Synutra International's Management Discusses F3Q2014 (Qtr End 12/31/13) Results - Earnings Call Transcript

| About: Synutra International, (SYUT)

Call Start: 8:02

Call End: 8:56

Synutra International, Inc. (NASDAQ:SYUT)

F3Q 2014 Conference Call

February 11, 2014 8:00 am ET


Weiguo Zhang - President

Clare Cai - CFO


Bo Pang - Oppenheimer


Thank you, everyone, and welcome to Synutra International Third Quarter Fiscal 2014 Earnings Conference Call. With us today are Mr. Weiguo Zhang, Synutra President; and Ms. Clare Cai, Synutra CFO.

Before we begin, I will read the forward-looking statements. During this conference we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on our current expectations, assumptions, estimates and projections about Synutra International, Inc. and its industry.

All statements other than statements of historical facts in this conference call are forward-looking statements. In some cases, these forward-looking statements can be identified by words or phrases such as anticipate, believe, continue, estimate, expect, intend, is or are likely to, may, plan, should, will, aim, potential or other similar expressions.

These forward-looking statements speaks only as the date hereof and are subject to change at any time and we have no obligations to update these forward-looking statements.

I would now like to turn the conference over to Synutra's President Mr. Weiguo Zhang. Thank you sir, please go ahead.

Weiguo Zhang

Thank you, operator. Good morning and welcome to the Synutra International third quarter fiscal 2014 earnings conference call. Today, I will begin with update on our operational initiatives. Then Clare will review our financial results and outlook in more detail. After that we will conduct a question-and-answer session.

Overall, we were quite pleased with our fiscal third quarter results. Net sales grew 14% sequentially and net income to shareholders grew 64% sequentially, primarily driven by stronger than expected sales in our infant formula segment, and the consequential operating leverage in our margin.

The powdered infant formula business we enjoyed increase in sales volume and alleviated ASP levels compared to average powdered results due to several important growth initiatives.

First, some of our competitors have scaled back their activities in hospital channels as the Chinese Government increases emphasis on the ban of illegal promotions of infant formula in hospitals. You may recall that a certain key multinational corporation competitor of ours was under investigation in September 2013, due to a bribery scandal.

Whatever the company was alleged to have bribed the doctors and nurses to recommend their infant formula to parents of newborns, we believe Synutra has benefited from this saturation as we are now the only licensed domestic producer of medical-purpose specialty formula, which is required to be used under the direction of the doctors for national manufacturing and usage standards of these products.

As a result, we have continued to visit hospitals in China to introduce our specialty formula products and optimize our interactions with doctors and healthcare professionals. As only licensed domestic producer of medical-purpose specialty formula, we are committed to maintaining the highest ethical vendors.

During the fiscal third quarter, we allocated our marketing budgets and effort to provide educational seminars about our specialty formula for doctors and nurses, as well as seminars on general healthcare and breastfeeding topics for parents of newborns. As a result, we have seen a pickup in sales volume of specialty formula products.

Second, we have taken advantage of the Chinese Government support of domestic dairy manufacturers and industry consolidation and acquired a leading infant brand to augment our market position. In November, we acquired YOUTH-BASE, a regional formula brand previously owned by Shanghai Newbaze, nutritional dairy product company. This brand acquisition provides us with a new distribution network in the Heping (ph), Jiangsu, and Zhejiang provinces contemplating our traditional geographical focus in the central and northern China region.

Under the terms of this brand acquisition, Newbaze will continue to manage the sales operations of the YOUTH-BASE trends exclusively and Synutra will take over its R&D and supply chain management including raw material sourcing, manufacturing, and quality control.

We are still in the process of transferring the ownership registration of the YOUTH-BASE trends with the required authorities. Therefore there is no revenue contribution from this acquisition in the third quarter; however when fully up and running this trend is expected to contribute $10 million to $20 million of sales annually. This is an important prospect for Synutra to adhere to the Chinese Government's call for cooperation and restructuring a non-domestic dairy company. Going forward, we will continue to selectively evaluate other brand acquisition strategic cooperation opportunity with industry partners in an effort to expand our platform and market position.

