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Executives

Winnie Yan - Investor Relations

Charles Zhu - Vice President, Business Development and Investor Relations

Sam Tsang - Chief Financial Officer, Director

Xiaodong Wu - Chairman of the Board, Chief Executive Officer

Analysts

Bin Li - Morgan Stanley

Jinsong Du - Credit Suisse

China Medical (CMED) F4Q08 and F1Q09 Earnings Call September 1, 2009 8:00 AM ET

Operator

Good day, ladies and gentlemen and welcome to the fourth quarter full year fiscal year 2008 and first quarter fiscal year 2009 China Medical Technologies Inc. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Miss Winnie Yan. Please proceed.

Winnie Yan

I am pleased to welcome you to China Medical’s earnings conference call. China Medical already announced its fourth quarter and full-year results for fiscal year ended March 31, 2009 and first quarter results for fiscal year ending March 31, 2010. A copy of the two 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; and Mr. Charles Zhu. 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 risks and uncertainties. As such, the results may be materially different from the views discussed today.

A number of 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

Thanks, Winnie. Ladies and gentlemen, welcome to our earnings call. In our fiscal year ’08, we achieved significant operational milestones. We continue to believe the China IVD market is largely under-developed and under-penetrated, with huge potential in many sub-sectors. Today we are proud that we have morphed into a leading Chinese IVD company with the largest footprint in the China IVD market. We are confident that our past success in developing specific IVD markets will position us to future success.

During the last several months, we have seen emerging growth drivers, primarily coming from positive research data. For example, the New England Journal of Medicine published a landmark study showing HPV testing significantly reduces death from cervical cancer compared to other diagnostic methods, including PAP smear. Second, at the yearly event of the American Society of Clinical Oncology, [inaudible] presented positive on Herceptin in treating stomach cancer which will expand the use of HER2 FISH probe into another cancer diagnostic area. We expect this data to impact significantly on the long-term growth of those two markets.

However, we have also encountered various challenges in recent months. First, while our ECLIA business has enjoyed high growth in the past, it has been under increasing market competition. Our customers have expressed many times to us in the past that our selling price of ECLIA reagent kits are no longer competitive in the market. During the past few months, some of our ECLIA customers already moved to our competitors. We have discussed a number of price adjusting proposals since April and recently adopted a final proposal which is effective this month. We believe the new pricing strategy will enable us to retain our existing customers and may also attract some new customers to use our ECLIA reagent kits in the future.

As a result of price adjustments, we expect our ECLIA revenue to decrease in the September quarter and should stabilize in the following December quarter.

Second, our FISH business -- our direct hospital customers are around 400. We are still planning to penetrate our FISH probes to remaining tier one large hospitals in China but at a slower pace. We are currently focusing on strengthening our relationship with the existing hospital and promoting the clinical benefits of FISH probes among relevant departments of our hospital customers.

Third, our SPR business -- we launched our SPR based analysis system to our existing FISH hospital customers in April 2009. However, the attention of our senior management has been significantly diverted to the internal investigation since April 2009, which has affected the progress on the placements of our analysis systems with hospitals. We expect to deliver our analysis system to some hospitals in October 2009 and will commence the training for the hospital personnel on the use of analysis system for HPV retesting. We expect to generate revenue from the sale of our HPV chips used with our analysis system in January 2010.

Next, our audit committee decided to initiate an internal investigation on the allegations contained in the -- in an anonymous letter. The audit committee’s independent review counsel and forensic accountants have investigated our senior management team and certain employees of our key departments of our operating subsidiaries since April 2009. The audit committee informed us that they have not identified any evidence to support any of the allegations in the letter so far.

Although we have encountered various difficulties and challenges in recent months, we remain confident in the fundamentals of the company and our prospect in the fast-growing molecular diagnostic sector in China over the next 10 years.

Finally, I am delighted with the promotion of Charles to our Senior VP of Operations. I am confident that he will increase the synergies and efficiencies among our existing operations.

I have finished Mr. Wu’s remarks and I would like to turn the call over to Sam and he will give you an overview of our results for the recent two quarters. Sam.

