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China Nepstar Chain Drugstore Ltd. (NYSE:NPD)

Q2 2014 Results Earnings Conference Call

August 28, 2014 08:00 AM ET

Executives

Dixon Chen - Grayling

Fuxiang Zhang - Chief Executive Officer

Zixin Shao - Chief Financial Officer

Analysts

Isabella Zhao - Morgan Stanley

Ryan Roberts - China Stock Research

Operator

Greetings and welcome to the China Nepstar’s Second Quarter 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Dixon Chen of Grayling. Thank you, you may begin.

Dixon Chen

Thank you. If you have not received a copy of Nepstar’s second quarter 2014 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 that are not 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 questions 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 ongoing efforts to support same store sales and overall revenue growth through promotion of non-prescription products and nutritional supplements continue to deliver results. Revenue increased by 7.5% in the second quarter and increased same-store sales by 6.2% on average value per transaction by 14.5%. Higher labor costs and lease expense impacted our profitability. So we begun streamlining managerial personnel to reduce costs and improve workflow efficiencies. Looking ahead, we will remain focused on achieving a sustainable balance between top-line growth and operational efficiency.

During the second quarter of 2014, we opened 31 new stores and closed 40 stores. As of June 30, 2014, we had 2,048 directly operated stores in total. Revenue for the second quarter [increased] by 7.5% to RMB686.6 million or US$110.7 million from RMB638.8 million for the same period in 2013. Same store sales for the 1,890 stores opened before December 31, 2012 and which were still operating as of June 30, 2014 for the second quarter increased by 6.2% compared to the same period in 2013. The increase in same store sales was primarily due to in-store promotional initiative and marketing of pharmaceutical products and nutritional supplements.

Second quarter revenue contribution by product category was 23.9% from prescription drugs 22.3% for the same period in 2013, 39% from OTC drugs, 38.2% for the same period in 2013, 14.8% from nutritional supplements, same with the second quarter of 2013, 3.5% from herbal products, 4% for the same period in 2013, and 18.8% from convenience and other products, 20.7% for the same period in 2013.

Second quarter gross profit was RMB292.9 million or US$47.2 million compared to RMB280.8 million in the same period over 2013. Gross margin was 42.7%, compared with 44% in the same period over 2013. The year-over-year decrease in gross margin was mainly the result of proactive promotional activity such as more discounts on certain pharmaceutical and the nutritional products.

Our portfolio of private label products included 2,115 types of products as of June 30, 2014. Sales of private label products represented approximately 18.4% of revenues and 25.7% of gross profit for the second quarter.

Sales, marketing and other operating expenses as a percentage of revenue were 39% for the second quarter compared with 38.9% in the same period over 2013.

General and administrative expenses as a percentage of revenue were 4.6% for the second quarter, same with the second quarter of 2013.

During the second quarter of 2014, we recognized the impairment loss of RMB5.2 million or US$0.8 million compared to RMB3.4 million for the same period in 2013, representing the reduction of the carrying amount of the property and equipment of certain underperforming stores.

Loss from operations in the second quarter was RMB11.5 million or US$1.8 million compared with loss from operations of RMB1.0 million in the same period over 2013. This loss was mainly due to the increase in sales, marketing and other operating expenses which outpaced the increase in gross profit.

Interest income for the second quarter was RMB1.9 million or US$0.3 million compared with RMB4.2 million for the same period in 2013. Income tax expense in the second quarter was RMB7.2 million compared with RMB7.5 million in the same quarter of 2013.

Loss before income tax expense for the second quarter of 2014 was RMB8.7 million or US$1.4 million while we generated an income before income tax expense of RMB3.6 million for the same period in 2013. The effective tax rate was therefore negative 82.8% for the second quarter of 2014, compared to 208% for the same period in last year. Such difference in the effective income tax rate was primarily attributable to the higher operating losses from certain of our loss-making subsidiaries for which full valuation allowances were made on their deferred tax assets.

Net loss for the second quarter was RMB15.9 million or US$2.6 million or RMB0.16 basic and diluted losses per ADS compared to a net loss of RMB3.9 million, or RMB0.04 basic and diluted losses per ADS for the second quarter of 2013.

As of June 30, 2014, the company had 197.4 million outstanding ordinary shares. Each ADS represents two ordinary shares of the Company.