Third, as the quality and trusted brand Synutra is in line with the Chinese government's determination to improve food safety. Our products have met all standards issued to-date and we will continue to implement any changes introduced by new regulation. In December, 2013 the Chinese State Food and Drug Administration updated the national guidelines for the renewal and reaffirmation of production licenses for manufacturing infant formula products in China. For any infant milk formula manufacturer whose license is expiring in 2014, the renewal process needs to be completed by March 31, 2014. For any infant formula manufacturers whose license is expiring in subsequent years the reaffirmation needs to be completed by May 31, 2014.

This regulation sets new rules and raises the bar for infant formula producers in nine areas including product safety control, purchase of raw materials, formula production inspection, manufacturing process, and product traceability. In particular the requirement of 100,000 grade clean space to meet the medical grade Good Manufacturing Practice is widely considered as the most challenging requirement in order to pass the examination and reaffirm and renew production licenses for our Qingdao and Zhangjiakou plants. We expect to incur approximately $2.5 million to $3 million in capital expenditures to meet the clean space and other requirements. Given that we already utilized advanced production methods that are largely in line with the new guidance. We do not expect any meaningful obstacles to passing the government exam and are confident we will obtain the required domestic production license before the deadline.

Overall we welcome these changes with new regulation, as they will ultimately benefited stronger and quality focus for users like Synutra and lead to new growth opportunities.

At this point, I would like to turn the call over to Clare to review our financial results as well as provide outlook on our business. Clare?

Clare Cai

Thank you, Weiguo. I would like to first review our financial performance in the third quarter. For the third quarter of fiscal 2014, our net sales were $101 million compared to the $88.6 million in the previous quarter. This exceeded our original guidance of $85 million to $90 million.

The branded powdered formula segment contributed $86.2 million or 85% of net sales in the quarter compared to the $71.7 million or 81% of net sales in the previous quarter. This performance was primarily driven by 29% increase in sales volumes 6,449 tons from 5,004 tons in the previous quarter. This reflects the continuous positive effect of the Goldmining strategy and was further augmented by additional discount incentives. However, I would like to note that at this -- at the consumer level, we have not rolled out any major promotional campaign since the beginning of calendar 2012 and the improving sales results in the last few quarters were a strong validation of our brand equity and market base.

As mentioned in last quarter's call for the third and fourth fiscal quarters, we are providing an extra 2.5% discount to our distributors to incentivize them to accelerate shipment activity during our most active selling period. It's also worth noting that during the fiscal third quarter we experienced an increase in the sales of product formula, a popular gift during the Chinese New Year. The added formula sells at roughly half the retail price of our instant formula brand and consequently carries lower margins.

As a result, average selling price per ton for the branded powdered formula increased by 7% from an exceptional second quarter, but remains at a high end of our historical range which is $13.04 per kilogram.

Net sales from the Nutritional Ingredients segment was $6.3 million or 6% of net sales, an increase from $5.3 million or 6% of net sales in the previous quarter. We continue to execute shipment orders from our customers who are under annual supply contracts and such (inaudible) and volume will help us manage production costs and turn this segment profitable in a few quarters.

Net sales from other products, which mainly consists of imported whole milk powder and whey protein sold to industrial customers was $8.6 million or 8% of net sales compared to $11.6 million or 13% of net sales in the previous quarter.

As noted before, sales to industrial customers will continue to be optimistic as we are currently buying raw milk powder from Fonterra month-to-month giving that their current raw milk product price is well above the historical average. We will have limited access raw milk powder inventory in the other segments over the course of the next one to two quarters.

Gross profit in the third quarter was $40.3 million, up from $38.9 million in the previous quarter. Gross margin in the period was 40% compared to 44% in the previous quarter. Powdered formula gross margin was 50% compared to 53% in the previous quarter primarily due to lower ASPs and the continuing increase in raw milk powder prices.

As we discussed last quarter 7.5% increase in raw milk powder prices would result in 1% reduction in the gross margin in this segment. We depleted the lower cost raw milk powder inventory that we built up in 2012, in August of 2013, and began pushing to month-to-month at the current market price. Therefore this total production cost fully reflects current elevated market prices and we expect unit prices to remain stable, if not lower, as New Zealand enters summer in the coming quarters.

