Protek Group financial statements (IFRS) 2013 & operational results for Q1 2014

Protek Group financial statements (IFRS) 2013

& operational results for Q1 2014

29 April 2014

Operator - Good afternoon, and welcome to the IFRS Financial Results for 2013, and the operational results for Q1 2014. With Vadim Muzyaev, President of Protek and Timofei Prokopov, CFO. For the duration of the call, you will be on listen only. And at the end of the call, you will have the opportunity to ask questions. I’m now handing you over to Vadim Muzyaev, your host to begin today’s conference. Thank you.

Vadim Muzyaev - Hello, and welcome ladies and gentlemen, we are happy to welcome you to our conference call, dealing with Protek Group’s financial results for the full year 2013. We hope you’ve had a chance to see our releases and slides, posted previously, so to save you time, I would like to say a couple of words on behalf of the company's management, and then we will be happy to take your questions.

So, in a nutshell, based on our 2013 full year performance, I can report that Protek’s management is satisfied with the performance delivered. First of all, we’re happy that our pharmaceutical market was growing at a double digit pace. According to various estimates, the average growth rate amounted to 10-12%.

Secondly, our consolidated revenues added 11%, which is generally in line with the overall market uptrend, and you know that our business is split into three segments, including distribution, production and retail sales. All of them are similar, dealing with health and beauty products. Each of them has their own specific characteristic features. So now, let me tell you about the performance by segment.

First of all, I would like to start with the production segments, with whose performance we are satisfied.

So, first of all the production segment. As I have already said, we are happy with the performance delivered over the full year 2013, and revenues of the production segment expanded by 26.8% year on year. EBITDA margin in the production segment also grew to 23.2% year on year, versus 21.6% in 2012.

This has been delivered on the back of one of our strategic missions accomplished, which is the expansion of proprietary brands and private label sales.

Now, the retail sales segment. We are also happy with its performance, since it expanded by 21.3% year on year, in terms of revenues. This was delivered through active organic growth. Just to remind you, in 2013, we opened up over 300 pharmacies. We have continued our multi-format pharmacist strategy, our private label expansion strategy and active marketing. For two years in a row, we are now the top one leader of the Russian retail pharmaceutical market.

As for the distribution segment; it delivered growth of 9%, which is slightly below the market.

That said, the commercial market, which is the key distribution market to the Protek Group, we delivered growth somewhat above the market.

As for the gross profit, that declined somewhat in full year 2013 in the distribution, it was the result of a reduction in our mark ups, and this was because we’ve been facing cut throat competition in the distribution market, for at least the last two years.

So, now in the distribution segment, we have two priority tasks. First, to deliver revenue growth at least at the market level and second, to reduce our operating expenses.

So now, let me get back to the beginning once again, to wrap it up, we are quite satisfied with the performance of the group, especially with the performance of our production and retail segments. As for the distribution segments, where we are going to be active and work to improve its performance further on.

Thank you for your attention. Now, we will be happy to take your questions.

Operator - Ladies and gentlemen, if you would like to ask a question on this call, please press star one on your telephone keypad now. Just another reminder, please press star one if you would like to ask a question. First question Marko Daljajev, SEB.

Marko Daljajev, SEB - Hello? Can you hear me?

Vadim Muzyaev, President - Hello, we can hear you well.

Marko Daljajev, SEB - Perfect, so if it’s okay, I will ask my questions in English? So, my first question would be regarding the competitive situation. If I’m looking at your annual report, then I see that you have both the market shares between different players, so if you could maybe describe a bit how...I understand that in 2012, you were the market leader in the distribution business, and today you are on a second position, so if you could maybe explain a bit about how different market players have behaved in the last year, and then also, maybe even more importantly, how is their behaviour and strategy looking like right now, in 2014?

Thank you.

Vadim Muzyaev, President - Thank you for your question. Yes, we’ve been ranked second in 2013. We are lagging behind Katren in direct sales, by 0.4%. I think 0.4 is a statistical error, so I think in reality, we are on par with Katren when it comes to number one. Hence, our task as I think similarly to Katren’s task, I believe is to become the operational efficiency leader, not the revenue leader in the market.

Over the past two to three years, there has been severe pricing competition in the market that led the distributors in the Russian market to the level of results you can see now in our materials.

