Cogo Group, Inc. (COGO) Q3 2009 Earnings Call Transcript November 4, 2009 4:30 PM ET
Jeffrey Kang – Chairman and CEO
Will Davis – SVP, Business Development and Chief Marketing Officer
Frank Zheng – Chief Financial Officer
Thank you and good afternoon to everyone. My name is Will Davis, and I'd like to thank you all for joining us today to participate in Cogo's Third Quarter 2009 Earnings Conference Call.
After the market closed today, Cogo issued a press release reporting final unaudited financial results for the quarter ended September 30, 2009. This release can be accessed in the investor relations section of Cogo's website at www.cogo.com.cn and on most other financial websites.
The discussion today will be hosted by Jeffrey Kang, Chairman and CEO, who will discuss the Company’s business operations; Frank Zheng, our CFO, who will report the Company’s financials; and Will Davis, our Senior Vice President of Business Development and Chief Marketing Officer will discuss guidance.
Before we begin, I'd like to remind everyone that the call today may contain forward-looking statements regarding future events and the financial performance of the Company. We wish to caution you that such statements are just predictions, and actual results may differ materially as a result of the risks and uncertainties inherent in the Company's business. We refer you to documents that the Company files periodically with the SEC, specifically the most recently filed Form 10-K, as well as the Safe Harbor statement made in today’s press release. These documents contain important risk factors that could cause actual results to differ materially from those contained in the Company's current projections. Cogo assumes no obligation to revise the forward-looking information contained in today's call.
At this time, I'd like to turn the call over to Jeffrey. Jeffrey, the floor is yours.
Thank you, Will, and thanks to everyone for joining our earnings call. During the third quarter of 2009, Cogo posted revenue of $82 million in US dollars, up 9.7% year-over-year and up 11.5% sequentially. Our Non-GAAP EPS Diluted was 18 cents, which is up nearly 30% from the prior year period, which I believe is a tremendous achievement given the current global economic environment and relative to other technology companies. Cogo posted a gross margin of 14.4% and Non-GAAP operating margin of 8.7%, up from 7.7% in the second quarter. We continue to target gross margin of 15% and Non-GAAP operating margin of 10%.
Cogo’s revenue breakdown in the third quarter is as follows (please note that digital media now combines both the original digital media and mobile handset segments): Industrial business represented 14% of total business. This segment grew about 260% year over year and increased about 29% quarter over quarter. Digital media made up about 60% of total revenue, representing a sales increase of 2% year-over-year and an increase of 9% quarter-over-quarter. Telecom infrastructure represented 25% of total revenue, showing a sales decrease of 9% year–over-year and an increase of 9% quarter-over-quarter. Service business represented about 1.6% of total revenue, with revenue increased about 86% year-over-year and 18% quarter-over-quarter.
In the third quarter of 2009, Cogo added 3 Blue-chip and 108 SME customers. As at September 30, 2009, Cogo has 77 Blue-chip customers and 1,318 SME customers, up 4% and 9% from the prior quarter and up 22% and 17% from the prior year respectively. More than 90% of them are long term, repeating customers. Average Revenue per User (“ARPU”) from Blue-chip customers in the third quarter was $726 thousand, up 7% sequentially and down 8% from the prior year period. ARPU from SME customers in Q3 was $18 thousand, up 2% sequentially and down 12% year over year.
Overall, we are very pleased with Cogo’s business results in the third quarter, and as we noted in our last conference call, we believe that the worst of the economic situation in China is behind us. We expect to return to a higher growth mode in 2010 and we are excited about a variety of growing revenue streams, particularly in our Industrial segment and through our Small and Medium Enterprise strategy. Our $82 million in revenue in the quarter exceeded our original guidance of $79-80 million and we made sequential progress in both gross margin and operating margin. In the third quarter of 2009, we posted Non-GAAP operating margin of 8.7%, up from 7% in the first quarter and 7.7% reported last quarter. We maintain our target of a 10% operating margin. We reported 14.4% gross margin and maintain our target of 15%, noting that our gross margin level is largely dependent on revenue mix. We reiterate that we expect to see more leverage on the operating line than on the gross margin line.
I’d like to spend a moment to highlight our Small and Medium Enterprise Strategy. We are increasingly confident that our platform service business model drives a very sticky relationship for our products and services with around 1,300 Small and Medium Enterprise customers. Roughly 30% of our revenue is from SME customers and we believe that over time this will be more in the range of a 50/50 split with our Blue-chip customers. Our SME customers thrived in the first half of 2009 during the global economic difficulties and in response to this we sharpened our existing SME strategy. It now includes about 10,000 existing targets. According to government statistics, there are 160,000 “innovation-based” SMEs in China out of a top SME base of 54 million.
