China Nepstar Q3 2007 Earnings Call Transcript

| About: China Nepstar (NPD)

China Nepstar Chain Drugstore Ltd. (NYSE:NPD)

Q3 2007 Earnings Call

December 11, 2007 8:00 am ET


Rachel Levine - The Global Consulting Group

Simin Zhang - Chairman of the Board

Jiannong Qian - Chief Executive Officer

Andrew W. Chen - Chief Financial Officer, Vice President

Lucia Qian - Director, Marketing and Investor Relations


Caroline Lee - Goldman Sachs

Ben Lee - Merrill Lynch

Hal Hong - Susquehanna

Barbara Miller - Federated Investors

Michael Cass - Barron Capital


Greetings and welcome to the China Nepstar third quarterearnings conference. (Operator Instructions) It is now my pleasure to introduceyour host, Ms. Rachel Levine with Global Consulting Group. Thank you. You maybegin.

Rachel Levine

Thank you. If you have not received a copy of Nepstar’sthird quarter 2007 earnings press release, it is currently available on thecompany’s website at A presentation to accompany today’s calland live webcast is also available on the website under the investor relationssection.

Before we begin, I would like to remind you that certainstatements that are not historical facts made during the course of thisconference call about future events and financial results constituteforward-looking statements that are made pursuant to the Safe Harbor provisionsof the Private Securities Litigation Reform Act of 1995. You should note thatthe company’s actual results may differ materially from those projected inthese statements due to a variety of factors affecting the business.

Forward-looking statements are subject to risks anduncertainties. Discussions of the factors that may affect future results arecontained in the company’s filings with the Securities and Exchange Commission.Nepstar undertakes no obligation to correct or update any forward-lookingstatements provided as a result of new information, future events, or evenchanges in expectations.

Joining us on today’s call are Dr. Simin Zhang, Chairman ofthe Board; Mr. Jiannong Qian, Chief Executive Officer; Mr. Andrew Chen, ChiefFinancial Officer; and Ms.

Lucia Qian, Marketing and IR Director, who will also be ourtranslator during the question-and-answer session. We will be translatingquestions and answers and ask your patience at that time.

Mr. Qian, the CEO, will now deliver his opening remarks. Pleasego ahead, sir.

Jiannong Qian

Thank you, Rachel. Good morning and good evening. I wouldlike to welcome you all to China Nepstar Chain Drugstore’s third quarter 2007financial results conference call, our first conference call as a publiccompany.

For those of you who are new to our company, we are China’slargest drug store chain by the number of directly operated stores. As ofSeptember 30, 2007, we have 1,791 stores in 62 cities in Mainland China. Inaddition, we also have 11 regional distribution centers and one headquarterdistribution center.

And 2007 has been an exciting year for us and it’s also atremendous milestone. On November 9, 2007, we successfully completed ourinitial public offering of 20.6 million American depository shares,representing 41.3 ordinary shares on the New York Stock Exchange. That deal hasprovided us with the financial wherewithal to continue to pursue our businessstrategy, which is to increase revenues through same-store sales and new storeopenings, drive margin growth through private label offerings and centralizedprocurement, and enhance operating efficiency and [keep] cost control.

Now let me turn the call over to Andrew, our CFO, who willdiscuss the financial results of the third quarter. After Andrew finishes hisprepared remarks, he will join me, Dr. Zhang, and Lucia to take your questions.Andrew, please.

Andrew W. Chen

Thank you, Mr. Qian. Ladies and gentlemen, I’m glad toreport a strong third quarter 2007, as indicated by tremendous growth in ournet income and our gross margin. One of our growth drivers for the quarter wasthe optimization of our product portfolio, specifically the increased share ofour private label products and the centralization of our procurement process.

Let me now walk you through our numbers. Our revenue grew6.6% RMB484.3 million, or $64.6 million, over third quarter 2006. Our growthwas affected by strategic initiatives implemented in August 2007 to optimizeour product portfolio. Specifically, we added more high margin merchandise toour product mix and pulled low margin ones off our shelves, which affectedrevenues for much of the quarter.

