Synutra International (SYUT) on Q1 2017 Results - Earnings Call Transcript

| About: Synutra International, (SYUT)

Start Time: 08:00

End Time: 08:51

Synutra International, Inc. (NASDAQ:SYUT)

Q1 2017 Earnings Conference Call

August 10, 2016, 08:00 AM ET

Executives

Clare Cai - CFO

Bill Zima - Partner, ICR, Inc.

Analysts

Aatish Shah - Susquehanna Financial Group

Operator

Ladies and gentlemen, thank you for standing by and welcome to Synutra First Quarter Fiscal 2017 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, Wednesday, 10 August, 2016.

I would now like to hand the conference over to your first speaker today, Bill Zima. Thank you. Please go ahead.

Bill Zima

Thank you, operator, and thank you everyone and welcome to Synutra International’s first quarter fiscal 2017 earnings conference call. With us today is Ms. Clare Cai, Synutra’s Chief Financial Officer.

Before we begin, I would like to read the forward-looking statement. During this conference call, the company will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on our current expectations, assumptions, estimates, and projections about Synutra International and its industry.

All statements, other than statements of historical fact, in this conference call are forward-looking statements. In some cases, these forward-looking statements can be identified by words or phrases such as anticipate, believe, continue, estimate, expect, intend, is or are likely to, may, plan, should, will, aim, potential, or other similar expressions. These forward-looking statements speak only as of the date hereof and are subject to change at any time and we have no obligation to update these forward-looking statements.

With that said, I would now like to turn the conference call over to Synutra’s CFO, Ms. Clare Cai. Clare, please go ahead.

Clare Cai

Thank you, Bill. Good morning and welcome to Synutra International’s first quarter fiscal 2017 earnings conference call. Today, I will begin with updates to our operational initiatives, followed by a more detailed review of our financial results and outlook for fiscal 2017. After that, we will hold a question-and-answer session.

During the June quarter, our overall sales decreased by 5.4% year-over-year and our net profit attributable to common stockholders was $43,000 in the fiscal first quarter, which included a non-recurring 2.8 million loss on the long-term purchase contract related to the French project and a 2.4 million foreign currency exchange loss.

Sales of our core Nutritional Food segment experienced a slight increase from 73.7 million in last year’s first quarter to 74.4 million in the first quarter of fiscal 2017, which was mainly attributable to the 2.3 million sales contributions from our newly launched DutchCow ultra-high temperature or UHT liquid milk product.

As I highlighted on our last earnings call, in January 2016 we launched our liquid milk product both online and offline by importing OEM products produced by European manufacturers.

Since the launch, we have seen sales for this product double each month. Excluding the impact of the liquid milk products, sales of our powdered formula and prepared food products were down by 2% year-over-year. This was mainly due to a 10.2% decrease in average selling price, which was partially offset by an 8.8% year-over-year increase in sales volume.

We are pleased to report the first meaningful increase to our sales volume since the first quarter of fiscal 2016. This is an encouraging sign for our core product sales, especially when factoring the intensified competition in China’s infant milk formula section. Volume growth was supported by a recovery in birth rates following the weaker Year of Ram in 2015, as well as the loosening of the second-child policy in later 2015.

The 10.2% decrease in ASP was largely due to the foreign exchange impact as the RMB to USD exchange rate used for our reporting depreciated by 6.8% year-over-year. In RMB terms, the average selling price decreased by 3.8% as our product mix moved from higher-priced Super brand infant formula products to a lower-priced private label product.

The ASP as reported is after discounts despite the continuously intense promotional environment with both the lesser known brands and the cross-border e-commerce brands making effort to flood the market in anticipation of a tighter regulatory environment. We have maintained a rather consistent discount policy. On the other hand, we have increased the volume of our promotional sample products. The increase of sample products impacts the cost of goods sold not sales or ASPs.

Looking a bit more closely at our product segments, we are glad to report that our sales of specialty infant formula products increased by 56% year-over-year. We submitted the application for our Qingdao factory shortly after the new regulation for specialty formula production license was announced in July.

