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SORL Auto Parts (NASDAQ:SORL)

Q3 2013 Results Earnings Conference Call

November 14, 2013 8:00 a.m. ET

Executives

Kevin Thiess, Grayling Global - IR

Jinru Yu - COO

Min Kan Lin - Accounting Manager

Raymond Lin - Investor Relations

Phyllis Huang- Investor Relations

Analysts

William Gregozeski - Mont Blanc Capital

Peter Siris - Hua-Mei

Operator

Greetings, and welcome to the SORL Auto Parts third quarter 2013 financial results conference call. [Operator instructions.] It is now my pleasure to introduce your host, Kevin Thiess, with Grayling Global. Thank you, Mr. Thiess, you may begin.

Kevin Thiess

Thank you for joining us today, and welcome to SORL Auto Parts’ 2013 third quarter and nine month conference call. This is Kevin Thiess, from Grayling, SORL Auto Parts’ U.S. investor relations advisor. Joining us today are Ms. Jinru Yu, SORL’s chief operating officer; Mr. Min Kan Lin, accounting manager; Mr. Raymond Lin, investor relations; and Ms. Phyllis Huang, also in investor relations.

Before we begin, I will remind all listeners that throughout this call, we may make statements that may contain forward looking statements within the meaning of the private Securities litigation Reform Act of 1995. The words believe, expect, anticipate, project, targets, optimistic, contend, aim, will, or similar expressions are intended to identify forward looking statements.

All statements other than statements of historical fact are statements that may be deemed forward looking statements. These forward looking statements are based on current expectations or beliefs, including but not limited to statements concerning SORL Auto Parts operations and its financial performance and conditions.

SORL Auto Parts cautions that these statements, by their nature, involve risks and uncertainties and actual results may differ materially depending on a variety of important factors including those discussed in SORL Auto Parts’ reports filed with the Securities and Exchange Commission from time to time.

SORL Auto Parts specifically disclaims any obligation to update the forward-looking information in the future. The 2013 third quarter results are unaudited numbers. They are in U.S. dollars, under U.S. GAAP.

I will begin with a brief overview of operations, and then I will review the third quarter financial results. Thereafter, management will conduct a question and answer session.

We are pleased to report record sales for any third quarter in the company’s history at $54.5 million, a 16.7% increase over the third quarter of 2012. We invested in our marketing program during the third quarter of 2013 to expand our market share, and realized better production economy of scale.

All three business segments achieved a higher year over year sales during the third quarter of 2013, and domestic OEM sales rose by 18.9%, the Chinese domestic aftermarket increased by 7.6%, and our export to international markets gained by 21.1%.

Our domestic OEM sales increased due to our excellent relationships with nearly 70 vehicle manufacturers as we are the industry leader and the Chinese economy grew faster in the third quarter than in recent quarters.

We gained market share as our sales growth of 16.7% was much higher than the total commercial vehicle production and sales increase of 10.9% and 9.5% respectively in the third quarter of 2013, according to industry data from the China Association of Automobile Manufacturers.

Increased demand for commercial vehicles in the 2013 third quarter was due to the continuing prebuy of new vehicles led by a renewed growth in the heavy duty truck sector before the strict enforcement of the new National IV emission standards and also inventory restocking.

The central government’s continued investment in infrastructure and transportation projects supported demand for trucks and greater urbanization created more demand for buses. We continue to seek to further diversify our customer base with sales into the construction equipment markets.

Aftermarket sales grew as our larger network of sub-distributors benefited from the significant number of vehicles sold over the past few years whose warrantees have expired and we have increased our aftermarket promotional activities during the third quarter to increase the awareness of our product’s abilities.

We attended the 2013 China International Public Transportation Expo held in Shenzhen August 15 through 17, 2013, where SORL’s Brake Master Cylinder won the first China Urban Transportation Most Trusted Product.

International sales increased year over year compared with the third quarter of 2012 due to our expanded marketing program and growing portfolio of advanced products introduced by our research and development program.

We exhibited, from October 16 to 20, 2013 at the EQUIP AUTO 2013 trade show in Paris to increase global awareness of the SORL brand and to demonstrate the advantages and value of our advanced products, especially in the European market. EQUIP AUTO 2013 is a key international aftermarket industry event that brought together manufacturers, distributors, and service personnel to spotlight the latest products and services. An estimated 1,800 exhibitors attended with companies from approximately 50 countries.

