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Executives

Jeffrey Kang- CEO

Frank Zheng- CFO

Will Davis-CMO

Analysts

Quinn Bolton – Needham and Company

Adele Mao – OLP Global

Richard Safranek – Wafra Investment Advisory Group

Brian White – Ticonderoga Securities

Amir Rozwadowski – Barclays Capital

Nathan Johnson - Pacific Crest

Rahul Khanwalkar – Jefferies and Company

Cogo Group, Inc. (COGO) Q3 2009 Earnings Call Transcript November 4, 2009 4:30 PM ET

Operator

Introduction

Will Davis

Good afternoon to everyone. My name is Will Davis, I am the Chief Marketing Officer of Cogo and I'd like to thank you all for joining us today to participate in Cogo's 2009 Third Quarter 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 the Cogo website at 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.

Jeffrey Kang

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 our 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% of 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 margin 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 our total sales. We continue to believe that our Industrial business will be the fastest growing segment in the short and medium terms 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 around 22%, it already represents the largest internet population in the world. We believe 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 High Definition 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’d like to turn the call to Will to discuss our guidance. Will, over to you.

Will Davis

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 in 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 earlier, 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 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 into 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. Frank?

Frank Zheng

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.

That 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 at around 5:30. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Quinn Bolton with Needham and Company. Please go ahead.

Quinn Bolton – Needham and Company

Thanks, guys and good job on the numbers. Jeffrey, I was wondering if you could talk a little bit more about your SME outreach program. You talked about 10,000 million targeted accounts. Are there certain attributes that you are looking at to decide whether you are going to target an SME account and are these geographically in the major manufacturing regions from China? Just a little bit more detail about how you intend to go after these new accounts?

Jeffrey Kang

Well, actually as you’re saying – that the current orders of existing customer, I mean, revenue customers that’s customer we generates revenue in every quarter from them. But, in order to expand our business, so we also have a much larger and a targeted customer in our category which means that some new customers. We are pursuing. We are doing the designing work. We are following them, but we haven’t generated revenue from them yet.

So, as you know, as Cogo expanded into the new verticals even in the digital media segment we still have something new segment to target. So usually our first step is to meet to list out who our targeted customers are. Usually the targeted customer [number] would be much larger than our revenue customers. And then using our platform to reach those customers and following their every project to [track] they are doing, and to provide some design solutions to them. And you eventually try to convert those targeted customers to the revenue customer to us. So as we just explained, we currently already have over like 1,300 revenue customers, but at the same time we already have the targeted customers in over like a 10,000 in our CRM database.

So, what are we trying to do is we are pushing our sales force and R&D team to pursuing those small medium sized customers, new customers, new possible customers and then try to follow any new projects which we can help them to get in some of our module solution to get in to. So, that’s what we are doing now.

And basically, this number is a still – our current penetration rate is still below 1% of the SMEs total numbers. So, we feel very confident that it will give us a significant growth opportunity in the next few years by executing of our growth strategy.

Quinn Bolton – Needham and Company

Go ahead, Will.

Will Davis

Quinn, I just wanted to expand maybe a little bit in terms of logistically how this might work in terms of – how you are looking at this opportunity. Let’s say you had one sales person handling a “Blue-chip” account you might have one sales person handling 20 SME accounts. Let's say each one, for argument sake, $50,000 that gives you a million in revenue. Then you strip out some gross margin for us in pretty limited R&D and then you have the cost of the sales person. It’s pretty easy you to see that if you can ramp the revenue like that it accelerates of getting close of that 10%.

I think the other thing to keep in mind is that when we are targeting these accounts, we’re typically not seeing a lot of competition from people like Cogo. It’s mostly going in and then from the accounts we have something to offer, then we can increase the (inaudible) then we can increase their access to high quality semiconductors companies. So you streamline that channel and allow them to focus on their own business, whether it’s designing an e-book or designing a Smart Meter module or whatever it is.

So, we can streamline that process for them, and obviously, the semiconductor guys are thrilled to get these leads to and to help participate, I mean, that 10,000 customer list is obviously going to be something that our semi-conductors partners are going to be very interested in being able to pursue.

Quinn Bolton – Needham and Company

So with the current sales force that you have today, how many of those 10,000 accounts can you reach versus how many additional sales people would you have to bring on board to really track new projects at each of those 10,000 targeted accounts. I am just trying to get a sense of, just sort of a three-year plan or is it something do you think you can penetrate those accounts in the next 12 months?

