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SORL Auto Parts, Inc. (NASDAQ:SORL)

Q4 2013 Earnings Conference Call

March 31, 2014, 8:00 AM ET

Executives

Shiwei Yin - IR, Grayling

Jin Rui Yu - Chief Operating Officer

Analysts

William Gregozeski - Greenridge Global

Peter Siris - Hua-Mei 21st Century

Operator

Greetings, and welcome to the SORL Auto Parts 2013 Fourth Quarter Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Shiwei Yin. Thank you, Mr. Yin, you may begin.

Shiwei Yin

Thank you, Rob, and thank you for joining us today and welcome to SORL Auto Parts' 2013 fourth quarter and full year conference call. This is Shiwei Yin from Grayling. Joining us today are Ms. Jinrui Yu, SORL's Chief Operating Officer; Mr. Min Kan Lin, Accounting Manager; Mr. Raymond Lin, Investor Relations; and Ms. Phyllis Huang.

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, intend, 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. 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 condition.

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 obligations to update the forward-looking information in the future. The 2013 fourth quarter result in unaudited numbers and full year results in audited numbers are represented in US dollars under US GAAP.

I'll give a brief overview of our operations in the fourth quarter and full year financial results. Thereafter, management will conduct a question-and-answer session.

2013 was a modest year for the commercial vehicle sales in China, as commercial vehicle unit production reached 4.0 million units, and unit sales were 4.1 million units, an increase of 7.6% and 6.4% from the previous year. After the commercial vehicle industry reached its highest point in 2010, it saw a decrease in both 2011 and 2012 and has started to grow again in 2013. In 2013, truck, including incomplete trucks and semi-trailer tractors, unit production and unit sales were 3.5 million units and 3.5 million units, respectively, an increase of 7.0% and 5.8% from previous year.

However, heavy-duty truck sales increased 21.0% year-over-year to 770,000 units, mainly due to four reasons. Number one, benchmark numbers in 2012 were comparatively low due to the slowdown in macroeconomic growth and lower investment in fixed assets. In 2013, the government policies aimed at railway transportation, real estate, infrastructure upgrades and further urbanization stimulated the growth in heavy-duty truck sales.

Two, 2013 also marked the beginning of the heavy-duty truck replacement period. Millions of heavy-duty trucks sold between 2007 and 2010 provide a base for new vehicle purchases.

Three, further delay in the implementation of National IV emission standard prompted companies to manufacture and sell more National III-compliant vehicles. And finally, four, sales promotion in the second half of the year, including some National IV-compliant vehicles, further stimulated the sales for the full year.

Such year-over-year growth should be viewed cautiously as an indication of a complete recovery of the heavy-duty truck market. Again, the benchmark numbers were low and the National IV implementation induced pre-buy and sales promotion in the second half of 2013, which more or less reduced their respective sales in the first half of 2014.

In addition, the Chinese central government seeks to change economic priority to building national consumption of domestic goods rather than emphasize on exports and fixed asset investments. In such end market environment, we'll continue to focus on increasing our market share and maintaining our industry-leading gross margin through our strategy of differentiating our products or enhancing our research and development program to design advanced brake products to meet the needs of our growing global customer base. We continue to introduce new advanced products with more robust features to enhance technology content and enrich total solutions for our customers.

In addition, we're giving more support to our marketing and promotional programs. As a result, we've gained further market share in the fourth quarter of 2013, as net sales increased by 13.3% to $55.3 million from $48.8 million for the fourth quarter of 2012, while the overall Chinese commercial vehicle sales only grew 4.8%. The net sales for the full year of 2013 increased by 8.5% to $208.6 million from $192.2 million in 2012, while the overall sales of commercial vehicles in 2013 only increased by 6.4%.

In addition, our undivided focus on better product quality has brought us a number of awards and increased orders from our OEM customers, including Dongfeng Liuzhou, Dongfeng Dana Axle and Qingte Group most recently.

Revenues from the company's domestic OEM customers rose by 23.1% to $29.3 million from $23.8 million in the fourth quarter of 2012. Revenues from the company's domestic OEM customers increased 11.9% to $105.0 million in 2013 from $93.9 million in 2012. A large portion of our OEM sales are due to the heavy-duty market. Given the current government spending in infrastructure, we also continue to seek to further diversify our customer base with sales into the construction equipment market as well as growth in other markets.