Our successful research and development program has upgraded our traditional braking products as well as introduced new models of electronically controlled braking components and systems. The value of our excellent products, manufacturing, and service has been acknowledged by our customers and enhances our relationships.

For example, in August 2013 we were selected as the exclusive developer for all air operated valves for the new generation model N211 medium truck introduced by JAC. JAC’s light duty commercial vehicles have been ranked number one in China for 10 consecutive years, and exports to a number of global markets.

We continue to maintain our strong financial position. As of September 30, 2013, we had $32.5 million of cash and cash equivalents, $54.8 million of net accounts receivables, and $22.6 million of bank acceptance notes from customers. The company’s working capital is $147.8 million at September 30, 2013, and the current ratio was 4.4:1.

Our focus continues to be on gaining market share with stable or growing margins to help generate positive cash flows from operating activities to provide the resources to invest in advanced production equipment and increase efficiency.

We are also augmenting our marketing and promotional programs and enhancing our research and development program to design advanced brake products to meet the needs of our growing global customer base. Commercial vehicle inventories are at acceptable levels and public policy continues to support public transportation.

We believe a new commercial vehicle replacement cycle is beginning, and we are cautiously optimistic on the outlook for the fourth quarter of 2013 and into 2014. With that, we’ll go ahead with the financial review.

For the third quarter of 2013, net sales increased by 16.7% to $54.5 million, or $46.7 million for the third quarter of 2012. Revenues from the company’s domestic OEM customers rose by 18.9% to $22.3 million from $18.7 million in the third quarter of 2012. Sales from China’s domestic aftermarket increased 7.6% to $13.1 million in the third quarter of 2013 from $12.2 million in the same quarter of 2012.

Revenues for international markets increased 21.1% to $19.1 million, compared to $15.8 million in the third quarter of 2012. SORL’s overall sales increased due to higher demand in the commercial OEM market and aftermarket during the third quarter of 2013 as SORL’s new product sales contributed to the sales increase in both markets.

New commercial vehicle unit sales in China increased by 10.9% during the third quarter of 2013, mainly due to the continuing prebuy of OEM commercial vehicles and the inventory restocking to meet future demand.

Aftermarket sales rose as the number of companies and sub-distributors increased compared with the same quarter last year. Additionally, expiring OEM warrantees increased and higher promotional activities and new products contributed to higher sales in the aftermarket segments.

To control the risk of late payments by international customers, orders in the second quarter of 2013 were not shipped until all payments were received. With these payments completed in the third quarter of 2013, the company’s export sales increased for the three months ended September 30, 2013, compared to the same period in 2012.

The gross profit for the third quarter of 2013 increased 9.8% to $14.5 million from $13.2 million for the third quarter of 2012. Gross margin for the third quarter of 2013 was 26.6%, from a gross margin of 28.3% in the second quarter of 2012. The decrease in gross margin reflected higher labor and raw material costs as well as currency appreciation.

Operating expenses increased to $10.5 million in the third quarter of 2013 from $8.7 million in the third quarter of 2012. The increase in operating expenses from the third quarter of 2012 reflected higher expenditures in selling and distribution as well as general and administrative expenses with comparable research and development costs.

As a percentage of revenue, these expenses were 19.2% in the third quarter of 2013 compared with 18.7% in the third quarter of 2012 and also compared with 19.5% in the second quarter of 2013.

Selling and distribution expenses were $4.4 million, or 8% of quarterly revenues, compared with $3.8 million, or 8.1%, in the second quarter of 2012. The increase in expenses was mainly due to higher packaging and personnel expenses during the quarter.

General and administrative expenses in the third quarter of 2013 were $3.7 million or 6.8% of revenue compared with $2.6 million or 5.6% in the third quarter of 2012. The increase in expenses was mainly due to higher personnel costs and administrative expenses related to higher revenues.

Research and development expenses were $2.4 million in the third quarter of 2013 and 2012. As a percentage of revenue, R&D was 4.4% in the third quarter of 2013 and declined compared to 5% of revenue in the third quarter of 2012, due primarily to the increase in revenues in the third quarter of 2013.

The R&D program continues to mainly focus on the development of new, higher-margin electronically controlled mechatronic products and to upgrade the company’s traditional braking products to capture market share.

