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Executives

Christy Shue – Executive Vice President, Finance and Investor Relations

Tianfu Yang – Chairman and Chief Executive Officer

Xedong Xui – Chief Financial Officer

Analysts

Brain Drab – William Blair & Co.

John Ma – Roth Capital Partners

James Behre –Perimeter Capital

Harbin Electric, Inc. (HRBN) Q3 2009 Earnings Call November 10, 2009 8:30 AM ET

Operator

At this time, I would like to welcome everyone to the Harbin Electric, Inc. third quarter 2009 earnings results conference call. (Operator Instructions) This call will be available for replay beginning at 9:30 am Eastern Time today through 11:59 pm Eastern Time on November 17th. The conference ID number for the replay is 38740658. Again, the conference ID number for the replay is 38740658. The number to dial for the replay is 1-800-642-1687 or 706-645-9291.

I would now like to turn the conference over to Christy Shue, Executive Vice President, Finance and Investor Relations of Harbin Electric Incorporated. Thank you. Ms. Shue, you may begin your conference.

Christy Shue

Welcome to Harbin Electric's 2009 third quarter earnings conference call. I have our Chairman and Chief Executive Officer, Ms. Tianfu Yang, and Chief Financial Officer, Mr. Xedong Xui, on the call.

We filed the quarterly report on the Form 10-Q for the third quarter yesterday after the market closed and issued a press release this morning to highlight the financial results for this quarter in comparison with the third quarter of last year and to the second quarter this year this morning.

During the call, we will make forward-looking statements that are subject to the risks and uncertainties outlined at end of our press release. Let me remind you to read our Safe Harbor statements listed there.

First of all, I would like to go over a few important events happened in the third quarter. It was indeed a very busy quarter for us. In August, we completed a public offering of about 7.2 million shares at $16 per share, generating a total of about $107 million net proceeds.

These proceeds allowed us to move to and complete quickly a significant acquisition of Xi'an Simo rotary motor company. Also in July and August, we repurchased the remaining 6 million 2010 notes and 26.5 million out of 38 million 2012 notes at some discounts. This resulted in about 4.2 million gain for this quarter.

In September, we paid another 2.4 mandatory redemption of 2012 notes. As of September 30th, we had only $9.1 million debts outstanding from the 2006 financing. Additionally, we terminated the [cross] currency interest rate swap agreement that the company entered with Merrill Lynch in April 2007.

This resulted in a $9 million loss. However, we are free of any liability and of this derivative instrument going forward.

For the third quarter financial results, other than the GAAP numbers reported, we also provided adjusted non-GAAP earnings numbers as there were a few special non-cash and non-recurring items in this quarter, though were not directly related to our operations. I will explain this item shortly.

The two financial summary tables presented in the beginning of the press release give you a summary of both GAAP earnings and adjusted non-GAAP earnings and a reconciliation of non-GAAP measures to GAAP net earnings.

I would like to highlight a few key points without going over every number. We have achieved the best quarter in terms of operating results in the company's history, the highest quarterly revenues, gross profit and operating profit.

Our total sales reached nearly $47 million, up 18% year-over-year and 22% quarter-over-quarter. The robust order volume in oil pumps is the bright spot. We delivered a total of 259 oil pumps during the quarter versus 64 units in 3Q08 and 105 units in 2Q09.

The strong sales in oil pumps helped to more than offset the sales decline in our [less] and linear motors and related systems. We also expanded margins both year-over-year and quarter-over-quarter. Both gross margin and operating margin are higher than the same quarter last year and the last quarter.

The order book in our industrial rotary motors was also very strong, which exceeded our current capacity. To mitigate the capacity constraints, our staff had to work many, many overtime hours in order to meet customer orders and to keep our customers happy.

With this effort, our Weihai facility achieved nearly $21 million revenue this quarter compared to about $15 million in 3Q08 and $17 million in 2Q09, respectively. In this quarter we reported a loss of $1.9 million or a loss of $0.07 in GAAP net income. However, the GAAP net income included a few special non-cash and non-recurring items.

One, about [4.1] million gain on debt repurchase due to repurchase discounts. Two, we had to report additional $7.3 million amortization of debt discounts and the debt issuance costs due to repurchase of the 2010 and 2012 notes I mentioned earlier. Three, we took a $9 million loss resulting from the termination of the cash flow hedge swap. Four, about $736,000 loss due to change in fair value of outstanding warrants.

