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China Expert Technology Q1 2007 Earnings Call Transcript

posted on: May 14, 2007 | about stocks: CXTI.OB

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TRANSCRIPT SPONSOR

China Expert Technology, Inc (CXTI.OB)
Q1 2007 Earnings Call
May 14, 2007 4:30 pm ET

Executives

Matt Hayden - Hayden Communications, IR
Simon Fu - Chief Financial Officer

Analysts

Josh Jabs - Roth Capital
John Henderson - JBH Capital
Jeff Feinberg - JLS Asset
Alice Cui - Brazos Capital
James Doyle

Presentation

Operator

Good afternoon. My name is Vanessa, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the China Expert Technology’s First Quarter 2007 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period (Operator Instructions).

It’s now my pleasure to turn the floor over to your host, Mr. Matt Hayden from Hayden Communications. Sir, you may begin your conference.

Matt Hayden

Thank you, Vanessa. We’d like to thank everyone who is joining us this afternoon to discuss China Expert financial results for the first quarter 2007.

Our call today will be hosted by Mr. Simon Fu, the company’s CFO, who will provide a summary of first quarter results including an update on recently announced contracts and implementations schedules, in addition the progress the Company has made in securing new contracts outside of the Fujian province.

Before we get started, I’ll review the Safe Harbor statements. Statements in this conference call that are not descriptions of historical facts are forward-looking statements relating to future events, and as such, all forward-looking statements are made pursuant to the Securities and Litigation Reform Act of 1995.

All forward-looking statements related to business of China Expert and subsidiary companies, which can be defined by the use of such forward-looking terminology, such as, believes, expects, or similar expressions involve known and unknown risks and uncertainties.

China Expert Technology under no obligation and expressly disclaims any such obligation to update or alter its forward-looking statements whether as a result of new information, future events or otherwise. The Company is subject to this consideration of risks in operating in the PRC. These risks are associated with political and the economical system as well as foreign currency exchange, etcetera.

I’d also like to make a GAAP note. In addition, this call includes financial measures for net income or loss and diluted earnings per share calculation, which exclude certain non-cash costs not calculated in accordance with Generally Accepted Accounting Principles or GAAP.

Management believes that these non-GAAP financial measures provide meaningful supplemental information regarding the Company’s performance that enhances management's and investors' ability to evaluate the Company's net income and income per share and to compare it with historical net income and income per share prior to the adoption of SFAS 123R by the company effective January 1st, 2006.

With that out of the way, I’d like to turn the call over to Mr. Simon Fu. Simon, the floor is yours.

TRANSCRIPT SPONSOR

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Simon Fu

Thank you, Matt. Thanks everyone for joining us for our call today. The first quarter of 2007 was a transitional quarter for the company as we're prepared to commence implementation on several of our new larger contracts announced in 2006.

In a few moments, I will provide investors with some more details to understand our first quarter performance and 2007 outlook. But before we begin, I would like to discuss a few of the positive developments that happened subsequent to the end of the first quarter.

I am pleased to report that on April 30th end of the day, we announced the signing of two new significant contracts, totaling US$58 million or $50.1 million net-off hardware purchase on behalf of customers and excluding the China business tax. This is extremely important for the company, as they are the first two contracts we have signed outside of Fujian and provide tangible evidence that both the electronic government solutions and China Expert's name are gaining momentum in the domestic Chinese markets.

The first contract we announced was with Jinjiang city for the creation and implementation of an electronic government system. The contract is valued at 48 million with the project commencing in September 2007 and continuing over the next two and a half years.

While we are extremely optimistic on the overall size of the Fujian market and believe there is still a sizable amount of business to be won. It has been a corporate initiative doing a portion of the multi-billion dollar electronic government business, a new and under penetrated market throughout China.

Xi'an is a great example of these efforts, as this city has a population of over 8 million, prospering many of the same favorable economical growth characteristics as the largest city, such as, Beijing and Shanghai.

We believe markets, such as, Xi'an where there is a tremendous opportunity for China Expert. As we have now established Xi'an market on successful electronic government project implementations, to do so optimizing on our competitive strengths as one of the largest domestic providers. The combination of these two attributes the importance of our confidence that we can sustain this momentum into new markets.

