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Ninetowns Internet Technology Group Company Limited (NASDAQ:NINE)

Q4 2006 Earnings Call

March 22, 2007 7:00 pm ET

Executives

Lisa Zheng - Assistant Vice President, Investor Relations

Tommy Fork - Chief Financial Officer

Shuang Wang - Chief Executive Officer

Analysts

Dick Wei - J.P. Morgan

Tim Shaw - Shaw Investments

Mitch Vitter - Maxim

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter and full year 2006 results for Ninetowns Internet Technology Group Company Limited earnings call. My name is Melanie and I will be your coordinator for today. (Operator Instructions)

I would now like to turn the call over to Ms. Lisa Zheng, Assistant Vice President of Investor Relations. Please proceed, Madam.

Lisa Zheng

Thank you, Operator. I would like to welcome everyone to Ninetowns' fourth quarter and full year 2006 results conference call. With me today are Mr. Shuang Wang, Chief Executive Officer; and Mr. Tommy Fork, Chief Financial Officer. After our presentation, we will have time for any questions.

Before we begin the formal remarks, participants are advised that this conference call will include statements about future events and expectations, which are forward-looking statements. All forward-looking statements involve risks and uncertainties and actual results may differ materially from those discussed in or implied by such forward-looking statements. These forward-looking statements speak only as of the date of this presentation, and while we may update some statements from time to time, we assume no duty to update them to reflect new, changing or unanticipated events or circumstances and you should not rely on such forward-looking statements.

In particular, the company expects to confront risks such as: one, the entrance of additional competing software product into the company’s marketplace; two, the need for the company to reevaluate and change its operating model; and three, potential further encouragement by the PRC Inspection Administration of the development of software product that may be competitive with the company’s existing software products, all or any of which may materially and significantly affect the company’s ability to generate total net revenue in the future.

Before turning the call over to our Chief Financial Officer, I would like to note the references in this call to dollars refer to amounts in U.S. dollars. For further information and to access the company’s earnings results presentation, please visit our English website at www.ninetowns.com/english.

I would now like to turn the call over to our CFO, Mr. Tommy Fork. Please go ahead.

TRANSCRIPT SPONSOR

China Direct Logo

China Direct (ticker: CHND.OB) is a diversified management and consulting company. Our mission is to create a platform to empower medium sized Chinese entities to effectively compete in the global economy. As your direct link to China, our organization serves as a vehicle to allow investors to participate directly in the rapid growth of the Chinese economy.

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Tommy Fork

Thank you, Lisa, and thank you all for joining us today. As we go through our remarks, I will reference our results presentation, which can be downloaded from our website, www.ninetowns.com/english.

As you have learned from our results press release, we continue to operate in a very challenging environment. Our performance for the fourth quarter and full year 2006 continues to be severely impacted by the transition due to the free software provisioned by the PRC Inspections Administration. Decreases in enterprise software sales adversely affect our revenue mix and consequently, our margins. We will discuss this a little bit more later.

In response to these challenges, we worked hard on a number of plans to revitalize our core B2G operations and to maintain the [inaudible] from our existing business.

Please look on slide 3 of the presentation. Our teams saw progress across a number of key areas in this regard. First, we were able to expand our installed user base by enhancing our customer service support, thereby incenting more customers to adopt our paid service contracts.

The advantages provided to our customers by the paid services include automatic restoration and industry specification updates, as well as a [inaudible] for [inaudible] customer support center, both of which have streamlined and solidified the overall users’ experience.

As a result of our efforts, let me refer you to slide four of our presentation. We sold approximately 2,400 iDeclare packages and approximately 10,000 iDeclare service contracts during the fourth quarter. For the full year, we sold roughly 8,250 iDeclare packages and approximately 29,000 iDeclare service contracts.

Also, as of the end of 2006, we have installed 20,500 free software under the PRC Inspection Administration’s directive.

