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Executives

Dixon Chen - Investor Relations, Grayling

Fuxiang Zhang - Chief Executive Officer

Zixin Shao - Chief Financial Officer

Analysts

Serena Shao - Bank of America/Merrill Lynch

Li Yu - Goldman Sachs

China Nepstar Chain Drugstore Ltd. (NPD) Q4 2012 Earnings Conference Call March 28, 2013 8:00 AM ET

Operator

Greetings, and welcome to the China Nepstar’s Fourth Quarter and Fiscal Year 2012 Earnings Call. At this time, all participants are in a listen-only mode. A brief 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, Dixon Chen of Grayling. Thank you Mr. Chen, you may begin.

Dixon Chen

Thank you. If you have not received a copy of Nepstar’s fourth quarter and fiscal year 2012 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 Relations section.

Before we start, 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 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 Mr. Fuxiang Zhang, Chief Executive Officer and Mr. Zixin Shao, Chief Financial Officer. I will be your translator during the question-and-answer session. We will be translating question and answers and ask your patience at that time.

With that, I would like to turn the call over to Mr. Shao. Please go ahead.

Zixin Shao

Thank you. Good morning and good evening to all of you. We are very pleased to report our solid performance in the fourth quarter highlighted by double-digit same store sales growth. The strong seasonal demand, our continued efforts to further diversify and optimize our product mix and our more aggressive marketing efforts all contributed to our top line growth in the fourth quarter, while our focus on store performance helped increase the number of transactions per store. We continue to see opportunities in the OTC drugs and convenience product categories. Cost control measures are starting to reduce our operating expenses and with continued improvements in same store performance, we are expecting a better performance in 2013.

Now, I will run through the numbers for fourth quarter and then the year. During the fourth quarter, we opened 22 new stores and closed 81 stores. Revenue increased by 2.1% to RMB671.9 million or $107.8 million, compared to RMB658 million for the same period in 2011. Same store sales for 2,009 stores opened before December 31, 2010, for the fourth quarter increased by 11.6%. The increase in same store sales was primarily the result of or closure of underperforming stores, (but that was) supported by promotional initiatives aimed at increasing transactions per store.

Fourth quarter revenue contribution from prescription drugs was 21.6%, OTC drugs was 40.1%, nutritional supplements was 13.3%, herbal products was 4.3%, and convenience and other products was 20.7%.

Gross profit was RMB308.6 million or $49.5 million compared to RMB314.6 million in the same period of 2011. Gross margin was 45.5% compared to 47.8% in the same period of 2011. The decrease in gross margin was mainly the result of mandatory price cuts on certain pharmaceuticals by the Chinese government and the changes in product mix as we introduced more convenience products with lower gross margin. Our portfolio of private label products included 2019 products as of December 31st. Sales of private label products represented approximately 24.7% of the revenue and 34.1% of the gross profit for fourth quarter.

Sales, marketing and other operating expenses as a percentage of revenue decreased to 37.6%, compared to 38% in the same period of 2011. This decrease was primarily due to the increase in same store sales.

General and administrative expenses as a percentage of revenue was 3.4%, compared to 5.4% for the same period of 2011. The decrease was mainly due to the continued implementation of cost management measures across the entire organization and write-off of certain aged payables on discontinued suppliers.

Impairment loss of RMB4.7 million or $0.8 million was recognized in the fourth quarter, which represents the reduction of carrying amount of the property and equipment of certain underperforming stores. Impairment loss recognized in the fourth quarter of 2011 was RMB13.2 million.

Income from operations in the fourth quarter was RMB30.2 million or $4.9 million, compared to RMB15.6 million in the same period of 2011. Interest income for the fourth quarter was RMB3.5 million or $0.6 million, compared to RMB6.6 million in the same period of 2011. Interest income decreased as a result of reduced cash balance after distribution of a special dividend in the second quarter of 2012.

Equity income of an equity method investee was RMB1.3 million or $0.2 million, compared to RMB1.6 million in the same quarter of 2011. The decrease was mainly due to weak performance of Yunnan Jianzhijia Chain Drugstore Limited, it’s down (hereafter). In the fourth quarter of 2012, on December 28th, we completed the sales of our 40% equity ownership in Jianzhijia Holding – in Jianzhijia to Jianzhijia Holding for a total cash consideration of RMB81.48 million, a gain of RMB68.4 million, or $11.0 million, was recognized in other income upon completion of the sales. Our effective tax rate was 23.9% for the fourth quarter, compared to 25.6% for the same period in 2011.