We saw sales begin to increase again at our projected pacein September, as we completed the product portfolio overhaul.

Let me give you a breakdown of our segments during the thirdquarter. Sales of prescription drugs accounted for 23.3% of our revenue,compared to 23.7% in the third quarter 2006. Over-the-counter drugs represented34.4% of the revenue compared to 35.9% in third quarter 2006. Nutritionalsupplements represented 19.3% compared to 17.1% in third quarter 2006. Herbalproducts represented 2.7% compared with 1.9% in third quarter 2006, and othermerchandise accounted for 20.3% compared to 21.4% in third quarter 2006.

We opened 179 new stores during the third quarter.Same-store sales for those that opened before December 31, 2005 declined 1.9%compared with the prior year’s period, due to the strategic decision todiscontinue certain low margin products and shift the revenue mix to highermargin private label products, which were mentioned above. Again, we havealready seen a recovery in the revenue trend from the shift.

In third quarter 2007, we also increased the number of ourprivate label products to 1,177. Private label products contributed 18.3% ofthe company’s revenue and 28.6% of the gross profit for the third quarter, andapproximately 17.8% of the revenue and 30.2% of the gross profit for thenine-month period. Developing private label products has been one of our corebusiness strategies.

Private label branding gives us more freedom and flexibilityin pricing and more control over product attributes and quality. Our long-termgoal is to raise the revenue contributions from private label merchandise to40%.

Our gross profit grew 40% for third quarter 2007 to RMB228.2million, or $30.5 million over third quarter 2006. Our gross margin increasedto 47.1% compared to 35.9% in the third quarter 2006. Again, this was drivenprimarily by the changes in our product portfolio to increase therepresentation of high margin products, as well as our enhanced efforts toconsolidate procurement of merchandise from fewer suppliers. By centralizingour purchases, we have been able to gain margin power with our suppliers andwin more favorable terms from them. Increased economies of scale realized byour large network of retail outlets have also contributed to significantimprovements in our gross margin.

Our sales, marketing, and other operating expenses for thirdquarter 2007 increased 14.2% to RMB154 million, or $20.6 million over thirdquarter 2006, primarily due to the costs of new store openings and additionalhiring to support this expansion.

General and administrative expenses decreased 1.3% to RMB15.9million, or $2.1 million, compared to RMB16.1 million for the third quarter of2006, thanks to our cost control initiatives.

Our operating income jumped 381.9% to RMB58.4 million, or$7.8 million over third quarter 2006.

Lastly, our net income surged 512.6% to RMB46.3 million, or$6.2 million over third quarter 2006. This translates into RMB0.28 or $0.04 indiluted earnings per share, compared with RMB0.03 in the third quarter 2006.

Now let me briefly tell you about our financial results forthe first nine months. Nine-month revenue rose 14.1% to RMB1.4 billion, or$190.9 million, compared to the first nine months of 2006. Nine-month revenuecontribution from prescription drugs was 24%; OTC drugs represented 35.1%;nutritional supplements represented 18.9%; traditional Chinese herbal productsrepresented 2.5%; and other products represented 19.6%.

We opened 376 new stores during the nine months of 2007.Same-store sales increased 4.6% compared to the same period last year.

Gross profit rose 42.7% to RMB608.6 million, or $81.2million for the nine-month period over the same period in 2006. Gross marginwas 42.5% compared with 34% for the same period of 2006.

Nine-month operating income was RMB119.4 million, or $15.9million, compared with RMB3.1 million for the same period of 2006.

Sales, marketing, and other operating expenses rose 15.6% toRMB437.1 million, or $58.3 million, over the same period in 2006, primarily dueto increased salaries and bonus payments in connection with an increasedheadcount as a result of the continuous expansion of our store network. Theincrease in sales, marketing and other operating expenses was also due largelyto higher rental and utility expenses for our drug store outlets anddistribution centers, and increased depreciation for store and distributioncenter leasehold improvements and store equipment, as we open additional drugstore outlets and additional distribution centers to accommodate our growth.

