Good morning everyone. Thank you for standing by and welcome to Mindray’s Third Quarter 2011 Earnings Conference Call. At this time, all participants are in a listen-only mode. After management’s prepared remarks, we will conduct a question-and-answer session. Today’s conference is being recorded for replay purposes. If you have any objections, you may disconnect at this time.
I would now turn the call over to your host for today’s conference, Ms. Cathy Gao, Mindray’s Deputy Manager of Investor Relations. Please proceed, Ms. Gao.
Thanks operator. Hi, everyone, and welcome to Mindray’s 2011 third quarter conference call. Our financial results were released last night and are available on the company’s website, as well as on newswire services. In addition, an archived webcast of this conference call will be available on the Investor Relations section of our website at www.mindray.com.
Joining today’s call are Mr. Xu Hang, our Chairman and Co-CEO; Mr. Li Xiting, our President and Co-CEO; Mr. Alex Lung, our Chief Financial Officer; Mr. Jie Liu, our Chief Operating Officer; Mr. David Gibson, our President of North America Operations; and Ms. May Li, our Deputy Chief Financial Officer.
Our management team will review third quarter highlights, as well as speak to the current financial and market environments of each of our major sales markets, after which, management will be available to answer your questions.
Before we continue, please note that this call will contain forward-looking statements made under the Safe Harbor provisions of U.S. Private Securities Litigation Reform Act of 1995. Statements made and views expressed here today that are not historical facts are forward-looking statements. You should be cautioned that forward-looking statements are only predictions and may involve inherent risks and uncertainties. As such our actual results may be materially different from the statements made and views expressed here today due to a variety of factors.
A number of such risks, uncertainties, and factors are outlined in our public filings with the SEC. In particular, please refer to risk factors beginning on page four of our Annual Report on Form 20-F. Any projections made here today are based only on limited information currently available to us, which is subject to change. Mindray does not undertake any obligations to update any forward-looking statements except as required under applicable laws.
I will now turn the call over to Mindray’s CFO, Mr. Alex Lung.
Thank you, Cathy. Good morning and good evening ladies and gentlemen. Thank you for joining us today for our 2011 third quarter earnings results conference call.
First, I will provide an overview of the company’s overall financial results of the quarter. Mr. Jie Liu will then discuss our performance in all geographical regions outside of America. Mr. David Gibson will then discuss our North American operations and Ms. May Li will discuss other company updates. Before opening the call to questions, I will discuss our 2011 outlook.
Despite a volatile global environment during the third quarter, we are pleased to report another good quarter, with close to 30% year-over-year increase on the top line of a total of $218.4 million. China revenues led growth and grew significantly by 35.4% year-over-year. This was primarily driven by our regular sales or non-tender sales, which represented over 90% of China sales this quarter.
We are happy to see the strong sales growth trajectory in the domestic market, thanks to the continued positive impact of our sales re-enforcement program as well as favorable hospital and government spending trends at county level hospitals.
International revenues were strong at $124.9 million with 25.9% year-over-year growth. This represents 57.2% of worldwide sales. Our good performance continued to reflect the success of our increased investments in the international delivery channels. In this quarter, emerging markets remained our key drivers for growth with more than 30% year-over-year growth. Eastern Europe, the CIS region and Asia-Pacific continued to deliver more than 30% year-over-year growth. The Middle East and Africa exceeded our expectations and grew over 40% during the period, thanks to big government orders in Turkey and our continuous sales efforts in public sector in major African markets. Developed markets also contributed nicely with double-digit sales growth increase, both in North America and Western Europe.
Non-GAAP gross margin was 55.5% as compared to 59.5% in the third quarter of 2010 and 57.6% in the second quarter of this year. The decline compared to the last quarter was mainly due to higher portion of tender sales which carried lower gross margins. Compared to last year the gross margin comparison was also unfavorably impacted by recurring factors including taxation and FX.
R&D continues to be our focus. In the past quarter, we introduced six products, the iMEC Series patient monitors, the new iPM patient monitors and the DP10, DP20 and DP30 black and white Ultrasound Systems and A3 Anesthesia System.
Non-GAAP selling expense was 18% as a percentage of revenue compared to 17.7% last quarter and 17.2% in the same period last year. The increases were mainly a result of higher compensation as well as increased sales and marketing activities. Non-GAAP G&A expenses were 8.9% of total net revenues compared to 7.7% last quarter and 8.8% in the same quarter last year. The sequential increase was primarily due to FX loss.
