China Medical F2Q09 (Qtr End 9/30/09) Earnings Call Transcript

| About: China Medical (CMEDQ)

China Medical (CMED) F2Q09 Earnings Call November 19, 2009 8:00 AM ET

Executives

Winnie Yan - Investor Relations

Charles Zhu - Vice President, Business Development and Investor Relations

Sam Tsang - Chief Financial Officer, Director

Xiaodong Wu - Chairman of the Board, Chief Executive Officer

Analysts

Analyst for Bin Li - Morgan Stanley

Jane Zhang - Ayers Asset Management

Jinsong Du - Credit Suisse

Michael Lan - ESG

Operator

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

Winnie Yan

Thank you. Good morning. I am pleased to welcome you to China Medical’s earnings conference call. China Medical already announced its second fiscal quarter results ended September 30, 2009. A copy of the press releases is also available on the company’s website at www.chinameditech.com.

Today your speakers will be Mr. Xiaodong Wu, CEO; Mr. Sam Tsang, CFO; and Mr. Charles Zhu, Senior VP of Operations. After they finish with their remarks, they will be available to answer your questions.

Before we continue, please bear with me as I take you through the company’s Safe Harbor policy. The discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the results may be materially different from the views expressed today.

A number of potential risks and uncertainties are outlined in the company’s public filings with the U.S. Securities and Exchange Commission. China Medical does not undertake any obligation to update any forward-looking statements except as required by applicable law.

As a reminder, this conference call is being recorded. A replay of this conference call will be available via webcast on China Medical’s website.

Now allow me to turn the call over to Charles who will give remarks on behalf of Mr. Wu. Charles.

Charles Zhu

Thank you, Winnie. Ladies and gentlemen, welcome to our earnings call. In this second fiscal quarter, we continue to experience a rapidly changing competitive landscape on our Eclia business and a temporary diversion of management focus in expanding FISH market and the launch of SPR-based analysis system and the related HPV DNA chip.

Despite all these challenges, we believe our operational execution was solid. We have seen stabilization in our Eclia business on volume and growth resumed in our FISH business. As for SPR based analysis system, we have completed the trial launch of the equipment in the small number of top tier hospitals.

After the initial usage and receiving feedback, we are well-positioned to have a full scale launch of the SPR equipment in the first quarter of calendar year 2010.

In addition, on regulatory effects, we have received SFDA approval for the additional FISH probes in haematology and SFDA approval for the SPR equipment in this quarter, representing a major milestone for the company.

Our Eclia business, due to increased competition and customer feedback on our pricing, certain customers left and resulted in a few bad debts. The majority of the remaining customers, their inventory level was reduced in anticipation of our price reduction. Considering the above factors and strong potential of Eclia reagent kits to replace the existing huge volume [we lost in the] reagent market in the future, we reduced our selling price on our Eclia reagent kit by 30% on average in September.

All of these contributed to the weakness in Eclia sales in this quarter. Since the price reduction, we have noticed that sales volume indicated an uptrend and there is no additional customer termination for pricing reasons.

Currently we are also experiencing inventory rebuilding by our customers. As a result, we anticipate our Eclia business to stabilize in the near future.

Secondly on our FISH business, we received SFDA approval for the additional FISH probes in haematology in detecting leukemia. As of now, we have regulatory approval for all five major categories for FISH usage, including breast cancer, bladder cancer, cervical cancer, leukemia, and prenatal diagnosis.

Now we have the broadest coverage of FISH probes in China in terms of the number of approved probes and hospital coverage. Our current direct hospital customers have reached over 400 and we are continuing the expansion. Currently our priority is deeper penetration of the existing top tier hospitals and expense coverage to other new top tier hospitals in China. Our field sales force is focusing on promoting clinical benefits on our FISH probes among relevant departments of existing hospital customers.

Next on the SPR business, in this quarter we received SFDA approval for our SPR based analysis system and we are expecting regulatory approval of the related HPV-DNA chip in the first half of the calendar year 2010. While system launch was delayed, I am happy to report that we have completed a trial launch in a few selected top tier hospitals. The feedback from the key opinion leaders and regulatory technicians in these top tier hospitals help us to optimize the SPR system. We are confident that we are well-prepared for a full scale launch in the first quarter of calendar year 2010.