Our aftermarket growth was moderate in 2013 as our focus remained on both higher market share into Chinese OEM segments and further international expansion where margins are higher. However, new products we introduced in the OEM market paved the way for a stronger foothold in the Chinese aftermarket segment in the future.

Braking systems are safety related components with high barriers to entry. We remain optimistic on our presence in highly reoccurring aftermarket business as we added more sub-distributors and brought in our coverage to service more and more vehicles coming off of warranty every year.

Sales from China's domestic aftermarket were flat at $11.6 million in the fourth quarter of 2013 compared with $11.6 million in the same quarter of 2012. Revenues from China's domestic aftermarket in 2013 increased to $46.7 million from $45.3 million a year ago.

International sales increased year-over-year compared with the fourth quarter of 2013 due to an expanded marketing program of our advanced products. In addition to exhibiting at the Equip AUTO 2013 Trade Show in Paris, we have also exhibited at the Automotive Aftermarket Products Expo in Las Vegas, Automechanika Middle East in Dubai, and China Import and Export Fair in Guangzhou among others.

Revenues from international markets increased 7.5% to $14.4 million compared to $13.4 million in the fourth quarter of 2012. Revenues from international markets in 2013 increased by 7.3% to $56.9 million from $53.0 million in 2012. For the 2013 year, export sales accounted for 27.2% of total revenue with the US, United Arab Emirates and Brazil as major export markets.

Now, we'll have a brief review of our quarterly and annual profits. The gross profit for the fourth quarter of 2013 was $16.6 million compared with $16.7 million for the fourth quarter of 2012. Gross margin for the fourth quarter of 2013 was 30.1% from a gross margin of 34.1% in the same quarter of 2012.

Starting in 2013, there have been reclassifications of certain costs associated with post-sales product modifications at OEM sites from cost of sales to selling and distribution expenses. Retrospective adjustments to the historical income statement have also been made to provide a consistent basis of comparison for the financial results.

During the fourth quarter of 2012, there was a much higher volume of such product modification as compared with that of the same period of 2013. As a result of such reclassification, the gross margin of fourth quarter 2012 was higher than the period of 2013.

Operating expenses increased to $15.2 million in the fourth quarter of 2013 from $14.1 million in the fourth quarter of 2012. As a percentage of revenue, the expenses were 27.6% in the fourth quarter of 2013 compared with 28.8% in the fourth quarter of 2012 and compared with 19.2% in the third quarter of 2013.

Selling and distribution expenses were $8.8 million o 15.9% of quarterly revenues compared with $8.6 million or 17.6% in the same quarter of 2012. The lower selling and distribution expenses as a percentage of revenue in the fourth quarter of 2013 was mainly due to higher cost associated with post-sale product modification at OEM sites in the fourth quarter of 2012.

General and administrative G&A expenses in the fourth quarter of 2013 were $4.3 million or 7.8% of revenue compared with $3.5 million or 7.2% in the fourth quarter of 2012. The increase in expenses was mainly due to higher bad debt provisions as the company experienced a longer collection periods for sales to some domestic OEMs. However, the company remains confident that these provisions will be reversed as the majority of SORL's OEM customers are top 15 OEMs in China, which have strong financial standing and solid payment histories with the company.

Research and development R&D expenses were $2.2 million in the fourth quarter of 2013 compared with $1.9 million in the fourth quarter of 2012. As a percentage of revenue, R&D was 3.9% in the fourth quarter of 2013 and declined compared to 4.0% of revenue in the fourth quarter of 2012, due primarily to the increase in revenues in the fourth quarter of 2013. Our research and development is focused on new products, including automotive electronics and energy-saving products as well as upgrading traditional air brake drive products to electronically controlled products to achieve a higher profit margin. Our new products contributed to our gain in market share as our sales growth accelerated faster than the market growth.

Financial expenses decreased by 47.8% to $0.4 million in the fourth quarter of 2013 from $0.7 million in the fourth quarter of 2012, primarily due to decreased currency exchange losses from the appreciation of the RMB against US dollars during the fourth quarter of 2013.

Income before income taxes was $1.9 million for the fourth quarter of 2013 compared to $3.1 million for the same quarter of 2012. The reduced income reflected lower operating income and other income during the fourth quarter of 2013 compared to the fourth quarter of 2012. The pretax income margin was 3.4% in the fourth quarter of 2013 compared with 6.3% in the fourth quarter of 2012.

