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China Gerui Advanced Materials Group Limited (NASDAQ:CHOP)

Q2 2014 Earnings Conference Call

September 4, 2014 9:00 AM ET

Executives

Kevin Theiss – Grayling, IR

Mingwang Lu – Chairman and Chief Executive Officer

Edward Meng – Chief Financial Officer

Operator

Greetings and welcome to the China Gerui Advanced Materials Group announces the Fiscal Year 2014 Second Quarter Results. At this time, all participants are in a listen-only mode. (Operator Instructions) As a reminder this conference is being recorded.

I would now like to turn the conference over to our host, Mr. Kevin Theiss. Mr. Theiss, you may now begin.

Kevin Theiss

Thank you. Good morning, ladies and gentlemen and good evening to those of you joining us from China. I’m Kevin Theiss from Grayling and I would like to welcome all of you to China Gerui Advanced Materials Group’s conference call, to discuss the unaudited financial results of the second quarter 2014 fiscal year.

With me today are China Gerui Chairman and Chief Executive Officer, Mr. Mingwang Lu and Chief Financial Officer Mr. Edward Meng. We will translate for Chairman Lu with his opening remarks and help with the Q&A.

I’d like to remind our listeners in this call, management’s prepared remarks contain forward-looking statements, which are subject to risks and uncertainties, and management may make additional forward-looking statements in response to your questions. Therefore, the Company claims the protection of the Safe Harbor or forward-looking statements that is contained in the Private Securities Litigation Reform Act of 1995.

Actual results may differ from those discussed today due to various risks including, but not limited to the availability of funds and working capital to finance its activities, the actions and initiatives of current and potential competitors, the company’s abilities to win new customers, merchants and vendors for its products, the development and acceptance of new steel products, marketing and promotional activities, pricing policies of suppliers and competitors, competition in the steel market and other risks detailed in the company’s filings with the Securities and Exchange Commission.

Accordingly, although the company believes that the expectations reflected in such forward-looking statements are reasonable, there can be no assurance that such expectations will prove to be correct. In addition, any projections as to the Company’s future performance represents management’s estimates as of today. China Gerui assumes no obligation to update these projections in the future as market conditions change.

The 2014 second quarter press release and the script includes the use of non-GAAP EBITDA, which is a financial measure that is not defined by U.S. Generally Accepted Accounting Principles or U.S. GAAP.

Non-GAAP EBITDA is defined in the 2014 second quarter press release and in this script as earnings before interest, taxes, depreciation, and amortization that were incurred in the second quarter 2014.

I will now turn the call over to China Gerui’s Chairman and CEO, Mr. Mingwang Lu for some opening remarks. Mr. Lu please begin.

Mingwang Lu

[Foreign Language]

Ladies and gentlemen, thank you for joining us today and welcome to China Gerui Advanced Materials Group’s 2014 second quarter unaudited financial results conference call.

[Foreign Language]

Our stock price reflect the results of our operations in the struggling Chinese steel industry business characterized by over capacity, greater than needed production and reduced demand. These conditions have led to intense price competition resulting in money loosing operations over the past few years. Second quarter revenues were down 24.1% and gross margin was positive, declined by 51.8%. Our stock price is trading at a fraction of book value and net cash. 2014 will continue to be a year of restructuring for China’s steel sector and for China Gerui as we faced numerous challenges during the second quarter of 2014.

While government policies and market forces are working to correct these imbalances. It will be several quarters to make a meaningful impact. We remain confident in the steel business, especially specialty’s demand, a more tightened credit environment and weak capital markets. The management has evaluated alternative investments to offset the pressure, related to the Company’s core metal business.

[Foreign Language]

Management and the Board of Directors have decided to take advantage of our rich cash position to make an alternative investment, we believe, will provide a better near term return on capital. And cash flow to support our steel operations, during the transitional phase of the steel industry restructuring, in particular, we were presented with the opportunity to invest in a valuable antique porcelain collection at a highly discounted price, due to financial pressure on the owner.

We are pleased to announce that China Gerui, acquired a rare porcelain collection, dating back as early as the Song Dynasty, more than 1,000 years ago for $234 million. This purchase price represents a 74% discount to the appraised value of $905 million. It is our intention to sell all 206 pieces over time, to reinforce our cash position and earn a substantial return.

[Foreign Language]

They will use the profit from the resale of this collection to support our steel operations, but the steel industry gained stronger fundamental balance. We intend to use these new financial resources to support our metals operations for geographic and international expansion, entrance into new end user applications, research and development and strategic acquisition. Our steel and iron ore prices have reached all-time lows over the past few years. Prices of the antique porcelain have risen shortly over the same time period.