In terms of target hospitals, we plan to first focus on the current FISH users, which consists of top tier hospitals that represent the largest end use volume for molecular diagnostics in the China IVD market in the next one to two years, and then gradually we are penetrating the second tier hospitals in longer term.

Through product bundling of FISH cervical cancer probes and HPV DNA chips, we should achieve expected synergies and thus cement our leading position in the molecular diagnostic market.

While we have experienced challenges in recent months, we remain optimistic based on the improving business fundamentals and encouraging trends in our three business lines. We are confident that our hard work in the past will pay off and we should see additional return on capital investment in the near future.

Finally, we believe we are well-positioned for the rapid growth of the molecular diagnostic sector in China for the years to come.

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

Sam Tsang

Thank you, Charles and welcome, everyone. Let’s talk about our financial results for this tough quarter, which is already behind us. Our 2Q09 revenues were down 14.4% year over year to RMB166.1 million or $24.3 million. Our 2Q09 loss from continuing operations was RMB47.1 million or $6.9 million. Our 2Q09 non-GAAP income from continuing operations was down 82.7% year over year to RMB17.7 million, or $2.6 million. Our 2Q09 non-GAAP diluted earnings from continuing operations per ADS were down 82.6% year over year to RMB0.67 or $0.10.

Let’s highlight certain financial numbers -- first, our revenues declined this quarter mainly contributed with the reduction in inventory levels of our Eclia customers in anticipation of a selling price reduction in our Eclia reagent kits, as well as the implementation of the selling price reduction in September 2009.

As mentioned, we have seen signs of stabilization and encouraging trends in our Eclia business, such as inventory rebuilding by our Eclia customers. The growth assumed in our FISH business and also the recent trial launch of our SPR equipment [by a selective] group of top tier hospitals are positive signs for our businesses.

Second, the gross margin declined sequentially from 73.5% to 65.4%, mainly due to price reductions in Eclia reagent kits. While the full impact of price reduction will be reflected in the December quarter, we have taken measures to lower the impact on the gross margin, including price negotiation with our key suppliers, which we have received some initial success. We expect the further decrease in gross margin to be mild.

Third, our SG&A increased from RMB36.7 million to RMB62.6 million, or $9.2 million. The increase was primarily due to the cause of the internal investigation and the increase in reserves for bad debt related to certain Eclia customers.

We expect our SG&A to decrease in the December quarter.

Next, our occurrence of income tax expense was primarily because certain expenses such as stock compensation expense, amortization of acquired intangible assets, and interest expense of convertible notes were not deductible for income tax purposes, as well as the accrual for withholding income tax on distributable earnings generated during the quarter in the PRC.

Next, our cash and cash equivalents at the end of September was about RMB1.2 billion, or $181 million. We have unpaid balance of about $52 million for the SPR acquisition and receivable of $30 million from the same of the HIFU business, which will result in a net balance of about $160 million.

Although we made a GAAP loss of RMB47.1 million or $6.9 million in 2Q09, we generated positive cash flow of RMB45.5 million, or $6.7 million from operating activities in this quarter. It is because certain of our expenses, including stock compensation expense, amortization of acquired intangible assets, a portion of interest expense on convertible notes, and reserve for bad debt are non-cash in nature.

Next, we held our AGM last Monday where our shareholders approved a new 2009 equity incentive plan. On the same day, we granted 245,000 ADS equivalent restrictive stock to our directors, officers, and employees. This restricted stock lasts over a period of three years.

Our accounts receivable at the end of September decreased to RMB317.9 million, or $46.6 million, from RMB343 million at March 31, 2009.

Last but not least, our outlook for 3Q09 -- given the full impact of certain price reductions on Eclia reagent kits to be reflected in 3Q09, while we have seen certain positive signs, we estimate the target revenues for Q3 2009 in the range from RMB117 million or $24.9 million, to RMB118 million or $26.4 million. We estimate the target non-GAAP income from continuing operations for 3Q09 to be more than RMB38 million or $5.6 million. The above targets are subject to change.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Bin Li with Morgan Stanley.