Nine-month net income was RMB89.7 million, or $12 million,compared with a net loss of RMB4.1 million for the nine months of 2006. Dilutedearnings per share was RMB0.54 or $0.07, compared with diluted net loss pershare of RMB0.14 for the same period of 2006.

Our cash position is strong. As of September 30, 2007, ourtotal cash and cash equivalents was RMB136.1 million, or $18.2 million,compared with RMB83 million as of December 31, 2006. Total shareholders equityincreased to RMB74.2 million, or $9.9 million, from a total shareholdersdeficit of RMB2.4 million as of December 31, 2006.

Let me switch gears now and talk to you about the outlook ofour business. Our IPO on NYSE on November the 9th raised gross proceeds of$384.2 million, including over allotment options with net proceeds ofapproximately $350 million. We intend to use the proceeds to open more storesand distribution centers in China, extending our market presence and customerreach. As we grow, our ability to leverage centralized purchasing will increaseas will our private label capabilities. We are also focused on enhancingoperating efficiency and cost controls through upgrades to our IT and inventorymanagement systems. Finally, we will be evaluating synergistic acquisitionopportunities where we can utilize capital for maximized returns and accelerateour growth.

At this point, I would like to spend a few minutesdiscussing [guidance] for fiscal 2007 and give you some perspective on ourbusiness operations.

For the fiscal year 2007, we expect to generate betweenapproximately RMB1.95 billion to RMB1.96 billion in revenue. Our net income isexpected to be between approximately RMB147 million to RMB150 million.

I would like to emphasize that this outlook is based on ourorganic store performance and approximately 210 brand new store openings in thefourth quarter. These target updates on our current views on the operating andmarket conditions, which are subject to change, of course.

As we move forward, we will issue annual guidance to thebest of our ability now that we are a public company. Of course, this guidancewill also be based mostly on organic growth and certain projected new storeopenings. We anticipate issuing guidance for fiscal 2008 in conjunction with orshortly after our release of fiscal 2007 results.

Finally, before we conclude, we would like to share somethoughts on the outlook for Nepstar and our industry in the future. Nepstar’sblend of superior customer service, broad geographic reach, and extensiveproduct offerings at competitive prices has made us the market leader and webelieve that we are well-positioned to capitalize on the demographic trends andregulatory changes in China’s pharmaceutical retail industry to enhanceshareholder value.

China’s fast-growing economy has led to increases indisposable income, improvements in standards of living, and acceleratedurbanization, which have made pharmaceutical products more affordable andspending on pharmaceutical products more common. Moreover, China’s agingpopulation is a key contributor to the increased expenditures on pharmaceuticalproducts we have seen in recent years. The portion of the Chinese populationage 60 and above has increased in both absolute numbers and as a percentage ofthe total population and we believe this trend is likely to continue in thenext decade.

Several initiatives implemented by the Chinese Government inan effort to improve consumer experiences and outcomes and reduce corruptionhave also been spurring the growth of the retail pharmaceutical industry.Anti-corruption measures targeting procurement and drug dispensing ingovernment-owned hospitals have created more growth opportunities for non-hospitaldrug stores. Pharmaceutical product labeling and prescription managementpolicies have weakened hospitals’ monopoly on prescriptions and prescriptiondrugs. Regulating the advertising of pharmaceutical products is expected toincrease manufacturers’ reliance on retail pharmacies to build brands amongstthe general public.

The increased availability of funding under the NationalMedical Insurance program and inclusion of more pharmaceutical products inChina’s National Medical Insurance scheme is also expected to significantlyincrease prescription purchases. [Additional participants] in the NationalMedical Insurance program mainly consisting of urban residents are entitled tobuy medicines when presenting their medical insurance cards in an authorizedpharmacy, as long as their medicines have been included in the insuranceprogram catalog published at the national or provincial level. Nepstarcurrently has 480 medical insurance designated pharmacies.

