China Nepstar Chain Drugstore's CEO Discusses Q3 2013 Results - Earnings Call Transcript

Nov.26.13 | About: China Nepstar (NPD)

China Nepstar Chain Drugstore Ltd. (NYSE:NPD)

Q3 2013 Earnings Call

November 26, 2013, 8:00 AM ET

Executives

Dixon Chen - Investor Relations, Grayling Global

Fuxiang Zhang - Chief Executive Officer

Zixin Shao - Chief Financial Officer

Analysts

Ryan Roberts - China Stock Research

Operator

Greetings, and welcome to the China Nepstar third quarter 2013 earnings call. (Operator Instructions) It is now my pleasure to introduce your host, Dixon Chen with Grayling Global. Thank you, Mr. Chen, you may begin.

Dixon Chen

Thank you. If you have not received a copy of Nepstar's third quarter 2013 earnings press release, it is currently available on the company's website at www.nepstar.cn. A presentation to accompany today's call and live webcast is also available on the website under the Investor Relations section.

Before we start, I would like to remind you that certain statements are not of historical facts made during the course of this conference call about future events and financial results constitute forward-looking statements that are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. You should note that the company's actual results may differ materially from those projected in these statements due to variety of factors affecting the business.

Forward-looking statements are subject to risks and uncertainties. Discussions of factors that may affect future results are contained in our filings with the Securities and Exchange Commission. We undertake no obligation to correct or update any forward-looking statements provided as a result of new information, future events or even changes in expectations.

Joining us on today's call are Mr. Fuxiang Zhang, Chief Executive Officer; Mr. Zixin Shao, Chief Financial Officer. I will be your translator during the question-and-answer session. We will be translating question and answers and ask for your patience at that time.

With that, I would like to turn the call over to Mr. Zixin Shao, our CFO. Mr. Shao, please go ahead.

Zixin Shao

Thank you. Good morning and good evening to all of you. Our strategy of strong promotional activities and our marketing campaigns continue to deliver strong revenue. During the third quarter, daily store traffic increased by 11 visits and same-store sales grew by 10.5% compared with the third quarter of 2012.

Our sales momentum garnered attention internally among store staff, as well as externally from our suppliers, who have shown their support. We believe that we are well-positioned for the recovery of the retail pharmacy industry in China. While this strategy has had a near-term impact on our gross margin, we believe we will make it up through positive contributions to our market share, customer relationships and long-term growth prospects.

I will now review results for the third quarter. During the third quarter, we opened 32 new stores and closed 44 stores. As of September 30, we had 2,059 directly operated stores in total.

Revenue for the third quarter of 2013 increased 7.7% to RMB683.2 million or US$111.6 million from RMB634.6 million for the same period in 2012. Same-store sales for the 1,925 stores opened before December 31, 2011, and are still operating, increased by 10.5%, again this was primarily due to promotional initiatives aimed at increasing store traffic.

Revenue contribution by product category was 23.1% from prescription drugs; 38.2% from over-the-counter drugs; 15% from nutritional supplements; 3.9% from herbal products; and 19.8% from convenience and other products.

Third quarter gross profit was RMB289.6 million or US$47.3 million, a slight decrease from RMB293 million for the same period in 2012. Gross margin was 42.4% compared with 46.2% for the same period of 2012. The decrease in gross margin was primarily the result of our more aggressive marketing strategies for certain pharmaceutical products, nutritional supplements and convenience products.

The company's portfolio of private label products increased to 2,103 types of products as of September 30, 2013. Sales of private label products represented approximately 24.4% of the total revenue and 33.4% of gross profit for the quarter.

Sales, marketing and other operating expenses as a percentage of revenue decreased to 38.3% from 40.1% in the same period of 2012. This decrease was primarily due to growth in same-store sales and the closure of underperforming stores.

General and administrative expenses as a percentage of revenue in the third quarter was 5.2% compared with 5% for the same period in 2012. This increase was mainly due to RMB5.7 million or US$0.9 million penalty imposed by Price Bureau of Yuexiu District in Guangzhou City of Guangdong Province on our subsidiary Guangzhou Nepstar for non-compliance with certain local government-guided pricing policies.

During the third quarter, the company recognized an impairment loss of RMB1 million, which represented a reduction of the carrying amount of the property and equipment of certain underperforming stores.

