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Executives

Hong Zhu – VP, IR

Tony Liu – Chairman and CEO

Lily Li – CFO, COO and Secretary

Wilfred Chow – SVP of Finance

Anindya Chatterjee – Chief Strategy Officer

Analysts

Hongbo Lu – Piper Jaffray

Julie Chen – CRT

Catherine Liu – Oppenheimer

Lewis Fan – Brean Murray Carret

American Oriental Bioengineering, Inc. (AOB) Q2 2008 Earnings Call Transcript August 11, 2008 5:00 PM ET

Operator

Good day ladies and gentlemen and welcome to the second quarter 2008 American Oriental Bioengineering Inc. earnings conference call. My name is Natasha and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions)

I would now like to turn the call over to Mr. Hong Zhu, Vice President of Investor Relations. Please proceed.

Hong Zhu

Good morning everyone. Welcome to our second quarter 2008 conference call. On our call today is Tony Liu, Chairman and CEO; Lily Li, Chief Financial Officer and Chief Operating Officer; Wilfred Chow, Senior Vice President of Finance; and Anindya Chatterjee, Chief Strategy Officer; Binsheng Li, Chief Accounting Officer.

Before we begin, I’d like to mention that this conference call may contain forward-looking statements within the meaning of the Federal Securities Laws. Forward-looking statements including those concerning plans, objectives, goals, strategies, future events, our performance and underlying assumptions, and other statements that are not historical in nature. These forward-looking statements are based on management’s current expectations and are subject to risks and uncertainties that may result in expectations not being realized, and may cause actual outcomes to differ materially from the expectations reflected in these forward-looking statements.

Potential risks and uncertainties include products, service, demand and acceptance, and changes in technology or economic conditions, the impact of competition on pricing, the impact of governmental regulation, and other risks contained in the periodic reports filed by the company with the SEC.

For more information on this matter, we encourage you to review the company's most recent 10-Q filings and its annual report on Form 10-K for 2007 filed with SEC.

With that said, I’d like to turn the call over to Tony Liu. Go ahead Tony.

Tony Liu

(Interpreted) Good morning and welcome to our second quarter 2008 conference call. During today's call, I will give you an update on the progress we are making towards achieving our strategic goal of becoming one of the China's top pharmaceutical companies. Lily Li will provide you with an overview of our financial performance for the second quarter. Lily will also discuss our outlook for the remainder of the year of 2008. Thereafter, we will open the call for your questions.

I'm pleased to report to you that we ended the second quarter of 2008 with strong financial performance in which all of our products performed ahead of our expectations. Our second quarter financial results reflect in particular the continued increasing demand for our prescription and OTC pharmaceutical products. Our brand recognition continues to improve and our distribution capabilities continue to expand into untapped rural areas throughout China.

In addition, we continue to realize the synergies of our acquisitions, CCXA and Boke contributed approximately $13.4 million to revenues this quarter. This is up sequentially from our first quarter and from prior quarters, continuing the momentum in this part of our business. We were particularly pleased to see these revenue results continue which we are very happy to see.

The results of this quarter indicate solid progress toward fulfilling our goal of being one of China's major pharmaceutical companies. In order to be successful, we are convinced we must build a company that can maintain flexibility in a constantly changing and evolving health care market in China.

In this regard, we are focused on vertically integrating our operations to ensure the self sufficiency required to maintain such flexibility in this changing environment. We will continue to seek acquisitions or strategic interests that strengthen our vertical integration. To this end, we are actually in the process of acquiring a large distributor, and Lily will discuss this momentarily. We believe we have exciting opportunities to continue the industry consolidation we have historically driven with prior transactions such as CCXA, Boke, HQ, and CAXG.

We thank all of you for your continued support. I will now turn the call over to Lily.

Lily Li

Thank you, Tony. I will first highlight our financial results and then give you the rationale behind the letter of intent that we signed today as well as discuss some key initiatives we are working on here at AOBO. Then I will conclude with our guidance for the year.