Financial expenses increased by $229,092 to $774,418 from $541,326, due to higher currency exchange losses from depreciation of RMB against U.S. dollars during the third quarter of 2013.

Income before income taxes was $4.1 million for the third quarter of 2013 compared to $5 million for the same quarter in 2012. The reduced income reflected lower operating income and other income as well as higher financial expenses during the third quarter of 2013 compared to the third quarter of 2012.

The pretax income margin was 7.5% in the third quarter of 2013 compared with 10.8% in the third quarter of 2012. The provision for income taxes was $0.3 million or an 8.2% tax rate in the third quarter of 2013, which is substantially reduced as compared with the $1.2 million or a 23.5% tax rate in the third quarter of 2012.

This change in provision for income tax primarily reflected that SORL received its high tech enterprise certification in December 2012 that lowered its income tax rate to 15% for the years 2013 and 2014.

That income, attributable to stockholders for the third quarter of 2013 was $3.3 million, or $0.17 per basic and diluted share compared with $3.4 million or $0.17 per basic and diluted share in the third quarter of 2012.

For the nine months, net sales increased 6.9% to $153.3 million from $143.4 million for the first nine months of 2012. Revenues from the domestic OEM customers increased 7.9% to $75.7 million from $70.1 million in the first nine months of 2012. Revenues from China’s domestic aftermarket increased 4.2% to $35 million from $33.7 million in the first nine months of 2012. And revenues from our international markets increased 7.4% to $42.5 million from $39.6 million in the first nine months of 2012.

Gross profit for the nine months of 2012 increased 6% to $42 million from $39.6 million for the same period in 2012. Gross margin for the nine months ended September 30 declined to 27.4% from 27.6% for the first nine months of 2012.

Operating income for the first nine months of 2012 declined to $11.4 million from $13.3 million in the same period in 2012. Operating margin was 7.4% versus 9.2% in the first nine months of 2012.

Net income attributable to stockholders for the first nine months of 2013 was $8.6 million or $0.44 per basic and diluted share compared with $8.7 million or $0.45 per basic and diluted share in the same period a year ago.

As of September 30, 2013, the company had cash and cash equivalents of $32.5 million compared to $41.3 million on December 31, 2012. The company significantly reduced short term bank loans to $6 million on September 30, 2013 from $14.6 million at December 31, 2012. Total equity increased to $203 million on September 30 compared with $188.5 million at December 31, 2012.

On September 30, 2013, working capital was $147.8 million, with a current ratio of 4.4:1. Net cash flow from operating activities was $1.1 million.

The business outlook for fiscal year 2013: management reiterates its outlook for net sales to be approximately $207 million and net income to be approximately $13.7 million. These targets are based on the company’s current views on the operating and market conditions, which are subject to change.

Operator, we are now ready to begin the Q&A session.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from the line of William Gregozeski with Mont Blanc Capital. Please proceed with your question.

William Gregozeski - Mont Blanc Capital

I was curious if you could provide any outlook on what you see for sales next year, both domestically and internationally, and how you think the gross margins are going to look?

Raymond Lin

[Translating from Jinru Yu.] Okay, it’s a long answer. Let me try to summarize this. First, 2013, we’re on track. We believe we’ve done a reasonable job, and we are on track to achieve full year guidance.

Regarding your question on 2014, after a number of years, the last three years the economic restructuring in China, and so we believe the automotive market, especially the commercial vehicle market, is entering into a rational growth stage, or healthy growth stage. So overall, we believe it’s going to be between 5% to 8% growth in 2014. That’s our sort of forecast for the entire industry, and we believe we are on track to achieve that or even exceed that.

Let’s break it down to different segments of our business. Starting from the OEM business, we now have nearly about 70 OEM customers. We have some high quality customers such as JAC, [Sun Chi], and we believe there is some room in those two OEMs. We want to continue to penetrate and reach a better economy of scale.

And in the meantime, we’re going to eliminate some of the smaller players, which the payment terms are not good, or some of their business outlook is looking not as strong, as a matter of fact. And the competitive landscape we have now, in the commercial vehicle market in China, these smaller players tend to be weakened, their market position.

On the aftermarket segment, again, our goal is focusing on market share increase as well as some of the high-quality products. We want to continue to bring out our high-quality products, along with our intensified campaign in those markets.

There are a few things we are specifically doing in the aftermarket. The first thing is, you know, there are a large number of vehicles, volume of commercial vehicles, on the road right now. So they are also looking for some of the new products to upgrade, to maintain the vehicle functionality. So we want to introduce more new innovative products into that aftermarket space.