Excluding these special items, we have achieved earnings of $0.40 per diluted share compared on the same basis to $0.34 per diluted share in 3Q08 and a $0.33 per diluted share in 2Q09. 2Q09 non-GAAP earnings excluded a $14 million loss from changing fair value of warrants and of $1.2 million income from government grants.

Operational wise, these are great results. At the end of the quarter, our cash position is about $155 million. Cash generated from operating activities amounted to $37 million during the first nine months of the year. In October, we used about $84 million to pay for the acquisition of Xi'an Simo. We may be required to make additional payment toward the purchasing price within seven months from acquisition closing date.

Looking ahead, we expect the fourth quarter to be another solid quarter, continue the robust demand in the rotary motor business in our Weihai facility, we will need our people to work again many overtime hours while dealing with limited capacity, but this is a good problem to have.

We're working on many fronts to expand the production, including investing in more equipment and production lines and invest in working capital. Realistically, it takes some time for capacity expansion.

For oil pump business, the fourth quarter is seasonally softer due to winter weather but we are working toward fulfilling the total 500 units for the year. Given that we have completed a total of 424 units in the first nine months, we're well on our way to the target. Additionally, our linear motor freight train project for coal transportation is on track and we expect it to contribute several million dollars to total revenues in the fourth quarter.

We have moved in the micro-motor production for our new Shanghai facility. While we are still working with our North American customers to speed up the process of start up the production of new products at Shanghai facility, we see some higher order volume for our existed micro-motors going into the fourth quarter.

Although we still have not obtained the green light on the linear motor subway train, we're informed that multiple organizations and the government agencies are involved in the process of final testing, evaluating and approval. We understand it is a complicated process for a critical project like this; however, we are optimistic that the process will move forward.

Lastly, we're excited that our newly acquired Xi'an Simo Motor will start contributing significantly to our fourth quarter results, becoming a major part of our business. While the integration is underway, our top priority on the new facility currently is to work every way to insure timely delivery of products to our customers given the facility is also experiencing strong order volume and dealing with constrained capacity.

Overall, we feel very upbeat about the fourth quarter and about the future of Harbin Electric. Now we are ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Brian Drab – William Blair & Co.

Brian Drab – William Blair & Co.

I guess I'll start just with the linear motor business. First of all, your gross margin was really strong in that business. Is that a function of stronger volume but also that the gross margins in the oil pump business are a little better than the average?

Christy Shue

Yes, you are right. The main reason of higher gross margin is it has a major contribution from the oil pump business because oil pump contribute a lot more in sales in terms of percentage, so that's a [miss] there on the gross margin, that's correct.

Brian Drab – William Blair & Co.

And then how is the Chinese auto market looking from your perspective? I understand it's been difficult in the North American market, but as you pointed out your sales were flat sequentially in the micro-motor market in general and Chinese auto market has been really booming lately. Could we maybe anticipate maybe some pent-up demand and strong orders going into the fourth quarter in the auto micro-motor market just driven by China growth?

Christy Shue

Let me give this question to Mr. Yang.

Tianfu Yang [interpreted]

First of all, Mr. Yang would like to emphasize that even Chinese auto markets are going strong, the sales are going well, but even the car sales have two different situations. One is the pure Chinese-made cars and the other higher end JV or foreign-brand cars.

For our products, as you know even the specialty motors, we mainly now we're mainly serving the foreign brand and JV made cars. However – and even these cars that we're serving most of the time, most of the time they're coming back.

You know we export our motors to North America and then they put the motors on the car seat and everything and then the car seat may come back to China and put in the JV brand and foreign brand cars in China, made in China.

And we have not been very much going after the Chinese – pure Chinese brand cars which is usually cheaper, lower price and lower end cars. However, the good news is the new products we have developed in the past are mainly towards serving the Chinese cars, but made by JV and foreign brands, made in China.

And so beginning in December, it is hopeful or we're expecting that one product that was designed for JV and foreign brand made cars in China would start some production. So that's the general situation now.

Brian Drab – William Blair & Co.

On your tax rate in the quarter, two questions on the tax rate. Could you tell us, in the third quarter, if you strip away all of the noise from some of these one-time items in the quarter, what was your tax rate on your core business?

And then the second question on the tax rate is, with Weihai and Simo contributing a significant portion of revenue, what tax rate, roughly, can we expect going forward?