As Tony mentioned, we are pleased with our results for the second quarter 2008 as we achieved our expectations. We generated net sales of $59 million for the quarter, which represented a 74% year-over-year increase.

Net income increased 43.4% to $30.9 million and our diluted earnings per share was $0.18 for the second quarter. Our strong revenue growth continues to reflect expansion and diversification of our portfolio of products and distribution capabilities as well as our acquisitions.

In particular, our organic growth was 35% during the second quarter, primarily driven by our leading OTC pharmaceutical brand including our Jinji series, and the Jinji Yi Mu Cau product line that was launched in early 2007. We believe that our effective marketing campaign continues to improve the brand recognition of this product.

In addition, the revenue performance of CCXA and Boke was significant. CCXA contributed $5.8 million for the quarter while Boke revenue was $7.6 million. Our combined business gave $13.4 million of revenue from these recently-acquired businesses compared to $10 million in the first quarter of the year and $7.4 million in the fourth quarter of 2007. So we are pleased to see that we are on target to reach our goals to double year-over-year revenue performance of this brand in 2008.

Note that in the second quarter of 2007 CCXA and Boke made no contribution to revenues as they were not subsidiaries of the company at that time. The performance of our three main businesses was as expected. We were pleased with our prescription pharmaceutical products revenues which increased 77% year-over-year to $20.4 million in the second quarter.

Revenue performance reflects increasing sales for Shuanghuanglian and Cease-Enuresis Soft Gel supported by our marketing efforts, brand recognition, effective pricing strategies, and our extending coverage into rural market areas.

Our OTC pharmaceutical product revenue continues to be very strong and increased 102.9% to $29.4 million during this period compared to last year. This increase was due to continued strength from marketing products like our Jinji series and the substantial increase in revenues as a result of acquisition of the CCXA and Boke, which I mentioned earlier.

Our pharmaceutical revenue exhibited modest growth in the quarter and came in ahead of our internal expectations, increasing to $9.2 million from the quarter as compared to $7.9 million in the second quarter of last year. This is mainly attributable to the increase in sales of peptide tablets and peptide powder.

Our second quarter gross margins declined to 67.9% as compared to the prior year at 69.9%. This was not a surprise, and as we have pointed out previously, we attribute this to the integration of the CCXA acquisition which has lower gross margin. Operating margins declined slightly to 51.7% for the second quarter of 2008 from 53.9% in the same quarter of 2007 and increased from 30.9% in the first quarter 2008. The decrease mainly reflects the Boke and CCXA integration and overall inflationary pressure.

However, it is important to note that China’s user [ph] price index increased most dramatically from 2.5% to approximately 10% year-over-year. Our reduction in operating margins is lower than the general inflation benchmark which we believe reflects successful control of operating expenditures.

Net margin for the second quarter of 2008 increased 43.4% to $13.9 million or $0.18 per diluted share compared to $9.7 million or $0.15 per diluted share in the prior year period.

Please note that in April 2008, we formed a strategic alliance with China Aoxing, a China-based pharmaceutical company specializing in research and development, manufacturing, and distribution of narcotic and pain management products. Because Aoxing has operated at a loss, we recognized an equity loss of $0.6 million. This accounts for less than $0.01 of our earnings per share. We are closely monitoring the development at China Aoxing. We are confident in the vast opportunity that pain management in China presents and Aoxing has a rich pipeline of products that we feel add value to AOBO for the future.

We closed the second quarter of 2008 with $144.5 million in cash. We’ve subsequently raised $80 million in net cash, bringing us to $224 million of cash available. We have a very strong fundamental financial position and we are excited to put our capital to use to ultimately reach our goal to be a top pharmaceutical company in China. One of these initiatives to help us reach our goal includes long-term cost rationalization and productivity gains through centralization of our infrastructure and facilities. We invested in the centralized R&D facility in Beijing where we will also host our management and sales training in our administrative function.