We have also recently learned that the Chinese Government isin the process of developing new regulations to separate drug prescribing anddrug dispensing in China. We are closely following these developments and areanalyzing how we may capitalize on opportunities coming out of any newgovernment policies.

With that, let me join Dr. Zhang, Mr. Qian and Lucia to takeyour questions. Operator, please begin the Q&A.



(Operator Instructions) Our first question comes from Caroline Leewith Goldman Sachs. Please state your question.

Caroline Lee -Goldman Sachs

Thank you. Well, first of all, congratulations on the verysuccessful IPO and a high growth quarter that just ended. I do have threequestions for the management. First, could you provide some more informationregarding potential acquisitions, especially around the timing and possiblesize of those acquisitions?

The second question is about store openings. I wonder ifmanagement could provide some guidance on store opening plan in 2008 and ’09,and the third question is regarding gross margins. Mr. Chen just mentioned onthe private label penetration is targeted to contribute 40% of revenue. I waswondering what kind of timing are we talking about and what is your view onsustainable long-term gross margins? Thank you.

Lucia Qian

Please allow one minute for me to do the translation.

Just then, the speaker was Mr. Jiannong Qian, our CEO. Mr.Qian said that at the moment, we have been contacting many of the potentialacquisition targets and we have been carrying out various negotiations and weare, at the management level, very much confident that the 2008, we will havesuccessful cases in terms of acquisitions, although at the moment, we do nothave anything to disclose.

For the fourth quarter of 2007, we will definitely completeour target of opening 210 drug stores in China and for the year 2008, our storeopening plan will be 1,050 new drug stores in China.

Caroline Lee -Goldman Sachs

-- beyond ’08?

Lucia Qian


Caroline Lee -Goldman Sachs

-- the guidance for 2009?

Lucia Qian

We do not provide guidance for 2009 at the moment but we dobelieve that we will open as many as, if not more than, year 2008.

To your third question of the timeframe for us to reach that40% contribution by private label products, we would aim to reach that 40% ofcontribution by year-end 2008 and we’ll see that in the year 2007 Q3, our grossmargin rate has already made quite a substantial improvement over that ofquarter two. Quarter three we had a gross margin rate of 47.1% and the numberin quarter two is 42.6%, and we will forecast a further improvement in terms ofgross margin rate in quarter four this year and of course, for next year, wewill see a further improvement of gross margin right along with that improvementof the private label products contribution.

I hope that we have answered those three questions that youraised, Caroline.

Caroline Lee -Goldman Sachs

Yes, just a follow-up on the gross margin; what ismanagement’s view on the sustainable long-term gross margin? Do you think -- atwhat level do you think you’ve reached the ceiling of the gross margin and onceyou reach there, do you think you are going to see it slightly decline or areyou going to stay at that level?

Lucia Qian

Before we really drop an answer to what is the ceiling ofthe gross margin rate, we would like to share our views as to the potentialspace for us to further improve our gross margin on top of our already prettyhigh 47% of the gross margin rate in Q3.

At the moment, you will see that 40% of our totalprocurement is still down at the regional level and those regionally procuredproducts actually have an average gross margin rate of less than 20%. Nextyear, we will enhance the proportion of centralized procurement and to minimizethe contribution of those products procured at the regional level.

With improvement of the contribution by centralizedprocurement, we will see that our gross margin rate will have a significantgrowth and at the same time, as we have just mentioned, that we will try tointroduce more of our private label products and the contribution, the growingcontribution made by our private label products will also contribute to ahigher gross margin rate. Therefore, although we cannot give you a specificdate, or specific data as to where the ceiling lies but we do see that at leastfor the next few years, there is great room for Nepstar to further improve itsgross margin rate.