Sam Tsang

Thank you, Charles, and welcome, everyone. Let’s talk about our financial results for the recent two quarters. Our 4Q08 revenues from continuing operations were up 37.3% year over year to RMB248.6 million, or $36.4 million. And 1Q09 revenues from continuing operations were up 28.9% year over year to RMB$209 million, or $30.6 million. Our 4Q08 income from continuing operations was up 8.6% year over year to RMB56.3 million, or $8.2 million. And our 1Q09 income from continuing operations was down 92.8% year over year to RMB2.9 million, or $0.4 million. Our 4Q08 net income was down 46.5% year over year to RMB56.3 million, or $8.2 million, and our 1Q09 net income was down 96% year over year to RMB2.9 million, or $0.4 million.

Our 4Q08 non-GAAP income from continuing operations was up 48.5% year over year to RMB120 million, or $17.6 million. And our 1Q09 non-GAAP income from continuing operations was down 7.7% year over year to RMB72.5 million, or $10.6 million.

Our 4Q08 non-GAAP diluted earnings from continuing operations per ADS were up 49% year over year to RMB4.56 or $0.67, and our 1Q09 non-GAAP diluted earnings from continuing operations per ADS were down 7.7% year over year to RMB2.74 or $0.40.

Let’s highlight certain financial numbers.

First, our revenues from continuing operations declined on a sequential quarter over quarter basis from RMB248.6 million, or $36.4 million, in 4Q08 to RMB209 million, or $30.6 million in 1Q09.

We have explained that revenue decline mainly contributed to the loss of some ECLIA customers to our competitors and the reduction of inventory level of our ECLIA customers in anticipation of selling price reduction by us, as well as the internal investigation on our senior management and certain sales employees of our operating subsidiaries. As we have reduced our selling price of ECLIA reagent kits this month, we expect our ECLIA revenue to continue to decrease in 2Q09 and to stabilize in 3Q09. As a result, our gross margin will also decrease following the price reduction.

Second, our SG&A continued to increase sequentially from RMB61.7 million or $9 million in 4Q08 to RMB87.8 million or $12.9 million in 1Q09. The increase was primarily due to the cost of the internal investigation and a provision for doubtful accounts related to certain ECLIA customers which moved to our competitors.

Our SG&A also in quarterly amortization of acquired intangible assets of about RMB27.4 million, or $4 million, related to the SPR technology in both 4Q08 and 1Q09. Because we have not generated revenue from the sale of SPR based HP re-chips. Once we have revenue from the sale of the chips, we will reclassify the amortization from SG&A to cost of revenues going forward.

Third, our high effective tax rate was primarily due to certain expenses of the company, such as amortization of acquired intangible assets, stock compensation expense, and interest expense of convertible notes were not deductible for income tax compensation in the PRC. And accrual for [inaudible] income tax on distributable earnings generated in the PRC.

Next, our deferral of a [inaudible] gain of about $15.5 million from the sale of the HIFU business was due to the subsequent even on the prohibition from selling HIFU systems required by the SFDA since April 2009. We have received a request for maximum compensation of about $15.5 million from [Chin-Chen], a company owned by our Chairman and CEO, due to its loss of revenues from the order of the SFDA after the purchase of the HIFU business from us in December 2008.

We have established a special committee comprising two independent directors to evaluate and handle this matter. The special committee also engaged legal counsel to advise on the compensation request.

Due to the uncertainty of the outcome, we have deferred approximately $15.5 million of the gain from the sale of the HIFU business in accordance with GAAP. Nevertheless, this accounting treatment does not indicate our agreement to Chin-Chen’s request for compensation. We seek to come up with a fair and acceptable solution to both parties.

Next, due to the adoption of the FASB [staff position number] APB 14-1, accounting for convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement, we recorded additional non-cash interest expense of RMB7.6 million or $1.1 million for our $150 million convertible notes in 1Q09. We have to adjust the related interest expenses of the $150 million convertible notes in prior quarters to adopt FASB APB 14-1 retrospectively in accordance with GAAP. The FASB APB 14-1 does not apply to our $276 million convertible notes.

Next, our cash balance at the end of June was about RMB1.5 billion, or $227 million. We have unpaid balance of about $100 million for the SPR acquisition and receivables of $30 million from the sale of the HIFU business, which will result in a net balance of about $157 million. We generated cash of RMB $94.3 million, or $13.8 million from operations in 1Q09. We have a healthy financial position. We have declared an annual cash dividend of $0.55 per ADS for shareholders of record as of September 30, 2009.

