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Executives

James Hong - Chairman of the Board, Chief Executive Officer

John Low - Vice President - Corporate Finance and Investor Relations

Chi Hon Tsang - Chief Financial Officer

Wang Chaoshen - Chief Operating Officer, Director

Analysts

John Sheehy - Private Investor

Dennis Pannulo - Lupine Partners

John Harold - Harold and Associates

Zuoan Fashion Ltd (ZA) Q2 2013 Earnings Call September 12, 2013 8:30 AM ET

Operator

Greetings and welcome to the Zuoan Fashion Ltd second quarter 2013 earnings conference 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.

With us today are James Hong, Founder and Chairman of the Board and Chief Executive Officer, Calvin Tsang, Chief Financial Officer, Mr. Wang Chaoshen, Chief Operating Officer and Mr. John Low, Head of Corporate Finance and Investor Relations. John will be translating for Mr. Wang and Mr. Hong during the Q&A session as well.

This call may contain forward-looking statements made pursuant to the safe harbor provisions for the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management's current expectations and observations that involve known and unknown risks, uncertainties and other factors not under the company's control, which may cause actual results or performance or achievements of the company to be materially different from the results, performance, or expectations implied by these forward-looking statements.

All forward-looking statements are expressly qualified in their entirety by the cautionary statements, risk factors and details of the company's filings with the SEC. Zuoan undertakes no duty to revise or update these forward-looking statements for selected events or circumstances after the date of this conference call.

At this point, I would like to now turn the conference over to Mr. James Hong. Mr. Hong, please go ahead.

James Hong

[FOREIGN LANGUAGE]

Good day and thank you for joining us for our second quarter 2013 earnings conference call.

[FOREIGN LANGUAGE]

We experienced a generally healthy second quarter of 2013 as our bottom line results exceeded our previous guidance. Our revenues increased from the previous quarter thanks to strong growth in sales which offset a noticeable decline in average selling prices. We further reduced selling and distribution cost during the quarter and continued the transition of our store models to improve operational efficiency and infrastructure.

[FOREIGN LANGUAGE]

As we move forward into the second half of the year, we expect our operating environments to be more challenging. In the second half of the year, we expect to incur a higher advertising cost and experience reduced orders at the distributor level even as we offer distributors lower wholesale prices.

[FOREIGN LANGUAGE]

Over the next year, we plan to embark on a strategy to increase awareness of our brand and intend to capitalize on the strength of our balance sheet to more aggressively increase our market presence at the expense of our competitors, many of which are not as well capitalized as Zuoan. We believe that along with our focus on improving the performance of our distribution network and maximizing the efficiency of our operations, can position Zuoan for better performance in the long run.

[FOREIGN LANGUAGE]

I just want to like to turn the call over to John Low who will further discuss our operational performance.

John Low

Thank you, Mr. Hong. We experienced solid results in the second quarter, resulting in the relatively healthy first half of fiscal 2013. I will begin with an overview of our second quarter performance and highlight our operational initiatives and then Calvin will review our financial results and outlook in more detail.

Zuoan reported revenue of RMB317.6 million in the second quarter, representing an annual increase of 5.3%, in line with our previous guidance, In the second quarter, distributor sales increased by 15.3% from the same quarter last year to RMB312.8 million while self operated direct store sales increased to RMB4.7 million. Gross margin was 44.1% which was lower than prior quarters, reflecting a higher unit cost and our transition from higher margin self operated flagship stores to distributor stores.

We experienced a drop in average selling price during the quarter mainly due to a change in sales mix with our apparel and accessory-items as well as a significant decrease in revenue from our direct flagship stores which transitioned to our distributors at the end of last year. As a result of this transition, we continue to see considerable declines in selling and distribution expenses resulting in higher second quarter net income levels of RMB67.6 million, an increase of 2.2% over the prior year second quarter period.

During the second quarter, one self operated direct store and net total of 20 distributor and sub-distributor stores were opened. We now serve the market with a nationwide network of 1,383 retail locations covering 31 of China's provinces. As Mr. Hong mentioned earlier, we will continue to work towards improving operational efficiency and maximizing the performance of our distribution network as we continue to close more of our unprofitable stores. Meanwhile, we also intend to strengthen our marketing efforts to capture additional market share as we face a challenging period of fierce competition and consolidation that is expected to last through 2014. We believe our strategy will not only lead us through these challenges, but will also leave us in a position to take advantage of the opportunities available following the consolidation.