[Foreign Language]

Chinese antiquities market is rapidly becoming one of the fastest growth markets in China and is recognized internationally among the global art community. For example, on April 18, 2014 during Sotheby’s Hong Kong Spring auction a Ming Dynasty cylinder was sold for approximately $36 million, an appreciation of 10 times its value compared to when it was previously sold to equal $2 million in 1999. This transaction broke the world record for any China porcelain auction.

Other novel pieces have sold in the range of $30 million to $80 million per item. We recognize there is a short term pressure on our cash position due to the purchase of the antiques, but potential orders are far greater that anything we can receive at our current metal business in the near future.

[Foreign Language]

During the second quarter, we continue to manage those aspects of our business that were within our control, such as unit productivity, controllable costs, product quality, sales and marketing, and our customer relations.

[Foreign Language]

Even the continuing imbalance in the steel market slowly and finally in type of credit policy we are revising China Gerui’s whole year 2014 revenue guidance to the range of $100 million to $110 million, reflecting the unexpected the non-recurring production shutdown in the third quarter due to a public works interruption in Xinzheng City that closed our production for 30 days. The Company may adjust such guidance as changing macroeconomic conditions and operational and competitive challenges dictate.

[Foreign Language]

Despite difficult macroeconomic conditions, utilization of our wide and narrow strip cold-rolled steel capacity was maintained between 60% and 62% in the second quarter of 2014.

More important the utilization of our chromium plating production lines increased to approximately 55% in the second quarter of 2014, compared to 51% during the first quarter of 2014. We are encouraged by this type of new trend and expect the chromium-plating utilization will continue to rise.

[Foreign Language]

As part of our mid-year strategic review, we focused our efforts on strengthening our working capital and cash management cycles while streamlining the Company's operations through stringent cost management and optimization of product mix. These actions have yielded measurable improvements in gross margins and EBIDTA in the second quarter when compared to the first quarter of 2014.

However, given the continuing unfavorable sentiments towards China’s steel industry and uncertain outlook, our operations continued to be streamlined to mitigate operational risk generated by industry wide excess capacity, weak demand in prices and restricted access to credit. We will continue with our stringent cost management and operating efficiency improvements to increase improvements in our financial results such as gross margin and EBIDTA.

[Foreign Language]

We had created competitive advantages with our innovative new products and with our broader product line we provide more solutions to our current customers and entered new applications we have to share in high margin markets. We are especially optimistic about the future of our laminated products to help lead our growth; exports remain in other market with great sales potential.

Also, the Chinese government’s plan to improve housing with construction of affordable public housing projects and the construction of more high-speed rail stations will help bolster steel demand in the near term.

In addition, we are also engaging a new strategy to develop alternative investment opportunity in the rapidly growing China in particular these market. This new operation will support our four operations, maximize shareholder returns and strengthen our future cash position.

[Foreign Language]

Thank you, everyone for joining us and I will now turn the call over to Edward Meng, our Chief Financial Officer.

Edward Meng

Thank you, Mr. Lu and thank you all on this call.

I will present a summary of the 2014 second quarter financials. For more details, please refer to our second quarter press release, which was distributed earlier today, your time in the U.S.

Revenue decreased 24.1% to $32.7 million in the second quarter of 2014, from $43.1 million in the second quarter of last year. The decrease in revenue was primarily due to a 4.6% decrease in the company’s average selling price to $660 per ton for the second quarter of 2014, as compared to an average selling price of $692 per ton for the second quarter of 2013, as well as a 20.5% decrease in sales volume to approximately 49,500 tons for the second quarter of 2014, as compared to approximately 62,300 tons for the same period of last year.

Gross profit decreased 41.8% to $1.7 million in the second quarter of 2014 from $3.5 million in the same quarter from last year. Gross margin was 5.2% in the second quarter of 2014, compared to a gross profit margin of 8.2% in the second quarter of last year. The decrease in gross profit and gross margin reflects the continuing economic slowdown in China and the resulting low demand for steel products, which exacerbates pricing pressures in the market.

Operating loss was $0.6 million in the second quarter of 2014, compared to operating income of $0.9 million for the second quarter of 2013. The decrease in operating income in the second quarter of 2014 was primarily due to a 41.8% decrease in gross profit.

Net loss was $1.4 million in the second quarter of 2014, or $0.02 per fully diluted share, compared to a net loss of $0.8 million, or $0.01 per fully diluted share in the second quarter of last year.

Non-GAAP adjusted EBITDA was $2.8 million in the second quarter of 2014, or 8.7% of revenue, compared to $4.0 million, or 9.3% of revenue, in the second quarter of 2013. Non-GAAP adjusted EBITDA is defined as earnings before net interest expense, taxes, depreciation and amortization.

Revenue was $59.1 million in the first six months of 2014, compared to $88.7 million in the first six months of 2013. Our gross profit was $0.5 million in the first six months of 2014, compared to $8.7 million in the same period of 2013.