Of course, one of the most important ways for us to reach our goal is to continue our acquisition strategy. We recently signed a letter of intent to acquire 100% of our holding company which focuses on distribution through its subsidiaries in which it holds various equity interests. The holding company is profitable with the combined revenue of subsidiaries approximately $550 million annually.

We anticipate that the purchase price for such acquisition will be in the $110 million range and will be paid in cash. This acquisition would significantly broaden our distribution reach in China. We are currently in the process of negotiating the final terms of the acquisition and are moving ahead to completing the deal this year.

Our decision to pursue the distribution business is based on our careful analysis of China's pharmaceutical industry. We evaluate many potential acquisitions over time and this transaction is particularly attractive to us because of several key factors. The pharmaceutical industry in China is receiving great support from the government, which is urging consolidation through reforms and policies.

We believe that gaining size, scope, and scale right now is the most important initiative to guarantee a stable and a competitive market position for the future. We believe that the point of sale expansion we would gain by acquiring this distribution company ultimately would bring AOBO greater sales network access than any of other competitors. This can lay the foundation for future acquisitions including new product lines which might require new or different distribution channels.

We also believe that this transaction allows us to benefit from greater scale. With a large distribution presence, we could negotiate more favorable terms compared to other peers. This size and the negotiating power is important given China's extremely faster changing market conditions and will provide us the tools we need to generate long term continuous growth. We are taking this step with the strategic and longer term perspective based on our understanding of the competitive landscape of China’s pharmaceutical industry.

Let me take a minute now and review for you our guidance for the fiscal year 2008. We continue to target our organic revenue growth at 30%, but anticipate overall revenue growth of approximately 50% for the year.

Consequently, we continue to expect revenue growth in 2008 of at least 50% and expect to reach total revenue of at least $245 million in the full year 2008. This anticipated year-over-year top-line growth reflects continued demand for our leading products.

We also anticipate net income performance of at least $62 million which reflects anticipated year-over-year net income growth of more than 44%. This full year financial guidance excludes the impact of our July convertible financing and excludes the financial impact of any pending acquisition or LOI [ph]. At such time that we complete negotiations, prepare definitive documents and close the contemplated acquisitions, we would expect to update the financial guidance at that time.

That concludes our prepared remarks for today. Operator, we are ready to take some questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from the line of Hongbo Lu with Piper Jaffray. Please proceed sir.

Hongbo Lu – Piper Jaffray

It's not sir, but anyway, good night – good evening, Tony, Lily, and Wilfred and everyone. Actually, apparently my question will be on merger acquisition, $580 million revenue of distributor probably will rank the distributor probably amount – I don't know if that will rank the distributor among top ten but it's a very decent size. And as we know, distributors in China actually have very, very low margin, typically less than 5% of operating margins. So can you help us to put things is perspective in terms of how this kind of large-scale acquisition would impact your margin and bottom line, and also how would you envision the integration is going to play out?

Lily Li

(Interpreted) Indeed, we are very excited to share some of the basics of the acquisition we are going to make and especially about the company we are going to acquire. As a matter of fact, I think that in the distribution area here in China, I think that the company we are going to acquire are indeed very outstanding in terms of the brand, operation, and personnel. And in a highly distributed market, I think the acquisition will certainly lay down foundation for the further development of AOBO.

As you may know that actually here in China for the pharmaceutical industry, I believe that we're in the process of reform and the promulgation of new policies. And also this will impact the structural evolution of the pharmaceutical sector. And be it for the producer or for the distributors here in China, I believe that in the short term, we are going to see a concentration and consolidation of this sector.

So, I believe that for the pharmaceutical sector here in China, for the pharmaceutical producers, it is very important for them to get the control of the distribution channels and the point of distribution. I believe that this certainly is indeed very important.

I certainly confess that the distribution channels and for the distributors, their margin is indeed pretty low. This is indeed practiced. But I believe that to look at the industry chain, I believe that we need to not only focus on the current situation but also we need to have a long-term view, we need to look at whether the distribution channels will be able to contribute to the further improvement of bottom line of AOBO. I believe that the acquisition will certainly further improve our bottom line.