And we would like to share with you our view of theimprovement that we are going to make in quarter four in terms of gross marginrate. We will improve our gross margin rate to a range of 48.5% to 50% inquarter four in terms of gross margin rate, and that already is an improvementover that of quarter three.

Caroline, are you happy with that answer?

Caroline Lee -Goldman Sachs

Yes, great. Thank you very much.


Thank you. Our next question comes from Ben Lee with MerrillLynch. Please state your question.

Ben Lee - MerrillLynch

Thank you. Congratulations first for the IPO. I want to aska few questions on the quarter first. First, you’ve improved gross marginsubstantially during the quarter. One might say this comes at the expense ofsoft or weak top line growth. I just want to hear your comments on that,because your top line growth for the third quarter is right around 7%, which islower than the first half, which is right around the high teens year-over-yeargrowth. Would you provide some color on that?

Lucia Qian

We’ll see that in quarter three, we successfully havebrought up the gross margin rate and we agree that the top line growth wasrather weak in quarter three compared to the growth of the first two quartersof this year, and we have to say that this is quite within the management’sexpectations.

This is partly because that in August, we started a campaignof streamlining our product portfolio and within that one-month campaign, wehave discontinued quite a lot of products that are of very low margin, andthose discontinuations of those low margin products did bring some disruptionto our store operations. Therefore, we’ll see in August that sales wereimpacted by this campaign, although as a result we have substantially improvedour gross margin rate.

But we are happy to see that in September, the revenue hasdemonstrated quite a strong comeback from a dip in August and we’ll share withyou some of the data of the same gross sales.

We took the 1,084 stores that were opened by year-end 2005and we see that for those stores, in the first quarter of 2007, per store perday output was RMB4,035, store revenue. And for the second quarter, per storeper day output was RMB3,962. And for quarter three, because of the reasons thatwe have just mentioned, the campaign, that the same-store sales did show adecline to RMB3,857. However, because we have seen the trend has come back, wewill be quite confident to say that for the fourth quarter, we will see thesame-store sales per store per day to be improved to RMB3,948 and that isalmost back to the level of the first two quarters.

And for this fourth quarter, we will try to grow our revenueas well as our gross margin rate at the same time.

Ben Lee - MerrillLynch

Great. Thanks for sharing the same-store sales number. Justa follow-up question on that; it is interesting -- you know, you comment onsame-store sales for your company but regarding whether you know any data,similar data for the industry. What is the trend for the same-store sales forthe industry?

Lucia Qian

Well, for the industry wide, national wide, we’re sorry butwe don’t have any accurate statistics released by the government, so we can’tprovide you with that. However, we do observe our peers in Shenzhen, where wehave some of the chains that are saying that they are reporting a quitedisappointing Q4 and some are having very flat growth. And we will see thatthis is possibly due to our very strong Q4 performance and that has posed acompetition pressure to our peers in the Shenzhen area.

And just then, it was our Chairman, Mr. Zhang Simin. Hewould want to add that as far as to his understanding, for a lot of our peersnationwide, those chains did not actually adopt as aggressive store openingstrategies as Nepstar does and most of them did not grow their scale for quitea long time.

And we know that there is actually no one within thisindustry except Nepstar that has the profitability level and the successfulprofitable model and we actually think that even for same-store sales, we areactually among the best.

And as to -- just refer to what Mr. Zhang just said, that inQ4 and in the long run, the company is determined to grow same-store sales orrevenue alongside with the growth of gross margin rate and we are now having aneven clearer view as to how we should implement all our strategies and how weshould try to in the long run to reach our strategic aim of bringing up thosevery important key indicators in our business. And for that improvement, thecompany and the management is full of confidence.

Ben Lee - Merrill Lynch

Great. If I could, just one more question on the guidance;if I take the midpoint of your revenue guidance, it implies that you areprojecting 4Q sales to be at roughly RMB524 million, which implies about a 10%year-over-year growth burst. Is my math correct?