We have plans to better manage our FX exposure and we are actively finding ways to reduce FX exposure going forward. Our non-GAAP operating margin was 20.1% compared to 25.2% in the third quarter of last year and 24.2% this quarter – this past quarter. Non-GAAP net margin was 19.4% compared to 23.5% in the third quarter last year and 22.9% in the previous quarter. The declines reflect higher selling and G&A expenses. While our investments in the sales channel continue which resulted in lower margins, we believe that this is a short-term consequence of our long-term strategy to enhance our global market position. We do expect selling expenses ratio to stabilize going forward.
EBITDA was $48.4 million during the quarter, representing a 5.7% increase over the same quarter last year. Our net cash generated from operations was $29.9 million, up 7.3% over last year. Our DSO in the third quarter was 71 days as compared to 64 days in the second quarter of 2011.
Inventory days were 100 days versus 94 days in the last quarter and accounts payable days were 58 days in comparison to 57 days for the previous quarter. Our cash conversion cycle was 113 days as compared to 101 days last quarter. DSO for this quarter was largely in line with sales changes. Going forward, we anticipate some receivable increases as well as possible fluctuation of DSO due to seasonal sales changes.
In regards to inventory, our inventory level was higher this quarter mostly due to seasonal pattern. We expect that inventory level to continue to normalize in the next couple of quarters. Overall, we continue to exercise cautious credit policies and reinforce insurance protection in our key markets worldwide and remain confident that we have a healthy working capital position.
I will now turn over the call to Jie, who will discuss our strategic initiatives and sales trends by region.
Thanks, Alex. I would like to first discuss our China sales. We are very pleased with our domestic sales performance this quarter. China sales grew strongly with 35.4% year-over-year. We have achieved positive results through our strategic initiatives and have also benefited from increased hospital and government spending particularly on county level hospitals.
As communicated in last few quarters, our enhanced domestic sales team structure coupled with our CRM system have both contributed significantly to boost our China sales. During the third quarter, we continue to increase investment in sales, marketing and service activities as well as distributed network strengthening. We expect all of this credits to further strength our long-term competitive position in China. County level hospitals is where Mindray has strongest presence. We have seen that county level hospital spending become more favorable to Mindray, and the patient traffic continue to increase.
And the same time, various government initiatives have been announced and are excluded to improve county level healthcare standards. These all forms basis for our optimism for an improving operating environment in China.
Now, I would like to discuss our international sales, especially emerging markets. In the third quarter, we recorded strong growth in our international markets of 25.9%. Our continued solid performance reflects the success of our investment to enhance international sales channels. Emerging market performance was again a key growth driver, growing by more than 30%. We continue to execute high growth of over 30% in East Europe and CIS region as well as Asia-Pacific.
In the Middle East and Africa despite the political unrest sales exceeded our expectations and recorded substantial increase of more than 40% during this period. Big government orders in the Turkey as well as our continued sales efforts in South Africa and the East African markets more than offset the glitches in other areas. However we continue to closely monitor the situation in this regions going forward.
Moving onto developed markets, North America operations grew close to 16%. Mr. David Gibson will provide more color on North American operations. In Western Europe, we delivered almost 17% year-over-year growth, thanks to our strategy to expand our direct sales team.
In regards to our BC segments, region sales continued to accelerate this quarter to over 31% of our IVD sales, versus 28.4% in the second quarter this year. Last quarter, we introduced the BC-6800, a high level automatic hematology analyzer together with several exclusive reagents. This is one of the most advanced IVD product that Mindray had so far, and we are optimistic about its long-term market potential as well as reagent sales it will potentially bring.
We continue to expect reagent sales to contribute a larger portion of our IVD sales in the coming quarters. Our mid to low range patient monitors anesthesia machines, defibrillator and surgical equipments all help contributing to patient monitor segments, strong performance this quarter. Just couple of weeks ago, we demonstrated three new patient monitoring systems at CMEF in China. The BeneView T1, the compact multi-parameter module and a lightweight transport monitor, the new iPM Series providing a flexible modular patient monitor solution and the iMEC Series providing the efficient green patient monitoring solution.
We also introduced to the U.S. market the A3 Anesthesia Machine, an expansion of A Series Anesthesia Machine. These products will further increase our product offering for different markets and will continue to have us gain market share in this segment. For the Ultrasound segment, color ultrasound products was the main growth driver, with the DC-8 Color Ultrasound System to be introduced in America in 2011. We expect to gain a stronger foothold in highlighting the segment in China and the emerging markets. With 10 product introductions so far this year, we delivered annual goal of 7 to 10 new product launches. Together with that, we are continued to actively seek external opportunities that could bring complementary technology in our all product to all company.
