Synutra International, Inc. (NASDAQ:SYUT) Q4 2016 Earnings Conference Call June 13, 2016 8:00 AM ET
Bill Zima - Partner, ICR, Inc.
Clare Cai - Chief Financial Officer
Pablo Zuanic - SIG
Ladies and gentlemen, thank you for standing by and welcome to the Synutra International Incorporated fourth quarter fiscal earnings conference call. At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session [Operator Instructions].
I must advise you that this conference is being recorded today, 13 June, 2016. I would now like to hand the conference over to your first speaker today, Mr. Bill Zima, ICR.
Thank you. Please go ahead.
Thank you, operator. Hello, everyone, and thank you for joining us for Synutra International’s fourth quarter fiscal 2016 earnings conference call. With us today is Ms. Clare Cai, Synutra’s Chief Financial Officer.
Before we begin, I will read the forward-looking statements. During this conference call, we will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on our current expectations, assumptions, estimates and projections about Synutra International and its industry.
All statements, other than statements of historical fact, in this conference call are forward-looking statements. In some cases, these forward-looking statements can be identified by words or phrases such as anticipate, believe, continue, estimate, expect, intend, is likely to, may, plan, should, will, aim, potential or other similar expressions. These forward-looking statements speak only as of the date hereof and are subject to change at any time and we have no obligation to update these forward-looking statements.
With that said, I would now like to turn the call over to Synutra’s Chief Financial Officer, Ms. Clare Cai. Clare, please go ahead.
Thank you, Bill. Good morning and welcome to Synutra International’s fourth quarter fiscal 2016 earnings conference call. Today, I will begin with updates to our operational initiatives, followed by a more detailed review of our financial results and outlook for fiscal 2017. After that, we will hold a question-and-answer session.
During the March quarter, we continued to see strong competition in the Chinese infant milk formula industry. Overall, our sales decreased by 21.8% year-over-year, impacted by the challenges of pricing pressure from cross-border e-commerce products, which enjoyed preferential tax treatment and have the appeal of being manufactured overseas, lower birth rates during Year of the Sheep, and the uncertainty related to the regulatory environment overseeing powdered infant formula products.
Our net profit attributable to common stockholders was $96,000 in the fiscal fourth quarter, factoring in the non-recurring $8.8 million loss on a long-term purchase contract related to the French project and a $1.3 million foreign currency exchange loss.
Looking at our product segments, at our core Nutritional Food segment, we experienced a 23.5% decline in sales, which was due to a 17.6% decrease in average selling price and a 7.2% decrease in sales volume. 5% of the decrease in ASP can be attributable to a change in our product mix from higher-priced Super and specialty infant formula products towards lower-priced private label products. Despite an increase in our promotional activities, which contributed a negative 4% towards the decline in ASP, sales under our Super brand infant formula products declined by 20% year-over-year due to an intensified competitive environment.
As we await the July 1, 2016 date when all manufacturers in China can begin to apply for the production license for specialty formula products, we continued to experience year-over-year losses as our sales focus under this category was limited to non-subscription, over-the-counter specialty formula, resulting in a 45% year-over-year sales decline in this category.
Our ASP was also negatively impacted by exchange rate changes. Excluding the foreign exchange impact, our ASP decreased by approximately 13% year-over-year in RMB terms.
The 7.2% decrease in sales volume in our Nutritional Food segment was mainly impacted by the decreased sales of our mainstream Super brand. We also faced lower sales in some niche markets due to regulatory uncertainties. For example, sales of our specialty IMF products continued to be impacted by the new regulation regarding the re-licensing of specialty formula production.
Currently, our specialty formula production is still limited to our OTC specialty IMF products. However, we believe this situation will be improved soon since the new regulation was recently announced and applications for new licenses will be accepted beginning July 1.
We are now actively preparing the application documents and expect to submit the application shortly after July 1. Again, we remain confident that we are well equipped to be among the first licensed manufacturers given that Synutra’s Qingdao factory was the only factory in China to receive a special formula production license in the past.
Sales of our direct-to-mom and baby store brand, My Angel, continued to be impacted by the uncertainty of the newly proposed regulation, especially the limitation of three brands that each factory can register with the Chinese Food and Drug Administration or CFDA.
However, with the opening of our French facility and the upgrade of our Inner Mongolia Meng Yuan factory, we believe we will have a sufficient number of brands to register for all of our mainstream products.
