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Executives

Winnie Yam – IR

Charles Zhu – SVP of Operations

Sam Tsang – CFO

Xiaodong Wu – CEO

Analysts

Bin Li – Morgan Stanley

Jack Hu – Deutsche Bank

China Medical Technologies, Inc. (CMED) F3Q2010 (12/31/10) Earnings Conference Call February 18, 2011 8:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2010 China Medical Technologies Incorporated conference call.

My name is Peggy and I will be your operator for today.

At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Ms. Winnie Yam. Please proceed.

Winnie Yam

Thank you. Good day, ladies and gentlemen. I’m pleased to welcome you to China Medical earnings conference call. China Medical already announced its third fiscal quarter results ended December 31st, 2010. A copy of the press release is also available on the company’s web site at www.chinameditech.com.

Today, your speakers will be Mr. Xiaodong Wu, CEO; Mr. Sam Tsang, CFO; and Mr. Charles Zhu, Senior VP of Operations. After they finish with their remarks, they will be available to answer your questions.

Before we continue, please bear with me as I take you through the company’s Safe Harbor policy. The discussion today will contain forward-looking statements made under the Safe Harbor provisions of the US Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risk and uncertainty. As such, the results may be materially different from the views expressed today.

A number of potential risk and uncertainties are outlined in the company’s public filings with the US Securities and Exchange Commission. China Medical does not undertake any obligation to update any forward-looking statement, except as required by applicable law.

As a reminder, this conference call is being recorded. A replay of this conference call will be available via webcast on China Medical’s website.

Now, allow me to turn the call over to Charles, who will give remarks on behalf of Mr. Wu. Charles?

Charles Zhu

Thank you, Winnie. We have seen growth in each business line again in the past quarter. We’re pleased to see the increasing contribution from our SPR business, where we sell our HPV-DNA chips directly to the hospitals after the placement of our SPR analyzers. We have placed 110 units of SPR analyzers to large hospitals which are – they are the existing [inaudible] by the end of the December last year. We will focus our efforts on the utilization of the analyzers for our HPV-DNA chips by these hospitals to increase the recurring chip revenue from each hospital users.

For FISH, our direct sales teams continues to drive the sales of recurring FISH growth revenue from three areas, first, by increasing the test usage in existing FISH applications in each hospital user; second, by expanding FISH applications to other clinical departments in the existing hospital users; and third, by adding new Tier 1 hospital users.

We expect to receive SFDA approval two to three of our new FISH applications, including prostate cancer detection, EGFR for lung cancer targeted drugs, and Type 2a for breast cancer drugs in the first half of 2011. We will continue to expand our FISH product portfolio to offer a more comprehensive diagnostic manual to physicians and patients which will support the sustainable growth of a recurring FISH revenue.

Revenue from our ECLIA business increased again on year-over-year basis. However we expect normal seasonal sequential decline in ECLIA revenue in March quarter due to the two New Year holidays in that quarter. The trial test on our fully automated ECLIA system by several hospitals is ongoing and we will receive feedback from those hospitals next quarter. We expect to make some modifications to improve the functionality of the system to meet the requirements of large hospitals.

To summarize, each individual business line is operating on track which demonstrated a success of our business transformation. We have transformed ourselves from a large capital medical equipment company to pure advanced IVD company with the focus on high-end molecular diagnostic products where 100% of our revenue is coming from recurring diagnostic consumables used by hospitals on daily basis.

We believe our current business model is more defensive on macroeconomic headwinds and will provide us with long-term stable stream of cash flow and sustainable growth.

I have finished Mr. Wu’s remarks and I’d like to turn the call over to Sam, who will review our financial results. Sam, please.

Sam Tsang

Thank you, Charles, and welcome, everyone. We have made some changes to the presentation of our recent earnings release to include our cumulative results for the fiscal year, that is nine months result ended December 31st, 2010 and reconciliation of GAAP to non-GAAP numbers on the consolidated financial income statements. We hope it will be helpful to our shareholders and investors to analyze our results.

