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Zhongpin Inc. (ZHNP.OB)

Q4 2006 Earnings Call

March 23, 2007 9:00 am ET

Executives

Crocker Coulson - President of CCG Elite

Xianfu Zhu - Chairman and CEO

Yuanmei Ma - VP and CFO

Baoke Ben - EVP

Analysts

Daniel Lee - Roth Capital Partners

Wilson Jaeggli - Southwell Partners

Presentation

Operator

Good day, ladies and gentlemen and welcome to the Zhongpin's Year-End Earnings Release Conference Call. My name is Nicole and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer towards the end of this conference. (Operators Instructions).

I'd now like to turn the call over to Mr. Crocker Coulson, President of CCG Elite. Please proceed.

Crocker Coulson

Thanks a lot. Good morning, ladies and gentlemen and welcome to Zhongpin's year-end 2006 conference call. I am Crocker Coulson, President of CCG Elite, Zhongpin's Investor Relations' firm. With us on the call are Zhongpin's Chairman and CEO, Mr. Zhu; Vice President and Chief Financial Officer, Yuanmei Ma; and also the Company's Executive Vice President, Mr. Ben, are all here in China this evening.

I'd like to remind our listeners that in this call management's prepared remarks do contain forward-looking statements that are subject to risks and uncertainties. Management may make some additional forward-looking statements today in response to your questions. Therefore, the Company claims the protection for Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Actual results may differ from those discussed today due to various risks, including but not limited to, unanticipated changes in product demand, interruptions in the supply of live pigs, downturns in the Chinese economy, delivery delays, freezer or facility malfunctions, poor performance of retail distribution network, changes in applicable regulations and other information that is detailed from time to time in the Company's filings with the SEC.

Accordingly, although the Company believes that the expectations reflected in these forward-looking statements are reasonable, there can be no assurance that such expectations will prove to be correct.

In addition, any projections we provide today with respect to the Company's future financial performance represent management's estimates as of today, March 23, 2007 and Zhongpin assumes no obligation to update these projections in the future due to changing market conditions.

For those of you who are unable to listen the entire call at this time, we are going to make a recording available via webcast for 90 days. You can find that on the webcast link in the press release that we have put out this morning.

Now, I am going to present the management's discussion section on behalf of Zhongpin's Chairman and CEO, Mr. Zhu.

Let me begin by saying how excited we are with the major accomplishments Zhongpin has made during 2006. We closed the year with strong results, generating record revenues of $143.8 millions; well ahead of the guidance we set forth at the beginning of 2006 of $117 million or 96% increase over 2005 revenues. The strong revenue growth during the year is attributed to our increased penetration to new markets as well as deeper penetration into current markets.

Gross profit for the year increased by 69.3% to $20.6 million, with gross margin of 14.3%. This again was well ahead of our earlier forecast for gross profit and gross margin of $16.4 million and 13.9% respectively.

Net income for 2006 was $6.4 million and net income adjusted for penalties, which we will discuss later, grew by 148.8% to $14.7 million, beating our full year guidance of $10.1 million by nearly 50%.

At the beginning of 2006, the management team laid out some very specific objectives in regards to the financial performance and strategic expansion goals. These included expanding our production capacity to meet the anticipated demand; growing our customer base by expanding each of our key distribution channels; expanding our geographic footprint to build a true national brand; enhancing our comprehensive logistic system; and also continuing to ensure that our products are both exciting and of the highest quality in order to retain customers and attract new ones.

We are pleased to report that we made significant progress on each of these key endeavors, and we are going to discuss each of them in turn.

Zhongpin started off 2006 by becoming a publicly listed company through a reverse merger in January. Simultaneously, we received proceeds of $27.6 million from private placement. We used the majority of these proceeds to expand our capacity. We constructed a new fresh-chilled meat processing facility at Zhongpin Industrial Park, which added 60,000 metric tons of capacity.

In November, we further expanded the capacity by leasing a processing plant in Heilongjiang Province, which has 28,800 metric tons of capacity. The outcome of adding these facilities was to increase the number of our facilities from five to six and increase the number of production lines from seven to nine.

At year end, total capacity had increased 110% to 187,000 metric tons. As we have said all along, a major part of our growth strategy is to build a leading national brand for pork products in China. Expanding our customer reach and consumer recognition is a critical part of this strategy. We employ four major distribution channels: Retail, food service distributors, restaurant and also non-commercial distributors and exports.

