China Medical Technologies F3Q07 (Qtr End 12/31/07) Earnings Call Transcript

China Medical Technologies, Inc. (CMED)

F3Q07 Earnings Call

February 28, 2008 8:00 pm ET

Executives

Winnie Fan - Investor Relations

Dr. Zhong Chen - Chief Technology Officer

Sam Tsang - Chief Financial Officer

Xiaodong Wu - Chairman of the Board, Chief Executive Officer

Analysts

Jinsong Du - Credit Suisse

David Ginter - Oak Ridge Financial

Luke Langford - Langford Capital Management

Presentation

Operator

Good day, ladies and gentlemen and welcome to the Q3 2007 China Medical Technologies Incorporated earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Winnie Fan. Please proceed, Ms. Fan.

Winnie Fan

Thank you, Operator. I am pleased to welcome you to China Medical’s third quarter earnings conference call. China Medical already announced its third quarter results. 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 Dr. Zhong Chen, CTO. After they finish with their remarks, they will be available to answer your questions.

Before we continue, please bear with me as I will 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 U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the results may be materially different from the views expressed today. A number of potential risks and uncertainties are outlined in the company’s public filings with the U.S. 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 the China Medical’s website.

Now allow me to turn the call over to Dr. Chen who will give remarks on behalf of Mr. Wu. Dr. Chen.

Dr. Zhong Chen

Thank you. Ladies and gentlemen, welcome to our earnings call. This is another solid quarter of the company. Our FISH business is growing rapidly, especially in the recurring reagent revenue, thus we believe it will become a major growth driver of the company to maintain our sustainable growth in the future.

I’m going to share with your our update on each of our operations, namely FISH, ECLIA, as well as HIFU.

FISH -- we have sold more than 200 units of the FISH equipment to tier one hospitals up to the end of December. We expect to sell similar numbers of FISH equipment to the other tier one hospitals in the March quarter as compared to the December quarter. We are confident that we will achieve the FISH revenue more in the target $20 million in this fiscal year.

ECLIA -- let’s move to our ECLIA operation. Currently, over 25% of our ECLIA revenue comes from recurring reagent sales and this percentage will continue to increase. We expect our ECLIA reagent sales to continue its growth momentum because of increasing equipment utilization, the introduction of more new reagents, and penetration to small and large hospitals. We expect our reagent offering to reach about 90 reagents by the end of 2008.

HIFU -- let’s talk about our HIFU operation. The HIFU business is stable and will continue to be a stable source of revenues. We will continue to work on various international approvals on our HIFU system and on developing our international markets.

I have finished Mr. Wu’s update on each operation and I would like to turn the call over to Sam and he will give you an overview of our third quarter results. Thank you. Sam.

Sam Tsang

Thank you, Dr. Chen and welcome, everyone. Let’s have a recap first. Our 3Q revenues were up 64.2% on a year-over-year basis. Our non-GAAP 3Q adjusted net income was up 34.9% on a year-over-year basis. Our 3Q adjusted diluted EPS on a non-GAAP basis was up 29.9% on a year-over-year basis.

Let’s look at more specific information for the quarter. 3Q revenues were up 64.2% year over year to RMB265.1 million, or $36.3 million. Our revenues are generated from our ECLIA system, FISH system, and HIFU system.

3Q revenues from sales of our ECLIA systems were up 74.4% year over year to RMB96.7 million, or $13.3 million. The key driver in our ECLIA operation is the recurring revenue from the sales of reagent kits. We expect the growth in reagents to continue and the reagent revenue already accounts for more than 85% of our total ECLIA revenue. Regarding equipment sales, we sold 210 units in 3Q07.

3Q revenues from the sales of our FISH systems were RMB52.8 million, or $7.2 million. We sold 94 units of FISH equipment and our reagent revenue grew rapidly. We expect the total FISH revenue in ’07 will exceed $20 million.

3Q revenues from the sales of our HIFU system increased 9% year over year to RMB115.6 million, or $15.9 million. We sold 39 HIFU units this quarter and have a backlog of 36 units.

