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Executives

Wanyee Ho - Investor Relations

Jeffrey Kang – Chairman of the Board, President, Chief Executive Officer

Frank Zheng – Chief Financial Officer

Analysts

Amir Rozwadowsky - Lehman Brothers

Ramesh Misra - Collins Stewart LLC

Quinn Bolton - Needham & Company

Bill Choi - Jefferies & Co

James Faucette - Pacific Crest Securities

Adele Mao - Susquehanna International Group

Cogo Group, Inc. (COGO) Q2 2008 Earnings Call August 6, 2008 4:30 PM ET

Operator

Welcome to the Cogo Group, Inc. second quarter 2008 results conference call. (Operator Instructions) Now I will turn the conference over to Wanyee Ho, Investor Relations Director.

Wanyee Ho

After the bell today, Cogo issued the press release for final unaudited financial results for the quarter ending June 30, 2008. This press release can be accessed in the Investor Relations section of Cogo’s website at www.comtech.com.cn and most financial websites.

The discussion today will be hosted by Jeffrey Kang, Chairman and CEO who will discuss the company’s business operations and our CFO, Frank Zheng who will report the company’s financial results.

Before we begin, I would like to remind everyone that the call today may contain forward-looking statements regarding future events and financial performance of the company. We wish to caution you that such statements are just predictions and actual results may differ materially as a result of the risks and uncertainties inhered in the company’s business.

We refer you to documents that the company files periodically with the SEC, specifically the company's Form S-1 and the most recently filed Form 10-K, as well as the Safe Harbor statement made in today’s press release. These documents contain important risk factors that could cause actual results to differ materially from those contained in the company's current projections. Cogo assumes no obligation to revise the forward-looking information contained in today's call.

At this time I would like to turn the call over to Jeffrey Kang, Chairman and CEO of Cogo. Jeffrey, the floor is yours.

Jeffrey Kang

During the second quarter of 2008, our revenue grew 35% year-over-year to $68 million US and the non-GAAP EPS diluted was $0.21, which represented growth of around 31% compared to the same period last year. The result was inline with our projections.

The revenue breakdown in Q2 is as follows. The mobile handset comprised 34% of total sales delivering an increase of 15% year-over-year and a slight decrease of 4% quarter-over-quarter. Digital media made up 32% of total sales which was 70% year-over-year and it was up 25% quarter-over-quarter. Telecom infrastructure represented 29% of total sales showing an increase of 28% year-over-year and an increase of 24% quarter-over-quarter. Service business represented almost 1% of total sales and a decrease of 66% year-over-year with a decrease of 68% quarter-over-quarter. The New Industrial Application business, which is mainly comprised of auto electronics, represented almost 1% of total business.

In Q1 2008, Cogo had 1,089 active customers and an average revenue per user at $65,000 in Q2 2008. Our customer base increased 62.1% to 1,556 active customers which generated assets of $59,000, up 6.8% quarter-over-quarter. In Q2, our repeated customer ratio was around 94%.

Now, I will provide some highlights of the second quarter as well as our business outlook for Q3 and the rest of ’08. China’s market in Q2 was the worst that Cogo has faced in the past few years, due to China’s tightening monetary policy and the world’s stock market and natural disasters. As always, we have outperformed expectations to deliver over 30% growth in the present markets around us.

While the tightening environment has reduced the demand for our mobile handset business, our business driven by infrastructure investment such as Pennycom and a carrier-related inter-mobile business is still growing as expected. In addition, Cogo’s growing international handset business has intended shipment growth hoping to offset domestic weakness. However, profit and margins are pressured because of the product mix in Q2 favored low-end handsets.

Although the handset business certainly picked up from July, management still has concerns about end-market growth in the second half of 2008. Assuming the current macroeconomic environment will remain unchanged in China, we have adopted a defensive business strategy to focus on maintaining and expanding market share by increasing revenue growth and cutting operating expenses to improve operating leverage. This will allow us to continue growing in a slowing economic environment.

Cogo has also strategically lowered pricing, largely on mobile handsets and partially on a few digital media business such as GPS but our telecom with most intermediate prices remaining intact. This will enlarge Cogo’s Total Address Market, for example, the low-end cell phone market that we strategically skipped in the past. This strategy will ensure Cogo is well-positioned for growth next year given that the end-market continues to slow up. If however, China’s end-market environment improves next year after the softening of macro policy and the strong rebound of domestic consumer spending, management will adjust the company’s growth strategy accordingly to either further expand revenue and profit growth by keeping the current market structure or reassess margin expansion as a priority.

