Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Wanyee Ho – Investor Relations Director

Jeffrey Kang – Chairman and Chief Executive Officer

Will Davis – Senior Vice President, Business Development and Chief Marketing Officer

Fuya Zheng – Chief Financial Officer

Analysts

Charles John – Canaccord Genuity

Amir Rozwadowski – Barclays Capital

Quinn Bolton – Needham & Company

James Faucette – Pacific Crest Securities

Cogo Group, Inc. (COGO) Q1 2011 Earnings Conference Call May 5, 2011 4:30 AM ET

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Cogo Group Incorporated First Quarter of 2011 Earnings Results Conference Call. During today’s presentation, all parties will be placed in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference is being recorded today, Thursday, May 5, 2011.

And I would now like to turn the conference over to Wanyee Ho, Investor Relations Director. Please go ahead.

Wanyee Ho – Investor Relations Director

Thank you very much, and good afternoon to everyone. I’m Wanyee Ho, Cogo’s Investor Relations Director and I’d like to thank you all for joining us today to participate in Cogo’s 2011 first quarter earnings conference call.

After the market closed today, Cogo issued a press release this morning unaudited financial results for the quarter ended March 31, 2011. This release can be accessed in the Investor Relations section of Cogo’s website at www.cogo.com.cn and on most other financial websites.

The discussion today will be hosted by Jeffrey Kang, Chairman and CEO, who will discuss the company’s business operations; Will Davis, our Senior Vice President of Business Development and Chief Marketing Officer who will discuss guidance; and Fuya Zheng, our CFO, who will report the company’s financials.

Before we begin, I would like to remind everyone that the call today may contain forward-looking statements regarding future events and the financial performance of the company. We wish to caution you that such statements are just – at present just predictions and actual results may differ materially as a result of the risks and uncertainties inherent in the company’s business.

We refer you to documents that the company files periodically with the SEC, specifically the most recently filed Form 10-K, as well as the Safe Harbor statement made in today’s press release. These documents contain important risk factors that could cause actual results to differ materially from those contained in the company’s current projections. Cogo assumes no obligation to revise the forward-looking information contained in today’s call.

At this time, I’d like to turn the call over to Jeffrey. Jeffrey, the floor is yours.

Jeffrey Kang – Chairman and Chief Executive Officer

Thank you, Wanyee, and thanks to everyone for joining this call. I will focus on three key points today. First, I will review our outstanding quarterly results. Second, I will review our recently filed Form S-4 which is approved by a shareholder proxy vote would change our domicile to the Cayman Islands. This would offer us the flexibility to dual-list shares of Cogo onto the Hong Kong Stock Exchange. Third, I will detail the launch of an exciting new online strategy called COGO 3.0, which will utilize the internet to aggressively ramp up SME customer penetration with lower acquisition costs.

We will create a unique online marketplace to be a one-stop shop for SME customers by providing them value-added solutions ranging from applications to logistics to products. I will be in the U.S. during the week of the May 5 for (indiscernible) show and I’m excited to have a chance to meet with many of you.

Cogo’s first quarter revenue of the $104.4 million was up 29% and showed a clear return of high growth modes. We saw strong booking with specific strength in the auto, health, smart grid, smart meter, and in the 3G smartphones and HDTV. I’m proud to say that we generated $10 million in operating cash flow in the first quarter. Other than having to build some inventory quickly following the Japan earthquake to make sure that we would meet the demands of our customers, our business was not materially affected by this tragedy. Our non-GAAP EPS diluted was $0.20 versus guidance of $0.19. We are on a clear path to show $1 in annual pro forma earning power.

Cogo posted a gross margin of slightly over 14.2% up sequentially. During the quarter, Cogo posted operating margin of 8.5% and we expect sequentially operating margin improvement every quarter for the rest of the 2011 and further progress in 2012. We are focused on driving leverage in the business model while also allowing for necessary investment needed to drive growth.

Now, onto some segment highlights, full details as in the press release. Our industrial business showed 77% year-over-year growth in the first quarter and now represents 23% of total revenue. For 2011, we expect that industrial revenue will be split 60% smart meter and grid, 15% to 20% for auto, 15% to 20% for high-speed railways and 10% for healthcare. Revenue from our MDC acquisition was nearly 5 million in the quarter. I’m very pleased with this result. MDC puts us in the sweet spot of hundreds of billion of dollars in the total healthcare and smart grid spending.

Our telecom business showed a normal seasonality and we expect that it will continue to grow nicely through 2011 and 2012 as the fiber and 3G rollouts continue in the typical fashion of ordering then installation, then more ordering. There is really no magic here. With digital media, handsets showed a typical seasonal decline in the first quarter and we expect that this business to grow nicely through the 2011 and the 3G smartphones to ramp up.

