China Nepstar Chain Drugstore Ltd. (NYSE:NPD) Q4 2013 Earnings Conference Call March 28, 2014 8:00 AM ET
Fuxiang Zhang – Chief Executive Officer
Zixin Shao – Chief Financial Officer
Dixon Chen - Grayling
Isabella Zhao – Morgan Stanley
Ryan Roberts – China Stock Research
Greetings and welcome to the China Nepstar Fourth Quarter 2013 Earnings call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star, zero on your telephone keypad. As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Mr. Dixon Chen with Grayling. Thank you, you may begin.
Thank you. If you have not received a copy of Nepstar's fourth quarter and fiscal year 2013 earnings press release, it is currently available on the company's website at www.nepstar.cn. A presentation to accompany today's call and live webcast is also available on the website under the Investor Relations section.
Before we start, I would like to remind you that certain statements that are not historical facts made during the course of this conference call about future events and financial results constitute forward-looking statements that are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. You should note that the company's actual results may differ materially from those projected in these statements due to variety of factors affecting the business. Forward-looking statements are subject to risks and uncertainties. Discussions of factors that may affect future results are contained in our filings with the Securities and Exchange Commission. We undertake no obligation to correct or update any forward-looking statements provided as a result of new information, future events, or even changes in expectations.
Joining us on today's call are Mr. Fuxiang Zhang, Chief Executive Officer, and Mr. Zixin Shao, Chief Financial Officer. I will be your translator during the question and answer session. We will be translating questions and answers and ask for your patience at that time.
With that, I would like to turn the call over to Mr. Zixin Shao, our CFO. Mr. Shao, please go ahead.
Thank you. Good morning and good evening to all of you. We are pleased to report our continued focus on product mix, store transaction efficiency, and increasing foot traffic is beginning to deliver results. We have achieved double digit growth in both revenue and in-store sales in the fourth quarter of 2013 compared to the same period in 2012. This was achieved through a combination of strengthening our marketing and promotional efforts, introducing our loyal member reward shopping program, improving our product range offering, and other proactive marketing strategies. Both our pharmaceutical and nutritional supplement products experienced strong sales in the fourth quarter of 2013 compared to the same period in 2012.
In general, we have steadily improved sales momentum and strengthened customer relationships throughout the year in a retail environment that can be challenging. While our promotional strategy has impacted our near-term growth margin and our profitability, we believe the long term benefit for increased store traffic and participation in our loyalty program will provide sustainable growth emerging over time and will ultimately enhance our competitiveness.
I will now review results for the fourth quarter. During the fourth quarter, we opened 40 new stores and closed 33 stores. As of December 31, 2013, we had a total of 2,056 directly operated stores. Revenue for the fourth quarter increased 11.6% to RMB 749.8 million or U.S. $123.9 million from RMB 671.9 million in fourth quarter 2012. Same store sales for the 1,893 operating stores opened up before December 31, 2011 for the fourth quarter increased by 13.8% compared to last year’s period. This increase was primarily due to in-store promotional initiatives, an improved product range, and strengthened marketing efforts for both the pharmaceutical and the nutritional supplement products. Fourth quarter revenue contribution by product category was 21.8% from prescription drugs, 40.5% from OTC drugs, 13.5% from nutritional supplements, 4.2% from herbal products, and 20% from convenience and other products.
Fourth quarter gross profit was RMB 317 million or U.S. $32.4 million, an increase from RMB 308.6 million in the fourth quarter of 2012. Gross margin was 42.3% compared to 45.9% in the same period of 2012. This decrease was primarily due to downward pressure on selling prices given more sales promotions initiatives to increase market share. Our portfolio of private label products included approximately 2,104 products as of December 31, 2013. Sales of private label products represented approximately 20.8% of revenue and 26.6% of gross profit for the period.
Sales, marketing and other operating expenses as a percentage of revenue decreased to 35.3% from 37.6% in the same period of 2012. This decrease was primarily due to growth in same store sales and the closure of underperforming stores. General and administrative expenses as a percentage of revenue in the fourth quarter was 3.8% compared to 3.4% for the same period of 2012. An impairment loss of RMB 2.6 million or U.S. $0.4 million was recognized in the fourth quarter which represented the reduction of the carrying value of the property and equipment of certain underperforming stores.