In addition, as we mentioned before, we believe such regulation will benefit us over the long run. We believe the limitation of three brands per factory will force out three-quarters of the approximately 2,000 small brands that are mostly made under private label arrangements, which, in total account for approximately 20% to 30% of the Chinese IMF market by sales.
If the new regulations are strictly enforced and some 1,500 small brands disappear from the market, we are well positioned to consolidate market share, particularly given the premium added to our own brands with the opening of our French facility.
In the fourth quarter, we also continue to see the intensified competition in the adult formula category. As mentioned earlier, many of our competitors in the powdered infant formula category launched their adult formula products to leverage existing production capacity. In the fourth quarter, we started to see such products penetrating mom and baby channels, resulting in intensified competition.
Nevertheless, sales of our Dutch Cow adult formula products increased 6% year-over-year. As discussed in our previous calls, we continue to emphasize the high-end value proposition of the Dutch Cow brand and shifted more of our sales expense budgets to the higher-priced tin products.
Moving on to our Offline-to-Online membership service platform, we continued to make good progress on our Thumb Mama membership community and the Thumb Mall e-commerce platform on WeChat.
In addition to our more than 6,000 full-time in-store promoters, who are also Thumb Mama consultants, we now have approximately 10,000 part-time nutritional consultants to promote our products and the Thumb Mall platform, using the sub-accounts under our public Thumb Mama WeChat account as their primary tool of communication. Our sales through Thumb Mall as a percentage of total sales continued to increase through the end of fiscal 2016.
Another significant development regarding products and sales during the fourth quarter was the launch of our Dutch Cow ultra-high temperature or UHT liquid milk products. We launched this product in 1 and 0.5 liter packaging sizes in January 2016 by importing OEM products produced by European manufacturers.
Given the price and quality advantage of EU raw milk, our existing network of distribution, which many of the importers of UHT milk to China do not have, and the brand equity of Dutch Cow, in particular in its traditional stronghold markets of coastal China [indiscernible]. We believe this product has the competitive edge to be established as a national brand with meaningful volumes. We have launched this product both online and offline. For the online sales, we have placed it with both our own Thumb Mall platform and general e-commerce platforms such as Tmall, JD, et cetera.
For the offline distribution, we have identified 40 key city markets consisted of tier 1 and 2 cities and have placed our distribution and marketing efforts in various channels, including supermarkets, minimart, to business channels such as schools and hotel supplies.
While initial sales were very small, we have seen a doubling of sales in each month since January. For fiscal 2017, we have allocated a substantial advertising budget for this product alone and we’ll provide updates on this promotional campaign and the resulting sales in future quarters. We believe such promotional efforts benefit not only the liquid UHT Dutch Cow product, but also the Dutch Cow brand overall, including the adult and infant formula products under it.
For our French project, although we had expected the project to be fully operational at the end of March 2016, as we discussed in our earnings call for last quarter, the adjustment and testing of one key piece of equipment for the spray drying towers actually took longer than our previous expectation, which was already extended from an initial operational start date of January 2016.
While the technology for such components is quite mature and usually such adjustments do not last longer than three months by industry standards, hence our previous estimates. In the case of our project, the testing took almost 9 months. The direct consequences of the delay include an increase in the total budget as other suppliers have to stay around for the prolonged testing period. And the loss we suffered under the supply contract with Sodiaal under which we expect to incur a one-time expense of $8.8 million to process or re-sell the excess milk that was supposed to be sent to our tower beginning in January 2016.
The adjustment period concluded on May 31, 2016 when our whole milk powder tower produced its first batch of whole milk powder. Currently, we have finished the fine-tuning of this tower to produce infant grade whole milk powder as required by our dry mixing product production method. We have also started the trial operation in the whey protein tower and expect this tower to generate infant grade, high oil whey protein powder by the end of June.
The dry mixing and canning facility was tested to be functional back in January 2016. In July, we will test run the dry mixing and canning line and test for finished products one formula at a time, starting with our biggest brand, the Super 58 series, as we want to ensure the process of ingredients feeding and the finished product testing is well run.
We expect to produce and export the Super brand infant formula from France in regular volumes in July 2016 and that our made-in-France products will be available for retail sales in China by September 2016, ahead of our high season in third and fourth fiscal quarters. We expect to receive the necessary operational approval and important accreditation from the French and Chinese authorities once we start our commercial operations.
When the French project turns from construction-in-progress status to fixed assets in July, we will begin to incur additional depreciation and interest expenses associated with this project, as well as other general expenses that were previously capitalized.