Loss from operations in the third quarter of 2013 was RMB8.5 million or US$1.4 million compared with income from operations of RMB4.2 million in the same period in 2012. The loss from operations in the third quarter of 2013 was mainly due to lower gross margin and the above mentioned RMB5.7 million or US$0.9 million penalty.

Interest income for the third quarter was RMB3.9 million or US$0.6 million compared with RMB3.6 million in the same period in 2012. Dividend income from cost method investments was RMB3 million or US$0.5 million in the third quarter compared with nil in the same period in 2012.

On December 28, 2012, we completed the sale of its entire 40% equity interests in Yunnan Jianzhijia Chain Drugstore Limited for a total cash consideration of approximately RMB81.5 million. So equity in income of an equity method investee was nil in the third quarter of 2013 compared with RMB0.3 million in the same period in 2012.

Excluding the effect of the above mentioned penalty at RMB5.7 million or US$0.9 million from loss before income tax expenses, which is not tax deductible, the company's effective tax rate was 75.3% for the third quarter of 2013. The company's income tax expenses was RMB3.1 million or US$0.5 million for the third quarter of 2013 compared with RMB6.3 million for the same period in 2012.

As compared to the PRC statutory tax rate of 25% applicable to our major operating subsidiaries, the difference in effective income tax rate for current quarter was primarily due to non-deductible expenses and the relatively high amounts of operating losses from loss-making subsidiaries, for which full valuation allowances were made on their deferred tax assets as compared to the overall results of the company.

Net loss for the third quarter of 2013 was RMB4.7 million or US$0.8 million, which represented RMB0.05 basic and diluted loss per ADS. Net income for the third quarter of 2012 was RMB1.9 million, which represented RMB0.02 basic and diluted earnings per ADS. Net cash flow from operating activities in the third quarter of 2013 was RMB10.6 million or US$1.7 million compared with RMB0.05 million for the same period in 2012.

As of September 30, total cash, cash equivalents, short-term and long-term bank deposits were RMB665.3 million and US$108.7 million. Shareholders equity was RMB1 billion or US$167.3 million. This compared with total cash, cash equivalents, bank deposits and restricted cash of RMB664.4 million and the shareholders equity of RMB1.03 billion as of December 31, 2012.

Now for our outlook. Fourth quarter is important for us. As winter is the high season for cold-cough medicines and nutritional supplements, we are working hard to maintain same-store sales growth and per store transactions. Our focus remains on optimizing product mix and improving margins.

With that, Mr. Zhang and I will address your questions. Operator, please begin the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first questions today's coming from Serena Shao with Merrill Lynch.

Unidentified Analyst

This is [ph] Richard asking question on behalf of Serena. Today my first question is what is to drive -- this trend in decline gross margin going to continue in the coming quarters? This is my first question.

Dixon Chen

Can you repeat your first question?

Unidentified Analyst

What is driving the gross margin decline? And is this trend going to continue in the coming quarters?

Dixon Chen

Okay.

Unidentified Analyst

Regarding the penalty in this quarter, can you give us -- are Nepstar the only drug store and do you see any risks or penalty to your stores in other cities in China? Your same-store growth to be very strong and your store closing continues, like you keep closing your stores. At what point you will to take advantage of your new product mix to grow new store sales?

Fuxiang Zhang

To answer your first question, it's part of our competitive strategy to continue to expand our market share to drive store traffic. And in the near term, we see some of the headwind on our gross margin. We will continue with our strategy to increase our competitiveness in this marketplace in the coming quarter. However, we expect to maintain our gross margin above 40% gross margin.

To your second question regarding the penalty, probably helpful to take you back to a little bit background from one of the government policy back in August 2010. In Guangdong Province, August 2010, there was a policy, specific targeting drug sales where we caught three area of price control.

First is the price coming out of OEM drug producers, they have a price ceiling for. And second is a wholesale markup percentage and they've set a maximum markup percentage for the wholesalers. And lastly is for our retailers, because they give us a markup percentage ceiling. For retailer, our markup can no longer exceed 35% at that point. So it was very challenging policy to affect our business.

At that time, this policy in Guangdong Province had what we could label as a trial policy in order to control the price to give patients a better access to reasonable priced pharmaceutical product. However, because of those intentional ceiling setup has affected a lot of businesses, especially the retail businesses. And a lot of retail company think these, that the government stipulated policy is very irrational and does not reflect a market condition and the market economy itself.

And a lot of industry players in the retail pharmacy space together filed some complaints and has been in multiple rounds of communication with the government. And the feedback is quite positive that came back from the government. They realized this is not the most reasonable price control policy. So there has been some change ever since.