And then, I’ve got a couple of quick follow-ons?

Jeffrey Kang

As Will said, that the simple math, if we, like one sales typically can cover the 20 SME accounts. So, what it means if that the all the new 10,000 SME accounts that we are able to convert them to the revenue customers so that we might need another 200 sales force. So that’s quite simple. If that one sales people cover through 20 SME accounts, we might have like a 500 and the new employees, the sales people to cover another of this new opportunities. Of course, that’s a couple of years’ time because we are going to ramp up this the customer base and the sales force together.

Will Davis

That’s important, I mean, you raised a good point in terms of it's not like we are going to go out and hire three or four dozen people when there is no business, right. I mean if this is going to be added profitability when we needed based on the ramp. So, except to comment on the inflection point, but obviously there is a lot of demand out there, and we feel like we can easily add people to meet the opportunities. So, I think that’s kind of a … the viewpoint is to add more people profitability, I think, that’s the bottom line.

Quinn Bolton – Needham and Company

Great. And then just, it looks like the a industrial business got a big, kick-started if, you will, last year when you added component suppliers such as Freescale, Maxim, I think you mentioned that now perhaps more recently. I guess I am wondering as you work in accelerating revenue growth in 2010, how dependent would that be on adding new sort of major supply partners, the likes of another Freescale or another Broadcom versus that sort of a SME outreach program that you just discussed.

Jeffrey Kang

Yes actually they already have something in our pipeline. We knew that’s a very good progress in terms of having the new leading technology suppliers to us. So, I think that the investor is going to see more and more global leading semi conductor companies waiting to watching with Cogo and by taking the advantage of Cogo’s platform penetrating these new opportunities.

For them as Will mentioned in specially our SME category is means that significant value to our U.S. partners. So that’s why we are, we believe in that next few quarters, investors are going to see we are going to add some different names in our supplier list. So, I think that it will give us – why we are also very confident to say we are going to ramp up our both industrial and this SME revenue in the next of few quarters.

Quinn Bolton

Great. And then just lastly, on the fourth quarter guidance. Can you give us some sense by the diverse settlements digital media, telecom and industrial which are, we sort of what your (inaudible) in terms of growth rate reach of the three businesses. Thanks, and that’s my last question.

Will Davis

Sure, Quinn, thanks. Within the kind of traditional handset space, we would think that would be roughly flattish sequentially in terms of revenue, and then some continued growth in the industrial space and maybe a little bit better sequentially from the kind of the old digital media space. So, the combined digital media up a little bit, but the traditional handset will be kind of flattish sequentially, and then a little growth in telecom. So, I think when you look at it you probably have the old handsets that’s 30% probably being flat and then the other 70% contributing that incremental $5 million or $7 million in sequential revenue.

Quinn Bolton

Thanks Will. Thanks Jeffrey.

Operator

Thank you. (inaudible) Our next question comes from the Brian Lyke [ph] with (inaudible). Please go ahead.

Brian White

Yes, I am wondering if you could talk Jeffrey a little bit about some of these emerging opportunities that are coming up in areas like netbooks and also some of the e-leaders as the cellphone providers out there actually moving in bigger markets, how does Cogo participate in this?

Jeffrey Kang

Well, we saw a lot of the new opportunities in the both the handset and other converged device other than new type of things, the mobile internet device. So, because, as you know, that’s been one of the growth driver, growth catalyst for Cogo in the rest of this year into 2010, and we actually participate into this market in a very early stage. We follow, in this category we have a 100s, 100s of the new customers, or most of the new opportunity, find a new opportunity for our new customers almost every week. So, we believe in near term, heading to the next year, we are going to see the demand for this type of business. We are going to see a significant demand increasing, so that’s why we are, and also in this segment the customer base is quite fragmented, so which is pretty much fit into our business model. We are very confident we are going to grow this business significantly in the next few quarter.

Jeffrey Kang

Okay. Great. Thank you.

Operator

Thank you. Our next question comes from the line of Amir Rozwadowski with Barclays Capital. Please go ahead.

Amir Rozwadowski

Thank you very much, and good afternoon, Jeffrey, Will and Frank.

Jeffrey Kang

Hi, Amir.

