China Nepstar Chain Drugstore Ltd Q4 2007 Earnings Call Transcript

| About: China Nepstar (NPD)

China Nepstar Chain Drugstore Ltd (NYSE:NPD)

Q4 2007 Earnings Call

March 19, 2008 8:00 am ET


Rachel Levine - The Global Consulting Group

Simin Zhang - Chairman of the Board

Jiannong Qian - Chief Executive Officer

Andrew Weiwen Chen - Chief Financial Officer

Lucia Qian - Marketing and IR Director


Michael Katz - Bearing Capital

Caroline Lee – Goldman Sachs


Greetings and welcome to the China Nepstar Chain Drugstore Ltd. fourth quarter earnings conference call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow formal presentation. (Operator Instructions) As a reminder this conference is being recorded.

It is now my pleasure to introduce your host Rachel Levine of The Global Consulting Group. Thank you Ms. Levine, you may begin.

Rachel Levine

Thank you. If you have not received a copy of Nepstar’s fourth quarter and fiscal 2007 earnings press release, it is currently available on the Company’s website at A presentation to accompany today’s call and live webcast is also available on the website under the Investor Relations section.

Before we start I would like to remind you that certain statements are not of historical facts made during the course of this conference call about future events and financial results constitute forward-looking statements that are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. You should note that the Company’s actual results may differ materially from those projected in these statements due to a variety of factors affecting the business. Forward-looking statements are subject to risks and uncertainties. Discussions of factors that may affect future results are contained in our filings with the Securities and Exchange Commission. We undertake no obligation to correct or update any forward-looking statements provided as a result of new information, future events or even changes in expectations.

Joining us on today’s call are Dr. Simin Zhang, Chairman of the Board, Mr. Jiannong Qian, Chief Executive Officer, Mr. Andrew Weiwen Chen, Chief Financial Officer and Ms. Lucia Qian, Marketing and IR Director who will also be our translator during the question-and-answer session. We will be translating questions and answers and ask your patience at that time.

Mr. Qian, CEO will now deliver his opening remarks. Please go ahead sir.

Jiannong Qian

Thank you, Rachel. Good morning and good evening. I would like to welcome you all to China Nepstar Chain Drugstore fourth quarter and the fiscal 2007 financial results conference call. Before Andrew gets into the specifics of the financial results, I would like to share a few highlights.

First we are especially pleased at the (inaudible) line performance we have maintained through the fourth quarter and frankly the entire year. Increase in net income more than ten-fold over 2006 is a testament to our focus on leveraging competitive advantages such as centralize the procurement in the private label products, maximizing operating efficiency and delivering phenomenal new store growth and we added 556 new stores in 2007 with 211 of these occurring in the fourth quarter.

Our outlook for 2008 is bright. We are well positioned to pursue our consolidation strategy and to capitalize on China's fragmented drugstore marketplace and the trend of increasing market share among the larger chains. We have entered into two definitive acquisition agreements to acquire and aggregate our 86 drugstores so far in 2008. We believe our organic growth and acquisition will further strengthen our leading position in the high-growth retail drugstore industry in China.

In the market of over 300,000 drug stores, it is part of our action plan to build out a fast number of stores in China quickly and solidly through both new store opening and acquisitions. With our chained network reaching critical announcing the foresee about the future. We expect to be able to fully leverage our centralized procurements and the private label category. Having said that we are more than determined to go central while we continue to increase gross margins. Certainly the Company has launched several innovative marketing initiatives focusing on driving our central sales. Meanwhile as we, Nepstar has officially kicked out the (inaudible) in March. We believe that implementation of the world class ERP systems while they accelerate foundation for the future products of the Company.

Now let me turn the call over to Andrew Chen our CFO who will discuss the financial results of the fourth quarter and the year. After Andrew turns his prepared remarks, he will join me and Lucia to take your questions.

Andrew Chen

Thank you Mr. Qian. Ladies and gentleman thanks for joining us today. We are quite pleased with the Company’s overall performance in 2007. Our Dong Guan Hui Ren Tang results did well of the strategy we have put into place to grow our margins and to establish a business model to maximize profitability. Then we now walk you through the numbers for the quarter and the year and then I should provide some commentary on our guidance, an outlook going forwards.

Our renewed in the fourth quarter 2007 growing 9.5% to RMB524.1 million or $71.8 million U.S dollars from the same period in 2006. Then we give you a breakout of different product segments. During the fourth quarter sales of prescription drugs accounted for 21.8% of our revenue. Over-the-counter drugs represented 37.2%, nutritional supplements represented 16.6%, herbal products represented 3% and other merchandise accounted for 21.4%.