Because Nepstar is a fairly large retail pharmacy in China, we oftentimes conduct a large scale procurement that give us advantage of lowering the procurement cost. That alone also affected our gross margin, because we can procure a large volume product at a relatively cheaper price.

So that affected our gross margin in a positive way. So our gross margin is exceeding 35% in Guangdong Province at that time. We also realized that -- so we have engaged more proactive communication with Price Bureau in Guangdong Province and seeking a solution for that.

Recently we have received a notice from the Price Bureau, some of the policymakers, some of the findings they have, throughout their investigation during that time. We have exceeded the 35% threshold they set during that period and the total amount reached RMB2.8 million excessive profit by the Price Bureau's standard.

So as one of those penalty arrangement, we have to pay twice of that, so we end up paying RMB5.6 million for that period of time as a violation of the price policy. And after that we have been more active in communicating with Guangzhou City Price Bureau as well as Guangdong Province Price Bureau, we are looking for some kind of discount going forward. And so for this quarter, what we have received is the lowest penalty within their range.

Based on our knowledge of other cities and provinces, we don't believe there will be similar risks in terms of price control violations. We are in close talk with Guangdong and Guangzhou City to help the government continue to adjust their policy. Hopefully, we'll be able to see a more positive contribution with the policy change in the region.

And we are increasing our marketing and promotion program. We are already seeing a sustainable same-store sales growth in the past number of quarters. And we believe with this momentum, some point mid next year, we will be back on track to reopen new volume of stores.

Operator

Our next question today is coming from Ryan Roberts with China Stock Research.

Ryan Roberts - China Stock Research

My first question is if you could give us some additional color on where you are in the overall turnaround process, in terms of improving margins. And you just mentioned that mid next year, you are to add some more capacities, some more stores to the network. Can you give us an idea kind of a bit more color on kind of where you are overall in terms of also the profitability outlook?

Fuxiang Zhang

Based on our goal to continue to expand our competitiveness and also market share, we want to maintain our gross margin above 40% going forward.

Ryan Roberts - China Stock Research

I guess if I could ask a quick follow-up on that. Could you give me an idea of profit-wise, how management thinks that the progress is going in terms of optimizing the mix? And it sounds like you're almost there, is that what I read by the mid next year kind of add new store growth?

Fuxiang Zhang

The product mix has been on good track. So we're seeing the store efficiencies has been improved. As a result, same-store sales has gone up as well as the total revenue has gone up. So this giving us more confidence, that's why we're looking mid next year, we'll probably be back on track to open more new stores.

Ryan Roberts - China Stock Research

Can I ask one more question?

Dixon Chen

Sure.

Ryan Roberts - China Stock Research

On the more kind of a macro kind of a condition question in terms of how, we discussed some of the price control issues and I guess something that's been a factor for some of the drug sales in the past. Does management have any kind of view, any kind of sense, of what's going on there in terms of what made change in the industry to kind of be a positive factor, be kind of a tailwind, going forward?

Dixon Chen

Can you repeat your last question?

Ryan Roberts - China Stock Research

Yes, I said does management have any idea, any view on what are kind of the macro conditions for drug retail companies? I think in the past, it seems like the price controls have been obviously been a factor, but I was wondering if they had any view, any insight on the trends that maybe developing?

Fuxiang Zhang

We still see some of the headwinds from macro perspective. For example, the new GSP policy is going to have some impact to the drug industry. And however, we also see some of the opportunities because of the competitive landscape, smaller chains and smaller mom-and-pop shops, now are facing a very dire situation. So it gives us a large established chain of good opportunity to grab more market share. So overall, I think the macro is heading in a good direction.

Operator

We have reached the end of our question-and-answer session. I'd like to turn the floor back over to management for any further or closing comments.

Fuxiang Zhang

Thank you for your support, our shareholders and analysts. Fourth quarter is going to be a key quarter for us. We will continue to focus on the sales growth as well as market share expansion.

With our topline growth and same-store productivity improvement, we believe at some point our margin is going to turn a corner. We have to thank our investors and shareholders, who continue to be supporting Nepstar's long-term growth perspective.

Dixon Chen

With that, we reached the end of our third quarter earnings call. Thank you for participating in Nepstar Q3 earnings call. We look forward to speaking with you.

Operator

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time. And have a wonderful day. We thank you for your participation today.

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