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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended March 31, 2012
Commission File Number: 001-32503
TELESTONE TECHNOLOGIES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
Floor 10, China Ruida Plaza
No. 74 Lugu Road
Shi Jingshan District
Beijing, People’s Republic of China 100040
(Address of Principal Executive Offices)
(86 10) 6860-8335
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of May 15, 2012, 12,333,264 shares of the Issuer’s $.001 par value common stock were outstanding.
TELESTONE TECHNOLOGIES CORPORATION
Except as otherwise indicated by the context, references in this Form 10-Q to:
“TSTC,” the “Company,” “we,” “our,” or “us” are references to Telestone Technologies Corporation
“U.S. Dollar,” “$” and “US$” mean the legal currency of the United States of America.
“RMB” means Renminbi, the legal currency of China.
“China” or the “PRC” are references to the People’s Republic of China.
“U.S.” is a reference to the United States of America.
“SEC” is a reference to the Securities & Exchange Commission of the United States of America.
ITEM 1. CONDENSED FINANCIAL STATEMENTS
Telestone Technologies Corporation (“TSTC”), formerly known as Milestone Capital, Inc., was organized under the laws of the State of Colorado in February 1987 under the name Shield Enterprises, Inc. In August 2004, TSTC reincorporated in the State of Delaware under the name Telestone Technologies Corporation.
Success Million International Limited (“SMI”), a company established in the Hong Kong Special Administrative Region of the People’s Republic of China (the “PRC”) on August 23, 2004, is a wholly owned subsidiary of TSTC and had no business operations since incorporation. Beijing Telestone Technology Company Limited (“Beijing Telestone”), a wholly-owned subsidiary of SMI established in Beijing, the PRC with an operating period until April 12, 2024, is engaged in the business of design, development, installation and trading of wireless telecommunication coverage system equipment.
Beijing Telestone Wireless Telecommunication Company Limited (“BTWTC”)(note), a company established in Beijing, the PRC with tenure of 20 years from June 17, 2005 to June 16, 2025 for provision of wireless telecommunication networking and system integration services, is owned by certain key management personnel of the Company (the “Owners”). Contractual agreements have been entered into between the Owners and Beijing Telestone so as to give effect that Beijing Telestone is the beneficial owner of BTWTC. Beijing Telestone does not hold the ownership interests in BTWTC directly because Beijing Telestone is considered as a foreign entity under the PRC laws. Due to the restrictions on foreign ownership to provide and engage in certain wireless telecommunication networking services in the PRC, Beijing Telestone, through loans to the Owners, established BTWTC with a view to conduct such operations without violating the relevant PRC rules and regulations. As a result of the above contractual arrangement, Beijing Telestone has obtained control and interest over BTWTC. Beijing Telestone is considered as the primary beneficiary of BTWTC and therefore BTWTC is considered as a variable interest entity (“VIE”) of Beijing Telestone so that the financial statements of BTWTC are consolidated into the financial statements of Beijing Telestone for all periods presented in accordance with ASC Topic 810 – Consolidation (ASC 810).
In December 2011 and March 2012, Beijing Telestone contributed RMB10,000,000 and RMB40,000,000 to the registered capital of BTWTC respectively, which made Beijing Telestone one of the direct owners of BTWTC. The capital contribution is intended to be temporary and the capital contributed by Beijing Telestone was transferred to the Owners in April 2012. Management, having consulted the legal counsel in the PRC, is of the opinion that such temporary shareholding structure would not have any significant impact on the business and operations of BTWTC.
On July 5, 2007, BTWTC, Shandong Guolian Telecommunication Technology Limited (“Guolian”)(note) and owners of Guolian entered into a Share Transfer Agreement (the “Agreement”). Under the Agreement, 100% equity ownership interests in Guolian and its wholly owned subsidiary, Pan-pacific Telecommunication Company Limited (“Pan-pacific”)(note), had been transferred by the owners of Guolian to BTWTC. Guolian and Pan-pacific were established in Jinan, Shandong Province, the PRC on February 9, 1999 and October 22, 1999 respectively. The principal business activities of Guolian and Pan-pacific are design, development, production and installation and trading of wireless telecommunication coverage system equipment.
On October 8, 2007, BTWTC established a wholly-owned subsidiary company, Beijing Telestone Communication Technology Company Limited (“BTCTC”)(note), with operating period of 20 years until October 7, 2027. The principal activity of BTCTC is developing and managing the business operations of the Company outside the PRC.
On December 14, 2009, Beijing Telestone established a wholly-owned subsidiary, Guan Telestone Telecommunication Technologies Company Limited (“Guan Telestone”)(note) in Guan, Hebei Province, the PRC with operating period of 20 years until December 13, 2029. Guan Telestone holds a land use right in Guan County for development of a research and development center and a manufacturing plant of telecommunication equipment.
On October 25, 2010, Beijing Telestone and BTWTC established a wholly-owned subsidiary, Guan Bopu Network Equipment Company Limited (“Guan Bopu”) (note) in Guan, Hebei Province, the PRC with operating period of 20 years until October 24, 2030. Guan Bopu is engaged in the trading of wireless telecommunication equipment.
On November 7, 2011, BTWTC and the owners of Sichuan Ruideng Telecom Corporation (“SRTC”) entered into a definitive agreement. Under the agreement, 100% equity ownership interests in SRTC have been transferred by the owners of SRTC to BTWTC in exchange of a cash consideration of $2 million and 1.8 million restricted common shares of TSTC. The acquisition was completed on December 30, 2011. SRTC was founded in 1993 and based in Chengdu, Sichuan Province, the PRC. It develops and provides telecommunication local access networks and system-integration services mainly in Sichuan, Yunnan, Guizhou, Hubei and Qinghai provinces.
In this report, TSTC, SMI, Beijing Telestone, BTWTC, Guolian, Pan-pacific, BTCTC, Guan Telestone, Guan Bopu and SRTC are collectively referred to as the “Company”.
Basis of presentation
These unaudited condensed consolidated financial statements have been prepared based upon Securities and Exchange Commission ("SEC") rules that permit reduced disclosure for interim periods and include, in the opinion of management, all adjustments (consisting of normal recurring adjustments and reclassifications) necessary to present fairly the financial position, results of operations and cash flows as of March 31, 2012 and for all periods presented.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("USA") have been condensed or omitted. The balance sheet as of December 31, 2011 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's Form-10K for the year ended December 31, 2011 filed on March 30, 2012. The results of operations for the three-month period ended March 31, 2012 are not necessarily indicative of the operating results to be expected for the year ending December 31, 2012.
