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SORL Auto Parts, Inc. (NASDAQ:SORL)

Q2 2008 Earnings Call

August 13, 2008 8:00 am ET

Executives

Dan Joseph - ICR

Xiao Ping Zhang - Chairman and Chief Executive officer

Jason Zhang - Senior Vice President

Li Min Zhang - Accounting Manager

Richard Cai - Director of Investor Relations

Analysts

Alex Harbin - Tollcross Securities

Chong-Min Kang - Gamco International

Peter Spears - Grower Capital

Operator

Welcome to the SORL Auto Parts second quarter 2008 earnings results conference. (Operator Instructions) I would like to turn the conference over to Dan Joseph.

Dan Joseph

Welcome everyone to the SORL Auto Parts 2008 second quarter earnings conference call. On our call today is Xiao Ping Zhang, Chairman and Chief Executive officer of the company; Jason Zhang, Senior Vice President; Li Min Zhang, Accounting Manager for SORL and finally Richard Cai, Director of Investor Relations. I am with ICR which is SORL’s Investor Relations firm.

Before we begin, I’m going to provide a disclaimer about forward-looking statements. In addition to historical information this conference call contains forward-looking statements regarding SORL Auto Parts. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance and underlying assumptions in other statements, other than statements that are historical in nature.

These forward-looking statements are based on management’s current expectations that are subject to risk and uncertainties that may result in expectations not being realized and may cause actual outcomes to differ materially from expectations reflected in these forward-looking statements. Potential risks and uncertainties include the nature of operating in China generally, the fact that the company is new to the U.S. public markets and its regulatory regime.

Product and service demand acceptance, changes in technology or economic conditions, the impact of competition and pricing, the impact of government regulation and other risks described in the statements and reports filed by the company from time-to-time with the SEC.

Also such forward-looking statement whether written or oral and whether made by or on behalf of the company are expressly qualified by these cautionary statements. Because forward-looking statements are subject to risk and uncertainties, we caution you not to place undue reliance on these statements.

Now we will begin the discussion of the quarter’s financial performance. I would like to turn the call over to Richard.

Richard Cai

We would like to begin to handing over to our CEO, Mr. Zhang who will make a few remarks. Mr. Zhang will speak in Chinese and I will translate.

Xiao Ping Zhang [Interpreted]

We are very pleased with the progress we’ve made in the second quarter. Revenue growth was strong across the automobile market segment and for our groups significantly during the quarter. One reason for this is that lower OEM business in India continued to make excellent progress. We look forward to continuing to be ready in this high potential market and expect it to be a model for how we will eventually to better in the OEM business.

Relative to the Chinese market we’d experienced very strong growth. As part of that, we were happy to see that profit of our transportation market which we began to develop last year continued to enjoy strong growth. We also made solid progress, relative to developing the market for agricultural vehicle, including entering into the supplier development agreement with Shi Feng Group, China’s largest agri vehicle manufacturer. We believe that this new market in conjunction with our traditional strength in a heavy and medium truck market will form a solid foundation for the future growth within the domestic market.

Relative to profit stability once again we achieved a gross margin above our prior historical average. We will continue to execute initially; such as improve manufacturing efficiencies and greater emphasis on system sales versus individual components that had allowed us to improve margins with a goal of maintaining the higher margin over the long-term.

We made a significant increase in research and development expenditures, which we think demonstrates our ongoing commitment to innovation, particularly as related to the development of electronic braking system which we believe would also be the key driver of future growth.

As we transition through the second half, we take a conservative will on Chinese OEM sales, in the second half of 2008. We see several cost flow developments that could be adjust on growth. Specifically, as it relates to the timing of orders, it relates to the change in emission standards in China on production scheduling issues related to the Olympics. We see this issues as reflected in timings and not indicating a fundamental status of our business, which we believe was made strong and pose for a continued growth over the long-term.

Richard Cai

Okay, now I would like to begin by providing an update as to our overall business and we will then discuss our financial results for the quarter. As you know SORL is China’s leading manufacturer of air brake valves and systems and one of the 100 vehicle parts suppliers in China, all that are generally used on commercial vehicle which weigh more than three tons, an example would include trucks and buses.

Our products are primarily into three market segments; Chinese original equipment and manufacturers, the Chinese aftermarket and export aftermarket. Since 2004 we had grown with a compound annual growth rate 35% on the top-line and 31% on the bottom line and have developed a very broad customer base, including more than 50 OEMs in China and export sales to more than 80 countries covering North America, Europe, Asia, Africa and the Middle East. Our competitive advantage includes offering customers an excellent cost quality ratio, which allowed us to compete both at home and abroad.