Income from operations was $11.9 million or 6% quarter, well increased from $8.9 million in the previous quarter. Collectively sales, dispositions, advertising and promotion expenses were $22.3 million, comparable to $24.3 million in the prior quarter reflecting our improved operating leverage on sales expenses in these areas as well as improved management on flexible expenses and less advertising in this quarter.

General administration expenses increased to $6.5 million from $5.8 million. However, G&A expenses as a percentage of revenue increased to 6.4% from 6.6% in the previous quarter. Overall, our operating expenses decreased sequentially from $30 million to $28.4 million.

Third quarter net interest expenses decreased sequentially to $2.8 million from $3 million. Our quarterly net interest expenses continue to remain stable at or below $3 million. We do not expect to experience an impact of interest expenses related to the project financing for our French project until fiscal 2015.

Third quarter income tax expenses remained stable at $14,000. We continue to utilize our deferred tax assets in this quarter, which largely reduced our tax expenses to zero although the full valuation allowance is provided on this asset category.

Net income attributable to common stockholders was $10 million or $0.17 per share for the fiscal third quarter compared to net income of $6.1 million or $0.11 per share in the previous quarter.

Looking at the balance sheet, we ended the third quarter with cash and cash equivalents of $61.6 million, and restricted cash of $123.8 million which includes the current and non-current portion. Total cash including restricted and non-restricted portion was $185.4 million versus $207.7 million at the end of last quarter. The reduction in cash was mainly due to our efforts to reduce debt and pay for capital expenses related to the French Project which are discussed in detail in our 10-Q.

Total debt was $295.2 million compared to $308.5 million as of September 30, 2013, we will continue optimistically retire our existing debt mix as our operating cash flows continue to improve.

Net accounts receivables decreased to $18.1 million from $26.3 million, while our sequential inventory position increased to $91.8 million from $75.3 million.

For the fiscal third quarter, cash generated from operating activities was $8.9 million compared to net cash generated from operating activities of $29.3 million in the previous or net cash generated from operating activities of $31.2 million in the prior year quarter.

Cash flow for capital expenditure in the third quarter was $17.6 million compared to $5 million in the previous quarter. This includes the CapEx for the French project.

At this point I would like provide an overview of fulfillment and update during the fiscal third quarter regarding the French project, which is a drying facility we are developing in the city of Carhaix in the Brittany area of France.

During the fiscal third quarter, we continued to make important progress on both the engineering and procurement side of the Project. We have signed a €40 million equipment supply contract with SPX, a company based in North Carolina, to manage the design, construction and delivery of the main evaporation and drying equipment for the project. We will tie up with the board an engineering, procurement and construction contractor based in Paris to supply the (inaudible) and the pipeline work at the project site soon.

On January 10, 2014, we held the ground breaking ceremony for the project, which was attending by Mr. Pierre Maille, President of General Counsel of Finistere of France, Mr. Wu Xilin, Minister-Counselor of Economic and Commercial Affairs in Chinese Embassy in France, and Mr. Pan Nuo, President of Bank of China Paris Branch, and our Chairman Zhang Liang. We expect to receive the environmental impact study report for the project around April of 2014 after which we can sign the EPC contract for the above ground construction work, finalize the project loan agreement with Bank of China Paris branch and start the above ground construction work.

However, as we have previous stated the timing of the completion of regulatory approval and loan agreements are not within our control. Due to elections at the local provincial government, our current expected timing to receive the approval for the environmental impact study is about six months later than our original expectations.

And now for our outlook for the first quarter of fiscal 2014, we currently expect total sales to be in the range of $90 million to $100 million. Net profit margin is expected to remain relatively stable compared to the level in the third quarter with the net income expected to be in the range of $9.5 million to $10.5 million.

This concludes my prepared remarks for today's call. Operator, please open up the call to questions.

Question-and-Answer Session


Thank you. (Operator Instructions) Our first question comes from the line of Bo Pang from Oppenheimer. Please ask your question.

Bo Pang - Oppenheimer

Hi. Can you hear me?

Clare Cai


Bo Pang - Oppenheimer

This is Bo, asking question on behalf of Ingrid Yin. So good morning Clare and Weiguo and congratulation on a strong quarter. So my first question is regarding the second batch of government's about infant formula companies. So why Synutra not trying to like enter the second batch of these companies in the January 2014, what's the reasons behind it?