Amir Rozwadowski

Just delivering a bit in terms of the industrial business. Jeffrey, you had mentioned some of the opportunities there in terms of the new markets that you folks are attacking. Now that you been in the business a bit now with the Mega Smart acquisition, I was wondering if you can give us any color in terms of what you think of longer term gross trajectory is there and how we should think about in terms of those various opportunity?

Jeffrey Kang

Well, in that field of business, industrial for us is our profits of the growing segment – end of last year, and we are already integration of Megasmart deal and we feel this is our big opportunity. So, as I said and we are very excited about Smart Grid and as smart Smart Meter business in China because in terms of the market size or the capital expenditure, could be like many, many times bigger than the internet spend in China.

So, internet, as everybody know is one of the growth driver in past few years and at this time the Smart Grid investment and Smart Meter investment in China could exceed in the fact that the size of the investment or capital expenditure in the internet business. So that’s why I feel will give us quite a confidence. We don’t need to worry about demand in the next five years in this segment, just with the Smart Grid and Smart Meter segment alone.

In addition to this business we feel, there are opportunities in our industrial segment like the railway – high speed railway, like the cleantech, like the medicare. So we see many new things come out. So we discuss how Cogo significantly expand our business in this new area. So in our conservative estimation, so far we in this quarter we already believe we can have like a 15% of our revenue coming from this segment in the comparative – almost build from scratch from last Q4. So we expect that our industrial business could contribute at least 20% or above percent of revenue next year. So that will give Cogo a tremendous growth opportunity in this segment in the next year.

Amir Rozwadowski

Great. Thank you, Jeffrey. And then you had mentioned that you expect 3G spending to be relatively healthy tracking into 2010. I was wondering if you can give us a little bit of color there because there seems to be some concern that sort of this year was a ramp up year in 3G spending, and perhaps we will see more tempered levels in 2010?

Jeffrey Kang

Well we don’t think so, and we still we believe the test of spending on the 3G equipment side will at least it should be next year the spending should be higher than this year. So as you know, China are adopted the three standards both the TD–SCDMA, WCDMA and CDMA wise with the three major carriers. So, that means that each of them kind of be a national wide network in order to offer their service. So as you know China is so big, the population is, there are billions in population. So they can, I believe they can – adopt those of the three standards.

So, that means in that every carrier depends on the money for the national wide coverage. So, as you know, for the telco service in China the 2G service, the coverage is very good. So, if anyone wants to offer a 3G service, so the coverage at least should be as good as the 2G, otherwise their consumer will not use the 3G service. So that will make – based on the current situation we don’t think that any of the existing 3G networks is mature enough to offer the national wide service. So, that means they can continue to spend money to build the networks in the next two or three years.

So, that’s why we don’t think that 3G equipment spending is going to be hold or slowing down in the next year, at least their spending is going to be higher than this year. So, that’s our view.

In addition to that, we are still seeing other opportunities in the telco spending from like the broadband access because Chinese internet users are increasing, the internet applications increasing, video-over-internet the demand is increasing. So we see fiber-to-home, fiber like a GPON application could become more and more popular in China. So investments or cut-throat expenditure in that area we are going to see another significant investment in the next year. So that’s why we still feel comfortable about the overall telecom spending next year which going to give us a stable growth business in the next year.

Amir Rozwadowski

Perfect. Thank you very much for your incremental color, Jeffrey.

Operator

Thank you. Our next question comes from the line of James Faucette with Pacific Crest. Please go ahead.

Nathan Johnson - Pacific Crest

Yes, this is Nathan Johnson calling for James. Just a couple of quick questions. One, you talked quite a bit about your expectations for 3G spending increasing in 2010. I just was curious to your outlook on how you felt about 2G infrastructure spending will trend next year? Additionally, you talked quite a bit about the industrial segment for next year. I was wondering in terms of the other segment, are you expecting moving out of a return to the growth teen, couple of years back but something along the lines of 15% growth, or do you think it’s going to be relatively tampered compared to previous years?

Jeffrey Kang

Well, as a company, we believe our growth was back to our like long-term normal mode since the 2010.

And in terms of the segment and in our traditional segment like the telecom business which I think is a relatively mature in that business. Even though – so we expect reasonably and a stable growth from that segment, and digital media feel we think we have the highest growth with event in the telecom business which because just media – today we combined mobile handset and other mobile internet devices business together, so we see more opportunities in that segment, and next year, I believe, we have already seeing a few growth catalysts in that area like a smart phone application, like e-book applications that's high definition set-top box in both the China domestic market and the global market.