Zedong Xu [interpreted]

Brian, our facilities are in China so they are subject to the tax rate levied by Chinese government. Currently the standard is for Harbin is 10%, although we get 2.5% back from the local government. And Xi'an Simo is subject to 15% standard rates. And Weihai is the one subject to – that's the standard rate for Weihai. And going for Shanghai ones, the Shanghai starts – Shanghai is subject to 15% in terms of the tax rates.

If you want to do effective tax rates, I think all you need to do is – we have provided the provision for income tax and then divide – we provided the adjusted net income so I think what you can do is to using the provision for income tax divided by our adjusted net income. Usually I do that, and that gives you about 15% of the overall right now.

But however, going forward once the Xi'an started that will – that probably will make some difference, but we don't have a number in terms of the effective tax rate yet.

Brian Drab – William Blair & Co.

And that 2.5% that you get as a refund after – in the Harbin facilities, does that show up in the net provision for income taxes or does that show up somewhere else?

Christy Shue

It shows on the other income.

Operator

(Operator Instructions). Your next question comes from John Ma – Roth Capital Partners.

John Ma – Roth Capital Partners

I have a few questions, first, I didn't hear clearly, you have $1 million other income on an income statement. Now, what is that?

Zedong Xu [interpreted]

Let me also add – first of all, let me translate Mr. Zedong Xu's reply. In the other income usually consists – and for this quarter, it consists mainly of the tax rebate we receive from local government. He explained that Harbin is subject to 10% tax rates to the government.

However, the local government gave us some back, 2.5% back, but that's not directly related to the tax and so it's not going under the tax provision but going under the other income. So that's part of the other income. The tax – we call it a tax rebate, but the government – actually it's a subsidy from the government.

And also the other part, a bigger part is the – for example on the Weihai facility they often have income by selling some semi-finished products and some scrap materials because they're big revenues so they have quite a significant income from semi-finished products and the scrap materials.

And so the small part of it for this quarter is also some, we got some award, a small amount of award from governments in terms of, like science and technology award that we got. But it's insignificant, so we did not give a detail on that number. The last quarter, obviously remember, we got $8 million R&D government grant. So it also went to the other income.

John Ma – Roth Capital Partners

Now second question to Mr. Yang is that now you have one rotary motor in Weihai and another rotary motor in the Simo in Xi'an and how, what to a point to achieve a synergy and so what's the future of your rotary business going to be?

Tianfu Yang [interpreted]

Yes, we have two facilities now producing rotary motors but these two facilities are, the products have a different [share rate]. In our Weihai facility, they're mainly focused on small to medium sized rotary motors. However in Xiang, their major products are large and specialized like the high voltage and EC rotary motors.

But although Xiang is also capable and sometimes they do produce some of the smaller rotary motors, for example the Y series rotary motors that Weihai also produces so there is some slight overlap. But what we're doing now is doing some consolidation work where actually as I took over and to do the integration and I moved or in the process of moving the small rotary motors to Weihai.

So each system would have their focus. Xian would just focus on the large motors and Weihai just focused on the small to medium sized motors. So the regions would take fully realizing their advantage and do their work.

John Ma – Roth Capital Partners

Another question related to Weihai, this quarter looks like it's gross margin from Weihai is a bit weak and so what's your plan to improve the gross margin in Weihai?

Tianfu Yang [interpreted]

That's a good question. You noticed that in our Weihai rotary motor business our gross margin is slightly lower than before and the reason, okay there are like two issues actually. One is we took over, acquired Weihai at the time raw material costs declined actually compared to previous periods. The raw material was in the process of decline.

So the raw material cost reduced, and at the same time to penetrate more market or earn more market share we actually adjusted the price lower so that we have gained a lot of the market share there. However, recently, once the raw material costs are going up and it affected the margins. We actually quickly moved to adjust the price upward. And so that was according to market. So once we adjusted the price that was reflected in a higher gross margin.

John Ma – Roth Capital Partners

My last question is that your linear motors for coal transportation, so I'm glad you had – this is on track. But my question is if this is project by project thing or you see this will be recurring revenue going forward?

Tianfu Yang [interpreted]

For the coal transportation, obviously this is the first project we are doing and this project is working with the – in the Mongolia provincial governments support it and working with them as first testing line. And this first testing line is viewed in [Erdoff] a mine there and that line is directly towards some mine to power generation plant, power plant. It's about 30 kilometers long.

And however, this – inner Mongolia has four additional plants and the other four additional lines has two for another two power plants and another two for goes to railway station. And in China, the main issue for the coal industry, mining industry is the transportation issue that is the bottleneck.