In 2006, we made significant progress in increasing our customers in each one of these channels. Over the course of the year, we expanded the number of retail outlets from 2,000 to 2,721 outlets. This includes 96 showcase stores, 856 network stores and 1,769 supermarket counters across China.

We grew from 1,200 institutional customers to 1,531 school cafeterias, factory canteens, army posts and national departments.

And during 2007, we grew from 30 export-registered processing factories to over 36 export-registered factories.

In addition to growing organically with our existing customers, resales are all expanding. We've also been successful in winning share and building new and sustainable customer relationships.

We've made considerable progress in growing our geographic footprint in second and third-tier cities during the year. We increased our presence from 44 to 75 second-tier cities and from a 142 to 226 third-tier cities. The number of provinces and first-tier cities remained unchanged at 24 and 29 respectively.

As our focus is more on increasing now the density of our distribution network, what we are discovering is that in many cases, the margins available in the second and third-tier cities and villages are often more attractive since the logistical difficulty of supplying fresh pork creates a less competitive environment in these locations.

One of our major competitive advantages is our comprehensive logistic system, which we are continuing to enhance with the latest technology, an APS Information Systems. Our logistic system now includes 192 temperature-controlled container trucks and railway service.

Given the very short shelf-life of chilled pork, the ability to manage inventories, logistics, customer demand and pricing strategies is critical to our success in this high-value segment. We've recently embarked on a significant enhancement to our systems to make sure we can sustain the same level of high efficiencies as we expand our scale of operations and move into new regions, and budgeted approximately $9 million for enhancements to our MIS and logistic systems in 2007.

We are also very active in keeping our meat product lines competitive. We work to strengthen our market position by continuingly [upgrading] and optimizing our product mix, enhancing our production lines and increasing production on our major high-margin products.

Our R&D center is dedicated in developing new processing technologies and products, and during the year we (inaudible) over 40 new products. As of December 31, 2006, we had over 200 unique meat products with 156 new products that are underdevelopment.

I'd now like to talk a little about the Company's growth strategy for 2007. Zhongpin's goal is to become the leading brand for pork products in China, which accounts for more than half of the world's total pork consumption. We are benefiting from very strong underlying growth in pork consumption, driven by the urbanization and growth of China's consumer class. We intend to grow faster than the market by leveraging our operational, logistics and retail platform and our very strong brand identity.

We have a very thoughtful multi-year plan to expand our market presence by targeting northeastern, central, and southwestern China, including the rapidly growing areas along the Yangzi River, the Eastern Coast and the Beijing-Guangzhou Railway. Given the importance of logistics to fresh-chilled pork business, we intend to be very methodical in this rollout. In order to supply these new target areas while maintaining our current market, we plan to significantly expand our pork production capacity in 2007 by 83% with a target of 321,000 metric tons by Q3 of this year.

As of April of 2007, we plan to add 10,800 metric tons of capacity to our Henan factory, which is dedicated to the production of prepared pork products. This expansion will increase our total annual prepared products by 75% to 25,200 metric tons. In addition, we plan to build two new facilities in 2007, which will increase our capacity for frozen and chilled pork by 84% to 295,560 metric tons.

Our first facility which will be located in Zhumadian in southern Henan Province, which is the largest pork producing city in Henan Province, supervised with significant geographic advantages. This $14 million facility is expected to come online in the second quarter of 2007 with annual capacity of 72,000 metric tons with 60% chilled pork and 40% frozen pork mix. We also plan to construct a new facility in northern Henan Province, with total annual capacity of 63,000 metric tons and a cost of $13.5 million with the same product mix. We expect the northern Henan facility to be completed in the third quarter of 2007. And this facility will be located in our major city also known for the production of live hogs.

Due to the very strong demand during the fourth quarter, we had to increase our reliance on OEM partners to meet demand. But as our new owned and operated facilities come online, it should contribute to improving our margins. Our production capacity for fruits and vegetables will remain at 12,600 metric tons annually in the coming year.

I'd also like to touch on our marketing and branding efforts with you. We market our pork products through a sales team in a network of regions in 24 provinces, including four cities with special legal status in the PRC. The sales team is responsible for securing orders for our pork products, maintaining and building relationships with existing customers and securing new customers. They are also involved in identifying new markets in line with existing customer base and our geographic expansion plans.

Our sales team travels to major cities in the PRC where they market and sell our pork products to wholesale markets and selected retail chains. In addition, our sales team markets pork products, vegetables and fruits to potential customers in Europe, Russia, Hong Kong and selected countries in Asia and South Africa.