Let’s highlight our financial results in the past quarter. Our 3Q ‘010 revenues increased by 30% year-over-year to RMB223.9 million or $33.9 million. Our 3Q ‘010 adjusted EBITDA increased 42.8% year-over-year to RMB131.5 million or $19.9 million. Our 3Q ‘010 non-GAAP net income increased 65.8% year-over-year to RMB75.6 million or $11.5 million. Our 3Q ‘010 non-GAAP diluted earnings per ADS increased 64.9% year-over-year to RMB2.57 or $0.43.

Let’s discuss in specific areas. First, our ECLIA revenue achieved a 16.7% increase year-over-year, and our FISH revenue achieved a 30.9% increase year-over-year. Our sales of SPR-based HPV-DNA chips increased substantially from RMB3.8 million of 2Q ‘010 to RMB9.2 million of 3Q ‘010. We installed 110 units of SPR analyzers with our top tier hospital customers by the end of December 2010. As mentioned by Charles, we will focus on our efforts on the utilization of our SPR analyzers to drive the recurring revenue of our HPV-DNA chips used by these hospitals.

Second, the non-GAAP gross margin increased from 76.4% to 79.9% on a year-over-year basis mainly due to more contribution from the sales of FISH probes which generate higher gross margin.

Third, our non-GAAP operating expenses increased by 8.1% year-over-year from RMB45.4 million to RMB49.1 million or $7.4 million in 3Q ‘010. The increase was primarily due to the increase in direct sales efforts and product registration and development for FISH probes and SPR chips.

In addition, our high effective income tax rate was primarily due to certain expenses such as stock compensation expense, amortization of acquired intangible assets and interest expense of convertible notes not deductible for China income tax purpose, as well as the accrual for withholding income tax on distributable earnings generated in China during 3Q ‘010.

Besides, our cash position at the end of December 2010 was above RMB1.1 billion or $170 million. We generated a net cash flow of RMB49.7 million or $7.5 million from our operations, and generated RMB77.9 million or $11.8 million from our investing activities in 3Q ‘010. Net cash flow generated from financing activities was RMB190.5 million or $28.9 million in 3Q ‘010.

The cash flow from financing activities related to the issuance of $150 million convertible notes in December 2010 and we used a large portion of the net proceeds from the new convertible notes to repurchase about $106 million of our 2011 convertible notes. The remaining balance of 2011 convertible notes was about $29 million on December 31st, 2010. We will continue to look for opportunities to repurchase the remaining 2011 convertible notes before the maturity in November 2011 and have repurchased some in January 2011.

Upon the issuance of the new convertible notes, we expensed off the cost of approximately $0.8 million in connection with the suspended high yield offering in 2010.

On the other hand, regarding the receivable from Chengxuan, we received two payments in the amount of $8 million and $4 million in November and December 2010 respectively from Chengxuan, a major shareholder owned by Mr. Wu, our CEO, in connection with the sale of our HIFU business to Chengxuan.

The remaining receivable from Chengxuan was $18 million by December 31st, 2010. Subsequently, Chengxuan made another payment of $3 million to the company in January 2011 to reduce the receivable to $15 million. Chengxuan indicate to the company that payments will be made to the company to payoff the remaining balance together with interest thereon before June 30, 2011.

Last but not the least our outlook for 4Q ‘010 and the fiscal year 2010. We estimate our revenues for 4Q ‘010 to be approximately RMB234 million or $35.5 million, representing a year-over-year growth of 33.2%. We estimate our non-GAAP net income for 4Q ‘010 to be approximately RMB71 million or $10.8 million, representing a year-over-year growth of 37.9%. We have taken into account the impact of incremental cash interest arising from the issuance of new convertible notes in December 2010 for the refinancing of the 2011 convertible notes.

