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Executives

Winnie Yam – IR

Charles Zhu – SVP, Operations

Takyung Sam Tsang – CFO

Analysts

Jack Hu – Deutsche Bank

Bin Li – Morgan Stanley

China Medical Technologies, Inc. (CMED) F1Q 2011 Earnings Call August 16, 2011 8:00 AM ET

Operator

Good day ladies and gentlemen and welcome to the First Quarter 2011 China Medical Technologies, Inc. Earnings Conference Call. My name is Dian and I will be your operator for today. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions]

As a remainder today’s conference is being recorded for replay purposes. I would now like to turn the call over to your host, Winnie Yam. Please proceed.

Winnie Yam

Thank you. Good day ladies and gentlemen. I am pleased to welcome you to China Medical’s earnings conference call. China Medical already announced its first fiscal quarter financial results ended June 30, 2011. A copy of the press release is also available on the company’s website 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 U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risk and uncertainties. As such, the result may be materially different from the views expressed today. A number of potential risks and uncertainties are outlined in the company’s public filings with the U.S. Securities and Exchange Commission.

China Medical does not undertake any obligation to update any forward-looking statements 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’re pleased with the financial result of the first fiscal quarter, in particular the continued growth of Molecular Diagnostic segment. We expect our FISH and SPR based HPV-DNA chip business to continue driving our growth.

As mentioned in our previous earnings call, we have been working on a number of initiatives to support our long-term growth. Since then we have established few strategic collaborations. The first one is the collaboration with Da An Health, a leading and fast growing independent service laboratory network in China for both our molecular diagnostic products to new group of potential uses small and mid-size hospitals in China through Da An Health network which currently covers over 2,000 hospitals.

The current usage of molecular diagnostic test by the small and mid-sized hospitals through either their pathologic department or also as independent labs is low. This is primarily due to the inadequate qualified technicians and high price of the tests.

However, with the increasing investment by the Chinese Government through its annual budget and healthcare reform budget and the increasing spending by the growing middle class for the help, we believe the use of more accurate molecular diagnostic tests for the earlier detection of diseases and disorders, we are very prevalent among small and mid-sized hospitals over time, in particular through also independent labs which can save the requirement of additional investment by these hospitals.

The partnership with the leading independent service laboratory networks will provide a first mover advantage for CMED and benefit both parties in the long run. The other collaboration being an important strategic move of CMED is the joint sales research and development collaboration with Leica Microsystems, our work leader in the anatomic pathology.

We always believe that our FISH products and SPR products are global products since our commercial offering in China. However, as the Chinese company, it is costly and potentially ineffective and risky to market these products in the international markets by ourselves considering different and complicated regulatory approval process in different countries and regions, various business practices, medical reimbursement condition and distribution channels in developed in emerging markets.

To partner with Leica, a leading global player will help us promote our FISH product to global market outside China effectively. The use of FISH probes on Leica’s BOND automated staining system has been proven and the Leica’s collaboration with Abbott has two FISH probes. We believe the joint research and development of competing diagnostic FISH probes including HER-2, EGFR and TOP2A on Leica’s BOND system will be successful.

In addition the further research and development have cytology based FISH probes for cancer detection and biomedical diagnoses on Leica’s BOND system is equally important. Leica’s BOND system has been widely used in many countries and we anticipate that Leica while leverages the existing customer base itself are automated FISH probes in the future which really expand the testimonial to its customers. And at same time, we will promote the automation of FISH test on Leica BOND system to a high volume uses through our well established network with over 400 tumor hospitals in China.

Apart from the two collaborations just mentioned we are also in discussion with a number of global players about different paths of collaborations for our other molecular diagnostic products. With respect to the update each business line, our SPR based HPV-DNA chip sales continue to grow at double-digit on a sequential basis.

We expect this trend to continue in the coming quarters. The suspension of riding free SPR equipment is because we want to focus our efforts to increase utilization of our HPV chips among existing users and we are confident that we can sell our new automated SPR equipment to other potential hospital uses in the future. The satisfaction from the existing SPR hospital uses combined with their increasing use of HPV-DNA chips and our discussions with the potential hospital uses make us believe that many hospitals will be willing to buy our new SPR equipment HPV chips.