Our motor manufacturing facility which is comprised largely with computerized equipment and is enriched with applied events, quality control and manufacturing capabilities, the most expensive aftermarket distribution network in China including 28 authorized distributors and more than 800 sub-distributors that cover most of China, an excellent product development group which has allowed us to continuously improve the functionality of our overall product. An example would be to air port, we are putting into this segment of electronic components, which we believe represents the essential opportunities for us in the future.

Now I would like to turn to our financial results for the first quarter of 2008, which were really strong and exhibits positive change in both growth and margin. Revenue for the second quarter of 2008 was $42.2 million, a 44.5% increase from $29.2 million for the same period in 2007.

The Chinese OEM market grew roughly 46% to $11.5 million, the aftermarket in China grew roughly 67% to $10.5 million and the export market grew 29% to $14.1 million. The Chinese OEM market comprised 42% of our further revenue followed by the export market as 33% and the domestic aftermarket at 25%. We saw a significant increase in orders from most of our major OEM customers reflecting a continuous strong growth of commercial vehicle market in China.

In 2007, the medium and heavy duty truck market in China experienced growth of 43% versus 29% at 2006. We think this large increase in trucks on the road in China helps us to achieve such high growth in the aftermarket this quarter as compared to the prior year period. Relative to export sales growth was strong in order market with particular trends in India as all the relationships with automotive continues to develop.

Gross margin for the second quarter of 2008 was $11.4 million as compared to $6.4 million for the same period in 2007. Gross profit margin was 27% versus 21.8% in the same period last year, an increase of 520 basis points. Although slightly lower than the last quarters of 28.2%, the second quarter’s margin was still significant above our historical average which has been in the range of 22% to 23.5%.

Similar to last quarter, the higher gross margin was the result of a wide sector including price increase, the sales of more systems versus individual components, and ongoing efforts to improve manufacturing efficiency. While it is too early for us to say with complete certainty that we can maintain this high margin levels, we are committed to continuing our efforts in this regards with the goal of maintaining higher gross margin over the long-term.

Operating expense increased 138% from $2.5 million in the second quarter of 2007 to $5.9 million in the second quarter of 2008. As a percentage of revenue, operating expense increased from 8.5% in the second quarter of 2007 to 15.9% in the second quarter of 2008. This increase in operating expense as a percentage of revenue was a result of several factors; one was an increase in transportation costs driven mostly by the impact of rising fuel costs. Also important was $1 million increase in our research and development expense from $0.3 million in the second quarter of 2007 to $1.3 million in the second quarter of 2008.

The increased investment went to support the general upgrade of our products, improvement of our existing facilities and the continued development of electronic braking system. We consider this to be as much an investment as an expense and plan to continue to invest significantly in developing the net generation of products upon which our continued our growth will be there.

Operating income increased 43.4% or $1.6 million from $3.9 million in the second quarter of 2007 to $5.5 million in the second quarter of 2008. Operating margin would remain relatively stable at 13.1% in the second quarter of 2008 as compared to 13.3% in the prior year period. This small decrease was a result of the combination of improved gross margins and the increase in operating expense as the percentage of sales.

Net income increased 15% or $0.6 million from $4.1 million in the second quarter of 2007 or $0.23 per share to $4.7 million in the second quarter of 2008 or $0.26 per share. Net margin decreased 290 basis points from 14.1% in the second quarter of 2007 to 11.2% in the second quarter of 2008.

In addition to the factors affecting margin that I would rather mention, net margin was negatively impacted by income taxes, which trends from $0.4 million credit in the second quarter of 2007 to $0.3 million charge in the second quarter of 2008. The difference in the tax segment related mostly to the government sponsored investment incentive programs that is like tax refund based on the purchase of invested capital equipment.

For the first half of 2008, net income was $8.3 million up $0.45 per diluted share, an increase of 33.9% as compared to $6.2 million or $0.34 per diluted share in the first half of 2007. That markets that were in the first half of 2008 was 11.3% as compared to 11.6% for the first half of 2007.

Looking ahead to the remainder of the year, we see two sectors that could put a check on growth; first due to the implementation of new emission standard in China as of July 1 2008, we believe there may have been a trend on the part of China’s OEMs to increase orders in the first half of the year, which may have a significant downward impact on OEM orders during the second half of the year.

Secondly, due to government-mandate traffic control related to the Olympics, some of our key customer will halt production during the third quarter. It is difficult at this time to project the precise impact of this market. While we do expect to have a strong year, it is possible we will be able to duplicate the growth rate of the second quarter.

Thank you for listening. Now we will open to take the questions you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Alex Harbin - Tollcross Securities.

Alex Harbin – Tollcross Securities

I’m wondering in terms of this OEM orders and the shutdown of certain customers during the Beijing Olympics, what percentage of revenue is represented by firms that are going to shutdown during the Olympics?