Our non-GAAP diluted earnings per ADS for 4Q ’010 is estimated to be approximately RMB2.69 or $0.41, representing a year-over-year growth of 25.9%. We estimate our revenue for fiscal year 2010 to be approximately RMB846 million or $108.2 million, representing a year-over-year growth of 17%. We estimate our non-GAAP net income for fiscal year 2010 to be approximately RMB269.1 million or $40.8 million, representing a year-over-year growth of 43.7%.

Our non-GAAP diluted earnings per ADS for fiscal year 2010 is estimated to be approximately RMB10.24 or $1.55, representing a year-over-year growth of 43.6%. The estimates are made based on our current views of operating and market conditions, which are subject to change.

This concludes our remarks. Now, we are welcome to your questions. Operator, please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from the line of Bin Li with Morgan Stanley. Please proceed.

Bin Li – Morgan Stanley

Thank you. Hi, thanks everyone. I have a few questions. The first question has to do with the guidance, I know just you changed the full-year guidance slightly. So the revenue now you’re saying it is to be RMB846 million, so the language has slightly changed from previous, you said at least RMB846 million. Can you explain what’s the change here? Also for the net income, I think you’ve lowered your guidance also slightly, if you could explain that as well?

Sam Tsang

Hi, Bin, this is Sam. I think this is break here because we are already in the fourth quarter and we are pretty visible to this quarter’s earning and we have crossed the first nine months already, reported the first nine-month results. So the full-year revenue is more predictable and so there will not be a big change from our estimate. And so usually we estimate – is still the same number RMB846 million, but we just use approximately, so we don’t think there will be a big change from this number, as you know how our business model is more on the recurring usage of our different products or consumables from ECLIA, from FISH, from HPV chips, so that’s the reason.

And change or the decrease in the non-GAAP net income and also the non-GAAP diluted EPS is pretty obvious, because we issued a new convertible notes, the coupon is higher which is 6.2%, till we finance our previously 3.25% coupon 2011 convertible notes. So in March quarter, we will have the full quarter impact from the new convertible notes. That means we will incur more interest expenses in this March quarter, and so our net income and also EPS is a factor compared to our previous guidance where we have low – we haven’t taken into account the impact of the convertible notes when we gave the guidance in November 2010.

So the major reason is purely from the impact of the convertible notes. And so you can see that – actually if you take into account the convertible notes impact, the estimated earnings for fourth – for the March quarter and also the EPS is actually less, because we expect a positive impact from the increase in gross margin and also the control in expenses. So the impact from the new convertible note actually is not as big as if we take into account the previous guidance we provide, because you will see that for the full year, we are expecting $1.55 EPS. And previously our guidance for the full-year, we felt it came back on the convertible notes is $1.60, so is only – with four months impact on the new convertible notes is only $0.05 lower than the previous guidance.

Bin Li – Morgan Stanley

Okay, thanks. So if I could ask questions on the business. And HPV seems to be doing quite well this quarter, and you said that you have installed about 110 units so far, or by the end of December, what’s the progress – what’s the latest progress there of HPV? And just based on – in the last six months of HPV installation, and obviously you’ve got a lot of feedbacks from the field, is there anything that you felt you need to change the strategy or improve the strategy, or anything on the technology front, if you could elaborate that a little bit.

Sam Tsang

I will ask Charles to translate this question for Mr. Wu to answer.

Bin Li – Morgan Stanley

Sure.

Xiaodong Wu

First, I want to address the question regarding the technology. Based on the feedbacks from the 110 users that are already using our SPR systems, we are satisfied with the – with our SPR technologies, because most of the – many of our SPR users, actually they have the option to use other HPV detection technologies. So actually they – before they make the decision, they actually compared our SPR technologies with the existing HPV detection technologies after they choose our technologies. So we think based on the feedback of the entire development, our SPR technologies for the HPV detection is maturing up for the market.

And also in terms of the utilization level, we see the trends of the existing users, especially for those users which has been installed for more than 1.5 year. The trend of the utilization development is very obvious. And also based on the hospitals that have higher utilization for our systems, we think the – our previous estimation of the HPV-DNA chips consumption per year is pretty accurate estimation.