Next, I would like to invite Mr. Dave Gibson to discuss North American operations.
All right, thank you, Jie. North American group had a good quarter with overall sales growth of almost 16% compared to the third quarter of last year including over 25% growth in equipment sale. This is the fifth quarter in a row of double-digit increases, and continue to grow much faster in the overall market. Execution of our plan to expand our certain markets with new products from sales channel has been excellent. Quarter growth this quarter again outpaced product sales growth and we expect our revenues for the remainder of the year to be on track.
The Ultrasound segment continues to be our largest growth driver. The expansion of the direct sales channels has delivered great result and this is the first quarter that direct sales exceeded distributor sales in the U.S. The positioning of our direct sales efforts into the emerging ultrasound market has yielded strong sales synergies with our pre-existing Mindray team. We also continue to strengthen our distribution channels for outpatient care and the distribution team delivered strong growth this quarter as well.
Our hard work to constantly improve and upgrade our existing products based on customer feedback has demonstrated with the enhancement to the M7 that we presented at the recent ASA. Adding an visualization with the iNeedle software of our newly (inaudible) treated patients with more confidence.
In the Monitoring Product segment, we are seeing robust order trends for the V Series platform. The V Series has already enabled us to target and win in larger hospitals that were out of reached before. Our plan is to continue to build on this platform so that we can penetrate the large hospital segment and double our market opportunity. We are so early in the rollout of the V Series with the result to-date are ahead of our internal plans.
In the Anesthesia segment, the A Series allows to execute our multimodality sales strategy more effectively with procedural ultrasound internal monitoring. The A5 continue to generate enthusiasm among customers including a successful installation in the university hospital. We are pleased with the sales and order trajectories since the launch in Q1 of this year. We also launched the A3 anesthesia system which is targeted at the outpatient surgery market.
Our profitability continued to improve significantly. We expect to further benefit from economies of scales as our overall sales level increases in addition improving our competitive position in the market products such as the N-7, the V series and A5 are significant contributors to our improved gross margins. Going forward, we’re going to plan to continue investing in market initiatives that build a stronger global brand among our hospital customers and build the direct sales channels. The North American team will also have a lead role in product development strategies for all of the development market.
I will now transfer the call back to May who will comment on the another announcements as well as the guidance for 2011.
Thanks David. As we have discussed in another press release, where Board of Directors had approved a share buyback program of up to US$100 million leveraging a strong balance sheet. The buyback program reflects our confidence in the long-term growth prospects of the company as well as our commitment to increasing shareholder value. As previously communicated, the company will continue to actively pursue other growth opportunities in the meantime.
Thanks May. I would now discuss our 2011 guidance. Based on the positive sales trajectory we have achieved so far, we are pleased to raise our full year revenue guidance to more than 20% growth from our previous guidance of more than 16%. We anticipate regular sales in China to be grow this year. Based on our strategic initiatives as well as continued favorable Chinese private and government healthcare spending, especially in county level hospitals.
We also expect our key emerging markets to demonstrate strong growth. In developed markets, we expect Mindray to demonstrate good growth in U.S. and Western Europe. We also reaffirm our non-GAAP net income guidance of more than 10% year-over-year growth. This figure excludes the tax benefits related to the key software enterprise status and assume a corporate income tax rate of 15% applicable to the Shenzhen subsidiary. Lastly our capital expenditure projection remains to be in the range of $70 million to $80 million for 2011.
Thanks Alex. We are now turning to the operator to open the line for questions.
Thank you. Ladies and gentlemen, we will now begin the question and answer session. (Operator Instructions) And I’d like to remind all participants, we will limit to one question to each participants. Thank you. Your first question comes from Jinsong Du of Credit Suisse. Please ask your question.
Jinsong Du – Credit Suisse
Thank you. Could you elaborate more on the third quarter margins and also the future margin trend, for example what is the margin differences between the tender announcement in China because if I remember correctly, you said that only 10% of the China sales is from tender, however the Q-on-Q gross margin was more than 2%. So if you could elaborate on that, that I will be great. And also on the gross and operating level what will be margin trend going forward? Thank you.
Hi, this is Alex. Thank you very much for the questions. With regards to the gross margin changes in this quarter compared to the same quarter – to the last quarter mainly, we have more tenders sales and actually in this quarter, we have increasing tender sales both in the China domestic market and also in the international market as well. As already pointed out, the gross margin in tender sales is actually lower than our regular sales. But it’s actually varies from market to market. To certain extent, yes it will be 10% but in certain situation also certain country it will be different and sometime the margin differential will be larger.