Management expects Q3 to be a transitional period with a lower than normal gross margin and operating margin as we start our market adjustment strategy. The company will also introduce a small restructuring plan to cap around 5% of headcount in Q3, mostly involving the mobile handset segment. At the end of Q2, the company’s headcount total was 533 people. The restructuring will reduce our current expenses.

The handset business will be back on track in Q4 and we will experience solid growth in 2009. Our digital media and telecom business have hardly been affected by the dramatic slowdown and are continuing to perform strongly. Management doesn’t view the current weakness in China as a significant issue but as an opportunity for Cogo to consolidate and enhance its position with industry to pave the way for long-term growth.

Management also decided to further diversify industry coverage significantly to expand in the new high-growth business area such as investor applications and lowering the percentage of the mobile handset business. We expect no single industry to exceed 30% of our total business in 2009.

We are heading into the Olympics season in Q3. Most of the investors view the Olympics as an economic stimulus for China and worry about what happens after they finish. I believe the Olympics have actually become a stimulus for business growth because of the recently introduced security measures. I don’t expect the business to go back to normal until the Games are over in September. Having said that, we do expect to see a strong return in business for Q4 after the Olympics are over.

In terms of the M&A, the company signed an agreement in July to acquire Long Rise, a China-based company specializing in low-cost CDMA mobile handset designs with a customer base of over 300 small and medium-sized enterprises. This acquisition is expected to expand Cogo’s product offering to address the demands of the rapidly expanding CDMA market, stimulated by China Telecom’s entrance into the CDMA market in the second half of 2008 following the restructuring of China’s telecom industry. The company will pay up to $8.75 million to acquire 70% of Long Rise and expects it to be well profiled and will generate an additional $15 million in revenue next year with an average margin structure similar to Cogo’s.

In another deal, Mega Smart which we announced the last time had to be closed unexpectedly because of compliance with regulations in China. The company expects to close it in Q3.

In terms of the stock repurchase program, the Board authorized the management to repurchase up to 5 million shares depending on the market’s situation. The company repurchased 405,000 shares at an average of $12.73 during the Q2 trading window. We are still able to repurchase 4.5 million shares in Q3 of the current business when the trading window opens.

As we announce outlook for the fourth quarter, please keep in mind, unless otherwise specified, the forecast doesn’t include the effects of any new acquisitions that might be announced after August 5. Please use the midpoint of the forecast range when making comparisons for past periods. We are planning for revenue to be between $70 million to $74 million. The midpoint of this range will be the increase of 7% from the second quarter on a year-to-year basis with an outlook of anticipated revenue growth of 30%. Our expectations for gross margin in the third quarter are 14% to 14.25% slightly lower than the normal range as we proceed with a new margin strategy.

Looking ahead we expect our gross margin to improve about 15% from the fourth quarter on the books. Non-GAAP operating expenses for R&D and SG&A in the fourth quarter should be approximately $4 to $4.5 million. Our estimate for non-GAAP operating margins is around 8.6%. Looking beyond the fourth quarter, we expect non-GAAP operating margin to be about 10% from Q4.

Interest income in Q3 is estimated to be around $600,000 US. The tax rate for each remaining quarter in this year is expected to be 7% to 8% unchanged from our last estimation.

While we expect to continue our share repurchase program, it’s difficult to predict the exact weighted average shares outstanding. We are now modeling shortcome to be flat or lower than 41.8 million shares in weighted shares outstanding for EPS purposes. We anticipate Q3 non-GAAP EPS to be $0.14.

In Q3, the stock compensation is estimated to be around $1.5 million. Authorization including cost and amortization of intangible assets will be up approximately $2.8 million US. Additionally, we anticipate a one-off restructuring charge of around $1 million. Other than the items noted above, the most significant difference is between the GAAP and non-GAAP results.

Looking at our 2008 full year forecast, we estimate a three-year revenue around $280 million to $290 million and a non-GAAP EPS of around $0.72. From Q4, we will be able to go back to the normal long-term growth model planning for the gross margin to be about 15%, non-GAAP fallbacks to be within 5%, and a non-GAAP operating margin to be about 10%.

With that, I would like to turn the call over to Mr. Frank Zheng, our Chief Financial Officer to report our Q2 financial results. Frank?