So, I think as a result today, Russian distributors are considering this market situation attentively and they have come to an understanding that there is no way that, it is impossible to operate at a negative financial performance level or at zero level.

However, this understanding has not yet delivered full parity in prices in the market, and there are still some market practices, like predatory pricing observed in the Russian market, aimed at countering bigger market shares.

Anyway, these pricing fluctuations are decreasing now, and I believe that on a horizon of 18 to 24 months, we will come to the situation when all the distributors will understand that the distributor in this market must earn, and I think this will suppress competition, and deliver equal pricing levels.

So, I think this year we are in the same competitive scope, so to speak. Besides, this market competition, this pricing rate has exhausted our peer’s resources, so I think in the years to come we will come to a civilised market, like that one which we see in Europe now.

Does that answer your question?

Marko Daljajev, SEB - Thank you, yes, for the answer, if it would be maybe possible to describe a bit more about who has been most aggressive on the market, and what sort of strategies have they been following differently, that has led to the changes in market share a bit, among the top players? It would be very informative for us, thank you.

Vadim Muzyaev, President - I can say that every distributor would change their market strategy and behaviour in the course of time. I’m now talking about the top ten distributors. At a certain time, Katren was very aggressive in trying to conquer as big a market share as possible. Ketren used this tool to address their then top, I’m referring to the time three to five years ago, so their core task was to become closer to the winner, to Protek and now we’re on par.

SIA International used to be the number two in the market, then they got lower in the rankings, and now they have resumed their aggressive pricing strategy to conquer additional market shares again.

Another five market players are also rather aggressive in pricing. Players with the numbers from six to ten in the top ten. They have emerged as distributors a bit later, so I think now they’re taking their time and opportunities to conquer bigger market shares, so that they can convert them into margins.

Market consolidation is on the way, with the top five distributors occupying a consolidated market share of over 60%, at the same time the top ten distributors are holding over 80% of the market, so I think on the horizon, in five years, these top ten distributors will be holding 90-95% of the Russian distribution market.

So, I believe the distribution market is maturing and in the process of gaining maturity, this market will arrive at the proper understanding, in terms of health and the need to earn money.

So, this is basically it.

Marko Daljajev, SEB - Thank you very much. So, if I may, my next question would be from the retail side of your operations, if you could describe, you have been opening new pharmacies in a rather active and aggressive manner, we could even say so, is that typical to the market, or how are your openings, how does it relate to the overall size of the market? Are you seeing that actually the overall number of pharmacies is decreasing on the Russian market, or the number is stable? Or, is it continuing to increase? Thank you.

Vadim Muzyaev, President - Thank you for your questions. So, as I have already said, in 2013, we opened up over 300 pharmacies, to be precise 326 pharmacies. We also did some pharmacy closures, to deliver a net opening number of 187 pharmacies. And, I can tell you that this is a record high for the Protek Group and for the overall Russian market. No one has managed to open this many pharmacies in a year, in the Russian market, except for Protek. And, we’re going to keep the pace of organic growth at this level or higher in the years to come. This is our core development strategy.

I can say that the overall number of pharmacies in Russia is growing, with national and local pharmacy chains delivering expansion. You know, this is quite typical of any emergent market, including Russia.

So, I think in a couple of coming years, the market will become more mature, will become saturated, in terms of the number of pharmacies, and we will move onto new strategic tasks, like operational excellence. Actually, this is the situation you see in the distribution segment now.

As for efficiency improvement or operational excellence too, they’re pretty much the same to what you have in Europe.

Does that answer your question?

Marko Daljajev, SEB - If it would be possible to explain a bit, how much, we know how much your chain increased. Do you have statistics, how much did the overall number of pharmacies in Russia increase, approximately? Is that information available, thank you?

Vadim Muzyaev, President - Unfortunately, we don't have that data now. As you know, Russia is way too big for that. And, a characteristic feature of the Russian market, that pharmacies and pharmacy chains are being licensed by local authorities in the regions. So, the situation, the number of pharmacies opened varies from region to region. And, all pharmacies do differ a lot, there are wholesales pharmacies, and pharmacy kiosks near outlets.

Just to remind you, Russia is an emerging market, and so our retail, including pharmaceutical retail is just shaping up now. Pharmacy retailers are licensed typically for five years in Russia, so there is some statistics on the number of licences issued, but some retail pharmacy operators do leave this market earlier, having not worked the full span of five years.