The unaudited condensed consolidated financial statements and accompanying notes are presented in United States dollars and prepared in accordance with generally accepted accounting principles in the USA ("USGAAP") which requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Basis of consolidation
The unaudited condensed consolidated financial statements include the accounts of TSTC, its subsidiaries and a VIE. All significant intercompany accounts and transactions have been eliminated upon consolidation.
Net sales of equipment represent the contracted value of goods, net of value-added tax (“VAT”) and returns. The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery occurs, equipment is received and accepted by the customer, the fee is fixed or determinable, and collectibility is probable. Service revenue is recognized when the service is performed and accepted by the customer. The Company has a policy of including handling costs incurred for finished goods, which are not significant, in the sales and marketing expenses.
The Company provides installation services for certain sales of equipment under fixed-price contracts. Revenues from these fixed-price service contracts are recognized on the completed-contract method. Under the completed-contract method, revenue and costs of individual contracts are included in operations in the year during which they are completed. Losses expected to be incurred on contracts in progress are recognized in the period such losses are determined. This method is used because the contract is completed within a short period of time, and the financial position and results of operations do not vary significantly from those that would result from using the percentage-of-completion method. A contract is considered completed upon completion of all essential contract work and the installation has been accepted by the customer.
The Company reports earnings per share in accordance with ASC Topic 260 – Earnings Per Share (ASC 260). ASC 260 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share.
Basic earnings per share is computed based upon the weighted average number of shares of common stock outstanding during each period presented, which has been adjusted for the shares of restricted common stock that the Company was obliged to issue as of the balance sheet date (see note 13).
Diluted earnings per share is computed based on net income attributable to stockholders and the weighted average number of shares of common stock outstanding during each period presented, adjusted for the effect of the dilutive common stock equivalents outstanding during the periods presented.
The dilutive effect of warrants and stock options to purchase common stock outstanding during the three-month periods ended March 31, 2012 and 2011 is reflected in the calculation of diluted earnings per share by applying the treasury stock method. Any anti-dilutive effect of the warrants and stock options is excluded from calculation of the earnings per share.
For the three-month period ended March 31, 2011, 40,000 shares of warrants are dilutive and included in the weighted-average number of common stock outstanding for calculation of diluted earnings per share while another 40,000 shares of warrants are anti-dilutive. For the three-month period ended March 31, 2012, 80,000 shares of warrants are anti-dilutive.
The outstanding stock option of 526,335 shares and 601,663 shares for the periods ended March 31, 2012 and March 31, 2011 are anti-dilutive.
Accounts receivable related to the Company’s major customers comprised 86% and 88% of the total accounts receivables as of March 31, 2012 and December 31, 2011 respectively.
Credit risk represents the accounting loss that would be recognized at the reporting date if counter parties failed to perform as contracted. Concentrations of credit risk (whether on or off balance sheet) arise from financial economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The major concentrations of credit risk arise from the Company’s accounts receivable. Even though the Company has major concentrations, it does not consider itself exposed to significant risk with regards to the related receivables.
The Company may also be exposed to the risks as a result of its principal operation being primarily in the PRC. These include risks associated with, among others, the political, economic and legal environmental and foreign currency exchange. The Company’s results may be adversely affected by change in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things. The Company’s management does not believe these risks to be significant. There can be no assurance, however, those changes in political and other conditions will not result in any adverse impact.
The Company mainly maintains its cash balances with various banks located in the PRC. In common with local practice, such amounts are not insured or otherwise protected should the financial institutions be unable to meet their liabilities. There has been no history of credit losses. There are neither material commitment fees nor compensating balance requirements for any outstanding loans of the Company.
Of the retentions balance as of March 31, 2012 and December 31, 2011, approximately US$531,000 and US$633,000 respectively are due to be paid by the debtors after one year.
Goodwill arose from the acquisition of Guolian and Pan-pacific by BTWTC on July 5, 2008 and the acquisition of SRTC by Beijing Telestone on December 30, 2011. The amount represented the excess of the purchase cost over the fair value of identifiable net assets acquired at acquisition date. Goodwill is tested at least annually for impairment in accordance with ASC Topic 350 – Intangibles – Goodwill and other.
Property, plant and equipment are summarized as follows:
Lease prepayment as of March 31, 2012 and December 31, 2011 represented the land use rights for a piece of land located in Guan County, Hebei Province, the PRC. The land use rights will expire in 2059.
The prepaid land use rights have been pledged to a bank in the PRC as collateral for short-term bank loans (Note 9).
As of March 31, 2012 and December 31, 2011, the bank loans of RMB 95 million, equivalent to approximately US$15 million, bear interest to be charged quarterly at the standard short-term borrowing rate as stipulated by the People’s Bank of China on the date of the first withdrawal. The loans are wholly repayable within one year and secured by guarantees provided by a third party guaranty company.
The guarantee provided by the independent guaranty company is secured by the following:
Inventories consisted of the following:
TSTC and its subsidiaries are subject to income taxes on an entity basis on income arising in or derived from the tax jurisdictions in which each entity is domiciled.
TSTC had net operating losses carried forward for income tax reporting purposes that might be offset against future taxable income. The use of these net operating losses carried forward is severely limited when TSTC experiences a change in control. Therefore, following the re-capitalization in August 2005, the amount available to offset future taxable income is limited. No tax benefit has been reported in the financial statements, because TSTC believes that it is more likely than not that the tax loss carry-forward will finally expire and therefore cannot be used. Accordingly, the potential tax benefits of the loss carry-forward are offset by a valuation allowance of the same amount.
No provision for withholding or United States federal or state income taxes or tax benefits on the undistributed earnings and/or losses of the Company's subsidiaries has been made as the earnings of these subsidiaries, in the opinion of the management, will be reinvested indefinitely.
The Company’s income is principally generated in the PRC by Beijing Telestone, BTWTC, BTCTC, Guan Bopu and SRTC. All these entities are subject to enterprise income tax (“EIT”) in the PRC at the following applicable rates:
Beijing Telestone and BTWTC are qualified as Hi-tech enterprises under the current Enterprise Income Tax Law in the PRC, so they enjoy the preferential tax rate of 15% in the PRC for a three-year period commencing from the year 2009. All other entities are subject to the unified tax rate of 25% for the three-month periods ended March 31, 2012 and 2011.