And second, also if I apply the same math, I think you aresuggesting your 4Q net income will be something like RMB60 million and thisimplies actually 11% net margin, which is substantially higher than your 3Q netmargin. So my question is whether the net margin improvement from mycalculation is mostly coming from the gross margin improvement or you are alsogetting some leverage on the operating costs?

Andrew W. Chen

Let me take this question. I think you are absolutelycorrect on your calculation and the numbers, both the revenue and net incomethat you quoted in your question were consistent with what we had projectedwhen we were doing the road show before the IPO in NYSE.

I would say that the improvement in our net income, thebottom line, is contributed to several factors. First of all, the top line hasbeen growing. I think the revenue is coming in at a significantly higher levelsthan in comparison with third quarter results and at the same time, our grossmargin is approaching 50%, estimated to be between 48.5% to 50%. And also wehave been keeping a very close eye on our expenses, so expenses are alsoexpected to be under control and actually for the first two months that alreadyclosed, that we have seen all these factors, all these pieces come in prettynicely, so we are standing behind with what we have promised the market when wedid the road show.

Ben Lee - MerrillLynch

Thanks. I’ll go back to the queue.


Thank you. Our next question comes from Hal Hong with SIG.Please state your question.

Hal Hong -Susquehanna

Good morning, guys. My questions are very similar to theearlier questions that have been raised by the other analysts. I just wanted tofollow-up on the same-store sales. Just now you disclosed the same-store salesfor the four quarters this year. I’m just wondering whether you have the samenumbers for last year.

Lucia Qian

Mr. Hong, would you please clarify your question? Should Iunderstand that you are asking for the same-store sales number for year 2006for the four quarters, right?

Hal Hong -Susquehanna

That’s right.

Andrew W. Chen

The same-store sales for the 1,084 stores during 2006 on anannual basis was RMB4,000.

Hal Hong -Susquehanna

For the entire year 2006?

Andrew W. Chen

For the entire year, yes, 2006.

Hal Hong -Susquehanna

Also, I understand that for this quarter, your top linegrowth was impacted by your change in the product mix. I’m just wondering forthe long run, what do you see as a sustainable same-store sales growth for yourstore network?

Lucia Qian

We’re happy to say that we are actually in the finishingphase of our streamlining of existing product portfolios, therefore we don’texpect to see severe campaigns in the next years to come.

And at the moment, we are trying to optimize our productofferings. We are, starting from this quarter, are going to put more emphasisin building stronger categories in terms of traditional Chinese herbs,nutritional supplements and personal care products. And we believe thosefront-end product offerings will improve the vast size of our traffic and atthe same time, increase the traffic into our stores. And that will contributeto a better same-store sales growth.

At the same time, because we are standing on a rather goodprofit margin and we will be even stronger and even aggressive in terms ofhaving our marketing campaigns and that will help us to gain a better marketingadvantage over our competition and that will actually help us to grow strongersame-store sales.

With all those measures that we are actively taking, wethink that the year 2008 will turn out to be a much stronger same-store salesperformance compared to what we had in the year 2007 and we again are quiteconfident that we are going to grow our revenue alongside with the growth ofour gross margin rate.

Hal Hong -Susquehanna

Okay. Also, another question on the gross margin; youmentioned that by -- probably by the end of 2008, you will have 40% privatelabel in your store. I’m just wondering then for the branded medicines and alsofor -- there’s another type of medicine. I think it’s called non-centralprocured, or central procured medicine. So what would be the percentage forthat mix for those products?

Lucia Qian

Okay. Our aim is that by the year end of 2008, private labelproducts is going to contribute 40% of the total sales and for our centrallyprocured, non-private label products, the contribution shall reach 40% and wewill bring down the contribution by those locally procured products to 20%.

We are actually changing our contributions or improving ourcontributions by different categories as we just described and at the sametime, we think because we have been literally growing our store networks ineach region that we are present in, for those regionally procured products weare actually having good chances to further improve their margin contributions.And at the moment, the gross margin for those products are less than 20%. Wehave good chances to improve that to above 20%.