Analyst for Bin Li - Morgan Stanley

This is Chris on behalf of Bin Li – on the HPV SPR, you mentioned the expected launch will be first quarter calendar year 2010. Will you tell us more about the margins and also when will the revenue be significant to help out the Eclia sales? And also, could you tell us about the hospital acceptance and also where the customer traction will come from? Thank you.

Sam Tsang

First, we mentioned that we expect the Eclia business to stabilize in the near future, so the HPV DNA chip sales, of which related to the SPR system is completely a new source of revenue because we have no such revenue before the acquisition, before the SPR acquisition, so we have discussed that. We have completed the trial launch of the SPR equipment in a small group of top tier hospitals and we are evaluating the system to optimize it before the full scale launch of the Eclia [inaudible] in the first quarter of 2010 and initially, you know that the equipment is free of charge, which we provide free of charge to the top tier hospitals and the revenue source will be based on their use of the HPV DNA chips. So we already expect that to generate revenue from the HPV sales also in that quarter.

Analyst for Bin Li - Morgan Stanley

What about margins?

Sam Tsang

The margin for the HPV DNA chips we expect should be over 70%.

Analyst for Bin Li - Morgan Stanley

I see. Thank you. I’ll get back in the queue.

Operator

(Operator Instructions) Your next question comes from the line of [Jane Zhang] with [Ayers Asset Management]. Please proceed.

Jane Zhang - Ayers Asset Management

Thank you. My first question is about the FISH -- although your FISH has a year over year growth compared with last quarter actually the revenue dipped. So I’m just wondering in terms of going forward what kinds of growth are you expecting for the FISH product and how about the margins?

Sam Tsang

The margin for the FISH products is pretty stable, which is over 80%. And we have seen the growth in the sales resume and the disruption is temporary, which is caused by the internal investigation and also some sales overlap during the period and [inaudible]. We have new sales people and we see that the trend has become very positive. The orders from the [sales business] has resumed the growth. And you may also look at we received additional SFDA approval for our leukemia FISH probe and we have the broadest SFDA approved FISH probes in various applications, including the bladder cancer, cervical cancer, leukemia, prenatal diagnosis, and also we have the largest top tier hospital coverage with over 400 top tier hospitals and so currently our sales team is working very hard to increase the penetration in these existing hospital customers to promote the clinical benefits of various application of approved FISH probes and so we believe the prospects for our FISH business is very, very strong in the future.

Jane Zhang - Ayers Asset Management

You talk about the growth rate resume -- does it go back to the pre investigation pace -- do you expect still above like 30% growth rate?

Sam Tsang

We believe that the growth rate will become very -- will become the normal level very soon.

Jane Zhang - Ayers Asset Management

One more question before I go back to the queue, about the HPV business, if you launched – is that being launched next year, do you expect that your revenue range will still be about the same as you previously guided for the first year? I remember first guidance, first year is about 150 million -- do you still expect this level [inaudible]?

Sam Tsang

I think it will be a better timing to make the estimate when we have conducted a full scale launch of the SPR equipment to the top tier hospitals in the first quarter. I think at that time I will be able to give a more accurate estimate.

Jane Zhang - Ayers Asset Management

I’ll go back to the queue then. Thanks.

Operator

We have a follow-up question from the line of Bin Li with Morgan Stanley.

Analyst for Bin Li - Morgan Stanley

On Eclia, when you say it is stabilizing, do you mean the price has stabilized or the volume has stabilized than what you are seeing now? And can I assume that when you say stabilize, it will be sustained for like the next few quarters? If that is the case, does that mean you will be flat or you will see growth from Eclia sales? Thank you.