We added 211 new stores during the fourth quarter. Same store sales for those that opened before December 31, 2005 increased 1.9% compared to the third quarter of 2007 but declined 3.7% compared to the same period in 2006. This was due to our strategic move to improve margins for this continuing certain low margin products in the third quarter of 2007 as well as the timing of the Mid-Autumn festival holidays, a public holiday based on Chinese lunar calendar. The Mid-Autumn festival holiday was in October in 2006, but was shifted to September in 2007 which resulted in weaker sales in October 2007 compared to the prior year.

In the fourth quarter 2007 we also increased a number of our private label products to 1,356. Private label products contributed 21% of the Company’s revenue and 31.6% of the gross profit for the quarter. Developing private label products has been one of our core business strategies. Private label branding gives us more freedom and adaptability in pricing and more control over products attributes and quality. The fourth quarter gross profit grew 39.8% from the same period in 2006 to RMB 254.1 million of $44.8 million U.S dollars.

Our gross margins increased to 48.5% compared to 38% in the fourth quarter 2006. The increase in gross profit and gross margin was primarily driven by improved sales contributions from centrally procured merchandise including private label products. By centralizing our purchases we have been able to gain bargaining power with our suppliers for more favorable terms. Increased economies of scale realized our large network of retail outlets has also contributed to increment in our gross margins.

Our sales, marketing and other operating expenses for the fourth quarter increased to RMB 169.3 million or $23.2 million primarily due to new store openings. Excluding share based compensation of RMB 1.8 million or $0.3 million sales, marketing and other operating expenses for the period increased by 20.5% to RMB 167.4 million or $23 million primarily due to new store openings. Sales, marketing and other operating expenses as a percentage of the Company’s total revenue for the fourth quarter of 2007 were 32.3%.

General and administrative expenses increased 34.5% to RMB 23.4 million or $3.2 million primarily due to share-based compensation expenses of RMB 6.9 million or $0.9 million recognized in the quarter. Excluding share-based compensation expenses, general and administration expenses declined 5.1% year-over-year.

Including share-based compensation expenses our operating income jumped 141.1% from the fourth quarter 2006 to RMB 61.4 million or $8.4 million.

Lastly our net income surged 231.5% to RMB 58.5 million or $8.0 million over fourth quarter 2006 which translates into RMB 0.29 or $0.04 in diluted earnings per share or RMB 0.58 or $0.08 in diluted earnings per ADS compared to RMB 0.11 per share in the fourth quarter 2006.

Now let me summarize our financial results for the fiscal year.

2007 revenue increased 12.8% to RMB 1.95 billion or $268.0 million. Revenue contribution from prescription drugs was 24.4%, OTC drugs 35.6%; nutritional supplements 18.3%, labeled products 2.6%, and other products 20.1%.

We added 556 new stores compared with 331 in 2006. Same store sales grew 1.9% as they were affected by our merchandise realignment in the third quarter of 2007 to focus on higher margin products. During the year we increased our portfolio of private label products to 1,356 from 1,020 at the end of 2006. Sales of private label products represented approximately 18.7% of revenue and 30.7% of gross profit for fiscal 2007.

Gross profit for 2007 rose 41.8% to RMB 862.7 million or $118.3 million, gross margin was 44.1% for the year compared with 35.1% for 2006. Including share based compensation expenses; operating income grew 532% to a RMB180.8 million or $24.8 million, primarily due to a substantial improvement in gross margins and slow network developments.

Net income for 2007 increased 989.3% to RMB148.2 million or $20.3 million. Diluted earnings per share were RMB 0.80 cents or $0.11 or RMB1.6 or $0.22 in diluted earnings per ADS, compared with diluted net loss of RMB 0.03 per share in fiscal year 2006. Our balance sheet was strengthened mostly due to our successful IPO. As of December 31, 2007 our total balance cash, cash equivalents and help to maturity investment securities were RMB 2.77 million or $379.6 million compared with RMB 83 million as if December 31, 2006.