Income tax expenses, comprising EIT, have been provided at the applicable rates on the respective subsidiaries’ / VIE’s estimated assessable income arising in the PRC during the periods.
During the three-month periods ended March 31, 2012 and 2011, all revenues of the Company are from its network installation and optimization services and trading of wireless telecommunication equipment. No financial information by business segment is presented.
As the Company operates mainly in the PRC and over 99% of its revenue during the three-month periods ended March 31, 2012 and 2011 are from the PRC and almost all of the Company’s assets are located in the PRC, no geographical segment analysis is presented.
TSTC had 12,333,264 shares of issued and outstanding common stock as of March 31, 2012 and December 31, 2011.
On December 31, 2010, the Board of Directors of TSTC approved a grant of 100,000 shares of restricted common stock with two years restriction for sale to certain senior officers of the Company as incentive compensation for their services rendered in previous years in improving the business result of the Company and their contribution to the success of the Company and these shares were issued on August 8, 2011.
As of March 31, 2012, the Company was obliged to issue 1,800,000 shares of restricted common stock of TSTC as part of the consideration for the acquisition of SRTC on December 30, 2011 (see note 1).
Summary of related party transactions
Summary of related party transactions (Continued)
As of March 31, 2012, the Company had outstanding capital expenditure commitments on construction contracts of approximately RMB16 million, equivalent to approximate US$2.6 million.
The following table summarizes the approximate future minimum rental payments under non-cancelable operating leases in effect as of March 31, 2012:
The Company recognizes its revenue upon the completion of contracts and has made full tax provision in accordance with relevant national and local laws and regulations of the PRC. A contract is considered as completed upon completion of all essential contract work and the installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. The Company follows the practice of reporting its revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. For PRC tax reporting purpose, the PRC subsidiaries of the Company recognize revenue on an “invoice basis” instead of when goods are delivered and services are rendered. This is not in strict compliance with the relevant laws and regulations. Accordingly, despite the fact that the PRC subsidiaries of the Company had made full tax provision in the financial statements, these PRC subsidiaries may be subject to interest and/or penalties for the deferred reporting of tax obligations. The exact amount of interest and/or penalties cannot be estimated with any reasonable degree of certainty. The board of directors considers it is more-likely-than-not that interest and/or tax penalties will not be imposed.
On June 27, 2005, a Stock Option Plan (the “Plan”) was approved at the 2005 annual meeting of stockholders. The purpose of the Plan is to promote the growth and general prosperity of the Company by permitting the Company to grant incentive and nonqualified stock options to purchase common stock and restricted stock of the Company to key employees, non-employee directors, and advisors. The Plan is designed to help the Company and its subsidiaries and affiliates attract and retain superior personnel for positions of substantial responsibility and to provide key employees, non-employee directors, and advisors with an additional incentive to contribute to the success of the Company.
On November 30, 2010, stock options to subscribe a total of 601,663 shares were granted to certain eligible employees of the Company as incentive compensation to attract and retain superior personnel for positions of substantial responsibility and to provide them with an additional incentive to contribute to the success of the Company.
As at March 31, 2012, certain of these eligible employees of the Company resigned and 75,328 shares of stock options were forfeited accordingly.
The following table sets forth the details of the stock options as of December 31, 2011.
The following table sets forth a summary of the nature of stock-based compensation recognized for the three-month periods ended March 31, 2012 and 2011.
The table below sets forth the functional classification of stock-based compensation recognized for the three-month periods ended March 31, 2012 and 2011.
No tax benefit was recognized for the stock-based compensation recorded for the three-month periods ended March 31, 2012 and 2011.
Stock-based compensation to employees
The 601,663 shares of stock options are accounted for as equity instruments issued in exchange for receipt of services. Costs are measured at the estimated fair value of the equity instruments issued and recognized as an expense over the employee’s requisite service period.
During the three-month periods ended March 31, 2012 and 2011, no stock option was granted by the Company.
For the three-month periods ended March 31, 2012 and 2011, the Company recognised stock-based compensation in relation to stock options granted to employees of US$158,000 and US$452,000 respectively.
A summary of stock option activity as of March 31, 2012 and changes during the three-month period ended March 31, 2012 is presented below:
Stock-based compensation to employees (continued)
The aggregate intrinsic value of all outstanding stock options and exercisable stock options at March 31, 2012 and December 31, 2011 amounted to US$Nil. There were no options exercised during the three-month periods ended March 31, 2012 and 2011. As of March 31, 2012 and December 31, 2011, the Company had total unrecognized compensation amounting to US$466,600 and US$668,900 respectively under ASC 718. The unrecognized compensation will be recognized over a weighted average period of approximately 2 years.
Stock-based compensation to employees (Continued)
For the three-month periods ended March 31, 2012 and 2011, no stock-based compensation in relation to restricted common stock granted to employees has been recognized.
Stock-based compensation to non-employees
For the three-month periods ended March 31, 2012 and 2011, no stock-based compensation in relation to warrants granted to non-employee has been recognized.
The following table sets forth the details of warrants outstanding, vested and exercisable as of March 31, 2012 and December 31, 2011.
Stock-based compensation to non-employees (continued)
In April 2011, the FASB issued ASU No. 2011-03, “Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements.” ASU No. 2011-03 removes the transferor’s ability criterion from the consideration of effective control for repurchase agreements and other agreements that both entitle and obligate the transferor to repurchase or redeem financial assets before their maturity. It also eliminates the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. This guidance is effective for interim and annual periods beginning on or after December 15, 2011. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards.” ASU No. 2011-04 provides a consistent definition of fair value to ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. ASU No. 2011-04 is effective for interim and annual periods beginning after December 15, 2011. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” ASU No. 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of stockholders’ equity. It requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU No. 2011-05 is to be applied retrospectively and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In September 2011, the FASB issued ASU No. 2011-08, “Intangibles – Goodwill and Other (Topic 350): Testing Goodwill for impairment.” The ASU No. 2011-08 permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. The ASU No. 2011-08 are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In September 2011, the FASB issued ASU No. 2011-09, “Compensation – Retirement benefits – Multiemployer Plans (Subtopic 715-80): Disclosure about an Employer’s Participation in a Multiemployer Plan. The ASU No. 2011-09 require that employers provide additional separate disclosures for multiemployer pension plans and multiemployer other postretirement benefit plans.
