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SORL Auto Parts, Inc. (NASDAQ:SORL)

Q4 2007 Earnings Call

March 27, 2008 8:00 am ET

Executives

Xiao Ping Zhang – Chairman and Chief Executive officer

Jason Zhang – Deputy General Manager

Richard Cai – Senior Manager of Investor Relations of SORL

Valentine Ding – The Global Consulting Group

Analysts

Albert Lee – Maxim Group

Alex Harbin – Tollcross Securities

Operator

Good morning and welcome to the SORL Auto Parts Fourth Quarter 2007 results. (Operator instructions) At this time it is my pleasure to introduce your host Mr. Kevin Theiss with SORL Auto Parts. Thank you Mr. Theiss. You may begin.

Kevin Theiss

Thank you and welcome to the SORL Auto Parts 2007 Fourth Quarter and Year End Conference Call. My name is Kevin Theiss and I’m with the Global Consulting Group, SORL’s US investor relations agency. Joining us today are Mr. Xiao Ping Zhang, Chairman and Chief Executive officer, Mr. Jason Zhang, Deputy General Manager, Mr. Richard Cai, Senior Manager of Investor Relations of SORL, and Mr. Valentine Ding, also with The Global Consulting Group. Before we begin, I would remind all listeners that throughout this call we may make statements which constitute forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. The following is management’s discussion analysis of certain significant factors that have affected our financial position and operating results during the period included in the company consolidated financial statements as well as information related to the plans of our current management.

This report includes forward-looking statements. Generally the words “believe,” “anticipate,” “may,” “will,” “should,” “expect,” “intend,” “estimate,” “continue,” and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risk and uncertainties including the matters set forth in this report or other reports or documents we file with the SEC from time to time which will cause actual results or outcomes to differ materially from those projected. Undue reliance should not be placed on those forward-looking statements to speak only as of this date hereof. We make no obligation to update these forward-looking statements. I will open today’s call to provide an overview of the quarter and year-end results and our recent events. Mr. Richard Cai and Mr. Xiao Ping Zhang will answer questions and provide concluding remarks. Mr. Richard Cai and Mr. Valentine Ding will also provide live translation. For our call today, I will review the financial results in US dollars.

We are pleased to report solid growth in sales and income for the 2007 fourth quarter and 2007 year. In 2007, the heavy-duty truck market increased the fastest among the segmented markets of the China Auto Industry. According to the statistics of the China Association of Automobile Manufacturers, the unit production of Chinese heavy-duty vehicles and medium vehicle sectors including trucks, chassis, and semi-trailers, grew over 43.3% to 724,433 units in 2007 as compared to 2006.

Our strategic growth plan consists of several segments. Our focus is on quality control with cost reduction. We believe that our products offer higher quality compared with our competitors in the commercial vehicle air brake valve market in China and a superior performance cost advantage in the international market. To sustain this competitive advantage and at the same time obtain higher profit margins, we will use our efficient manufacturing base in China to continue focusing on quality control and cost reduction.

For example, we continue to improve implementation of lean production methods in our manufacturing process. This resulted in a 30% reduction of the manufacturing cycle time, less production waste, and lower unit cost. We believe that innovative products will ultimately define a manufacturing company’s success. So, we can continue to expand our R&D activities and we’ll continue to promote the SORL brand name based on our technological innovation.

We have expanded our production capabilities and we’ll continue to do so to meet our customer’s rising demand for our products. During the 2007 fiscal year, we added 65 computerized numerical control machines, 11 dye casting machines, and 15 units of other equipment.

To further support the expansion of our production capacity, we purchased a plant in September 2007. Due to the acquisition we have enough space to double our capacity and we will add equipment as necessary and incrementally to meet rising demand. The management believes our products are competitive in the international market, and we plan to set up additional authorized sales distributors internationally and to actively seek strategic partnerships with international distributors and manufactures.

During 2007, our India-based sales force successfully expanded our sales to the local OEM market. We are seeking synergistic acquisition targets which can be easily integrated into our product manufacturing and corporate management or companies that have strong joint venture partners that will become major customers. We have engaged Jefferies and Co. as our lead advisor for mergers and acquisitions related to consolidation opportunities in the automotive parts industry and further penetration of international markets in the future.

Revenue for the fourth quarter of 2007 was $32.5 million, a 34.8% increase as compared to $24.1 million for the same period in 2006. Revenues from China’s domestic OEM, China’s domestic aftermarket, and international market for the fourth quarter of 2007 were $11.1 million, $10.1 million, and $11.3 million respectively. Revenue for the OEM, China’s domestic aftermarket, and international markets for the fourth quarter of 2006 were $8.6 million, $6 million, and $9.5 million respectively. As these numbers indicate, we have seen growth in all three segments in 2007.