Clare Cai

Hi Pang, actually Bo, I'm happy to answer your question. We were invited to join the second batch of recommended brands organized by the Chinese Association of Dairy Industries. However, unlike some media reports, the recommendation is purely for the branding purpose. We do not see or expect any monetary or policy support for those recommended brands, especially in the M&A or CapEx expansion areas.

And the reason we declined to participate in the second promotion event is because we are number five among the most domestic players and we have always positioned ourselves as with international raw material source and also with our French project and origin as a joint venture between Chairman Zhang and the office bearers.

We have always positioned ourselves as a internationally leading brand or with internationally leading quality. And some of the 12 recommended brands actually regional players, which were mostly unheard of outside of the region. So in between, we viewed as was a leading brand with international quality versus being viewed side-by-side with regional players we choose not to participate.

And we've seeing similar promotion organized by the industry expectation in other in the consumer industry and we do not see a significant impact on the sale by just being picked by the industry expectation. Eventually it will be our individual dialogue communication with the consumers that will set the branding, the brand power.

So with all these considerations we decline to participate in the second batch, but should the national policy changes and there is monitorial policy favors for leading domestic brands for M&A or CapEx or other areas given our market position, we fully expect to still be a very valid contender to receive those support.

Bo Pang - Oppenheimer

So are you it's not that important to enter the bunch benches of company. So how is your --?

Clare Cai

I think it depends on your existing position verses the recommendation for those small original players definitely being listed in the -- it is a recognition by the nationwide industrial expectation. So there are like four or five regional players, who hardly heard off before they gain the national recognition. So it's good for them, but for us we are already a top player so.

Bo Pang - Oppenheimer

Yes, so actually almost all of the well-recognized local brand has entered and it doesn't matter the first batch itself, the second batch itself. In the future, you're not going to make any efforts on this anymore right?

Clare Cai

Well, it depends on if there will be future recommendations or future events and depending -- depends on the nature of future government organized promotions if there is concrete support such as expenses, allowances, before marketing campaign, advertising and that would be a different story.

Bo Pang - Oppenheimer

And regarding your gross margin, just wondering it's kind of mixture of your production mix and the cost inflation. So looking forward what do you think and what's your expectation of your gross margin trend?

Clare Cai

As I've noted in the call that the unit price for the production cost, the cost you pay for raw materials and to make a can of formula is expected to remain at the current level or come down if Fonterra's volume price come down this season. The margin wise we also expect our ASP to remain stable or if not increase because as I also said December and January is a peak season for our adult formula product, which are only half priced compared to the infant formula price and we expect the volume of that category to come down in the coming quarters. So we expect gross margin will remain at current level if not improved.

Bo Pang - Oppenheimer

So yes, I'm still a little bit loss about the ASP decline around 7% sequentially. So what should I expect looking forward on the ASP trend still maintain at that level?

Clare Cai

Should remain stable if not improve. We should see a -- we should -- well two growth areas of our business are the specialty formula segment category, which carries a higher ASP, higher unit price compared to other products, and the newly acquired brands where we would have exclusive marketing arrangements with existing brand operator or distributor. So for the newly acquired brands we would have lower ASPs, lower gross margins but high net margins because we do not have any sales costs with those expenses and we will be -- dollar wise we'll be incremental to net income. And so in terms of ASPs it will be at the mix of the two, the gross of these two segments.

Bo Pang - Oppenheimer

So about your specialty formula it's doing quite well in the last quarter. So we are wondering could you please introduce a little bit about comparative dynamic here in hospital channels because we know Mead Johnson, Wyeth, and Abbot something like this multinational brands quite strong on the hospital channel. So how -- what's your strategy to compete with them. I know you took advantages of them last quarter due to the interruption or something. So looking forward what's your strategy here?

Clare Cai

I think you are -- your question covers two points. One is our marketing or penetration in the hospital channel, the other is our specialty formula product and to answer your -- I will start with the specialty formula product. I said in the call we are the only manufacturer who is licensed to produce specialty formula products within China. The multinational brands have imported specialty formula products in China in more amounts because it's still a great area in whether they can import specialty formula which will be, each country would have their own standard for their specialty formula. So in terms of the ability to supply the market we are unique for now and we expect this advantage to last at least for the next one or two years.