Hongbo Lu – Piper Jaffray

Thank you, Lily. Can you just – just quickly, can you show us what their operating margin on that margin in 2007?

Lily Li

(Interpreted) I’m sorry, we are not in a position to disclose any further details about the company we are going to acquire, but I can tell you that the margins – the net and operating margins are indeed above the industry standard.

Hongbo Lu – Piper Jaffray

Thank you.

Operator

Your next question comes from the line of Julie Chen with CRT. Please proceed.

Julie Chen – CRT

Yes. Hi Tony and Lily. Congratulations on a good quarter. Just would like to follow up on this acquisition if I may. I'm actually not going to go into the details of the distributor but more into the financial statements that's been filed with the 10-Q. There are two items that is of great interest. One is refundable deposits which have declined about $10 million. The second item is the deposit for long-term assets which is a new item, which is about $34.9 million. Could you provide a little bit insight on it and how it relates to potential acquisition pipeline?

Wilfred Chow

(Interpreted) This is Wilfred and I would like to take your question on this one. The short-term deposit listed on the balance sheet is related to a refundable deposit regarding the acquisitions. And the long-term deposit is a payment that we made for a certain land and property that we’re going to invest in Beijing and some of the legal documentation (inaudible) the deposit is going to be transferred to long-term asset as a property.

Julie Chen – CRT

So, if I could –

Wilfred Chow

(Interpreted) Yes. The land is, as mentioned by Lily before, the long-term cost that is going to be rationalized and is going to generate gains for us to centralize our infrastructure and the land is going to be used for R&D as well as administrative function together with some training purposes.

Julie Chen – CRT

So, in terms of this land, Lily mentioned that this is an investment in an R&D facility in Beijing. Is this an R&D or is it more an operational center or is it more an administrative office, could you –?

Anindya Chatterjee

Katherine, let me jump in. This is Anindya. Hi. I think we need to tie this to the big picture of the company. And it will result in long-term cost rationalizations and productivity gains through various ways. There is room for centralization of R&D, administrative functions, and also management training. Bear in mind, the company has not made significant investment on infrastructure thus far. Most of our facilities are leased. This is a long-term commitment of the management towards taking – Beijing is strategically important location and we want to have our presence there. The company's decision is also considering the owning versus leasing argument, and I think given the current rent inflation in Beijing in particular, it makes sense to have a longer term commitment and own rather than lease. That's our perspective.

Julie Chen – CRT

Great. In terms of the distribution, if I may just go back to that as well, could you talk a little bit about the footprint? Are we looking more into a footprint that focuses on the company's forte which is the rural areas or are we looking in terms of footprint expanding out of the rural areas into the metropolitan areas?

Lily Li

(Interpreted) Yes, indeed, the rural area in China for the pharmaceutical standpoint is indeed gorgeous. I believe the potential of the consumption here in the rural area is indeed vast, especially due to the fact of pharmaceutical reform here in China. And so, we will certainly follow the strategy of development of rural area here further. And with the increased acquisition and mergers by the company, I believe that we still need to have the consolidated distribution channels in order to target the major hospitals, the community clinics for the inpatients and also we believe that the consolidated distribution channels will be able to further improve our sales into these major areas.

Julie Chen – CRT

Thank you very much. I will move to the back of the queue. Thank you.

Lily Li

Thank you.

Operator

And your next question comes from the line of Catherine Liu with Oppenheimer. Please proceed.

Catherine Liu – Oppenheimer

Hi. Good morning. Thank you for taking my questions. My first question is also regarding the acquisition. First of all, could you give some of your expectations in terms of the timing of the close of the acquisition? And second, I understand we saw revenue of roughly 550. The sales from this acquisition target is actually almost twice of your current sales. So, how should we be thinking about the integration, a roadmap for this acquisition, how would you translate your path to success on the integration to successfully integrate this distributor to your current business?