So that area, we are going to see a stronger growth from that area. And, again, we think that the fastest growth is coming from the industrial business. So, that’s our view about that the growth from these segments. In general, every segment showed a good growth and at telecom relatively at the lowest growth. Digital media is in the middle and the industrial has shown a tremendous growth. So, that’s how our view about our growth prospective in next year.

Nathan Johnson - Pacific Crest

Okay great and then as far as the 2G infrastructure spending in China for 2010, or what’s your view there?

Jeffrey Kang

Well 2G spending, as you can see, Cogo telecom is only equipment is only a 25% of our total revenue space these days. And even within, telecom business only half of the business coming from the wireless line and half of them coming from like a broadband data transfer alike other telecom business. So for us, we are not going to see a significant slowdown in the wireless investment in China.

We are still going to grow our – the top telecom business. So, even within the industry, even within the wireless business of our wireless business, we are not about a highly rely on any network 2G or 3G spending that much, because we still has our business that WiFi related infrastructure business which contributed revenue to us. So, from that angle, we are optimistic about the telecom in expenditure in China next year. But we also don’t think it will have any significantly bad impacts to us.

No matter they are spending too much money or they are spending not as much as people expected, we don’t think that it will impact our growth pattern next year.

Nathan Johnson - Pacific Crest

That’s very helpful. One last thing from me, just I was wondering if you could talk about the recent order trends in each of the business segment kind of throughout the quarter and then also as it trended into the fourth quarter?

Jeffrey Kang

I think the order pattern is very strong, so we can quite confident – interested in Q4 – it will still be another good quarter. So that’s why if you look at our guidance number we still believe we are continue grow the business. Even Q3 is very good comparing with our internal estimation, but we still believe that Q4 should better than the Q3. So that’s why we would give the Q4 growth number today as our guidance. So, we believe this good trend at least can carry over to the next Q1 not only just in the Q4 of this quarter. We still believe the next Q1 we see a very good pattern of the order track from our customers.

Nathan Johnson - Pacific Crest

That’s very helpful. Thanks for taking my questions.

Jeffrey Kang

Well, thank you

Operator

Thank you. Our next question comes from the line Bill Choi with Jefferies and Company. Please go ahead.

Rahul Khanwalkar – Jefferies and Company

Hello, this is Rahul Khanwalkar calling in for Bill Choi. Jeffrey, could you talk a little bit about your Smartphone strategy, you’re working on Windows mobile operating system Android? What kind of companies are you targeting, what kind of customers are you targeting for that, and what exactly will be value added from Cogo in those products?

Jeffrey Kang

Well, Smartphone should be – I think that’s a good opportunity to us in the next year as our growth catalyst. In China, in the past the Smartphone only can be produced by a very limited few Bue-chip customers like Huawei, ZTE, Lenovo and alike. So, the volume also very low and comparing with the normal cellphone. But I think since recently the technology barrier, I believe, because of a lot of design house like Cogo, we are working with our customers. So I think the overall and the smart phone, the technology barrier had been significant lower.

And at same time, because of many people working together and the cost could be go down significantly. So, for example, iPhone I like the cellphone. We are going to sell the $400 in the US market but we – our pocket is – we can help our customers to produce the $100 an iPhone alike cellphone in China which has every functions that iPhone has. So that's basically a concept, and I also in terms of the customer base I believe most of our existing middle size of the customer could produce the Smartphone since the begining of next year. But that will give the – if you are asking me the Smartphone vendors, I can give you a 100 names in China just the next Q1.

So from that angle, I can say the Smartphone will become one of the mainstream cell phone in China that’s produced by or designed by the Chinese vendors and in the end market it could goes to Chinese domestic market as well as the global market as well. So, that's our view. So that’s why we believe the Smartphone could be our growth opportunity. Within the Smartphone what we are offering, we offered just like in other cell phone business, we provide the solution, the module solutions. We offer like Games solution and we offer like in the GPS solution, we offer in autos like a Bluetooth module, WiFi module or all kinds of and functional solutions to help our customer to differentiate their products with others. So that’s what we are doing in this Smartphone and we were very confident about the business in this segment in next year.

Rahul Khanwalkar – Jefferies and Company

Great and on the wireless infrastructure side. China obviously, has all three next generation technologies being deployed there. So do you have any idea or any visibility, which technology will be deployed much faster or on a much wider scale than the other, or do you think all three will be about the same in terms of revenue contribution for you?