Due to the snowstorm in Southern China in January 2008, our delivery and installation of several HIFU systems were delayed. We expect to achieve the unit level of HIFU sales not less than 4Q06 this coming quarter.

Gross margin decreased to 63.2% this quarter from 72.6% in 3Q06. The decrease was because of the amortization of FISH intangible assets of RMB18.2 million, or $2.5 million, and our sales of FISH equipment, which generates lower gross margin. Excluding the impact of FISH amortization, gross margin would have been 70%. This indicates that our gross margin has been stabilized, after taking into account the impact of FISH amortization and FISH equipment sales. In the future, we expect our gross margin should go up with increasing FISH reagent sales.

3Q operating expenses increased 63.4% year over year to RMB44.2 million, or $6.1 million. RMB expenses increased 24.9% year over year mainly because of the development of new ECLIA reagents and FISH reagents.

Sales and marketing expenses increased 99.7% year over year, mainly due to the establishment and expansion of our direct sales force for FISH systems and related promotional activities.

G&A expenses increased 78.4% year over year, mainly due to the increase in employees to accommodate our rapid growth, annual salary increment in June 2007 and stock compensation expenses arising from an incentive stock grant in June 2007.

Operating expenses as a percentage of revenue were 15.7% for the quarter compared to 16.8% in 3Q06.

3Q interest income decreased 35.8% year over year to RMB7.1 million, or $1 million, primarily due to payments for the FISH acquisition and the decrease in U.S. dollar interest rate.

3Q income tax expense increased significantly to RMB22.7 million, or $3.1 million, primarily due to an increase in revenues and effective income tax rate. 3Q income effective tax rate was 18.9%, primarily because of a higher income tax rate at that time and certain expenses, such as convertible note expenses are not deductible for PRC income tax.

3Q net income increased 10.6% year over year to RMB97.8 million, or $13.4 million. 3Q non-GAAP adjusted net income, which excludes stock compensation expenses and amortization of acquired intangible assets, was up 34.9% to RMB124.8 million, or $17.1 million.

The lower growth rate compared to revenues was primarily due to convertible notes interest expenses and amortization of RMB11.7 million, or $1.6 million, a decrease in interest income, and an increase in effective income tax rate.

3Q cash flow from operating activities was RMB109.7 million, or $15 million. At December 31, 2007, we had a cash balance of RMB950.3 million, or $130.3 million.

Accounts receivable at December 31, 2007 was RMB253.2 million, or $34.7 million, representing an 11.4% increase from the September ending balance last quarter. The accounts receivable turnover days improved to 115 days from previously 119 days.

Regarding our outlook, our BBE acquisition began to contribute revenue in 4Q07 and the FISH business continued to grow rapidly. However, the heavy snow storm in Southern China in January 2008 delayed the delivery and installation of several HIFU systems. The substantial decrease in U.S. dollar interest rate has affected our interest income and the higher income tax rate in accordance with the new income tax law has increased our income tax expense.

As a result, we maintain our current targets for financial year 2007, but we are confident that we will achieve at least the high end of the guidance range.

This concludes our remarks. Now we will be happy to take your questions. Operator, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jinsong Du with Credit Suisse. Please proceed with your question.

Jinsong Du - Credit Suisse

First of all, on the FISH business, could you tell us the split, the detail split between the probes and the microscopes in terms of the sales?

Sam Tsang

We already -- equipment is 94 units, and so actually the FISH reagent revenue increased rapidly if you look on the numbers of FISH equipment sales. And so currently, it’s about over 30% of our total FISH revenue for the reagents, while last quarter it accounted for only about 20%. It’s more than 30% this quarter.

Jinsong Du - Credit Suisse

Right, and do you expect maybe in the coming quarter the FISH probe sales will exceed the microscope sales?

Sam Tsang

Definitely, because we already expect the FISH reagents will continue to grow and the equipment sales -- you know, we are selling the equipment to the tier one large hospitals in China, so there will be a point in time that the equipment sales will stabilize or even go down, while the recurring FISH reagent sales will continue to grow.

Jinsong Du - Credit Suisse

So for the next quarter, basically the last quarter, the March ’08 quarter, the probes revenue will exceed the equipment revenue for FISH?