In terms of the strategy, we think as we hit the install base of more than 100 installed in SPR analyzers, we think it’s better for us to slowdown the pace of the placement a little bit to shift more efforts and focus on the utilization for the existing install base.

And then, of course, based on latest feedbacks from the existing 100 users, there are some minor problems that we need to address. For example, still we need to revise our manuals – operating manuals for the machines, more user-friendly. So there are some more issues that we think we still need to improve in terms of the technology and the result [ph].

And previously – we estimate that for chips installed SPR system, we estimate 4,000 to 5,000 DNA chips per year per system. And so we are hoping that for the existing 110 systems, we hope that those systems can reach this level earlier in the coming year.

Bin Li – Morgan Stanley

Thanks. If I could also ask one more question, the fully automatic ECLIA machines, you said you are still in the testing stage. I was wondering whether there was any early feedbacks. And also if you could describe to us little bit more on the competitive landscape in this fully automated machine space, and what is your machine’s edge, or the pros and cons versus the incumbents?

Xiaodong Wu

In terms of the feedbacks, actually this is an ongoing process. We are collecting the feedbacks on daily basis. And for some of the minor issues that if we could modify the systems based on the currently that we have already done some of that. And for some of the other problems, we want to wait a little bit to before we collect more information to determine the best solutions to improve the current functionalities of the systems.

And compared to the existing fully automatic machines on the market, comparing to those imported systems, our fully automatic system is still – is a kind of a low-end fully automatic system to those international players’ products. For example, we only have the throughput of processing 90 samples per hour instead of comparing to those imported products, they can process more than few hundreds per hour.

However, our strategy is not to compete head-on with those international players in the large hospitals, because all the large hospitals they are already using the imported products and we – it is impossible for us to replace all the – to replace the system that they are using or to replace all the test items that is performing on their machines. Our strategy is to use some of the unique menu of the consumer goods to add some of the test that is not performing on the existing imported products.

Bin Li – Morgan Stanley

Okay, thank you very much.

Operator

Our next question comes from the line of Jack Hu with Deutsche Bank. Please proceed.

Jack Hu – Deutsche Bank

Good evening, can you hear me?

Sam Tsang

Hi.

Charles Zhu

Hi Jack. Yes, we can hear you.

Jack Hu – Deutsche Bank

Okay. Thank you for taking my questions. So I actually have a question regarding your FISH and fully automatic – ECLIA on the usage side to each of [inaudible] you said targeted year usage 4,000 to 5,000 DNA chips per year. What is the desired average usage for FISH per hospital and average ECLIA test per hospital for fully automatic machine? [inaudible] actual number, maybe a range could –

Xiaodong Wu

Utilization for FISH is quite different than compared to the HPV, because for example, a very big application for FISH is the cancer detection. And you know for cancer patients, they are very concentrated in the large Tier 1 hospitals in China. Even among the Tier 1 hospitals, the number of the patients varies a lot.

So we actually – if we want to have a range of the number we can give you an estimation for top 100 largest Tier 1 hospitals, we estimate the FISH revenue per hospital is around RMB3 million to RMB5 million per year. And the other is smaller, but it’s still Tier 1 hospitals, the average FISH uses – FISH revenue will be around RMB1 million per year.

And also it’s actually the same case for ECLIA utilization. In the large Tier 1 hospitals, for example for those hospitals with the RMB2 billion each year, their clinical diagnostic departments revenue is around – is about – is – will be around RMB100 million. And in those – among those RMB100 million diagnostic revenue, about 20% are related to amino acid test. Of course, a big proportion of that is still down by ELISA [ph]. So about EUR10 million is related to ECLIA test. And, of course, we cannot capture the majority market share in that RMB10 million in each hospitals’ departments.