While the process of granting the license may take several months, given that our Qingdao factory was the only factory in China to have previously received the production license, we remain confident we will be among the first ones to receive this license, and our estimate is towards the end of fiscal 2017. Once we receive this license, we would naturally expect sales of our specialty infant formula products to improve further.

Looking at our adult formula products, sales of this group increased by 33% year-over-year mainly driven by the launch of our new sheep adult formula product. Excluding the contribution of this new product, sales from the existing DutchCow cow formula product increased by 7% in a traditionally low season.

As I mentioned earlier, we have been focusing our promotional efforts on the DutchCow liquid milk products, including intensive use of Internet-based marketing such as headlines/deals on e-commerce platforms and the sponsoring of dairy of Internet video live broadcasting events, among others.

Such promotional activities improve the overall brand awareness of DutchCow. Throughout our market campaigns we have emphasized the high quality, nutritious and the source are made-in-EU features off the DutchCow brand, which is consistent across different product categories.

Sales of our private label products increased by 21% year-over-year during the first fiscal quarter, due to a heavily influence by the newly announced government regulation, in particular the limitation of three brands that each factory can register with the Chinese Food and Drug Administration or CFDA. That will become effective January 1, 2018.

Given the regulatory environment there is uncertainty of operating continuity among the majority of approximately 2,000 to 2,500 more brands currently in the Chinese market. Like most of the operators of such brands are trading oriented rather than focused on brand building, their intention is to sell as much as they can before the new regulation takes effect.

As such, these operators including buyers of our private label products increased all their volumes looking to stock up during the June quarter. Similarly, we continued to see strong inventory pressure from cross-border e-commerce brands as they also faced a regulatory door closing situation.

This type of import trading used to enjoy preferential tax treatment. However, in April 2016, a regulation eliminated such preferential tax treatments but this new regulation was put on hold in May 2016 where it remains to-date. While the timing of the resumption of the new taxation is unclear, operators of many cross-border brand products have tried to import under the still effective tax rate as much as possible.

Sales of our mainstream Super brand were negatively impacted by the channel inventory pressure of these smaller brands. Assuming the CFDA strictly imposes the curtail limitations, it is possible we may need to cease production of some of our smaller private label brands. However, we remain confident that we will have enough quota to register all of our mainstream products.

Moreover, as I mentioned in the past, we believe such regulations will benefit us over the long run. If the new regulations are strictly enforced, we believe the limitation of three brands could force out up to 80% of the existing 2,000 to 2,500 brands in the Chinese market, which represents an opportunity for us to consolidate market shares particularly given the premium added to our brands with the opening of our French project.

Moving on to our online to offline membership service platform, we continued to make steady progress on our Thumb Mama membership community and the Thumb Mall e-commerce platform on WeChat. We now have approximately 6,500 full-time in-store promoters, who are also Thumb Mama consultants with approximately 10,000 part-time nutritional consultants to promote our products and the Thumb Mall platform.

Our part-time consultants have demonstrated strong sales abilities with over 20% of them delivering average sales that are on par with our full-time consultants. For the Thumb Mall e-commerce platform, we have expanded our product offerings to include the DutchCow brand formula and the UHT products, our prepared food products and the Huiliduo brand and the pregnancy cosmetic products under the Precious Care or Zhen Yun brands.

We are working to expand our product offerings over a wider range of mom and baby products. Going forward, we plan to focus on targeted marketing activities such as member events in designated areas based on the membership behavior data we have collected through our Thumb Mama community. We believe such marketing initiatives can protect and enhance our brand foods position against the ongoing price competition in the IMF market, while also supporting sales of additional ancillary mother and infant products.

I’d like to update you all on the latest developments at our French project. We commenced trial operations in June 2016 and have focused on adjusting the whole milk powder in July 2016. As we discussed in our last earnings call, the adjustment and testing of one key piece of equipment for the spray drying towers took longer than previously expected, while the previously expected completion date was in July 2016, the tower was not able to produce the powder that meets the density requirements for our standard 900 gram or 400 gram cans during the month of July.

