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Executives

Tina Ting - Chief Executive Officer and Director

Albert Chen - Chief Financial Officer and Director

Analysts

Scott Henry - ROTH Capital

Brian Tanquilut - Jefferies

Yi Chen - Aegis Capital

Alberto Bassetto - Jayhawk Capital

China Cord Blood Corporation (CO) F2Q 2014 (Qtr End 09/30/2013) Earnings Call November 15, 2013 8:00 AM ET

Operator

Welcome, everyone, to China Cord Blood Corporation's earnings call for the second quarter and first half of fiscal year 2014. (Operator Instructions) Now, I would like to introduce [ph] Mr. Kevin Zhang, to begin the presentation.

Unidentified Company Representative

Thank you, Derek. Good morning, everyone, welcome to our earnings conference call for the second quarter and first half of fiscal 2014. A press release discussing our financial results has already been released and a copy is available on our company's website. During the call, our management will summarize corporate developments and financial highlights for the quarter. A question-and-answer session will follow.

Before we begin, please note that today's discussion will contain forward-looking statements that are subject to risks and uncertainties and actual results may be materially different from these forward-looking statements. Please refer to our SEC Filings for detailed discussions of potential risks. In the interest of time, we will begin with our CEO's English remarks. After discussing our second quarter financial performance, Mr. Albert Chen, our CFO, will be available to answer questions during the Q&A session.

Let's begin our presentation.

Tina Zheng

Good morning, ladies and gentlemen. Welcome to our earnings conference call for the second quarter of fiscal 2014. Overall, our performance was in line with management's expectations, as we added 15,928 new subscribers in the quarter, representing moderate sequential growth, but declined year-over-year largely due to the Dragon Year baby boom in the prior year period.

As of September 2013, the total accumulated subscriber base increased to 343,170. In the second quarter, we continue to build our brand and expand our position, as China's leading domestic cord blood banking provider in terms of local market coverage and service quality, as recognized by the AABB accreditation received by our Beijing subsidiary.

Safety implementation of our new pricing policies at the beginning of the current fiscal year, we have been carefully monitoring the market response to our upwards pricing adjustments for both our processing and storage fees. Based on the increase in new subscribers' numbers in the second quarter with a very significant portion of these customers choosing the upfront payment option, we are inclined to believe that a solid portion of customer demand was not treated by pricing changes.

Management believes this is due to several factors, mainly our deficient focus on the high income market segment, our exclusive rights to all the cord blood banking services in our licensed regions and our premium brand image would continues to expand in the areas in which we operate.

Given our efficient business operations and favorable payment structure, we continue to generate a steady level of operating cash flow in the second quarter of fiscal 2014. In terms of our new capacity build-out, we continue to record good progress.

In Guangdong, our initiative to more than double our capacity to 800,000 units has experienced solid progress and remains on schedule. We expect the new capacity to be ready by the end of March 2014. As our Guangdong operation continues to record steady volume with growing accumulated subscriber base. Our expansion will strengthen our ability to satisfy the demand in the region.

For the Zhejiang province, construction of a new facility is proceeding as scheduled. We strive to complete this project at the end of our current fiscal year. Utilizing our premium brand, sales and marketing expense, we believe we will be able to penetrate effectively into the largely untapped and affluent Zhejiang market, which will be a growth driver in the coming years.

As the market work is way through the after-effect of the Dragon Year and fully adapted to our new pricing policy, management will continue to closely monitor our fund flow data across all relevant regions and work through markets uncertainties to reach our guidance of 65,000 new subscribers for fiscal 2014.

This concludes my overview of our second quarter results and developments. I want to thank you for your support of CCBC. And now I'll turn the call to our CFO, Mr. Albert Chen, to lead you through our financial highlights.

Albert Chen

Good morning, everyone. As mentioned in our CEO remarks, we are slowly moving away from the after-effect of the Dragon Year baby boom. In the second quarter, we added 15,928 new subscribers, which demonstrated a healthy single-digit improvement when compared to the first quarter of fiscal 2014. As of September 30, 2013, our accumulated subscriber base reached 343,170.

Total revenues for the quarter increased by 10.3% year-over-year to approximately RMB142 million, primarily driven by our 33% year-over-year increase in the revenue derived from storage fees from our continued increasing subscriber base.

We also managed to report a modest increase in revenues related to processing fees, as the revised pricing help narrowed the revenue gap caused by the decline in the numbers of babies born across the regions, in which we operate. In terms revenue mix, revenue related to processing fees and storage fees accounted for 71.6% and 28.4% respectively.