The Russian pharmaceutical retail market is very interesting and appealing in terms of margins, I think, so as soon as the market matures and gets more civilised, I think we will deliver something comparable to the Boots Pharmacy Chain of England.

This is basically it.

Marko Daljajev, SEB - Thank you very much, and my maybe final question before others can ask some as well would be, could you explain how the consumer behaviour has changed? What sort of trends do you see, maybe any slowdown, or increasing price sensitiveness of the buyers in pharmacies? Thank you.

Vadim Muzyaev, President - Thanks for that one. In this, the Russian pharmaceutical retail market is evolving, and it is mainly driven by the consumer demand.

Over the past five to six years, which was after the 2008 credit crunch, our pharmaceutical retail market has been growing at a double digit pace. In terms of growth, growth rate, it ranks third after China and Brazil.

This growth is mainly fuelled by the growing purchasing power of the Russian consumer, since the year 2000, over the recent 14 years, it has grown several fold.

The purchasing power growing, the Russian consumer has got an opportunity to obtain more expensive and more effective medications, hence over the recent years, the average packet price has been growing, while the number of packages sold has been reducing. This is for the fact that the Russian consumer is headed for the higher end of the market, where more expensive, and more effective, better medications are concentrated.

The same trend can be traced in the para-pharmaceutical market where turnovers are growing, including cosmetics, body, hair and beauty goods. Many products of American and European origin are coming into the Russian market, and people are buying more and more of such products, so the Russian consumer wants to be healthy and beautiful.

So, the purchasing power and the overall wealth of the Russian people grows, and you know, when I occasionally come to Milan, and drop in some boutiques, I see mainly Russians, and very few French people or Italian people.

Does that answer your question?

Marko Daljajev, SEB - Thank you for the answer, if I may clarify a bit, so do I understand correctly that you don't see, with the recent in let’s say the first four months that are now past of 2014, you don't see any weakening of the consumers that are shopping in your pharmacies, and you are not adjusting your offering in any way, in terms of that, so it’s business as usual, basically?

Is it so, or are there any changes visible right now, thank you?

Vadim Muzyaev, President - I see what you are driving at, you mean the overall economics of Russia may be reducing, like GDP growth slowing down and so on. You know, I think we may feel it, but if we do, we will feel it later, because usually it takes time. I think in the Russian environment it may happen nine to 12 months later, if this trend impacts the purchasing power of Russian people.

So, that said, I think that medications are items that are constantly in demand, together with food. These are the basic basics of our life, and for the Russian consumers, if we feel this impact, they will most likely cut down costs on cars, apartments or household appliances at the end of the day, but not on food and medical products.

I think we will feel some impact, but I don't think there will be a market dip. Probably we will experience some slow down in the market growth, from the current 12-14% down to 8-10%.

So, all in all, we’re quite confident about the market, and its growth prospects, and we’re sure of the process of our company. The strongest and biggest do deliver growth in hard times. Thank you for your questions.

Marko Daljajev, SEB - Thank you.

Operator - Next question is from Kseniya Arutyunova at RMG Securities.

Kseniya Arutyunova, RMG Securities - The retail segment shows excellent 14% growth as of Q1, however I’m a bit concerned with the traffic outflow of 8%, could you kindly provide some colour on that matter? Thank you.

Timofei Prokopov, CFO - Thank you for your question. The dip in like for like traffic is a concern to us, and we are active. We’re working on it, working to improve our performance, we’ve been doing that since January.

But here, we must not lose out the Q1 2013 against which we’re comparing the performance. In Q1 2013, we had a very severe flu season, which delivered a high base effect, both in terms of traffic and other economic factors.

If you take a look at our production segment performance in Q1, you will also see some softening in the performance, due to the lack of flu season this year. For example, our Merkel product Anvimax, the anti-flu medicine was selling much slower in 2013 than in 2012. In a flu season, Russian consumers go to pharmacists four, five or even six times more frequently.

You see that the number of pharmacists however is still growing in Russia, and the number of people per pharmacy is decreasing, because again Russia is an emerging market, and it is maturing, and it will be maturing going forward, and as soon as it becomes more mature, I think we will arrive at that regular benchmark, of the 4-500 people per pharmacy. Does that answer your question?