The provision for income taxes was $1.0 million in the fourth quarter of 2013. However, tax rate remains 16.3% for the full year 2013. The local government granted SORL high-tech enterprise certification in December 2012 that lowered its annual income tax rate to approximately 15% for the 2013 and 2014.

Net income attributable to stockholders for the fourth quarter of 2013 was $0.8 million or $0.05 per basic and diluted share compared with $4.1 million or $0.21 per basic and diluted share in the fourth quarter of 2012.

For the 2013 year, SORL's gross profit increased 4.2% to $58.6 million from $56.3 million in 2012 due to higher sales. Gross margin was 28.1% in 2013 compared with 29.3% for 2012. Operating income for the full year of 2013 declined to $14.9 million from $17.4 million in 2012. Operating margin was 7.1% versus 9.0% in 2012. The net income attributable to stockholders in 2013 was $9.4 million, $0.49 per basic and diluted share compared with $12.8 million in 2012 or $0.66 per basic and diluted share in 2012.

As of December 31, 2013, the company had cash and cash equivalents of $28.2 million compared with $41.3 million on December 31, 2012. The company significantly reduced its short-term bank loan to $4.5 million on December 31, 2013, from $14.6 million at December 31, 2012. Total equity increased to $199.5 million at December 31, 2013, compared with $188.5 million at December 31, 2012. On December 31, 2013, working capital was $144.7 million with a current ratio of 4.13 to 1. Net cash flow from operating activities was $1.4 million.

We believe commercial vehicle inventory levels remain positive for continuing growth and the pre-buy before the strict enforcement of the National IV emission standards will continue over the near term. We remain optimistic that our international sales will contribute more to our sales growth over the next few years as customers in local and foreign markets recognize the value in performance and quality that our products provide.

For the fiscal year 2014, management reiterates its outlook for net sales to be approximately $225.0 million and net income to be approximately $12.5 million. These targets are based on the company's current views on the operating and market conditions, which are subject to change.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of William Gregozeski with Greenridge Global.

William Gregozeski - Greenridge Global

I'm just a little bit curious as to how the big miss in net income happened. Given you had a consistent guidance pretty much throughout the year and you reported the third quarter halfway through the fourth quarter, I'm just wondering why there was such a - it seems like a surprise in such a big miss in the fourth quarter for net income.

Jin Rui Yu

The management's answer is that the sales for the fourth quarter was actually okay, but because the expenses increased, therefore that cost to profitability declined. And the increase in the absolute number of the expenses were mainly due to a couple of factors, the first one being the reclassification of the post-sale product modification from previously cost of sales now to the sales in distribution expenses. And this item was actually higher in 2012 than it was in 2013. And the second factor is because of the increase in the packaging expenses and also the labor costs. The packaging happened mainly because both the OEM and export customers, they were demanding a higher quality packaging, because during the transportation process, sometimes products may get damaged. So the customers were having a higher demand on those packaging.

William Gregozeski - Greenridge Global

Right. Yeah, I understand these are more longer term trends throughout the year. But I'm more asking what happened in the last 45 days of the quarter that resulted in what seems to be a big miss from the guidance that had been there the whole year?

Jin Rui Yu

Another factor in causing the decline in profitability in the fourth quarter was increase in the G&A expenses. And specifically, it was due to the increase in the bad debt provision. So the previous agreement that we had with OEM clients and on bad debt provision, it was on the three-month basis before these would be considered bad debt. But these agreements were signed 10 years ago, so 2004. So now 10 years later, some of these customers they are – first of all they are the top 15 OEM companies in China. And so they are demanding for the new term for these bad debt provisions, so it went from three months to six months.

So from the company's point of view, we want to establish and maintain good relationships with these top 15 OEM customers. And given that they have had very good payment history with the company and also their own solid financial standing, we are confident that we're going to be able to collect these payments. So that's also another reason for the decline in profitability in the fourth quarter.

William Gregozeski - Greenridge Global

Okay. How much was that bad debt provision in the fourth quarter?

Jin Rui Yu

It was about $2 million.

Operator

Our next question is from the line of [Guy Dowen] [ph] of [inaudible].

Unidentified Analyst

I've got a question regarding your sales guidance for 2014. Your current guidance is for sales of $225 million. Does this include or not possible other orders from your top three customers from which you got supplier award in March? I had a press release in March saying that these three top major customers could give you additional orders. So does this include or exclude the possibility of additional orders, the $225 million?