And also in this quarter, compared to same quarter last year, other than the tender sales impact and there is also a taxation impact and Forex impact as well. With regards to the taxation, I believe we have explained it in our previous quarters that since the end of last year, the China government has imposed the China construction tax and also the education surcharge. And together with that it has an impact to our margin of one percentage points. And also since most of our manufacturing is made in China and eventually denominated mostly in RMB, and our international sales has actually expand actually our FX exposure as a result of more of our cost bias toward RMB has actually increased our FX exposure and reflected in our gross margin line.
Going forward, well in terms of gross margin, I would expect the gross margin will behave in the same seasonal manner as what we have experienced in the past. In terms of operating margin, I would say in the – you would see our fourth quarter we should actually show a sign of increased and then you would see more positive impact in the 2012.
Jinsong Du – Credit Suisse
Your next question comes from Shaojing Tong of Bank of America. Please ask the question.
Shaojing Tong – Bank of America
Hi, can you hear me?
Shaojing Tong – Bank of America
Hello. Thanks for taking my question. Again it’s sort of pretty hard for me to early had to – of this various factors. So I would just ask it in a simple way because the first half of the year or the first quarter I think management did give a pretty clear guidance potential marketing erosion [ph] this year which at that time was expected to be around 200 basis points to 250 basis points down on non-GAAP operating margin. So after three quarters, obviously you’re on track to achieve that target?
Hi, it is Alex. Thank you for the question. Just first of all, answer your question on overall yearly basis, we still stand by the overall movement on our gross margin. With regard to this quarter I think the principal reason is that we have served down more tender sales actually coming in not just from China but also from the international market as well. And that actually maybe in this quarter delayed from the historical trend.
Your next question comes from Ingrid Yin of Oppenheimer. Please ask your question.
Ingrid Yin – Oppenheimer
Hi, good evening everyone, thank you for taking my question. Could you explain a little bit more on the tender sales? Exactly how much of tender sales is from China and how much is from abroad? We know governments tenders really it’s hard to predict, because we trying to figure it’s a rapid growth, is sustainable on both domestic side and on the export front?
Okay. Actually I have the – thank you for the questions Ingrid, hi. The China tender sales account for approximately 8% of this quarter.
Ingrid Yin – Oppenheimer
8% on the China sales.
Ingrid Yin – Oppenheimer
Okay. So that’s about $8 million to $9 million. And from abroad, how much is that?
From abroad, that is quite significant amount in terms of tender sales. I think to my record it’s in the region of $6 million to $8 million or so.
Ingrid Yin – Oppenheimer
Okay, great. Yes and you also mentioned the operating margins for 4Q should increase and the same for next year. I wonder what is the magnitude of the increase, we should expect for another – the coming quarter, end the year?
Okay. Well I think just go back two days to the same point we were expect the gross margin to be in the region of – sorry, the gross margin for the year will be in the region of 56% to 57% this year and for the next year, I believe the gross margins will be within that range as well. But if we – if we I mean next year, we will see more opportunities coming into China and also for the emerging market as well, so the margin change maybe different as a result of the sales mix and also the geographical mix.
Ingrid Yin – Oppenheimer
Okay, that’s good to hear. And also they are expecting SG&A leverage for next year, right?
Yes. We will, I mean – we would see more leverage on the SG&A side going forward. And it is our aim to further enhance our cost structure, so that the overall operating expenses as a percentage of revenue should – to improve. But having said that, Mindray is still a growing company. We would continue to invest in our infrastructure, our system and people, try to increase our sales.
Your next question now comes from Jack Hu. Please ask the question.
Jack Hu – Deutsche Bank
Yes, good evening, congratulations on a strong quarter. I actually have a different question. You mentioned that if you are investing across the China, the emerging market and the developed markets, my question was can you share with us your return on investments status in these region kind of in a normalize period and also what is your view on the outlook of ROI improvement in the medium to long term especially in U.S. and E.U.?
Okay. Hi, thank you for the questions. Well first of all, I think we look into investment into our different segment primarily in the China region, and the developed market region and the developing market region. Actually the return on investment in this region, actually vary quite differently. In our developed market region it is mostly on a direct tax basis and then in our China and our developing market, it’s mostly on distributing model. So the return would be different. And generally based on the distribution model, we find these actually higher.