Our [catalyst and SPQA] business are other key drivers of our digital media business. Regarding the potential for Cogo to dual-list on the Hong Kong Exchange, we have $85 million in net cash. So we don’t need capital. But under the right circumstance, we would choose to raise money upon dual listing. Existing NASDAQ shareholders could choose to register their shares on the Hong Kong Exchange and shares could trade on both exchange. Increased buying of Cogo’s shares on the Hong Kong Exchange will ultimately drive a higher price on the NASDAQ through arbitrage.

Assuming a successful redomicile, the dual listing could be complete three to six months. I believe that this to significantly broaden our shareholder base to a non-US investors and reach our goal to maximize shareholder value.

Now, I would like to further discuss our exciting new business initiative. I believe this is the most exciting new strategy that we have announced in the history of Cogo and it will be the basis for our next phase of growth in the next five years. We have both planned to create a transaction based online B2B platform of technical solutions that have no peer in China marketplace. We are the clear leader. A key point to understand then is that other companies like Alibaba have created the B2B e-commerce platform in China, however, those revenue models are based on membership. Our model is based on transactions.

For simplicity sake, thinking of this as Alibaba in reverse, Alibaba’s suppliers are our customers and Alibaba helps its SME base find buyers, we take the other side. We help the SME design products in the soup and nut way. We are taking the basis of all the success that Alibaba has showed in leveraging the Internet and we put our unique spin on it to monetize our own SME customer base.

I believe we are the first to market and we are ahead of any other competition and we intend to aggressively push ahead to maintain the first mover advantage. I believe that this new initiative is only to distance ourselves from the competition and create an even stronger barrier of entry. Take a step back and think about how to scale to create, how to scale to a bossiness 1600 SME customers across all of China, across many different industries and involving 1000 of engineers. We cannot do it overnight. And think about how much more difficult it will be to approach us once; we really start to ramp up the SME customers.

We have adopted a new strategy to aggressively accelerate our ability to grow our SME business and lower the customer acquisition cost by creating an online soup-to-nuts marketplace platform for SME applications and products.

Note that our business model will remain the same and our blue-chip strategy will not change, that this strategy relate exclusively to this specific demand and in an office of the SME market. We believe that in order to successfully scale our operation to maximize the scale and efficiency of our SME business. We must begin using a internet-based approach. Bold action is needed.

We expect this service to go live this quarter. COGO 3.0 marks to beginning of a new era at this Company. In Cogo 1.0, we only served the blue-chips, to the Cogo 2.0 during, which added around 1500 SME customers. COGO 3.0 will be the era in which Cogo grows its SME 50,000 to 100,000. SME market in china will be the key revenue driver for us in the next five years. 42 million SMEs contributed 60% of China’s GDP and 80% of the total employment and we have been transitioned Cogo to take advantage.

We have showed some success. Since the Q1 ‘08, we have increased our SME customer base by 50% to over 1,500, but we hit a wall of all sorts. The number of potential SME customers in China and the rise in the customers demand for solutions grew much faster than what we can traditionally serve them.

SME customers are adding more product lines crossing over in the new industries and focusing on exporting. They have increasing needs for access to technology and backend services. The traditional strategy of knocking on doors and operating in an offline environment got us to this point, but the market is screaming for the faster and more efficient execution and we plan to deliver this to them.

SME needs our help, and they need it faster and more comprehensively than ever, and we plan to be there for them. We quickly decided that we needed to move our platform online to make it more scalable, make it available to add value-added service and more able to deal with real-time complexities of the business.

We currently have around 10,000 registered SME customers. 5,000 of which are engaged in some type of the design work and 1,500, who are paying customers. We are in touch with above 500,000 engineers in China and are engaged with 50,000 of them and have between 1 million to 10 million specific data points each day. This is half of the market with 50 to 100 million engineers. The only way to reach them is through virtual interaction. Simply put the pieces in place, all we need to do is to leverage our advantage more completely and then take the platform to the next level.

COGO 3.0 will be divided into two distinct, but heavily (indiscernible) parts, applications, and products. The applications store will allow customers to access solutions online, and the products side will allow customer to access the commodity – commoditized products. We are going to operate operations store through our own platform, while we will operate the product store in conjunction with a partner. Each side of the equation will be important in driving overall efficiency, higher touch points with the customer, and ultimately lead to a much higher stickiness.

Cogo has a very strong pull in the engineering development community. We can utilize Internet to expand our influence in viral fashion. We are already an effective data collecting and a data mining service for our customers, and in online, we’ll broaden our reach through an aggressive use of online networking. Engineers in China, particularly at the SME level, have a tremendous amount of influence over the decision-making process. And they are looking for guidance to effectively bring in new highly technical products to market. The use of social networking and engineering blogs will be critical. We will produce a platform where viral nature of our solutions will drive new customers into Cogo’s pool. The type of platform does not exist in China yet. We will be the first.

At Cogo, we have four steps for acquiring and retaining customers and our COGO 3.0 strategy and our relationship with engineers are critical in all four stages. First, we identify customer through referrals and recommendations. The viral nature of 3.0 will strongly increase this result. Engineers are critical here.

