WuXi PharmaTech Q3 2007 Earnings Call Transcript

| About: WuXi PharmaTech (WX)
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WuXi PharmaTech (NYSE:WX) Q3 2007 Earnings Call November 13, 2007 8:00 AM ET

TRANSCRIPT SPONSOR

Executives

Hai Mi - IR

Ge Li – Chairman, CEO

Benson Tsang - CFO

Analysts

Jinsong Du - Credit Suisse

Tycho Peterson – JP Morgan

Bin Li - Merrill Lynch

Dave Windley - Jefferies

Hai Mi

Thank you, operator. Good morning and good evening. Thank you for joining us for WuXi PharmaTech investor conference call on our third quarter 2007 results. Joining the call today are our Chairman and CEO, Ge Li, and our CFO, Benson Tsang. This conference call is also being broadcast on the Internet and is available through the investor relations section of the company website. We also have provided a summarized presentation which may be downloaded from our website.

Before the management's presentation, I would like to refer to the Safe Harbor statement in connection with today's conference call and our earnings press release. During the course of this conference call, we may make forward-looking statements, statements which that not historical facts, including statements about our future expectations, plans and prospects. Forward-looking statements involve inherent risks and uncertainties and a number of important factors could cause the results to differ materially from those contained in any forward-looking statements. Further information regarding these and other risks are included in our filings with the SEC.

Additionally, we may be discussing non-GAAP financials during this call. We believe these non-GAAP numbers help investors to better understand our core operating results and the future prospects, consistent with the manner in which management measures and forecasts the company's performance. These non-GAAP financials exclude the stock-based compensation expense and investors should refer to the reconciliation of non-GAAP measures to GAAP measures for the indicated period attached to our Q3 earnings press release that can be found in the investor relations section of the company website.

Following management's prepared remarks, we will open the line for a brief Q&A session.

With that, I would like to turn the call over to our Chairman and CEO, Dr. Li.

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Ge Li

Thank you. Good morning and good evening, everyone and welcome to our third quarter 2007 earnings call. Before I start to discuss our third quarter results, I would like to take this opportunity to give you an overview of WuXi PharmaTech, since some of you may be hearing our story for the first time.

WuXi PharmaTech is the leading China-based drug R&D outsourcing service company. As noted on slide 2, the company was founded in December 2000 with the mission to transform the drug R&D industry and a vision to provide fully integrated drug R&D services to improve the success of research and shorten the time of development.

Our company is headquartered in Shanghai. We provide pharmaceutical and biotechnology companies around the world with a full spectrum of drug R&D services under two segments: laboratory services and research and manufacturing. WuXi PharmaTech has experienced strong growth since our inception by delivering a high quality of services to our customers, leveraging the cost and talent pool advantage of operating in China, and by capitalizing on the strong demand of the global drug R&D offshore outsourcing.

A key testament to the strength of our company is the quality of our customer base. We have worked with 80 customers so far in 2008, including nine of the top ten global pharmaceutical companies and we have experienced 100% repeat business from our top ten customers over the last three years.

Slide 3. In line with our vision to be the leading, fully integrated and scalable drug R&D service provider, we now provide a wide range of services including discovery chemistry, service biology, toxicology, bioanalytical and analytical services, pharmaceutical development, process development and research manufacturing services.

We're going to continue to grow our core service capacities, expand our manufacturing capability and capacity and develop significant preclinical and biology capabilities.

Now let me turn to our third quarter performance. Please turn to slide 4. Our strong third quarter performance demonstrates the strength of our business model and our strong execution ability to capitalize on growing market demand for drug R&D outsourcing services.

Both laboratory services and the research and manufacturing segments performed well during the quarter, as net revenues increased 78% to $34 million, and the net income tripled to $8.6 million over the same period of last year. The robust revenue increase is mainly driven by our top ten customers, whose average revenue contribution grew to $7.4 million for the first nine months of 2007, an increase of 126% over $3.3 million for the same period of last year.

On the operational front, we continued to execute on our strategy, aimed at delivering long-term, profitable growth by delivering high quality services to our customers. As part of this effort, we broke ground on September 29th to build our GLP preclinical drug safety evaluation center in Suzhou, China, which is about 60 kilometers from Shanghai.

It will be a 267,000 square foot, state-of-the-art facility and expected to be China's largest modern drug evaluation center, providing comprehensive preclinical and toxicology services. The Suzhou center will be completed in 2009. At the same time, our interim facility in Suzhou is already operational.

In Shanghai, we are on schedule with our expansion plan for our 220,000 square foot manufacturing facility in the Jinshan district. It will quadruple the current production volume after its completion in 2008.

Both projects are expected to augment our current service capacities and the capabilities to provide better and more services to our customers.

Lastly, we have begun providing formulation services from our newly completed 22,000 square foot GMP quality formulation lab in Shanghai.