Operating loss was $4.4 million in the first six months of 2014, compared with operating income of $3 million for the same period of 2013. The decrease in operating income in the first six months of 2014 was primarily due to a decline in gross profit. Net loss was $5.6 million in the first six months of 2014, or $0.09 loss per fully diluted share, compared to a net loss of $0.9 million, or $0.02 loss per fully diluted share in the year ago corresponding period of 2013.

Non-GAAP adjusted EBITDA was $2.7 million in the first six months of 2014, or 4.5% of revenue, compared to $9.1 million, or 10.3% of revenue, in the second quarter of last year.

Please see the section entitled, Use of Non-GAAP Adjusted Financial Measures and the reconciliation table at the end of 2014 second quarter press release for an explanation and quantitative comparison of non-GAAP measures used in this call and also press release to their GAAP equivalents.

Now about the financial condition of the company. As of June 30, 2014, the Company had $3 million in unrestricted cash, $10.8 million in current certificates of deposits, and an additional $76.1 million in restricted cash, as compared to $237.1 million in unrestricted cash, $24.2 million in current certificates of deposit and an additional $114.8 million in restricted cash as of December 31, 2013.

The Company’s short-term debt consisted of notes payable, term loans and financing obligation, which is current portion that totaled $240.6 million at June 30, 2014, compared to $282.9 million as of December 31, 2013. The Company had long-term debt $9.2 million in financing obligation, this is net of the current portion at June 30, 2014, compared to $13 million as of December 31, 2013.

Shareholders’ equity was $285.7 million at June 30, 2014 as compared to $299.1 million as of December 31, 2013. Net cash used in operating activities for the six months ended June 30, 2014 was $226.6 million, compared to $22.4 million in 2013.

We will now begin the business update and outlook to provide better insight into China Gerui’s strategies in the difficult domestic marketplace, even as we begin to focus on streamlining our long term strategy.

I will begin with a brief review of China’s overall steel market in the second quarter. In the first half of 2014, China’s GDP grow by 7.4% was down 0.2% compared with the same period of last year. In the first half of 2014, national production of crude steel reached 412 million tons. Pig iron production reached 362 million tons and steel production reached 552 million tons, year-over-year, representing growth of 2.99%, 0.51% and 6.45% respectively.

However, the growth rate declined by 443 basis points, 522 basis points and 376 basis points, respectively, compared to the same period of last year. Second quarter operational and financial results of the China’s steel industry reflected recent government policies to stabilize economic growth, there is a few, I mean, challenges ahead.

For example, the large and the medium-sized member steel mills of the China Iron and Steel Association posted a meager total net profit margin of 0.42%. Excluding non-core business operations, losses totaled $107 million.

China is currently facing slower than anticipated GDP growth which have caused a decrease in consumption for steel and steel-related products. Simultaneously steel production, has not decreased in relation to the decreased consumption, therefore creating over supply in the marketplace. These macro economic factors have subsequently led to price erosion for manufacturers, as evidenced by our deteriorating average selling price, since 2012. While China Gerui has maintained relatively (indiscernible) volume, an industry of demand for our premium products, a decrease in pricing power has eroded our margins and profitability.

Many of our competitors have realized severe financial losses, being forced to suspend operations, cut back our production, or have filed for bankruptcy.

The economic structure is changing from investment-oriented to consumption-oriented, and from industry-oriented to service-oriented. New characteristics of the national economy, reflected the progress in the change of economic structure and economic growth will gradually require less steel over time, making the product and difficult to achieve significant growth in steel consumption. In the first half of 2014, domestic consumption contributed 102.9% to GDP growth whereas exports declined by 2.9%.

Various government agencies have enacted policies to urge major steel provinces, including the important Hebei and Shandong province to cut back production capacity, improved product structure and enhanced production technology, to propel enhanced earnings ability within the industry as a whole. However, according to industrial experts, the steel industry will need at least two to three [adjacent] (ph) years to realize actual recovery and the balance of supply and demand.

China’s plan to reduce excess production capacity by closing small factories and limiting investment has resulted in 8.4% decrease investments in steel industry. The National Development and Reform Commission indicated that the plan to reduce the excess capacity and thereby improve efficiency will continue, but is expected our industry to take years to restore balance in the demand-supply equation. We have every intention of preserving and continuing to grow the methods, processing business of us during this difficult time.

Over the last year, we have witnessed a tightening of credit policies and increase interest rates from the local banks. As you are aware China Gerui is a working capital intensive business and relies on loans from the local banks to secure raw material from our suppliers. While we have very strong relations with our local banks, we didn’t (indiscernible) in the position of being beholden for local creditors if and when the situation further deteriorates.

Managements recognized the need to be more proactive, demanding stability to secured trends for the core business in a depressed market with the limited access to the capital market.