Second, we engage the customer. Online interaction will speed up the process, improve the accuracy, and end up with a faster time to market and a deep customer relationship. Engineers are in charge here also.

Third, revenue generation, once the relationship is set, the online nature of 3.0 can quickly bring the whole of the Cogo’s IT and value-added service to the doorsteps of our customer with one click.

Four, retaining customers. Clearly, strong engineering relationship and increased access through the viral nature of COGO 3.0 and the ease of use we will create in bringing products to market will only enhance our already very high retention ratio of customers.

Here are some of the milestones I would have liked to reach. To grow our SME customer base from 1,500 to the 50,000 to 100,000 to grow our SME revenue (indiscernible) of $5 billion to $10 billion annually and lower our SME acquisition cost by 30% per SME, to increase our engaged engineer from the 50,000 to 1 million, and to increase our tight engineer base from 0.5 million to 10 million. I want to create another equivalent for SME B2B marketplace in China. This – they are aggressive targets, but the market is there for taking and we are well on our way. And we invigorated, and so is my team. Companies always needed to be evolving aggressively and/or will lose their edge and die. This is our new dream and we are committed to making it work.

With that, I would like to turn the call over to Will to discuss our guidance. Will, over to you.

Will Davis – Senior Vice President, Business Development and Chief Marketing Officer

Thank you, Jeffrey. Good afternoon everyone and thank you for joining the call. In the second quarter of 2011, we expect our revenue to be in the range of $111 million to $113 million and non-GAAP EPS diluted to be $0.22. At the midpoint of this range, our projected revenue growth in the second quarter would be around 23% from the prior year period. We expect gross margin to pick up slightly in the second quarter perhaps 20 basis points. As we have indicated our gross margins are largely dependent on revenue mix and we expect to make progress towards our 15% target, but we won’t reach that target overnight.

You should continue to expect more operating margin leverage than gross margin leverage. We remain optimistic about the overall economic situation in China and we expect to continue to benefit from powerful multiyear growth opportunities in autos, smart grid, healthcare, HDTV, and 3G smart phones. We expect to remain in high growth mode in 2011 while also expanding operating margins.

Cogo ended the first quarter of 2011 with 92 blue-chip customers flat sequentially and up 15% from the prior year period. The company grew its SME customer base sequentially by 32, reaching 1540 at the end of the first quarter up 14% year-over-year and 2% sequentially. Cogo’s total customer base is now 1632 at the end of the quarter up 14% year-on-year and 2% quarter over quarter.

Cogo’s blue-chip ARPU was US$745,000 in the first quarter of 2011, up 8% year-over-year. The company’s SME ARPU in the quarter was 23,000 up 22% year-over-year. Total Cogo ARPU was up 13% year-over-year.

Now, here are some specifics to help you with modeling in the second quarter of 2011. From the prior year period we expect our SME and blue-chip customer count to each increase by over 10% and we expect our SME ARPU to grow around 20% and our blue-chip ARPU to grow around 5%. We expect that each of our three operating segments will have a mid to high single-digit growth sequentially. Non GAAP operating expenses for R&D and SG&A in the second quarter expected to be approximately 6.3 million to 6.4 million, with the split remaining consistent at about 35% for R&D, 65% for SG&A.

Our R&D as a percentage of total OpEx has increased over the last several quarters as we have continued to invest new resources in our engineering capabilities with new supplier partners and customers. As indicated, we maintain our longer-term gross and operating margin targets of 15% and 10% respectively. Our minority interest obligations were lower than expected in the first quarter totaling 373,000. In the second quarter we expect this to be in the range of 500,000 rising to 1 million in the third quarter and 1.5 million in the fourth quarter. The primary reason for variability in the minority interest line has to do with customer choices related to whether or not our Hong Kong or China subsidiary is used for the transaction. We’ve built a fair amount of cushion into the estimate for the first quarter given the factors and clearly aired aggressively on the side of conservatism. We continue to view that minority interest outlays the critical measure to retail talent both in driving existing business and as a point of validation in driving new relationships. In this discrepancy in the first quarter payment will ultimately be made up, but after restructuring the minority interest arrangements will allow for changes in the subsidiary use. It is somewhat of a moving target quarter-to-quarter based on several factors, but we will continue to be as transparent and accurate as possible.

Interest income in the second quarter is estimated to be zero. For modeling purposes, you should assume the same for the rest of 2011. We continue to estimate our non-GAAP effective tax rate to be around 8.5% to 9% in the second quarter and the same through 2011. In 2012, we continue to expect our tax rate to be in the similar range.

In the first quarter, total stock comp related to SG&A was around $6.5 million and it was $1.26 million for R&D. Acquisition and amortization of intangible costs in the first quarter were 800,000. In the second quarter we estimate the total stock comp for SG&A, R&D will be each be in the range of $1.5 million to $1.6 million.