At this point, I would turn the call over to Calvin to review our financial results as well as provide an outlook on our business.

Chi Hon Tsang

Thank you, John. I would like to first review our financial performance in the second quarter. Revenue for the second quarter was RMB317.6 million, a 5.3% increase from RMB301.6 million in the same period last year. The increase was driven by growth in distributor level sales volume.

During the quarter, distributor sales increased 15.3% to RMB312.8 from RMB271.2 million in second quarter of 2012. One self operated direct store and 20 distributor and sub-distributor stores were opened in the second quarter of 2013, resulting in a total of 1383 store locations as of June 30, 2013, compared to 1362 at the end of the first quarter.

Cost of sales increased 13.7% to RMB177.4 million in the second quarter of 2013 from RMB156.1 million in the same quarter of 2012, mainly as a result of the increase in sales volume and the higher quality of raw materials used for production. As a percentage of revenues, cost of sales increased to 55.9% in the second quarter of 2013 from 51.8% in the second quarter of 2012.

Gross profit in the second quarter decreased 3.7%, year-over-year, to RMB140.1 million from RMB145.5 million in the same period of 2012. Second quarter 2013 gross margin was 44.1% compared to 48.2% in the same period last year. The decrease in gross margin was mainly due to higher unit costs and the transition of the company's self-operated flagship stores to its distributors in the fourth quarter of 2012. Gross margin at the company's self-operated direct stores and distributor stores was 60.7% and 43.9%, respectively.

Selling and distribution expenses in the second quarter were RMB31.1 million or 9.8% of revenue compared to RMB41.0 million or 13.6% of revenue in the same period last year. This percentage decrease was mainly due to the significant decrease in direct store expenses resulting from the transition of our direct-operated flagship stores to our distributors.

Administrative expenses in the second quarter were RMB15.3 million or 4.8% of revenue compared to RMB14.5 million or 4.8% of revenue in the same period last year. Effective tax rate in the second quarter was 26% compared to 26.1% in the same quarter of 2012. Net income for the second quarter increased by 2.2% to RMB67.6 million from RMB66.2 million in the same period last year. Second quarter net margin was 21.3% compared to 22% in the prior year period.

Diluted earnings per ordinary share were RMB0.61 in the second quarter, the equivalent to RMB2.43 per ADS compared to diluted earnings per share RMB0.60 or RMB2.38 per ADS in the second quarter of 2012. The company's diluted number of shares outstanding was 111.3 million in the second quarter ended June 30, 2013.

As of June 30, 2013, the company had cash and cash equivalents of RMB1,204.5 million compared to RMB918.5 million as of December 31, 2012. Net cash provided by operating activities was RMB70.1 million in the three months ended June 30, 2013 compared to RMB42.9 million in the three months ended June 30, 2012.

We estimate that our cash flow will trend downward in the second half of the year due to decrease in cash flow from operating activities. This decrease stems from a decrease in our wholesale price offered to our distributors which is now at 35% compared to 36% offered in the recent quarters, as well as a cancellation of orders from our fall and winter collection.

Accounts and other receivables were RMB465.6 million compared to RMB608.5 million at end of December 2012, mainly due to subsequent settlement of the old debt and no outstanding balance from lower selling types of our spring and summer collection. At the end of June 2013, 79% of our AR was aged within 90 days. CapEx spending in the second quarter was RMB21.9 million for the (inaudible) improvement of our new office located in Shanghai.

For the third quarter of 2013, the company currently anticipates revenue in the range of RMB370 million to RMB390 million, gross margin of approximately 40% to 42%, net income of approximately RMB30.8 million to RMB34.3 million and basic and fully diluted EPS of approximately RMB0.28 to RMB0.31, equivalent to RMB1.11 to RMB1.23 per ADS. Approximately 180 to 200 new retail stores are expected to be closed by distributors and sub-distributors in the third quarter of 2013.

The soft performance expected in the third quarter is a result of order cancellations from our most recent fall and winter offering, our implementation of the decrease in wholesale price offered to our distributors and an increase in advertising cost as we ramp up marketing efforts to capture bigger market shares.