Frank Zheng

All of the figures I am describing here unless otherwise noted are in U.S. dollars.

Now let me review the line items for the second quarter. Revenue was $68.2 million US, an increase of 34.9% year-over-year. Gross margin was 18% compared with 19.3% reported in the same period last year. Operational expenses was 9.4% of the total revenue which included R&D expense of 2.3%, and SMG&E expense of 7.1% of total revenue.

Operation margin for the second quarter was 8.6% versus 9.9% for the same period in 2007. However, excluding the stock-based compensation and acquisitions related to cost which includes amortization of the purchase of intangible assets, non-GAAP operation margin would have been 11.9%. Flat income for the second quarter was $6.5 million US representing a GAAP EPS of $0.16. Non-GAAP EPS was $0.21. The weighted number of average shares used in the calculation of EPS by management was 40.1 million.

Our prime tax rate for the second quarter of 2008 was at 4.7% compared to 8.1% for the same period in 2007. A decrease in prime tax rate was primarily due to the reduction of the Hong Kong income tax rate of 17.5% to 16.5% which resulted in a decrease in recollection of deferred taxation of $195,000 for the quarter ended June 30, 2008. Capital expenditure was $2 million and depreciation was $4 million reported in the second quarter.

I will now go through a brief overview of total results for the first six months period ended June 30, 2008. Revenue for the period increased 35.5% year-on-year and $129.7 million. Gross margin was 18.7% of sales compared with a gross margin of 19.2% for the same period last year. Net operations were $11.6 million, an increase of 46% compared to $9.3 million for the same period last year.

Income from operations was $10.7 million, an increase of 17.4% from the $9.1 million reported in the prior year period. Non-GAAP operation margins excluding share-based compensation and amortization was 11.9%, a downslide of 0.2% when compared to the same period of last year.

As a result of low gross margins, net income totaled $11.9 million up 33.4% year-on-year. Non-GAAP proforma diluted EPS was $0.40 compared with $0.24 for the same period last year.

Turning to our balance sheet, we have maintained a strong balance sheet. As of June 30, 2008, the company completed the quarter with $122.5 million in cash with no bank forwarding. We continue to be in a strong financial position with a credit ratio of 5.5:1.

Shareholders’ equity as of June 30, 2008 was $217.5 million. Inventory turnover was shortened to 25 days. Receivables were collected in an average of 98 days. Operation cash flow was up at $4.5 million for the quarter ended June 30, 2008.

We are confident that we will overcome the current times and continue to deliver strong performance with solid organic growth and accretive acquisitions. This concludes my comments. Thank you everyone for joining the call to discuss our 2008 second quarter unaudited results.

Jeffrey Kang

I will turn the call over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Amir Rozwadowsky from Lehman Brothers.

Amir Rozwadowsky - Lehman Brothers

Just wanted to understand a little bit more about the demand environment. What has drastically changed between your reiteration of guidance in the June period and the tempering of your outlook? Jeffrey, you mentioned in your prepared remarks that your other businesses continue to see healthy traction. How do we get comfortable in the visibility that the softening demand won’t impact those other businesses?

Jeffrey Kang

The first thing we saw was the natural softening in the monthly demand that I just mentioned. I believe the worst timing was in Q2 especially in May, in the April and May time periods because of the natural disaster, the earthquake in China which kind of softened the domestic demand. So what we fit into the ’09, we see in the second quarter we are actually still strong in terms of the end-market demand. In terms of our view, we actually estimate that in the first half, the business is actually tough in terms of the end-market. That’s why a lot of the preparation was at the end of last year. That’s why we’re still able to deliver over 30% of growth in the first half of this year.

Moving to the second half, even though the end-market will become better, what is from our view is not this. If we are keeping our old margin structure, even though we are still able to do a lot in a high performing quarter that we can face a relatively shrinking total-addressed market. That will eventually hurt our long-term growth strategy. That’s why the management team made a strategic decision to strategically lower a few percentage of our gross margin structure. After that, we will realize our Total Address Market will be much better than our top of the market assigns. That will enable us to deal with the long-term if any. Even though the kind of heightening environment can last for one or two years, this will enable Cogo to still be able to grow in a slowed-down economy.