The ASU No. 2011-09 are effective for annual periods for fiscal years ending after December 15, 2011, with early adoption permitted. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
In December 2011, the FASB issued ASU No. 2011-10, “Property, Plant and Equipment (Topic 360): Derecognition of in Substance Real Estate – a Scope Clarification (a consensus of the FASB Emerging Issues Task Force). The ASU No. 2011-10 requires that a parent deconsolidate a subsidiary if the parent ceases to have a controlling financial interest in the subsidiary (except for a sale of in substance real estate). However, in situations other than a sale of in substance real estate, differing views exist in practice on whether the parent of an in substance real estate subsidiary must satisfy the criteria in Subtopic 360-20, Property, Plant, and Equipment – Real Estate Sales, in order to derecognize the in substance real estate. For public entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2012. Early adoption is permitted. The adoption of this ASU is not expected to have a material impact on the Company’s operating results and financial position.
In December 2011, the FASB issued ASU 2011-12, “Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05” (“ASU 2011-12”). ASU 2011-12 deferred certain aspects of ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income” (“ASU 2011-05”). The new guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Other than enhanced disclosures, the adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
The Company has evaluated subsequent events up to the date that these consolidated financial statements were approved and authorized for issue by the Board of Directors.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following is management’s discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. This report includes forward-looking statements. Generally, the words “believe,” “anticipate,” “may,” “will,” “should,” “expect,” “intend,” “estimate,” “continue,” and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents we file with the SEC from time to time, which could cause actual results or outcomes to differ materially from those projected. Undue reliance should not be place on these forward-looking statements which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements, except to the extent required by law.
The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Quarterly Report on Form 10-Q.
We are a leading access-network solution provider serving the Chinese market. Since 1997, we have operated in the Chinese market and in 2006, we expanded our marketing efforts to include Vietnam, Indonesia, Malaysia, Thailand and India. In 2007, BTCTC was established as one of our subsidiaries focusing on developing and managing our overseas businesses. Currently, our marketing efforts have expanded to 29 countries around the world, including the U.S., Vietnam, Mexico, Brazil, Russia, India, the Philippines, Thailand, Ireland, Ecuador, Mongolia, South Africa, Turkey, Indonesia, Colombia, Costa Rica, Argentina, Ukraine, Kazakhstan, Singapore, South Korea, Hong Kong (SAR), Saudi Arabia, New Zealand, Bangladesh, the UAE, Canada and Iceland. Continued expansion outside of China is one of our core strategies. We believe that the quality of our products and services will allow Telestone to be increasingly competitive internationally.
Our access-network solutions include the research and development (“R&D”) and application of access-network technology. In addition to our homegrown access-network equipment, which includes repeaters, antennas and radio-frequency peripherals, we also offer project design, project management, installation, maintenance and other after-sales services to our customers. Our access-network solutions are designed to further enhance the coverage of mobile telecommunications networks, which in turn improves the quality of reception for mobile phone users. The solutions we provide to the telecommunications industry can be used in indoor and outdoor environments, including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels.
In 2008, we launched WFDS™ (as defined below), a next generation wireless distribution system. WFDS™ is an all-optical network that combines the technologies of both wireless and optical telecommunications. This system supports all mobile telecom networks and various other networks, including WLAN, FTTH, traditional telephone, and video surveillance systems. In 2010, we began generating revenues from WFDS™ installations, and, as of March 31, 2012, we have completed 226 WFDS™ installations.
In addition, our WFDS™ technology provides several important benefits to Telestone and its investors: WFDS™ offers an opportunity for us to diversify our customer base; and WFDS™ generates 41.25% of the gross margin of the company; WFDS™ also targets a different customer base — property developers and managers — rather than large telecom carriers, and these customers tend to make payments more quickly, which should reduce our accounts-receivable days’ sales outstanding (“DSOs”) over time, as WFDS™ grows as a percentage of our revenues. Finally, WFDS™ is a technology platform, and we have a pipeline of WFDS™ technologies slated for launch over the next several years.
While we expanded our sales from purely consisting of a RF-based wireless product portfolio to one including sales from our Unified Local-Access Solution (“WFDS™”) products, our traditional RF-based products still remain a strong growth driver for Telestone and we received more than 89.72% of our revenues from RF-based products in the first quarter of 2012.
We are committed to the research and development of wireless communication related technology. Over 90% of our technology is developed in-house at our research and development center. We employ an experienced and highly trained professional staff of scientists and engineers that concentrate on the invention and further advance of wireless communication technology. We have over 100 R&D specialists, many of whom are industry experts in telecommunications — all have at least a bachelor’s degree, and 40% have a master’s degree or above. As a result of our commitment to R&D, since its introduction, our innovative WFDS™ technology has received recognition in the telecommunications industry and has won awards and praise from several telecommunications carriers.
Also, in order to provide a speedy response and a high level of service to our customers, we have established more than 30 locations throughout China. These locations offer sales, project survey, design, project management and installation and maintenance services. We believe that this sales and service strategy enhances our ability to increase our existing customer base in the PRC and enables us to provide timely responses to customers’ inquires as well as technical and maintenance service upon our customers’ requests. Our sales efforts are not focused in nor dependent upon any particular region or province of the PRC.
As the mobile market in China continues to mature, mobile operators have begun to invest in the future. In particular, the Chinese telecommunications industry has witnessed accelerated development in recent years with a rapid rollout of 3G network investments as well as commitments to introduce 4G technology since 2011. Such is also evidenced by China Mobile, China Telecom, and China Unicom’s €1.178 billion ($1.625 billion) purchase of network and application solutions, and integration and maintenance services from Alcatel-Lucent on November 5, 2010 during the visit of Chinese President Hu Jintao to France.
We also believe that disparate technologies used by mobile carriers in the United States, and the continued roll-out of 3G and 4G also provide a conducive environment for creating potential demand for our WFDS™ enabled equipment and solutions in the United States.
The Rapid Growth of Wireless Subscribers in China
China has repeatedly expressed a commitment to continuing economic growth, aimed at improving the living standards of its population and at expanding its middle class. This growth has led to increasing urbanization amongst the Chinese population with migrant workers moving to cities. There is now a growing demand among both enterprises and households in China for improved wireless bandwidth and network performance. Although China is the largest wireless market in the world, there is still opportunity to expand as the mobile user penetration rate in China is currently relatively low. The number of wireless subscribers in China across both 2G and 3G platforms surpassed 900 million as of the end of August 2011.