Kseniya Arutyunova, RMG Securities - I have another question about [unclear] costs, namely the advertising costs, which saw a rapid increase from about 118 million Roubles to 460 million Roubles, thank you very much.

Vadim Muzyaev, President - This is Vadim Muzyayev speaking, I will take this question, because this is, I believe more about our operations than financial activities. Indeed, we incurred bigger advertising expenses, because this was the first year when we actually started active promotion, active marketing of our new OTC products in the production segment.

I mean, Anvimax products, like Anvimax, our first AnviLap brand and others, because we had to engage in active advertising, including TV advertising, which is quite costly.

We also did advertising, promotion campaigns to boost the sales of other products. This is basically it.

Kseniya Arutyunova, RMG Securities - So, thank you very much. Do you expect the advertising costs to be on the level of 2013 this year, or some downward correction may follow, thank you?

Vadim Muzyaev, President - Yes, now we’re in late April already, so nearly a half year has passed, and there has been no advertising practically, because there was nothing to advertise, due to the lack of flu season this year, so we hope something like that will happen in Q4 now, so on an annual basis this year, I don't think our advertising expenses will be that big. I think they will be lower.

Cost cutting is our operational excellence priority and we are really attentive to our expenses, including advertising expenses, where we’re attentively monitoring them all the time.

Kseniya Arutyunova, RMG Securities - Thank you very much, that has been very helpful, as always.

Operator - Next question is from Vitaly Baikin at GazProm Bank

Vitaly Baikin, GazProm Bank - Hello, thank you for your presentation and my question is about the distribution revenues. Back in Q4 2013, the distribution delivered a revenue growth of 2%, as soon as in Q1 2014, the growth rate expanded up to 6%. What did it take you, what did it cost you, what did you do to deliver that uptrend?

Timofei Prokopov, CFO - Thank you for your question. Again, let me remind you that in 2013, we had a very high base effect.

So, again our core task in the distribution segment is to deliver revenue growth rates ahead of the market growth rates. According to market research agencies, in Q1, the pharmaceutical market net of para pharmaceuticals grew by 5%, so this is approximately the inflation rate level.

Besides, we cannot rule out the high share interest and last year the dollar and Euro grew about 10% in their exchange rates against the Ruble. Now finding your way strategically in the market is now a constant trade-offs between revenues and margins and we’re in a constant search on the spot. We are sharing our economics with producers, with manufacturers in order for them to share it with customers. This is kind of the path that we’re going down.

And again that I would like to reiterate that the distribution segment is challenged by fierce competition in the top ten distributors and this pricing competition has not come to an end yet. This is basically it.

Vitaly Baikin, GazProm Bank - Thank you for that answer, another question if I may. It’s about distribution revenue guidance for 2014; what level of revenue growth in distribution would you consider good or maybe minimal, like a four level in the distribution.

Timofei Prokopov, CFO - Our task is to deliver revenue growth 2-3% above the market and what the market will be at Full Year 2014 I think is quite hard to project now as it’s largely driven by the flu season; will it happen in flu-season or not, what kind of a summer will we have, so it’s highly dependent on epademics and weather conditions.

Vitaly Baikin, GazProm Bank - Thank you and another question is on capex, what is your capex for 2014 in terms of total capex and how will it be broken down in to segments?

Timofei Prokopov, CFO - So in the distribution segment, we have completed building up the distribution system, we completed this 2-3 years ago, so this year, the distribution segments are only going to invest in automating the warehouses to streamline our operations and boost performance.

In the retail sales segment, you’ll see we are going down in organic growth costs, with some of the costs capitalised, recognised as capital expenditure including fixed assets repair costs, extension capex, maintenance capex and so if the number of openings stays flat, the amount of capex will stay flat as well.

So the production segment, we are going to expand our production capacities, production facilities actively, to accommodate the newer and newer products delivered and registered. For example, in 2014 we are going to register about 10 new generics and logically, we are going to invest heavily in the production segments infrastructure.

So to sum it up, I would like to say that we are going to invest as much as we need as we feel necessary for the developments of our business segments and we do have the cash to do it.

Vitaly Baikin, GazProm Bank - My next question is about dividends, so you have cash shareholders, so it is very interesting for the shareholders whether you are going to keep your generous dividend pay-out policy and so what is your guidance for dividend pay-outs this year?