Income from operations in the fourth quarter was RMB 21.2 million or U.S. $3.5 million compared to income from operations of RMB 13.2 million in the same period of 2012. This decrease was mainly the result of lower gross margin. Interest income for the fourth quarter of 2013 was RMB 3.5 million or U.S. $0.6 million, which was the same figure as recorded in the same period last year.
Our effective tax rate was 46.2% for the fourth quarter compared to 23.9% for the same period in 2012. Income tax expense was RMB 11.4 million or U.S. $1.9 million for the quarter compared to RMB 24.7 million for the same period in 2012. As compared to the PRC regulatory tax rate of 25% applicable to our major operating subsidiaries, the difference in the effective income tax rate for the current quarter was primarily due to non-deductible expenses and a relatively high amount for operating losses from loss-making subsidiaries for which full valuation allowances were made on their deferred tax assets compared to the overall results of the company. Shareholders are reminded that in the PRC, losses in companies which are part of a group are not allowed to be offset against the profits arising in other companies in the same group.
In addition, in early February 2014, the Hong Kong Inland Revenue Department denied us our Hong Kong tax residence which had applied in fiscal 2012. We are therefore now subject to a standard withholding tax rate of 10%, rather than a reduced tax rate of 5% under the tax treaty previously applied by us, for the dividend to be paid or appropriated from our PRC subsidiaries. This has led to a charge of withholding income tax of RMB 11 million or U.S. $1.8 million for the year ended December 31, 2013.
Net profit in the fourth quarter was RMB 13.3 million or U.S. $2.2 million, or RMB 0.14 basic and diluted earnings per ADS compared to net income of RMB 78.8 million or RMB 0.18 basic and diluted earnings per ADS in the same period of 2012. This decrease was primarily due to the one-time disposal of our 40% equity interest in Jianzhijia and a subsequent recognition of a gain of RMB 68.4 million in income in the fourth quarter of 2012, which was non-recurring exceptional income last year.
Net cash outflows from operating activities were RMB 25.2 million or U.S. $4.2 million compared to net cash inflow of RMB 10.2 million in the same period of 2012, primarily due to increased purchases of merchandise on increased sales achieved in the fourth quarter of 2013.
Now let’s turn to fiscal 2013 results. In fiscal 2013, we opened 122 new stores and closed 188 stores. As of December 31, 2013, we had a total of 2,056 stores in operation. Total revenue for 2013 increased to RMB 2,699.1 million or U.S. $445.9 million from RMB 2,549.9 million in 2012. Same store sales for 1,893 operating stores opened before December 31, 2011, for 2013 increased by 7.3% compared to 2012. The increase in revenue and same store sales was driven by continued optimization of our merchandise portfolio through diversification into non-pharmaceutical categories, the closure of underperforming stores, and the more intensive sales promotion initiatives. In 2013, revenue contribution from prescription drugs was 22.3%, OTC drugs was 39.2%, nutritional supplements was 14.5%, herbal products was 4.1%, and convenience and other products was 19.9%. Private label products accounted for 23.5% of total revenue and 31.8% of gross profit respectively compared to 26.8% of revenue and 38% of gross profit in 2012.
Gross profit was RMB 1,178.3 million or U.S. $194.6 million for 2013 compared to RMB 1,180.5 million achieved for 2012. Gross margin was 43.7% compared to 46.3% in 2012. The difference in gross margin was mainly due to downward pressure on sales prices as a result of increased sales promotion initiatives to increase market share. Sales of private label products represented approximately 23.5% of the revenue and 31.8% of total gross profit for fiscal 2013.
Total operating expenses accounted for 42.5% of total revenue in 2013 compared to 44.2% recorded in 2012. Income from operations was RMB 23 million or U.S. $3.8 million for 2013 compared to RMB 46.9 million for 2012. Interest income for 2013 was RMB 13.7 million or U.S. $2.6 million compared to RMB 16.4 million in 2012. Dividend income from cost method investments was RMB 5.2 million or U.S. $0.9 million for 2013 compared to RMB 4.5 million in 2012. Equity income of an equity method investee was nil in 2013 compared to RMB 1.3 million in 2012 due to the disposal of our 40% equity interest in Jianzhijia in 2012, which was recorded as RMB 68.4 million one-time gain in 2012.
Our effective tax rate was 73.1% in 2013 compared to 34.6% in 2012. Income tax expenses was RMB 32.1 million or U.S. $5.3 million for 2013 compared to RMB 47.6 million for the same period in 2012. I already explained the changes in our tax rate and certain expenses in 2013.