Gross profit grew even faster than revenue in the fourth quarter at 52.4% to $8.3 million compared to $5.5 million for the 2006 quarter. Income from operations for the fourth quarter of 2007 was $2.8 million, an increase of 13.8% as compared to $2.4 million in the same quarter of 2006. Net income for the fourth quarter of 2007 was $2.4 million or 13-cent earnings per diluted share as compared to net income of $1.9 million or 13-cent earnings per diluted share in the same quarter of last year. The difference between the increase in net income and EPS was due to the issuance of 4.9 million new common shares to a secondary public offering completed in December 2006 which weighted the average diluted shares more heavily in the fourth quarter of 2007.

Revenue for the 2007 year was $115.8 million, a 36.4% increase as compared to $84.9 million for the 2006 year. OEM revenue for the 2007 year was $41.2 million, a 52% increase as compared to $27.1 million in 2006. Aftermarket revenue in the 2007 year was $31.1 million, an increase of 30.1% as compared to $23.9 million a year go. Export revenue was $43.4 million in the 2007 year, an increase of 28.1% as compared to $33.9 million in 2006. A revenue breakdown shows that OEM sales in China, aftermarket sales in China, and international sales accounted for approximately 35.6%, 26.9%, and 37.5% respectively of the 2007 annual sale compared to 31.9%, 28.2%, and 39.9% in 2006. For the OEM market, the company sells its products to 51 vehicle manufacturers including all key truck manufacturers in China.

In addition to heavy-duty trucks, the valves are also widely used in air brake systems for buses. The 52% OEM sales increase in 2007 was generated by new product R&D and timely delivery of products and services. With the rapid growth of commercial vehicle output in recent years and the increasing number of vehicles on the road, demand for brake products has become stronger. Thanks to our nationwide sales network as well as increased production capacity, 2007 domestic aftermarket sales of $31.1 million increased by $7.2 million or 30.1% compared to 2006.

Chinese custom data shows that China exported a total of 535,000 commercial vehicles reflecting a 72% year-over-year increase. Our overseas sales to Asian countries and the North American markets, the company’s largest overseas market segments, increased by 40.3% and 47% compared with 2006. As a result our export sales increased by $9.5 million or approximately 28.1% to $43.4 million for 2007 compared to $33.9 million for the same period of 2006. We had expanded market coverage with 72 countries and regions in 2006 to 81 in 2007. Since we began to sell our products to a major truck manufacturer in India, we have continued to get attention from international OEMs in some emerging markets. As more Chinese trucks are being exported, we are positioning our replacement products in those large and fast growing international markets to capture those replacement sales as well as penetrate the OEM markets.

Gross profit in 2007 was $27 million, an increase of 40.1% as compared to $19.3 million in the 2006 year. The gross profit margin increased to 23.3% as compared to 22.7% in 2006. The company is using a lean manufacturing system with cost control measures to continuously improve manufacturing cycle times, reduce production waste, and lower unit costs to continue to try to improve gross margin through achieving greater economies of sale, shifting the product mix, and introduction of new valve products with higher profit margins.

In the year 2007 selling expenses increased by approximately 46% mainly due to the fact that transportation and packaging cost increased by $1.7 million as a result of more product ship and rising shipping expenses as fuel prices rose. We also added 15 new sales and marketing personnel during 2007 to enhance our market penetration in China and abroad. The company recorded $2.2 million of product launching expenses for 2007, an increase of $285,465 or 12.1% due to higher sale levels.

General and administrative expenses were $6.5 million for 2007, an increase of $3.3 million or 100.7%. The increase was mainly due to the following factors. R&D expense which is included in general administrative expenses increased by $1,021,951 as compared to 2006. The higher R&D expenses reflect to the greater number of engineers and accelerated activities to develop new innovative products.

During the year ended December 31, 2006, we reversed a bad debt provision, provided an increase of $944,848 as we collected a significant portion of accounts receivable over 1 year old which had already been reflected as a reduction in G&A expenses. That bad debt reversal in 2006 helped to contribute to a poor G&A comparison between 2006 and 2007. The expansion of our business activities, facilities, and work force resulted in increased depreciation, office expenses, staff salary and welfare, travel expenses, supplies and utilities totaling $1,405,602 as compared to 2006. As a larger company, SORL experienced higher associated costs including increased personnel costs, higher depreciation, greater office and supply expenses, and advertising expenses of about $251,000. Reflecting the increased sales and profitability for higher expenses, income from operations for 2007 was $12 million, an increase of 21.8% as compared to $9.9 million. For 2006, income tax expense declined to $636,976 in 2007 compared to $1.3 million for 2006, a decrease of $615,882. The company received an income tax benefit of $991,133 for the purchase of domestic equipment which reduced current income tax expense.