As we have highlighted on slide five, some of the various clients who purchased iDeclare package in the fourth quarter include: Shiseido Liyuan Cosmetics, Mondo Floorings China, GS Caltex Langfang Plastics, Marubeni Qingdao, Shandong Longxi Group, Qingdao Gingerking International Trading, Bengeng Group International Trading, and Beijing Electric Wire and Cable General Factory.

To conclude, we end the year with an installed user base of 130,000. You can see on slide six and seven, the size and scope of our user base coupled with our leading technology present us with unparalleled market intelligence and unique competitive advantages. With this in mind, we have been hard at work in developing a B2B business platform that will leverage these two key rings of our core business. As noted in past communications, we have been directing increasing resources towards the development of the B2B platform.

In the fourth quarter 2006, our R&D investment was about $1.7 million and totaled over $3.8 million for the full year. This investment underpins our strategy for growth, as noted on slide eight of the presentation. Simply put, we will continue to increase our large B2G user base, drive customer conversion to paid premium services, and leverage our extensive customer base and large base into our next generation B2B platform, a key basis for our future growth. We will provide further details when they are ready.

Now, we will turn to a brief review of the financial results. A summary of the following information can be found on slides 9 and 10 of the presentation.

For the fourth quarter of 2006, we generated total net revenue of $4.5 million, representing a decrease of 33.2% compared to $6.5 million for the fourth quarter of 2005.

Net revenue from enterprise software for the fourth quarter was $2.5 million, representing 55.6% of total net revenue, as compared to 88.4% for the fourth quarter of 2005. Net revenue from software development services for the fourth quarter of 2006 was $2.0 million, representing 44.4% of total net revenue, as compared to 11.1% for the fourth quarter of 2005.

For the full year 2006, we generated total net revenues of $19.6 million, compared to $29.7 million for the full year 2005, representing a 36.1% decrease.

Enterprise software net revenue was $15.0 million, representing 76.2% of total net revenue, as compared to 84.7% for the full year 2005. Software development services revenue was $4.6 million, representing 23.8% of total net revenue, as compared to 15.0% for the full year 2005.

Our gross profit for the fourth quarter 2006 was $3.2 million and $17.5 million for the full year.

We achieved gross profit margin of 72% for the fourth quarter and 88.9% for the full year 2006. This compares to 92.1% for the fourth quarter of 2005 and 92.0% for the full year 2005.

We experienced a decrease year over year in gross margin, which is attributable to a number of factors. First and foremost, the decreased sales in 2006 of iDeclare enterprise software units. The lower sales resulted in a shift in our revenue mix from a typical 60% to 20% enterprise software to software development to a 56% to 44% breakdown.

Given the lower margin nature of software development work, which in the fourth quarter includes also a number of very low margin small system integration projects, our overall margin has been adversely impacted.

In addition, and on a more positive note, margins were impacted by an increased spending on R&D, sales and marketing, and SG&A. This is as a result of our ongoing efforts to develop a leading edge B2B platform, which we have mentioned earlier.

Selling expenses for the fourth quarter of 2006 were $342,000, representing a decrease of 69% from the fourth quarter of 2005. Selling expenses for the full year 2006 were $1.7 million, representing a decrease of 47% from the full year 2005.

General and administrative expenses for the fourth quarter of 2006 were $2.7 million, representing an increase of 48% over the fourth quarter of 2005. General and administrative expenses for the full year 2006 were $8.4 million, representing an increase of 53% over the full year 2005.

As we mentioned before, we have directed considerable resources towards the development of our B2B platform, resulting in total R&D spend of $1.7 million for the fourth quarter of 2006 and $3.8 million for the full year 2006. This compares to $545,000 in Q4 2005 and $1.4 million for the full year 2005.

Total operating expenses for the fourth quarter of 2006 were $4.8 million, representing an increase of 36% from the fourth quarter of 2005 and an increase of 66% from the third quarter of 2006.