To answer your question directly, we strongly believe in the second half, the end-market will be better than the first half. In order to mature, we are able to grow long-term, we changed our strategy. The reason why is we’re largely in the mobile handset segment, to keep the Pennycom and additional media of business, to keep them relatively stable. That’s because of the market environment. In China, the cell phone market is very huge. That’s why we’re after our strategy changing, so we are able to address a bigger portion of the market business. For our existing telecom and additional media business, because we still have a very comfortable business with margin and with growth, additional media should grow about 17% year-over-year. So we still think we’re able to by keeping the old margin structure to grow that business. Just in the cell phone market, so we will want to keep it strong in the rapid year growth. It’s better for us to have a much larger market size. That’s the reason why we made the adjustment.

Amir Rozwadowsky - Lehman Brothers

Moving briefly to your acquisition strategy, I assume that the new revenue guidance incorporates the delay in the closing of the Mega Smart deal. Is that correct?

Jeffrey Kang

No, not yet. The guidance we’re giving only includes the Long Rise deal that we have an agreement and for Mega Smart, we haven’t included that deal in our guidance yet.

Amir Rozwadowsky - Lehman Brothers

Can you remind us again how much Mega Smart could contribute potentially in ’08 and ’09?

Jeffrey Kang

Since we haven’t closed this deal yet, I think it’s better for us when we sign the purchase agreement or close the deal, so we might have the press release to have that deal in detail. Right now, we are still waiting for the opinion from our legal counsels.

Amir Rozwadowsky - Lehman Brothers

Lastly, just a housekeeping question. Do you happen to have the stock-based compensation by line item for the quarter?

Jeffrey Kang

Yes. Do you mean for the total quarter or the second quarter?

Amir Rozwadowsky - Lehman Brothers

For the second quarter, yes, in terms of how much is included for operating expense.

Jeffrey Kang

I think in the second quarter, our compensation-related cost was around, I think it’s around $900,000 US. Our amortization of the acquisition was around $800,000 US.

Operator

Our next question comes from Ramesh Misra from Collins Stewart.

Ramesh Misra - Collins Stewart LLC

My first question is in regards to your acquisition price of Long Rise and also when it closes?

Jeffrey Kang

We actually already signed the purchase agreement in July. It hasn’t closed yet. We estimate maybe another one or two weeks so that is still in our projected logistical issues. We will get through the week when the closing condition has been lifted. Our legal counsel is saying that it will be then.

Ramesh Misra - Collins Stewart LLC

Will you be able to talk about what the acquisition price is, Jeffrey or is that only until the offer is closed?

Jeffrey Kang

We already mentioned in our script, in total we paid up to $8.75 million US to acquire 70% majority shares of this company. It’s coming in at around $10 million US and we acquired 70%. We get a couple of years to match up funds with the management.

Ramesh Misra - Collins Stewart LLC

You said in the prepared remarks, Jeffrey that you have already lowered prices. Can you give us an estimate of how much the delta is, how much of a decline it is?

Jeffrey Kang

In our previous business, in our cell phone business, the gross margins are around 18%. So at this time, we strategically lowered it to make 12% of the gross margin and that will help us to overcome the loss in a bigger portion of the business. It will insure us to gather enough growth from the mobile handset segment.

Ramesh Misra - Collins Stewart LLC

Is it reasonable to estimate that your prices are down, pardon the embarrassment of doing the math, down about 20% or so, 20% to 25%?

Jeffrey Kang

Yes, that’s correct.

Ramesh Misra - Collins Stewart LLC

In regards to the handset business, Jeffrey, can you help us get a sense of what kind of volumes you have been doing, what kinds of volumes you anticipate doing by expanding your region to the low-end handsets, and finally, can you give us a sense of what percentage is overseas sales and what percentage is China sales?

Jeffrey Kang

I think in the first half we still have like 60% of our business in the domestic Chinese market and 40% in international business. So I think in the second half, we still believe it will be 60%/40% ratio of domestic and international business. In general, for the domestic business, we actually sell the high-end cell phone and for the international business, most of the sales are for the low-end cell phone. So that’s the market. In terms of the volume, last year, we totaled, in bulk, around 90 million units of cell phone. This year we’re able to reach over 120 million bulk units of cell phone business.

Ramesh Misra - Collins Stewart LLC

For last year, did you say 119 million or 19 million, I’m sorry?

Jeffrey Kang

Last year, it was 90 million. 9-0. We are looking at a loss of 20 million in the units business.

Operator

Our next question comes from Quinn Bolton of Needham & Company.