The sale of new SPR equipment will add another revenue stream for our SPR business line. We expect a new SPR equipment to be available for sale after receiving FDA approval in second half of calendar year 2012 and we plan to start promotion of the new equipment in early 2012 so that hospital buyers can start their internal purchasing process in advance.

Before the launch of new SPR equipment, we will selectively provide our existing free SPR equipment in certain hospitals, which are expected to have high HPV test usage.

For the FISH business line, we are delighted to see the continued growth in the use of our FISH probes and our hospital uses. We expect the growth to continue in particular the use of new SFDA approved FISH probes for the detection of prostate cancer and TOP2A Gene Amplification. We have other four applications under the examination by SFDA including lymphoma, miscarriage, myelodysplastic syndrome and soft tissue sarcoma.

We expect to receive SFDA approvals for these applications during the next half. We are also excited that FISH test for certain hematological malignancies have been included for the first time in the clinical guidelines issued by the Chinese Ministry of Health recently. The inclusion is mainly attributed to the hospital results are using FISH test in the relevant studies of MOH and Chinese Medical Association.

We expect that inclusion of the FISH test in the clinical guidelines together with the positive comments from the tier one hospitals participating in these studies will stimulate the use of FISH test in clinical diagnosis over time. We expect other studies conducted by the MOH as well as Chinese Medical Association using FISH will help MOH considering including FISH test in clinical guidelines for other diseases in the future.

Turning to our immune-diagnostics segment. Our [inaudible] remain a stable business. We have seen a relatively stable pricing environment and increasing volume of test by hospitals. However we experienced slower payments from some of our ECLIA distributors. To control the bad debt risk from distributors, we have totally monitored slow paying distributors and have recently taken measures such reduction in the credit limit for some of the low paying distributors, then control over their order fulfillment according to the payments.

The measures have had some impact on our ECLIA business, but deals with our significant bad debts. Meanwhile we continue to add qualified distributors which diversified the bad debt risks. We expect some ups and downs in this business between quarters but in general ECLIA will remain a stable business for us.

We understand the massive concerns on our account receivable selection period or DSO and also our ability to handle our convertible debt before maturity. Sam will address these matters later.

I have finished, Mr. [inaudible] remarks and I would like to turn the call over to Sam. Sam, please?

Takyung Sam Tsang

Thank you, Charles, and welcome everyone. Let’s highlight our financial results in the first fiscal quarter. Our first quarter recurring revenues increased by 27.4% year-over-year to RMB227.1 million or $36.7 million. Our first quarter net income increased 6.1% year-over-year to RMB45.7 million or $5.5 million. Our first quarter diluted earnings per ADS increased 4.7% year-over-year to RMB1.55 or $0.21.

Our first quarter non-GAAP net income increased 58.7% year-over-year to RMB 90.5 million on US $14 million. Our first quarter Non-GAAP diluted earnings per ADS increased 56.9% year-over-year to RMB $3.42 or US $0.53. Our first quarter adjusted EBITDA increased 46.7% year-over-year to RMB 154.3 million or US $23.9 million. We generate cash flows from operations in the amount of RMB 62.2 million or US $9.6 million during first quarter.

Let’s discuss our accounts receivable collection period of DSO first. Our DSO increase in recent quarters due to slower payments from some of our ECLIA distributors and the change in sales mix [inaudible] as mentioned the slow payments from some ECLIA distributors and the measures we have recently taken to reduce the risk of bad debts from distributors. Change in sales mix related to the increasing portion of our revenues from sale of FISH probes and SPL based HPV-DNA chips. As you know, we sell our FISH probes and HPV chips to hospitals directly and ECLIA via agencies to distributors.