Next, our net accounts receivable at the end of June increased to RMB346.9 million, or $50.8 million. The increase was primarily due to the significant increase in sales of our FISH probes to hospitals, which normally pay in longer term. As they are tier one large hospitals, we do not expect a default problem.

Last, our outlook -- due to the uncertainties relating to various aspects of our business, we can only provide the target revenues for 2Q09, which range from RMB165.0 million, or $24.2 million, to RMB180.0 million or $26.4 million.

The above targets are still subject to change.

Recently, we have changed our independent auditors from KPMG to PWC. Both of them are big four global corporate accounting firms. KPMG did not inform us of any disagreement to our accounting treatments on our historical financial statements. PWC also has not informed us of any similar disagreement since their appointment as our independent auditors last month.

As mentioned in our previous earnings press release, we believe that PWC will provide our shareholders with the best combination of costs and quality going forward. We also expect PWC to provide fresh insights to enhance our internal controls over financial reporting.

We are working very closely with PWC and KPMG with a view to filing our annual report on Form 20-F for our fiscal year 2008 on or before the deadline of September 30, 2009.

This concludes our remarks. Now we are welcome to your questions. Operator, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from the line of Bin Li with Morgan Stanley. Please proceed.

Bin Li - Morgan Stanley

Thanks for taking my questions. My first question is regarding ECLIA -- can you give us more color in terms of the competitive dynamics, what are the competitors doing right now? And you mentioned about inventory and can you talk about inventory levels or at least by your best estimates what is the inventory level out there? And how much has that impact to your top line? And in terms of price reduction, can you give us more color on that?

Also, you mentioned about the double count in your statement. Can you elaborate that further?

Sam Tsang

I do not hear very clearly all the questions but I understand what you ask and I will try to answer this question and if I miss any of your questions, please repeat.

We have operated the ECLIA business for over five years and over this five years, we have enjoyed a pretty high growth in this business because we opened up this business in China. And so over the years, the number of competitors has increased as well in this area. And also the pricing of our products, at the beginning we have a pretty substantial discount compared to international players on our equipment and our reagent kits but over the years, the price differentiation has become narrower and until recently, our price before reduction is just slightly lower, about 5% to 10% below the international players pricing because they also reduced their price over the years. And at the same time, because of the increasing number of domestic players in the ECLIA business and they entered the market and also tried to get the market at lower price compared to our pricing. And so before our reduction there, the domestic players’ pricing is roughly about 50% lower than our price.

And so you see the competition and the pressure on us has increasing substantially. And so this time for our price reduction we wanted the price to be only a one-time adjustment and so we adjust the price relatively big on average, our ECLIA price -- we have been reduced about 30%, so -- which makes our pricing still about 30% to 35% lower than the international players pricing after the adjustment. And also we are in the very similar level of domestic players. But of course we are mainly concerned about international players because we believe we should have certain premium pricing compared to domestic players but now we are on an equal level and so we also expect we can and should be able to enjoy a longer period of stable pricing.

Bin Li - Morgan Stanley

Right. And you mentioned about you lost business to competitors and this is something I didn’t hear clearly -- you said this is a double count. Can you explain that? What is it?

Sam Tsang

I am not sure what you referred to, the [double count]. We mentioned the double count in which aspect?

Bin Li - Morgan Stanley

I think this is in the context where you mentioned that you lost some business to competitors.

Sam Tsang

Right, right. We -- for the June quarter or 1Q09, our ECLIA revenue dropped and we expect one of the reasons is some of our ECLIA customers, they are distributors and basically our ECLIA customers are basically distributors and they move, some of them moved to our competitors and so that means the orders from these customers are -- we lost after they moved to our competitors. Is that what you want to clarify?

Bin Li - Morgan Stanley

Yeah, okay. And can you quantify that for us? How many distributors do you think you have lost to competitors?

Sam Tsang

In terms of number, roughly about 15%.

Bin Li - Morgan Stanley

Fifteen percent of all your distributors?

Sam Tsang

I am talking mainly for our major customers.