Wireless Infrastructure Growth Drivers in China
During the 2G era, the majority of mobile traffic was comprised of voice, and hence network coverage mainly focused on breadth rather than on depth. However, as we entered into the 3G era in China, approximately 70% of the 3G traffic was comprised of data. As a result, in-depth network coverage has become the 3G operators’ first priority and we believe that the demand for wireless enhancement equipment has become much more important than in the past. We believe that the room for growth in such demand is evident as the population coverage levels of existing 3G networks are still below 70% in most cities currently offering 3G, and less than half of China’s 650 major cities support 3G.
Telecom Carriers’ layout for Next-generation Communications Market
The industry trend amongst international mainstream telecom carriers is to accelerate the shift towards the construction of next-generation communications networks, such as LTE. At the 2012 World Mobile Communications Conference, held in Barcelona, China Mobile and its partners jointly published plans to construct more than 500,000 TD-LTE base stations over the next three years that will service a population of up to 2 billion people. In China, nine cities, including Shenzhen and Hangzhou, and the construction of over 20,000 base stations will be involved in commercial testing of China Mobile’s plan. In Hong Kong, China Mobile will begin to provide LTE-TD/FDD services. China Unicom’s LTE Trial Network construction plans also conform to this trend. These investments are expected to create new opportunities in our industry.
To speed up China's Wireless City, Smart City Construction
In recent years Chinese large and medium-sized cities have actively constructed “wireless cities” using a variety of wireless access technologies to provide on-demand anytime, anywhere wireless network access in such cities in order to offer a full range of information, government, business and public services, to promote the development of tourism and other industries, and to enhance the image of the city.
“Big 3” carriers all target the use of WiFi to accelerate the development of such wireless cities. At present, the extent to which the Big 3 have publicized the efforts to develop wireless cities clearly demonstrates that wireless cities represent not only a “flagship” product of the carriers but also the future of the telecom industry in China.
A new revolution has been caused by electronic information technology from urban information to intelligent city construction have led to a growing number of cities implementing smart city -building strategies. In 2012, China will focus on building smart cities. In building smart cities, the government will promote the use of wireless, digital, and intelligent buildings which will inevitably become an important part of service-oriented government construction. At present, China has hundreds of cities proposing to begin construction of smart cities and/or wireless cities. Creating smart cities could provide better promotion of construction of a service-oriented government, and also will provide a more scientific and external environment for social transformation.
Growth in Mobile Subscribers
Growth in the wireless infrastructure market has also been driven by the significant increase in the number of mobile subscribers and in the amount of data transmitted over wireless networks by smart phones in China. This growth results in increasing burdens being placed on the carriers’ wireless infrastructure that can overload the network. Overworked wireless networks result in poor wireless service, slow data transfer rates and dropped calls. In order to alleviate the burdens being put on the wireless infrastructure and to increase wireless network capacity, the Big-3 continue to deploy and upgrade their wireless infrastructure equipment.
“The Internet of Things”
In China, a budding phenomenon has developed, referred to as “The Internet of Things” in organizations and businesses. The Internet of Things literally translates into “the connection of things”, whether they are products, components or systems, so that individuals can communicate intelligently with one another and can communicate remotely with their home and office computers, home appliances and other electronic devices. Everything from home appliances, public infrastructure and facilities, to logistic processes will be assigned an IP address and connected to the Internet of Things through a wired or wireless connection. This demand is expected to increase the need for wireless infrastructure.
Increasing and Evolving Need for Indoor Wireless Coverage
Historically, “indoor wireless” meant only Wi-Fi enabled laptops, but currently, mobile users in China also rely on mobile and smart phones, BlackBerry devices, PDAs, and two-way radios to communicate. All of these devices require indoor wireless coverage to operate effectively. However, while many residential and commercial properties in China may have wireless local-area networks (LAN networks), the vast majority do not have indoor wireless cellular coverage for mobile or smart phones. In order to better serve the needs of their tenants, we expect that property owners will increasingly look to deploy indoor wireless coverage solutions.
The state has decided the integration of telecommunications networks, TV and radio broadcasting networks, and the internet to be the next step in the evolution of these industries. Such integration shall include telecommunications, broadcasting, internet communications, broadband, digital TV, next-generation internet, network interoperability and resource sharing, voice, data and broadcasting a variety of services, etc. The integration of telecommunications networks, TV and radio broadcasting networks and the internet, etc. does not mean unification of of these industries, but rather integration of services provided by players in each of the respective industries. This broad extension of the market space will create more development opportunities.
Integration involves system, management, business and the other complex distribution of benefits problems. In order to overcome these integration issues, the potential monopoly issues must be overcome. The integration really needs to consider how to achieve true peer-to-peer access, in other words true distribution of business content and business interests in order to form an effective mode of operation.
It is crucial to break the barriers created by potential monopolies to ensure coordination between the broadcasting businesses and telecommunications services. Users should be able to select networks to surf the net, watch TV, communicate over the phone and use other telecommunications value-added services through the network. As a result, old trade monopolies will be diminished, and gradually new industry standards established, and the integration will play a significant role in the ecology of the entire telecommunications and broadcasting industries.
We design, engineer and sell RF-based local-access network solutions for indoor and outdoor wireless coverage and WFDS™ solutions for unified local access-network coverage. In the past, our focus has been on RF-based local access-network solutions, but in the future we expect to leverage our WFDS™ technology to transition our customers to a unified local access-network solution. Our WFDS™ solutions are designed for use by property owners of all types of buildings including enterprises, municipalities, small businesses and homes. Our unified local access-network WFDS™ solutions integrate multiple access services, have a lower total cost of ownership and provide better wireless coverage.
Unified Local Access Network WFDS™ Solution
We plan to leverage our first-mover advantage with our WFDS™ technology in order to increase our penetration into the Chinese market and to strengthen our relationships with the Big-3 for whom we believe our WFDS™ solution is a critical component to remain aligned with industry trends and government-sponsored initiatives.