Hal Hong -Susquehanna

Thank you.


(Operator Instructions) Our next question comes from BarbaraMiller with Federated Investors. Please state your question.

Barbara Miller -Federated Investors

Thank you. Just a clarification; you have talked aboutcontrolling your corporate expense but you are growing rapidly. What exactlyare you doing now and how sustainable is that as you go into next year, just onthe corporate expense line? Thank you.

Andrew W. Chen

The controls on corporate -- when you talk about corporateexpenses, are you referring to general administrative expenses or overallexpenses?

Barbara Miller -Federated Investors

Yes, I understand.

Andrew W. Chen

Are you referring to overall expenses or are you onlyinterested in administrative expenses?

Barbara Miller -Federated Investors

I was interested in the administrative, the centraladministrative expenses.

Andrew W. Chen

We have been taking actions, including we have relocated ourheadquarters from a more expensive location to the current location and savedsignificantly on our rental expenses. And at the same time, we keep a veryclose eye on the headcount that we hire into the headquarters to support ourbusiness across the country. And at the same time, I think for the logisticsexpenses, which are part of this administrative expenses, the distributioncenter related expenses, we are also tracking them very closely and we believethat -- I can quote you some numbers.

For Q3, the expense ratio for general administrative expenseswas 3.3%, which is a -- there was a 0.3 -- in comparison with the Q2 of 2007,there was a 0.8% decrease and then that’s because if you -- in Q2 of 2007,there was a RMB5 million of auditing fees that were charged in Q2. If you takethe fees out, I think the two quarters, the expense ratio for administrativeexpenses ratio have remained very stable.

And then into Q1, we are estimating that the expense ratiofor the administrative expenses is going to further go down to 3.1%.

Barbara Miller - FederatedInvestors

Okay, so you don’t foresee any significant expenses relatedto the growth as you go into next year?

Andrew W. Chen

No, I don’t think so. Because our growth is actually on astore level, right? And then as you increase the store network, it doesn’tnecessarily would have to increase -- you have to increase the headcount or youhave to lease for bigger offices, those kinds of things. I don’t expect this tohappen.

Barbara Miller -Federated Investors

Okay. Thank you very much.


Thank you. Our next question comes from Ben Lee with MerrillLynch. Please state your question.

Ben Lee - MerrillLynch

Thanks for taking my follow-up questions. I have a couple ofquestions regarding the government policy. We noticed recently, actually justlate last week, the government said that they are considering some newmechanisms to control the drug prices in China and we noticed that there weretwo proposals specifically related to the drug store industry.

First, the government is saying that they want drug makersto print or to display the manufacturing price on the drug package. That’s thefirst thing. Also, the government wants to equalize the drug price in hospitalsand the retail drug stores, making the price to be the same.

I was wondering whether you have a view on these proposalsand what do you think the potential impact is to your company or to theindustry.

Lucia Qian

Mr. Qian would like to tell everyone that last week, heattended a committee meeting of CACDS, which is China Association of Chain DrugStores and over that quarterly meeting, several drug stores and the associationhad various discussions over those said proposals to the government. And it isdiscussed that first of all, there have been so to speak rumors that there willbe such a proposal taken by the government but it is still within very heateddiscussion and we don’t foresee that it will be launched in the very nearfuture.

Even if it is one day adopted by the administration, westill don’t think it’s going to be a negative impact to Nepstar because whileNepstar actually is the biggest chain drug store in China and with the biggestprocurement volume, and we do have our private label products and as you know,for any manufacturer, if you want them to specifically calculate theX-manufacturer prices, you have to take into account not only the raw material,labor costs, but lots of other factors like goodwill, et cetera. And we don’tthink that the manufacturers will be strictly controlled, or will be strictlymanipulated by any forces to demonstrate very similar factory prices andNepstar, as you know, has always been quite price competitive compared to thosesmall chains.