Quinn Bolton - Needham & Company

My first question is when you took action to reduce margin in the handset business, you said it went from 18% down to 12%, my question, I will play devil’s advocate, what gives you confidence that six months, 12 months from now, you won’t have to further lower that gross margin? I don’t know if your team can structurally talk about the market or if you can review perhaps where you think competitors’ gross margins are in the handset business? What gives you confidence that we’re going to take this step down in gross margin in Q3 to 14% to 14.5% level and then you will be able to sort of maintain 15% or better gross margins from Q4 ’08 and beyond?

Jeffrey Kang

The reason why we made a strategic adjustment is because we have to pad the sales of the low-end cell phone business. In general, our high-end cell phone business, we have a different gross margin at 18% to 20% of gross margin, but for the low-end cell phone business, we have to be realistic. For most of the low-end cell phones, the price is below $50 US so in that portion of the business, we need to be in the 10% to 12% of gross margin. For the product mix, we have to lower our gross margin for the cell phone segment. Again, as you know, the cell phone business itself is a billion dollar business in China and it can turn itself. No matter how you view this market, it can turn itself. The overall market in China is growing at 20% year-over-year. So we still believe we can exit the wealth. We’re still able to get a different growth from this high-growth market.

Again, from running a business model, you know gross margin has to be at a certain level to commit money. So the reason why Cogo in this margin level we are still very profitable because of our operating leverage and customer base. That’s why. I believe that there is no room to get a lower price. That’s why in this strategy, we believe we have a competitive advantage within the industry and it’s helping us take more market share in the slowing economy. When the market gets better, we will be certainly able to move our gross margins step by step for the demand picking up. We think that this will help Cogo to increase our competitive advantage in this highly competitive industry.

Quinn Bolton - Needham & Company

So really what you’ve done is you historically hadn’t broken into some of the lower ends of the cell phone market because it required lower margin. Due to strategic fit, you are now addressing the entire cell phone market and that causes a mid-shift on margins.

Jeffrey Kang

Yes, we are strategically on the cusp with the low-end segment of the cell phone business because of the margin. We lowered our target range. This time, we estimated the lower end of cell phones could have a decent portion of the overall business in China. That’s why we strategically got into this new business so that we have as a result a mixed gross margin in our existing market reach.

Quinn Bolton - Needham & Company

The second question I have is if you look out, I know you had this margin, structural shift in margins but I think you historically talked about Cogo’s ability to grow revenue from the 25% to 30% per year range. Is there anything that has changed that you think would prohibit you from achieving that kind of revenue growth in 2009-2010? Is that still a good long-term growth rate to be thinking about for the company?

Jeffrey Kang

No, we’re still thinking of 25% to 30% of growth. It is still possible. As we go through this macro environment, actually in China, it is a relatively tough environment in the first half of this year. We also have concerns about in how long the slowing down will last. This is a punitive base on the government, the monetary policy and overall in the international market. So our initial projection is very conservative. I’m not saying that 30% isn’t possible but at this moment, based on our existing visibility, we want to make it more of a conservative estimate to the street.

Quinn Bolton - Needham & Company

Going back to 30%, it is an attainable revenue growth rate, if the China market is happy, obviously if the China market is soft, in the coming year, you may grow less than 25% to 30%. Longer-term, that kind of growth is still possible given your entry into new markets, industrial, green technology, etc.

Jeffrey Kang

Yes.

Quinn Bolton - Needham & Company

Lastly, two quick ones. One, you talk about what happened in the services business. That business looked like it fell 1/3 quarter-over-quarter. Lastly, can you tell us about the orders coming in through July and here in early August for the Olympic Games.

Jeffrey Kang

The service business is in a very small portion of our overall business. It is a high margin business portion. In the second quarter, the end of month is very high so that’s why this business is slowing down. Moving forward, heading into the second half especially in auto electronics, we will expect the service business will come back. In terms of the Olympics, as I just mentioned, most of the macro view in the Olympics is in our stimulus for the Chinese economy. Actually know that the situation could be reversed. We believe that the Olympics is one of the major factors for the Chinese business growth. So that’s why because of the recently introduced security measures which have shown up in a lot of cities, a lot of our business has been mitigated because of the security measures. So we don’t think the business will come to normal until the Olympics are over in September. Many businessmen in China share the same view that I have. The business will have a very strong rebound in October after the Olympics are over.

Operator

Our next question comes from Bill Choi of Jefferies & Co.