Key benefits of our unified local access-network WFDS™ solution include:
RF-based Local Access Network Solutions
We provide RF-based local access-network solutions to the telecommunications industry for environments including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels. Our suite of products that we deploy as part of these solutions includes base station and tower mounted amplifiers, antennas, couplers and splitters. Our RF-based products support various 2G and 3G transmission standards, including CDMA, W-CDMA, GSM and TD-SCDMA.
TIPS (Telestone Intelligence Premises System) is a groundbreaking technology based on Telestone’s WFDS™ technology. The core of TIPS is Telestone’s Unified Premises Information Network System (“UPINS”) technology, which distributes all information generated or required at any time and at any location within a premises network in a timely manner. TIPS networks are characterized by ultra-wide bandwidth, long transmission distances, and multi-cascading technology. So far we have completed the theoretical research and development of the core technology for TIPS.
TIPS is expected to be used in a broad range of applications including municipal projects, airports, railways, highways, streets, communities, buildings, houses, and medical facilities, etc. For internal communications capabilities, the functions of TIPS can be divided into IP fiber optic networks and wireless telephony features, office computing optical networks and wireless access capabilities, and wireless access teleconferencing, etc. For the external public communications services, the functions of TIPS can be divided into wireless signal coverage for public communications, WLAN converage for telecommunications carriers, and cable TV access functions, etc. For network management and maintenance, the functions of TIPS can be divided into network monitoring and traffic management, information security management, and behavior management, etc. For security management, the functions of TIPS can be divided into entrance guard and attendance management, video intercom management, and multimedia publishing, etc.
TIPS is closely related to the integration of telecommunications, TV and radio broadcasting and internet access into one unified network, a project initiated by the State Council. TIPS also provides reliable solutions to developing “smart cities” via its comprehensive network integration capabilities, intelligent management, cost-saving materials and unique energy-saving features.
Our Competitive Strengths
We believe that the following competitive strengths enable us to compete effectively and to capitalize on the growth opportunities in our markets:
Strong Research and Development Capabilities
Our R&D capabilities rank among the best in the PRC’s telecommunications industry. We have a robust engineering project management system and an experienced engineering team. Our research and development center is equipped with the latest equipment and testing facilities, which give our research and development personnel the tools they require to make significant advances in access-network technologies. In addition, we provide our employees with continuing education administered through internal programs.
Our R&D capabilities are recognized and approved by the PRC government and have won accolades such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. We are focused on increasing our research and development efforts to develop superior and proprietary technologies.
Our proprietary WFDS™, the result of our R&D efforts, is one of the leading indoor access-network products in China. Compared with other traditional wireless distribution systems, our WFDS™ system has many advantages. Firstly, WFDS™ uses fiber optic cable to transport signals. Based on the low signal-loss characteristic of fiber optic cable, through which signals can be transmitted over long distances, the main unit (“MU”) can be placed closer to the signal source, and the remote unit (“RU”) can be placed closer to the subscribers. Therefore, a micro-power signal source can be used, which reduces interference and noise, generates low electromagnetic interference, and expands the coverage area. Secondly, due to the input port of the MU connecting to the signal combiner, WFDS™ systems can support multiple signals’ access and network integration. WFDS™ can provide all broadband communication services access in the 500 kHz ~ 3 GHz band for subscribers. Thirdly, due to the fact that each node of the system has the same bandwidth and flow characteristics, WFDS™ can provide the same communication services for every subscriber. WFDS™ systems are also easy to manage and flexible for implementing expansion and upgrades of systems with minimum cost.
Broad and diverse market base
Our business covers a wide region. We have 30 branches throughout China and our business covers approximately 29 countries worldwide.
Experienced marketing staff
We employ a group of experienced telecommunications experts and an experienced and technologically savvy marketing staff in China.
Strong customer relations
We have maintained long-term relationships with China Unicom, China Mobile, China Telecom and China Netcom as customers for approximately 14 years.
As a high-tech enterprise with an established track record, our company enjoys the stimulus plans offered by China’s industry governmental authorities and by local authorities, including the Ministry of Science and Technology, the Ministry of Industry and Information Technology, the Beijing municipal government and the Administrative Committee of Z-Park.
Our Growth Strategy
In order to maintain our position as one of the leading companies in the PRC’s access-network solutions sector, and expand and diversify our revenue streams, we have adopted the following strategies:
Continue to focus on research and development
We plan to continue to invest in research and development for our key technologies and products to enhance our leading position in the access network technology market and take full advantage of the PRC’s investment in 3G and 4G networks. We have dedicated research and development programs to advance access-network solutions for the continued development of our business.
Seek selective acquisitions and strategic investments
In the domestic market, we intend to maintain strong relationships with Chinese mobile telecommunications carriers and potentially make selective acquisitions in major provincial markets where we do not have a leading market share. Our potential targets are companies that enjoy a leading market position and have strong business networks in their provincial markets, that have strong production capabilities, that own applicable value added products and whose customer network platforms adapt to WFDS™. We believe that we will further our penetration into provincial markets and raise our overall market share through selective acquisitions and the promotion of new solutions.
Strengthen international market presence
We plan to focus on increasing our presence in markets outside of the PRC. We will continue to strengthen our presence abroad by leveraging our expertise and our leading access-network products and solutions. In the United States, we plan to seek cooperation with peers that have strong research and development abilities and develop technology and products that are suitable for the PRC market. We also seek partners within the integration business to sell our products. In developing countries, we only seek cooperation with local integration partners to deliver our access network solution technologies. We then work with these partners to set up our local product distribution channels.
Description of Products and Engineering Services
We design and sell electronic equipment used to provide access-network solutions to our customers. Many of these types of equipment, including WFDS™ products, RFPA products, passive components and base station antennas for 2G, 3G, Broadband access and CATV networks, are highly specialized active microwave components designed to meet the needs of our customers.
In addition to designing and selling our products, we also provide systems integration services to our customers. The primary systems integration services provided to our customers are project design and engineering, specifically, the development and design of indoor (living quarters, hospital systems, and hotels) and outdoor (expressways, railways and no coverage zones) wireless signal complementary coverage solutions and their applied products. This includes the design of the required equipment, implementation, project quality evaluation as well as after-sale maintenance and optimization for system integration products, constructive products for engineering design projects and wireless network optimization products.