Net income in the fourth quarter was RMB78.8 million, or $12.6 million, which represented RMB0.80 or $0.13 basic and diluted earnings per ADS. This compares to a net income of RMB17.7 million, which represented RMB0.17 basic and diluted earnings per ADS in the same period of 2011. In the fourth quarter of 2012, net cash flows from operating activities was RMB21.4 million or $3.5 million compared to a net cash outflow of RMB30.4 million in the fourth quarter of 2011.

We will now turn to the results for fiscal year 2012. In fiscal year 2012, we opened 56 new stores and closed 319 stores. As of December 31, 2012, Nepstar had a total of 2,132 stores in operation. Total revenue for 2012 increased to RMB2,549.9 million or $409.3 million from RMB2,491.3 million for 2011. Same store sales for 2012 increased by 9.1% compared to 2011. The increase in revenue and same store sales was driven by the same factors I mentioned earlier for the fourth quarter.

In 2012, revenue contribution from prescription drugs was 20.4%, OTC drugs was 39.1%, nutritional supplements was 15.7%, traditional Chinese herbal products was 3.9%, and convenience and other products was 20.9%. Private label products accounted for 26.8% of total revenue and 38% of gross profit respectively, compared to 30% of revenue contribution and 41.3% of gross profit contribution in 2011.

Gross profit was RMB1,180.5 million, or $189.5 million for 2012, compared to RMB1,188.6 million for 2011. Gross margin was 46.3% in 2012, compared to 47.7% in 2011. The decrease in gross margin was mainly due to changes in product mix and the negative impact from mandatory price cuts on pharmaceuticals by Chinese government.

Total operating expenses accounted for 44.2% of total revenue in 2012, as compared to 45.6% in 2011. Income from operations was RMB46.9 million or $7.5 million for 2012, compared to RMB38.6 million for 2011.

Interest income for 2012 was RMB50.4 million or $2.6 million, compared to RMB23.2 million in 2011. Dividend income from cost method investments was RMB4.5 million or $0.7 million for 2012, compared to RMB3.6 million in 2011. Equity in income of an equity method investee was RMB1.3 million or $0.2 million, compared to that of RMB1.6 million in 2011. The decrease in equity income of an equity method investee was mainly due to weak performance of the Jianzhijia throughout the year.

Our effective tax rate was 34.6% in 2012, compared to 46.3% in 2011. The decrease in effective tax rate was mainly attributable to the reversal of deferred tax liabilities arising from equity method investment of RMB6.3 million as a result of dividends distributed from Jianzhijia and the utilization of tax losses carryforwards of which valuation allowance of RMB7 million was the previously provided for as the result of the disposal of the company’s 40% equity interest in Jianzhijia.

Net income was RMB90.1 million or $14.5 million for 2012, compared to RMB35.9 million for 2011. We reported RMB0.90 or $0.14 basic and diluted earnings per ADS for 2012, compared to RMB0.45 (sic) (RMB0.35) basic and diluted earnings per ADS for 2011.

Net cash-flows from operating activities was RMB52.6 million or $8.4 million for 2012, compared to RMB108.2 million for 2011. The total number of outstanding ordinary shares as of December 31, 2012 was 197.4 million. The weighted average number of ordinary shares in 2012 was 199.2 million, each ADS represents two ordinary shares.

As of December 31, 2012, total cash, cash equivalents, bank deposits and restricted cash were RMB664.4 million or $106.6 million, and shareholders’ equity was RMB1.03 billion or $164.7 million. On April 27, 2012, we have announced a special cash dividend of $0.60 per ADS. Approximately $60 million was subsequently paid to shareholders.

We remain cautiously optimistic about rest of 2013. We believe the strategic changes we have implemented to drives sales, control costs and improve store efficiencies will help us remain competitive.

With that, Mr. Zhang and I will address your questions. Operator, please begin the Q&A. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of (indiscernible) with Morgan Stanley. Please proceed with your question.

Unidentified Analyst

Hello, good evening. Congratulations for the good results. (Foreign Language) I will do my question in English and then translate it to Chinese if necessary. My first question is regarding for the fourth quarter same store sales, it jumped 11.6% year-over-year is no good and but I realize it’s slightly lower than the 12.8% year-over-year growth in the last quarter. I believe the fourth quarter is usually the seasonal high quarter for the retail store. Can management give us a little bit color on the reason of the slightly decrease? And my number two question is about the 2013 outlook such as how many stores you expect to close and how many new stores you expect to open? And thank you.