Bill Choi - Jefferies & Co.

I just wanted a little bit of a clarification on the strategic pricing reduction. You mentioned the tier gross margin between high-end and low-end. I just wanted to make it clear since you guys do make customized modular, what you are doing to tie up that low-end? Are you taking the same module that you sell to the high-end and just reducing prices and therefore getting those low gross margins? Are you able to still maintain any kind of healthier margins when you sell to the high-end or is it umbrella pricing that comes all the way down? When will you have customized modules that are lower priced reduced to target the low-end and therefore get back to the 10% to 12% gross margin from the low-end? I also have a couple of follow-up questions.

Jeffrey Kang

I think that in general that the module from the high-end to the low-end, they are different. For example, the high-end cell phone we offer that in a CMDA based digital CB module. It is not a module but it has like a 20% gross margin. That is for the high-end cell phone. For the low-end cell phone, we offer the basic module like the camera module and other modules, so the gross margin is much lower in this offering of other modules. So the module that we’re offering for the high-end cell phone and the low-end cell phone are usually different. Even though they sometimes overlap but most of them are different. So then our gross margin from the cell phone business, most of it comes from the product mix. Sometimes when we have disproportionate cell phone revenue for a gross margin business, our gross margin will be higher and for low-end cell phones, you have a much bigger portion. So our gross margin will be lower. At this time, as I just mentioned, it is tough. We are strategically aligned with the low-end cell phone business because of the margin structure and this time, it should fuel our long-term growth by rolling this cell phone business into our business umbrella. That’s why our gross margin from our cell phone business is lower than our normal range.

Bill Choi - Jefferies & Co.

I guess what I am trying to find out here is when you had to do a break in pricing adjustment for everybody because now you are trying to sell modules to lower-end. Did you have to give a similar reduction to the high-end? Secondly, when you talk about getting into low-end, you would have to have a few modules to be geared towards that low-end. Should that have a lower cost basis and when do you expect those to come out?

Jeffrey Kang

In general though, for the high-end cell phone and the low-end cell phone, it could have come from the same customer. So they may want the high-end cell phone business so we would need to offer the high-end cell phone business. We will also need a good portion of the low-end cell phone business. So we plan for each of the higher-module and lower-module. For any single module, we have a broad customer base. That’s why we are still able to have a long-term effect for when we win one project from one customer and we’re able to resell them to another customer base in China.

Bill Choi - Jefferies & Co.

You reported strategically lowering pricing one month ago; are there a number of design units that you think are incremental especially on the lower end?

Jeffrey Kang

We are actually starting because the reason why is it is a strategic trend. On June 5, we find that the low-end portion of the business, that is a big portion overall on the business in the second quarter. That’s why we estimate. Usually with the economy slowing down, so the low-end cell phone will have a much bigger portion. When the business comes back, the high-end cell phones will have a much bigger portion. So we estimate that the second half in China for the business deal, we believe the economy will come back strong, so that’s why we estimated that the low-end cell phone would have a different portion of the business in the second half. We don’t have the exact number how much designs it will be because of our new strategy. I am sure because of the new strategy we are still able to keep over 30% of revenue growth this year.

Bill Choi - Jefferies & Co.

Moving on a little bit, one other thing is that you experienced a slowdown in the market, is that due to the fact the unseen and unknown inventory that might be out there even in China through the OEMs or perhaps even with the warehouses of these OEMs of your products, etc? Can you just give your thoughts about where you think overall China inventory is?

Jeffrey Kang

Right now we don’t have any China inventory problems so we see a strong rebound since July and we also see very strong ordering in August. So I had thought there may be an inventory issue at the end of September so that’s why, I think, in July and August, business is very strong. So there may be an inventory problem coming at the end of September, one month.

Bill Choi - Jefferies & Co.

One final question for you, in terms of looking at the $130 million in net cash you have, there have been some deals but with your stock down here, CAPEX, $20 million, enterprise, $70 million, how aggressively do you look at buying back your own shares versus doing more deals?

Jeffrey Kang

We don’t have the cash or resources to do both in the cashback of our stock repurchase program as well as in our projected acquisitions.

Bill Choi - Jefferies & Co.

What would you view as sufficient cash you would need on hand to really be comfortable at running your business so you would have some for acquisitions and how much to be flexible about your buybacks?