Hospitals pay us from six to 12 months and the bigger the hospital the longer the payment cycle. Meanwhile, distributors pay us in about three months. We consider the risk of bad debt on hospitals to be very low given that they are tier 1 hospitals have a strong financial position and are government owned.

We haven’t had a bad debt from a hospital since the commencement of our FISH business in 2007, but had bad debts from several key distributors in the past. Recently, we increased the compensation of our direct sales people based on cash collection from hospitals to increase incentive for collection.

On the other hand, we want to highlight that we continue to generate sizable cash flows from operations in the past few quarters even though our DSO increase. We expect to see stabilization and decline in our DSO in the coming quarters.

Regarding our ability to handle our convertible debts, we have above $17 million of convertible debts maturing this November which are mainly small compared to our cash position of about $192 million. The next maturity of our $247 million will be in two years. We believe that our cash position, our future free cash flows and assets to other sources of funds such as commercial banks in China will provide sufficient liquidity to pay-off the debts before maturity. We have noticed that our convertible debts maturing in August 2013 have been trading at a substantial discount. We believe this condition is reasonable to reduce our convertible debt.

Let’s turn to our financial results. First, our FISH recurring revenue achieved both year-over-year and quarter-over-quarter growth during fresh quarter.

FISH recurrent revenue increased 31.5% year-over-year to RMB 142.1 million or US $22 million. Our HPV chip recurrent revenue also achieved both year-over-year and quarter-over-quarter growth during first quarter. HPV chip recurrent revenue increased 17.8% quarter-over-quarter to RMB 14.1 million or US $2.2 million in the first quarter. Our ECLIA recurrent revenue was RMB 81 million or US $12.5 million in the first quarter. Our ECLIA recurrent revenue remained stable during the first quarter.

Second, our non-GAAP gross margin in the first quarter increased from 59.1% to 83.1% on a year-over-year basis mainly due to more contribution from the sales of FISH probes and HPV chips, which generate higher gross margin and the decrease in the number of free ECLIA analyzers provided to distributors and free SPR analyzers provided to hospitals.

We expect the benefits from the change in sales mix to offset the annual increase in wages of production personnel and the potential increase in raw material costs going forward and therefore expect the non-GAAP gross margin to remain stable at the current level. Our non-GAAP operating expenses increased by 12.7% year-over-year from RMB 43.5 million to RMB 49 million or US $7.6 million in the first quarter.

The increase was primarily due to increase in diverse sales efforts and increasing salaries of personnel. We expect the operating expenses to increase faster in the following quarters primarily due to increase in sale expense for additional compensation to sales people for collection of accounts receivable from hospitals, and annual increase in salaries of personnel.

We have taken into account these factors in providing our target non-GAAP net income for second quarter. 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 loans about typical for China income tax purpose as well as the accrual before the income tax on distributable earnings generated in China.

Our cash position at end of June 2011 was about RMB1.2 billion and $191.8 million. We generate like cash flows of RMB62.2 million or $9.6 million from our operations in first quarter. We receive payments from [inaudible] which increase our net cash flows from the investing activities to RMB96.7 million or $15 million in first quarter. Net cash flows used in financing activities of RMB41.6 million or $6.4 million in the first quarter primarily related to the repurchase of our convertible loans.

Last but not the least, is our outlook for second quarter. We estimate our revenues for second quarter to range from RMB238 million or US$36.8 million to RMB240 million or US$37.1 million, representing a year-over-year growth of 17.9% to 18.9%. We estimate our non-GAAP net income for second quarter to range from RMB82 million or US$12.7 million to RMB84 million or US$13 million, representing a year-over-year growth of 25.4% to 28.4%.

Our non-GAAP diluted earnings per ADS for second quarter is estimated to range from RMB3.07 or US$0.47 to RMB3.15 or US$0.49, representing a year-over-year growth of 28.8%, 22.8% to 26%. Regarding the outlook for fiscal year ending March 31, 2012, we maintained a target annual revenues. Given the better non-GAAP gross margin, we have raised the range of target non-GAAP net income. And accordingly the range of target non-GAAP diluted earnings per ADS. This estimate on May based on our current views of operating and market conditions are subject to change.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from Jack Hu, Deutsche Bank.