Total share holders equity increased to RMB 2.96 million or $405 million from the deficit of RMB 2.4 million as of December 31, 2006. At this point I would like to spend a few minutes discussing pricings for 2008 and share some of our more recent developments. We are giving guidance for the first quarter in light of extreme circumstance of the massive snow storms which have affected much of the countries economy. As a retail business Nepstar naturally been profit. This has compounded the traditional seasonal weakness of fifth quarter compared to a reminder of the year. Usually in the first quarter both the sales and stock openings are affected by the Chinese new year during which people often visit pharmacies and then (inaudible) reluctant to be able to leasing related metrics if they are focused on celebrating holidays.

Fourth quarter 2008 revenue is expected to be between approximately RMB 417 million to a RMB 500 million with targeted net income between approximately RMB 40 million to a RMB 42 million. This guidance is based on approximately 140 planned organic new store openings in the first quarter 2008.

Targeted revenue for fiscal 2008 is expected to be between approximately RMB 2.4 million to RMB 2.6 million excluding revenue contributed from future acquisitions. Targeted net income is expected to be between approximately RMB 330 million to a RMB 380 million. This guidance is based on approximately 1,050 planned organic new store openings in 2008. This target are as always based on our current views on the operating and market conditions which are subject to change.

I would like to conclude by highlighting some of our recent strategic initiatives for 2008 which are intended to position us well for continuing success. First and foremost we are focused on driving growth through improved new store and same store sales as well as making complementary acquisitions. This is evidenced by a few recently implemented programs. We are deploying a SAP based ERP system and trying to improve our operating efficiencies. The system will improve individual store inventory management and we are in favor of to budget, analyze and use store level business efforts.

We have established a store level promotion of the force program across the Company. Dedicated regional branch schemes are charged with promoting regional force and developing creative in store promotions to increase sales. On a mutual and acquisition front we already announced that the two definitive acquisition agreements for 68 drug stores owned by Ningo New Century Medical in satellite districts of Ningbo in Zhejiang Province; as well as 18 drugstores owned by Dong Guan Hui Ren Tang Pharmaceutical Co. Ltd. in Dong Guan City, Guangdong Province. Both acquisitions are in high growth market and our in line with our overall business development strategy.

The demographics of our industry continues to support our dynamic expansion strategy and we are working hard to ensure that China Nepstar is positioned to take advantage of every opportunity to ensure profitable growth in the coming years. With that let me join Mr. Qian and Lucia to take your question. Operator please begin the Q-and-A.

Question-and-Answer Session


Thank you. We will now be conducting the question-and-answer session. (Operator Instructions) Our first question comes from Caroline Lee with Goldman Sachs. Please take your question.

Caroline Lee – Goldman Sachs

Good evening. I have a couple of questions. Question number one just in line with what Mr. Qian was talking about, could you give them more guidance on the acquisition progression especially in regarding of 2008. We have already two acquisitions. Are there any more expected and what is the progress in that? And second question is about same store sales; I was wondering if you can give more guidance on what observed year-to-date and the reverse trend of connective comps and what are the waste managements is using to improve store sales, you can elaborate that, that will be helpful and my last question is on gross margin expansion. For 2008 what is managements view on high margin private label product penetration potential and what does that translate to gross margin. Thank you very much.


Thank you, Caroline. Just leave one minute to do the translation quickly.

Jiannong Qian (Interpreted)

As to the acquisition, actually we are in active negotiations with quite a handful of the pharmaceutical retail industry, businesses and we are having good health of achieving some acquisitions in the very close future as negations are not determined by the Company only. We cannot provide a very definitive guidance for the year but we are very happy to see that quite a lot of negotiations are progressing in a very positive way.

Simin Zhang (Interpreted)

Okay. The Chairman commented on the acquisition progress. At the moment, the two acquisition cases we have completed, we actually acquire at a forward-looking plea of around five times or below. If we can be more lenient with that of course we can achieve the deals quickly but what we see is that given the tightened credit line in China in this year, we don’t think that we need to lower our threshold in terms of acquiring the businesses. So we do think we will be able to complete several deals at a reasonable price. We do think that in second half of this year, the progress is going to be speeded up. This is because we do think that the tightened monetary policy adopted by the Chinese government is going to impact many medium or small size businesses and with that consideration, we have -- we do think that in the second half of the year, the possibilities of breaking deals are much higher.

Jiannong Qian (Interpreted)

As for the same store sales actually for the fourth quarter of last year we do see in absolute numbers that the same store sales has grown compared to the quarter three of last year. In the first quarter of this year, of course in the first two months, our business was impacted by the snowstorms. Therefore there was a negative same store sales in the first two months. However, we are very happy to see that from the 1st of March until now, we do observe a very strong positive same store sales growth.