Acquisition-related costs including amortization and impairment of intangible assets will be approximately $1.2 million. Total diluted share count will probably be around 39.5 million shares. Other than the items noted above, there are no significant differences between GAAP and non-GAAP results.

With that, I’d like to turn the call over to Mr. Fuya Zheng, our Chief Financial Officer.

Fuya Zheng – Chief Financial Officer

Thank you, Will. Good afternoon, everyone. Unless otherwise noted, all items are in U.S. dollars. Cogo continues to have a very solid capital structure. That is a true competitive advantage. We ended the quarter with $85.3 million in net cash or $2.2 a share about a $5 million sequentially, as we generate about a $10 million in operation cash flow in the first quarter, I’m very pleased with this result.

While operation cash flow will be volatile quarter-to-quarter based on various business conditions, this quarter demonstrated a strong ability for the Cogo business model to throw off cash. Please note that our focus has been to deliver high quality revenue and earnings growth.

We recently passed our fifth-year anniversary with KPMG Hong Kong as our auditor. We are pleased have the consistency of this relationship and feel that it helped us to distinguish. We did not purchase any share in the quarter, as we consider buyback to be a strategic use of cash. In the quarter, we spent $5.5 million on acquisition. We plan to file our 10-Q in the next week and we can directly begin a buyback in two business days after we file our 10-Q.

This concludes my remarks. Thank you everyone for joining this call to discuss our 2011 first quarter unaudited results. At this time, I’ll turn the call to the operator to open the floor for question. We look to end this call at around 5:30. Operator?

Question-and-Answer Session

Operator

(Operator Instructions)

And our first question comes from the line of Charles John with Canaccord Genuity. Please go ahead.

Charles John – Canaccord Genuity

Hi, Jeffrey and Will. Congratulations on the good quarter.

Will Davis

Thank you.

Charles John – Canaccord Genuity

Thanks for taking my question. Just a quick clarification first. Will, do we just assume no engineering services related revenue going forward?

Will Davis

For simplicity's sake, on a number of levels we just decided to roll all of that in to the respective business lines so it just going to be three business segments going forward.

Charles John – Canaccord Genuity

Perfect, okay. And so, then, maybe just looking at the results, it seems to be across the board strength in all your segments, Jeffrey. But, just focusing on the handsets, 3G seems to be taking off finally in China; a lot more subsidiaries, carriers getting really aggressive. How should we think of your digital media business, and does your rate of growth change in the segment as the 3G ramp finally occurs in China?

Jeffrey Kang

Yeah, we believe that the direction based on our demand and the feedback from our customers thinking of this year could be a very and strong year of the 3G business and 3G and smartphone business. So we are seeing the demand from our customer is very strong for both China domestic market and as well as exporting market.

So, that’s why we are expecting a very strong demand in this year. And in Q1 normally is not the best quarter of the whole year for the consumer-related business, but we're going stay the situation with ramp up the in the next few month.

Will Davis

I would add that one of the big benefits for us on the 3G handset side is the higher ASP. Some of those have mobile TV and more content. So it's improving units, but it’s also better ASPs for us.

Charles John – Canaccord Genuity

Okay, great. And so, are we looking at almost growth in the slightly below the industrial division, can maintain that strong a growth for 2011 for this?

Jeffrey Kang

Yes, industrial still will be our strongest growth segment among all our business. So, as we expand the industrial many times, we are starting to ramp up this business since one or three years ago and we did a lot of the investment and preparation in the past and now we believe we can take that through, to take advantage of our investments in the past. And we are going to see this revenue from the industrial segment will grow dramatically in the next few quarters.

Charles John – Canaccord Genuity

Okay, that's good. Thanks for the color. And then, maybe just talk about the timing of your 3.0 strategy. Was there any specific catalyst that caused this change by Cogo management? Do you see competition increasing and you need to, you have a need to get to the market faster? Just curious about what drove that decision. And then also just some color on what this change in strategy means for your OpEx for 2011. Thank you.

Jeffrey Kang

Will, can you start that?

Will Davis

Yeah, I would say that we started looking at this, I would say, a few quarters ago as we started to see the SME business really take off. I think one of the issues was that the amount of business that we were getting was overwhelming and the traditional method of knocking on doors to sign up new customers it was working, but it wasn’t efficient enough. And it wasn't scaling like we had hoped. So I think we started looking at the SME market and realizing that in the last year to 18 months they’ve been gaining share, they’ve getting into new industries, they’ve been increasing their share of exports and we really needed to change the platform that we were using to more efficiently serve these guys. And that really is what drove it about, instead of adding 35 or 40 SME customers a quarter, we want to be able to add 5 to 10 times that amount. And I think one of the ways that you are going to do that is by using engineering chat rooms in a vital way to get referrals and to leverage our relationship within the engineering community. I mean it’s important to keep in mind that engineers really drive the process at these SMEs. And if you have good relationships with the engineers, you just speed their time to market, you make them aware of new technologies, you open their eyes to what are the chips guys providing, what's on the roadmap, you act as a sounding board for them they will repay you with new business. And there is no need for them to go anywhere else because you are effectively the ones who are making their time-to-market, meet all their plans.