Net income for 2007 was $10.7 million, an increase of 39.6% as compared to net income of 7.7 million for the 2006 year. Net income growth of 39.6% exceeded the revenue growth of 36.8%. Fully diluted earnings per share for 2007 were 59 cents, an increase over the 56 cents earnings per share for 2006. The difference between the increase in net income and EPS was again due to the issuance of 4.9 million new common shares during a secondary offering in December 2006 which weighted the average diluted share more heavily at the end of 2007.

Cash and cash equivalents totaled over $4.3 million with a current ratio of 4.3 to 1. Total working capital as of December 31, 2007, was $44.7 million. Net cash from operating activities was $8.9 million for the year ended December 31, 2007. Total shareholders’ equity as of the end of 2007 increased to $72.5 million as compared to $57.4 million as of December 31, 2006. At December 31, 2007, accounts and notes receivable increased to $39.9 million from $30.1 million a year ago due primarily to the increase in sales. Inventory rose to $8.2 million from $4.5 million at the end of 2006. This inventory increase reflects both an increase in raw materials to support higher production levels and larger inventory of products exposed to ensure prompt delivery to customers. The management believes these levels are consistent with the level of business activity. The company’s current financial resources are adequate to meet the working capital requirements for 2008.

During 2007, capital expenditures were approximately $19.4 million mainly for the acquisition of plant, land use rights, and new equipment to support the growth of the business to meet the increasing needs of our customers. As previously mentioned, we added 65 CNC machines, 11 dye casting machines, and 15 units of other machines to expand our production capabilities. We also redeployed and streamlined production and assembly line enabling us to rapidly expand production capacity to meet increasing demand for our products.

For September 2007, the company purchased land rights, a manufacturing plant, and office building with a total floor area of 712,333 square feet from The Ruili Group Co. Ltd., for an aggregate purchase price of approximately $20.2 million. The purchase price was paid by transferring to The Ruili Group our $9 million investment and the existing project and the remaining balance of $11 million was paid in cash. As a result of this transaction, the additional space was expected to meet our demand for production space for the next few years. With that, I will turn the call to Richard Cai and CEO and Chairman, Mr. Xiao Ping Zhang, for final remarks. Richard will provide the English translation. Richard?

Xiao Ping Zhang

[Presentation in Mandarin – translation below]

Richard Cai

Thank you for joining us today ladies and gentlemen. We’re very excited to close a strong 2007 as we demonstrated a robust 36.4% growth in revenue and a faster 40% growth in net income. During the year, we took the decision to ensure the corporate growth including acquiring a new plant and advanced equipment which adds production capacity and enhanced efficiency. We have also specifically targeted research and development to make sure we are investor leaders in brake technology, and we developed innovative products that meet global standard and help build SORL brand recognition.

When recognition increased in 2007, a symbol quality of our customer such as Baotou North-Benz Heavy Duty Trucks, the second largest heavy-duty truck manufacturer in China, a leading chassis manufacturer in South Africa, a large aftermarket distributor in the United States, and leading OEM truck manufacturer in India, and FAW Group who will only renew contracts, but designate SORL as an outstanding supplier who would also have a breakthrough sales year in the municipal bus market in China. We look forward to continued penetrations of expanding domestic market for Chinese OEM and aftermarket products and we believe SORL international sales will grow because of our growing land recognition and also the growing number of Chinese trucks sold internationally.

We thank our employees for their dedication and hard work. We appreciate the support of our shareholders. Thank you.

We will now open the line for questions. Operator?

Question and Answer Session

Operator

(Operator Instructions) And our first question comes from Albert Lee with Maxim Group.

Albert Lee – Maxim Group

Hi. The first question is the 25.5% gross margin you guys put up in Q4, I believe, is by far the highest we’ve seen at least in the past few years, so given some of these cost saving initiatives you have in place on the manufacturing side, and I guess, partially offset by higher fuel and transportation cost, what level of gross margin do you guys view as sustainable here in 2008?

Xiao Ping Zhang

[Response in Mandarin – translation below]

Richard Cai

Actually, 25.6% is very exciting, and we think that in 2008, what we have targeted is to have steady growth and fast growth. At the same time we are targeting to improve our gross margins. We think that 25.6% is a little bit higher, but we are targeted at a level that’s from 23% to 24%.

Albert Lee – Maxim Group

23% to 24% is more normalized.

Richard Cai

Yeah, normalized. But that was normally much more than the 22% at the beginning of this year.