As mentioned above, our total budget for building investments and major production related equipment for the French project increased by 7% to €173 million due to the prolonged testing and adjustment. Including pre-opening expenses and the capitalized interest, our total budget for this project is estimated to be approximately €198 million. We do not expect any further material increases to this budget.
At this point, I would like to review our financial results as well as provide an outlook on our business. For the fourth quarter of fiscal year 2016, our net sales were $86.1 million, a decrease of 21.8% from $110.2 million for the prior-year period. Net sales from our Nutritional Food segment, which mainly includes branded powdered formula products, were $80.4 million or 93.4% of net sales in the fourth quarter. This represents a decrease of 23.5% from the prior year period, in which we recorded sales of $105.1 million or 95.4% of net sales.
Sales of powdered formula products decreased to 6,827 tons in the fourth quarter compared to 7,356 tons in the prior-year period. Average selling price was $11,774 per ton compared to $14,283 per ton in the prior-year period.
Net sales from the Nutritional Supplement segment were $1.1 million or 1.2% of net sales, a decrease from $4.6 million in the prior-year period. This segment is primarily comprised of sales of ingredients such as chondroitin sulfate to international pharmaceutical companies.
Our two largest clients of this segment temporarily withheld their orders in the fourth quarter as one worked on upgrading product specifications and one managed down its raw material inventories. We are working with these clients to resume orders. However, no significant order has been materialized so far in the June quarter. And we may see the hiatus in sales under this segment to continue in the second quarter of fiscal 2017.
For the longer run, however, we believe that our position as the number one supplier worldwide of chondroitin sulfate is supported by our proprietary technology and know-how and that our industry-leading product quality in terms of purity and stability will support profitable sales with existing and new clients.
Net sales from the Other Business segment, which mainly consists of imported whole milk powder and the whey protein sold to industrial customers, was $4.7 million or 5.4% of net sales as compared to $550,000 or 0.5% of net sales in the prior-year period. These sales are always opportunistic. The year-over-year increase in the Other segment sales this quarter was mainly driven by the sales of excess milk powder. Sales under this segment will increase significantly after July 2016 when powders from our French project become available for sale to third parties.
Gross profit was $38.9 million in the fourth quarter of fiscal 2016 compared to $45.2 million in the prior-year period. Gross margin for the Nutritional Food segment was 48.8%, a decrease from 51.4% in the prior-year period as the decrease of raw material costs for this segment, in particular whole milk powder prices, was more than offset by the lower average selling price.
Overall, gross margin was 45.2%, a decrease from 49.2% in the prior-year period. In addition to the decline in gross margin for the Nutritional Food segment, overall gross margin was negatively impacted by the negative gross margin for the Nutritional Supplement segment.
Selling and distribution expenses were $10.7 million in the fourth quarter of fiscal 2016 compared to $14.5 million in the prior-year period. The decrease was primarily due to lower employee bonus costs associated with lower sales. Advertising and promotional expenses were $12.2 million in the fourth quarter compared to $10.9 million in the prior-year period as last year’s expenses in this category benefited from a one-time government subsidy.
Selling and distribution and advertising and promotion expenses combined accounted for 26.6% of sales compared to 23.1% in the prior-year period due to lower operating leverage.
General and administrative expenses were $7.0 million or 8.2% of sales compared to $6.5 million or 5.9% of sales in the prior-year period. The increase was mainly due to some one-time expenses to engage financial and legal advisors to the special committee formed to evaluate the going-private proposal from our Chairman Mr. Zhang Liang.
Income from operations was $476,000 or 0.6% of sales in the fourth quarter compared to $16.6 million or 15.0% of sales in the prior-year period. As mentioned above, this number includes a non-recurring $8.8 million loss under the supply contract with Sodiaal due to the delay of the French project.
Net interest expense remained stable year-over-year at $1.8 million. Not included in the net interest expense is a $1.3 million capitalized for the French project, which will be included in current interest expenses from the second quarter fiscal 2017.
Net foreign exchange loss was $1.3 million compared to $2.1 million gain in the prior-year period. This loss was primarily due to the depreciation of the RMB against the US dollar and the euro during the quarter. While our main operating entities are all based in China and generates revenue in RMB, we have significant USD and euro borrowings through our subsidiaries outside of China.
We recognized an income tax benefit of $2.3 million on a pretax loss of $2.2 million in the fiscal fourth quarter compared to an income tax benefit of $7.5 million in the prior-year period.