Sam Tsang

For the pricing, because we reduced the selling price on average by about 30% in very early September and so this pricing impact will affect us for the entire quarter of December, or to effect fully in December quarter and the day after, there is no more impact because it has been reflected in the December quarter. And we already see the good signs of increasing purchase from our Eclia customers and we already see some inventory rebuilding by our Eclia customer which they have decreased their inventory level before our price reduction. And so the volume is actually going up and also we have no more customer termination after the price adjustment and so in fact we also see some new customers joining our customer base and so we believe that the volume will -- should be much higher than, should be higher than the -- the volume in the December quarter should be higher than the September quarter based on these signs but the price is -- the price impact will affect the December quarter so if this -- to [inaudible], we still expect the entire Eclia business will stabilize and so in the future, it should not go down any further after that and the upside is coming from the more utilization of our Eclia reagents from the existing and new customers and also the approval of -- the SFDA approval for our fully automated Eclia equipment, which we target the mid-sized and large sized hospitals in the future.

Analyst for Bin Li - Morgan Stanley

I see. May I ask a quick follow-up? What about margin? I know you said the FISH margin is around 80% and the HPV will be around 70 and Eclia obviously drags down the margin. You told us about the price decrease and price cut -- what about say long term margin? What are you looking at say next year or in a few years from now?

Sam Tsang

I think after taking the full impact of the price reduction and also our current assets of reducing our production costs, I think the further impact to our overall margins from the Eclia business may be around 2% to 3%. And so that is why I expect the further decrease in gross margin will be mild.

So the current gross margin is about 65 and so if the overall impact is about 2% to 3%, it will be 62%, 63% range, considering these factors.

Analyst for Bin Li - Morgan Stanley

So we are looking at going forward, it will be around -- between 62% to 70%?

Sam Tsang

I think going forward, we will have to consider the revenue mix because the -- currently the FISH contribution already exceeds the Eclia contribution in terms of revenue and FISH margin is about 80% and also the contribution from the sales of HPV chips which we estimate at about 70%, so I think 62%, 63% may be accurate and going forward, gross margin should go up if more contribution from FISH business and also new contribution from the HPV chips.

Analyst for Bin Li - Morgan Stanley

I see. All right. Thank you.

Operator

Your next question comes from the line of Jinsong Du with Credit Suisse.

Jinsong Du - Credit Suisse

I would just like to -- could you give us a bit more detail on the upcoming launch of the SPR system or [the HPV testing]? For example, what will be the HPV testing chips time to start actual sales? And also, can you give us a bit more detail in terms of the [projected profitability from these systems]?

Sam Tsang

Jinsong, could you repeat the second part of your question?

Jinsong Du - Credit Suisse

Basically the timing for getting the sales in and also the margin, the profitability level, the margins, just a rough estimate what we -- for example, [in terms of FISH and Eclia]. I’m talking about the HPV testing chips, not [inaudible].

Sam Tsang

Jinsong, are you asking the gross margin for the HPV DNA chip?

Jinsong Du - Credit Suisse

Yes, if you could comment on both the gross margin and the net margin, or maybe operating margin in terms of a rough estimate, that would help.

Sam Tsang

We expect HPV DNA chips to generate about 70% gross margin for the company at the current stage.

Jinsong Du - Credit Suisse

How about operating margins?

Sam Tsang

Operating margins or net margin will be difficult because the business shares some of the expenses and so it will be difficult to separate the -- for each business but overall, you will see that the selling and G&A currently is pretty high as a percentage of revenue but the G&A as we expect will decrease because some uncertainty in expenses is -- we expect one-off or not recurring. And -- but selling expenses currently is about 6%, 7% of the revenue so let’s say the SG&A is about 25% and 75% -- 70% of the gross margin for HPV minus 25% or 30% plus R&D, so that will be about 40% operating margin if we work in this rate.

Jinsong Du - Credit Suisse

Okay. Thank you.

Operator

You have a follow-up question from the line of Jane Zhang with Ayers Asset Management.

Jane Zhang - Ayers Asset Management

Just a question about your investigation -- last time you mentioned the investigation is not complete yet. Can you update us the status on that?

And in terms of SG&A this quarter, how much is related to the investigation? Going forward, how many expenses do you expect?

Sam Tsang

We explained that the September quarter SG&A increase is mainly because of the costs related to the internal investigation and also the bad debt reserves. And the reason why we expect the December quarter SG&A will decrease is because such expenses should have very minimal portion in our December quarter.

Jane Zhang - Ayers Asset Management

So in terms of the investigation, what is the status right now?