Sam Tsang

I don’t think it is an appropriate time to comment on the amount --

Jinsong Du - Credit Suisse

Okay, what --

Sam Tsang

-- at this point in time. But definitely say the equipment -- we still expect the equipment sales for FISH to at least achieve a similar level of December quarter in the March quarter and also at the same time, the FISH reagent revenue should continue to grow.

Jinsong Du - Credit Suisse

Sure. How about the backlog for the microscopes so far at the end of the quarter?

Sam Tsang

I think the indication we expect to achieve a similar level of FISH equipment sales is an indication already.

Jinsong Du - Credit Suisse

Okay, so basically the number you --

Sam Tsang

The December quarter, we sold 94, so you can expect that we, what our expectation is from this number.

Jinsong Du - Credit Suisse

I see. How about the backlogs for HIFU?

Sam Tsang

Thirty-six.

Jinsong Du - Credit Suisse

Thirty-six? That -- but is that -- that because of the snowstorm, maybe some of them are not going to be delivered on time during the quarter?

Sam Tsang

Some of them will not be delivered. That means that they will be deferred to the next quarter.

Jinsong Du - Credit Suisse

I see. Could you tell us a little bit about the newly acquired BBE? You mentioned in the press release that the growth there has been very rapid. Could you quantify a little bit the contribution in this quarter and perhaps the future contribution and also its growth rate?

Sam Tsang

We just completed the BBE acquisition in January, so last month and the size of BBE is relatively small compared to the entire China Medical. So expect that the contribution is positive but proportion to our group will be not much in the current size of BBE. Remember that we only spent roughly about 30 million for the acquisition.

Jinsong Du - Credit Suisse

Right. And also maybe my last question before going back to the queue, the tax rate you mentioned in the press release, any -- so we should assume the higher tax rate for sure? And how about the long-term tax rate? What is the chance do you think we can get the -- basically go back to the 15% tax rate because of the high tax status?

Sam Tsang

You know, under the new income tax law, the 15% is only applicable to the qualified high-tech companies. But currently, the detailed guidelines for the application of the new high-tech company status are still unclear and so we are still waiting for the release of relevant guidelines.

And so before the release of the guidelines and before the -- we certainly will apply once we understand the guidelines from the government, but the timing of our approval is uncertain. So until we get the approval to the high-tech companies under the new income tax law, probably we have still to pay the higher, relatively higher income tax rate under the current transitional arrangement, which ranged from 18% to 25% over a period of five years.

Jinsong Du - Credit Suisse

So shall we say that you are confident that eventually we’ll get the high-tech status?

Sam Tsang

Yes, I think it is not the right time to comment on that until the release of the relevant high-tech guidelines from the government, which is already quite late to be released from the government.

Jinsong Du - Credit Suisse

All right. Thank you. I’ll go back to the queue. Thank you.

Operator

(Operator Instructions) Your next question comes from David [Ginter] with Oak Ridge Financial. Please proceed with your question.

David Ginter - Oak Ridge Financial

Good morning. In regards to your HIFU, do you have a timeline when you believe you will have CE approval in Europe?

Sam Tsang

For the CE market application, we just start the preparation a couple of months ago and based on our understanding of the clinical trail refinement, the CE market may take two to three years to complete.

David Ginter - Oak Ridge Financial

Okay, and is that about the same time you expect FDA approval in the United States?

Sam Tsang

The clinical trial requirement is -- I mean, the number of clinical patient number is much more than CE market requirements, so it should take a more longer time compared to the CE market application.

David Ginter - Oak Ridge Financial

Okay, so two to three years in Europe and then are we talking a five-year range in the U.S.?

Sam Tsang

Yeah, a longer time for the U.S.

David Ginter - Oak Ridge Financial

Okay, how about Russia?

Sam Tsang

Russia -- actually, we are thinking about that and we are understanding the requirements of Russia for approval of similar large equipment, so it is still under our understanding stage.

David Ginter - Oak Ridge Financial

Okay, and what size of a market would you look at in Russia and Europe?