For China, we have seen a good growth as a result of our investment in infrastructure and people. I think going forward we should see more of enhancement when we actually come to the point whereby we more refined our sales team and the business process. For the international, I believe the return will be vary from country to country because the developing market actually quite have one big joint [ph] segment.
For developed markets, we continue to see good growth in the U.S. and the Western Europe region. And we see more opportunities other than patient monitors, but also the other tool line of our business. And we believe that developed market would have good return as well.
Your next question now comes from Bin Li of Morgan Stanley. Please ask the question.
Bin Li – Morgan Stanley
Yes, hi. I have a question on the balance sheet and cash flow, and can you explain that the – I understand the fluctuation almost on the AR days and inventory but if you can shed more color on this and also in terms of the cash flow norms, things could be slightly lower and also on the balance sheet, I think you’ve raised your short-term – long-term loans in 2011 a bit slightly above, very healthy balance sheet in terms of cash, and can you explain the rationale?
Hi, thank you for the question. As you have pointed out also, we in this quarter we have increase in inventory balance and the balance sheet and overall our account receivables. Actually if you look at whole trend, our account receivable is actually is still relatively high during the year for third quarter and for inventory balance as well. For inventory, mostly it’s actually related to our ramp up in production and also keeping extra stock in order to cater for our Q4 production. We see that inventory balance coming down when we are moving towards the end of the year. With regards to account receivable, you’ll notice that they will increase also in line with our overall increase in revenue.
As we also pointed out, because of this two we have a slightly lower number in terms of operating cash generated in this quarter as compared to the previous quarter. You also mentioned about our loans. Actually, in Mindray, in terms of our cash reserve, the distribution of this cash reserve on mostly in China and (inaudible) reside in our individual overseas countries. Actually the loan that we took out is actually to support the working capital requirements for our overseas operations.
Your next question now comes from Sean Wu of JP Morgan. Please ask you question.
Sean Wu – JP Morgan
Hello. Hi, can you hear me? This question actually I think for Jie. I would like to know more about the new development, product development efforts. So first of all, how I believe will the sales of newly launched MRI 360 (inaudible) doing very well, trying to penetrate into technology hospitals. Do you have any kind of plan to be more competitive against the multinational (inaudible) which are seeing maybe year-over-year costs appear to be stronger and you guess with the investment, (inaudible).
Hi Sean, this is Jie. In terms of the radiology product line, we are still a newcomer, and we are focusing more on the digitized MRI system. MRI system is the – we have – our system is probably lower than magnetic MRI systems because of their are rare metal price increase. It’s kind of product property may not have the price future. But back to the radiology for the digital x-ray, we are still growing faster but that because of the base is small we believe this segment will be still some have some place to go.
So probably we’ll gain some shares gradually in this line, but in terms of our overall business, the radiology line series are very small business. Our major focus is focusing on whether actually it’s not for the medical imaging system this line, the major focus from actually the cost that’s the big driver for our imaging line of growth. So it will give us a very good foundation for the future especially for the DC-8 and this product will be launched very soon and we believe this kind of product will opens the door for the relatively higher segment to the Mindray product.
So this comes to customer [ph] we didn’t have the products to reach. And with the introduction of DC-8, we believe we have more customers and bigger addressable market for the cost side.
Your next question comes from Du Wei of Goldman Sachs. Please ask your question.
Du Wei – Goldman Sachs
Hello, can you hear me?
Du Wei – Goldman Sachs
Hi, I actually have one question. It’s for the IVD segment, I did see you seeing have an increasing contribution of reagent sales at IVD. So I want to know how much if you can give a little bit more color how much that will help overall gross margins, and that’s the first question. The second question I am sorry, I have to ask this one is more broad, given I think if you’re looking into next year, we all know this year government has putting a lot of emphasize on the county hospital sales, infrastructure expansion, so that’s how we’re seeing a tremendous amount of money put in that space. I think from the management level, how do you view your business in next year? Do you see more challenging, or are you still seeing the environment is very capable? Thank you very much.
Hi, Du. I think go back to the reagents sales, the margin, we need to really consider as what’s the business model is. For the IVD products especially for the high end machine, typically you go through some reagents rental model that is not only for their – for reagent, the perspective property you get revenue and higher margin but with the machine perspective is that you – that’s a different story. So combined together I think we are in line with our margin structure historically. So but gradually when you have more inflation and consumption of reagents become bigger probably you get some improvements that’s the structure of the reagents and machine itself. As well as there are another customers like (inaudible) favorable to us because we are and that’s our traditional strong area and also we have very good distributive network and a good service structure. That is not there in other company, you can really copy in the short term.