Sam Tsang

Basically for the investigation for the [inaudible], the audit committee told us they have concluded or completed the investigation [on the letter] and they don’t find any merits for the allegation in the letter.

Jane Zhang - Ayers Asset Management

So there is still an incomplete part -- can you update us the status?

Sam Tsang

Sorry?

Jane Zhang - Ayers Asset Management

I remember last time you mentioned it’s not fully completed. How about those non-completed ones?

Sam Tsang

Because last time, we need to tell why we delayed earnings and so at that time, it was only substantial time period.

Jane Zhang - Ayers Asset Management

So all the investigation has been done, right?

Sam Tsang

Yes, the investigation for the letter is complete.

Jane Zhang - Ayers Asset Management

Okay, so for the next quarter, you probably won’t have any expenses related to the investigation?

Sam Tsang

Even though there are expenses, this is a small amount.

Jane Zhang - Ayers Asset Management

Also for the bad debt expenses, you mentioned it is related to the Eclia customers -- how much are those bad debt and how -- for those customers, is it because -- did they go away or is it because the price reduction, they don’t want to pay for that?

Sam Tsang

All the bad debt reserve for the Eclia customers, these Eclia customers are the customers who already left us, so -- but these customers do not have any more business relationship with us. So there will be zero from them. We have from a conservative prospective, we have make [some reserve] for this amount for the time being. But we are still trying to collect these reserves from these former customers.

Jane Zhang - Ayers Asset Management

So in terms of the working capital, can you tell us how much is the working capital for this quarter and did you see any changes in terms of the working capital terms?

Sam Tsang

I think the best indication is in this September quarter, even though we made a loss of RMB47 million, we generated from the operation of about RMB45 million.

Jane Zhang - Ayers Asset Management

That’s operating cash flow -- how is working capital?

Sam Tsang

The working capital, you will see that is improving in terms of our accounts receivable going down. Even though the inventory is going up, it is basically a reclassification from -- formerly we put certain expenses in the containment category and our accounts payable therefore is going down, so working capital is actually improving.

Jane Zhang - Ayers Asset Management

One more question about the Eclia, your customers’ inventory level, you mentioned they started to rebuild. Have they gone back to the normal levels?

Sam Tsang

I would say that all the purchase orders from some customers is actually higher than normal levels because of the inventory rebuilding but I think that that is probably temporary and after the rebuilding the inventory, the purchase orders should be at least a normal level and maybe higher because of the reduction in price which may help them sell more reagents to the end user hospital customers.

Operator

Your next question comes from the line of Michael Lan with ESG.

Michael Lan - ESG

I was wondering if you could quantify for us the amount of bad debt provision or expense? And can you quantify the magnitude of the expenses associated with the internal investigation this quarter?

And then regarding the investigation, can you remind us exactly what was the investigation looking at and are there any findings from it in terms of internal controls where going forward, you will have additional SG&A expense because you need to implement certain better controls or systems, anything like that?

Sam Tsang

The increase in the G&A as we compare in this quarter to the corresponding quarter last year, the increase is as we discussed mainly coming from the internal investigation and the bad debt reserve, and I would say the major portion related to the internal investigation. And so you asked about the related investigation is coming from an anonymous letter and an anonymous letter accused senior management of certain fraudulent activities in the company’s FISH acquisition, in the company’s SPR acquisition, in the company’s Hifu disposal, in the company’s revenues, in the company’s relationship with stock analysts and so this is the scope of the internal investigation and we have mentioned that the audit committee told us there is no merit to these allegations. And we already expected that the SG&A in the December quarter will decrease because we expect the expenses from the internal investigation and also bad debt reserve will not be recurring.

Michael Lan - ESG

Okay, and then did the investigation reveal anything in terms of -- I don’t know if they were looking at your internal control systems or anything like this and if there were any findings that these systems need to be strengthened, will that create higher expenses going forward?

Sam Tsang

The audit committee did not inform us we need to implement any special controls which will increase our operating [inaudible].

Michael Lan - ESG

Okay, great.

Operator

At this time, I would like to turn the call over to Sam for closing remarks.

Sam Tsang

Once again, thank you for joining us today. Please don’t hesitate to contact us if you have any further questions. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a good day.

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