Dan Joseph

This is Dan Joseph again with ICR. I’m going to provide the translation for the questions.

Richard Cai

Hey, Alex this is Richards. Yes, we’ve not suffered the impact from the shutdown of OEM customer and the implementation of (inaudible) from the feedback of our customers within that basic -- some of our major customers had told me they may produce like 50% less in the second half of the year, that will be significant impacts.

Alex Harbin – Tollcross Securities

So, in terms of how you guys review your growth rate, do you have any comments on made be a target year-over-year growth rate for the second half?

Richard Cai

For the second half?

Alex Harbin – Tollcross Securities

Like versus last year.

Richard Cai

Alex this is Richard. We think that overall combine this three market segments; the OEMs, aftermarket and export market, we expect that the growth rate will be moderate. Although compared with the second half of the last year it could be flat, the growth rate.

Alex Harbin – Tollcross Securities

It could be flat with the second half of the last year.

Richard Cai

The OEM portion, altogether. In the second half for OEM we think that it could be 40% or maybe even 50% less than the first half.

Alex Harbin – Tollcross Securities

Than the first half of this year or than the second half of last year, because obviously you have…

Richard Cai

This year, but the aftermarket sales and export sales will keep moderate growth.

Alex Harbin – Tollcross Securities

Okay, so overall on a blended side, do you guys have the target on the growth rate in the second half or are you seeing…

Richard Cai

It is still very difficult to make the precious estimate. Somebody said during the fourth quarter the OEM sales will pick up. So, right now we do not provide guidance, we’re just trying to give you a sense how we are conservative on the OEM sales. Conservatively, we think compared with the second half of last year, this year would be flat, the second half.

Alex Harbin – Tollcross Securities

Okay and so I guess this would lead into next question, if you guys are expecting a flat second half, you’re operating expenses have obviously gone up significantly in terms of transportation and what not. I’m wondering, can you guys not pass this transportation increase on to your customers and it should we…

Richard Cai

You mean the transportation increase or the transportation cost. The transportation cost [Inaudible] sales growth.

Alex Harbin – Tollcross Securities

Okay, but I mean your operating expenses as a percentage of sales have gone up significantly in ‘08?

Richard Cai

Actually, the growth in the transportation costs already showed up in the third quarter and fourth quarter of last year because the rise in price has showed up in the third quarter in 2007.

Alex Harbin – Tollcross Securities

So, in terms of where you guys see your operating expenses in the second half, would you not expect to have the same kind of increase that you did in the second quarter?

Richard Cai

For the transportation costs?

Alex Harbin – Tollcross Securities

Well, just operating expenses it says the most prominent of which, “the operating expenses as a percentage of revenue were increasing as a result of several factors, the most prominent of which was an increase in transportation charges related to rising cost of fuel.” so do you see that not having an impact in the second half or versus last year is what I’m saying. Like in terms of your operating expenses as a percentage of revenue are they going to stay at this 13.8% ratio?

Richard Cai

Our accounting Manager will answer this question. Zhang, could you provide the translation for this. Zhang?

Li Min Zhang [Interpreted]

Overall some component of the operating expense are partially fixed, so therefore the percentage of sales, the operating expense might cap it up, the cost of the EPS to grow a little bit.

Alex Harbin – Tollcross Securities

Okay, so in that case you think you guys are looking at probably a decrease in net income in the second half relative to last year because I mean if you’re going to have flat revenue growth and increased operating expenses obviously the end result is a decrease in net.

Richard Cai

We are still maintaining higher gross margin, but compared with the first half of 2008, yes, you are right. The net income of the second half of the year will be flat than the net income in the first half of 2008.

Operator

Our next question is from [Peter Spears with Grower Capital].

Peter Spears - Grower Capital

Okay, yes, I’m confused so I would like to follow up on the last question okay, because I’m just completely confused. Last year you earned $0.51 for the year, is that correct?

Richard Cai

$0.59 for the whole year.

Peter Spears - Grower Capital

Is it 51, when you were in last year?

Richard Cai

$0.59.

Peter Spears - Grower Capital

okay and in the first half of last year you earned what $0.34; I’m just trying to juggle too many numbers at the same time. In the first half of last year you had $0.34, right?

Richard Cai

Yes.

Peter Spears - Grower Capital

Okay. So with that said in the second half of last year you earned $0.25, that’s correct right?

Richard Cai

Yes.

Peter Spears - Grower Capital

If the earnings per share were going to be flat with last year, that would bring you the $0.70 for the year this year. Okay, so here’s what I’m trying to understand…

Li Min Zhang [Interpreted]

Yes.