This resulted in our inability to move on to the whey protein powder as the whole milk powder had not been done [ph] with adjustments. Adding to the problem in our first quarter was our contract with Sodiaal which requires us to take in high volumes of milk every day. And once the whole milk powder began trial operations, we took in the required amount of milk and operated the tower at close to full capacity leaving limited time for daily adjustments.

The output during this period is standard industrial whole milk powder which can be used by the market with only the density not meeting our own requirements. We are now close to completion on the adjustment of the whole milk powder tower, have started the adjustment on the whey protein powder tower and expect both towers to be ready for further operations at the end of August.

With the addition of the dry mixing and canning ability, we expect the entire project to commence formal operations in early September, in time for our planned grand opening ceremony on September 28, 2016 and also in time for the sales high season of the mid-autumn and National Day holiday.

Based on our supply contract with Sodiaal, the additional delay resulted in additional expenses of 2.8 million to process or return the excess milk that was supposed to be sent to our towers from January 2016. We have introduced our made-in-France products at a major industry exhibition in June and the reception has been very positive. Our made-in-France products will be widely available for retail sales in the fourth quarter of calendar 2017 benefitting sales for the second half of fiscal 2017.

We still expect to receive the necessary operating approval and import of accreditation from the French and Chinese authorities soon after the commencement of commercial operations. While the fixed asset budget for this project remains unchanged as the delay involved additional work by mainly one equipment supplier, by extending the opening date from July 2016 to September 2016 the total budget including preopening expenses is expected to increase by approximately €5 million to €10 million, which includes capitalized preopening expenses and interest, but excludes the already reported $11.6 million losses under the Sodiaal supply contract.

At this point, I would like to review our financial results as well as provide an outlook on our business. For the first quarter of fiscal 2017, our net sales were 77.9 million, a decrease of 5.4% from 82.3 million for the prior year period. Net sales from our Nutritional Food segment, which mainly includes branded powdered formula products, were 74.4 million or 95.5% of net sales in the first quarter. This represents an increase of 0.9% from the prior year period in which we recorded sales of 73.7 million or 89.6% of net sales.

Sales of powdered formula products increased 8.8% to 5,892 metric tons in the first quarter compared to 5,414 metric tons in the prior year period. Average selling price was $12,236 per metric ton, compared to $13,618 per metric ton in the prior year period.

Net sales from the Nutritional Supplement segment were 0.7 million or 0.8% of net sales, a decrease from 8.1 million in the prior year period. This segment primarily consists of sales of ingredients such as chondroitin sulfate to international pharmaceutical companies.

As we expected, our two largest clients in this segment temporary withheld their orders and the delay in sales could continue for this segment into the second quarter of fiscal 2017. We have worked closely with these two clients over the past few months and expect the orders to resume at a regular pace soon.

Net sales from the Other Business segment, which mainly consists of imported whole milk powder and whey protein powder sold to industrial customers were 2.8 million or 3.6% of net sales as compared to 0.5 million or 0.7% of net sales in the prior year period. These sales are always opportunistic. The year-over-year increase in the other segment sales this quarter was mainly driven by the sales of excess whole milk powder.

Gross profit was 34.0 million in the first quarter of fiscal 2017 compared to 41.9 million in the prior year period. Gross margin for the Nutritional Food segment was 46.8%, a decrease from 55.7% in the prior year period, primarily due to decreased average selling price, higher raw material costs and the sampling of the newly launched liquid milk products under this segment.

While the negative impact of exchange rates hurt our ASP in U.S. dollar terms, unit cost remains largely unchanged as most of our products cost are based on raw material denominated in USD in the worldwide market. Overall, gross margin was 43.6%, a decrease from 50.9% in the prior year period, which was also negatively impacted by the decreased margin contribution from the Nutritional Supplement and Other Business segments.

Selling and distribution expenses were 11.5 million in the first quarter of fiscal 2017 compared to 12.7 million in the prior year period. The decrease was primarily due to lower employee bonus costs associated with lower sales.

Advertising and promotional expenses were 7.3 million in the first quarter compared to 10.3 million in the prior year period, as we adopted a new form of sales management by product brands at the beginning of this fiscal year and each product management team took time to readjust their advertisement schedule in the first fiscal quarter.