It is kind of like our city transportation, passenger transportation, it's a bottleneck there. And so the government decided or in general the overall premise to build dedicated transportation line for the coal transportation, so this is what the inner Mongolia province is doing.

And after our first line is – right now we're building the first line and the revenues are showing up in the future quarters. Every quarter would show some revenues but in the future and we – after the first line is successful we'll expand it to the other four lines and obviously in other cities where they have coal mines in Hunan [Shaanxi], [Anhui] Province and they will also build dedicated coal transportation lines.

And the government is investing $10 billion. It changes to $100 billion, I believe in [R&D] for building this infrastructure for coal mining industry.

Operator

Our next question comes from the line of James Behre – Perimeter Capital.

James Behre – Perimeter Capital

You had some, I guess, very strong oil pump revenue and do you think – do you – you borrowed some of those sales from the fourth quarter or do you think that strength is continuous and repeatable?

Christy Shue

Well, usually third quarter is our seasonally stronger quarter for oil pumps, pretty much because our pumps are sold to Daqing oil fields. Daqing is in the north part of China, so once it goes into the winter seasons, winter quarter, like for what we mentioned in the fourth quarter, it will be seasonally softer. So fourth quarter we wouldn't make – we would not expect that strong in oil pumps.

James Bear – Perimeter Capital

Right, but they were significantly above expectations. That's why I asked the question, so they'll be – I know they'll be softer in the fourth quarter, but to do you think they'll be better than what we were looking at, say, a quarter ago?

Christy Shue

Our total target units I mentioned is 500 units for the year, so for the first nine months we have completed 424, so you can be expecting about 80 units, 70 units there to where we're trying to finish the 70 units there total.

Doesn't look like we have further questions, [Carrie]?

Operator

There are no further questions at this time.

Tianfu Yang [Interpreted]

I would like to make short closing remarks. I would just summarize some key points this year with this downside. First of all, I would like to thank the analysts and the investors on your interest and your continued attention to the company and one thing I would like to say is well, last quarter we successfully completed the financing and the proceeds helped us to acquire Xi'an Simo Motor.

And this quarter, obviously Xi'an has not been consolidated into our earnings and but next quarter, I mean, fourth quarter, and we will see that the Xi'an will contribute to – not only to our operating results significantly, but also we will see that actually Xi'an Simo has helped our Harbin Electric strength and our position in the industrial rotary motor business in China and it's actually in the entire electric motor business in China and it's going to play important role there.

In terms of our business, we expect it to continually grow. Given that the financial crisis and we experienced the financial crisis and not in China but in the U.S., but in China we also experienced some weaknesses in economic, but they think that it's – looks as if it's going past and the Chinese government has been made a lot of investment and committed to continue stimulate the domestic economy and has planned additional investment into stimulating the Chinese economy and the keep GDP growth in China 8%. Not just for this year and continually for the next two to three years.

And for China the issue is not just this year that the government is concerned and the government goal is to keep the Chinese economic activity to grow for the next three to five years at this level. That would be the way to really solve a lot of the problems or issues in China.

So we are promising and we are confident that our industry and our company will continue to benefit from Chinese government to the stimulus package. And as a matter of fact, right now we only see about one one-third of the government stimulus package into working and there is still – we are still expecting another two-thirds of that investment will continue to work in stimulating the economy next, for the future years.

And additionally, on the other hand, the international markets in North American market, also we're seeing recovery and for our company we're positioning and once the international market coming back, North American coming back, we will be able to serve international market and meet the needs and the demand in the international market's growth.

Overall we are – we feel that the company – we're confident that our company will continue to grow and benefit and for the next three to five years at a healthy growth rate and we ask our investors continue to pay attention and watch our growth. Thank you very much and that's all for today's conference.

Thanks everyone and if you have any follow-up questions feel free to give me a call or send me an email and thank you for coming to the conference and see you next quarter. Good-bye.

Operator

This concludes the Harbin Electric Incorporated third quarter 2009 earnings results conference call. This call will be available for replay beginning at 11:30 am Eastern Time today through 11:59 pm Eastern Time on November 17th. The conference ID number for the replay is 38740658. Again, the conference ID number for the replay is 38740658. The number to dial for the replay is 1-800-642-1687 or 706-645-9291. Thank you for your participation in today's conference. You may now disconnect.

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Source: Harbin Electric, Inc. Q3 2009 Earnings Call Transcript
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