Jack Hu – Deutsche Bank

Thank you for taking my questions and congratulations for another good quarter. My questions is actually regarding your prepared remarks on your sales model and channel changes, also including your on-sales incentive changes. Can you elaborate on these each business line?

Takyung Sam Tsang

Jack, this is Sam. The increase in incentive to our sales pallet, particularly pallet sales people is to help speed up the collections. As the sales people, they visit hospital frequently, we also see the collection time is long which is low more for hospitals to pay the vendors, not only us but also all other vendors, to hospitals. But we believe that we increased compensation to our direct sales people based on the cash collection will help to work on each process of the cash payment that the hospital hopefully can soften the cash collection from hospitals for our molecular diagnostic products. Jack, I just missed your other questions. Can you repeat?

Jack Hu – Deutsche Bank

Sam can you elaborate on sales channel or modular changes and also including the incentive changes for each of business line including ECLIA, FISH and HPV is anything on the fields or distribution channel changes or what incentive program?

Charles Zhu

For the channel, actually we do not have changes in the sales channel. We still using distributors for our ECLIA business, which we sell our ECLIA products to distributors and distributors sell to the small and midsize hospitals. And for the HPV and FISH we still maintain our direct sales force to sell our FISH and HPV products to hospital customers and the message we mentioned above the ECLIA business is to reduce the quite limit for some of the slow paying distributors because we see some risk from this slow paying distributors.

And so we believe that to reduce the credit limit which means the amount of goods they can purchase on us and pay later. We reduced the Marshall debt in any case of unexpected bad debt situation it will reduce the potential launch for the company. So this is what we mentioned the measures we taken consuming our increasing DSO, but a lot has changed in the channel. We have some measures to protect the companies or accounts receivable.

Jack Hu – Deutsche Bank

Thank you. Just one more question. So, how many distributors you have for the year and then just to see how – what a percentage you decided to face out and then how many are you going to add in channels?

Charles Zhu

I just wanted to confirm that we didn’t have any changes in the sales model in the channel.

Takyung Sam Tsang

Yeah and we have about 200 distributors and the concern is mainly the relatively larger distributors which pay – which took longer time to pay because the risk we saw is also higher or the potential loss is also higher for the major distributors. For smaller distributors, normally we [inaudible] on the cash collection and normally they will have this often more of slow payment.

Jack Hu – Deutsche Bank

Thank you, I will jump back in to the queue then.

Operator

And the next question will come from the line of Bin Li, Morgan Stanley.

Bin Li – Morgan Stanley

Hi, thanks for taking questions. This is Christopher on behalf of Bin Li. On the HPV, can you give us the progress of HPV? We saw the sales were up sequentially. Do you have some sort of color for us in terms of the trends for this year and also next year? Will there be any catalyst in the next 12 months about the business? Thanks.

Takyung Sam Tsang

Hi, Chris. This is Sam and we expect sequential increase in our HPV chip sales. We will continue because we see that there is still a lot of room to for existing hospital users to increase the use of our HPV chips for their patients. So we expect these sequential double-digit growth in our HPV chip sales to continue. At the same time we mentioned that the new second-generation SPR equipment which we expect to receive as of the approval in the second half of calendar year 2012 that is about in one year’s time and which we expect to generate a new [inaudible] stream for the company by selling the SPR equipment to the potential hospital users, most of them will be our existing FISH customers and so we think that we will strengthen the HPV revenue.

We have two stream of revenue from the equipment and also from the HPV chips and so before the formal launch of the SPR equipment, new SPR equipment our sales people will start working, promoting this to the potential hospital users so that these potential buyers they can start their internal process for the equipment purchase which normally take quite some time between the hospitals. And also we will selectively provide our existing SPR equipment some hospitals which are considered high volume HPV test user, so this will also increase the HPV sales during this period of time and also in the future.