Jeffrey Kang

In general, we are in a running or existing business. We would need additional cash to fuel our growth but I think the permanent cash we need, most of it is the base for our estimation. The slowing down economy could have hurt. With Cogo, we have been running this business for over 10 years. So with a slowdown in the economy, from our balance sheet it has affected our credibility with enterprises. So now we will go back to our management’s estimation, how long this slowdown in economy will last. In general, we’re going to balance our internal cash demand for working capital as well as cash needed for acquisitions and a stock buyback. One thing for sure is we are comfortable with our cash to do the repurchase as well as our expenses for acquisitions.

Operator

The next question comes from James Faucette from Pacific Crest.

James Faucette - Pacific Crest Securities

My first question is the increase in orders out of the handset business that you’re seeing right now and you have been seeing since July, is that basically the handset makers planning to increase the inventory of handsets in anticipation of improved orders starting in September or do you feel like these orders are a response to sales that have already improved?

Jeffrey Kang

I think both. I think one of the reasons why that in July we’ve seen these sorts of strong rebounds. One of the reasons is that in the second quarter, the demand is much weaker than what people have expected. So we need all of that to fill this demand. What we are supposed to have in the second quarter has been postponed until the third quarter. Also, we believe that some of the vendors are coming for the big savings before the October Chinese holidays. That’s why, certainly in July and August, the vendors will increase their expected volumes to prepare for those prices in September and October. So that’s why, it is a good question that you ask because I believe we have both. One, the extra demand is increasing. Also we believe that there are some volumes coming from the cell phone vendors to prepare for the future prices.

James Faucette - Pacific Crest Securities

My next question is, as you mentioned in the press release and again in your prepared comments, that you are seeing increased amounts of CDMA handsets as China Telecom takes over the CDMA network against to promote that. What is your sense as to how much of an increase in CDMA handsets you would expect to handle now versus what your previous expectation was?

Jeffrey Kang

Currently, we don’t have much of the CDMA portion because most of the CDMA business is in low-end cell phones. So after China Telecom, and you can get that figure from China Telecom, we believe that there is a most visible demand in the next 2-3 years because China Telecom very rapidly pushed the figure up in China. I think it is a very visible customer base and the first step was China Telecom tried to switch their existing customer demands, their biggest customer in the CDMA customer business. So that’s why we believe they need our leases, 30 million units of that low-end figure cell phone in the near-term. It’s hard to keep up in the wireless customer subscriber base. That’s the reason why we have tried to specialize in the low-end CDMA cell phone business. We don’t have a specific number right now but certainly we can say a few million, 10 million in business possibility next year.

James Faucette - Pacific Crest Securities

What adjustment in strategy in the small restructuring that you are planning to undertake does this change your plans for doing further acquisitions beyond those that you already talked about or that you are already working on? That is should we expect you to do further acquisitions later this year or early next year?

Jeffrey Kang

We don’t think our acquisition strategy has been changed. So while we are talking about a restructure, the restructuring is for our existing headcount in our sales, marketing and R&D divisions. We want to make them more effective and efficient. Again, we are still in a new operating strategy. In addition to the Long Rise deal as well as the Mega Smart deal, we are still looking at some other new deals in this year and into next year as well.

Operator

The next question comes from Adele Mao from Susquehanna International Group.

Adele Mao - Susquehanna International Group

Jeffrey, you had a pick-up in industrial applications. What type of growth rate do you see in this area heading into 2009 and how much do you think industrial applications could contribute to 2009 revenue?

Jeffrey Kang

That’s one of our growth engines in the next year for our digital media business and for our industrial business. We believe that our target for the industrial business in the coming year is 16% of our total business. This year, our target is just 5% of our total business. In the growth rate, it could be another 200% of the growth rate in that segment.

Adele Mao - Susquehanna International Group

Just to clarify, last quarter you also had some other electronics revenue that was classified as digital media, right?

Jeffrey Kang

Yes.

Adele Mao - Susquehanna International Group

In this quarter, it’s being grouped into industrial applications?

Jeffrey Kang

Yes.

Adele Mao - Susquehanna International Group

Can you review the gross margin range for each segment that it represents?

Jeffrey Kang

We think that our long-term existing benefits and we think we have a combined gross margin of around 15% of the combined gross margin. We estimate in the digital media, it could have 20% of gross margin. The industrial business could have about 20% of the gross margin. Telecom and mobile handset is around 12% of the gross margin. In these segments, we believe that we have about 40% of the gross margin. Combined, we believe we have about 16% of the gross margin and we want to control our fading expenses at 12% of the sales. So we still have over 10% of the operating margin.