Jeffrey Kang

I think that’s – we think that WCDMA and the CDMA wide adoption could be faster. And because the true carriers China Unicom and China telecom they are more aggressive trying to have the national wide networks to offer service. So, comparing with the China Mobile they already have, they are already been a dominated player in the wireless segment. So that’s why we said part of their TD ramp should be, will be slower than the CDMA and/or the WCDMA in China. So that’s our view, but in terms of the revenue contribution we think, because our business will stick with our customer we are not in that technology or that stick with any specific technology in itself. So we don’t see there is a too many difference, no matter it is the WCDMA ramp up faster than the TD. So, we will, as long as they have the capital spending in the infrastructure investment, and we will benefit from that trend.

Rahul Khanwalkar – Jefferies and Company

Okay. Thank you, Jeffrey.

Jeffrey Kang

Next?

Operator

Thank you. (Operator instructions) Our next question comes from the line of Adele Mao with OLP Global. Please go ahead.

Adele Mao - OLP Global

Hi, guys. My first question is really the two – your SME contribution to total revenue. You mentioned that currently SME is contributing about 30% and you are looking to increase that number to 50% down the road. I was wondering if your SME revenue contribution is currently coming from all different business segments or is it more a concentrated in a particular business segment?

Jeffrey Kang

You are right. Currently 70% of our revenue coming from our blue chip customers, and the 30% are coming from like over 1,300 SME customers. And in terms of the SME customers, most of the SME customers so far is from the digital media segment which is mobile and previously mobile handset and the digital media business. Also, a portion coming from the telecom related business, especially in the datacom segment, and I still believe in moving forward and we are going to see more and more industrial SME business. And so that’s why for the – currently we are most of SME in these two segments and the digital media and telecom. And going forward, we are kind of going to see the SME customer across all of our business segments.

Adele Mao - OLP Global

Great. That’s helpful. How is your pricing different for SME versus blue chip customers, and I guess how will the increasing revenue mix of SME revenue contribution impact your overall growth margin?

Jeffrey Kang

We think about because we – our strategy is that they are using us, taking solution from our large library which we have done for the tier one guys and then do a little bit of tweak and change for sales for in broad SME business. So to us, we don’t have the too many – like a too much of a new incremental R&D cost to us when we sell to the SME business. But in terms of the margin I think the gross margin sale to the SMEs is higher than the gross margin we sell to that Blue-chip customers.

And at the same time because – but the operating cost to sale of SME is higher, because if you consider that logistic cost and other cost related, so the operating cost is higher than– business which is the Blue-chip customers. But when we reach a certain level of the scale so I think operating level is similar. So as Will said, we still targeting 10% of the operating margin when we sell to the SME business. So that’s our margin target in terms of the SME business.

Adele Mao - OLP Global

Great. Regarding the Smart Grid and railroad industry opportunities that you discussed earlier, who does Cogo compete with in these respected business segment?

Jeffrey Kang

In this segment, right now it is very fragmented. I think the most of the competition we are faced in our daily work are those smaller – the Chinese local companies, and as I said it is a new opportunity for everyone. And so, that’s why we haven’t seen too much of a competition from the international players. Most of the, because another difference with the telecom business is that, first is that since day one the Chinese government policy is try to convert this into Smart Grid business to help the local economy. So that’s why – and that they basically they prefer all the local technology suppliers. So that’s why we think our competitor in this area will be mostly the Chinese domestic vendors.

Adele Mao - OLP Global

Okay. Thanks so much for that details.

Jeffrey Kang

Thanks, Adele.

Operator

Thank you. Our next question comes from the line of Richard Safranek with Wafra Investment Advisory Group. Please go ahead.

Richard Safranek - Wafra Investment Advisory Group

Hi, thanks for the call. I just had a few questions regarding the Mega Smart acquisition. Did you make the $6 million payout in the quarter that was described in the filing when you made the acquisition did that payment hit this quarter?

Jeffrey Kang

Yes.

Richard Safranek - Wafra Investment Advisory Group

And in terms of the employees and retain the employees it seems that the real value of the acquisition was really the employees. What are your plans to retain those employees? Is it what we expect traditional through stock incentives down the road once the cash payments have been made within the next 12 months.