Jin Rui Yu

Yes, it does include those three customers.

Unidentified Analyst

So does it mean these three customers have given recently additional orders? Your press release in March that says that you were very happy to have these awards from these, okay, Dongfeng and Qingte Group. And in the press release, it says that these could in the future lead to additional orders. What I am asking you is this projection of $225 million, does it include some or nothing of additional orders?

Jin Rui Yu

So just a little background on how these awards work, usually is that these customers at the end of the year, they would do a review of all their suppliers. And then based on the quality and the price, they would give out awards. And for those companies that receive the awards, the customers, they would tend to upwardly adjust the percentage of sales to these companies in the following year. So meaning in 2014, as long as the sales for these customers increase, then that would tend to increase our sales from these customers as well.

Unidentified Analyst

Now just to have an idea about the ability to pass on price increase, could you ask them what kind of price increase they have passed in their selling price in the three markets, OEM, aftermarket and international, what has been that price increase on average in each of these markets?

Jin Rui Yu

Just generally speaking, the pricing for the export market is the highest among our products. With the OEM products being priced at the middle, and then our products sold in the aftermarket tend to have the lowest pricing points.

Unidentified Analyst

But are they being able to increase the pricing, for example, in the aftermarket?

Jin Rui Yu

So the market condition in China is such that it tends to be difficult for suppliers to increase price in traditional products. So the strategy for the company is to roll out new and more advanced products to have higher pricing. And usually, the company would sell these products to the OEM customers first and from OEM then to the aftermarket.

Unidentified Analyst

So to come back to the OEM, roughly what was the percentage of new innovative products in 2013, what was the percentage of new products which were not existing or not for-sale in 2012 compared to 2013?

Jin Rui Yu

It was around 5%.

Operator

Our next question is from the line of Peter Siris of Hua-Mei 21st Century.

Peter Siris - Hua-Mei 21st Century

I'm wondering why the inventories are up so much. Does that have to do with projected sales, with what?

Jin Rui Yu

Usually March is the month of the year when the company experiences weak production and specially in the OEM segment. And previously the company had experienced product short supply in the aftermarket segment. So the management decided to take advantage of the downtime to produce some additional products in anticipation of the March peak.

Peter Siris - Hua-Mei 21st Century

Okay. So that means that you should have pretty good sales in the first quarter. Is that a reason?

Jin Rui Yu

The management expects the sales in the first quarter of this year to be about 10% higher than the previous year.

Peter Siris - Hua-Mei 21st Century

Secondly, I see that the decline against US dollar and some other international currencies, how does that impact your international business?

Jin Rui Yu

Historically when the RMB and US dollar exchange rate went from 8.5, 8.-something to 6.8 that overall bode very well for our export sales. But even that the RMB has been appreciating because of the high value added of our products. So we're still doing okay in our export segment. And obviously customers do like our products. But as we have also seen at the end of 2013, RMB started depreciating a little against the US dollars. So that in the near term should be additional advantage for our export business.

Peter Siris - Hua-Mei 21st Century

While reading about the capital constraints, do you see competitors encountered problems and does that give you an opportunity to pick up share from smaller companies?

Jin Rui Yu

And so starting from 2012 going into 2013, the market that we're operating has seen a reshuffling particularly when it comes to smaller sized competitors. I mean we've also seen some mergers and acquisitions among these smaller competitors. So overall, going forward, the competitive landscape bodes well for SORL.

Peter Siris - Hua-Mei 21st Century

When you reported the third quarter, the original guidance for 2013, $13.7 million in earnings. Now we come to 2014 and the currency is working in your favor, competition is working in your favor, likely you have the same bad debt losses, business is getting better, so my question is why is the guidance for 2014 only $12.5 million? It seems to me that you would earn a lot more money than that in 2014.

Jin Rui Yu

So the overall macro-environment is that the bank rates are increasing in China and the financing and labor costs are increasing as well. Given that export only accounts for 20% of our sales, OEM sales is still the majority. And our OEM clients, they have been demanding a little pricing. So given that OEM is our largest component of sales, that is going to have some impact on our profitability. But we still believe that our overall sales, we will see some increase in 2014.

Operator

At this time, I will turn the floor back to management for concluding comments.

Shiwei Yin

Thank you, all, everyone, for joining us today and we wish you a good day and speak to you on our next call. Thank you.

Jin Rui Yu

Okay, thank you. Bye.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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