The second contract we signed recently was with Baise City located in Guangxi Province. This contract is at 1st Phase implementation of the electronic government system for the city valued at US$10 million, the project to be commenced in December 2007 and project to be completed within 12 months.

Before we get to the first quarter results, I’d like to address the importance of the remaining debenture holders converting their position into equity. As a matter of perspective in 2006, we incurred almost US$19 million in non-cash charges that directly impacted our reported GAAP earnings, of which almost US$8.2 million was related to the debenture. With the remaining piece of the debenture now converted, we can expect to see a dramatic reduction in non-cash items impacting our future reported results. Just making it more transparent for investors to recognize the true progress within the business.

Additionally, we continue to move closer towards registering these shares with the SEC, and with its eventual completion, we look forward to moving the company onto a national trading exchange. We will continue to update investors on our progress over the next several quarters.

Now turning to the first quarter results. There were a number of factors that impacted the quarter with the primary reasons relating to contract signing. During the second half of 2006, we completed a substantial portion of the 3rd and 4th Phase of Jinjiang City, the 4th Phase of Dehua, and the 1st Phase of Nan'an, which collectively represented approximately US$25.2 million in total recognized revenue in 2006 and 83% of these contracts in (inaudible).

Most specifically, during the fourth quarter of 2006, we recognized US$5.7 million in revenue from all these contracts, which represents approximately 33% of our total fourth quarter revenue. But during the first quarter of 2007, the revenue from these contracts contributed to less than 5% of our total reported revenues.

While we announced we have $251.7 million in total contracts in 2006, many of these were not expected to meaningfully contribute until the second quarter of 2007 with the pace of new contract implementation expected to accelerate throughout the balance of the year. Such timing issue caused the year-over-year decrease in reported revenue in the first quarter of 2007. We’ve done explanation, now out of the way.

Revenue for the first quarter decreased by 12.4% to $13.3 million as a result of the above mentioned factors. As we look towards the second quarter and beyond, we have several significant contracts that are expected to begin, mainly the Licheng and Shishi city contracts.

These two contracts alone represent US$65.7 million in remaining revenue over the next three years. Additionally, for 2007, excluding both Licheng and Shishi, we believe that there are over RMB180 million in contract that are expected to commence in this year, with an additional RMB6.1 million in partially completed contract that should be recognized by yearend.

Cumulatively, these contracts translated into a backlog of US$257.3 million, of which most of these projects are expected to begin at some point this year. As a reminder to potential new investors, all project start date have occasionally issued.

China Expert has not incurred any contract cancellation or reduced scope of work in the past. Cost of revenue decreased by 22.1% to US$5.7 million, as compared to US$7.3 million in the first quarter of 2006. As a result, gross profit decreased approximately 3% to US$7.5 million. Despite the decline in gross profits, we increased gross margins by 5.4% to 56.9% as compared to 51.5% last year.

The increase in gross margins resulted from the reduced proportion of subcontracted work by means of better utilization of the company’s own workforce to deliver the services, especially for installation of hardware, software, training and system maintenance. We expect that we can maintain this level of gross margins going forward, as we drive higher utilization of our own workforce combined with higher overall revenue level.

Total operating expenses decreased by 51.5% to US$2.3 million, primarily as a result of a positive gain of $2.9 million for non-cash expenses related to change in fair value and amortization of prepared stock based expense and a $1.7 million decrease in non-cash expenses for employee benefits, which was one-time in nature and was experienced in the first quarter of 2006.

As a component of total operating expenses, advertising and marketing costs were US$2.9 million compared to $2.5 million last year. As the company continue to amortize prepaid cash commission in the first quarter of this year for sourcing of those contracts, namely, Cangshan District, Minqing County, Quangang District, Pingtan County, Mawei District and Yongtai County contracts.

On a GAAP basis, operating income increased by 72.6% to US$5.2 million, with reported operating margins of 39.5% compared to US$3 million and 20.1% less, excluding the gain from non-cash expenses related to the change in fair value and amortization of prepaid and stock based expenses during the first quarter of 2007, and also the $0.1 million in amortized prepaid expenses incurred during the first quarter of last year.

Pro forma operating income increased 38% to $4.4 million by excluding the aforementioned items. Operating margins would be 32.9%. The reported net income for the first quarter 2007 increased by 211.9% to US$4.5 million or $0.12 per weighted average fully diluted share as compared to US$1.5 million in the first quarter of last year or $0.04 per weighted average fully diluted share.