And specialty formula category, one statistic that I've seen, it accounts for 20% of U.S infant formula market. Even in Brazil its 7% of the overall market. It's a very small fraction for the Chinese market and that's understood and understandable because there's only one guy allowed to manufacture. But in any ways it's a segment with high growth potential and we are putting just by itself is a very good product to promote and to enhance our brand image, enhance our position with the doctors and hospitals.

And in terms of its giving us premise or reason to visit hospitals after the Dumex scandal in September. That it's really has really a great hub. As we've had there are multinational brands all have strong hospital network. But as far as we, we've seen all hospitals have been very careful to communicate with infant formula manufacturers after the September media reports Dumex, and they are very necessitate in cooperating or working with the infant formula manufacturer. It is not allowed to promote infant formula in hospitals where breast feeding should be advocated.

It's not only a Chinese regulatory prohibition it's also international law. However specialty formula under the National Quality Standard and guidance should be used under the provision and guidance of doctors, and that's why we need to visit the hospitals to introduce our product to the doctors and so that they are able to give directions to the patients -- to their parents.

So we are still within hospitals organized conferences for the doctor to educate the doctors. I can't see a business as usual for the communication with hospitals because they are transparent but we definitely are legitimate and a much more hungering or actively approaching the hospitals compared to all of our competitors.

Bo Pang - Oppenheimer

So some follow-ups here. Could you please breakdown the gross contribution of your specialty formula here in this quarter? And as a only licensed owner I think producer of the specialty formula as you said, do you of course see domestic competitors participating into this segment in the short future?

Clare Cai

The contribution this year sales has increased tempos compared to last year. We obtained the license in March of 2012. So fiscal year '13 is the first fiscal year to launch the specialty product. And fiscal year '14 we expect a tempo to growth in sales. Right now the sales contribution per doctor is about 6% of overall sales, and we expect further strong growth in the six months and next year.

In terms of when do we expect other manufacturers to gain the specialty license? I think what I heard from the market is that every grant has emphasized their specialty product after -- since the summer. And all multinational companies have the manufacturing ability outside of China to make such products and so this is not unfamiliar concept or unfamiliar product for them. But as to when the license will be issued within China by the Chinese Food and Drug Administration especially after development.

Bo Pang - Oppenheimer

So the barrier of entering the segment is not, I mean, is not that vigorous, right?

Clare Cai

In terms of technical barrier or -- well technical or non-technical --

Bo Pang - Oppenheimer

Regulatory, so what you find the right I mean here?

Clare Cai

There is a regulatory barrier which will go up to the development.

Bo Pang - Oppenheimer

Regarding to the production permit renewed by June 2014, so is there any additional expenditure or something required here to go forward?

Clare Cai

The total expense is for our two sites, two components to the guidance. We have also included some periodical CapEx on to go on at the same time as we close down factory to renovate. The total expense is only $2.5 million to $3 million. So it's not very high cost. Although it sounds very hi-tech the 100,000 grade clean space. But in essence it's basically a healing and ventilation issue. So the cost to generate -- to make a 100,000 grade clean space is approximately 2000 to 3000 R&D per square meter, so that's not very high. And how largely clean space needs to be depends on the layout of the plan. Based on our plans we are going to do some other renovation together with this ventilation upgrade such as surveillance camera, electronic wiring, so with all these in it's only $2.5 million to $3 million, which is high.

Bo Pang - Oppenheimer

So about your SG&A expense ratio it improved a lot in this quarter. So how should we think of this, can we look at like a stable trend looking forward?

Clare Cai

The most significant item that helps the margin was we have much lower advertising cost this quarter compared to the last quarter. But that more periodical, we have annual advertising budget as to when we do add with specific media will be from time-to-time. So I think the margin wise, we have operating leverage this two-thirds of those expenses are flexible and grow upwards with sales and what's one-sixth that's the rough number. So with the one-sixth of sales expense, sales and advertising expenses being fixed, we will see operating leverage. And the G&A expense is fixed by nature and there will be operating leverage. So in terms of SG&A expense as a ratio of sales will go down with our sales, as our sales grows.

Bo Pang - Oppenheimer

And are you going to increasingly invest into your e-Commerce channel or penetration, because we monitor that the channel and we again find a lot of surprise from the data of the nutra. So we want to hear your voice on it.