Research & Development
We maintain a research and development center where the majority of our products are designed by our staff of engineers and scientists. Our research and development center is equipped with the latest equipment and testing facilities, which give our research and development personnel the tools they require to make significant advances in access-network technologies. The center is comprised of three research centers including (i) the Premises Neural Network Research and Development Center, (ii) the Joint Development center, and (iii) the System Product Research Center, and seven professional research departments including: (i) the Resident Neural Network Research and Development Department, (ii) the Radio Station Network Development Department, (iii) the Equipment R&D Department, (iv) the Parts Development Department, (v) the IP Resident Network Research and Development Department, (vi) the Government Intelligent Systems Research and Development Department, and (vii) the Business Intelligent Systems Research Department.
We seek to remain at the forefront of current and future technologies, paying close attention to evolving development trends in domestic and international technologies. Our R&D capabilities are recognized and affirmed by the PRC government and have won awards such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments.
Our main domestic competitors are Guangdong Comba, Wuhan Hongxin and China GrenTech.
Our potential international competitors include Powerwave Technologies and Andrew Corporation. We believe that our overseas competitors are not key threats to Telestone because they have no competitive advantage with respect to product costs and are not accustomed to the marketplace of the PRC.
The following is a summary of the principal governmental laws and regulations that are or may be applicable to our operations in the PRC. The scope and enforcement of many of the laws and regulations described below are uncertain. We cannot predict the effect of further developments in the Chinese legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement of laws.
The telecommunications industry, including certain access-network solution provider services, is highly regulated in the PRC. Regulations issued or implemented by the State-owned Assets Supervision and Administration Commission of the State Council, Ministry of Information Industry of PRC and other relevant government authorities cover many aspects of telecommunications network operations, including entry into the telecommunications industry, the scope of permissible business activities, interconnection and transmission line arrangements, tariff policies and foreign investment.
The principal regulations governing the telecommunications services business in the PRC include:
Our gross margin has been, and will continue to be, affected by a variety of factors, including:
Operating expenses consist of sales and marketing expenses, general and administrative expenses, and research and development expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, benefits and other compensation for our employees. We had approximately 1412 full-time employees as of May 15, 2012.
Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of sales and marketing expenses, including all related expenses and compensation for sales personnel and travel expenses related to sales of products and market development. We expense sales and marketing expenses as incurred.
We plan to continue to invest strategically in sales and marketing with the intent of adding new customers and increasing penetration within our existing customer base, expanding our domestic and international sales and marketing activities, building brand awareness and sponsoring additional marketing events. We expect future sales and marketing expenses to continue to be our most significant operating expenses.
General and administrative expenses primarily consist of compensation for personnel, travel expenses, materials expenses related to ordinary administration, fees for professional services, and provisions for doubtful accounts.
Research and development expenses primarily consist of compensation for research and development staff, material expenses, travel expenses and facility expenses. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest in our research and development efforts because we believe they are essential to maintaining our competitive edge. The amount invested in our research and development activities will increase as we continue to increase our revenue. However, as a percentage of revenue, research and development costs are expected to remain relatively low.
Interest expense includes interest we pay on our short-term bank loans.
Other Income (Expense), Net
Other income (expense), net includes interest income on cash balances, gains or losses from disposal of assets, gains or losses on the conversion of non-Renminbi transactions into Renminbi, and gains from governmental subsidies. Cash has historically been invested in highly liquid investments with original maturities of three months or less.
Income Tax Expense
Income tax expense is computed based on pre-tax income included in the condensed consolidated statement of operations. Income taxes have been provided, using the liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities and their reported amounts. The tax consequences of those differences are classified as current or non-current based upon the classification of the related assets or liabilities in the condensed consolidated financial statements.
Critical Accounting Policies
Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). These accounting principles require us to make estimates and judgments that affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, foreign currency translation, inventory valuation, allowances for doubtful accounts, and goodwill.
Our revenue is derived primarily from two sources: (1) product revenue and (2) professional services revenue.
Product revenue represents the contracted value of goods, net of value-added tax (“VAT”) and returns. The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery occurs, the fee is fixed or determinable, and collectability is probable. Professional service revenue is recognized when the service is performed and accepted by the customer.
As part of professional services, the Company provides installation services for certain sales of equipment under fixed-price contracts. Revenues from these fixed-price service contracts are recognized on the completed-contract method. Under the completed-contract method, revenue and costs of individual contracts are included in operations in the year during which they are completed. Losses expected to be incurred on contracts in progress are recognized in the period such losses are determined. This method is used because the contract is completed within a short period of time, and the financial position and results of operations do not vary significantly from those that would result from using the percentage-of-completion method. A contract is considered completed upon completion of all essential contract work and once the installation has been accepted by the customer.
Foreign Currency Translation
All major subsidiaries of the Company consider Renminbi as their functional currency as a substantial portion of their business activities is conducted in Renminbi. However, the Company has chosen the United States dollar as its reporting currency.
Transactions in currencies other than the functional currency during the year are translated into the functional currency at the applicable rates of exchange prevailing at the time of the transactions. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at the applicable rates of exchange in effect on the balance sheet date. Exchange gains and losses are recorded in the condensed consolidated statements of operations.
For translation of financial statements into the reporting currency, assets and liabilities are translated at the exchange rate on the balance sheet date, equity accounts are translated at historical exchange rates, and revenue, expenses, gains and losses are translated at the weighted average rates of exchange prevailing during the period. A translation adjustment, when material, resulting from this process is recorded in accumulated other comprehensive income within stockholders’ equity.
Inventory consists of equipment and related component parts and is stated at the lower of weighted average cost or market value. We record inventory write-downs for potential excess inventory based on forecasted demand, economic trends and technological obsolescence of our products. If future demand or market conditions are less favorable than our projections, additional inventory write-downs could be required and would be reflected in cost of product revenue in the period the revision is made. At the time of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.
Allowances for Doubtful Accounts
We record a provision for doubtful accounts based on historical results and a detailed assessment of the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, our management considers, among other factors, (1) the aging of the accounts receivable, including trends within and ratios involving the age of the accounts receivable, (2) our historical write-offs, (3) the credit-worthiness of each customer, (4) the economic conditions of the customer’s industry, and (5) general economic conditions. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected.
We apply ASC Topic 350 – Goodwill and Other Intangibles and perform an annual goodwill impairment test, or test more frequently if events or changes in circumstances indicate that the carrying value may be impaired. Goodwill is allocated to cash-generating units for the purpose of the impairment test and determination of gain or loss on disposal.