For the first quarter of 2007 and for the first quarter of last year, earnings per share calculations were based on $36.4 million and $30.2 million diluted shares respectively. From a balance sheet perspective, on March 31st, we ended the quarter with $21.2 million in cash, an increase of $11.1 million compared to the end of 2006.

During the quarter, we generated US$10.7 million in cash flow from operations and in conjunction with effective working capital management; we increased significantly our cash balance. Working capital stood at US$61.7 million at the end of the first quarter and we have a current ratio of 8.1 times to 1.

Accounts receivable decreased by 8.4% to US$30.8 million, compared to the first quarter of last year with overall receivable across year remaining high at no deferral debt. The company maintains a very strong financial position and we anticipate that existing cash on hand together with positive future cash flow will be sufficient for the working capital requirements for both existing and new contracts.

As for the business outlook in the coming years, the Central Government in China has established a goal that by the end of year 2010, 50% of the government administrative approvals have to be processed through online systems.

The Central Government in China sort of believes that the implementation and the deployment of electronic government systems can improve both the transparency and efficiency of government administration and we anticipate that the ultimate goal will be hiring all administrative approvals to be processed online and electronically.

These factors in combinations with our recent geographic expansion provide the foundation for an optimistic future outlook for China Expert. At this point, given our substantial backlog reach of US $257.3 million and based on the current project implementation schedules, we’re issuing our prior guidance for 2007 and 2008.

For 2007, we expect to report between US$72 million to US$74 million in revenue, with net income of US$20 million to US$21 million. For 2008, we anticipate revenues of between US$124 million to US$126 million and US$35 million to US$36 million in net income.

As a reminder, there are at least two variables to taking into considerations and that is the non-cash charges related to the changes in fair value and amortization of prepaid stock based expenses and also the number of shares outstanding utilized for the diluted earnings per share calculation in each respective reporting period.

The first charge could potentially impact the reported GAAP to net income, but it’s account to anticipate such fair value adjustments. The second factor could impact the reported diluted earnings per share. Currently, the maximum number of shares the Company could have outstanding for calculation of fully diluted earnings per share would be approximately 38.8 million shares.

In conclusion, the first quarter of 2007 targets towards our internal expectations, and we believe we are well positioned to seek our financial guidance, although, we remain to win new contracts both in Fujian and across China, while successfully implementing our contracts in Dehua in timely manner.

With that out of the way, I would like to now open the floor up to any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from Josh Jabs from Roth Capital.

Josh Jabs - Roth Capital

I missed on the contract and thanks for taking my call. And looking at it what it means for other opportunities and maybe in Shaanxi. Can you talk about the process on how the company won the Xi'an contract and what the competitive dynamics are in the province?

Simon Fu

Okay. So basically of Fujian we just announced the recent signing of the contract with Xi'an and also Licheng these two contracts, which are outside Fujian province.

For the Xi'an contract, we have been working on that for quite a long time and because of the business sensitivity we cannot exactly mention that how long we have been penetrating into that new province, which is the Shaanxi province.

And because of the size of it’s project and of course you have pretty some -- of course a little more time for us to penetrate to get the best with the contract. And we have the within that process in the past as we prepared the specific studies and reports for the government and to convince them for the implementations, the benefits. Okay.

And of course the process of the contract has to go through the competitive bidding process. Okay.

And regarding the Baise contract and in fact we tried to immediately note from the project where is some these city government officials has been traveling to Jinjiang, -- our reference site.

And they have a very good hands on experience knowing that what China Experts have performed for the Jinjiang City government, as a result and with efforts of all management team we have kept the Baise the second contract outside the Fujian province.

Josh Jabs - Roth Capital

Okay. And has there been any changes to the way in which you are recognizing the consultant fees, so what do you expect going forward?

Simon Fu

Can you repeat your question? Did you want us to…?

Josh Jabs - Roth Capital

The consultant fees that are paid for the contracts…

Simon Fu

Okay.

Josh Jabs - Roth Capital

There are some -- there had been some discussion on amortizing those costs and how should we look at it? Okay.