So from that standpoint we’re working with, say, 50 to 100,000 engineers depending on which ones are paying revenue and which aren’t. We need to get that into the millions. And the markets there, there are 50 to 100 million engineers in China and that's growing rapidly. So, stepping back it was – we were showing in the SME side. Our acquisition costs were higher than we had hoped, I think from, just from the standpoint of knocking on doors. At some point we should be able to add customers without having to go and knock on any. Right, I mean that’s the way the market is going. No one else seems to be doing this except for us. We’ve trailing that for a couple of quarters. The websites are up and ready to go. We’ve been working with 10 or 20 different entities to figure out what’s the best way to create a web blog, what’s the best way to create social networking for this, and so it’s come to fruition and we’re going to be ready to launch it sometime this quarter. I think ultimately the goal is to significant ramp our exposure to engineers to be the technology source of choice for these guys and you ultimately lower our subscriber acquisition costs. Just in running the numbers, we think over a few years we can probably lower that by 30%. And I think if you look at the lifetime value of a SME subscribe just running some basic numbers, they get to be pretty attractive. If you can lower your subscriber acquisition costs and you can grow your revenue with them over a 10-year period, you are talking about lifetime acquisition or a lifetime value of $50,000 to $100,000 per customer. And when you start then adding thousands of customers, it gets to be a pretty attractive number. So that’s ultimately what drove this was the need to attack the market more efficiently and we feel like we’re way ahead of everyone else. We don’t see anyone else doing this.

Charles John – Canaccord Genuity

And just on the OpEx part of the question, Will?

Will Davis

OpEx, yeah, I would say that not going to have much effect this year, but I think going forward, this is definitely going to help us push towards the 10% operating margin and hopefully above if things go well. I mean, we’re not in the position to change that now, but if you can lower your subscriber acquisition costs sufficiently it should help us push to that 10% number.

Jeffrey Kang

But in terms of the cost related to this, I don’t think this year we have any significant change in terms of our operating expenses, even though, we’re adding this online platform. Please bear in mind that in Cogo, we are a well-established business. So, even today, we’re launching our new 3.0 strategy, but actually we spent over a year preparing for this, and we do all kinds of the research. And at the same time, we have already have a very big platform already and (indiscernible) across the country. So moving forward and in the future, I think the FX, in terms of the dollar amount, we definitely will increase, because if we get more customers or we need to set up more new service center across the country, acquiring more customers. And as Will mentioned, so our CapEx increase should have been in line with our strong revenue growth in the future. So that’s why it will help us to increase our operating margin in the longer term.

Charles John – Canaccord Genuity

Thanks guys.

Jeffrey Kang

Thank you.

Operator

Thank you. And our next question comes from the line of Amir Rozwadowski with Barclays Capital. Please go ahead.

Amir Rozwadowski – Barclays Capital

Thank you very much and good afternoon folks.

Jeffrey Kang

Hi Amir.

Amir Rozwadowski – Barclays Capital

I was wondering if we could talk a little bit more about the revenue opportunities when it comes to the 3.0 strategy. I mean, are you folks factoring this in as a means to incrementally grow your top line sort of above the high growth range that you’ve achieved so successfully in the past or is this sort of a means to help drive growth among your existing SME customer base? Just trying to get a sense as to what this could mean from a top-line perspective? Thanks.

Will Davis

Well, from the top line, so we mentioned in our press release, we actually divided our this COGO 3.0 to two portions. One is we call it application store. Another is we call it the product store. In generally speaking in the application store, we use an application store even in the same online platform we will mostly introduce and sell our solution-related stuff to our SME customers. And the product store is relatively new which is we want to sell more commodity types of products which in the past, we don’t have that portion. So our focus is still one – because the application store, the business in application store is relatively high margin business. Well, normally it’s in our existing margin range or sometimes even higher than our existing margin range. So, our focus still in how to expand our application store because of the whole Cogo business we are the solution. So, today even on online platform, the thing we promote, the thing we are selling and the things people are talking about in the business social network, mostly it’s Cogo solution.

The solution is our core to drive our business. At the same time, we got to consider the customer taking for example in the past within $100 Cogo solution cost. We made only sale like $3 or $5 contents there. Today, because that’s the high margin portion of the business, but today using this platform we will try to sale more and the commodity business to the same customer base.

So, from the top line perspective, so if that we are going to see the revenue, we will continue grow, but most of the revenue are application related revenue. So, that’s why we will run the application store by Cogo by ourselves, but on the other hand like no margin commodity product of the business, so we will run it working with a third party. So, third party will handle all the logistics, but Cogo will share the profit through the service base, get revenue. So, we get a lot of business.