Sam Tsang

Currently, because we are working on the CE market application for Europe and so you know the CE market approval allows us to assess to an entire new market. But at the current stage, we do not make the estimation because we [are on top] of the clinical trial stage and then we can understand more about how the European physicians wield such kind of equipment and how the reaction after the CE market result. So it is still too early to comment about the market potential in the E.U.

David Ginter - Oak Ridge Financial

Okay, and can you comment anything on the market potential in Russia?

Sam Tsang

I think this is even difficult because we are currently trying to understand the approval requirements in Russia.

David Ginter - Oak Ridge Financial

Okay. Thank you very much.

Operator

Your next question comes from Luke Langford with Langford Capital Management. Please proceed with your question.

Luke Langford - Langford Capital Management

Three questions, if I can; the first, on the BBE acquisition, could you guys provide a little color on where you saw the complementary products on the ECLIA side? Did they have completely different reagents than you guys do currently and you are just able to sort of bolt them on into your current systems or was there some overlap or could you comment on that?

Sam Tsang

This is one of the three questions, the first one of the three questions you mentioned?

Luke Langford - Langford Capital Management

Yes, the first question.

Sam Tsang

Okay, and on the BBE, because they are previously ELISA supplier and moved to the similar ECLIA market, and currently most of the reagents of BBE are also -- China Medical also has such reagents. We have made much longer offering, reagent offering than these but there are some other reagents of BBE. For example, they have some reagents which we don’t have. For example, the parasitic reagents and also the food safety reagents. And also, their ECLIA technology is a bit different from our ECLIA technology, and they are [magnetic] based ECLIA technology, which we believe is a better technology for the application of fully automated high throughput equipment.

So in terms of reagents, they have some [rich] reagents and in terms of technologies, their technology is considered better in application to the fully automated system.

Luke Langford - Langford Capital Management

Okay, so in other words, when you launched the fully automated into the larger hospitals, the thought process was that you were going to be able to have a better product line and that was a large part of the rationale for the $30 million?

Sam Tsang

I think the fully automated equipment, the current BBE status is they are also prepared to apply for FSDA approval and so we were thinking that when we launched the fully automated system, probably BBE’s machine will be the one we will launch to the market.

Luke Langford - Langford Capital Management

Okay. Excellent.

Sam Tsang

But it will take time up until the FSDA approval.

Luke Langford - Langford Capital Management

Right. Understood. I think, if I heard correctly, in Mr. Wu’s opening remarks that were translated for him that he mentioned that there was going to be 200 units sold by the end of the year, implying if there was 94, that you guys are expecting around 106 in Q4. Is that accurate?

Sam Tsang

We expect a similar level of the December quarter.

Luke Langford - Langford Capital Management

Okay. Did I hear a number of 200 for the year though or by end of Q4, you were expect to have sold 200?

Sam Tsang

Yes, 200 is the accumulated number.

Luke Langford - Langford Capital Management

Right, that’s what I thought. Okay. All right, and last question if you can translate for me to Mr. Wu, I’m wondering if there’s any partnership work or any research going on with the Academy of Science of Peking on the acoustic side that you guys are willing to share or can share, and just how you’ve used those partnerships so far in general?

Sam Tsang

Dr. Chen will translate for Mr. Wu. Mr. Wu will make the remarks.

Xiaodong Wu (Translation)

The major cooperation with China’s Academy of Science is primarily related to [HIFU for the transfuser] and currently, the [profits] is quite promising and it’s in accordance with our guidance.

With the [inaudible] and our products related to software, is all our software upgrade related to our equipment. That’s kind of some information we would like to share with you guys.

Luke Langford - Langford Capital Management

Okay, so there’s -- but potentially there’s other work going on, you guys can’t comment currently, correct?

Dr. Zhong Chen

You’re talking about in terms of what, in terms of --

Luke Langford - Langford Capital Management

In terms of research and development, future projects and other things that you could potentially be working on with them?

Xiaodong Wu (Translation)

And for the R&D part, primarily it is based on our current platform technology. We’ll expand our products, especially try to increase the products, the types of products, it is important.

For ECLIA related business, currently we are developing more reagents which we believe will reach about 90 -- even more than 90 reagents by the end of 2008.