Second quarter gross profit increased by 4.7% year-over-year to approximately RMB114 million and our gross margin expanded by 180 basis points to 80.7% compared to 78.9% of last year. This growth was encouraging, particularly given that we processed 14% less volume compared to the same period last year.

Yes, we are able to benefit from the rising contribution from the higher margin storage related revenue and also our timely price adjustment as well.

We recorded an increase in sales and marketing expenses in the second quarter to approximately RMB27.6 million compared to RMB23.5 million in the prior year period. This increase is consistent with our focus on the continued expansion of our sales force to deepen our penetration in Guangdong and the development of our Zhejiang marketing team in preparation for the future launch.

While the sales and marketing expenses may seem high on an absolute basis. We are glad to report that it is by large under control. And as a percentage of revenue, it decreased to 19.5% compared to slightly more than 22% in the first quarter of the current fiscal year. We will continue to monitored sales and marketing expenses and aim to keep them at the current level in the near-term.

Thanks to the team's hard work on monitoring cause and improving administrative efficiency, G&A expenses for the second quarter remain stable at RMB28 million. As a percentage of total revenues, our second quarter G&A expenses further decreased to 20% from 21% in the previous quarter and 23% in the same quarter of last year. This is a great accomplishment considering how operating cost seems to be rising daily.

Combining our result of improved topline performance, modest margin expansion and stringent operating cost controls, operating income increased by approximately 20% to RMB56.3 million. Operating margin also improved 310 basis points to 39.7%. Depreciation and amortization expense for the second quarter were RMB8.7 million.

Now, in terms of non-operating items, we reported an interest expense of RMB16.5 million during the second quarter of fiscal 2014, which was considerably less than ticking US$115 million convertible notes and applied a 12% IIR. As addressed this in our public disclosure, approximately RMB6.8 million interest related expense was capitalized due to the Guangdong capacity expansion and establishment of the new Zhejiang facility.

The second quarter income before tax increased by almost 25% to RMB44.7 million, while margin for this line item improved by 3.7 percentage point to 31.6%. Income tax expenses were higher in the second quarter, because we applied for the first time and additional reporting tax to current and anticipated future payments, which are related to the company's convertible notes.

With the growth in profit before tax accounted by the increase in income tax expenses, net income attributable to company shareholders increased slightly by 0.8% year-over-year to RMB24.9 million in the second quarter. That represents a net margin of 17.6%.

Basic and diluted earnings per share for the second quarter were RMB0.33. In terms of cash flows, cash flows continue to be healthy with a substantial or significant portion of subscribers deciding to adopt an upfront payment options.

Net operating cash flow for the second quarter amounted to RMB121 million, after taking into account the coupon payment made to the company's convertible note holder. Now this is just a very quick overview of our second quarter financial performance. And we rather got more time that we can spend on the Q&A session. So with all being said, I mean, we can move to the Q&A now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Scott Henry from ROTH Capital.

Scott Henry - ROTH Capital

I just want to ask a little bit more about the tax rate. Obviously bumping up towards the 44% level in Q2 was an increase, I know you did mentioned that earlier, but could you give you any guidance on where you expect the tax rate to normalize kind of for the full year 2014 and 2015?

Albert Chen

As mentioned early on, the income tax expenses for the second quarter has jumped as a result of couple of things, but namely related to the convertible notes that we have issued. The increase in income tax expenses to a certain extent is related to the coupon payment, which we need to make and anticipate to make in the future. As a result of that we are actually upsizing or increasing the reporting tax provision as a result of such.

Now in terms of the guidance itself, I would like to highlight that the interest expense -- my apology, the income tax expense is exceptionally high for the second quarter and we do anticipate it to come down because we do have a one-time adjustment in this quarter. I think most of the analyst and investor, I believe, they have a tendency in calculating forward income tax expenses on a pro forma basis or on an adjustment basis.

I think most of the calculation derived are based on using the profit before tax and then add back the interest expense, which incur outside of China, which are not tax deductible, and then minus the dividend income, which we received from Cordlife or from our equity investment in Shandong, in order to derive what they call a pro forma profit before tax.

Now, if you use the first quarter numbers and apply this pro forma methods, you'll probably derive at a effective tax rate of somewhere along the line like 20%. And that should be a good starting point. Now, in terms of the additional tax provisions, because of the CBs, I think one way that you can look at it is to use the effective tax rate based on what I've just told you as a guiding point and then you add approximately RMB1.5 million per quarter, that should give you a good estimates of future tax expenses.