This concludes our prepared remarks for today. Operator, we are now ready to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from John Sheehy. Your line is open.

John Sheehy - Private Investor

Hi, everybody. Thanks for taking my questions. I think I just heard a comment about store closings. Could you explain that in a little bit more detail?

Wang Chaoshen

[FOREIGN LANGUAGE]

Hi, John. Okay, Mr. Wang explained about the store closure. In the first half of the year, the distributors and the sub-distributors have experienced an increased excess inventory situation. Mr. Wang was just thinking of effects of the close to 30% of excess inventory, which is way above our desired level. Mainly for this reason, the distributors and sub-distributors have come to us and discussed with us regarding closing some of their unprofitable stores and also to how to further get rid of this excess inventory throughout this year and then next year. So after discussion, we have agreed with them to close down these stores gradually. The company mentioned, like in the third quarter, we are looking at anything between 180 to 200 stores and throughout the entire year, we are talking about possibly up to 300 stores closure for the rest of the year. This is really, what we are talking about the consolidation of the stores and to improve the efficiencies and the operational efficiencies of the better performing stores.

John Sheehy - Private Investor

So this would be the lower selling least profitable outlets throughout the country will be closed?

John Low

Sorry, what type of stores?

John Sheehy - Private Investor

So you haven't lost any particular distributors? It's spread through the country, just closing the least profitable and lowest selling stores?

Wang Chaoshen

[FOREIGN LANGUAGE]

Yes, he confirmed that there is no change in distributors, in main distributors and then that the stores that are closed are really just the underperforming stores or unprofitable stores.

John Sheehy - Private Investor

Okay, thank you very much for the detailed explanation. Then I would also like ask about the extremely hot weather in China all this summer. Has that had an impact on your sales and inventory levels?

Wang Chaoshen

[FOREIGN LANGUAGE]

John, the hot weather is definitely affecting our early autumn collection which is being sold right now, but the spring summer collections, its really more a macro situation where it is just everybody is experiencing some sort of contraction in demand for their products and not so much to do with the hot weather.

John Sheehy - Private Investor

Okay, thank you and then in the introductory comments, you mentioned a more aggressive competitive strategy over the next year. Could you share a little bit more detail about the kinds of opportunities that are available to you?

Wang Chaoshen

[FOREIGN LANGUAGE]

Okay, John the closure of the underperforming stores, that is part of the strategy already. The overall picture is really to enhance the performance or the per store performance of the remaining performing stores. So overall on average basis, we are looking to really increase the efficiencies of the remaining performing stores. Other strategies would be things like adjusting prices for our products and also increasing A&P, advertising expenses as Calvin explained earlier. So that will be all part of the strategy.

John Sheehy - Private Investor

Okay, thank you very much. Nice to see that you remain in extremely strong financial condition and that you remain as a profitable return through all of the difficulties. Thanks for answering my questions.

Operator

(Operator Instructions) The next question comes from Dennis Pannulo with Lupine Partners. Your line is open.

Dennis Pannulo - Lupine Partners

Good morning, guys. Thanks for taking my call. My question comes from - you guys had an IPO priced at $7 a couple years ago. Due to your cash position, with your stock-price at a multi-year low, I was wondering what the shareholder support you might have in place or upcoming maybe a stock dividend or maybe a share buyback?

James Hong

[FOREIGN LANGUAGE]

Hi, Dennis. Yes, we are enjoying a strong balance sheet especially on the cash flow side of things. However, as you can see and hear from the presentation and see from the guidance numbers, we are facing an extremely precarious situation going forward and at the moment, the management is very, very concerned about the business, well, at least for the next few months where we are pretty certain that the business has been affected quite significantly already and as well as the up and coming sales fair very shortly.

So management more keen to preserve the company resources at this point in time just to see how the market turns out and how the business turns out and Mr. Hong was saying, we are always open and always monitoring the situation and he mentioned that by the time we announce the Q3 results, hopefully the picture will be a bit clearer at that point in time for us take to any other corporate actions, for example the ones that you mentioned before.

So right now, we are being extremely conservative with our resources right now just to see us through for the immediate future, for the foreseeable future and later on we will make a clearer decision as to what corporate actions to take.