Our penetration of this SME Addressable Market is currently less than 1%. Just to put some rough numbers behind this opportunity, if we add 1,000 SME customers to our existing base and maintain our current ARPU for SME customers of around $70,000, this would add $70 million in annual revenue. Within that context, we expect that new SME accounts will not be a drag on our operating margin profile given that these accounts will require limited incremental R&D. In fact, we believe that accelerating our SME customer ramp will actually help us achieve our 10% operating margin target even faster due to accelerated top-line growth.
I would like to make a few brief comments about the Chinese economic situation. While we are not immune to the current global economic conditions, we are encouraged by the Chinese government’s monetary and fiscal policy to stimulate demand and our optimism on this front has only grown since our last conference call in August. We continue to believe that China’s economic growth will exceed that of most other developed markets as we head into 2010.
Let me discuss a few highlights from our business segments, starting with our Industrial segment.
I continue to remain very excited about the growth prospects in our Industrial segment. Our Industrial business grew roughly 260% year over year and was 13.5% of total sales. We continue to believe that our Industrial business will be the fastest growing segment in the short and medium term and observed significant contract activity in the quarter. Currently, Cogo is an active participant in the rapid growth of the modernization of China’s electric grid and the nationwide upgrade of the electrical meters to a “Smart Meter” system. The annual capital expenditure on China’s Smart Grid is estimated to reach 280 billion yuan by 2011, from 180 billion yuan in 2009. From 2009-2011, the capital expenditure on Smart Meter is expected to be at around 50 billion yuan for the 3 years combined. We believe that the electric network could be more than 1,000 times larger than the Internet. While China’s internet penetration rate is low, at just over 22%, it already represents the world’s largest internet population. Electricity access will eventually be available to everyone in China and we see tremendous opportunities in this area. These main drivers of our Industrial business are poised to continue to grow strongly as we head into 2010. We will also pursue opportunities in other industrial verticals such as the build out of domestic railway system, auto electronics and medical equipments.
Our major component partners in the industrial segment are those leading global semiconductor players like Freescale, Atmel, and Panasonic. Longer term, we see potential in the automotive, cleantech, security and medical sectors. While some of our end market customers and the technology utilized in our industrial segment are different from those in our core segments, the business model is exactly the same: Cogo is a gateway for component suppliers wanting to do business in China, and we accelerate time to market for our customers. Our Industrial business continues to carry a gross margin higher than our corporate average and we expect this to remain the case for the foreseeable future.
Within our digital media segment, which combines our original digital media business with the old mobile handset segment, we saw improving consumer trends in the third quarter of 2009. We believe that the sell-through from the Golden Week Holiday was solid. Mobile handset demand grew sequentially at a fairly normal pace and we believe that the handset foodchain is roughly in equilibrium and handset inventories in the channel appear normal.
In the fourth quarter and into 2010, we expect to benefit from a number of growth drivers in the digital media segment. We believe that Chinese handset vendors will work to aggressively drive down the cost of Smartphones to the $100 level and this should help to drive incremental Smartphone demand for both domestic consumption and exports. We have announced design wins on both Android and Windows Mobile platforms. We expect that handset vendors within the SME segment of our business will pursue the Smartphone market, including WCDMA and we expect to benefit from these trends. Additionally, the overall handset export business from China should continue to show good growth.
We expect that 3G trends will improve in 2010, although the timing of a material ramp of TD-SCDMA subscribers at China Mobile is unclear. We do expect the number of TD-SCDMA devices in the market to increase and we plan to benefit from this replacement cycle.
From our traditional digital media business, we expect to benefit from the roll-out of HD in China through new set-top boxes and a variety of other converged devices and Mobile Internet devices, including the e-book.
Our telecom business grew 9% sequentially, a strong showing following a strong second quarter. 3G spending is proceeding as we expected. Additionally, we participate in optical, wireline and connectivity businesses, so our business is tied to much more than the rollout of 3G. We expect 3G builds in China to remain material for many quarters to come as the networks are not yet close to matching 2G coverage. We expect that 3G spending in China could be larger in 2010 than in 2009. Additionally, fixed-line broadband demand is increasing and we are seeing strong order patterns for Fiber to the Home and G-PON.
Relationships with Huawei, H3C (Huawei-3 Com), ZTE and Alcatel Lucent should continue to benefit Cogo as they are all likely to be share gainers in the Chinese wireless market. Additionally, Cogo benefits from the continued rapid international telecom growth of Huawei and ZTE.
I’d like to briefly discuss our M&A strategy. We are very pleased with the integration of Megasmart, which contributed about $3 million revenue in the third quarter and we maintain our guidance for Megasmart to contribute $15-20 million revenue in the first year after closing. We remain committed to pursuing a successful acquisition strategy that is instantly accretive and a good cultural fit within our existing corporate structure.