Peter Spears - Grower Capital

Okay, that’s just a straight number, there’s no add in that. So are you saying that this year will be lower than that $0.70 number, the same or higher, I’m confused on that.

Li Min Zhang [Interpreted]

All the factors including the implementation of China’s three mission standard and the shutdown of some of our customers due to the Olympic here, mostly the impact will be on the OEM sales. So right now it is still difficult to make the precise predictions.

Peter Spears - Grower Capital

I understand that it’s difficult to make the precise predictions. I’m just curious; I have no understanding of what you’re telling me. If you had to make a guess, could you give me a range of where you think the year will turnout? I mean I understand there’s uncertainty; I just want to understand what you guys are thinking at this time?

Li Min Zhang [Interpreted]

If considering the macro economy in China it makes things different, it makes things complicated, so right now we’ll not provide guidance on the EPS earnings, but we will do our best to make our performance better than the last years, the second half of last year.

Peter Spears - Grower Capital

Well, I understand that you will do your best and I know that you have a very fine company with very fine management. I’m just trying to understand because I feel that you guys should be able to at least give us a range to understand, what is going on?

Li Min Zhang [Interpreted]

Peter, if you would like to know the estimation of management, $0.70 is our target, but we will do our best to do the financial performance, to do the EPS higher than $0.70, $0.70 will be the target.

Richard Cai

We have the confident, to deliver a satisfying performance to our inventors.

Peter Spears - Grower Capital

And one last question, when do you think that you will see a pick up in the OEM business?

Li Min Zhang [Interpreted]

Right now it’s is very difficult to tell, but we can have a better understanding around September this year. We will updates, when we get a better understanding of this market.

Operator

And next we will hear from Chong-Min Kang with Gamco International.

Chong-Min Kang - Gamco International

I’m just wondering, can you give us an idea of what your tax rate looks like for this year and going forward to next year, two years, three years.

Li Min Zhang [Interpreted]

This year the tax rate will be 12.5%. Right now we are applying for the tax benefit for another five years. We are doing well with the 12.5% tax rate for another five years.

Chong-Min Kang - Gamco International

Okay, with the changes in the tax log, I guess in a case that you guys aren’t for some reason able to get the tax benefits, these rates jump up right, they jump up to 25%?

Richard Cai

We are applying for another five year tax benefit here.

Chong-Min Kang - Gamco International

Okay so I guess how confident are you guys that you’ll be able to get these benefits?

Li Min Zhang [Interpreted]

We already got the governments permission on the tax benefits. The last thing will be in which level of the tax rate. They will confirm that with us in the next couple of months.

Chong-Min Kang - Gamco International

Okay. So, if I look beyond 2008, if I look at ’09, ‘10 I mean is it fair to kind of project that it will carryout to about 12.5% increase?

Richard Cai

We don’t want to apply the specific guidance. The Accounting Manager and our CEO just conformed with me that the tax benefit has been admitted, it has been approved by the government, but the thing is that at which tax rate. The government officers didn’t give us an idea on this. So, we don’t provide guidance before we get the final confirmation from the government.

Chong-Min Kang - Gamco International

Okay. So it will be under the 25, but you guys just don’t know to what degree yet?

Richard Cai

Yes.

Chong-Min Kang - Gamco International

Okay and then just one more question, in regards to I guess the operating capacity of your factories right now, where are you guys operating and at this growth rate how much longer will you need to have, yes.

Richard Cai

Considering the current situations we will make adjustments on our CapEx budgets in accordance with the marketing picture, but in the next couple of years we’re looking forward to increasing our capacity to exercise demands on international markets and the aftermarket. Right now we’re making adjustments to the CapEx budgets considering the trends we have here.

Chong-Min Kang - Gamco International

Okay. So do you have a kind of a ballpark figure for what your peers will look like and maybe what ’09, ’10 is going to look like. I mean last year it looks like CapEx was about $20 million or $19.5 million

Richard Cai

We don’t have such detailed information on hand right now. We are evaluating the current market situation, because or we just mentioned within the second half of 2008 there will be a negative impact on the OEM market. With all these issue we meet, it’s difficult for us to make adjustments of our CapEx rate. So we don’t provide those numbers right now.

Operator

And we will take a follow-up from Alex Harbin.

Alex Harbin - Tollcross Securities

I am wondering about R&D expenses in the second half; are you guys seeing that to stay consistent with $1.3 million in the third quarter than you have in the second quarter?

Richard Cai

The management just said, we will maintain the current levels of R&D investment.

Operator

There are no further questions in the queue.

Dan Joseph

I would like to again thank everyone for joining today’s call. I hope we have been able to address all of your concerns. We will continue to work hard to improve results and look forward to communicating with you in the future about our progress. Thank you, thank you very much.

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