Albert Lee – Maxim Group

Okay. I got you. Lastly you mentioned of your relationship with this large Indian OEM and how it’s helping you guys initiate new relationships, the markets; I believe you also signed out with another large Indian OEM recently as well, but given comparisons being made, China with India, can you talk about how meaningful the contributor India could become for you guys – I know it is marginal in 2007, but are we talking about the contribution being much more meaningful in 2008?

Valentine Ding

[Mandarin Translation of Question]

Xiao Ping Zhang

[Response in Mandarin – translation below]

Richard Cai

Yes. We can say is that we will achieve much better performance in 2008. First, we can see that forward sales to India OEM markets increased a lot in the first quarter this year; second we can see that our content per vehicle actually increased, and also we provide much more products to the markets, and therefore we expect that our sales to India market will have a steady increase in 2008 and 2009.

Albert Lee – Maxim Group

Okay. You seeing a ramping in orders from this particular OEM; and did you mention that this first quarter or the first quarter of 2007 grew nicely – you talking about Q1 of 2008, the current quarter, you’re seeing steady increases out of the same OEM as well?

Richard Cai

Yes.

Albert Lee – Maxim Group

Currently, right? Okay. Great. Thank you.

Xiao Ping Zhang

[Response in Mandarin – no translation]

Operator

Thank you. Our next question comes from Alex Harbin with Tollcross Securities.

Alex Harbin – Tollcross Securities

Hi guys. I have the question about your capacity. You said in previous releases explaining the acquisition of factory that you’d have enough room to meet your needs for 2 to 3 years, and then in this call you said you’re doubling up capacities; so do you guys still see – I suppose the doubling of capacity in say 3 years, and if that’s the case, what kind of equipment capital expenditures would be needed to double capacity?

Valentine Ding

[Mandarin Translation of Question]

Xiao Ping Zhang

[Response in Mandarin – translation below]

Richard Cai

Yeah. We are now targeting to double our capacity within 2 to 3 years – we always depend on the increasing demand for our products. We’d expect that the acquired production space will support our expansion of capacity in the next 2 to 3 years, and we also already have the plan to acquire equipment to support such growth.

Alex Harbin – Tollcross Securities

Okay. Do you have specific numbers on what your capital expenditures would be on equipment in order to double you capacity?

Valentine Ding

[Mandarin Translation of Question]

Zong Yun Zhou

[Response in Mandarin – translation below]

Richard Cai

Our financing manger just answered the question that we are planning to invest about 50 million Chinese Yen RNB to acquire equipment next year; so that would be $6 to $7 million.

Alex Harbin – Tollcross Securities

When you say next year, you mean that’s the total amount for doubling capacity or that’s what you’re going to be spending this year?

Richard Cai

Planning next year’s.

Alex Harbin – Tollcross Securities

Okay.

Richard Cai

That’s the total amount we allocated for Cap-Ex in case we need to expand capacity as needed.

Alex Harbin – Tollcross Securities

Okay. 37.5% of your revenue this year was exports – maybe you could break down the exports into your major countries of export and percentage – say your top 3 or something, and I’m wondering if you see any effects from the downturn in the US economy spilling over into your exports sales.

Valentine Ding

[Mandarin Translation of Question]

Zong Yun Zhou

[Response in Mandarin – translation below]

Richard Cai

Actually, we don’t provide the data with any specific country because not too many countries exceed 10% of our overall sales. If we breakdown them to the continents – the first one would be Asia, the second would be North American, and the third would be African.

Alex Harbin – Tollcross Securities

Okay. Can you break….

Richard Cai

And also the US downturn – the US markets – the US economy looks like not very good at this moment but we’re targeting at the aftermarket sales, there is still a lot of room for newcomers like us to increase, and also this year, considering and evaluating the potential acquisition target, we are focused on building up the sales network in North America.

Alex Harbin – Tollcross Securities

Okay. In terms of the sort of outlook that you provided for 2008, you provided a lot of qualitative heavy-duty vehicles are strongly growing, etc.; is there some sort of top-line guidance that you can give for the year?

Richard Cai

We’ve not provided guidance yet.

Alex Harbin – Tollcross Securities

Okay. Are you planning to do that at some point or…?

Richard Cai

We have such plans, but that depends on the management’s decision finally.

Alex Harbin – Tollcross Securities

Okay. Alright, thanks guys.

Operator

Thank you. And once again, ladies and gentlemen, if you would like to ask a question, please press *1 on your telephone keypad.

There appears to be no further questions. I’d like to now turn the call back over to Kevin Theiss for any closing comments.

Kevin Theiss

Thank you all for joining us today. We look forward to sharing with you our progress in future calls. Have a good day. Thank you.

Operator

Thank you. This concludes this teleconference. You may disconnect your lines at this time. Thank you for your participation.

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