With that, I would like to turn the call to Will to discuss our guidance. Will, over to you.
Thank you Jeffrey. Good afternoon everyone, and thank you for joining the call. In the fourth quarter of 2009, we expect that our revenue will be in the range of $86-88 million US dollars and non-GAAP EPS Diluted of 18-19 cents. We expect gross margin to remain roughly stable from the fourth quarter, in the range of 14-15%, and we anticipate continued good OPEX discipline, that allows for profitable pursuit of new opportunities, particularly within the Industrial and SME segments.
As typical, we are not providing full annual guidance for 2010. However, given our increased confidence in the growth prospects within our Industrial business and the SME space coupled with our belief that the worst of the China economic situation is behind us, we expect to clearly accelerate our growth rate in 2010 versus 2009. We expect to continue to broaden our customer base and see opportunities to gain share against some weakened competitors, particularly given our strong capital structure. Additionally, we expect to continue to add new component suppliers in 2010, while also enhancing our status with current suppliers such as Broadcom, Freescale and Atmel. We expect to further broaden our Industrial business to include even more new verticals in 2010.
Here are some specific guidance items to help in your modeling for the fourth quarter of 2009: Non-GAAP Operating expenses for R&D and SG&A in the fourth quarter should be approximately $5 million, split approximately 25% for R&D and 75% for SG&A. As indicated, we maintain our longer term gross and operating margin targets of 15% and 10%, respectively. Interest income in the fourth quarter is estimated to be around $350 thousand and we would expect that to remain roughly constant over the next several quarters. In the fourth quarter of 2009, we expect to be continually affected by these lowered interest rate environments and we do not believe it is prudent to alter our current cash strategy to pursue higher yields.
We continue to estimate our Non-GAAP effective tax rate to be around 8% for the fourth quarter 2009 and 2010. In the fourth quarter, stock compensation is estimated to be around $2 million, which will likely be split evenly between R&D and SG&A. Acquisition related costs, including amortization and impairment of intangible assets, will be approximately $1.2 million.
Other than those items noted above, there are no significant differences between GAAP and Non-GAAP results. With that, I would like to turn the call over to Mr. Frank Zheng, our Chief Financial Officer, to review our unaudited third quarter balance sheet and cash flow.
Thank you, Will. Good afternoon everyone. For clarity, all the figures I’m discussing here, unless otherwise noted, are in US dollars. Now, let me review the line items from the third quarter.
Since Jeffrey highlighted the main points of the P&L statement, I will focus on the balance sheet and cash flow. Cogo continues to have a very healthy balance sheet. As of September 30, 2009, Cogo had a total net cash position of over $118 million, consisting of $101.5 million in cash, and $17 million in pledged bank deposits. The Company had bank borrowings of $14 million as of September 30, 2009 for working capital purposes. We used bank facilities because the borrowing cost was very low, just about 2 to 2.5% per annum, which had been off-set by our RMB interest income.
As we mentioned earlier in the call, we are leveraging our strong balance sheet through our inventory and accounts receivable to target new opportunities as we head into 2010. We remain very committed to cash flow, but this will vary quarter to quarter depending on the need to use working capital to drive new business. The Company continues to be in a strong financial position with a current ratio of 4.6 to 1. Inventory turnover was 27 days versus 31 days in the second quarter of 2009. Accounts receivable were collected in an average of 95 days versus 96 days sequentially. Net cash used in operating activities for the nine months ended September 30, 2009 was $3.6 million.
We did not buy back any stock in the third quarter but continue to view repurchasing stock on a strategic basis to be an important element of our use of cash going forward.
This concludes my remarks. Thank you everyone for joining the call to discuss our 2009 third quarter unaudited results. At this time let’s turn the call to the operator to open the floor for questions. We will look to end this call around 5:30. Operator?
Jeffrey Kang (Closing comments):
Thanks everybody. I am very encouraged by Cogo’s results posted in the third quarter of 2009. Our EPS grew nearly 30% year over year and I have increased confidence in our ability to accelerate revenue growth in 2010 as compared to 2009, while at the same time expanding our operating margin. We are using our balance sheet to help drive growth and we see tremendous new opportunities in both the Industrial segment and with new Small and Medium Enterprise customers. I would like to reiterate that we believe that the worst of the China economic situation is behind us and we are ready to move forward into high-growth mode in 2010.
I want to take this opportunity to thank all of Cogo’s believers, employees, customers, partners and long term shareholders. You have provided Cogo with the opportunity to deliver robust and sustainable growth in the past, and I appreciate your support as we move into 2010. Management is committed to driving sustainable high growth and providing significant returns to our shareholders. Thank you again for joining this call. I look forward to talking with you soon. Thank you.
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