And secondly, we want to continue to maintain our relationship with our large customer base, but we do want to increase our penetration through our aftermarket sales network. So by pushing into some of the new areas.

And lastly, as we have been traditionally very strong in the truck market, we want to continue to expand our coverage into the bus and construction equipment segment for the aftermarket. So those three will complete our aftermarket push for 2014.

And in terms of exports, we’re seeing the U.S. market and European market are on track for very healthy recovery. But again, there are some areas we definitely want to be mindful. One is India and the other is Brazil. And these two markets are going through some turbulence right now, mainly due to the currency risk. And so we’re carefully monitoring those regions to adjust our strategy.

So for instance in South America, we’re going to try to develop some of the new customers and increase our product SKUs and hopefully those new customers can increase volumes with us. And some of the other markets, for instance, we don’t have a large volume, but we want to start to build our presence.

So we’re looking for some new customers in a market that’s relatively new for our coverage. Those international markets, over time it will become highly profitable and become a potential growth driver for us. So we actually attended 10 different international conferences this year. So that kind of paved the way for our expansion as well as signing of the new customer in 2014.

Thirdly, we already have a warehouse in Bulgaria. We want to leverage that distribution center we have there to better service that region to shorten the supply time in the European market and create some of the value for our customers.

And lastly, our R&D is always our strength, so we want to continue to strengthen our R&D capability and continue to churn out new products to fit into international markets. Some of the markets require some different products from the Chinese customers. So we see there’s good potential in those areas, those regions. We’re actively developing product to be suitable for those markets.

So it’s a combination of intensified global marketing as well as new products, or more a more complete product suite, strategy. So that’s kind of our strategy for 2014.

William Gregozeski - Mont Blanc Capital

And how are you guys looking at gross margins? Staying within that 28% range?

Raymond Lin

Third quarter 2013, just this quarter we’re reporting, we did some of the marketing campaigns, some of the promotional activities. By reducing the price, it did help with the volume. But that, in turn, affected our gross margin for the quarter. And again, it really helped us book our strongest third quarter in recent history. So if you look at our first nine months blended gross margin, even with the weaker third quarter margin, our gross margin for the first nine months is around 27.4%. And we remain confident going into 2014. We should be in that range. We’re looking at between 27% and 27.5%.

Operator

Our next question comes from the line of Peter Siris with Hua-Mei. Please proceed with your question.

Peter Siris - Hua-Mei

I wanted to ask a couple of questions. First, the general and administrative expenses were up by $1 million, which is a lot of money. And I’m curious what you spent that money on. Is that for some of these things we’ve talked about, the future international and domestic development? Or what are the increases there?

Raymond Lin

In addition to the recruits for new talent to expand our business, we also, in the G&A category, introduced some of the welfare-related subsidies for our current employees, including the benefit for transportation and housing, and work-related dining. So we increased a bit for those employees to maintain our overall team’s morale.

Pete Siris - Hua-Mei

And keep turnover down and production good?

Raymond Lin

Yes, we’re doing that.

Peter Siris - Hua-Mei

A couple of questions about the future of the business. First, do you think over the next several years that international will increase as a percentage of sales, stay the same, or decrease?

Raymond Lin

The short answer is we believe it’s going to increase over time. We’re looking at between 5% to 10% annual growth. That’s already inclusive of some of the countries where doing business we may experience some of the currency challenges, as well as anti-dumping related tariff introduction. So all in all, there are some markets where we’re going to see some turbulence and some markets we think are going to catch up. So, overall, we’re projecting 5% to 10% growth on an annual basis, for the next few years.

Peter Siris - Hua-Mei

I guess I’m curious, with an increase in replacement of some of the older vehicles in China, with some of the new construction projects that are starting, why can’t you do better than 5% to 10% growth? Or are you just being conservative?

Raymond Lin

And so to answer your question, we are tracking the industry closely. Again, this is a conservative team here. And also, the industry, there are some uncertainties. But overall, we believe we definitely will track industry growth rate, and potentially will exceed that.

Operator

There appears to be no further questions at this time. I’d like to turn the floor back over to management for closing comments.

Kevin Thiess

Thank you for participating in this conference call. We look forward to speaking to you again next quarter, and we wish you all a good day.

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