We are only – we want to penetrate into those large hospitals by some of the unique – many operators like liver fibrosis, because they have imported products cannot provide this test on their machine. So we estimate for good users that has a very high utilization rate on our liver fibrosis kits. It can generate RMB400,000 to RMB500,000 on the ECLIA revenue for us for each hospitals each year. That’s for the largest yields for ECLIA hospitals.

Jack Hu – Deutsche Bank

Thank you. I have one other question. So you mentioned there are few probes for SFDA approval this year, can you maybe just share with us what they are and also what are all kind of opportunity you see in this areas?

Xiaodong Wu

The new applications we expect to get SFDA approvals into the prostate cancer detection FISH probes and also the Type 2a FISH probes that is also used to guide the breast cancer treatment, and also the third one is the EGFR FISH probes that can be used for guiding the lung cancer treatment.

Let me go through one by one. For prostate cancer probes, once we get the SFDA approval, we will be the first and only FISH probe supplier for the prostate cancer detection in China market. In terms of the patient population, market potential, each year about more than 100,000 patients are going through the biopsy to – for the prostate cancer diagnosis and those are all the potential users for our FISH probes. And this number actually is also increasing every year due to the changing lifestyle.

For example, in Shanghai, prostate cancer has become the number one urology cancer for male, surpassing the bladder cancer as the number one urology rated cancer in Shanghai. And also please be reminded that for the urology related applications, we already had the bladder cancer FISH probes in the markets. So by combining the existing bladder cancer probes with the new prostate cancer probes which is also tied into the same urology department in the hospitals, we can achieve more sales synergies, because we don’t need to incur any incremental sales cost. We can just sell the more – the new FISH applications into the existing urology users in the existing FISH users for us.

And for the Type 2a is a biomarker that is related to the mainstream chemotherapies for breast cancer, because this is related to the very mainstream chemotherapies, not only related to those target – new targeted therapy drugs. So we think the potential users will be also –the number of users will be very large as well.

And for EGFR for lung cancer, because we have already launched our PCR-based reagent for EGFR kits for detection. So by combining the FISH probes for EGFR with the existing PCR-based reagent kits, we can diagnose both amplification and the mutation gene basis for the lung cancer patient. So this is also – it’s going to be a very good package for us for the lung cancer patient.

Jack Hu – Deutsche Bank

Okay.

Operator

We have a follow-up question from the line of Bin Li with Morgan Stanley. Please proceed.

Bin Li – Morgan Stanley

Yes, hi, thanks for taking my follow-up questions. My question is on the price control policies or intentions from the government. We know the government right now has been very aggressive on doing price control for drugs. And recently they’ve also said they want to take a look at the pricing for consumables – medical consumables. I just want to hear from Mr. Wu and management, are you hearing anything – any measurement or intention from government to try to control prices or regulate the prices on the reagents?

Xiaodong Wu

If you look at the history of the government’s control on the drugs, actually it took some more than 10 years from the beginning of the – before development really implement the actual policies for controlling the price on the drugs. And you are right, somebody is paying more attention on the consumables and regions pricing. But we think it will take quite a long time before any concrete detailed policies can be implemented.

And even for the price control issue for the diagnostic area, we think the first area that government will be looking into is the clinical diagnostic instead of the pathology diagnostic area, because for clinical diagnostic it’s mainly done by fully automatic machines and not a lot of medical labor expertise are required.

But on the contrary, for pathology related diagnosis it’s nearly done by the physicians. So it’s quite labor intensive compared to the clinical diagnostic area. So we think pathology department which is the key market for our FISH users will now be the concentration for the government – will now be the focus for the government to think about the price control in the near term.

Bin Li – Morgan Stanley

Okay, thank you.

Xiaodong Wu

Thank you.

Operator

I would now like to turn the call back to Sam Tsang for closing remarks.

Sam Tsang

Thank you for joining our call. Please do not hesitate to contact us if you have any questions. Have a nice day. Thank you.

Operator

Ladies and gentlemen, that does conclude today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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