Dixon Chen

The disparity of the same store sales growth in fourth quarter and third quarter is mainly attributed to the Chinese New Year holiday. In 2012, the Chinese New Year holiday landed in January while 2013 Chinese New Year holiday was in month of February. As you know, typically sales are stronger prior to holiday, some of the gift shoppers and so the fourth quarter of 2011, because it’s closer to the holiday in January and sales were stronger and by same talking in 2012 fourth quarter is further away from the holiday, which is in February 2013. Hence, the sales is less stronger in comparison to the prior year same quarter.

The answer to the second question in terms of store opening and closure plan, we are looking at 2012 we closed over 300 stores. 2013, the closure will be dramatically lower. So, we are looking at the range of 180 stores closing in 2013. By and large, our goal is to maintain our total store counts above 2,000.

Unidentified Analyst

Okay.

Dixon Chen

Operator?

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Serena Shao with Bank of America/Merrill Lynch. Please proceed with your question.

Serena Shao - Bank of America/Merrill Lynch

So, I have two questions to you. So, the first question is, it’s about the macro trends. So, can you comment about current macro trends in healthcare industry, how does that going to affect our company and how – well, our company strategy going to be adjusted to fit into the new trends? And also, my question is regarding the current tax rate, so it was noticed it’s being reduced in Q4, although it’s mainly due to the deferred tax liability and then our disposal of equity interest in Yunnan Jianzhijia. So, can you comment about on the future trends of the tax rate, is it going to be stable at current level or any further decrease in the tax rate? Thanks a lot.

Dixon Chen

Thank you. We are happy to see the transition of the government leadership taking place this year, it has been very smooth. As our understanding of this new government is more open for further reform actions and this will help accelerate the healthcare reform in particular and we believe if the healthcare reform progresses well or accelerated well and that would become a positive boost to our retail pharmacy industry. The other factor that we think it’s positive to our industry is the real estate sector. We believe the new government are working diligently to regulate that sector and to put also on the cooling factor to the real estate sector and that will be a positive contributor to our industry, particularly our retail store rental price can be stabilized.

As we disclosed in our press release, the decrease of tax rate is mainly attributable to the reversal of deferred tax liability. And we think this is a factor because of the fourth quarter is accounting a much higher portion of annual number, so it also lowered the annual effective tax rate for that particular reason. And going forward, we believe the tax rate on an annual basis more meaning towards the 2011 tax rate, which is about 46%. Fourth quarter tax rate on a quarterly basis tend to be lower than the other quarters.

Serena Shao - Bank of America/Merrill Lynch

(Foreign Language)

Dixon Chen

Thank you.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Li Yu with Goldman Sachs. Please proceed with your question.

Li Yu - Goldman Sachs

Hi. This is Li with Goldman Sachs. And I have a question on the fourth quarter’s trends, we can see that the same store sales is okay, but there seems that we’ll see something around single, lower single-digit revenue growth. And also I spotted that the administration expenses has been lowest in the fourth quarter and for the year, and usually that fourth quarter should be the year, the quarter where admin expenses are the highest. My question is, is the company scaling back on investment for the development of the company or is this just temporary cost constrained measures? And what is the ultimate plan that we are seeing, that we are going to see our top line growth back on track again? Thank you.

Dixon Chen

(Foreign Language)

Li Yu - Goldman Sachs

I mean, the fourth quarter usually is the highest, but this quarter is the lowest of all the four quarters?

Dixon Chen

Okay. To answer your question on the G&A expenses, in the fourth quarter, the G&A expenses typically are the highest in comparison with other quarterly G&A expenses. But this year G&A is unusually lower due to a few reasons. Number one, there are some accounts payables over three years. According to the law here in China, we are entitled to write-off these types of aged payables from discontinued suppliers. And so that write-off has become a one-time, impacted our overall G&A expenses and helped lower our G&A expenses. That’s a major contributing factor. And the other thing is our PPE impairment during the fourth quarter also has some factor – contributing factor to our G&A expenses.

The other reason – the answer to your question on the revenues, yes we are only growing our top line by low single digits, even with the strong same store sales growth. But one factor is, we have been aggressively doing closures on our store, non-performing stores. And so during 2012, we closed 319 stores, that’s about 10% of the total counts. And that’s affecting our top line growth but going into 2013, on the store closure side, we are probably only going to limit our self around 180 stores. So, that should help us to grow top line with our same store sales growth momentum continues.

Operator

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

Dixon Chen

We thank our shareholders and analysts continued to show support. We will continue to work on improving our store productivity and improve our efficiency in the stores and we hope we can generate more profit in the coming quarters. Thank you.

Operator

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

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