We don’t actually think, first of all, this is somethingvery practical for the government to adopt because we have 6,000 manufacturersin China and it’s just impossible to really gauge who is going to or who istelling the factual price on their boxes. And at the same time, as you do know,Nepstar is very price competitive and we don’t think that we are going to leaveany bad impression to our customers because our products are very pricecompetitive compared to our peers.

And at the same time, the company is going to carefullymonitor what possible actions that the government is going to take on thattopic. Mr. Zhang Simin just said that we’ll have to see it from the otherangle, which is the intention of the government to launch various actions tocurb the price, curb the selling price of certain pharmaceuticals. And webelieve that the intention of the government is trying to lessen the burden onthe patient because there is actually quite serious over prescription in thehospitals to those patients. And if there is no incentive for the doctors toover prescribe as the result of any government measures and those hospitalswill not withhold all those prescriptions within their hospital pharmacies andthe patients will have more freedom to take their prescriptions out to befilled at the chain drug stores.

Ben Lee - MerrillLynch

Thank you.


Ladies and gentlemen, we are out of time for questions. Thiswill be our final question. Anyone who was not able to ask their questions,please feel free to follow-up with investor relations after the call. Our finalquestion comes from Michael [Cass] with Barron Capital. Please state yourquestion.

Michael Cass - BarronCapital

Thank you. Could you give a little more detail on how youtrade off during the inventory streamlining? How do you trade off revenues forgross profit? Because obviously there was some impact on your revenue growthduring the streamlining, so I guess I’m trying to understand -- was that justan inventory issue or could you be specific about when you switch over toprivate label, how much lower the products revenues are but then how many grossprofit dollars come back versus what that product was replacing? Thanks.

Lucia Qian

Actually, to elaborate on what we did over that campaign, wediscontinued quite a lot of known products that have a very low margin contributionand those mostly are those locally procured products. We replaced thoseproducts with very low margin contribution with our private label products orwith the products that we procured centrally.

And you know, if we do such replacing of the productportfolio, we will actually incur those re-planogramming of our stores and wewill actually move things from this shelf to the other shelf and that willactually disrupt our store operations. And because of such disruptions, we dosee that for the transaction traffic in Q3, we are losing certain of ourtraffic.

For example, in quarter two, our per day per storetransaction volume is 145 times for those same stores opened by year-end 2005and in Q3, we see that the transaction times was down to 136. That means thatwe are losing around 9 transactions per store per day and the loss oftransactions, or I’ll say the loss of traffic is the trigger to a lowersame-store sales performance in year 2003.

But as our store sales are gradually used to the new planogramsand our customers are gradually used to the new store display and actually tryand come back for those new products, we see that we are getting back thosetransactions gradually and especially in Q4. Every month we are seeing apick-up in terms of transactions for those same-stores. We think thatdisruption to our traffic and to our same-store sales is quite temporary and in4Q, we are actually going to have a stronger same-store sales.

And in this quarter, quarter four, we are still graduallygrowing our gross margin rate but we are also seeing that the revenue andsame-store sales is recovering and that recovery is actually ascending on ahigher platform of our gross margin rate, therefore we see that we have met ourgrowth when we started that campaign in August.

Michael Cass - BarronCapital

Thank you.


There are no further questions at this time. I will turn theconference back to management for closing comments.

Jiannong Qian

Thank you for joining us on this conference call and we lookforward to updating you on our first quarter results. Thank you, everyone.


Thank you. To access a replay of this conference, pleasedial 877-660-6853, and for international dialers, please dial 201-612-7415. Thereplay account number is 286 and the conference ID number is 264885. Onceagain, to access a replay, please dial 877-660-6853; international dialers dial201-612-7415. The replay account number is 286 and the replay conference IDnumber is 264885. This replay is available until December 18, 2007.

Thank you. Have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!

About this article:

Tagged: , Drug Stores, China,
Error in this transcript? Let us know.
Contact us to add your company to our coverage or use transcripts in your business.
Learn more about Seeking Alpha transcripts here.