The fourth quarter increase in expenses were attributable to an increased investment in the development of our B2B initiative, expenses incurred in reorganization of our B2G distribution channel, increase in legal professional fees attributable to our investment in [inaudible], and a general increase in the scale of our operations.

Total operating expenses for the full year 2006 were $14.0 million, representing an increase of 26% from the full year 2005.

As a result, operating loss for the fourth quarter of 2006 was $1.5 million, representing a 156% decrease compared to $2.6 million for the fourth quarter of 2005.

The operating income for the full year 2006 was $3.5 million, representing a 79% decrease compared to $16.6 million for the full year 2005.

Operating margin for the fourth quarter and full year of 2006 were minus 33.8% and 18.0% respectively. These compare to operating margins of 40.1% and 55.9% for the fourth quarter of 2005 and the full year of 2005 respectively.

We posted a net loss for the fourth quarter of 2006 of $0.8 million, or a loss of $0.02 per ADS on a diluted basis, compared to net income of $3.4 million for the fourth quarter of 2005.

Net income for the full year 2006 was $5.9 million, or $0.17 per ADS on a diluted basis, representing a 17% decrease compared to net revenue of $18.8 million for the full year 2005.

The diluted ADS or share counts for the fourth quarter of 2006 and for the full year 2006 were 35.5 million and 35.6 million respectively.

Finally, in accordance with our revenue recognition policy, in which our enterprise software sales and the related maintenance contract sales are recognized over a 12-month period, our unearned revenue balance at the end of the fourth quarter of 2006 was $3.4 million. This compared to $3.6 million at the end of the third quarter of 2006. We expect to recognize this unearned revenue balance of $3.4 million as revenue in the next 12 months.

Despite the challenges we faced throughout the fourth quarter and full year 2006, we believe we remain in a comfortable financial position, with a debt-free balance sheet and with a cash and bank deposit balance of $116.1 million.

Operator, that concludes our formal remarks. We will be happy to take any questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of Dick Wei with J.P. Morgan. Go ahead.

Dick Wei - J.P. Morgan

Good morning, Tommy and Lisa. I have a couple of questions. My first question is in terms of the sales and marketing, R&D, and G&A expenses. They went up quite a lot in the fourth quarter. I just wonder what kind of trend do you expect to see in the first quarter ’07 and going forward? Also, if you can break out between the software business and the B2B business, that would be great.

Tommy Fork

Dick, for the expenses, because we are now developing the B2B platform, so we expect that would be slightly increased in Q1 of 2007. For the whole year 2006, we incurred total expenses of $14 million, of which $1.6 million would be attributable to the B2B platform development.

Dick Wei - J.P. Morgan

So that is for the whole operating --

Tommy Fork

For the whole year.

Dick Wei - J.P. Morgan

Okay.

Tommy Fork

We incurred about $14 million in total expenses, out of which about $1.6 million is for the B2B platform.

Dick Wei - J.P. Morgan

Okay, great. Then, in terms of the gross margin level, I wonder, the reason for the decline, was it mainly due to the revenue mix between the two businesses, or is it there is some other reason for the margin to decline?

Tommy Fork

The main reason is the shift in sales in the revenue mix, because we had a decrease in the high-margin enterprise sales and decreased the total percentage of that enterprise software sales, so the margin is going down.

Dick Wei - J.P. Morgan

Okay, and my next question is in terms of the B2B business, can you give us some update in terms of some of the progress you have made, like when revenues are going to start coming in or some of the operating metrics that you can share with us?

Shuang Wang (Translation)

We have been working on our B2B platform for the past year and we are still in the preparation stage right now. But we will be ready to announce to the market our development as soon as we are ready.

Dick Wei - J.P. Morgan

Any expectation when we will see revenue, or would you rather not say at this time?

Shuang Wang

(Translation Not Provided)

Dick Wei - J.P. Morgan

(Translation Not Provided) Thank you.

Lisa Zheng

Just to make sure everybody else hears, this is a new business, upcoming new business so we are not ready to disclose its revenue model yet, until we are ready.