So, having doing that what we believe is that we are going to continue to see the revenue growth, the top line growth and mostly are application-related revenue and we will also want to say more service revenue from through our product strategy. So, that will help both the Cogo the top line growth and we are going to achieve the same margin and higher margin growth margin. At the same time, we're going to see more profitability in Cogo’s financial reports.

Amir Rozwadowski –Barclays Capital

Great. Thank you very much for the incremental color, Jeffrey.

Jeffrey Kang

Thanks, Amir.

Operator

Thank you. And our next question comes from the line of Quinn Bolton with Needham & Company. Please go ahead.

Quinn Bolton – Needham & Company

Hi Jeffrey. Hi Will. Hi. Hi, Zheng.

Jeffrey Kang

Quinn Hi.

Quinn Bolton – Needham & Company

Jeffrey, just a follow-up question on that. Obviously, the product store gross margins, since it's a commodity product, sound like it's going to be much lower than your corporate gross margin that you get today or that you'll get on the application store.

You mentioned a third-party will be running that product store. Will you be recognizing the revenue flowing through that product store and associated cost of goods or will you only recognize some either minority interest or some level of profits from that store, but you don't get the hit on the gross margin line?

Jeffrey Kang

Yes, you are right. What we try to do is that we still only booking the revenue from the application store. For the product store, we're going to show the investor what's the revenue get that, that revenue is not Cogo's, we want to put that revenue on the Cogo so because these belong to the third party, but we get a share of the profits from that business.

Quinn Bolton – Needham & Company

So, will you effectively be making an investment in a third party and retain some equity interest in that? Is that how the accounting will work?

Jeffrey Kang

We are working with an independent third party, and it's more like outsourcing all the logistics to third party to run that business and we are the way we have taken the profits from that operating business. So, it’s just a purely business arrangement at this moment.

Quinn Bolton – Needham & Company

And then, I certainly understand the greater reach out for buying online B-to-B marketplace, but just sort of curious, the Cogo historically has been a design company. I'm just wondering, how do you sort of do custom design through the application store?

Is it really you're going to be selling some of the custom designs you've already got in your portfolio that you might have designed in conjunction with your blue-chip base, and then taking those designs, putting them on the application store and letting engineers discuss how they might be used without the need for further customization or do you intend to do customization on a SME-by-SME basis in the new application store?

Jeffrey Kang

That’s a good very good question. I actually asked the same questions to myself a thousand times before I announced it as a new strategy during our preparing period. So, what I believe is, in China based on my experience, my understanding for this market for our business. So that most of the decision has been made by the engineers who are working in that company, no matter in the blue-chip or in the SMEs. So basically, the reason why I am thinking about putting orders online is that we want to just – as we always explain to the investor, Cogo internally. We have to actually develop or like a solution pool. We have a solution library there, because we offer a lot of the solutions to the blue-chip customer and the customized solutions. So today, what we’re thinking about is that we’re going to list some of the business, so our own IT solutions online, letting more people easily these solutions. And at the same time, we’re going to spread the solutions information using the social business network among the engineer communities. So that going to help us to let our solution far reach and easier to reach to much broader SME customer.

And then, once the customers reach their interesting level, once they’re interested, they will come back to Cogo. So, eventually – so for Cogo, the business model, that’s the key point how to help us to increase our (indiscernible) customer base. Once the customer using our first design it will become our revenue customer, and Cogo today, we have a platform available to attracting every customer, every new project. That will keep them be our customer forever. So that’s how – that is our strategy to think about how to use online is the best way, because that will significantly lower our average acquisition cost new customer. And that will significantly help our reach much deeper SME customer base by leveraging what we are doing in our technology side.

And then once this platform becomes bigger and bigger, so and then that will – where we’re going to have more and more suppliers join this platforms, join this application store. So that will create a much bigger scale and will make our existing and new customers harder and harder escape from the Cogo platform. So that’s our idea that we already and on the other hand, we are not just blindly doing this, we have – we think we’re using offline to reach or already but already each, but 1, 500 customer base in China in less than a two years. And then I just believe using Internet and an online strategy will significantly accelerate the speed for us to acquiring new customer.

Quinn Bolton – Needham & Company

Thanks for the additional detail, Jeffrey. One other question for you, just the dual-listing, it sounds like -- to the extent you get shareholder approval, is the dual-listing – is that something that you expect to go forward with or is that just one option? I’m just trying to get a sense of how likely that outcome is, assuming you get shareholder approval?