Selling and distribution, and advertising and promotion expenses combined accounted for 24.0% of sales compared to 28.0% in the prior year period.

General and administrative expenses were 7.6 million or 9.8% of sales compared to 6.5 million or 7.9% of sales in the prior period. During the same period last year, we released or reversed approximately 0.8 million of reserves. Excluding such a reversal, G&A expenses remained almost flat year-over-year.

Income from operations was 4.9 million or 6.2% of sales in the first quarter compared to 12.5 million or 15.2% of sales in the prior year period. As mentioned above, this number includes a non-recurring 2.8 million losses under the supply contract with Sodiaal due to the delay of the French project.

Net interest expense was 1.5 million, a decrease from 1.8 million in the prior year period, which excludes a 1.3 million interest expense capitalized for the French project in the June quarter. The capitalized interest amount was 0.7 million in the same period last year. We borrowed more euro-denominated loans from France with a lower interest rate offset by an increased loan balance.

Net foreign exchange loss was 2.4 million compared to 0.3 million gain in the prior period. This loss was primarily due to the depreciation of the RMB against the U.S. dollar and the euro during the quarter. While our main operating entities are all based in China and it generates revenue in RMB, we have significant U.S. dollar and euro borrowings to purchase raw material and to build the French project.

Our income tax expenses were 1.1 million compared to 2.8 million in the first quarter of fiscal 2016. Net income attributable to common stockholders was 43,000 or $0.07 per share for the fiscal first quarter compared to net income of 7.6 million or $0.13 per share in the same period last year.

Looking at the balance sheet, we ended the first quarter with cash and cash equivalents of 79.7 million and the restricted cash of 214.3 million, which includes current and non-current portions. Total cash including restricted and non-restricted portions was 294.0 million versus 308.9 million as of March 31, 2016.

As of June 30, 2016, total debt was 535.6 million representing an increase of 29.4 million from the end of last quarter. Our net debt, which is total debt less total cash, was 241.6 million as of end of the first quarter, representing an increase of 34.3 million over our net debt position at the end of the fiscal 2016.

In addition to the residual fixed asset investments for the French project, we started to invest in the working capital assets for the facility in the June quarter. In addition, we have increased the inventory for our UHT milk products. We expect the requirements for additional working capital investments to be more limited going forward.

Net accounts receivable decreased from 29.9 million at the end of the first fiscal 2016 to 18.6 million as of June 30, 2016. As mentioned in the last quarter, the higher than usual balance last quarter was due to some particular trades with clients under the Nutritional Supplement and the Other segments, which has returned to a more normal level this quarter.

Finally, I would like to discuss our outlook for fiscal 2017. Our previous guidance for fiscal 2017 was revenue of 500 million to 550 million and net income of 25 million to 30 million was based on the expectation that our French project will begin operation in July 2016. This original guidance will be difficult to achieve due to the impact associated with the additional French project delay and the foreign exchange loss we incurred in the first quarter.

We now expect total net sales for fiscal 2017 to be between 450 million and 500 million and net income to be between 15 million and 20 million. We have not factored in additional one-time or foreign exchange impact in our forecast other than what have already occurred in the first quarter. Despite the lower expectations for fiscal 2017, we remain optimistic about the gross potential for Synutra once its French facility becomes fully operational.

This concludes my prepared remarks for today’s call. Operator, please open up the call to questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions]. Your first question comes from Pablo Zuanic from Susquehanna Financial. Please ask your question.

Aatish Shah

Hi. Good evening, Clare. This is actually Aatish in for Pablo. Just have two questions around the business first and then two about the industry in general. Starting with the business questions, could you comment roughly on the price point of the local product versus the imported product? And do you see any differences in terms of channel mix for these products? And relatively, as you roll out the imported product, will you lose space with the local product and will you have to promote that local product to help clear retailer inventory and space for the local product? If you could address those first, that would be great.