In the second quarter, net cash outflows from operating activities was RMB79.0 million or US$12.7 million, compared to net cash inflow of RMB14.6 million for the same period in 2013. The cash outflow is primarily due to more prepayments made to suppliers and greater operating losses incurred in the current period compared to the previous year.

As of June 30, 2014, total cash, cash equivalents, short-term and long-term bank deposits and restricted cash were RMB306 million or US$49.3 million and shareholders equity was RMB811.3 million or US$130.8 million is compared with total cash, cash equivalents, bank deposits and restricted cash of RMB622.8 million and [shareholders] equity of RMB845.5 million as of December 31, 2013. Decrease in total cash, cash equivalents, short-term and long-term bank deposits and restricted cash was primarily due to cash dividend of approximately RMB191.2 million or US$31.6 million being paid to the shareholders in January 2014 and the net cash outflow of RMB101.6 million or US$16.3 million from operating activities for the first half year of 2014.

Looking for the rest of the year, we are taking proactive steps to improve customer experience and further gain loyalty, such as offering free consultations on basic health issues at our stores. We believe our optimized product offerings, continuously improved service, strong store network and customer loyalty program will help us achieve greater economies of scale and improve operational efficiency.

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

Question-and-Answer Session

Operator

Thank you. At this time we will be conducting a question-and-answer session. (Operator Instructions). Our first question is coming from the line of Isabella Zhao with Morgan Stanley. Please proceed with your question.

Isabella Zhao - Morgan Stanley

Thank you for taking my question. I will translate my question to Chinese later. I have two questions. Number one is regarding the same store sales growth that is in this quarter the same store sales growth decreased to 6.1 and versus last year it was 8.6. I want to know why it is slowing down. And also if Mr. Zhang can give us a sense how should we look at the same store growth in the next year or in 2015? And my second question is regarding the in-store [consultation] you just mentioned. Can you give us more color, what kind of services you provide, how does it different from other drug stores?

[Foreign Language].

Unidentified Company Representative

[Foreign Language].

To answer your question the first question our one of the major divisions Nepstar major division in Thailand is recently affected by a government policy change. Currently the local government issued a new policy to provide more subsidy to patients who will visit the community clinics and that’s one of their movement to promote traffic to the clinics, local clinics, community clinics.

So we believe that traffic has a 20% impact to us, to traffic loss. So that in turn affected our overall same-store sales growth. So, we experienced a somewhat slowdown in the growth of same-store sales in general.

Fuxiang Zhang

[Foreign Language]

Unidentified Company Representative

As we said, Thailand is just one of our divisions, one of the regional market for us. And we believe with a more proactive approach to grow the rest of the country same-store sales capacity, we will have overall double-digit growth in the second half of the year, in terms of same-store sales. So we're confident, we'll get that.

Fuxiang Zhang

[Foreign Language]

Unidentified Company Representative

Secondly, regarding your question on the in-store consultations, the free of charge consultation, yes, we have launched a program what we call total healthcare solution. What this solution does is we first categorize all the most common diseases or symptoms when a customer walks in the door. They can ask certain questions or direct them to each categories. For instance, if the customer recently caught a cold, so we will come in to consult them and how they feel and we’ll provide entire solution of the prescription or OTC medicine to all the way to nutritional product or family product and so give them overall picture how to deal with the symptom they're going through and also help them to better understand how to utilize our healthcare solutions in the store and our pharmacies service on the ground. And with that kind of service we believe is going to help increase a stickiness of our customers and also to increase the per basket -- per customer basket, shopping basket in each transaction, each visit.

Isabella Zhao - Morgan Stanley

Thank you.

Operator

Thank you. (Operator Instructions). Our next question is coming from the line of Ryan Roberts with China Stock Research. Please proceed with your question.

Ryan Roberts - China Stock Research

Good evening, and thanks for taking my questions. I guess my first question was asked was if I could get an update on where we are kind of in the rationalizing the store network. But I think in couple of quarters ago, I think as Q3 we talked about possibly with the -- to more expansion plans in mid-year, but I also think we still kind of clean out some underperforming locations. I’m just kind of curious from management perspective where are we in that process and additionally if there were any kind of conditions or things that kind of changed along the way that required some more aggressive store closures since then?

