CNTF

China TechFaith Wireless Communication Technology Limited (CNTF)

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TRANSCRIPT SPONSOR
ChinaDirect Logo

China Techfaith Wireless Comm. Tech. Ltd (CNTF)
Q1 2007 Earnings Call
May 14, 2007 7:00 pm ET

Executives

David Pasquale - EVP, The Ruth Group
Defu Dong - Chairman of the Board, Chief Executive Officer
Gilbert Lee - President and Chief Operating Officer
Christopher P. Holbert - Chief Financial Officer

Analysts

Li Tang - Pacific Crest Securities
Adele Mao - Susquehanna Financial Group
Brian White - Jefferies & Company
Tien Yu Sieh - Merrill Lynch
Julie Chen - Brean Murray, Carret & Co.

Presentation

Operator

Good day, ladies and gentlemen and welcome to the first quarter 2007 China Techfaith Wireless earnings conference call. We also would like to thank you for standing by. (Operator Instructions) A replay will be available approximately one hour after the call today throughout midnight on May 21, 2007. At this time, I would like to turn the conference over to Mr. David Pasquale. Please go ahead, sir.

David Pasquale

Thank you, Operator and thank you, everyone, for joining China Techfaith's first quarter 2007 earnings call. With us today are the company’s Chief Executive Officer, Mr. Defu Dong; President and Chief Operating Officer, Mr. Gilbert Lee; and CFO, Mr. Christopher Holbert.

After management’s prepared comments, we will have time for any questions. If you have not yet received a copy of today’s results release, please call the Ruth Group at 646-536-7003, or you can get a copy of the release off of Techfaith's website.

The company’s attorneys advise that this call will contain forward-looking statements. These statements are made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by terminology such as "will," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates" and similar statements. Among other things, the business outlook and quotations from management in this announcement, as well as TechFaith's strategic and operational plans, contain forward-looking statements. TechFaith may also make written or oral forward-looking statements in its periodic reports to the U.S. Securities and Exchange Commission on Forms 20-F and 6-K, et cetera, in its annual report to shareholders, in press releases and other written materials and in oral statements made by its officers, directors or employees to third parties. Statements that are not historical facts, including statements about TechFaith's beliefs and expectations, are forward-looking statements.

Forward-looking statements involve risks and uncertainties. A number of factors could cause actual results to differ materially from those contained in any forward-looking statement. Potential risks and uncertainties include, but are not limited to, TechFaith's limited operating history, mobile handset brand owners' discontinuation or reduction of the use of independent design houses, TechFaith's ability to retain existing or attract additional international customers, TechFaith's earnings or margin declines, failure of competing against new and existing competitors, and other risks outlined in TechFaith's filings with the U.S. Securities and Exchange Commission, including its annual report on Form 20-F.

TechFaith does not undertake any obligation to update any forward-looking statement, except as required under applicable law. All information provided on today’s conference call is as of today’s date. China Techfaith does not undertake any obligation to update the forward-looking statements.

I would now like to turn the call over to Mr. Defu Dong. Please go ahead, sir.

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Defu Dong

Thank you and welcome to our first quarter call. Our business continues to perform. There were many good signs. We are still not where we are to be and the results do not yet reflect Techfaith's value.

The revenue came in slightly lower than our guidance because of unexpected sales returns by one of our major customers. During Q1, the company allowed this customer to return certain products that were sold in 2006. The customer was not satisfied because by the time the product shipped, the customer missed the Christmas window. Since this was an important customer, we decided it was best to accommodate this request. We continue to work together and have received new orders from the customer.

This return resulted in a decrease in revenue and accounts receivables of $1.2 million. The corresponding cost of sales and inventory accounts were also adjusted accordingly. We booked the impact of this return in Q1 2007 as management was only informed of the customer in Q1 and because this is a special negotiated arrangement and it is not our common practice and is not part of any of our contract terms. We agreed to this arrangement in order to keep a long-term relationship with this customer.

Design fees rebounded in the quarter, up over $10 million from just over $4 million in Q4 2006. We expect the design number will continue to fluctuate, reflecting the uncertain timing of design wins and customer projects.

For design fees, we finished one new model in Q1. This model is on schedule to be launched in Q2.