Jeffrey Kang

Yeah, once we are – based on our existing management decision and so once we get shareholder approval in terms of the re-domicile and so that we will – I think we will go ahead with the Hong Kong dual-listing strategy. The reason is as I – as Will just mentioned, what we believe is, today Cogo, our investor base is pretty much the US focused investors. We were mostly US-tech investor base and most of them are taking the institution investors. And we are – we actually tried to expand our other Asian investors, but most are based in Hong Kong and China. And actually, a lot of people are actually interested in Cogo, but the problem is that, a lot of the restrictions for them to buy and (indiscernible) U.S. business stock at this moment, but they can buy – a lot of funds can buy Hong Kong listed stock. And I believe to them, they are much easier for them to understand Cogo’s business model – can understand in the China, the direction and (indiscernible). So that’s why I believe, Cogo can trade off Hong Kong and we can attract a lot of new investors. And that will help our strong Cogo stock demanding in the market, but that’s the view of this management. So we think we will go to that direction once we get the shareholder approval of our redomicile.

Quinn Bolton – Needham & Company

Great. And then just a couple of quick model questions for either Will or Frank. First, just the gross margins, I think you’ve guided up to be about 20 basis points sequentially, yet I think you said that each of the three business segments will grow roughly mid to high single digits. So it doesn't sound like you're seeing much of a mix shift in Q2. So, I'm just curious what drives the gross margin increase in Q2. And then, the second question is you saw an increase in the inventory levels at the end of Q1 given the Japan earthquake situation. Where do you think inventories end the quarter here in June? Thanks.

Fuya Zheng

We are thinking the inventory in the Q1, we intend to purposefully increase the inventory because they are still, we are worrying about the supply chain and the supply capability from our suppliers because still, I still think 100% clear in a way, because a lot of material, some key parts are still from Japan. And so that’s why we, purposefully increased the inventory level to try to meet our customers demand. So, I think after one month or quarter, in the end of the Q2, I believe the inventory levels to come down to the normal level, which is like 30, 40 days and our normal business inventory level. But at this time we just intentionally increased the inventories to try to avoid any possibility of the shortage of supply in the market.

Quinn Bolton – Needham & Company

Great, and then just gross margin?

Will Davis

Quinn, on the gross margin, I think that the 20 basis point improvement kind of the 14.4%, 14.5% range. That’s for next year.

Quinn Bolton – Needham & Company

Well, that’s not second quarter ’11 gains, that’s more where you see gross margins next year.

Will Davis

That’s more kind of where we see for 2012.

Quinn Bolton – Needham & Company

Yeah, did that make more sense given the mix?

Will Davis

And so, that’s, I think that the 15% target is a longer-term, we’re heading that direction. We’re going to see more operating margin leverage than we’re seeing gross margin leverage. But over time as the SME business grows and the industrial business grows, we should continue to make more progress. Sequentially, gross margins probably pick up similarly to what they did in the first quarter sequentially and for the rest of the year. So, we’ll end up exiting the quarterly, exiting the year at 14.3%, 14.4% something like that gross margins. So, making progress, I think we’ve been pretty clear that this is going to be a long road, but we are making progress and we will see more operating margin expansion in gross margin.

Quinn Bolton – Needham & Company

Great, thank you.

Will Davis

Sure, thanks Quinn.

Operator

Thank you. And our next question comes from the line James Faucette with Pacific Crest Securities. Please go ahead.

Jeffrey Kang

Hi James.

James Faucette – Pacific Crest Securities

Hey, sorry, guys, stumbling with my mute button. I just wanted to ask also a couple of questions following up on the COGO 3.0 portal, if you will. First, can you talk a little bit – I know that you mentioned, Jeffrey, in your prepared remarks your targets for revenue contribution from that channel. Can you just repeat those and maybe give us an outline of the timeframe you're thinking about in terms of hitting those different operating metrics?

Jeffrey Kang

Well, we think about how to using that online to expand our business, so we are – the first thing in my mind is that, if you look at Cogo financial model, we actually have three components, three revenue components, the chief components. One is the customer number, the second is ARPU, the third one is gross margin, a very simple model. So, the more customer we are adding, the higher average revenue per account and higher gross margins. That will contribute more to Cogo’s both revenue and bottom line. So, the reason, because we are in the past, in the Cogo our focus is the customized solution, which is relatively at the higher margin portion of the business and even for the same customer. What we always talking about Cogo we have the 1% to 5% of the purchase and demand among they are 1% to 5% of our customers purchasing. So, because why a lot of the investor asking me why we only have 1% to 5% rather than 20% or 30% given our strong relationship with the single customer is simply because Cogo historically our business is only focusing on the customize high margin business. So that’s why we have this business. And then we always standardize the business, but business strategy makes sense, when we do with the Tier 1 guys. We deal with Huawei, Nokia others that are Motorola and ZTE and (indiscernible) that business strategy makes sense. Those Tier 1 customers, the blue-chip customers in the view of Cogo the main progress is our design capabilities and are specific at some point.

But, when we face the thousands of the SME customers and we think our value not only offers them the solution, but at the same time we can offer them in orders, but even -- just even this platform to give them the one-stop shopping opportunity to a single small business somewhere in China. That has still give them the tremendous advantage for that customer to use Cogo.