We've successfully advertised at peak hours on CCTV or China Central Television, which is the most well-known television station in China and has the largest broadcast coverage. We've also increased our brand recognition by continuing to add Zhongpin's showcase stores, network stores and supermarket counters, each of which prominently displays the Zhongpin logo and brand name.

I'd like to now take a few moments to discuss the impact of our business of the recent increase in corn prices and subsequent increases in live hog prices.

During 2006, our average purchase price for hogs increased 8%, which did play some pressure on our gross margins. While we can partially pass on some of these cost increases to consumers, there is typically a lag between the increase of live hog prices and the prices at supermarket counters. And if we want to continue to gain market share, we are not always able to pass through all of these costs.

During this fourth quarter, corn and hog prices increased over 20% according to industry sources. And we anticipate the corn prices will continue to increase into 2007, which will also push up the price of live hogs.

In response, we are implementing several measures to minimize the impact to our margins. First, as our increased capacity comes online, we are going to have greater flexibility and be able to capture more of the production margin for ourselves.

Secondly, we are going to continue to work on optimizing our sales channels, so as to continue to capture market share while meeting our margin goals. For instance, our retail channel helps us to build a consumer brand and has higher associated gross margins, while the institutional channel has lower associated operating expenses and of course, higher volumes.

To make it clear, we intend to grow all our sales channels with a primary focus on operating profitability and the bottom line. In this respect, we think 2006 has been a milestone for our company with a rapid growth, and believe 2007 presents many opportunities to build on this success.

With that, I am now going to turn the call over to Yuanmei Ma, who will go in to further details on the financials for the year.

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Yuanmei Ma

Thank you, Crocker. Good morning ladies and gentlemen. I would like first to state that in today's call I will provide financial results before and after the penalty expense, so that you can understand our financial performance based on our operations.

Please refer to our press release issued earlier today for a reconciliation of these non-GAAP or adjusted items to the nearest GAAP measures.

I will now review our financial performance for the full year 2006. As Crocker mentioned at the beginning of the call, we are very happy to say that we exceeded our guidance set out at the beginning of 2006. Revenue for the full year of 2006 increased to a record of $143.8 million, an increase of 96% from $73.4 million in the same period of 2005. The revenue increase for fiscal 2006 was driven by a 128% increase in sales of chilled pork to $71.8 million, which represented 50% of sales.

Frozen pork increased 54% to $50.9 million and represented 35% of revenue. Processed meat increased 123% to $15.4 million and represents 11% of revenue for the year. Fruits and vegetables increased by 195% to $5.7 million and accounted for 4% of revenue. Our retail channel continued to generate the largest percentage of revenue, representing 45% in 2006. Restaurant and the non-commercial organizations represented 27% of revenue. Our food distributor represented 20% and exports represented the remaining 8% of revenue.

Gross profit for the full year of 2006 was $20.6 million, up 69% from our 2005 gross profit. Gross margin was 14.3% in 2006 compared to 16.6% in 2005. The decline in gross margin in 2006 was mainly attributed to increased cost prices in China.

In addition, during the fourth quarter, we increased reliance on OEMs to meet the higher market demand. We would expect going forward that our decreasing reliance on OEMs will help us minimize the impact of the increase of hog price on our gross margin in the coming year. We also encourage our investors to focus on operating margins and net income, which are the metrics that we as a management team focus on most closely.

Our G&A expenses for fiscal 2006 were $3.0 million or 2.1% of revenue compared to $2.4 million or 3.3% of revenue in 2005. The increase in the dollar amount of G&A expenses was primarily the result of increased expenses from being a publicly traded company.

As many of you who have been following Zhongpin know, our registration statement was delayed in becoming effective, primarily due to the change in SEC policy of Rule 415 under the Securities Act, which affected the number of shares we could register in the registration statement.

As a result of the delay, in June 2006 we began accruing penalties to the investors that participated in our January private placement.

While we are happy to say that our S-1 registration statement is now effective, we did recognize a one-time penalty of $8.35 million as a result of the cash we paid into the common stock and warrants we issued during the fourth quarter as a part of our negotiated settlement with these investors.

Our operating expenses for the year were $3.5 million or 2.4% of revenue in fiscal 2006 as compared to $2.3 million or 3.1% of revenue for 2005. The decrease in operating expenses as a percentage of revenue was the result of our increased total sales and operating scale.