Adele Mao - Susquehanna International Group

My next question is on the product of telecom restructuring in China. Can you just talk about how that is going and how will that touch on near-term revenue opportunities?

Jeffrey Kang

I think to the more observable business in the near-term, the figure may affect business as I just mentioned, the figure may rollout in China. They will become a major competitor to China mobile in this business. We view that as our growth opportunity in this business. China Telecom had started out with the low-end cell phone to replace their existing handsets. We also believe we will expect from the medium-end and high-end figure in the cell phone market with existing GFM, or GDIS, high-function cell phones available in next year. That’s why we viewed this as opportunity. Secondly, in the CDMA market given those issues in this year, we don’t have too much expectation on this business but we certainly believe that next year, the CDMA business will also jump next year. We think about it as true wireless business and it will help us to increase our business next year following the restructuring of the industry in China.

Adele Mao - Susquehanna International Group

Now, with Cogo getting into many industry verticals, how do you make sure that you have the in-depth knowledge for each industry and the market insight that’s necessary to compete with other players who are maybe more focused in certain areas?

Jeffrey Kang

Well, I think we are in the area of the industrial and digital media business, again I think our business model and our strategy has been a proven model. We are tied to the customer base and we are using a similar strategy in the telecom segment that we used previously to reach a broad customer base. Then we will leverage our platform to win that business. In terms of the technology angle, we really look at the value, you don’t look for similar businesses. If you look at the electronics business, like an energy saving electronics business, the technology and vision fuel those semiconductor companies. So we are positioned globally in the module business. Our customer is the provider and our semiconductor companies like Ericsson, Maxim, all of those leading companies. We are using their chip sets to design modular solutions to help the OEM and OED makers in China. Since we are using this basic strategy and the customer provides a lot of overlap, so that’s why we’re very confident that we are able to grow our business dramatically in this new industrial areas.

Adele Mao - Susquehanna International Group

The SG&A for the quarter is lower than that of Q1 ’08. Can you give me your comments on that, is that the way it will be going forward? Is there any factor that contributed to lower expense in the quarter?

Jeffrey Kang

We have always been profitable and some things go wrong in the quarter, even in 10 years. One of the reasons we have a very flexible cost structure. For example, our employees’ salary or their compensation is tied to the business performance. So that’s why in general if we have less profit in a single quarter, our operating cost should be lower. That’s the first reason. The second thing is that is the operation average. When we grew the revenue, operating expense would then be much lower than our revenue growth. That’s why we have operation leverage. In the third quarter, we believe as I just mentioned, we will have the restructuring plan. We are even considering cutting 5% out of the headcount. So that will further help us reduce our operating expenses. Moving forward, as an investor, I think they would say Cogo has more and more operating leverage.

Operator

At this time, there are no further questions in the queue.

Jeffrey Kang

Thank you very much. Cogo has been able to create a pattern of sustainable and outstanding growth in the past five years because of our ability to identify growing industries, expand our customer base and generate repeated revenue from its customers. Historically, Cogo has a repeated customer ratio of over 100%. As a managed telephone service provider serving the tech industry in China, we believe that long-term robust growth is more available than having one or two high-performing quarters. We are optimistic about maintaining our existing growth pattern and we will always try to share with our shareholders in a very transparent way both our reasons for optimism and operational caution. The caution we shared going into the second half appears to have been appropriate. This is from the perspective of the macro-environment and the consumer spending power in China.

Although China today faces challenges in the near-term, management still believes it is one of the highest growing countries with many potential growth areas for our business. Management tends to view the weakness in China as a significant issue but there is the opportunity for Cogo to consolidate and enhance its position in the industry to pave the way for the long-term growth. With our best knowledge of industry and the strategic market inside, we are confident that management has established their strategies quickly to address any challenges that we face.

I would like to take this opportunity to thank all of Cogo’s believers, employees, customers and planners and long-term shareholders. You have provided Cogo with the opportunity to deliver robust and sustainable growth in the past and we appreciate your support as we move into the second half of 2008. Management is committed to driving the sustainable high growth and providing significant returns to our shareholders. Thank you again for joining this call and I look forward in talking with you soon.

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Source: Cogo Group, Inc. Q2 2008 Earnings Call Transcript
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