And FISH, we’re in the process of, for example, developing a prostate cancer related FISH probe and also we’re in the process of R&D and the development of fungus, or some microbiology related FISH probes. And the prostate cancer related FISH probes we believe we’re probably the first provider to penetrate it to the hospitals in the market.

And also we are in the process of try to R&D HFR related detection kits. And I assume you guys know HFR. HFR is coming for the non-cancer. It’s a [type of therapy] target for non-cancer chemotherapy. And currently there are two types of products related to HFR; one is PCR-based, one is FISH-based and we’re in the stage of trying to develop these two products, one related to PCR technology and one related to FISH technology.

So our strategy is to try to -- our strategy is always to try to expand our current products and make a package and that’s our goal. And our focus is going to be in the IVD and high-end IVD related products.

And another strategy is also try to make for example ECLIA and FISH as complementary kits to each other. For example, for pre-natal diagnosis, case in point, we have a pre-natal screening kit from the ECLIA and also we have the FISH probes for pre-natal diagnosis, so this is a perfect kind of combination of case in point.

Luke Langford - Langford Capital Management

Right, I realize that was a large part of the FISH acquisition, was some of the complementary products, so now that you’ve said that, he’s got me on to a fourth question, so I apologize. The last time I spoke to you guys you mentioned that when he was talking to your large hospital clients that there seemed to be a market for HPV opportunity as well. I’m wondering what he’s hearing lately from his road trips in terms of other opportunities that you guys may be looking at.

Xiaodong Wu (Translation)

Several points Mr. Wu would like to make to that. Number one, as you guys know, currently internationally there are tons of companies focusing on HPV detection kits, such as [Third Wave], Cryogen, Diogen, whatever, and also domestically there are [quite a lot of companies]. That further point, HPV is a hot spot for our [to pursue]. That’s number one.

Number two, in terms of the products, one we are interested in is a particular genotyping product which can identify 24 [sub-groups] of HPV. That’s what we are doing right now and also that’s what we are interested in.

Number three, and Mr. Wu would like to talk to you guys is the reason we want to do HPV is because we are going to make our products as a package, as a package. Case in point -- currently we have the FISH products and the FISH products where we’ll have for the cervical cancer detection, which is the [inaudible]. And ideally, we’ll have the FISH will have HPV and to go further, we’ll have the PCP, the PAP smear, and all together as a package, that will make us more competitive. That’s the third point.

And the fourth point Mr. Wu would like pointed to you guys is you look at the three or four products. If you penetrated the products, three or four different products to the hospital by three or four different companies versus one company providing the same three products, cost wise for us to do that it is more cost effective.

And number four, currently we are building the direct sales force for FISH, we’ll use the FISH product we’re building our direct sales force. So based on this direct sales force, it would be easy for us to penetrate our other related products and a case in point, just Mr. Wu pointed out that HPV and the FISH and maybe ECLIA or maybe other advanced products in the future.

So those are the points Mr. Wu would like to make to you guys.

Luke Langford - Langford Capital Management

Okay. Thank you. I’ll jump back in the queue. I have one more but I want to let other people talk first.

Operator

(Operator Instructions) Your next question comes from the line of Jinsong Du with Credit Suisse.

Jinsong Du - Credit Suisse

Thank you for taking my questions again. I’d just like to understand more about what Mr. Wu mentioned earlier on the future developments. So in the future, I’d just like to understand, what do you envision -- this is for Mr. Wu -- how much percent of our sales in the long-term, like in three years time, how much percent of sales will be coming from the visual diagnostic business rather than the -- you know, versus the HIFU business?

Sam Tsang

You would like Mr. Wu to make the expectation?

Jinsong Du - Credit Suisse

Yes.

Sam Tsang

Okay, so we will translate that for Mr. Wu.

Xiaodong Wu (Translation)

The IVD related business of the company we believe within three years we’re going to reach 80% or above. And in terms of FISH itself, probably it will come about 50% or above.