Operator

Our next question comes from the line of Tim Shaw with Shaw Investments. Go ahead.

Tim Shaw - Shaw Investments

Good morning, everybody. A quick question; Tommy, if you can answer, in the third quarter conference call, you mentioned about 50% customers would be renewing 2007. Are you still on that pace and going to stick with that trend?

Tommy Fork

This is our original target but as the sales of the service contract have been affected by the free software at the beginning of the year, so we allow -- and also, during the year we over-met our sales channel, so there is some negative impact on that, so we allow approximately -- at year end, the ratio is approximately 25%. But we are still aiming at achieving the 50% in the coming year.

Tim Shaw - Shaw Investments

Okay, great, and just one question; what was your employee headcount at the end of the year?

Tommy Fork

It is about 650 staff.

Tim Shaw - Shaw Investments

Okay, and that was up from 446?

Tommy Fork

Yes.

Tim Shaw - Shaw Investments

Okay, very good. Thank you.

Operator

(Operator Instructions)

Our next question comes from the line of Dick Wei with J.P. Morgan. Go ahead.

Dick Wei - J.P. Morgan

I have a couple of follow-up questions. First is, do you have any expectations for the SGS business for 2007? Do you have a bit of a strategy at this point?

Tommy Fork

We expect the SGS sales will remain at a similar level as Q3 of this year. We do not expect any increase in SGS activity.

Dick Wei - J.P. Morgan

What about the tax rate and capital expenditure expectations for ’07, and maybe for ’08?

Tommy Fork

As we are actively involved in tax planning, we expect the effective tax rate for 2007 will be below 5%. For the CapEx, we expect to have $1.8 million to $2.5 million in the coming year.

Dick Wei - J.P. Morgan

Great, thanks.

Operator

Our next question comes from the line of Mitch Vitter with Maxim. Go ahead.

Mitch Vitter - Maxim

Most of my questions tend to go with how poorly the stock has performed over the years. Has there been any thought of bringing in a new management team or potentially opening up an investor relations department in the United States, and/or using all that cash that you have to buy another company, or to expand in a different area? Because the shareholders are just paying a heavy price for owning shares in this company.

Shuang Wang (Translation)

We are constantly evaluating possible targets for acquisition. Now that we are engaged in both B2G and B2B business, there are more targets available for us to evaluate. As soon as we have some firm information, we will release it to the market.

Lisa Zheng

By the way, Mitch, we do have an investor relation consulting firm with an office in the U.S.

Mitch Vitter - Maxim

I have never seen in any of the releases anything that -- any company in the United States.

Lisa Zheng

We just recently engaged them, so probably it is our fault that we have not told everybody.

Mitch Vitter - Maxim

I mean, the whole trick of being a public company is enhancing shareholder value. You cannot disagree with that. It just does not seem like the company has been heading in the right direction. I am not an authority on what the problems are but it certainly seems like there are some issues in enhancing shareholder value. The stock has performed rather poorly. For a publicly traded company, the management team has a fiduciary responsibility to try to get that stock to perform better. Nobody could argue with that.

Thank you very much and keep up the progress.

Operator

Ladies and gentlemen, there are no further questions at this time. I would now like to turn the call back over to management for any closing remarks. Please proceed.

Shuang Wang

Thank you, Operator. Thank you for joining us today, everyone. While the conditions remain challenging, we are working hard as a management team to shape the future of our business and look forward to updating you on progress in the near future. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. That does conclude this evening’s presentation. You may now disconnect.

TRANSCRIPT SPONSOR

China Direct Logo

China Direct (ticker: CHND.OB) is a diversified management and consulting company. Our mission is to create a platform to empower medium sized Chinese entities to effectively compete in the global economy. As your direct link to China, our organization serves as a vehicle to allow investors to participate directly in the rapid growth of the Chinese economy.

To sponsor a Seeking Alpha transcript click here.

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