Net income attributable to common stockholders was $96,000 or near zero per share for the fiscal fourth quarter compared to a net income of $24.1 million or $0.42 per share in the same period last year.
Looking at the balance sheet, we ended the fourth quarter with cash and cash equivalents of $102.7 million and restricted cash of $206.2 million, which includes current and the non-current portions. Total cash, including restricted and non-restricted portions, was $308.9 million versus $289.3 million at December 31, 2015.
As of March 31, 2016, total debt was $506.2 million, representing an increase of $32.2 million from the end of the third fiscal quarter. Our net debt, which is total debt less total cash, was $197.3 million as of the end of the fourth quarter, representing an increase of $12.7 million over our net debt position at the end of the fiscal third quarter as we continue to invest cash into the CapEx for the French project. There will be approximately $26 million of capital investment for the French project in the first half of fiscal 2017 in the form of remaining payments under equipment and construction contracts as well as other pre-opening expenses in the June quarter.
We also plan to spend approximately $4 million for other one-time projects at our other facilities such as the qualification of infant formula production license at Meng Yuan and the qualification of specialty formula license at Qingdao.
Other than these one-time capital expenses, our ongoing maintenance capital expenditure after the French project opening will be between $15 million and $17 million a year.
Net accounts receivable increased from $24 million at the end of the third quarter to $29.9 million as of March 31, 2016, reflecting increased sales to one particular client under the Other segment for bulk powder and the increased sales of raw milk in transit as Synutra France purchased part of the required volume under the Sodiaal contract and then sold such raw milk at losses. Please note that there have been no changes in our payment policy for clients under our Nutritional Food or Nutritional Supplement segments.
Our inventory position was $98.4 million compared to $86.9 million at the end of the prior quarter as we placed large orders of liquid UHT milk to launch under the Dutch Cow brand, which was in transit on the sea as of March 31.
Finally, I would like to discuss our outlook for fiscal year 2017. The company expects total net sales for fiscal year 2017 to be between $500 million and $550 million and net income to be between $25 million and $30 million. The increase in sales will be driven by the expected increase in the sales of powdered formula products, the increase in the sales of liquid milk as this product continues to be launched, and the increase in the sales of bulk milk powder and bulk whey protein powder as our French project is expected to start operation in July 2016.
As the sales increases are more weighted towards lower-margin liquid milk and bulk powder and as the start of operation at the French project also means the commencement of depreciation and interest expenses under this facility, the increase in net income will be more limited. We have not factored in one-time or foreign exchange impact in our forecast.
This concludes my prepared remarks for today’s call. Operator, please open up the call to questions.
Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] Your first question comes from the line of Pablo Zuanic from SIG. Please ask your question.
Yes. Hello. Good evening, Clare. Two questions from my side. First, on that guidance you’re giving of sales of $500 million to $550 million, just give us a sense of what underlying growth are you assuming for the market as a whole for IMF and what’s your assumption of market share. Do you retain market share or do you gain?
And number two, if you can just give us more color at the total market level in terms of your growth by channel, what’s happening in the baby or the mom baby store channel? What’s happening in e-commerce? And if you can compare that in terms of the underlying trends for the market in those channels with your growth, where are you gaining, where are you losing? And then I have a follow-up. Thank you.
In terms of total market growth, we are expecting in our fiscal year 2017 – or more for the general market, calendar year 2016 – we will recover back to the year – to before the Year of the Sheep or back – basically to the year before. So we will regain the growth that was enjoyed by the Year of Horse, which I think the overall market grew by over 8% to maybe over 10%.
In terms of market share changes, we of course, are expecting a higher market share driven by the opening of our French facility.
In terms of channel shifting, we continue to see the growth of mom and baby store channels, taking shares from the traditional minimart channels and to a certain extent from the supermarket channels.
In terms of e-commerce, we see a flattening of e-commerce sales overall, although there is even shifting from more regular platforms to cross-border platforms with the reasons I mentioned in the call.
Right. And just the last question, in terms of the recent regulatory changes, we’re all aware of the changes that have been announced over the last 12 months, but what are you seeing in terms of – have any of those changes actually begun to be implemented or enforced and are they having any effect on the market itself? For example, restrictions on how many SKUs a factory can make, suppose [ph] restrictions on parallel imports, the introduction of new taxes on imports, have any of those changes been implemented on imports and are they having any effect so far? I mean that at a total market level, please. Thanks.