Dennis Pannulo - Lupine Partners

Well, you still projected a very positive and profitable third quarter. You are $0.20 or $5.5 million in that profit. So its not like you are going broke. You are talking about having another $200 million with the (inaudible) and your current market captured $66 million. Your shareholders deserve a little support and I think you are going to still remain profitable. It wouldn't take much effort to support your shareholders a little bit. That's all I am saying.

John Low

Yes, we can understand, Dennis.

Dennis Pannulo - Lupine Partners

It was very frustrating. You guys IPO'd at $7 a share and not to be a $2 a share at some point you do need to step up and support your shareholders. You guys have generated a lot of cash. You have generated $45 million in cash this year in the first six months. There is nothing wrong with being to putting a few dollars to support your shareholders.

John Low

Yes, we appreciate your comments and we understand. As Mr. Hong explained just now that we will make a quick - probably make a decision towards the end of our Q3.

Dennis Pannulo - Lupine Partners

Okay, thank you.

Operator

(Operator Instructions) our next question comes from John Harold with Harold and Associates. Your line is open.

John Harold - Harold and Associates

Yes, good morning. First off, congratulations on another great quarter. I have a question about the cash verification. Of course, being a Chinese company and an investor here in the United States, I am really certainly concerned about the numbers that the Chinese companies are reporting. What steps do the auditor take with regards to verifying cash?

John Low

Okay, John, I will translate this.

[FOREIGN LANGUAGE]

Wang Chaoshen

[FOREIGN LANGUAGE]

John, Mr. Wang was saying, GHP Horwath, who are our auditors, they go directly to the respective banks and not through us. They go directly to respective banks and request for confirmation of the accounts of the cash balances directly from banks and get printouts from the banks directly.

John Harold - Harold and Associates

Okay and my second question is with regards to what the previous caller was hitting on, with regards to a cash dividend. I believe, I am not sure about this, but I believe that in the IPO, that your company raised about $50 million from American investors. Now since that time, of course, you have been able to generate millions and millions of cash and you have posted $200 million in cash right now. I am not sure why you can't return that $50 million to investors that helped you kick things off? Why such a hesitation with regards to paying a dividend or buying back stock to make your company appear legitimate like companies in the U.S. would do. I don't know one publicly traded company in the U.S., an American company that wouldn't be paying a huge cash dividend based upon the numbers that you report.

John Low

[FOREIGN LANGUAGE]

Both Mr. Wang and Mr. Hong reiterated that coming up the times are very, very challenging and we do have certain plans in place and also need to monitor how the market turns out over the next few months. So as I mentioned before, probably a decision will be made when we announce the Q3 earnings and in the meantime, management is working hard really on the business and really conserving the resources, the financial resources, i.e., the cash to see us through these extremely difficult times.

John Harold - Harold and Associates

When you talk about extremely difficult times, but you said $0.40 share. You have been guiding to $0.36 and now you are forecasting $0.20 next quarter. You are still making a truckload of money. I mean, it just doesn't any sense. I don't understand why you guys don't immediately say, okay, we are going to pay $50 million return to shareholders in the form of a cash dividend. It just doesn't make sense.

John Low

We will take that into consideration and over the next foreseeable future we will be discussing this internally.

John Harold - Harold and Associates

Let me ask you this. Have you got any recent interest from institutions at all?

John Low

As in, on buy old stocks?

John Harold - Harold and Associates

Yes, have you been contacted by any institutions that are wanting to take a position in stock?

John Low

As far as I am aware, I do know there are some institutions that came in recently. We are talking about recently.

John Harold - Harold and Associates

Such as?

John Low

I need to go back to my records to look at the names of the institutions.

John Harold - Harold and Associates

Right. You can't name one?

John Low

Let me get back to my records to answer you that, if you really need to know and I am not sure, even I am liberty to mention any names at the conference call here.

John Harold - Harold and Associates

Yes, I really need to know.

John Low

Okay, can we talk - can we discuss offline about this then?

John Harold - Harold and Associates

I would like to discuss it right now.

John Low

[FOREIGN LANGUAGE]

Operator

There are no further questions at this time. At this time, I would like to turn the conference back over to management for any additional or closing remarks.

John Low

Well, on behalf of the management team, I thank you once again for attending this conference call. We look forward to speaking to you again in our next earnings conference call. Goodbye and good night.

Operator

Thank you and that does conclude today's conference. Thank you for your participation.

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