For smartphone, several new models were put into the market in Q1. There are four new models to be launched in Q2 and 10 other new models are under development now. We will control the new product launches based on the product life cycle and the market response.

For feature phone business, we have launched four models. The market response is positive. The new feature phone models, including a dual mode WCDMA and HSDPA, will be launched in the second half of the year.

Aside from contracts, we took more costs after our business. We announced a very important segment in Q1. This gets us even closer with two tier one customers. We shipped 300 into the joint venture, [inaudible] operating cost to taxes.

The joint venture with one of the leading one-stop component providers for handset manufacturers makes perfect sense to both TechFaith and our partner, given our partner's expertise in supply chain management and TechFaith's handset design capability. Demand for this ODM business model has been strong and we expect the joint venture will create the synergies needed to win contracts from global leading customers for both TechFaith and our partner.

Techfaith has a great future ahead. We have everything in place for a record 2007. We will continue to work around the clock to grow our company to build value for our shareholders. We are well along the way and expect our results will start to better reflect our progress.

We thank you for your support and hope you will continue on with Techfaith. Let me now turn the call over to Dr. Gilbert Lee for a further review of the business. Gilbert, please go ahead.

Gilbert Lee

Thank you, Mr. Dong. Good evening, everyone. I will give a few key points from this quarter. We will then take your questions. We finalized the [liquidation] of the NEC relationship in Q1. We stopped all the projects in process and booked revenues of NEC projects reached milestones. At the same time, the costs of NEC projects were booked a bit less than the revenue. So excluding NEC projects, the gross margin of design is around 52%. We firmly believe this trend will continue for the design business.

For the future quarters, PCBA business will phase out. For Chinese customers, we will collect royalties based on the shipment of open BOM, bill of material. We are very confident that the gross margin of NRE and the royalty will remain in the 50% range.

I will go through several business issues one by one now. The first one, the progress in TD-SCDMA; we have the first design contracts from one of the wireless industry’s top five customers worldwide. They may add a second project in the second half of this year.

Design -- in Q1, we have finished sample testing for two local customers. At present, we are working on the sample testing for the third local customer. In the meantime, there are five other projects under discussion, so we have a total of 10 TD-SCDMA projects under development.

Next, about our smartphone business, our smartphone business continued to gain momentum. We already have around 30 customers now. 50% are international and 40% are domestic. Smartphone shipments in Q1 were 23,000 due to almost a [mass] shutdown of EMS in the Chinese Spring Festival period. ASP was $220. Shipment expectation in Q2 is 30,000 units, with an ASP of $200.

Next, we also continued to gain strong momentum in our feature phone solutions. In Q1, feature phone shipments started to grow, reaching 40,000 units with an ASP of around $100. In Q2, shipments should be more than doubled to around 100,000 units, maintaining the ASP level. For the whole year, the shipment will be around 400,000 units.

Feature phone customers are mainly in emerging markets such as Southeast Asia, Africa, Latin America. We also have customers in Ukraine and some European countries.

Feature phone sales start with CDMA 1X. Market response was very positive. Dual mode and the 3G phone will be launched in the second-half of 2007. We expect high sequential growth for feature phones. Existing customers will place rolling orders on a quarterly basis and a new launch model will bring customers from South Korea, Vietnam, Turkey, Taiwan, India, and Egypt. We are having contact with some European countries, too.

Next, with regard to the PCB, PCBA and the wireless module segment, PCBA revenue in Q1 was from our existing orders. There will be some revenue in Q2. The company will control the shipment of the PCBA and phase the business out gradually, due to its low margin. For the Chinese domestic market, we will continue to design products for available customers and a royalty will be collected based on the shipment of open BOM.

We are launching new products for modules in the data card business in Q1. Due to Chinese New Year, shipment of new product was negatively effected. Revenue was low compared to previous quarters, and at the same time we sold some module inventory of an old platform. The overall margin did not look good.

In Q2, revenue from data cards and module will reach more than $5 million. Module will resume as we sell more new product.

In terms of outlook, as we look out into 2007, our smartphone, feature phone business will enter a high growth period. Strong demand from operators in Europe and South American countries will increase our feature phone revenue. Revenue of data card and wireless module will double the level of 2006.