Your next question now comes from Richard Yeh of Citigroup. Please ask the question.
Richard Yeh – Citigroup
Thanks for taking my question. On the selling expenses, I would like to get some color on what’s actually driving up the costs and how we should think about the fourth quarter and 2012? And the second question related to the county level hospital growth. I would like to get some color on what’s your thoughts on – what’s actually driving at the county level hospital it is, I think if we recently had done some checks and it looks like the county level hospitals growth is as similar to the cost to hospitals, and what you’re seeing in the county level hospitals and then what will be growth like in 2012? Thanks.
Richard Yeh – Citigroup
Hi, thanks. Hi Alex.
Yes. Okay. The G&A expenses actually as I mentioned just now, actually part of the increase is also – is actually related to the increase in compensation because as we expand our sales team that include a international headcount and also in China domestic headcount. And also in China, you understand that the inflation has actually gone up and together with exchange impact, actually that actually we are bearing more of the compensation costs.
And also with the investment in the sales re-enforcement program, we have developed a key account team. The key account team actually will visit the hospital directly and understand the hospital needs and bring opportunities to us. This actually key account manager that we set up has actually increased the exposure of the organization towards the hospital at the same time that also increased our cost on traveling and also marketing activities. We also have some cost in relation to the infrastructure of the sales re-enforcement program that we initiated a couple of quarters ago. Its costs incurred in this quarter are mostly related to refining the process training and also improving the (inaudible) platform.
The second question is about the county level hospital. And most county level hospital are class two hospital. So your answer is right. It’s similar and its.
Richard Yeh – Citigroup
What will be growth rates next year?
What’s the growth? Which growth?
Richard Yeh – Citigroup
The county level?
County level hospital, their spending. The different market business has different answers but its relatively most of their county level hospitals the growth rate is higher than the tier-one hospital, that’s the class three hospitals. So they are only one (inaudible) actually it’s the 5% higher than the tier-one hospital.
Your next question comes from Katherine Lu of Cowen & Company. Please ask the question.
Katherine Lu – Cowen & Company
Hi, thank you for taking my question. I’d like to ask a follow-up question on the gross margin line. Alex, you mentioned you expect full year 2011 gross margin to be in the range of 56% to 57%. And then you also mentioned that this year we should see similar seasonality as we have seen in the past. I think in the past the 4Q tend to be the weakest in terms of margins including some of the inventory write-downs. So I am just wondering how should we be thinking about 4Q for this year and perhaps that also leads to another question, I have on the revenue guidance. You had very strong first three quarters, and you’ve raised the guidance, but I think that implied – the guidance basically imply revenue growth of over 8.3% in fourth quarter, I understand you used the word at least, but that just seems to be a quite modulation from the first three quarters. I am just wondering if there are any particular reasons for the conservatives on the revenue guidance at this moment. Are you trying to control some low margin sales in order to support a stronger than expected fourth quarter margins? Thank you.
Hi, thank you for the questions. With regards to your questions on the gross margin, I believe the gross, I mean you are right, actually in the fourth quarter we do have some adjustment in our inventory reflected in our Q4 margin. But actually overall, if you look at the margin in the same period last year, actually the gross margin as we estimated has already taken into account obviously there are no changes. And together with the annual impact as a result of the tax and also to the FX. So we believe the margin that we suggest is still achievable. And also actually in this fourth quarter you mentioned about our revenue guidance. I would say in this quarter China will continue to perform well over 20%.
And in our emerging markets, we believe that the emerging markets will continue to do well in high teens segment. But in terms of the developed market region, because of the uncertainty of the European countries debt issues and also the still relatively uncertainty on the U.S. market, we’ll expect the U.S. to be on a single-digit growth. So I mean that’s how we arrive at the Q4 expectation. And of course we will continue to do our best in order to exceed our current guidance.
Your next question now comes from Jessica Li of CICC. Please ask the question.
Jessica Li – China International Capital Corporation Limited
Thank you for taking my questions. I’d like to actually understand your capital allocation strategy (inaudible), how would you strike a balance between R&D, acquisitions and returning cash to investors. And also how much of your cash is overseas? Will you fund the share repurchases with overseas cash? And then finally just on your FX, given that your exposure to FX is increasing, I wonder whether you really a hedging strategy in place or are you contemplating one? Thanks.