Clare Cai

Hi, Aatish. Thank you for the question. We do intend to charge a higher price point for our made-in-France products at approximately 10% to 15% higher than our current local made products. We think this is supported by the general perception that the wholly imported products are of superior quality to the local products, and this actually meets the demand or psychological demand of our customers. In terms of channel segregation, we do plan to launch our made-in-France products first in the mom and baby channels but we haven’t ruled out the possibility that it will later expand to the mini-mart or key mart channels. But first we think the reception from the mom and baby source have been very highly positive and we think it will be – and it was above the initial volume from our French factory. In terms of cannibalization, there would inevitably be some but overall we hope to target customers who are outside of our current customer base but who will be more receptive to a made-in-overseas project. We have successful launched our advanced Super products back in, I think it’s in a year and a half ago and the advanced Super products has been a star of our own product offerings. And while some can argue that it takes away our regular Super product sales that it’s also gained us some share in the ultra-high priced premium product category. And we expect the made-in-France product to do the same.

Aatish Shah

Great, that’s very helpful. Now just regarding the market overall, as more local companies import their own products, is the imported segment beginning more price competitive? And what percentage of the market is imported now based on your estimation? And on that same vein, how are the new regulations for the imported products affecting the market in terms of – are the higher processing and tax cost pushing up the prices for these products? And is that as a result creating stock outs as these products get delayed or stuck at customs?

Clare Cai

I think from your question, I think it mainly refers to the cross-border e-commerce imported products because product imported by offline brands have not experienced custom or tax challenges. For imported products, first we need to distinguish whether they are operated or they are sold by an online only manufacturer or OEM trader or they are operated by an offline manufacturer who may also have online sales channel but mostly have an offline sales team. And the price sensitivity are different for these two types of products. For online only products, price is highly sensitive because the consumers are not getting anything else other than the price. But for offline – for products with offline operations or the O-to-O operation like our Thumb Mama platform, the consumer is paying for not only the can of products, they are also paying for the service. And the service is not cheap. You have to have a field service team of nutritional consultants or promoters or however they are called by each manufacturer and you have to have local management structure of supervising this team. And you probably need to have some store space to let these people to stand and they’ll have face-to-face interactions with their customers. So all these are not cheap and that’s why for the offline products, we haven’t seen a product price sensitivity that we see for online products. In fact, for the offline products the expectation for retail price is actually upwards not downwards. As you can see that some of our competitors continue to launch ultra-premium products and we are also pricing our made-in-France products higher rather than lower. On the other hand, we do mention to a price competition in our own transcripts. This is more towards the B2B pricing or ex-factory pricing for distributors or mom and baby store owners, although the retail price may be – the manufacturer suggested, retail price may be higher and higher but to maintain competitiveness in a highly promotional environment and the competition in the channel itself intensifies as more and more mom and baby stores open, they demand higher discounts which historically has come from the manufacturer only. So that’s basically the pricing situation that is the difference between online and offline products. There is difference between B2C and B2B prices but not so much difference in trends between imports or domestically-made products.

Aatish Shah

Okay, that’s very helpful. Thank you. Just one last thing, just generally I’m taking a step back. In China, at what rate do you think the whole IMF market is growing and that growth also is specific to baby stores and e-commerce? And between those two channels, what share of the market do they have overall? Is there an estimation that you have for that?

Clare Cai

Our estimate is that the volume growth this year will be over 10%. We have seen a 9% growth in the first quarter and this year has just begun. So towards later this year, we see more and more people will benefit from the second-child policy and things. And in terms of ASP retail, ASP will think it will flat if not growing slightly because the heavy promotions will be offset by the trading up to premium product category. And we think the main pressure on market ASP, which is the advancements of the Internet channel has come to a halt or plateau in recent months. If we see higher and higher volume to lower and lower prices, the majority of it will be stocking up by mom and baby store owners in response to special promotions rather than direct sales to end users, because only that many consumers are Internet-fluent or Internet comfortable with IMF products.

Aatish Shah

Okay, great. That’s all for me. Thank you so much for your time.

Clare Cai

Thank you.

Operator

[Operator Instructions]. Your next question comes from the line of Samuel Pritchard from [indiscernible]. Please ask your questions.