Operating income for the year was $5.8 million compared to operating income in the year of 2005 of $7.5 million, adjusting for the one-time penalty we incurred. The non-GAAP operating income increased 89% to $14.1 million as compared to $7.5 million we earned for the same period a year ago.

Interest expense decreased to $1.6 million in fiscal 2006 from $1.8 million for the year of 2005, which represented a decrease of 13%. The decrease in interest expense was primarily a benefit of the equity private placement in the first quarter of 2006, which enabled us to repay and reduce our higher-interest-bearing bank loans.

Today we have a total of $83.8 million in undrawn credit facilities available to use.

Net other income increased to $1.2 million in fiscal 2006 from an expense of $1.1 million in fiscal 2005. This increase was primarily the result of an increase of $2.4 million in allowance income from the Chinese Central Government.

GAAP net income for the full year of 2006 was $6.4 million or an increase of 7.5% from $5.9 million in the full year 2005. Adjusting for the one-time penalties, non-GAAP net income was $14.7 million or an increase of 149% compared to the year of 2005.

GAAP fully diluted earnings per share for the year was $0.31, which reflects the additional 6.9 million preferred A shares, other common stock and warrants issued during and after our private placement compared to $0.50 in 2005. Adjusting for the one-time penalties, non-GAAP fully diluted EPS for the year of 2006 was $0.72.

Now, briefly turning to the balance sheet. As of December 31, 2006, we had $21.7 million in cash and cash equivalents and $1.9 million in long-term debts. Shareholders' equity stood at $52.7 million, up from $14.5 million at the year end of 2005.

Net cash provided by operations was $9.5 million. For the fiscal 2005, accounts receivable turn over days improved from 42 days in 2005 to 30 days. With respect to our existing investment plan, capital expenditures will be approximately $26 million for 2007. This includes the $70 million cost for the new facilities and additional $9 million for the construction of our low-temperature logistic and IT system.

We believe our existing cash and cash equivalents together with our available line of credit will be sufficient to finance our investment and operating requirements. However, we may determine to sell additional debt or equity securities in fiscal 2007 to raise funds to additional capital projects or strategic acquisitions that will enable us to strengthen our market position and accelerate our growth.

As we've disclosed in May 2006, the guidance for 2005 called for achieving $185 million in revenue and $15 million in net profit. We believe this guidance estimate to be conservative.

Now, Crocker Coulson will provide some final remarks before we open up the call for question and answers. Crocker?

Crocker Coulson

Thanks a lot, Yuanmei. To conclude, I'd like to say that the transformation of China's meat industry is still in its early stages. China is the world's largest market for pork, accounting for approximately 53% of global production and consumption. Yet, currently 80% of the meat sold in China is sold at open-air wet markets with only 20% sold in clean, temperature-controlled, hygienic environments found in supermarkets and convenient stores.

China is working diligently to quickly replace the traditional open-air wet markets with safe meat sold in markets with refrigeration, as the primary source of meat.

As a part of this program, Zhongpin will continue to receive from time to time grants and subsidized financing. More importantly, it creates a tremendous opportunity for Zhongpin and supports the trend of high growth rates for top and bottom lines.

We now have a very strong footprint in Henan Province with three factories, and have now expanded into Heilongjiang Province. The Heilongjiang factory not only expands our domestic presence to the northern part of China, but also is located close to the Sino-Russian Border, which facilities Zhongpin's international expansion with the Russian market.

We have in place continued expansion, which nearly doubles our current capacity, combined with expanding distribution channels. In addition, we foresee the potential that our organic growth may be further enhanced at some point in the future through acquisitions of other high-quality companies in a massive and highly fragmented industry. With these favorable market conditions and strong management team that has established a track record of success, Zhongpin looks forward to providing updates regarding these new developments in future quarters, as we continue to execute this expansion strategy and build a national premium brand for pork products in China.

I'd like to thank you all for your interest in Zhongpin. We look forward to updating you on the Company's progress next quarter.

Right now, we are going to open up the call to any questions that you may have for Mr. Zhu, Ms. Ma, or Mr. Ben, and [Michele Fong] will be providing translation.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Daniel Lee from Roth Capital Partners. Please proceed.

Daniel Lee - Roth Capital Partners

Congratulations on a strong quarter. I have a question. Can you just tell me, what was the sales volume in metric tons for Q4 in 2006?

Xianfu Zhu

[Foreign Language].

Daniel Lee - Roth Capital Partners

No, actually, I am looking for the actual sales volume not the capacity.

Yuanmei Ma

[Translated]. Sorry, ladies and gentlemen, it took time to dig out those numbers. We didn't disclose the Q4 numbers, but we did disclose the full year number of 2006, which is as follows:

For the sales volume of chilled pork is 59,284 tons. For frozen pork, it's 43,785 tons. For prepared meat, it's approximately 9,838 tons. And then for the fruits and vegetables, it's 9,504 tons -- metric tons.

Daniel Lee - Roth Capital Partners

Okay. Great, thank you. What was the capacity utilization rate for Q4 and I guess, as the Q1 is almost over, for Q1 also?

Xianfu Zhu

[Translated]. All right. For the utilization rate, it's really we need to consolidate and balance a lot of different facts, including the product mix and also balance the usage of resources and raw material. So, in general, for chilled and frozen pork the capacity utilization rate is around 80% to 90%. And for prepared meat, it's around 85% to 95%. And then for the fruits and vegetables, it's around 80% to 95%. And we believe for the utilization rate for both Q4 2006 and also the fourth quarter of this year, they haven't changed a lot.

Daniel Lee - Roth Capital Partners

Okay, great. Final question is can you shed some light on the average sales price for the three product segments, namely, chilled pork, frozen pork and processed pork?

Xianfu Zhu

[Translated]. Okay. All right, for the ASP of chilled pork it's around $1,210 per metric tons. For frozen pork it's around $1,162 and then for prepared meat, it's around $1,569 per ton.

Daniel Lee - Roth Capital Partners

Okay. Can you also tell us the margins for each?

Xianfu Zhu

[Translated]. Okay. So, for the gross margin, the prepared meat is the highest. Then we come to see chilled pork and then frozen pork.

Daniel Lee - Roth Capital Partners

Okay, great. Thank you very much.

Yuanmei Ma

Thank you.

Operator

(Operator Instructions). Your next question comes from the line of Wilson Jaeggli from Southwell Partners. Please proceed.

Wilson Jaeggli - Southwell Partners

Crocker, this is a question for you. I didn't really understand what you were saying about the corn prices here. You said something about 20% increase. Was that in the fourth quarter? Clarify that, if you would please.

Crocker Coulson

I believe that was an annualized price that we got from a publicly available website.

Wilson Jaeggli - Southwell Partners

Okay. So that's the price for the year '06, is what you are taking about, right? And that led to an average price increase for live pigs of 8%?

Crocker Coulson

Yes. An 8% is our figure.

Wilson Jaeggli - Southwell Partners

Right.

Crocker Coulson

We have more confidence in our internal figures.

Wilson Jaeggli - Southwell Partners

I can understand that. The second question is this. There is a substantial increase in revenues here in the fourth quarter over the September quarter. Revenues are up about 40%, up to almost $48 million. What is the cause of that major increase in revenues? Is this has to do with anything seasonal? Is it capacity additions coming online? What is the cause of that major jump in revenues?

Crocker Coulson

I think we will let Mr. Ben to handle that one.

Baoke Ben

[Translated]. Okay. The big jump of the revenue in Q4, 2006 is mainly due to two reasons. First of all, we got very big demand from the market. Usually for the fourth quarter the market demand is slightly bigger than the rest of the year. So, that's the first reason why the revenues grew a lot.

Secondly, as you know that we will expand our production capacity in Q1, 2007. So, before that, we need to do a lot of marketing initiatives. We need to do a lot of preparation in terms of the branding campaign and promotions, try to further enhance our brand recognition. So, this is also the reason why the revenues boosted in Q4, 2006.

Wilson Jaeggli - Southwell Partners

Okay. Thank you very much. If your run rate here at the fourth quarter would generate, if you were to keep that up without any new capacity addition, it seems like it would generate a run rate of $190 million for '07 in total revenue. So, that versus your lower guidance. I congratulate you on a very conservative guidance there. And thank you very much for a very successful ramp.

Yuanmei Ma

Thank you.

Crocker Coulson

Thank you.

Operator

(Operator Instructions). And there are no further questions at this time. I'd like to turn the call back over to Mr. Crocker Coulson.

Crocker Coulson

I think we'd like to conclude by thanking everybody for their interest this morning or this evening here in China. As we said, we have an exciting expansion plan for 2007 and are looking forward very much to coming back to you after we report our first quarter results. So, thanks a lot for your time, and we look forward to speaking to you soon. Bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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