Okay. Thank you very much for the questions. First of all in terms of R&D, yes, our coverage strategy to invest around 10% of our annual revenue into our R&D development. We see R&D as a very key segment of our business growth and in terms of R&D – actually both of the core development on the R&D is going to have us to develop our future products roadmap as well. When you mentioned about the cash application in terms of M&A, in terms of our M&A strategy, we basically focus on three-pronged aspects. The first is we’re interested in continue with product in the same segment as us. And it can actually utilize our existing channel to improve or expand our business.
And second is actually for technology, that actually complements to our existing product lines and that can help us to shorten our time to market. And thirdly, we are also interested in business in the similar medical segments but also demonstrate high growth and high profitability. We actually look at investment both in China domestic and also in the international space as well and you would see in the past two quarters, we have invested in domestic Chinese companies. These are all funded by our internal cash resources.
In terms of capital transactions, I mentioned earlier, since our distribution of our cash actually mostly in China domestic market, we will fund the capital transactions with our cash in the overseas first and let’s comes to the point whereby we see the needs of additional cash and we will look into hospital financing, that can actually help us to achieve the capital transactions. And the third part you mentioned about the FX. In the past we do not engage in any hedge arrangements. And mostly because most of our transactions are actually denominated in U.S. dollar and the trend of RMB appreciation is actually affected into our business. And actually in this quarter we were affected by the European debt issue whereby there was a significant depreciation of Euro hedges [ph] in September because of the lack of hedging arrangement we’ve occurred additional exchange loss as a result of this.
We are aware of this situation and we have a plan in place to closely monitor this hedge arrangement with this FX exposure including enter into FX cash contract and also in order to monitor our receivables more closely or pick the other possible financial instruments such that we will be at a more certain position of our FX position going forward.
Jessica, this is May. I just want to for take a minute, on one point with regards to allocation of capital, our model there is initiatives such as R&D, M&A opportunity as well as various forms of the Chinese to shareholders such as the buyback dividend payment thinking of the obviously the principal has always been to try to maximize shareholders return. And I think if you take a closer look at our balance sheet position we are in that net cash position of more than $440 million at the end of third quarter. And given our cash inflow – continuous cash inflow quarter in, quarter out, and we have obviously consider all of that and to make sure that we have sufficient cash. Therefore our working capital need as well as M&A opportunities are in the pipeline before we consider options such as special dividend or share repurchase programs.
Your next question now comes from Dave Turkaly of SIG. Please ask your question.
Dave Turkaly – SIG
Thanks, quickly on the FX one. I think you said there was an impact in gross margin, could you just give us the absolute dollar amount of the top and or the bottom line impact from FX?
Hi, thank you for the question. I think overall our FX impact is such that I mean for a change in 10% of the RMB against the dollar, that will be about 1% impact to our net margin, whereas with regards to the U.S. dollar against Euro, if it is 10% to 15% change, it actually affects our net margin about 0.2% to 0.3%.
Dave Turkaly – SIG
That’s the net market impact, was there – can you quantify the top line, and I guess my follow-up would be you have a lot of cash on your balance sheet, it looks like you drilldown $15 million in the quarter, and your interest income was kind of up $2 million sequentially. Do you think you need to drawdown more and how was that so strong in the quarter? Thanks.
Okay. Yes, with regards to our cash balance, you’re right, as May also earlier pointed out, we do have a substantial cash reserve of $5.3 million in total. Again that offset debt we already carrying, actually we have a free cash of roughly above $450 million plus. So actually these are the cash we can actually apply in low including expanding our operations and also for our R&D activities.
Your next question comes from Shaojing Tong of Bank of America. Please ask your question.
Shaojing Tong – Bank of America
Hi I just want to ask a minor question regarding your reported nine months non-GAAP earnings growth, in your report it shows about 7% growth, our retrospect that [ph] is 8.5% growth. Is that different from the tax benefit from the base of last year, can you clarify that?
Hi Shaojing, this is May. Yes, you are absolutely correct that the first nine months year-over-year non-GAAP net income growth of 7% plus has included the tax benefit of $8.6 million recorded last year as well as $7.6 million recorded this year. But given our guidance was based on exclusion of those tax benefits. So more inductive first nine months non-GAAP income growth rates or more relevant to our guidance will be 8.5% year-over-year growth.
Your next question now comes from Anthony Petrone of Jeffries Group. Please ask the question.