Clare Cai

Yes, we are still highly interested and confident in the expense of this channel and we are planning for strong growth for the e-Commerce panel for in our -- we are in the process of building up next year's budget and we are expecting strong growths for this channel for next year. As we've introduced before we have a online only -- e-Commerce only brand, which is fully imported the infant formula category product and we will be focusing on the promotion of this brand and as well as other categories that we find to be suitable for e-Commerce for the next fiscal year.

Bo Pang - Oppenheimer

Any specific ideas about the development of e-Commerce channel like O2O platform application?

Clare Cai

We have some ideas that we have in mind. But I prefer to provide a more concrete update next quarter, when we provide our next fiscal year's forecast and we would like to provide a complete and well budget out explanation of why we think the numbers for next year will look like this and that. Right now we are still in the budgeting process and well although the general direction is positive the retail tactics needs to be verified internally.

Bo Pang - Oppenheimer

So one big question here regarding the whole industry. So what's your outlook for the China infant formula industry trend in fiscal year '15 and beyond and how much incremental do you expect from the loosened one child policy? And the last one is what do you think about the competitive dynamic between the domestic player and the multinational players? Who should be the beneficiary here?

Clare Cai

I would expect it would be a second child policy or one child policy the sell side analyst report after the announcement of the policy that I've seen have had the impact on new born rates but percentagewise we see the lowest is 7%, the highest is 15%. In terms of infant formula consumption, says newborn, stage one is about half of the consumption of overall consumption or 45%. So the immediate next year impact will probably be divided into half. So it will be 3.5% to 7.5% in the consumption volume. That is -- the volume has been in the last one or two years has been flat. So that's an incremental volume. The growth of last one or two years of this market has been driven by ASP growth. We will say, in this way, the government interference in the industry since May, although ASP grows on the same product as things slowed but the upgrade of product mix has continued. For example our specialty, the launch of our specialty formula product is also one way to improve our product mix and --

Bo Pang - Oppenheimer

How much higher is your price at specialty formula over the routine?

Clare Cai

It's usually 100 on the higher per can, depending on how special the product. There are I think 18 products in the category and some are very, very special lots, for very special, like medical purpose and more drop-line such as lactose intolerance or prematurity, those are cheaper. But I think on averages though we're 100 yen per can in different or per kilo.

So back to the market growth, the marketwise ASP will continue to grow and the two forces combined, we think the market will continue to grow at 10% to 15%, although may be lower than the growth we've seen in the last five years, we're still expecting strong growth industry. That's to the market growth.

And in terms of competition, what we've seen from the Dumex market share change since August when they had this quality concern related to Fonterra yearly supply, is that 80% of the market share lost by Dumex went to multinational players. Only 20% was captured by domestic players. So I think overall with the government support for the domestic players, the trend is shifting towards the domestic players, but it will be very gradual because Dumex fall out, has proven that the consumers for multinational brands, they do have preference for multinational brands over the domestic brands. If one brand is reported to have problems they would switch to another multinational brand. So the shift to domestic brands will be gradual. However for the leading domestic brands, you will see more consolidation opportunities for them similar to ours, not similar. For example our news base acquired acquisition, one way to grow our market share.

Bo Pang - Oppenheimer

My last question is I just wanted to confirm the applicable ETR for the future?

Clare Cai

ETR is earnings what?

Bo Pang - Oppenheimer

Effective tax rate.

Clare Cai

Effective tax rate. We have net loss carryforwards from previous periods loss and although we've provided allowance for the corresponding tax assets, the credit are still valid with the tax bills. So when, as we generate net profit, we are able to credit against the NOL. And we expect to utilize the NOLs over the next six to eight quarters. So basically we do not expect to pay any forward tax expenses for the next six to eight quarters.


Thank you for your questions. (Operator Instructions) There are no further questions at this time. I would like to hand the call back to the presenters for any closing remarks.

Weiguo Zhang

Thank you, everybody, for joining us for our third quarter 2014 conference call and we are keeping our communications open with our investors and people who are interested in our company and we appreciate your continued support and interest. And with this I want to say have a healthy and prosperous year of course and thank you everybody.


Ladies and gentlemen, that does conclude our conference for today. You may now disconnect the lines.

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