Timofei Prokopov, CFO - Unfortunately, as a management representative I’m not authorised to give such comments but soon we will our board meeting when we will consider our AGM agenda. Our AGM typically takes place in June and we will consider this matter.

Operator - Our next question is from Alexi Krashakov, Vector Capital Russia

Alexi Krashakov, Vector Capital Russia - My question is about selling expenses, administrative, commercial expenses. Your payroll grew by 16%, which is ahead of the revenue growth rate. So why did it happen and what is your guidance for payroll growth in 2014?

Timofei Prokopov, CFO - Yes we did deliver strong growth in payroll expenses. This was driven by the following: First we opened up 226 pharmacies; then in the production segment, our staff headcount has grown to successfully implement our strategic tasks, both in production and in marketing. As for the distribution segment however, our headcount is decreasing and this is going to be decreasing in the time to come.

Another driver is that we have equalised, we have marked to market some compensation packages of our managerial staff.

So in 2015, we do not envisage any [unclear] like that. We are going to further optimise our staff headcount in the distribution segment. As for the retail and production segments, we are going to be active in streamlining our processes and business, because operation excellence is our priority. And payroll is quite a heavy expenditure item; you’ll see that it accounts for 60%+ of our total expenses of our business segments.

Alexi Krashakov, Vector Capital Russia - Thank you and my next question is about buyback. CV Protek has announced the bidding process for a buyback. Now that bidding is over, could you please give some colour as to the number of bids that you got and about your plans. Is the core shareholder going to expand the equity stake?

Timofei Prokopov, CFO - Indeed, we have announced buyback bidding, based on the average price, over the previous six months but we received practically no bids. I think that the market does believe in Protek.

Operator - We have another question from Alexey Krivoshapko at Prosperity

Alexey Krivoshapko, Prosperity - Hello, I have been waiting for the opportunity to ask a question and I have two. The first one is about working capital; we’ve seen a big deterioration in your working capital – why did it happen? And the second is about your right-offs on all [unclear], including 769million ruble on the distribution segment and 375million on the production segment, so in total 1billion ruble. So why is that?

Timofei Prokopov, CFO - Hello, this is Timofei Prokopov, the CFO and I will take the first question on our trade working capital. I would say that the situation is actually good – as at the 31st December 2015, we’ve increased our working capital by an extra 1billion ruble, year-on-year. There were some fluctuations in accounts receivable and accounts payable but the key driver here is the expectations that they did not materialise in reality, as I just said. The core part of that extra billion of working capital is attributable to those full expectations on the back of which we extended our stock. So effectively, there has been no deterioration in working capital. After our accounts receivable, I see what you are driving at, last time it was discussed and it has been said that we are streamlining our operations and processes in terms of our accounts receivable, we are getting more and more active in collaboration with large retail chains. Some parts of the operations have been moved on to factory solutions, so this is on track and there is no deterioration in working capital.

Vadim Muzyaev, President - Thank you for your second question about law suits write-offs. Let me just refrain from reading what is said in our IFRS disclosures on law suits, you can see pages 17 and 18 of our presentation.

Alexey Krivoshapko, Prosperity - Thank you and my follow up question is procurement, purchase and volumes, I mean those purchases, your retail segments, regular pharmacy chains are … from Protek itself. Over the recent five years, the share of such intergroup purchases has been declining steadily, so the first question is why? And the second question is how do you see it, what are your mid-term and long term targets in this respect?

Vadim Muzyaev, President - Thank you for your question Alexey, actually, there is no secret about it as we have already said several times. The relationship between our segments within the Protek Group are of an ‘at arm’s length nature’, entirely and wholly. So regular buyers from our distribution segments or from other distributers in the market, this is actually a wide spread market practice do to electronic trading and this is something we are REGLAR is involved in, similar to other retailers in the market. So, if Protek’s distribution segment wins a bid, then regular buys from our distribution segment, if not, then from other distributors. This situation will be there as long as there are pricing discrepancies in the distribution market. However, as I have already said, we hope that soon, our market will get more mature and as soon as we a European environment, REGULAR will be buying from Protek’s distribution only.

Operator - We have no further questions coming through.

Vadim Muzyaev, President - Ladies and gentlemen, thank you very much for your time and involvement. If you have any further questions, please feel free to contact us, we would be happy to take any questions of yours. So, stay healthy, enjoy love and happiness.