Finally, a few comments on the balance sheet. Inventories increased more than $4 million in Q1, as compared to the previous quarter. The increase is mainly due to the procurement of a material for the production of the company’s ODM business in smartphone, feature phone, and PCBA.

Our cash balance declined about $9 million from Q4. $6.7 million was a deposit and payment related to the prepayment for the office building construction in Hangzhou.

Our accounts receivable was up slightly from 103 days to 128 days. This is essentially due to a delayed payment from one major customer. They paid us in April. Starting from Q1, we made some changes to revenue breakdown due to the fast development of ODM model business. Product sales, including smartphone, feature phone, wireless module, and PCBA and the other components, including PCB and other sales of testing line and materials. We believe this will better illustrate our business development.

In terms of our specific outlook, we expect the second quarter to be in the range of $32 million to $35 million.

Operator, that concludes our formal comments. We are now ready to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Li Tang of Pacific Crest Securities. Please proceed.

Li Tang - Pacific Crest Securities

Thank you. First question is regarding the $1.2 million return; does that impact your design fee revenue in Q107, or is it product sales?

Gilbert Lee

It is product sales.

Li Tang - Pacific Crest Securities

So if you were to restate your previous quarter, which quarter would be hit?

Gilbert Lee

It will not restate previous quarter. It is put into the quarter, Q1.

Li Tang - Pacific Crest Securities

Does that mean that all the product was returned and you took a loss on the cost of the product sales? I’m trying to understand -- what is the $1.2 million? Is that cost or is that revenue?

Gilbert Lee

It is taken out from our total revenue and we also took out a corresponding part.

Li Tang - Pacific Crest Securities

And the product cost has been written off?

Christopher P. Holbert

Actually, that goes back to inventory.

Li Tang - Pacific Crest Securities

It goes back -- so you expect to sell those products in the future?

Christopher P. Holbert

Most definitely.

Li Tang - Pacific Crest Securities

Okay. Another quick question is regarding your net loss in equity. Is that associated with your new JV or that’s something else?

Christopher P. Holbert

No, that’s actually with a previous investment. It’s not associated with the new JV.

Li Tang - Pacific Crest Securities

Okay, so is there any loss from the JV or anything you can comment on that?

Christopher P. Holbert

There is no loss associated with our new JV.

Li Tang - Pacific Crest Securities

Could you talk about, for your guidance for Q2, what is the revenue from design fees you are expecting in Q2?

Gilbert Lee

It is too early to say. Our forecast still is about $6 billion.

Li Tang - Pacific Crest Securities

Does that include royalties or just design fees?

Gilbert Lee

Including royalties.

Li Tang - Pacific Crest Securities

Including royalties -- and my last question is on your operating costs. If we look at Q1 2006, look at the design fees, it is roughly the same but your R&D costs is substantially higher in Q1. How many people are involved in the design process and how many are involved in the product sales? What is the future plan for leveraging the synergy between those two and maybe downsizing some of your R&D costs, if you have such plans?

Gilbert Lee

Our headcount is really difficult to separate that way, how many are R&D and how many are product sales, because they share many functions together. Roughly 60% are in the R&D, development engineers and the other 40% are product sales or kind of a supporting function. They also have hardware and software engineers.

In the current headcount, we are below 1,900. I know many people are asking us, do we have any headcount reductions planned? Our answer to that is no, we don’t have any active reduction plans because there is a workload there. I think our challenge is to get more revenue.

In the meantime, we do have several efficient platforms we will transfer in the form JV to let those teams more focus to generate revenue. That is the only thing if you want, say a kind of shrinking our staff number. So the only thing we would do is identify JV opportunities and transfer some of our key employees to that JV.

Li Tang - Pacific Crest Securities

Thank you.

Operator

Your next question comes from Adele Mao of Susquehanna International. Please proceed.

Adele Mao - Susquehanna Financial Group

My question is related to smartphone. It looks like your first quarter shipment is pretty light and your second quarter guidance is pretty light. I’m just curious -- you have a lot of models under development. I’m just curious why this is below expectations.