So that’s why give me that idea how to leverage the platform to sell some even standarlize the product to those SME customer. But we only once we move in to that direction so that will hurt our gross margin because there are no way we sell the standardize the products you can keep this sign of high margin for a long term. On the other hand, there is a lot of the logistics support to do that. So, that’s why we are internally we make this business decision. Cogo, even though we put online strategy we sill focusing on application business.

At the same time, we are going to bring with new partner they have experience how to run internet business, at the same time, they know how to handle this kind of logistic or other stuff amount of volume in the revenue business, which is Cogo strengths at this moment mostly is the high margin business and they have experience to handle orders as high volume, but no margin business.

So, we will have a business agreement with them to working on the same customer base and we will share all the data with them, but on the other hand we can share – let them handling all this low-margin commodity business, but we can share percent of profit from that operation. So, that our arrangement for this new business. By believing that they can serving the same customer base better and well and Cogo can keep our revenue growth with very much profitable with reasonable higher margin and we will also eventually increase our customer base as well as our profitability from any single new customer we acquired. So, that’s why my strategy to run this business.

James Faucette – Pacific Crest Securities

That's great. That's very helpful. And then, finally, I know we want to wrap up here, but just wanted to quickly get your impression on the impact on your business. We seem to have seen a pretty marked slowdown in demand for automobiles in China.

There also seems to be some excess optical equipment inventory, as well as, I guess, there maybe some changes in the rail modernization project. At the same time, your revenue and outlook from those different industries seems to be quite strong. So, I'm just trying to get a sense for if you've seen any changes or modifications in those different sub-segments and how you're coming through those.

Jeffrey Kang

What we are seeing in the market we are looking at even just maintain an auto as well as high-speed railway and in the smart grid, smart meter. So, we're still seeing very strong demand. I think based on my experience so I think because we reached so many customers in China. So, we think the demand we are connecting think about it. Everyday we are talking with over 10,000 engineers working in over in the thousand of the SME customers in China. We are getting their feedback everyday. So we get roughly 1 million data directly everyday from our engineer bases. So, after we do the data, collecting and data mining that will reflect a real market demand in the market. So, our view is virtually, we are very confident, this year, overall demand is still going to be very strong and both the auto industry and high-speed railway as well as smart grid, smartphone as well as like iPad related business in China is going to be very strong. So, even though that the government talking about cut downs on the spending on like high speed railway or things like that, so that said, in general and that, today they cut the budget that maybe impacting three years later in the overall spending But, quite a lot of new projects, the new field two or three years ago. So, as of today with few benefits from that kind of the strategy because orders are pending at least, once it’s issued two or three years ago, if you list enough, at least last another two or three years.

So, our view, we are very confident the overall business will be very good. We are going to still continue to increase the number. Even though for example and you talked about telecom, people talking about the software demand, but based on our information or few our key customer like Huawei or something, they project another 30% of growth this year. So, if we can grow 30%, we’ll at least stay in match. So, that’s our, basically, our view, just give your views on how we will continue to benefit from the strong demand from our customer and grow our business in the next few quarters.

Will Davis

James, I would just add a couple of things. For instance on the autos, let’s say the auto market in China grows 10% this year units versus maybe 25 next year. That looks like a big slowdown. But we really announced for customers and the domestic China auto players only have 20% to 25% of the market. So they're probably going to take share. We are going to add more customers. And it looks like a lot of the international auto guys are going to start doing more and more design work in China instead of just assembly and sales. I think that gives us a good opportunity to work with the GM's and Ford’s of the world who have JVs in China.

So I think that even in a slower market lot of opportunities to grow. And going back to the fiber, I think that there are gestation periods, consistently in the process of these rollouts and we probably had one earlier this year. But things look pretty good for the back half and I think when you look at our telecom business, it’s going to grow nicely this year.

Jeffrey Kang

James, I maybe add one thing. Actually what I’m worrying about today, it’s not demanding, if we are going to face another some kind of the shortage of supply in the next few quarters, so I think that in terms of fear of the supply shortages, I have more complain about that other than the demanding stuff.

James Faucette – Pacific Crest Securities

That's really valuable commentary. Thank you, guys.

Will Davis

Thanks James.

Operator

And I’m showing no further questions in the queue at this time. I’d like to turn the conference back over to management.

Will Davis – Senior Vice President, Business Development and Chief Marketing Officer

Jeffrey?

Jeffrey Kang – Chairman and Chief Executive Officer

Yes. Yeah. Okay, thanks very much for the call. And I believe that 2011 will be the milestone year for Cogo as we continue to execute well and implement our new COGO 3.0 strategy and purse creative ways to maximize our shareholder value. I would like to thank all the shareholders and employees of Cogo for their support. And I look forward to meeting with many of you next week on my (indiscernible) show in the US. Thank you.

Operator

Ladies and gentlemen, this does conclude our conference for today. We thank you for your participation and you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Cogo Group's CEO Discusses Q1 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts