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Executives

Winnie Yam – IR

Charles Zhu – SVP, Operations

Sam Tsang – CFO

Xiaodong Wu – CEO

Analysts

Jack Hu – Deutsche Bank

Chris Lui – Morgan Stanley

China Medical Technologies, Inc. (CMED) F2Q 2011 (09/30/11) Earnings Conference Call November 18, 2011 8:00 AM ET

Operator

Thank you for standing by. Welcome to the second quarter 2011 China Medical Technologies’ earnings conference call.

At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. (Operator Instructions). I must advise you that this conference is being recorded today, November 18th, 2011.

I would now like to hand the conference over to your speaker today, Ms. Winnie Yam. Please go ahead.

Winnie Yam

Good day, ladies and gentlemen. I am pleased to welcome you to China Medical earnings conference call. China Medical already announced its second fiscal quarter financial results ended September 30th, 2011. A copy of the press release is also available on the company’s website at www.chinameditech.com.

Today, your speakers will be Mr. Xiaodong Wu, CEO; Mr. Sam Tsang, CFO; and Mr. Charles Zhu, Senior VP of Operations. After they finish with their remarks, they will be available to answer your question.

Before we continue, please bear with me as I take you through the company’s Safe Harbor policy. The discussion today will contain forward-looking statements made under the Safe Harbor Provisions of the US Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risk and uncertainty. As such, the results may be materially different from the views expressed today. A number of potential risk and uncertainties are outlined in the company’s public filings with the US Securities and Exchange Commission.

China Medical does not undertake any obligation to update any forward-looking statements except as required by applicable law.

As a reminder, this conference call is being recorded. A replay of this conference call will be available via webcast on China Medical’s website.

Now, allow me to turn the call over to Charles, who will give remarks on behalf of Mr. Wu. Charles?

Charles Zhu

Thank you, Winnie. Looking at our FISH business, our direct sales team kept driving the sales of FISH probes revenue by increasing the test usage along our hospital customers. Besides, we have received SFDA approval for our second PCR-based companion diagnostic assay on KRAS mutation for colorectal cancer targeted therapy. The approval extends our companion diagnostic manual which includes FISH HER-2 kits for breast cancer and stomach cancer, FISH BCR/ABL kit for leukemia, FISH EGFR kit and PCR EGFR assay for non-small cell lung cancer, as well as the latest approved PCR KRAS assay for colorectal cancer targeted drug. We see huge potential on personal lives medicines for cancer patient in China and we continue to develop this market segment.

For SPR HPV-DNA business, we see the increasing recurring revenue from the sales of HPV-DNA chips among our hospital customers which conduct HPV test for their women patients. In addition we are in final stage to complete the development of our second generation SPR analyzer, which will be more compact, more user-friendly and has higher throughput. The future sales of new SPR analyzer to hospitals will add another revenue stream for our SPR HPV business line.

For our ECLIA business, we have implemented change in control of our credit sales to our distributors, in particular the slow paying distributors in view of higher risk of bad debt. As a result, we have experienced a decline in our ECLIA revenue.

As the general credit environment for our distributors is airtight [ph], we continue to maintain our control measures in the near-term. I have finished Mr. Wu's remarks and I like to turn the call over to Sam. Sam.

Sam Tsang

Thank you, Charles. Let's highlight our financial results in the second fiscal quarter.

Our 2Q '11 recurring revenues increased by 18.1% year-over-year to RMB238.5 or $37.4 million. Our 2Q '11 net income was RMB33.3 million or $5.2 million compared to net loss of RMB2.9 million during 2Q '010. Our 2Q '11 diluted earnings per ADS was RMB1.26 or $0.20 compared to diluted loss per ADS of RMB0.11 during 2Q '010.

Our 2Q '11 non-GAAP net income increased 36.9% year-over-year to RMB89.6 million or $14 million. Our 2Q '11 non-GAAP diluted earnings per ADS increased 35.2% year-over-year to RMB3.38 or $0.53.

Our 2Q '11 adjusted EBITDA increased 30.1% year-over-year to RMB151.4 million or $23.7 million. We generated cash flows from operations in the amount of RMB79.1 million or $12.4 million during 2Q '11.

Let's turn to our financial results. First, molecular diagnostic recurring revenue increased 38.5% year-over-year to RMB164 million or $25.7 million. Within molecular diagnostic system segment, our HPV chip recurring revenue increased significantly year-over-year to RMB16.3 million or $2.6 million in 2Q '11. Our ECLIA recurring revenue declined 10.8% year-over-year to RMB74.5 million or $11.7 million in 2Q '11. The decrease was primarily due to more stringent control over credit sales to distributors in order to mitigate the risk and magnitude of bad debts.

Second, our non-GAAP gross margin in 2Q '11 increased from 79.7% to 84.8% on a year-over-year basis, mainly due to more contribution from the sales of FISH probes and HPV chips, which generate higher gross margin and a substantial reduction in provision of free ECLIA analyzers and SPR analyzers.

Third, our non-GAAP operating expense increased by 19.3% year-over-year to RMB57.6 million or $9 million in 2Q '11. The increase was primarily due to increase in direct sales efforts for molecular diagnostic systems and sales incentives to direct sales personnel.

In addition, our high effective income tax rate was primarily due to certain expenses such as stock compensation expense, amortization of acquired intangible assets and interest expense of convertible notes weren’t deductible for China income tax purpose, as well as the accrual for withholding income tax on distributable earnings generated in China.

Our cash position at the end of September 2011 was above RMB1.3 billion or $206.5 million. We generated net cash flows of RMB79.1 million or $12.4 million from our operations and used RMB0.6 million or $0.1 million for our investing activities in 2Q '11. We did not have any financing activities in 2Q '11.

Last but not the least, our outlook for 3Q '11, we estimate our revenues for 3Q '11 to range from RMB245 million or $38.4 million to RMB250 million or $39.2 million, representing a year-over-year growth of 9.4% to 11.6%.

We estimate our non-GAAP net income for 3Q '11 to range from RMB85 million or $13.3 million to RMB88 million or $13.8 million, representing a year-over-year growth of 12.4% to 16.3%. Our non-GAAP diluted earnings per ADS for 3Q '11 is estimated to range from RMB3.20 or $0.50 to RMB3.30 or US$0.52, representing a year-over-year growth of 11.5% to 15%.

Regarding the outlook for fiscal year ending March 31, 2012 we narrow our target annual revenues to the range of RMB970 million or $152.1 million to RMB980 million or $153.7 million.

Given the estimated higher non-GAAP gross margin, we raise our target non-GAAP net income to the range of RMB335 million or $52.5 million to RMB340 million or $53.3 million, and accordingly a range of target non-GAAP diluted earnings per ADS to RMB12.40 or $1.94 to RMB12.60 or $1.98. These estimates are made based on our current views of operating and market conditions and are subject to change.

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

Question-and-Answer Session

Operator

(Operator Instructions). And you have a question from the line of Jack Hu of Deutsche Bank.

Jack Hu – Deutsche Bank

Good morning and good evening. I actually – I’m going to start the question with your guidance. So I see you slightly narrowed down your top line but increased your bottom line. Can you share with us what's the driver behind that?

Sam Tsang

Hi Jack, this is Sam. Yes, you see we narrowed annual revenue target and at the same time we increased net income guidance. The increase in the net income – non-GAAP net income guidance, as we mentioned, is because of the higher than expected gross margin, and one – there are two reasons for the increase in the non-GAAP gross margin.

The first related to the sales mix, because we sell more of our higher gross margin FISH probes and also the HPV chips. At the same time we have lower contribution from the lower gross margin ECLIA products. This is one reason. Another reason is we provide much less numbers of free ECLIA analyzer and SPR analyzers, which reduced our cost of revenue.

For the ECLIA analyzer, because we implement stringent credit control on our distributor and so at the same time less distributors are qualified who receive free ECLIA analyzers. And for the SPR analyzers, we are in the final stage of finishing the research and development of the second generation. SPR analyzers, which we tend to sell these analyzers to the hospital customer, and so at the same time we are providing much less of free first-generation SPR analyzer to the hospitals, and so – which reduce a certain amount of our costs and as a result the gross margin increased or improved as a result. And so we are able to increase the net income – non-GAAP net income target for this fiscal year.

Jack Hu – Deutsche Bank

Okay, thank you. So my next question is a kind of a follow-up on this one – on your margin expansion from both the gross margin and EBIT margin. Basically, as far as I can tell, this could be the only margin expansion story in our universe, China healthcare universe for at least for this quarter, well, even for this year. I'm just trying to understand what are the drivers actually behind operating margin improvement? You actually talked about the gross margin, say, on EBIT margin, how should we expect this going forward?

Sam Tsang

For EBIT margins which also include operating expenses items. If you saw – if you look at our operating expense items, it is a mixed picture, because we do have some – as a percentage of revenue some operating items like G&A expenses which we are able to reduce because of our control on the G&A items. And at the same time, you will see we have our selling expenses increases as a percentage of revenue compared to previous quarter, and this is because we increased our sales incentives to direct sales team for molecular diagnostic system. For RMB, it is relatively stable.

So I think, overall, we still expect our selling expenses to increase as a percentage of sales and at the same time, we are controlling our G&A expense item which are offsetting each other. And this we expect to continue in the next quarters. So I would say that because of the gross margin improvement, the EBIT margin improvement can be maintained.

Jack Hu – Deutsche Bank

Thank you. The next question is regarding your DSO and inventory days and also the cash converging cycle. We notice your ER base increased to 230 days from 221 day actually last quarter. Also inventory days increased to 51 days from 45 days from last quarter, and also cash converging cycle increased also. Can you share with us what happened here and how should we think of basically going forward? And most importantly, if we more than 200 days above the ER base, we see some – actually some issues – actually could be some potential issues for the working capital going forward and how should we understand it [ph]?

Sam Tsang

Yes. Jack, I think this is not something new for the higher potentially slower days as we explained because of the continued change in sales mix. When we experienced a better gross margin from the direct sales of FISH and HPV, at the same time we had to set the longer payment cycle from the hospitals. So we had more contribution from molecular diagnostic products; at the same time, we enjoy the higher gross margin and also by the [inaudible] in customers. And at the same time, we have to set longer payment cycle from hospitals.

So even though we look at ECLIA product which has a softer payment cycle than lower gross margin, actually we see a high risk from the receivable of distributors. Even though they have softer payment cycle but we see that the bad debt risk is higher among the distributors. So you can see, in this quarter we provide more bad debt reserve, which are mainly related to the distributors.

For the working capital – that's why we will tie up some of our working capital, but at the same time you can see our products generate pretty high gross margin. So the working capital required or the cost required to maintain or increase our supply of products will not be a problem to us. You can at the same time see that the operating cash flow from our operation is also pretty healthy even though we have higher accounts receivable days or inventory days, but you can see that our operating cash flow increases in this quarter, so – which should provide enough resources for us to support our business.

Jack Hu – Deutsche Bank

Okay, thanks. Fair enough. My last question actually is for Mr. Wu on a bigger picture question on policy. So in this year we have seen the city of Shanghai implemented a reimbursement of cost to control, so which is called – actually in Chinese called a double control, and also we have known that for next year around 40 cities in China is going to implement medical reimbursement of cost to control including 15 capital cities and 25 Tier 2 cities. Just based on our understanding, we understand actually these kind of security cost of control is mainly focusing on the items, actually especially on the drug items, that is reimbursed on the government insurance program. So my question to you is how should we evaluate the impact on your products? Secondly, if you can share with us, like what proportion of the product is reimbursed right now and what proportion of the revenue is not reimbursed? Thank you.

Xiaodong Wu

[Foreign Language – Chinese]

Sam Tsang

Jack, this is Sam again. We think that is still at the fair value stage of each program. As you know the program, they start slowly and also gradually. And I think even hospital, they are also trying to understand how to look which is a good time. For us we don't foresee a significant negative impact from this initiative to have products, because we think that our products for any – which is used for diagnostic purposes even though we've cost structure, the hospitals for the benefits of patients still have to use. So I think it will take some more time for companies and the hospitals to see how to work with this program, but currently is still in a smallest group and also is a pilot program. So we don't foresee a significant impact on our product.

Jack Hu – Deutsche Bank

Thank you. Congratulations again for a good quarter. I’ll jump back in the queue.

Sam Tsang

Okay, thank you.

Operator

Your next question comes from the line of Bin Li of Morgan Stanley.

Chris Lui – Morgan Stanley

This is Chris Lui calling on behalf of Bin Li. Can you tell us your clear trend in terms of ASP and also the volume growth?

Sam Tsang

Chris, we see that the kind of ECLIA is coming from the volume because of more control on the credit size to the distributors. For the ASP, there is – nothing has changed in the overall ASP four ECLIA products. Chris?

Chris Lui – Morgan Stanley

A follow-up question on accounts receivable days. Is there a target that you kind of had, say, by the end of next year [inaudible] you're just trying to see how it goes?

Sam Tsang

I think the accounts receivable days which will change in accordance with our sales mix. Currently we feel, even though we have a higher rate of molecular diagnostic sales to our overall revenue, we still have a portion of revenue coming from the ECLIA. So we continue to expect more contribution or increasing contribution from our molecular diagnostic product sales to hospital directly which will continue to impact our accounts receivable days.

And at the same time, we – actually, even though the distributor sales contribute softer receivable days, actually we see higher risk from distributors, compared to longer payment hospital customers. So there will be measures or – yes, measures we implement to mitigate risk of bad debt and for the ECLIA distributors through our stringent credit control, and also at the same time we increased sales incentive to our direct sales people which are related to the collection of our hospital customers. So we continue to see the effects – the positive effects from these measures to our accounts receivables.

Chris Lui – Morgan Stanley

Okay, thank you.

Operator

At this time there are no audio questions. I would like to turn the call back over to Sam for closing remarks.

Sam Tsang

Thank you for joining our call. Please do not hesitate to contact us if you have any questions. Have a nice day. Thank you.

Operator

Thank you for your participation. This concludes today's conference. You may now disconnect.

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