To the measures the management took to grow same store sales, first of all we have established a dedicated promotional team at the branch level. At the moment there are a 100 promoters at our 13 branches and those promoters will focus on handling promotion in all the stores, not only the older stores but also for the newer stores and we had seen that all those promotions carried in a leisure way on the store level has substantially brought in incremental sales. The second measure is that we have been strengthening the operating in those incremental categories like traditional Chinese herbs, nutritional supplement and personal care products. To share with you first some of the herbal products. We have see that in March the proportion of herbal products has increased from the 2.6% to 3% and also we see categories on the personal care products and consumables is also experiencing a strong growth.

And the other thing is that we have been stream lining our training systems to our store level staff. We have been strengthening the sales skill training, especially targeting on the new product and with a part of being monthly how to sell new products we will see that those incremental categories will perform even better. Well, for our year 2007 our overall same store sales experienced 1.9% growth year-over-year and we do have strong confidence that we will not only reverse declining trend of same store sales; we have good hope of growing same store sales in the year 2008.

Up to the gross margin we actually had expected in a conservative way that year average gross margin in 2008 will be along the 51.9%. This is actually significantly higher than our current level with 8.5% in 4Q 2007. In the year 2007 our gross margin actually experienced a 9% growth year-over-year. In the year 2008 overall we do not expect to grow our margins in such an absolute number but you will see that we will grow our margin in around 7% and 7 percentage points and that has taken in consideration of our various initiatives of growing sales revenue at the same time.

To the penetration of private label products you will see that given our various initiatives and actions -- our private label penetration has increased from 18.3% in the third quarter of 2007 to 21% in the fourth quarter 2007 and we are happy to see that we are still having a quite a lot of private label products in the pipeline to roll out. We expect around 125 new private label products SKU’s to be delivered by May. We have very ambitious plans of growing the penetration of private label products to 40% by year end 2008. Caroline, I guess we have answered all three of your questions.

Caroline Lee – Goldman Sachs

Just a real quick follow up question. In addition to private label I know we have centralized a product which is also a high gross margin category. What is our expected penetration for this one in 2008?

Jiannong Qian (Interpreted)

At the moment we see that the non-private label is centralized procurement account for around 37.2% of the total revenue. We are actually making every effort to squeeze in the contribution of those products that will regionally procure it and try to centralize more products procurement on the head quarters level. Thank you.


Thank you. (Operator Instructions) Our next question comes from Michael Katz with Bearing Capital. Please state your question.

Michael Katz - Bearing Capital

Hi, thanks. Just a couple of quick questions. First on the same store sales could you go through a little more detail on what percent of your base of stores have now transitioned or lets say maybe not now but through that fourth quarter, looking at that fourth quarter that you just reported, was there more of the base transitioning to the new products that -- I am going to assume that you don’t take your entire chain of stores and change it out to the product to the new private label all at once, but is that part of what’s driving the deter -- you had a set of slightly worse comp effect in the fourth quarter than the prior quarter on a year-over-year basis. It sounds like it’s improving now. Could you just walk through how that’s likely -- how that transitioned and how it’s likely to see it in the next couple of quarters?

Jiannong Qian (Interpreted)

Well, through the impact of the transaction which is described of the pricing, the low margin products with our high margin private label products, actually on the long run, we don’t think it’s going to eternally bring adverse impact to the same store sales but in the due progress as we are changing the Plano gram and the merchandizing of the store, it definitely has brought some impact to the daily operation. At the same time because private label products sometimes do have slightly lower pricing compared to some grenit products reducing that -- in the process of knowing some of the pricing of the private label products we have improved out per SKU contribution from this margin and we have expected this. We are very confident that in the first quarter we have seen a leaping month of very significant reversing trend and we are as we just said making every effort to keep this momentum and to see a positive same store sales in the next few quarters.

Well, first of all we do see that in absolute number in the fourth quarter for the year, 1084 stores that was opened by year end 2005. There was a growth of 1.8% quarter-over-quarter and that was for the 1084 stores opened by 2006 and we do see that for the 331 stores opened in 2006 the growth was 4.8% and for the first two months of this year we actually have experienced very serious nationalized snow storm and if we do see the performances of those stores in March. We see a much stronger growth year-over-year.