Gilbert Lee

In the second quarter, I think we can double that number. I think just now I have put 30,000 units as to date our shipment and secured order status, but definitely we have one-and-a-half more months going on. We will see. I believe there is a big upside because of the current negotiations going on.

Adele Mao - Susquehanna Financial Group

Okay, so your comments earlier mentioned because of the holiday that was why first quarter was light. What was the March run-rate, in terms of volume shipment, so we can get four months of --

Gilbert Lee

In March, in the month almost we shipped 20,000. It was back-end loaded.

Adele Mao - Susquehanna Financial Group

Okay, back-end loaded but you did reach 20,000 in March?

Gilbert Lee

Right.

Adele Mao - Susquehanna Financial Group

Okay. Would you expect your volume to pick up dramatically in the second half?

Gilbert Lee

I will not say exponential growth, but it will be a steady growth.

Adele Mao - Susquehanna Financial Group

It will be a steady growth. Okay, that’s fair. Would you go through how many models you launched and how many models in development? Because I didn’t get all the numbers.

Gilbert Lee

Let’s separate into three; for design, for smartphone, and for feature phone. For design, in Q1 we finished one model and a model on schedule to be launched in Q2. For smartphone, five new models were put into market in Q1. There are four new models to be launched in Q2. Ten other new models are under development now. We will control the new product launching pace based on the product lifecycle and the market response. For feature phone, we have launched four models in Q1. The market response is very positive. New feature phone models, including dual mode WCDMA and HSDPA, will be launched in the second-half of this year.

Adele Mao - Susquehanna Financial Group

Okay, so if I remember it right from last quarter’s conference call, you mentioned your smartphone models, 30 to 35. Now it seems like if you add everything up, it will be 20. Is there a reason for the scale-back?

Gilbert Lee

Because so many newcomers coming, we are concentrating on the high tier model. We are not going to mid-tier model, so we are realigning our product portfolio at this time.

Adele Mao - Susquehanna Financial Group

I see. My last question, can you comment on your margin prospects, smartphone versus feature phone, and how does that shape up for the rest of the year?

Gilbert Lee

Pretty much the same as previous communications. I think for the handset design, we maintain 50%. For smartphone, we will still see 25%. I know many people are asking us and there is so much news in the market about the newcomer. In the second quarter, probably you will see a little bit below 25%, but in the third quarter and fourth quarter, because dual mode and the 3G WCDMA smartphone comes out, we think our margin will come back at over 25%. Just like Q1, it is 28% for smartphones.

For the rest of that wireless module feature phone, if you take a whole year approach, we are very confident on 15%, again because of all the high tier and the 3G products that we will be rolling out one by one.

Adele Mao - Susquehanna Financial Group

Okay, great. Thank you.

Operator

Your next question comes from the line of Brian White of Jefferies. Please proceed, sir.

Brian White - Jefferies & Company

Good morning. Could you talk a little bit, Gilbert, about what you are targeting in terms of units for smartphones in ’07? You said feature phones, 400,000. I think on the last call you said smartphones 400,000 but I think it’s clear it will be difficult to reach that. What should we target for the year in smartphones?

Gilbert Lee

You are right. Based on the market response, and also we try to get the high tier phones, we try to avoid the low tier competition. Now we are [inaudible] our following shipment. I think in the [bare] cases, we are producing 250,000 units for this year.

Brian White - Jefferies & Company

Okay and we should just use $80 million in revenue you were targeting last time, so now we should target maybe like $50 million, or $55 million?

Gilbert Lee

Correct.

Brian White - Jefferies & Company

Okay, and do we have customers over 10% in the March quarter? Who were the customers over 10% of revenue?

Gilbert Lee

No, only one technically you can count on, is NEC because as I said, that is the last run we tried to clean out, plus they owe us -- we owe them. If you are including this one, NEC will be. Then, aside from that, there is not any single one that is over 10%.

Brian White - Jefferies & Company

Okay, and can someone just comment, equity in loss of an affiliate -- what is that related to? Should we look at that as a one-time item?

Christopher P. Holbert

It is related to one of our previous joint ventures with one of our previous long-term investments. As you know, we do on a regular basis attach statements from those investing companies, and then we will have to take a share based on our percentage in their loss. So it’s pretty much just related to that.