Net income was RMB 11.8 million or U.S. $2 million for 2013 or RMB 0.12 basic and diluted earnings per ADS. Net cash flows from operating activities was RMB 6.9 million or U.S. $1.1 million for 2013 compared with RMB 41.4 million achieved in 2012.
The total number of outstanding ordinary shares of the company as of December 31, 2013 was 197.4 million. The weighted average number of ordinary shares in 2013 was also 197.4 million. Each ADS represents two ordinary shares of the company.
As of December 31, 2013, our total cash, cash equivalents, bank deposits and restricted cash was RMB 622.8 million or U.S. $102.9 million, and shareholders equity was RMB 845.5 million or U.S. $139.7 million compared to RMB 664.4 million and RMB 1.03 billion respectively as of December 31, 2012. On November 26, 2013, we announced a cash dividend of U.S. $0.32 per ADS. Approximately U.S. $31.6 million was subsequently paid to shareholders during January 2014.
While the immediate outlook in 2014 for retail operations across most sectors in mainland China remains challenging, we believe our broad and varied selection of product offering, improved retail services, and customer loyalty programs well position the company for envisaged future improvement for the retail pharmacy sector in China. Our objective is to capitalize on our existing extensive store network, customer loyalty to our retail brands, and constantly improving product mix to achieve improved economies of scale and leverage our operational efficiencies, thereby improving margins in the long term.
With that, Mr. Zhang and I will address your questions. Operator, please begin the Q&A. Thank you.
Question and Answer Session
Thank you. [Operator instructions]
Our first question comes from the line of Isabella Zhao with Morgan Stanley. Please proceed with your question.
Isabella Zhao – Morgan Stanley
Hello, thank you. (Chinese spoken)
I will translate the question in English. My first question is first of all, congratulations for the solid results. We have seen continuously sales growth in the same store sales growth. My question is are we expecting the same store sales growth will continue in 2014? And also, I notice that the gross margin has been declining year-over-year. What should we think about the gross margin trend in 2014?
My second question is about our cooperation with Alipay. Can management give us more color of the details and what kind of positive impact we expect from this cooperation. Thank you.
(translated) Let me address your first question. 2013, as you commented, we posted a strong same store sales growth. We believe 2014, we can continue that kind of trend to record a double-digit growth in the same store category; however, there will be some headwind in the first couple quarters as five to six of our subsidiaries are in the process of applying the new GFP certification, and due to that reason our marketing effort will be somewhat limited in the near term. So that’s going to happen in the first and second quarter; however, we believe that the second half of the year will make up on the loss in the first two quarters and we will continue to grow on a full-year basis double-digit in-store sales category.
Key cards have been growing very strongly in China. We believe the partnership with Alipay will contribute positively to our business as more and more integration and cooperation between online and offline presence continues, and especially we believe with that kind of online presence will help us with the store traffic, so overall we think it’s a positive sign for our business.
As you know, retail business is traditional business; however, with the emergence of online ecommerce platforms attracting more and more young consumers, given our physical store presence, we believe we’re going to help to enhance that consumer experience when they visit our stores and increase purchases. So we believe this synergy we are making is going to help—it’s a win-win situation.
Isabella Zhao – Morgan Stanley
Thank you. (Chinese spoken)
Oh, sorry. (translated) We are closely following our gross margin trends. As you know, in general in 2013 it has been a down year; however, that has given us a strong tool to compete in this marketplace. So going into 2014, we will continue to focus on our competitiveness through all different kinds of tools. However in terms of product mix, we’re going to introduce more nutritional products and TCM product as well as personal care, and we believe we can increase sales in these categories. These generally carry higher gross margin, so our effort is to increase the sales in those product categories to increase our overall blended gross margin in 2014.
Once again, if you would like to ask a question, please press star, one at this time. Our next question comes from the line of Ryan Roberts with China Stock Research. Please proceed with your question.
Ryan Roberts – China Stock Research
Good evening. First of all, thanks for taking my question and congratulations on some strong comps this quarter. My first question is on comparable store sales. Can you give us some color kind of on what’s driving that? You mentioned in your prepared remarks it was traffic and some other factors. Could you give a bit more information on kind of what you see as driving the overall trend there?
You say the same store sales, right?