Jinsong Du - Credit Suisse

All right. Thank you. Going back to Sam’s comment on the gross margins at the beginning of the call, Sam, you mentioned that the -- you expect the gross margin continues to increase. So given the development, you know, obviously the higher growth rate in the IVD segment and obviously the higher growth rate for the consumables, what do you see as the long-term sustainable gross margin?

Sam Tsang

You can see that if you compare the gross margin from this quarter versus last quarter, even though the gross margin is suffering from the amortization of intangible assets and also the FISH equipment sales actually generate lower gross margin but is for the sake of generating recurring FISH reagent sales in the future, and you can see that from the results that the gross margin already fully reflected the indication of these two items. And so that’s why we expect with more and more FISH reagent sales, we expect the gross margin will continue to increase. And because the FISH reagents, we are expecting to generate over 80% gross margin.

Jinsong Du - Credit Suisse

I see. Okay. All right. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Luke Langford with Langford Capital Management. Please proceed with your question.

Luke Langford - Langford Capital Management

Last two -- the SG&A was up pretty big this quarter but that was primarily the addition of the FISH sales force. Should we look at those numbers as normalizing from here on out, as we are not expecting at this point any greater additions to the sales force, at least that’s been publicly announced? Or should we expect those numbers to stay fairly flat from here for the next couple of quarters?

Sam Tsang

It is still in the early stage of developing our entire direct sales force for the FISH business, so we expect SG&A -- mainly selling expenses will continue to increase and we consider that as an investment for the establishment of this direct sales force with large hospitals. And as management [inaudible], this balanced sales level will not only benefit our FISH product sales in the future.

Luke Langford - Langford Capital Management

I agree completely. Last question is in some of our on-the-ground checks, we’ve heard that there’s been a drive recently, especially among some of the larger hospitals, that there’s obviously less state aid coming in and they are having to go to a profit driven model to run their businesses, and that is driving them to really focus on expenses and therefore take a look at your guys’ equipment as being so much better priced than the competition, as well as your reagent kits. Are you hearing that in your dialogs with your clients and your prospective clients, that there’s -- that that driver is really in play now more than in the past?

Sam Tsang

Are you talking about the privatization of some hospitals or --

Luke Langford - Langford Capital Management

Correct.

Sam Tsang

Because the privatization is still an unclear policy in the government and there will be a healthcare reform policy to be announced in the near future. I think it is probably more appropriate to weigh the government policy before commenting on the privatization issue because there are still many different discussions and some of the discussions are in the operators’ opinion.

But currently, we [inaudible] see the [inaudible] you mentioned.

Luke Langford - Langford Capital Management

Currently you do or do not? I’m sorry, I didn’t hear you.

Sam Tsang

Do not.

Luke Langford - Langford Capital Management

Okay. So it’s -- but people are still going with you guys based on the value proposition, that’s a fair statement?

Sam Tsang

Sorry, can you repeat?

Luke Langford - Langford Capital Management

People are still selecting your product over others based on the value proposition. The hospitals are still selecting you guys over other analyzers based on the value proposition.

Sam Tsang

Yes, better quality, closed system, and more reagents and of course also cost advantage.

Luke Langford - Langford Capital Management

Right, right. So prospectively, if the cost advantage becomes a greater factor in a privatization, that would play to your strengths even more so was my question, but I respect the fact that you can’t comment. That’s fine. We’ll wait.

Sam Tsang

Okay, I just want to mention that hospitals, the cost is only one of the factors to be considered by the hospitals because it is the diagnostic products and so product quality and available, different or more comprehensive reagent kits are also important factors to be considered by hospitals.

Luke Langford - Langford Capital Management

Right. That’s fair. We heard a couple of reports where competitors’ equipment was sitting idle while the hospitals were now utilizing your guys’ equipment for various reasons, cost being one, product quality being another, so I was just wondering if the privatization trend, has Mr. Wu and yourself have seen any trend on how that potentially may benefit you and the company, but we’ll wait to see what unfolds with the government announcement.

Operator

There are no further questions at this time. I would like to turn the call back over to Mr. Sam Tsang for any closing remarks.

Sam Tsang

Once again, thank you for joining us today. Please don’t hesitate to contact us if you have any further questions. Thank you.

Operator

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

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