Scott Henry - ROTH Capital

I guess just a final question, your guidance for the year in terms of new subscribers of 65,000, do you look at that more as a goal or what is your comfort level in that number?

Albert Chen

As you know right now we are in a transitional period as we move away from, I'll say, the hangover effect from the Year of the Dragon, so we are actually to a certain extent facing a slight decline in terms of the numbers of babies born in the region, which we service. Now, in conjunction as that we look to price adjustment, which took place in April and May, so we are having this kind of double renminbi effect, which is kind of affecting our numbers of new subscribers that we tick in on a quarterly basis.

However, you're do aware that because of the timely price adjustment or timely price revisions that took place in April and May this year, and although at the same time helped to bridge the revenue gap, as a result of the decline in volume. So with all these being said, I think as of now, I think for the past six months, we have done probably, approximately 31,000 new subscribers for the six months ending September 30. So what that means in order to fulfill the rest of the years or to meet our guidance, we're probably looking at 34,000 at least and this is the target, which we aim to achieve.

However, as pointed out in our CEO remarks, this is not a year without uncertainties. We do see uncertainties and challenges ahead of us in order to meet that number. But we are striving out very best to actually accomplish that. So I guess long story short, is that this year it's different from the Year of Dragon, where you can simply beat the forecast and [indiscernible]. I think this year will be a interesting year, but at least based on the information or the statistic, which come through, we remain hopeful. That's probably the best way to put it, Scott.

Operator

Your next question comes from the line of Brian Tanquilut from Jefferies.

Brian Tanquilut - Jefferies

Just had a couple of questions for you, so in answering Scott's questions, you've talked about your normalization of volume both from the Year of the Dragon lapping and the price increase, so as I think about 2015, obviously '14 is a different year, fiscal '14, but how should we think about your growth outlook for '15 and going forward?

Albert Chen

The way that we look at the underlying markets, the view and the fundamental of company hasn't changed. The transition from fiscal '13 to fiscal '14, the key difference is as because a lot of clients get front-loaded to the Year of the Dragon, which create a abnormal seasonality in these two years.

Now, with that being said, I mean our near-term growth would still be coming from, for example, the continuous penetration in the Guangdong operations. And at the same time, we are paying the rights to operate in the surface of Zhejiang market, which even as of to date, we have not fully launched our operation, because of various reasons.

So we believe that in the near-term, I mean once the new facilities is up and running, it should help to address the concerns that we currently have. So with the maiden contribution from Zhejiang, as well as the continuous penetration from Guangdong, we believe we'll be able to resume a more normalized growth trend. It is not our policy to provide the fiscal '15 guidance as of now. But it is our internal goal to try to achieve a normalized growth rate, which is likely to be around 15%, let's just say, in the quarter next two years and this is what we've tried to achieve.

Brian Tanquilut - Jefferies

And then on Zhejiang, when should we expect that to ramp up? And if you don't mind, just share with us your experience, back when you open Guangdong in terms of how long it took for you to hit kind of like optimal yields on the investment in assets?

Albert Chen

I think there are two fold to your questions. First of all, in terms of the new capacities, we are now striving to get the new facilities completed at the end of the current fiscal year, which is March of 2015. But in the absolute worst-case scenario, assuming that for example, the review and approval process take longer than we expected, we still try to get it done probably in the April and May of 2014, so this is the timeframe.

And with the establishment of the new factories in Zhejiang, we will basically remove the processing capability. So we'll be able to truly reflect our marketing muscle and tap into the Zhejiang market. And as you know the Zhejiang market is above 500,000 babies per annum, so it's a fairly sizeable market to tap into.

To answer the second question, which is regarding how long it takes to reach a plateau period, I regret to tell you that I strongly believe that there is still a lot of room to grow even in the case of Guangdong, so we have not yet reached the plateau in the Guangdong market. But if you look at our previous historical performance for our Guangdong operations, it takes us probably about starting from 2007, I think it probably take about two, three years to run the operation into a really sizeable entity. As of today, Guangdong has been in operation for, this is actually the sixth year now, and it has become a very sizeable animal, but I think is a still growing at a monstrous pace.

Brian Tanquilut - Jefferies

And then last question for you. So I guess it's safe to assume that the lapping of the Year of the Dragon is impacting demand this year and also the price cut? So are we at that point now where you're starting to see at least some improvement, because I figured you've got visibility into your volume going forward, so are you starting to see a demand improvement at this point?