Now I would like to turn the call over to Benson Tsang, our CFO, to discuss the financials and our revised full year guidance.

Benson Tsang

Thank you, Dr. Li. As you have all seen our earnings release by now, I will focus on the main highlights for the quarter. We continue to benefit from the strength of our business model and strategies, and have posted a strong set of financial results characterized by the solid top and bottom line growth.

As noted on slide 4, net revenues were $34 million representing a 77.8% year-over-year increase. Net income was up 205% year over year. Laboratory services remained our main revenue driver for the quarter. Net revenues increased by 59% to $26.7 million in the third quarter of 2007, compared to $16.8 million in the third quarter of 2006. Our laboratory services business accounted for 79% of our net revenues in Q3.

Our second business line, research manufacturing, generated $7.3 million in revenue, accounting for 21% of total net revenues in the third quarter. This represents a 212% increase in revenue over the same period of last year, compounded with an improved profit margin due to the increased scalability.

Gross profit increased 76% to $16 million in the third quarter of 2007. Overall gross margin was 47% in the third quarter of 2007, slightly lower than the third quarter of 2006, mainly attributable to the costs related to our expanded facilities such as rentals and depreciation for our equipment. As we are growing steadily, operating expenses are increasing. They grew by 38% to $8.5 million in the third quarter of 2007, up from $6.2 million in the third quarter of 2006. This increase was primarily a result of our business expansion, increased hiring and growing service capabilities.

Nevertheless, as a result of our ongoing efforts to maximize cost efficiency in our operations, expenses have declined as a proportion of revenue, decreasing to 25% for the third quarter 2007 from 32% in the prior year period. We will track the figure going forward to ensure we are keeping our costs and profitability in line.

Moving to slide 5, our solid balance sheet had cash balances of $213 million. We have not used any of our proceeds from our IPO and these funds are generating interest income for the company. Diluted earnings per ADS was $0.12 for the third quarter of 2007. However, our share-based compensation expenses decreased by $1 million to $1.5 million U.S. in the third quarter of 2007 from third quarter 2006. Diluted earnings per ADS, excluding share-based compensation charges, on a non-GAAP basis was $0.15 for the third quarter of 2007.

Finally for our guidance, please turn to slide 6. Due to our solid results in the third quarter and better visibility into market conditions and our business growth, we are raising our full-year revenue guidance to the range of $131 million to $135 million.

Now, let me turn it back to Dr. Li.

Ge Li

Thank you, Benson. In closing, we have maintained the same strategic directions and focus on building our capability and the capacity in order to provide fully integrated, high-quality drug R&D outsourcing services to our customers. We continue to benefit from positive macro environments, including the increase in R&D expenditure, growing global outsourcing trends and the sustained advantage of doing business in China.

Together, we believe the combination of these external and internal factors provide a strong basis for our long-term growth.

Thank you and we'll be happy to take your questions.

Question-and-Answer Session

Operator

Your first question comes from Jinsong Du - Credit Suisse.

Jinsong Du - Credit Suisse

Congratulations on the results. You mentioned in the slides that you now have 80 clients. I remember during the IPO road show that it was at 70. I understand you may not be able to disclose the specific names of the additional clients, but could you share with us these additional ten clients, whether they are mainly for research manufacturing or for the lab services? Also, whether they are major pharmaceutical companies or small biotech companies, please?

Ge Li

Hi, Jinsong. Thank you for your questions. During the last nine months indeed we had new customers. The customers are from both laboratory services and the research manufacturing. Mainly, we have added some large biotech companies and also some small biotech companies.

Jinsong Du - Credit Suisse

Is it very well spread, in the sense of 50-50, or is it geared more towards one segment?

Ge Li

I would say about 80-20 and more towards our laboratory services.

Operator

Your next question comes from Tycho Peterson – JP Morgan.

Tycho Peterson - JP Morgan

Starting out with the manufacturing business, you talked last quarter about some of the issues in Europe and Vertex not taking delivery of the API. Can you give us a sense of whether that's been worked through? The underlying question stems around the fact that I guess the deferred revenue balance increased a little bit.

Benson Tsang

For the deferred revenue, if you look at our balance sheet we have $19.9 million as of September 30, 2007. This represents primarily payment from our customers for services provided and material we manufactured. A significant portion of the balance is actually from our manufacturing customer. We are in discussions with the customer right now about the shipment schedule. We actually have started a shipment in Q3 and we expect to ship the remaining goods in our inventory in the next few months.

Tycho Peterson - JP Morgan

Has your visibility around that customer changed at all? There's been some noise on the competitive front from Vertex. Has there been any kind of underlying change in the level of visibility you have? It sounds like the drug is supposed to move forward in the first quarter next year now.

Ge Li

Well Tycho, as our company policy, we don't discuss customers' information without the consent from the customer.