Jeffrey Kang

Well you are right the employee is a very valuable to us, what are we actually to my value is not only just the employees, they still have certain customer base. They have the existing technology or solutions ready to sale, all of these are very valuable to us. Basically we are and the total is – as I said, we are running a platform business. We are not a direct bet on any single people. So, the reason why we are able to acquire a good company and to generate the good business after that, is because we have the platform, we have the customer base. We have our own internal platform. So that’s why we will – historically experience usually in the first few months it’s very important to keep those people, your first few quarter of the year. But after one year I personally don’t think any single individual will have a very significant role in our company. So we are running a business not betting on any single people. So that’s why I am very confident we are able to retain the people and we are able retain the business we acquired.

Richard Safranek - Wafra Investment Advisory Group

Okay, thank you. The other question I had was obviously you have the very strong balance sheet and you mentioned that there were no share buybacks conducted in the quarter, which price the share is about six bucks during the quarter, now you are shooting here at 5.60. I am just sort of curious, I mean given that you are presenting such a bullish case for 2010 and you are so optimistic on the business, can you give us some little insight in terms of how you balance out the decision on the share buybacks versus other uses of the cash in terms of acquisitions or dividends or what have you, got to say, given the picture that you are painting, you are suggesting that 2010 is going to be very optimistic. So you would be inclined to consider acquiring shares at these levels?

Jeffrey Kang

Yes, we have been using cash to both the acquisition and other share buyback. As Will explained we also see a lot of opportunities. We also want to use the cash that we are having right now to finance our working capital, to increase our working capital to finance other new business growth in the next year. So, we certainly view all the opportunities, so stock buyback will have a, legally we have few limitations. We are only able to buy the stock, when there is no use of that information which is, they only have very limited window where you can give us to buy the stock. So, that's why we are – at the same time our company with – I think we view this opportunities – what I want to tell you that we are still trying to do the both to use the cash to the stock buyback, to the acquisition and also use that, more importantly use the cash to finance our internal growth.

So in the next few quarters we still well that the management still will execute our strategy at a right timing.

Richard Safranek - Wafra Investment Advisory Group

Okay. Thanks.

Will Davis

I would just a bit – maybe add a little more color on the use of cash and then we certainly bought back shares in the past. We've – I think we have got about a million shares less than on our 5 million share authorization

Right now, we have been very successful in using the cash to drive new business. I mean this is an example, let's say we are working with a major component supplier and they needed to fund, let's say 5 million or 6 million US to mend inventory upfront. Before a project starts we will get that money back over time, but a fully capitalized to privately help the company probably wouldn’t be able to do that on a short term notice without any issues. So from that standpoint if – this may be a little bit more on unorthodox than buying back stock, but it’s been a huge benefit for driving growth, and I think we are probably a little too skittish in the first part of last year 2009. Because we are worried about the economic situation, and I think that now we are getting more aggressive. The other thing that statically on the buyback to the keep and manage that we’ve only got 38 million shares out, and the insiders on 35%. We hit the balance kind of float issues too but we’ve done M&A, we’ve done M&A in the last six months from the closing I guess smart reviews the working capital and we bought back shares may be not exactly recently. But we’ve been using cash in all three of those, and I think given the situation we will continue to like to look at all three.

Richard Safranek - Wafra Investment Advisory Group

Okay that’s fair enough. Thank you.

Will Davis

Okay. Sure, thanks.

Operator

Thank you. And there are no further questions in the queue. Please go ahead with any closing remarks.

Jeffrey Kang

So, thanks everybody, I am very, I am very encouraged by Cogo’s results posted in the third quarter. And our EPS grew nearly in 3% year-over-year. And I have increased the covenant in our penalty to accelerate revenue growth in 2010.

We are using our balance sheet to help drive growth, and we see tremendous new opportunity in both the industrial segment and our SME strategy. I would like to reiterate that we believe the worst of China economic situation is behind us. And we are ready to move forward in to the higher growth mode in the 2010.

I want to take this opportunity to thank all our Cogo’s believers, employees, customers, partners and the long-term shareholders. You have given us tremendous opportunity to deliver the robust sustainable growth, and I appreciate you support as we move into 2010. Management is committed to driving a sustainable higher growth and providing significant returns to our shareholders.

Thank you again for joining this call. I look forward talking with you soon. Thank you.

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Source: Cogo Group, Inc. Q3 2009 Earnings Call Transcript
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