Michael Katz - Bearing Capital

Okay I understand all that. I guess I just want to go back to my original question. My original question is simply if you looked at your base of 2000 stores what percent of those stores have gone through the transition? What percent would you say have completed their transition and what percent still have to go through their transition and if you looked at that in the third quarter and the fourth quarter that you just reported, the last two quarters could you comment on that?

Jiannong Qian (Interpreted)

Well, for the 2000 stores actually all of them have been having that transition in August and we do see that the impact brought by this transition was reflected in the third quarter and fourth quarter.

Michael Katz - Bearing Capital

Great thank you.

Jiannong Qian (Interpreted)

Well, as a consequence of this transition we do see that our gross margins improved from 42.6% in quarter two to 47.1% in quarter three and 248.5% in quarter four further. So, we do see that the transition has transcended the profitability of our stores. Michael I guess we have answered all you questions.

Michael Katz - Bearing Capital

Sure, yeah that’s for great for now. Thank you.

Jiannong Qian (Interpreted)

Your welcome.


(Operator Instructions) I'm not receiving any questions at this time. I will turn the conference back over to management. Excuse me, we did receive one question. Please stand by. Our next question comes from Michael Katz with Bearing Capital. Please state your question –

Michael Katz - Bearing Capital

Yeah, thanks just one last question. I was just looking at the progression of the operating margin. The gross margin is definitely improving really well and when you look at the operating expenses, it’s probably a function of the increase in new stores you are opening and the acceleration of the new stores. Would you expect that as you move through this year the sales, marketing, operating expenses and G&A expenses will begin to decline as a percent of sales. I understand the first quarter will have some disruption due to the storms but maybe for the balance of the year would you expect some operating margin expansion.

Andrew Chen

Actually we are going forward in 2008 we are seeing a slight increase in expense ratio which is a percentage of -- if you take the total sales, marketing and other operating expenses divided by total revenue debt ratio is expected to be at 35% which is higher than our Q4 level of that 31.9% and then for administrative expenses debt ratio is expected to be at 3.5% which is also slightly higher than our Q4 normalized level at 3.2%. So, the reason that we have raised the forecast of expense ratio is based on -- first based on conservative principle just to stay conservative, second is to recognize that the labor cost will be increasing due to the general inflation experience by the whole economy and also with the store place it’s going to be cheerful if there was more newer stores. That’s going to create a different cost structure at the newer store which typically have lower productivity. So, overall which we are budgeting -- overall expense ratio as 38.5% for this year, so that builds our effect into our guidance for 2008.

Michael Katz - Bearing Capital

Okay thank you.


Thank you. Ladies and gentleman there are no further questions at this time I will turn the conference back over to management for any closing comments. Please go ahead.

Jiannong Qian (Interpreted)

Well, we do see a quarter-over-quarter or year-over-year in next half higher achieved, a really significant achievement in the year 2007. We maintain high growth as well a significant growth in terms of net income. We do see our net income in 2007 at about tenfold of that about 2006. On the looking forward basis we do see around a fast track drug growing our store network. We have speeded up our organic store openings and at the same time we do have a positive outlook in terms of our position in the first quarter given that we have quiet occupied by a traditional Chinese festival we still achieved completed acquisition.

In other sectors of our operation we also have great progress for example in the procurement side by the mid of March 2008 our procurement team has literally completed the negotiations for annual contract of the existing suppliers and they will start to shift their focus on building up the operating under those incremental categories and what they have achieved now -- we are laying a quite good solid foundation for the future growth in the next few quarters.

On the other hand we are trying our best to improve the operation efficiency. As you all know that we have signed a definitive agreement with SAT to implement their ERP system and we have employed the company of [Bane] as our execution consultant to further streamline our operation procedures and we do see that this will actually build a more efficient run business for the next half. Thank you

Simin Zhang (Interpreted)

Thank you very much just one moment our Chairman has some other comment. Well with the in depths of medical reform undergone in China we see that the government is actually exerting strict regulation over the industry and I mean the stock holder entry has been raised and that has provided better opportunities for acquisition and for employee competent employees because all those mediocre companies who experience a quite hard time.

We, do observe that to the whole team of Nepstar of more than 10,000 people are having extremely high morale and with our accumulated experience for the past 12 years we are fully confident that we will deliver our guidance, we will deliver the best of value to our share holders. Thank you very much.


Thank you. Ladies and gentleman this concludes today’s conference you may disconnect your lines at this time thank you for your participation. For a replay of this conference please dial 877-660-6853; international dialers, 201-612-7415. Use the replay ID number of 277575 and the replay account number of 286. Thank you.

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