The limitation on number of SKUs per factory, that policy which is the governing policy on IMF production license granting in China has come to effect after June 10, so just recently. And in terms of its enforcement, we are still yet to see because it just became effective. But the regulation itself provides a running period for the factories to become fully compliant which is through January 1, 2018. So there is still quite some time before we can see how strictly this regulation will be enforced.
In terms of the cross-border tax treatment, there has been one month that the preferential tax treatment was called off, but perhaps it was due to the resistance or outcry from the cross-border e-commerce business community that the tax treatment was restored after one month of halt. And although the regulatory direction is to cancel the preferential tax treatment in the long run, when will it be enforced is still yet to be seen.
Thank you. Can I ask you one last question? Again, for your company and for the industry as a whole, is there any seasonality in this business? From outside, you would think that, of course, baby formula has no seasonality. Or is there anything we should keep in mind around Lunar New Year? Is there a quarter where sales go up because of gifting? Is there any seasonality at all? Or maybe there are particular preferences by moms in terms of when babies are born, but is there any seasonality in this business at all in China? Thanks. That’s all.
Yes. There is seasonality. Overall, for the dairy products, people always consume less dairy products – fewer dairy products in the summer months and consume more in the winter months, which is just the opposite of how much the cow produces. That’s for the overall daily segment.
For the IMF products, interestingly, there is also this seasonality that the summer is a lower sales season. For our company, the April to September season, the first two quarters are lower. They usually have between 20% to 22% of annual sales in these two seasons – in these two quarters whereas the later half would account for somewhere between 55% to 58% of sales for the whole year.
So there is seasonality for the industry and for us. And although you would think that infant formula will be less subject to appetite change, one reason can be that the Chinese families choose to wean off the babies from infant milk formula during the summer months.
And does Lunar New Year play any factor at all in all this or it’s not relevant? It’s only the things that you just explained.
For us, Lunar New Year and the mid-autumn festival/national day festival are two big seasonal drivers for the adult milk formula, which also contributes to our sales fluctuation. In terms of infant milk formula, there is some impact of consumption increase. There can be the – some of our consumers are parents who are separated from their children and when they go back home during the spring festival, they would buy, stock up IMF product for their children.
Right. Thank you.
[Operator Instructions]. There are no further questions – sorry, Mr. Pablo Zuanic from SIG still has a question. Please continue.
Yeah, sorry. Thank you for the follow-up. Just one last question, Clare. Obviously, you’re now building this plant in France. Just two questions. Remind us, in terms of your total capacity to produce milk, IMF particularly, how much does that increase your capacity or is the idea just replacing local – the imports with the local – is that the idea or are you assuming that your total capacity increases?
And point two, if your total capacity is going to increase, by how much is it? And where are you going to try to place that additional IMF? Is there any particular channel or regions that you would focus on to sell that increased output or maybe it’s just replacing what you already have? Thanks.
Thank you, Pablo. Our French project consists of three parts – a 45,000 ton spray drying tower of whole milk – or skimmed milk powder, a 45,000 ton spray drying tower of whey protein powder or high-oil whey protein powder, and a maximum capacity of 90,000 tons of dry mixing and canning facility. So the maximum capacity is based on a 24-hour shift. And at the beginning, we plan to start with one shift daily, which means 30,000 tons per annum in dry mixing and canning capacity. And then we will – depending on the increase of our sales volume, we will increase the shift by 30,000 ton installments every time.
Our existing dry mixing and canning capacity in Qingdao is 75,000 tons. The spray drying towers, you can view it as that we were paying our suppliers the cost of depreciation for their product and their towers and now we are building our own towers and our cost of production – there’s maybe different basis of depreciation due to the time and budget to construct those towers, but the components are the same. We’re paying depreciation to our suppliers before and now we are paying our own depreciation. So that’s for the two towers.
But for the dry mixing part, yes, it is an addition to our total capacity without a direct increase to our ability to sales. So our plan is to increase our ability to sell in the long run by emphasizing the advantage of made-in-France products, the state-of-art of French facility, the quality of ingredients, and the quality of our management. So not only we plan to emphasize the advantages to our consumers in China, we have also tried to make sales in other regions. We have completed sales to Pakistan, to Turkey, and to Nigeria. So we think we have some potential in opening a new market in the Middle East and North Africa, which is the traditional stronghold of French business.
There are no further questions at this time. I would now like to hand the conference back to today’s presenters. Please continue.
Thank you, operator. And thank you all for participating on today’s call. We look forward to speaking to you on our next earnings conference call. Thank you and have a good day.
Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.
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