Bin Li – Morgan Stanley

Thanks. On selling expenses, R&D and administrative costs, operating expenses we see that they are pretty low as a percentage of sales. Can you share with us your actions and will this be sustainable. Is this the – one of the reasons that you revised up your bottom line guidance? Thanks.

Charles Zhu

The sales and marketing expenses or some expenses relate to the promotional activities and some events of hospital customers that they have different events and gatherings and so this may happen even over the years or in the June quarter we just has less of such activities and so which makes the selling expenses are little bit lower. And we expect next quarter some more activities conducted between our hospital customers and these expenses will become lot more gain, and also we expect to incur more compensation expenses to our sales people, direct sales people which related to the collections from hospitals. For the R&D expenses, it relates to the projects ongoing.

Some projects – the different projects have different stage and at different stage they require different amount of purchases of materials and also certain surfaces. And so, it just happens some projects to require much spending in this first quarter. So we think that overall R&D expenses will be – will still be around 5% to 6% of our revenue.

And I think the adjustments to – divestment to the outlook for the full fiscal year 2012 in non-GAAP net income relates more to the improvement in our gross margin, GAAP gross margin based on the sales mix of more contribution from the higher gross margin products of FISH and HPV and also the decrease in the number of free ECLIA clear equipment and also free SPR equipments.

Operator

And the next question is a follow-up question from the line of Jack Hu of Deutsche Bank.

Jack Hu – Deutsche Bank

Thank you. Zhu, actually I have another question actually on DSO. Zhu, I heard you bringing this up, but would you be prepare to write down some of the [inaudible]?

Charles Zhu

Check the DSO – the question about DSO is what sorry.

Jack Hu – Deutsche Bank

My question is would you be prepared to write – to write it down some of the debt AR and if you do it generally what kind of percentage is there if you have to write down all?

Charles Zhu

We mentioned in our press release the amount of bad debt I will share we believe for this quarter which is about RMB2.4 million and we reveal our accounts receivable at the quarter and also based on different criteria including the paging the payment history and other relevant factors to determine bad debt we share – we provide. So the – in case of the actual bad debts we will utilize the bad debt reserve to offset the specific bad debt incurred on any customers so the current bad debt we serve which we provide every quarter is used to deal with the bad debt situation in the future.

Jack Hu – Deutsche Bank

Thank you. Actually I have another two questions regarding the [Inaudible] alliance under their recent deal. It’s first for this independent mail, can you maybe just give us timeline on how this collaboration is going to move forward and also most importantly how when it have any impact on top line and the bottom line?

Takyung Sam Tsang

[Foreign Language – Chinese]

Charles Zhu

There is the first collaboration is with Da An Health. Da An Health is service lab with each branch laboratories across China.

Takyung Sam Tsang

[Foreign Language – Chinese]

Charles Zhu

Pathology is one of the most important in their service lab.

Takyung Sam Tsang

[Foreign Language – Chinese]

Charles Zhu

Very simple in their [inaudible] There are any pathology sample based test. Pathology samples is around 200,000 test and the annual tissue of some probe is around 60,000 to 70,000 tests.

Takyung Sam Tsang

[Foreign Language – Chinese]

We think there are two major benefits they can be generated from the collaboration with Da An. The first one is our current 400 tier 1 hospitals or the large hospitals and they capture most of the cancer patients in China and the rest of the smaller hospitals in China, the cancer patients are not as large as in those 400 large hospitals. [Foreign Language – Chinese] And hence current coverage of the 2000 hospitals include some of the smaller tier 1 hospitals and some tier 2 and tier 3 hospitals same time.

[Foreign Language – Chinese]

Initially, they purchase less than worth of – RMB 1 million worth of FISH probes from us and we see the potential of providing more FISH probes to – so we – that’s why we initiate this collaboration with them.

[Foreign Language – Chinese]

So, we are planning to penetrate more of the new – more and new hospitals interest through their coverage.

[Foreign Language – Chinese]

From the number of the tissue samples they have seen each of their service labs is equivalent to the number of the tissue samples from three tier 1 large hospitals and this number is still growing very fast.