Albert Chen

We've been seeing the gradual adoptions and the conversion rates back to what we're expecting. So that is an encouraging sign, but at the same time because of the price adjustment and our focus in high-end market, so it is inevitable that we're going to lose some bottomline demand. But like I had pointed out early on, I mean the guidance that we gave of this year, which is 65,000, at least based on early indications, I think we have remained relatively hopeful that we can actually meet that target and things so far seems to be performing on track.

Operator

Your next question comes from the line of Yi Chen from Aegis Capital.

Yi Chen - Aegis Capital

My first question is how much money will still need to be spent on the construction of Guangdong and Zhejiang facilities?

Albert Chen

I think based on the current stage. We are still finalizing some of the, I will say, the fine details in terms of the renovation work. So if I may, I would like to provide you with a range between US$20 million to US$25 million as a indications. But I think based on the existing construction timeline or renovation timetable, I think the remaining US$20 million to US$25 million it's very likely to be spent within this fiscal year.

Yi Chen - Aegis Capital

It is safe to assume that the Guangdong facility will finish construction before the Zhejiang facility?

Albert Chen

This is something that we strive to achieve. Right now, I think there is high possibility that the Guangdong operation will finish before the Zhejiang -- sorry, the Guangdong facilities will be completed before the Zhejiang facility, as its bit difficult.

Yi Chen - Aegis Capital

My second question is, could you provide us with geographical breakdown of this quarter's, your subscribers, how much is from Beijing and how much is from Guangdong?

Albert Chen

Well, the second quarter of fiscal 2014, approximately 34% of new subscribers came from the Beijing Municipality area and approximately 58% came from the Guangdong province and approximately 7% came from Zhejiang.

Yi Chen - Aegis Capital

Final question is as the recent government investigation of GSK bribery case in China has any impact at all on your marketing activities?

Albert Chen

We actually don't feel much of a impact, but I think that's crackdown, so it will certainly affect other industry participants. Our operations didn't get affected too much, because in our line of businesses, because we do our own direct marketing to the retail clients, so we don't have a lot of issues and we don't have a lot of dealings with the hospitals from a financial standpoint. And we don't even rely on the hospitals or the employees to promote our service. We have to do our own marketing. So I guess the pros and con to that is that we have to build a very sizable sales force in order to cover all the hospitals that we need.

Operator

Your next question comes from the line of Alberto Bassetto from Jayhawk Capital.

Alberto Bassetto - Jayhawk Capital

Albert, two questions. One is can you tell how the 16,000 new babies paid, actually, the question is already clear, but can you breakdown what's your regular upfront installment, please, for the quarter?

Albert Chen

For the second quarter new subscriber that chose normal payment options are approximately 40%. And approximately 51% of new subscriber chose to pay 18 years of storage fee upfront. And then the remaining is pretty much what we call others, so when we have promotional activities, those fall into others.

Alberto Bassetto - Jayhawk Capital

And going forward, should we consider this kind of breakdown should be maintained?

Albert Chen

Unless we change our market positioning as well as our sales and marketing strategy, based on information available to us, as well as our internal discussion, we believe that we will try to maintain a higher concentration or focus on developing people that have the affordability to pay upfront payment. So in another words, I think that we will try to maintain upfront payment portion as the more significant portion in terms of customer mix and then normal payment options likely to be the second tier or the second most significant group I should say.

Alberto Bassetto - Jayhawk Capital

And then, one thing I would like, if you don't mind to comment, I think you did in one of the prior conference call, is the following. This morning the [ph] Wall Street Journal talk about once again China losing up a little bit the one-child policy, which I don't think that's much new at all, but in a way or the other this point a direction where China as a country is going. So do you mind to share your opinion, how the loosening up of the one-child policy is going to affect your business? I know that is a big topic, but in a couple of sentence can you share your opinion?

Albert Chen

I think the impact or if the government decided to actually loosen up the single-child policy, I think the impact on our spend will probably be either neutral or maybe mildly positive-only. Now because for the customers that we go after, I mean these are already rich and affluent individuals, so I guess their decision of having a baby or not may not entirely related to the existence of a single-child policy.

And on the contrary though, if for the individuals who are kind of reasonably affluent, but not rich to a certain extent and they are concerning about their affordability, if they're going to bring a new baby to this world, this kind of people may not necessarily be the target centers that we are going after because if they have trouble for example bringing food to the table, I guess, cord blood banking to them may seems like to be a luxurious service beyond rich, and as a result of that they may not even consider that.