Unidentified Company Representative

Okay. [Foreign Language]

Okay. In the first -- in the second quarter, we opened 31 stores, closed 40 stores. In the first quarter, we opened 15 stores. So, in that sense we've actually increased a little bit on the new store opening. The reason we cannot open faster or expand faster is still to go back to some of the limiting factors such as rental and labor cost, and both are growing at a faster pace than our gross margin expansion.

So with that reason we took a -- we're taking a very prudent approach, more focusing on the quality of the store than the volume of new store opening. So that's been a factor at this moment.

[Foreign Language]

Yes, regarding the visibilities, I think we're still carefully measuring a big -- one of the key indicator is same store sales and how we perform in that category will influence our decision on new store openings.

So we are still carefully watching and also proactively working on a solution to improve and accelerate same-store sales growth.

Ryan Roberts - China Stock Research

Okay. Thank you for that. But if I could just kind of follow up, I think in earlier calls we talked about the cost pressure from labor and from rents. I'm just wondering, headlines about real estate and all these kind of stuff. I'm just wondering if management can kind of give us their perspective on where those costs, where do you feel those costs are going to go?

[Foreign Language]

Fuxiang Zhang

Okay. In the second quarter, if you look at our labor costs, it went up 9% year-over-year. The rental was up 7% year-over-year. In the near term, we don’t see any other changes in terms of those high cost items.

However, we're doing other things to improve our efficiency. We've been making major effort in second quarter to streamline our back office managerial provisions. And so, with that change, we're expecting RMB3 million reduction on the managerial cost expenses. So that’s one of the approach we make.

Ryan Roberts - China Stock Research

Okay, thank you very much for that. If I can may be switch a little bit kind of more towards the some of the discussion earlier about the sales and the sales mix, I mean it looks like private label is little bit smaller than in previous quarters, I am just wondering if you can comment a little bit on maybe just even just some color in terms of how the mix is going according kind of the earlier discussion about trying to shift away from some of the drug, I guess into some drug sales to some of the other categories and also kind of how private label fits in that?

Unidentified Company Representative

[Foreign Language].

Yes, the second quarter, our private label sales accounted to a lower percentage of total revenue compared with other quarters, reason being there has been a cautious shift from drugs in larger package to a smaller package. We are introducing, we're more aggressively introducing a smaller package drugs with similar molecule capsules. With that change because the package changed, it comes with -- it will go with the price change as well. Per package price will go down and it has been coming down. That overall changed the perception of our store merchandise; give us a more positive effect attracting for traffic. So that’s a cautious decision we made to upgrade our price perception amount of customers.

Fuxiang Zhang

[Foreign Language]

Unidentified Company Representative

Going forward, we’ll continue to strengthen our private label category to improve our competitiveness. And we believe we will have a good recovery with good support from private label category.

Ryan Roberts - China Stock Research

Okay. And if I can just follow-up on that a little bit. So in terms of -- I know it’s like the margin has been improving, also the gross margin has been improving as well. And I’m just wondering if that is part of the mix, kind of change in product mix and kind of more of the lot taking about the improving private label, when should we expect to see that? So, I guess a larger scope of my question is kind of how should we look at maybe second half and where gross margins might be and kind of what’s driving that?

Unidentified Company Representative

[Foreign Language]

Fuxiang Zhang

[Foreign Language]

Unidentified Company Representative

As you said, our gross margin has increased sequentially and even up from fourth quarter 2013 and the reason being is our expected product mix change. And also one other contributing factor was our promotion on the price discount strategy; we have relaxed a bit on the price discount in the second quarter versus first quarter. And we believe going forward we can maintain -- our gross margin can maintain at this level, with continued adjustment on a product mix we conservatively think we're going to be 41% to 42% for on that range for the gross margin.

Ryan Roberts - China Stock Research

Okay. Thank you very much, that's very, very helpful.

Unidentified Company Representative

Thank you.

Operator

Thank you. (Operator Instructions). It appears we have no further questions at this time. I would now like to turn the floor back over to management for any additional concluding comments.

Fuxiang Zhang

Okay.

[Foreign Language]

Thank you again for our shareholders, analysts for continued support. In the second quarter, our number came out a bit soft. However we are still confident we can turn this around. Our goal remains on improving our topline and as well as continue to improve our gross margin. We will make continuous effort on cost control and at least we want to control the percentage of our cost, operating cost.

With that, I would like to conclude today's earnings conference call. Thank you for all attending today's call. Look forward to speaking with you again.

Operator

Thank you. Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation and you may disconnect your lines at this time.

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