Tycho Peterson - JP Morgan

On the gross margins, if you can give us a sense, particularly on the manufacturing side, as to how we should think about the sustainability of the margins and the underlying margin trends going forward, that would be helpful.

Benson Tsang

Our overall margin is 47% for Q3 2007, and versus Q3 2006 it's 47.4%. For our research manufacturing business, our gross margin actually improved from 8.2% in 2006 to 14.3% in 2007. This is the direct result of our growth in the project and also the achievement of economies of scale and efficiency on our production facilities. We will continue to focus on the operational efficiency both in terms of labor and material and to maximize cost and production efficiency on our manufacturing facilities.

For the margin I would also like to draw your attention to our operating margin. It increases from 12.6% in 2006 to 21.2% in 2007 for the nine month period. Our effort is not only limited to the cost of sales line, we also monitor our SG&A expenditure closely to ensure we can maximize the efficiency. Thank you.

Tycho Peterson - JP Morgan

Benson, can you break out that $1.5 million between 123 R and stock?

Benson Tsang

It's actually 100% FAS 123.

Tycho Peterson - JP Morgan

I don't know if you gave the CapEx numbers and depreciation, I know you talked about some of the general CapEx spending, but if you could quantify those that would be helpful, too.

Benson Tsang

Up to Q3 2007, we had invested approximately $30 million in CapEx. Approximately $6 million is for our manufacturing and Suzhou projects. The rest is actually for equipment purchases and laboratory facility expansion; that is about $24 million. As you know, we budget about $18 million for both the Jinshan and the Suzhou projects -- that is the manufacturing and the drug evaluation center. So this money shall likely be spent in the next two years.

Depending on the eventual payment schedule, we expect a fair amount will be spent in 2008 and for the maintenance CapEx, we shall spend in accordance with our business growth. Thank you.

Operator

Your next question comes from Bin Li - Merrill Lynch.

Bin Li - Merrill Lynch

A follow-up question on the gross margin; Benson, you mentioned the manufacturing gross margin has expanded significantly sequentially and the lab service gross margin declined at the same time. You attribute the gross margin decline to increased depreciation and the appreciation of RMB. I was wondering whether you can quantify the impact of the depreciation and the RMB separately?

Benson Tsang

Bin, I don't have the data with me. I can get that to you later on.

Bin Li - Merrill Lynch

Perhaps more importantly, how should we think about these two factors going forward? Is the negative impact of depreciation here to stay? As for the RMB appreciation, in light of the strong RMB, what is your expectation on RMB impact to your gross margin going forward?

Benson Tsang

For the RMB, during the period from January 1, 2007 to September 30, 2007 the Chinese currency has appreciated about 4.2%. From the company perspective, we have purchased foreign exchange forward contracts to minimize our U.S. dollar/RMB exposure. We have been able to achieve better results during this period. Currently, there are very limited effective tools that we can actually minimize the exposure. We shall continue to purchase foreign exchange forward contracts and we believe it is the most effective way, a no-risk tool.

Bin Li - Merrill Lynch

Are you fully hedged with the forward contract, or partially?

Benson Tsang

Partially.

Bin Li - Merrill Lynch

A continued question on the margin, you mentioned operating margin has improved significantly, which is very encouraging. Now, can you identify for us what other line items within your operating expense can be reduced? Also, can you tell us how should we think about further reduction in that line?

Benson Tsang

For the operating expenditure, since day one we have been very, very cautious in spending items in the operating category. I think what actually we're trying to get at is the overall efficiencies. We invest in our operating expenditure, but we are squeezing all the efficiency we can get to maximize the outputs. We'll continue to do so and we are comfortable we can continue to monitor well.

Operator

Your next question comes from Vicky Chen - UBS.

Vicky Chen - UBS

Congratulations on the strong quarter. Looking at the quarterly earnings for last year, '06, what I see here is that there is a sequential growth and the last quarter was the strongest quarter we saw. For this year, is it because of the seasonality or it's just the sequential growth that you saw last year specifically? Are we going to see this pattern showing this year or for the years going forward?

Ge Li

I don't think we see seasonality. Actually, last year probably is last-year specific because the sequential growth has a lot to do with customers' spending patterns last year.

Vicky Chen - UBS

How many people or scientists have you recruited this year as of now?

Ge Li

Well, as of September 30th we have over 2,700 employees, including slightly over 2,100 staff members [inaudible].

Vicky Chen - UBS

So for this year alone, how many people? I guess I wasn't clear in asking this question.

Ge Li

It's almost a net addition of 1,000 people up to now.

Operator

Your next question comes from Dave Windley - Jefferies.

Dave Windley - Jefferies

I wanted to follow-up on the stock charge. Benson, you said that 100% of that is actually FAS 123R?

Benson Tsang

Yes, share-based compensation charge.