Ryan Roberts – China Stock Research
(translated) In terms of drivers, in terms of the contributing back to our same store sales growth are the following. First is we worked really hard to broaden our Rx product, prescription drug product offerings. We also are working with different regions to procure particular products more suitable for that region, and also we’re working with the insurance program to target different kind of customer audience. Secondly, we’ve been successfully executing our pricing strategy in the prescription drug category, and that helped us to win more customers, increase store traffic, and also enhance our competitiveness.
Lastly, as you know in the past year or so and recent quarters, we have been actively streamlining our store network. With the closure of some of the non-performing stores, we now are able to our resources and management time on some of the better performing stores to drive the better economy of scale from those high productive stores.
Ryan Roberts – China Stock Research
Okay, thank you for that. (Indiscernible), a second question then on the tax item (indiscernible), can you give an idea kind of what the breakdown was – I think you identified two factors in the prepared remarks. Can you give us just a little bit of an idea what the breakdown was between the Hong Kong issue as well as what happened to your mainland China, and also maybe you could kind of maybe discuss a little bit about when those—kind of what management (indiscernible).
(translated) Before we explain that, let me give you a little background why we are—why we applied for Hong Kong residence for our corporation. There are the following three reasons. First, we have five members of our board of directors all together, and four out of those five are Hong Kong residents. Secondly, we frequently host our (indiscernible) in Hong Kong. Thirdly, our main bank account is actually in Hong Kong, so that gave us a good reason to apply for Hong Kong domicile corporation status. However this year when we applied for Hong Kong enterprise status, we got—unfortunately we got rejected for Hong Kong residence.
In terms of breakdown of the number, 10.7 million out of 11 million of the withholding tax was charged to the fourth quarter as the tax position has changed, and the 11.4 million of the income tax expenses for the quarter was the net effect of income tax charge of about (indiscernible) subsidy and subsidiaries, and net off by deferred assets recognized during the period of about 6.6 million. For the subsidiary, those deferred assets are recovered in the future, which were negative income tax expenses and plus the withholding tax effect we just mentioned. So that gives you a little color of the tax breakdown.
Ryan Roberts – China Stock Research
Okay, thank you. And sorry – maybe I could just ask one final question. In terms of the guidance, you mentioned that retail environment is still going to be pretty tough in China (indiscernible) full year basis you can do a double-digit (indiscernible) double digit comp and so, I think, same store sales for the year. Can you give us a little bit of any kind of color on (indiscernible) main factors are (indiscernible) and kind of how long—how likely to continue, when we can kind of expect some kind of gross margin recovery on the year. Can you talk a little bit more about kind of where you see 2014 shaking out, that’d be great.
(translated) The drugstore industry is actually a little bit different from other retail businesses, and our traffic is a lot slower than some of the fast consumer products, i.e. supermarkets or convenience stores. So that being said, it’s our decision, our long-term vision to grow our market share. To reach that goal, it takes a long process, which means if we want to continue to grow our market share to win more customers, we need to continue to invest and to focus our marketing campaigns and increase—continue to make promotion programs.
Secondly when we talk about gross margin, we believe a more optimized product mix is going to stabilize and help recover our gross margin. As we mentioned earlier, we’re going to focus on some of the higher margin categories, such as personal care products, traditional Chinese medicine, as well as the nutritional products, and we’re going to increase sales in that area and that will help us with the improved blended gross margin.
So all in all, we believe if we can continue to grow our same store sales, improve our store efficiency, our 2014 top line growth with continue and also at the gross profit level, as well as the gross margin level will see a steady increase.
The dynamics of Chinese consumer market have changed quite a lot in recent years, and more and more attention is now placed on healthcare-related products. We believe we are well positioned and we are focusing on bring our small, high quality products to meet our customers’ demand, such as nutritional products and other types of products to improve their life and health. A lot of those—our effort in the procurement area is already underway. We’re looking for high quality products to sell to that market.
Thank you. We have come to the conclusion of our question and answer time. Mr. Chen, I’d like to turn the floor back to you for closing comments.
Thank you for attending China Nepstar Chain Drugstore’s fourth quarter and 2013 earnings conference call. Let me turn the call back our CEO, Mr. Fuxiang Zhang to give his closing remarks.
(translated) Thank you for our investors and analysts to continue to show their support. 2013 has been a strong year for same store sales growth and top line growth; however, we are not satisfied with that yet because our gross margin hasn’t been performing. So we believe coming into 2014 we are going to make extra effort to improve that, and then we can give the best return to all our shareholders and investors. Thank you for your support.
With that, I would like to conclude today’s call.
Thank you. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.
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