Lily Li

(Interpreted) So, thank you, Catherine. Indeed, we're in the smooth progress of acquiring the company and we do hope that we can complete and close the deal as soon as possible.

I certainly agree with you, Catherine, that this acquisition is indeed a very major one in terms of the scale. And indeed, what we have been focusing our attention is how to integrate the acquired company after the close of the deal. This is indeed very important.

I believe that’s what is important in the integration of the acquired company for the AOBO. I believe that we are very well positioned in terms of the successful experience in the past acquisitions and mergers, and we are able to bring into the acquired company the unique and outstanding culture of the company, and also, we certainly would bring the very good incentive plans for the personnel and also for the staff members of the acquired company and certainly we'll further improve the operation and the management of the company because we can bring to the company the advanced management know-how and techniques.

For the second point is that we believe that it is indeed very exciting for us to see that the company we are going to acquire certainly enjoys a very experienced management team, and if we can give them a very proper and right incentive plan, certainly, I believe the team will be able to display their potential in terms of improving the company's operation. And also, I believe that they certainly will and devoted to the further improvement of AOBO's current performance.

Catherine Liu – Oppenheimer

Okay. Thank you. I'd like to chew down a little bit in terms to translate this successful integration more quantitatively. Where should we be seeing synergies? Is it mainly from the sales synergy or we will also see some margin improvements?

Lily Li

(Interpreted) I believe certainly this acquisition will contribute and improve our strategic development as well as the daily operation.

I believe that for the long-term development, the integration of the pharmaceutical producers and the distribution channels is indeed very important because with the integration, certainly we'll be able to gain advantage in terms of the industry’s change. I believe that this acquisition will lay the foundation for AOBO's further development.

So for the short-term operation, I believe that this acquisition will certainly improve our network with further and even more coverage of the channels, and also certainly, it will improve our sales.

So, what I can say is that this LOI stage I can only offer as much information as I said just now. I hope that in the last stage we can again offer further information about the acquisition.

Catherine Liu – Oppenheimer

Okay. Great! Thank you very much. I'll get back to the queue.

Lily Li

Thank you.

Operator

(Operator instructions) And your next question comes from the line of Lewis Fan with Brean Murray Carret.

Lewis Fan – Brean Murray Carret

Hi. Thanks for taking my call. My first question is kind of a follow-up question to Catherine's previous question. It's regarding your acquisition. So, basically as you mentioned that for this new pending purchase for the distributor, you will have an annual revenue of approximately $550 million per year. So we compare that to our kind of projected – the existing AOBO's revenue. So we're talking about a new company for the new company. Two-third of the revenue will be from distribution business. So, my first question I guess is asking, does the management view that your company's business model has been changed or will have been changed to more of a distributor rather than a pharmaceutical manufacturer?

Wilfred Chow

(Interpreted) I would like to take this question. I think the investor should look at this acquisition or this potential acquisition as a step that they will be going to transform itself to a more integrated company with manufacturing as well as more owned distribution network. From the surface, the revenue from manufacturing may seem to be lower than the distribution after the integration of the company but the assets of the company is still going to be a – based on manufacturing as a face and with distribution as an arm to solidify this position in the market. The financial of AOBO going forward most likely after the acquisition is going to be what I would say a more segmental reporting on manufacturing as well as distribution. So, the number and the performance of those segments will be easily checked. And so the overall longer term, I will hope the people is going to wield AOBO as a fully-integrated company instead of either a distributor or a manufacturing company.

Lewis Fan – Brean Murray Carret

Okay. The next question is for this new distribution business, I would assume that since currently it's a stand-alone distributor, so it kind of distributes quite a few pharmaceutical manufacturer’s product. So once the acquisition is complete will this new distribution unit – will they exclusively distribute AOBO's product or will the unit distribute other company's product?