Unidentified Analyst

Hello. Thank you for taking my questions. I just have a very small question and quick. It’s just about the going private. Do you have first any update on the going private? Did you have any return from the special committee? And the other question is if not, which is I think is the case, what is the timeline to evaluate the going-private proposal? Do you think we will have an answer in the coming weeks or it can last many months more? So this is just about an update on the going private. Thank you very much.

Clare Cai

Thank you. The going private transaction as the management knows is still ongoing. We haven’t heard of any change of plan by the proposal Chairman. As to the timing of the next development, we will release promptly any development that needs to be reported to the market per the SEC regulation as soon as possible. But right now, we don’t have anything beyond what’s being already disclosed.

Unidentified Analyst

Okay. Thank you very much.

Operator

Your next question comes from the line of Peter Siris from HuaMei Capital [ph]. Please ask your questions.

Unidentified Analyst

Hi, Clare.

Clare Cai

Hi, Peter.

Unidentified Analyst

I’m confused about what’s actually happening in the Chinese market. So let me sort of raise a couple of issues. Last year we said that the Chinese government was going to take steps to reduce competition and to increase the share coming from Chinese producers. And it seems to me that sort of the opposite has happened, which is the market is growing but the competition is getting more intense. And so I’m just curious from a regulatory point of view, what do you see happening and do you still expect this to benefit you; if so, when?

Clare Cai

I think the government’s intention to push the consolidation of the market has been very clear since 2013 when they raised or revamped the production license regulation then. However, this market is of three competitive markets and the government regulations will be adapted to absolve by the operator. So we do see actually higher and higher number of brands. I think the primary reason is the higher and higher retail price. With all the price margins there can be many different combinations of slices between the value chain operators, including the manufacturer, the distributor, the store owner, the promoter. So with these possibilities, this industry remains a highly attractive industry especially among a general downturn of economies. So that’s the background. And this new regulation to limit brands that each factory can produce or register with the CFDA too is really certainly another major push towards consolidation. However, by doing simple math we can see that even if the three per factory limitation was strictly adopted, it will still leave the market with about 500 brands as there are about 180 factories that are licensed or accredited by CFDA. With that, you can still offer the mom and baby store owners or distributors plenty of choices to negotiate the bulk of margins to them rather than leave the margin or the value to the manufacturer. So that alone is unlikely to hose out the small brand phenomenon. However, it’s a step towards the right direction and we hope by strictly enforcing the quota, it will force out factories that are living on only OEM contracts and gradually we will see consolidation both on the manufacturing and on the distribution end.

Unidentified Analyst

So given that you have these 500 brands, I understand the strategy with the higher margin French product that will start coming in. Is there a strategy – what is the strategy, as somebody asked before, for the domestic business? How do you differentiate yourself from those other – because 500 brands is too many long term for the market, so how do you differentiate yourself domestically from the others?

Clare Cai

If you’re talking about how are we going to sell our domestically produced brands, our domestic factory, the Qingdao factory positioning is quite clear. It will manufacture our DutchCow adult formula, which is not subject to a limitation of brands. And it will manufacture a specialty formula product which we are applying for the license. And it will manufacture the box or paper bag products for Super and My Angel, which are in the same brand family but a lower end version. And it has the appeal to price sensitive customers who wants the same brand, which account for still a significant portion of our sales although decreasing. And we are trying to open up an export market for our Qingdao factory. We have exported to Pakistan, to Kenya. I think one of the northern African countries and Turkey and one more country. So we have trial exports to these countries and we’ve seen returning orders from at least one of them. Although these orders are small but we are making in-roads there. So eventually we hope the growth of our niche market products will be enough to support the volume at the Qingdao factory and our mainstream Super brand product will grow enough to justify the investment in the French project.

Unidentified Analyst

Great. Xiè xie nǐ.

Clare Cai

Thank you.

Operator

There appear to be no further questions. I would like to turn the call back to management for any closing remarks.

Clare Cai

Thank you, operator, and I thank everyone for taking the time to join us for this quarter’s earnings call. If you have any further questions, please feel free to reach me or ICR IR representative. Thank you. Bye-bye.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.

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