Bin Li - Morgan Stanley

Okay. And I have a question on the HPV -- I think you mentioned briefly in your remarks and in Mr. Wu’s remarks about the HPV status. So can you tell us what are the necessary things you need to do before you start to sell the first equipment in terms of paperwork or anything else? Any hurdles that are in front of you before you make the first sales?

Sam Tsang

Charles, can you translate this question for Mr. Wu?

Xiaodong Wu (Translation)

Since we are going to give the SPR analysis system free to the hospitals, there’s not much hurdles for us to sell this product to the hospitals. The key process we are going to take is the hospitals need to go through the internal application process, approval process to get the required space to install the systems as well as to assign the relevant personnel to operate this system. And so that process will take some time.

Bin Li - Morgan Stanley

Thanks. And I guess versus your expectation, it’s probably fair to say the installation of HPV machine is behind schedule. If we look back, what are the things that you probably have not anticipated that caused this delay and whether a similar factor would exist to cause further delay?

Sam Tsang

As we mentioned just now, I think the delay of the placements of HPV analysis system into the hospitals is mainly due to the -- this internal investigation captured a lot of time and resources of the senior management of the company. You know, for the new product launch stage, it requires a lot of close attention from the senior management to -- at the early stage of the placements, so that is something that we didn’t expect earlier.

Bin Li - Morgan Stanley

Okay. And one more question from me, it’s on FISH -- I think -- I am looking at this quarter’s sales. Am I right that the quarter on quarter sales actually I think we are seeing a decline, just by the fact that the year-on-year you show a pretty good growth. But why there will be a sequential decline? Is there any particular reason that has to do with the ongoing investigation or seasonality? Can you explain that to us?

Xiaodong Wu (Translation)

Also as we have discussed in our earlier announcement, the senior management resources and attention also got diverted to this internal investigation. You know, for FISH business, we have already built up a direct sales force of over 200 people in the field and this large number of sales team requires a lot of resources, management resources to lead this team for effective results and this internal investigation covers not only the senior management but also it covers the many personnel, [inaudible] personnel seen in other departments as well.

But I believe that this kind of issue, as it is not originated from operations, is going to be a temporary issue and we will be back on track after this issue is over, very soon.

Bin Li - Morgan Stanley

Okay. Thanks.

Operator

We’ll take our next question from the line of Jinsong Du with Credit Suisse.

Jinsong Du - Credit Suisse

I would just like to understand a bit more on the visibility of the full year. I understand that you only gave out the guidance for the next quarter but maybe qualitatively, if you could let us know in terms of how much confident you are for the full year and specifically if you could elaborate a little bit on each of your business, you know, the ECLIA, the FISH, as well as the SPR product?

Sam Tsang

I did not hear your questions very clearly but I sense that you are asking questions about the guidance and respective business, so again, if I miss any of your questions, please repeat.

So you see we -- in ECLIA we just reduced our price quite substantially and so it is hard to estimate the effect over the longer period of time and so -- and also for the SPR, we have some expectations on this area for the placement of the equipment in October and also the sales of our [inaudible] in January 2010 with the volume and also the result is difficult to estimate for the time being, so we can only provide the guidance on revenue for these quarters, for this upcoming quarter 2Q09 or September quarter. And so we of course we will update our outlook when we report our September quarter and see -- and assess our circumstances to see whether we can provide guidance over a longer period.

Jinsong Du - Credit Suisse

Okay. And maybe just a follow-up on this HIFU issue. Do we have a -- when that transaction was made previously, was there any clause saying that if anything happens to the SFDA registration there will be a renegotiation of price, or something like that?

Sam Tsang

Can you repeat the second part -- renegotiation of the price?

Jinsong Du - Credit Suisse

I think it looks like, you know, investors will be interested to know why there will be a renegotiation of the price when the transaction was actually already completed because in theory, whatever happened after the transaction should have nothing to do with the original seller, right?