Dave Windley - Jefferies

Does that mean then that 100% of it relates to ordinary shares as opposed to any that would be attributable to the preference shares for the portion of the quarter?

Benson Tsang

Correct, 100% common share or options.

Dave Windley - Jefferies

Following up on the labor question, I got your number. From an acceptance rate standpoint, Dr. Li, have you seen your number of offers being accepted remaining at about the same rate, or has that increased or decreased this year?

Ge Li

Actually, our reported acceptance rate is better than in the past years.

Dave Windley - Jefferies

My angle there is competition and I guess WuXi is seen as a preferable place to work relative to the competition. Are you able to differentiate yourselves in that respect?

Ge Li

I would like to think so, yes.

Dave Windley - Jefferies

On the labor rates, are you seeing any acceleration in the labor rates from the new hire base?

Ge Li

David, I'd like to report to you I am happy, actually. In 2007, we strengthened our leadership position in China, because to the best of our knowledge, the revenue difference, the number of customers between WuXi and other companies in China actually are widening. So we feel very comfortable about our leading position.

Dave Windley - Jefferies

Did I understand correctly that the average revenue generated year-to-date by the top ten was $7.4 million. Was that right?

Ge Li

Yes.

Dave Windley - Jefferies

The top ten revenue concentration on a year-to-date basis is how high?

Ge Li

It's around 75%.

Operator

Your next question comes from Jinsong Du - Credit Suisse.

Jinsong Du - Credit Suisse

Specifically on the Vertex project, could you share with us in the research manufacturing revenue in the third quarter, what percent is from this single largest contract with Vertex.

Ge Li

Jinsong, it's our company policy we don't discuss customers’ specific information without consent from our customers.

Jinsong Du - Credit Suisse

Could you tell us then -- because this quarter the gross margin from research manufacturing, my calculation was 42.4% which is higher than in the past. So is that mainly Vertex-related projects having a higher margin than other research manufacturing projects, or are they similar?

Benson Tsang

They are similar. In fact, Jinsong, I just want to highlight with different projects we may have a little bit of variation in the gross margin, but overall it's about the same range.

Jinsong Du - Credit Suisse

Going forward for the research and manufacturing, do we expect more than 40% gross margins or even improving gross margins going forward for research and manufacturing?

Benson Tsang

Jinsong, as I mentioned earlier, we will continue to focus on the operating efficiency including the cost and production efficiency of our manufacturing facilities.

Jinsong Du - Credit Suisse

New clients you signed up for both lab services and research manufacturing, did you manage to basically because of the appreciation of the RMB, did you manage to pass the impact of the RMB appreciation into the ASP you are quoting to the clients? Basically, do we see an increase in the general pricing with the new customers?

Ge Li

Jinsong, I'm sorry, we don't comment on commercial details of our contracts with the customers.

Operator

Your next question comes from Bin Li - Merrill Lynch.

Bin Li - Merrill Lynch

I want to follow-up on the Vertex question and I hope you don't mind because I think you appreciate this is something that's going on in a lot of investors minds as well. On that, can you tell us from your understanding from your partner, Vertex, on the drug production schedule for Phase III and presumably for early commercialization batch, is there any change in your delivery schedule? Can you tell us that?

Ge Li

Bin, again, as our company policy, we don't discuss customers’ confidential information without consent from the customer. But I'd also like you to pay attention on our revised annual results, because in 2007 we revised up our annual guidance from $128 million to $132 million to $131 million to $135 million.

Bin Li - Merrill Lynch

The bigger question for me is when you will have a better idea on whether you will become the long-term supplier for this contract, for the commercialization of Vertex's drug?

Ge Li

Well, again, it's our company policy that we don't discuss customer information without consent from the customer.

Bin Li - Merrill Lynch

Presumably you're also seeking other manufacturing contracts to increase revenue stream and to diversify risk. I was wondering whether you can give us some updates on the progress on that effort/

Ge Li

Bin, if you remember, we built our research and manufacturing to take advantage of our strong process research capabilities. This year we expanded our process capacity and we see more projects coming in and we certainly hope in the future we will have more Vertex-like projects.

Operator

Your next question comes from Tycho Peterson – JP Morgan.

Tycho Peterson - JP Morgan

I'm just wondering if you can comment generally about pricing trends, to the extent you've had any increases or how you view your ability to command pricing from your customers going forward?

Ge Li

I think since day one we focused on building our capability and capacities to provide value-added, high quality service to our customers. I think during the past six or seven years we have demonstrated ourselves. I think our customers acknowledge that and again, we don't comment on commercial details of the contracts with our customers.

Operator

There are no further questions at this time. At this time I'd like to turn the call back over to management for any additional or closing remarks.

Ge Li

Thank you, everyone for joining WuXi PharmaTech's third quarter 2007 earnings conference call. See you next quarter. Good morning.

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