Lily Li

(Interpreted) To the acquired company, the distributor, I believe that certainly once the deal is closed certainly it will have the stand-alone performance index in order to measure their performance and it will not only sell AOBO's product, but also it will further expand it's sales by representing and sell other products from other manufacturers.

Lewis Fan – Brean Murray Carret

Okay. Thank you. Then how do we – obviously the management has not provided – it doesn't seem like that you guys will provide any more tangible timeline into this acquisition. So, how do you think we as investors and analysts we need to model into our future margin projection since there is obviously going to be significant differences based on the existing product margin and distribution margin?

Anindya Chatterjee

(Interpreted) Let me take this up. Bear in mind that we are maintaining our guidance. We are in the process of creating a company and we also very recently raised capital. So we will update our guidance as soon as it is feasible. At this point, we are maintaining with our previous guidance.

Lewis Fan – Brean Murray Carret

Okay. Well, thank you.

Operator

And your next question is a followup from the line of Julie Chen with CRT. Please proceed.

Julie Chen – CRT

Hi. Just wanted to follow up in terms of your neutriceutical. Neutriceutical enjoyed a pretty good quarter this second quarter. How should we think about the neutriceutical moving forward?

Lily Li

(Interpreted) The neutriceutical business is indeed one of our traditional ones for AOBO. I believe that for the pharmaceutical sector, we certainly have more alternatives than neutriceutical business. Our focus of attention – we'll be focusing on the prescription and OTC products. And the neutriceutical business will certainly constitute one of the integral parts of our business.

Julie Chen – CRT

I’m sorry to ask this question again. In terms of the distributor that you are potentially looking at, will this distributor have the ability to help expand your neutriceutical business down the road or is it a strictly pharmaceutical distribution business that you're looking at?

Lily Li

(Interpreted) So, currently I believe that for the distributor that we are going to acquire, I believe that they are only focused on the distribution of pharmaceutical products. Certainly, they will contribute to a small part to the improvement of sales of the neutriceuticals, but I don't believe that the distribution channel we are going to acquire will have a major improvement in terms of the sales of neutriceuticals.

Julie Chen – CRT

I would like to go to the selling and marketing expenses. In terms of 2008, we view 2008 as a very special year, we got the Beijing Olympics, we have inflation going on and so forth, we have some natural disasters in China that started with a snowstorm, and then we have the typhoon and so forth. How will we think about the selling and marketing expenses particularly the advertising expenses after the Beijing Olympics in terms of its potential impact to the company?

Lily Li

(Interpreted) After the Beijing Olympics we'll certainly will have some evolution of our advertising strategies. The current advertising program is defined according to the increasing cost as well the Olympic Games’ features, and with the further improvement of the microenvironment in China, especially after the games, we will make some of the evolution of the advertising strategy according to the future changes.

Julie Chen – CRT

Thank you very much Lily and Tony.

Lily Li

Thank you.

Operator

And your next question comes from the line of Hongbo Lu with Piper Jaffray. Please proceed.

Hongbo Lu – Piper Jaffray

Thank you, Lily and Wilfred. Just a quick follow-up question on the pharmaceutical prescription products, did you have any new products launched in the second quarter?

Lily Li

(Interpreted) No. No new products in the second quarter.

Hongbo Lu – Piper Jaffray

Okay. I'm kind of curious because, if I recall correctly, in the first quarter '08, the prescription revenue was around $10.6 million, in this quarter, the second quarter, we had $20.4 million which represent about over 90% quarter-over-quarter growth. So, Lily, can you give us a little bit color on what's the driver behind this phenomenal growth with Shuanghuanglian and the soft gel?

Wilfred Chow

(Interpreted) Okay. For the second quarter of 2008, we don't have any new prescription product launch into the market but we do see some additional growth of the – revenue growth of prescription product sold by Boke and CCXA. So those two companies have – some products are categorized as prescription product. I think that explains your question.

Hongbo Lu – Piper Jaffray

Thank you.

Operator

This concludes the question and answer question as well as the conference. You may all now disconnect. Good day.

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