Sam Tsang

I think there is some misunderstanding about our update on the HIFU sale. The HIFU transaction was completed in December 2008. We also issued a press release about the [competition]. And you know for transactions and like order transactions, there is always representation and warranties contained in such kind of agreements and such kind of representation and warranties normally do not terminate, just [inaudible]. And so -- and also the current accounting treatments is because we receive a request for compensation and that is not a kind of renegotiation on the transaction or renegotiation on the price or the HIFU is because there’s -- unfortunately events happened which affect the buy seriously, just four months after the completion of the transactions and so we mentioned we have already -- the company has already established a special committee comprising only the independent directors to evaluate this matter. But because of accounting requirements, since we have received such a kind of compensation request for conservative reasons, we have deferred a part of the gain on the sale of the HIFU business, not -- and this accounting treatment we mentioned very specifically. This does not mean the company agreed to this compensation request. Currently our special committee is working on this matter and also already engaged legal counsel to advise the committee but of course, we would like at the end to have an acceptable and fair solution to both parties.

Jinsong Du - Credit Suisse

Right, and if I [inaudible] correctly, you basically imply that the possibility of paying out is -- this sum of money is actually low. Is that a correct understanding?

Sam Tsang

Pay out -- sorry, I missed your question again.

Jinsong Du - Credit Suisse

What I meant is that -- you know, can I assume that the -- it is very unlikely for CMED to actually pay this amount?

Sam Tsang

Currently I think I will leave that matter with our special committee which was established to handle, and so the case we already outlined, this amount of money is the very worst case scenario and it cannot be any worse than that, and so the outcome if we can achieve a better outcome on behalf of the company that means you should be -- anyway, better than the worst case scenario.

Jinsong Du - Credit Suisse

All right, I understand. Just one last question regarding cash flow -- obviously there are two convertible bonds that the company has but one is expiring in 2011. Obviously that’s quite a long time. There’s still quite some time to go but if you could, could you comment that given the current business situation and current cash flow situation, would that be any danger to pay back that convertible bond?

Sam Tsang

Right, the $115 million convertible bond which matured in November 2011, so that there -- they are still two years and we expand our current cash position already. Currently we have up until June, we have $227 million on hand but we have $100 million cash -- we have $100 million payable for SPR acquisition; at the same time, we have -- we still [inaudible] $30 million from the sale of HIFU, so the net balance is about $157 million. And we have a pretty healthy cash flow and CP will only mature in about two years time and we believe over these two years, our business will continue to generate healthy cash flow for the company and so I do not see any problem. If by November 2011, the circumstances require the CV holder to require repayment of the convertible instead of converting to our shares, we should have sufficient cash to redeem the convertibles.

Jinsong Du - Credit Suisse

All right, thanks.

Operator

(Operator Instructions) Our next question is a follow-up question from the line of Bin Li with Morgan Stanley.

Bin Li - Morgan Stanley

Thanks for taking my follow-up question. This is a question for Sam -- can you tell us what’s the non-GAAP margin, non-GAAP gross margin for this quarter? Is it very high? Because according to my calculation, it’s about 90%. But can you tell us what is the non-GAAP gross margin?

Sam Tsang

Right, the -- you see the GAAP margin is about 75% and we -- if we exclude the stock compensation expense, which is not much, roughly about $2 million -- sorry, if we exclude amortization of intangible assets, which is about $27 million, $22 million, and which should give us over 80% of the gross margin.

Bin Li - Morgan Stanley

Okay. Thanks.

Operator

And at this time, I show we have no further questions in queue. I would like to turn the call back over to Mr. Charles Zhu for closing remarks.

Charles Zhu

Thanks. Ladies and gentlemen, I would like to make the closing remarks on behalf of Mr. Wu. I would like to emphasize that the issues we encountered are temporary and will be overcome in short time. These issues are not originated from operations but rather company operations are impacted by these issues. We remain confident in the fundamentals of the company reflected in the following three aspects. First, we have the largest market share in China molecular diagnostic markets and we have the largest [inaudible] in terms of top tier hospital coverage. Second, what will best predict our future success resides in our past [inaudible] performance. Within one year-and-a-half, we developed China’s FISH business from scratch, from almost zero to current 47 million markets in total and it is still growing. And third, our financials are healthy -- for example, our operational cash flow continues to grow, so does EBITDA. We have very strong cash position and we increased our dividend.

That’s all for today’s remark and thank you for joining us today. Please do not hesitate to contact us if you have any further questions. Thank you and goodbye.

Operator

Thank you for your participation in today’s conference. This concludes your presentation. You may now disconnect. Good day, everyone.

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