tier-1 hospitals in China who have direct sales force and so the direct selling expense, we expect to continue to increase and to establish the direct sales coverage.

Also we will start OIC SPR equipment to the existing Tier-1 hospitals starting from April next month and so we will need to in Tier-1 time expenses in pacing the equipment to this hospital before generating the consumable revenue from HPV chip sales and so we have some one-time selling expense to re-quote in our selling expense when we launch and pace these equipments with the hospitals.

Currently we expect the cost recovery time for this SPR equipment will be about four to six month to cover the cost of our SPR equipment from the sales for HPV chips. So we also expect the selling expenses to increase because of this reason, but we should be able to leverage our G&A expense, which a more fixed in nature.

In addition, the R&D expenses were about to increase at a higher rate when we sold the HIFU business, because this actually we incurred a lot of U.S. and Europe chemical cost in conducting the trial here, but the R&D expenses for the development of new reagent kits for ECLIA, FISH probes or either SPR products will be much lower than the cost for overseas chemical chart. So, I expect R&D expense should maintain at the current level.

Ho Ki Luc – Citigroup

Okay, and then just one last question. For the HPV acquisition, I think you mentioned $180 million that’s currently unpaid. When do you need to pay it off and over how many installments?

Sam Tsang

The $180 million unpaid balance will be paid in 2009 by three installments.

Operator

Your next question comes from Hao Hong - Brean Murray.

Hao Hong - Brean Murray

More questions on the margins. Basically I’m seeing, just now you mentioned your margin is improving, but I am hearing you mention mostly margin is improving because the product mix is different, but if I, specifically focusing for our FISH growth product, can you comment specifically on the reagents margin year-on-year and quarter-on-quarter and how is that changing and also on the ECLIA margin as well?

Sam Tsang

I think FISH probe margin is over 80% and so the ECLIA margin as we mentioned previously, the gross margin actually for ECLIA reagent kits actually range from about 70% to 80% because we had so many types of reagent, in more than 75% types. So the average is above 74%, 75% and overall margin for the ECLIA is where they’ve been stable and the FISH margin is also pretty stable and so it is mainly because of the proportion of revenue change, which drives up the gross margin.

If the see the gross margin in 2007 or early 2008, the gross margins from FISH is much lower than 50% and the reason is because at that time we are selling FISH microscope, which actually we bought from a microscope manufacturer and sell to hospitals at a gross margin of above 40%, because we do not manufacture this microscope, we just buy and sell to the hospitals.

We also already explained the rational to stop selling the microscope from April 2008. So, without the microscope trading, the sales inflation is mainly from the sales on FISH probes and the gross margin from FISH probe is over 80%.

Hao Hong - Brean Murray

So, can we say that you’re not seeing much competition on your reagent or the effect of competition on your reagent gross profit then?

Sam Tsang

I would say that, the gross margin in our ECLIA business, we remain relatively stable because we launched new reagent and the new reagents to gross margin is normally higher and just a little diagnostic based. Also our systems, our co-systems and so, is more relatively stable demands from our existing hospital customers, the distributes.

Hao Hong - Brean Murray

Right. Just to follow-up on the competition, I remember previously when you guided the hospital expansion for the FISH; I remember that you mentioned you’re going to get to 500 plus hospital by the end of this year. For some reason now I’m seeing more than 400, is there a change in sort of your outlook in efficient expansion in the Tier-1 hospitals?

Sam Tsang

Well, when we expand the direct sales coverage, we said we can get a 500 and we work towards this quantity and during that process we also see the importance to strengthen the relationship in each of the existing hospitals and also we see more account needs and also opportunities in each of the existing hospitals.

For example, we see the demand for our FISH probe actually increase faster and we spend more from adverse to promote the beneficial different FISH probes and different cancer related FISH probes, the different chemical departments in each of the hospital uses which drive up the cash volumes.

So, to balance the effects of our dialysis people in penetrating new hospital and strengthening and increasing the demand of the hospital, we have to make some R&D in these aspects.

Even though we only expect more than 400 Tier-1 hospital by end of March, we already become one of the largest player in China to have the Tier-1 direct sales coverage. Also we have to continue to expand the direct sales coverage in the next financial year and we believe by the end of the next financial year we will be the biggest diagnostic company in China, to have the largest direct sales coverage for Tier-1 hospital in China.

Operator

Thank you. I would now like to hand the call over to Sam Tsang for closing remarks.

Sam Tsang

Once again, thank you for joining us today. Please don’t hesitate to contact us if you have any further questions. Thank you.

Operator

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Source: China Medical Technologies Inc. F3Q08 (Qtr End 12/31/08) Earnings Call Transcript
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