So my short conclusion will be the impact in our case may seems to be less direct or that's why I said that relax in single-child policy, the impact in our case would probably be neutral to mildly positive. If I am for example selling necessities, such as baby clothing, diapers, shoes whatever, I may benefit immediately from the increasing demand because then simply more babies being born, but because I am not selling a service of necessities, I am not selling commodities, I am selling a quality healthcare service, which only appeal to people that have got a open-mind concept towards clinical application of stem cells and at the same time carries a high economical means.

As a result of that I don't think we will be the first direct beneficiary under the relaxation of single-child policy in China, however, there is no hardcore evidence which we need to believe that there is a immediate relaxation of single-child policy in China. And again, I don't speak on behalf of the company; it's just my personal opinion.

Operator

Your next question comes from the line of [ph] Darren Wang from River Valley Asset Management.

Unidentified Analyst

This is [ph] Darren from River Valley Asset Management in Singapore. Basically I have two questions. The first one is what is the status of the application on the preferential tax treatment in Beijing and Guangdong? I understand that Zhejiang now is also paying 25% tax rate. Do Zhejiang subsidiary enjoy preferential tax treatment next year after the new launch?

Albert Chen

In terms of the tax status to self our Guangdong operation, preferential tax treatment has expired in December 31 of 2012, so we are in the process of renewing that. And if once that tax gets renewed, we'll definitely announce it to the market. But as you know, I mean when dealing with application of such kind, normally it's hard to depict a particular timeline as to when the government is going to grant the preferential tax treatment, but we'll continue our monitor the process.

As for the Beijing operation, Beijing is currently paying 15% and that preferential tax treatment will expire in December 31, 2013, which is a month away. And we will again attempt to renew our preferential tax status, after it expired. So I guess we will be submitting the relevant documents in the following calendar year, namely in calendar year 2014.

As with Zhejiang, right now, I think after we commence a full scale operation, then we'll explore the possibility to apply for the preferential tax treatment. But rest assure, I mean, we will explore any means necessary, because we do believe that given the business that we are in and the prior history or prior record of our Beijing as well as Guangdong operations, we will definitely attempt to apply for a preferential tax treatment in Zhejiang as well.

But just to manage your expectations, normally the first time application takes quite some time to complete. Renewal tend to be easier. So I will say that, normally if it is the first time to apply, you don't necessarily get in the first year. It may take more than a year to actually process it.

Unidentified Analyst

My next question is about the average revenue per subscriber. If we do the calculation for this quarter, but average processing fee per new subscriber has gone up from about RMB5,800 to RMB6,400, which looks very encouraging. In my opinion this is a very good reflection on the new pricing. However, I did the same calculation on the average storage revenue for existing subscribers, that does not show any increments. Do you have any reason for this?

Albert Chen

First, because there are two questions in one question, so I'll probably answer one at a time. The reason that you observed an increase in processing fee per sub comparing the second quarter to the first quarter is because normally our clients sign up prior to the babies being born. And in the case of the April, May and June quarter, because we did the price adjustment in April and May, the new subscriber that should deliver babies in the first quarter, some of them accurate.

Quite a fortunate of them, actually signed the contract prior to our price adjustment. So as a result of that the weighted average processing fee per subscriber in the June quarter is actually lower as compared to the September quarter, because September quarter we have the full quarterly effect on the price adjustment. So which is part of the reason, why the average processing fee per sub is higher in the second quarter as compared to first quarter. And the second quarter average processing fee per subscriber should be a good reference point going forward.

And you also bring out a very good question about the average storage revenue per subscribers. How come the differences is not so significant, because as you imagine we have more than 300,000 subscribers and they all sign up at different time and also at different price point. So you will see the incremental increase in the average revenue per subscriber of storage fees gradually climbing up. But the impact is not as imminent as the processing fees. And I can assure you that that improve in process, it will take longer than the processing fees.

Unidentified Analyst

So we expect to see an upside on the average storage fee per subscriber?

Albert Chen

You should see average storage fee per subscriber crawling its way up overtime.

Operator

At this point, there appears to be no further questions. I will now turn the call back to [ph] Mr. Kevin Zhang

Unidentified Company Representative

This concludes our earnings conference call for the second quarter and first half of fiscal 2014. Thank you for your participation and ongoing support. Have a great day ahead. Thank you.

Operator

That does conclude our conference for today. Thank you for participating. You may all disconnect.

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