Simon Fu

Yes. So basically, right now there are two accounting treatment for the consultancy fees. So for those consultancy fees paid in terms of common stock basically is once we issued the shares then we will recognize the expenses based on the fair value, as of the date of the issue. Okay

And other treatment is for those cash commission that we paid recently for the previous fixed contracts that we have signed in the late 2006. And regarding those cash commissions that we paid at the case of the position of those agents and we have got a gain of amortization of those cash expenses, over the period from the contract at what date up to the project commencement period.

So, basically there are two accounting treatments for the consultancy fee or the commission expense.

Josh Jabs - Roth Capital

Okay. That's helpful. And then finally, you mentioned on the gross margin improvements that some of those improvements came from handling more of the contracts with internal resources. Are you looking to hire additional resources, as you move into some of these new contracts? What are the expectations for gross margins going forward?

Simon Fu

So, definitely we have seen we think among with others as we mentioned in the past, because for the latter part of this year, we are talking about commencement of originally, is around 6 new contracts and in view of the recent filings and that mean we have to commence a total of 6 contracts eventually.

So, we will have to round up our all workforce and resources and it is a heavy project, as Tao mentioned. And of course, regarding the future margin levels, as we mentioned in the past is in a long run basis. We expect that the margin level will be in the range of around 45 to 50.

And at this moment, our margin levels have exceeded and basically because it really depends on the component just like the mix of those revenues that we are earning, especially if the revenue includes 1% or more just like training income and more installation income and this kind of income we have been handling by ourselves. So that’s why we will enjoy a higher percentage of gross margin.

Josh Jabs - Roth Capital

Okay. Great. Thank you.

Simon Fu

Okay.

Operator

Your next question is coming from John Henderson from JBH Capital.

John Henderson - JBH Capital

Hey, Simon congratulations. Actually all my questions have been answered. So, I look forward to next conference call. Thank you.

Simon Fu

Okay. Thanks, John.

Operator

Your next question is coming from Jeff Feinberg from JLS Asset.

Jeff Feinberg - JLS Asset

Simon, congratulations particularly on diversifying revenue mix.

Simon Fu

Thanks, Jeff.

Jeff Feinberg - JLS Asset

Just had one comment, with the excellent cash collection. At least the shareholders would like it. They are using over $20 million in cash I think for a buyback. You could buyback up to 10% of your shares at this very low-P/E, or potentially an accretive acquisition and certainly geographies to continue your excellent performance and to continue to create shareholder value.

Simon Fu

Okay. Jeff thanks for you idea and of course, and although I didn’t know when we do have any plans for low merges and acquisitions. And of course management will always be kind of open minded and we will look for opportunities if there is good term and recent evaluation.

And also we have to look at installations we have our business and principles and business strategies and it is also one of the ways that we can look forward essentially on more geographic expansion.

Jeff Feinberg - JLS Asset

As stated, because I am hearing trying to know and you are always already trying to acquire the brand and whilst the smaller companies would like to be called the growth opportunities. Anyhow thank you very much.

Simon Fu

Thanks, Jeff. Thanks for the idea. Yes.

Operator

The next participant, it’s a follow up from Josh Jabs from Roth Capital.

Josh Jabs - Roth Capital

Simon, just one quick point of clarification here, what was the backlog at the end of the quarter and what is it now?

Simon Fu

So as we have put our numbers on our 10-Q and it’s evaluation is based on cut off, around at the end of April. So it is US$267.3 million, and if we add, today we just announced the second contract outside Fujian Province, the Baise City contract with a net contract sum of 7.7. So, it will come up to a figure of around US$265 million in the backlog by now.

Josh Jabs - Roth Capital

Great. Thank you.

Simon Fu

Okay. Thanks.

Operator

(Operator Instructions) There appears to be no further questions at this time. I would like to turn the floor back to Mr. Simon Fu for any closing comments.

Simon Fu

Okay. So, first I would like to thank everyone to participate in our company’s first quarter earnings call. And thanks for showing patience and especially as I mentioned that, we have some quite positive developments recently. Our first strong point is we have successfully explored to other provinces in China, and hopefully we want to further explore our business and balance our customer base in the future and of course we still get a mix of the debentures right now.

Its really eliminates a lot of those so-called non-cash items. So, hopefully that our investors and readers of our financial statements will have a much easier vision in understanding our business development. And I think that sum up with our first quarter result and thanks to every one.

Operator

Excuse me Mr. Fu, we have Alice Cui from Brazos Capital, want to ask question.

Simon Fu

Okay.