Anthony Petrone – Jeffries Group
Thank you for taking my questions. I guess, I want to begin with revenue performance in the quarter, strong across all divisions particularly in China. I am wondering if you could walk us through how that relates to the distributor relationships that you’ve developed throughout the year specifically within the tier-one and tier-two segments of the market. How long have those distributor relationships been in place and how competitive were the wins experienced in the quarter? And then just a follow-up on use of cash, there has been a lot of that with the net balance I believe of $440 million partly from the equity raise, drilldown some debt as well. You mentioned usage of cash, so I am just wondering if uses of cash due become larger if indeed they are targeted for M&A, you’ve made two small acquisitions earlier this year, I am just wondering if we can see something substantially larger next year? Thanks again.
Hi Anthony, this is Jie. I’d answer the first part of the question regarding the competitive position for the China sales team probably in the past few quarters we continuously communicate with investors internally, I would call the CRM structure changed behavior all changes the way we do business as well. So we set up the strategic account team to really target some selected hospitals that means 240 tier-one hospital and other private hospital group that will be the different way doing the business. In the past probably the distributors had a different product line due to the different distributors where we have a project, the different distributor which has a hospital separately.
And the hospital were getting little bit with different (inaudible) but the recent changes for the projects our people will be as our cognizant or behavioral, all people will organize all the difference together to have a one team to negotiate or do the business with hospital. That’s the way of changing the big projects. And also for the county level hospital and for some other tier-one hospitals that’s similar structure, with use our people [ph] as a account manager to really manage the business. It’s not like in each different product line going to the different distributors. The distributors are still there, but in a more organized ways. So that’s the major change we’re getting from the past.
Hi, it’s Alex. With regards to your second question on use of cash front. Actually well M&A we actually actively looking for acquisition opportunities that complements our business or that help us to grow. But as you may know M&A – they are in negotiation process in more than some time the timing of completing the transaction doesn’t mean necessarily within our control. That actually including opportunities in both China domestic and also international as well. But we still actively pursuing in terms of sizes you have seen to China domestic M&A that happened. We’ll continue to look at if we haven’t really set ourselves a limit of that but we will actually look into potential which is comparable size to our operation, our regional operations.
Your next question comes from Ding Ding of UBS. Please ask your question.
Ding Ding – UBS
Thank you and good afternoon, or good evening and good morning everybody. On your guidance you raised your revenue guidance but maintained the guidance on the net profit. I wanted to know what expense line that you did not or you underestimated before and what cost line do you expect or do you think could potentially pose next year surprise for the remainder of the year or going into 2012? Secondly relates to the margins. County level hospitals sales is what percentage of your China revenue and is there any margin difference between the county level hospital sales versus other tier hospital sales? Also relates to your direct sales versus distributor sales. Can you give us a percentage by the major markets? What percentage of your sales are from direct sales now, and do you have a target of what level of direct sales you wanted to achieve and how would that affect your margins going forward? Thanks.
Hi Ding Ding, this is Alex. First of all, when you mention about the expense line, actually as we discussed in previously call and also in this call, we continue to invest in the infrastructure in particular like the sales re-enforcement program. And also because of our growth in the international market as well, we also increased and enhanced our set up in the international as well. That’s why in the past three quarters you noticed that we have a relatively higher total expenses ratio as a percentage of revenue. As we discussed it earlier in the fourth quarter, we will expect the total expenditure as a percentage of our revenue to come down to a more stabilized manner.
In terms of absolute expenditure, you would also see the quantum to be most favorable in the Q4 as well. And as such it will enhance operating margin and also our net margin in Q4. Which we do think [ph] going forward we’ll be adopting a similar cost structure that what we have offset – what we will be expecting in the Q4 going forward. With regard to your questions on the expenses level, also well put it this way, as Mindray is in investment – investing mode which is actually our plan, our intention to invest and also to expand our global coverage in international and also in the China domestic market as well. Actually these activities we believe that is important in the competitive environment but when the competitive environment becomes more fierce and we need to increase our expenditure in order to maintain our plan, and that will be the case whereby the expenditure maybe beyond our original plan.
Another question of your revenue in terms of direct sales, actually our direct sales are mostly in relation to the developed market covering the U.S. and the Western Europe, and that accounts for mostly above 20% of our overall revenues.
Ladies and gentlemen we have now reached the end of our question and answer session. I’ll now turn the call over to your host, Ms. Cathy Gao. Thank you.
Thank you everyone for participating into this call. As always, we appreciate your support of Mindray. The replay of today’s webcast will be available later today. Our CFO and COO, Deputy CFO, my IR team and I will be available for questions today. Thank you for joining us and we look forward to speaking with you soon.
Ladies and gentlemen that does conclude our conference for today. Thank you for your participation. You may all disconnect. Have a great day.
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