China Gerui is based with limited options with improving return on equity, in the near term from this core metal processing business and have thought new investment channels to support the Company’s core operation. This has led us to consider alternative investments that would protect our working capital interests.

China Gerui thinks its debut on the U.S. capital markets has been very forthcoming about the state of the industry. Despite the various corporate access to sustain our stock price including share repurchases, our stock performance has been tied to our operational performance. During unorganized competitive domestic landscape, increased homogeneity in enterprises and products, limited pricing power and limited access to capital markets, management re-examines its profit development plan to improve capital utilization and to maximize the shareholder value.

After careful deliberation and with the support of the Board of Directors, China Gerui was able to capitalize our unique opportunity to entering the growing culture, antiquities our market which will propel faster growth of corporate assets that will sustain our full metal processing business during this transitional period.

At this time, management views the incidence into the China antique market as a viable alternative to maximize the long term capital appreciation of its cashed assets. While we do recognize that there will be short term pressure on the Company’s strategy and we do feel that in next three to five years that investment will alleviate the pressure our capital needs for fixed asset investments and the working capital in metals processing business.

Proceeds from the sale of the acquired antiquities will be used to fund working capital for the metals processing business, geographic and international expansion, entrance into new end-user applications, research and development and the strategic acquisitions. This has long been our long term strategy and we’re continuing to divert resources to the realization of the strategical reason.

Having said that, the management want to state that while we are excited and optimistic of the recent acquisition, there’s no assurance that the auctions will be completed in a timely fashion. Or we’ll realize the appraised value of the assets.

That said, we anticipate that listening our earnings announcement of the second quarter there would be a lot of questions from the investors. So we prepared some questions to tap on the anticipated questions.

First one, I would say, why this acquisition? China Gerui has always been a cash rick company, but the stock price does not really reflect that fact. Stock is selling out to one half of the book value and the half of net cash. Actually, over the last couple of quarters, we have looked out acquisitions and related businesses. But it is difficult to make an acquisition when the stock price and the market value of the company are so low. So we decide to foot back on those, instead of trying to buy a steel company or aluminum company, for example, we have this opportunity to buy a valuable antique porcelain collection at a very attractive price, those at the financial price of the (indiscernible). So we see this as a viable alternative investment opportunity, so we jumped at it.

The other question people might ask is where do the antique porcelain collection come from and who authenticated and appraised them? The collection came from a private entrepreneur, who was under financial pressure from his personal – and business. The collection was appraised and authenticated by Class A certified China Artwork Appraisers with national levels of authentication qualifications.

Comparable pricing was referenced to similar porcelain pieces of various auction markets, both in and out of China in recent years, and each acquired piece is granted with authentication and appraisal certificates, each of which is listed with their photograph.

The next question will be how did China Gerui account for or recourse the pressures? The sums used to pay for the acquisition came from China Gerui’s existing cash accounts and a quite antique porcelain is recorded on the balance sheet as inventories available for sale.

China Gerui followed all appropriate profitable teams for negotiations for the purchase. The company has registered the collection and all documents and the financial records related to this purchase have been disclosed to our auditor and our legal and Audit Committee and the Board is putting the loop.

Now, apart from the recent acquisition what other investment will be required to run the auction, other than the cash investment? I would say 50 – there would not be additional investment required to follow-up to run the auction. We will consign the acquired pieces in lots should auction houses both in and outside of China and then have them sold and the proceeds properly recorded by the company.

The question is has the transaction been approved by the Board of Directors? Yes, the acquisition has been approved by Board of Directors and has been reported to our auditors and our legal counsel.

Since the company intends to resell the acquired antique pieces, question is how have auctions re-formalized and what is the timing? We are actually in the process of contacting low cost and potential auction houses, so that we can auction the pieces in a timely manner. We are also in the process of evaluating which pieces can be auctioned domestically in China versus in international markets such as Hong Kong and Macau.

We anticipate to follow the two primary international core auction seasons, that is the autumn and the spring season, which run from October to February for the fall season and then April to August for the spring season. The ultimate purpose is to rebuild the acquired antique porcelain collection so that the proceeds would come back and that this existing business fits the company to implement the long-term strategy.

Beyond this initial antique porcelain collection purchase we do not anticipate any purchase of other collection in the near-term. So this is a pilot program for us. So we compete with the acquisition. We’ll make sure that we safeguard the outlets and then put them through the auction process as soon as possible to realize the sale of the collection.

In addition to the questions we just mentioned, we do expect numerous questions and it relates to the acquisition and also relates to the operational height of the company (indiscernible) current time constraints there will be a follow-up with requests individually.

Thank you very much for your participation in China Gerui’s 2014 second quarter conference call. And we will now conclude the call and you may disconnect your lines. Thank you very much.

Question-and-Answer Session

[No Q&A session for this event]

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