[Foreign Language – Chinese]

we are expecting the number of tissue samples they collected in their service labs there – independent labs will be growing in the future we expect our FISH business can generate additional revenues from the collaboration with Da An Health.

[Foreign Language – Chinese]

We hope that by next fiscal year all up there branch service labs will start offering FISH diagnosis services.

[Foreign Language – Chinese]

That’s for the first collaboration.

Jack Hu – Deutsche Bank

I have a just a one quick follow-up you mentioned it one independent on that or one site is equivalent to three Tier I hospital in terms of simple collection. How many sites do they have?

Charles Zhu

Eight.

Jack Hu – Deutsche Bank

Eight, okay, thank you. And then second question actually is for the Leica collaboration and its implication. I recall about a two or three years ago when Rouche launched at least 40 automatic device actually for immune-chemistry, they actually increased ASP from around RMB80 to RMB100 to around RMB140 to RMB150 so it’s somewhere around at least 50% to 60% price increase.

So my question here is first RMB10 million for this collaboration when you are agreeing to have the probes ready if that could be applied directly into the Leica system? And second are you planning any price increase?

Takyung Sam Tsang

[Foreign Language – Chinese]

To answer your first question, regarding the timeline, right now we are – we will start to develop the automated FISH probes 3D applications first [inaudible] and the timeline actually is very much depending on the SFDA requirement. Right now, we are in discussion with SFDA to determine what the additional application requirements are required for the new automated FISH kit.

If there is no additional clinical trial required, then the timeline could be shortened significantly if we only need to add a new usage on our existing FISH application – FISH registration. Then in this case the timeline could be very short because we have already done the validation on our existing probes on the Leico’s BOND system and it’s been successfully performed on their system already.

[Foreign Language – Chinese]

Regarding the second question I think that’s a good question and we also noticed that the price increase on the IHT reasons of applying on the automated staining system. One of the purposes for the collaboration for performing the FISH test on the automated system on Leico’s BOND system is also to explore the potential to increase the ASP for FISH test in the future.

[Foreign Language – Chinese]

As you know, to increase the selling price that will also involve the – applying for the new price quote in each provincial government, so during the process of the developing of this new product, we will start talking to the provincial government in preparing for them to applying for the new price quote.

[Foreign Language – Chinese]

To summarize if SFTA does not require us to perform additional clinical trials on the new automated FISH probes, then we expect the new product can generate a contribution for the Company in about one year’s time. If we have to perform additional clinical trials, then it will take a little bit longer timer than we expect to see the contribution in around year 2013.

[Foreign Language – Chinese]

And actually one of the other important benefits we hope to generate from this collaboration is the development on the cytology-based FISH probes.

[Foreign Language – Chinese]

These applications submitting to the applications, the tests done on the affluent, the urine samples and done other blood samples for the hematological related disorders.

[Foreign Language – Chinese]

Because from our current FISH utilization and consumption data, the cytology-based FISH applications are growing very fast.

[Foreign Language – Chinese]

For example, one of our last uses in Shanghai is in hospital in Shanghai and they are performing the pre-natal diagnosis using our FISH probes and their annual test is around 4000 tests and many of the hospitals they do not form the avenues and tissues every day so they usually select the avenues once a week. So once a week the test volume could be very concentrated, very acquired, high throughput processing.

Unidentified Company Representative

[Foreign Language – Chinese]

Takyung Sam Tsang

And also we see the same situation in some of the hospitals performing the hematology related disorders then that the weekly samples are exceeding 100 samples, the bone marrow. Okay. That’s it.

Jack Hu – Deutsche Bank

Okay. Thank you.

Operator

And this concludes the question-and-answer portion fort today. I’d like to turn the call back to Sam for closing remarks.

Winnie Yam

Thank you for joining our call. Please don’t hesitate to contact us if you have any question. Have a nice day. Thank you.

Operator

Ladies and gentlemen it does conclude today’s conference. Thank you again for your participation. You may now disconnect and have a great day.

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