As far as will we see it going forward, we don’t really anticipate seeing too many more of these types of entries going forward, but just have to continue to monitor our investments to make sure.

Brian White - Jefferies & Company

Okay, so it’s a non-operating item -- how about the exchange loss? Just remind, what is that related to?

Christopher P. Holbert

The exchange loss is just related to the -- I guess just simply put, we hold a certain amount of money in U.S. dollars.

Brian White - Jefferies & Company

Okay, so that’s what it’s related to. Great, thank you.

Operator

(Operator Instructions) Your next question comes from the line of Tien Yu Sieh of Merrill Lynch. Please proceed.

Tien Yu Sieh - Merrill Lynch

I just wanted to ask a little bit about the joint venture with Qualcomm, the software development. What is that status of that? Wasn’t it supposed to start contributing in the first quarter? If it isn’t, then what’s the latest update?

Defu Dong

[Parts of] product not go to market and from our schedule, Q3 we will commence product launch in market. Today, the [inaudible] -- also product ready to market. I have confidence Q3 we will have product launched in the China market. Also, in the Qualcomm, [inaudible] also nearly finished.

Tien Yu Sieh - Merrill Lynch

The follow-on question is with regard to the returned products, you said it went into inventory. There’s roughly a $5 million step up in inventory in the quarter. How much of this step-up is due to, or how much did this handset return account for in terms of the inventory?

Gilbert Lee

This return is about $800,000 is related to this return.

Tien Yu Sieh - Merrill Lynch

So only $800,000?

Gilbert Lee

Right. I’ll explain -- mainly the inventory increase is we are procuring all this material ready for the ODM business.

Tien Yu Sieh - Merrill Lynch

Right.

Operator

Your final question comes from the line of Julie Chen of Brean Murray. Please proceed.

Julie Chen - Brean Murray, Carret & Co.

Just trying to understand in terms of operating expenses, how should I be looking at operating expenses moving forward?

Christopher P. Holbert

We see operating expenses should go down a bit, especially because of the joint venture. The joint venture that we are setting up is going to be transferring some key employees who will be working on that joint venture.

Julie Chen - Brean Murray, Carret & Co.

So particularly, I would just like to reiterate the question, I was asking in terms of R&D, how should we view the R&D expenses moving forward in the year 2007?

Gilbert Lee

R&D is pretty much proportional to our headcount. If we have more projects, all that headcount costs should be costs of goods. I think in the next several quarters, you will see R&D decrease.

Julie Chen - Brean Murray, Carret & Co.

In terms of tax rate, how should we be thinking about the tax rate for the year 2007?

Christopher P. Holbert

Basically zero.

Julie Chen - Brean Murray, Carret & Co.

Okay. Thank you very much.

Operator

Actually, we do have one final follow-up question from the line of Brian White of Jefferies. Please proceed, sir.

Brian White - Jefferies & Company

A question on the inventory related to the ODM; Gilbert, are you saying this is related to the joint venture ODM inventory?

Gilbert Lee

No, it is our sales.

Brian White - Jefferies & Company

It’s your sales, okay. And just finally, when do you think we can generate a profit, Gilbert?

Gilbert Lee

We try in Q2 and definitely in Q3 we want to make it black.

Operator

At this time, we have no further questions. I would like to turn the call back over to management.

Defu Dong

Thank you for joining our Q1 announcement release. I hope you will give Techfaith support and continue on with Techfaith. We have confidence we are on the right way to give the shareholders good feedback. Good-bye.

Gilbert Lee

Representing our management team, I would like to say thank you and I know our team’s mission is increase the sales and control the costs, control the expense. I believe in Q2 you will see a big improvement. I firmly believe our team can deliver the results you guys are expecting. Thank you.

Operator

Ladies and gentlemen, as a reminder a replay will be available approximately one hour after the call today through midnight on May 21, 2007. The replay dial-in number is 1-888-286-8010, and also 1-617-801-6888, with a passcode of 84362929. Once again, the passcode is 84362929. The replay will also be accessible at www.techfaithwireless.com.

This concludes the presentation for the day. You may now disconnect. Good day.

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