Goodwill on acquisition of businesses, being the excess of the cost of the acquisition over the Company’s share of the fair value of the identifiable assets, liabilities and contingent liabilities, is recognized as a separate asset. Goodwill is carried at cost less accumulated impairment losses. An impairment loss on goodwill is not reversed. We did not recognize impairment charges in any of the periods presented.
RESULTS OF OPERATIONS
Results of Operation
Our operating results are presented for the quarter ended March 31, 2012, as compared to the quarter ended March 31, 2011.
For the three months ended March 31, 2012: our revenue was $17,103,000; the gross profit was $6,540,000; the net income was $479,000; the net profit ratio was 2.80%. For the three months ended March 31, 2011: our revenue was $14,472,000; the gross profit was $6,598,000; the net income was $1,619,000; the net profit ratio was 11.19%. As a result of the decrease in gross profit margin and the increase in sales and marketing expenses, our net income decreased when compared to the same period of last year. In the first quarter of 2012, our revenue increased by 18.2% when compared to the first quarter of 2011, mainly because Si Chuan Rui Deng’s results started to be consolidated by the Company in the first quarter of 2012. Despite the increase in revenue contributed by Si Chuan Rui Deng, our gross profit margin decreased as Si Chuan Rui Deng’s gross profit margin is lower than that of the Company.
Three months ended March 31, 2012 and 2011:
For the three months ended March 31, 2012, revenue generated from product sales was $3,531,000.
For the three months ended March 31, 2012, revenue generated from professional services was $13,572,000.
Compared with the same period of 2011, the service revenues recorded a substantial increase, which accounted for 79.4% of total revenue.
For the three months ended March 31, 2012, revenue generated from product sales decreased by $3,461,000. Major declines in product sales were seen in Beijing and Hubei which contributed a decrease of $2,852,000 in total. In the Beijing area, 2012 equipment bidding occurred in the first quarter. Thus, first quarter equipment sales are typically lower than subsequent quarters.
In Hubei Province, telecommunication carriers’ WLAN investment decreased significantly in the first quarter of 2012 which affected the first quarter equipment sales. For the three months ended March 31, 2012, revenue generated from service sales increased by $6,092,000, which was mainly contributed by Si Chuan Rui Deng.
Breakdown by Customer
Three months ended March 31, 2012 and 2011:
Revenues from the wireless telecom carriers were the Company’s major source of revenue. For the three months ended March 31, 2012, our revenue generated from China Mobile accounted for 57.0% of our total revenue. Our revenue generated from China Unicom accounted for 25.3% of total revenue. The revenue from China Mobile increased significantly in the first quarter of 2012, which was mainly contributed by Si Chuan Rui Deng whose major customer is China Mobile. In the first quarter of 2012, Si Chun Rui Deng’s revenue from China Mobile was $5,140,000.
Breakdown by Type of Technology
Three months ended March 31, 2012 and 2011:
The revenue of WFDS products was $1,758,000 in the first quarter of 2012, which accounted for 10.28% of total revenue. Income from traditional products increased substantially due to Si Chuan Rui Deng as its business projects are mainly traditional product projects.
For the three months ended March 31, 2011 and 2012, a tabular summary of our gross profit is presented below:
The gross margin was 38.24% in the first quarter for 2012, compared to 45.59% in the first quarter of 2011, decreased by 7.35%. We recorded a decrease in gross profit margin for both equipment sales and service revenues.
The gross profit margin for service income decreased from 45.9% to 38.1% mainly because Si Chuan Rui Deng’s gross profit margin is lower than that of the Company.
Three months ended March 31, 2012 and 2011:
Sales and Marketing Expenses
Sales and marketing expenses were $3,617,000, or 21.15% of our revenue for the three months ended March 31, 2012, as compared to $2,131,000, or 14.72% of our revenue for the same period in 2011. The increase was mainly because of the increase in staff costs as a result of increase in headcount to cope with the expansion of the business of the Company in 2011.
General and Administrative Expenses.
General and administrative expenses were $1,346,000 or 7.87% of our revenue for the three months ended March 31, 2012, as compared to $2,005,000 or 13.85% of revenue for the same period in 2011. The decrease was mainly due to the decrease in share based payments from $452,000 in the first quarter of 2011 to $158,000 in the first quarter of 2012.
Research and Development Expenses
Research and development expenses were $463,000, or 2.71% of revenues for the three months ended March 31, 2012, as compared to $248,000, or 1.71% of revenues for the same period in 2011. R&D expenses increased due to the increase in number of R&D personnel.
Three months ended March 31, 2012 and 2011:
Interest expenses were $271,000 for the three months ended March 31, 2012, an increase of 81.9% as compared to $149,000 for the same period in 2011. The increase in interest expense in 2012 was mainly due to the increases in both interest rates and average bank loan balances.
Liquidity and Capital Resources
We generally finance our operations from cash flow generated internally and short-term bank loans. As of the three months ended March 31, 2012, we had current assets of $286,130,000. Our current assets were comprised of: inventories of $9,799,000, accounts receivable of $256,477,000, prepayments of $2,565,000, other current assets of $5,123,000, cash and cash equivalents of $12,166,000. Current liabilities were $159,175,000, comprised of accounts payable of $48,947,000, tax payables of $18,863,000, short-term loans of $15,039,000, customer deposits for sales of equipment of $2,901,000, other payables of $71,582,000, and amounts due to related parties of $1,843,000.
Our net cash used in operating activities was $(6,558,000) for the three months ended March 31, 2012. As of March 31, 2012, cash and cash equivalents were $12,166,000. Current assets were $286,130,000 and current liabilities were $159,175,000, reflecting a current ratio (current assets/current liabilities) of 1.80:1.
Our trading terms with our customers are mainly on credit. The accounts receivable turnover period for the three months ended March 31, 2012 was 1,291 days. The long accounts receivable turnover period is due to the Company’s marketing strategy for rapid-growth, which results in a larger amount of accounts receivable.
In 2011, although the Company focused on strengthening the collection of accounts receivable as a sales strategy; the amount of time necessary for the collection of payments is still less than ideal, and this trend has continued in the first quarter of 2012.
We have experienced long accounts receivable turnover periods. This is due to the fact that most of our projects are integrated projects and the accounts receivable turnover period for these kinds of sales has been relatively long. Most of our major competitors focus on pure equipment sales, which lead to shorter accounts receivable turnover periods. In addition, most of our customers are the ”Big Three”, which are known as “blue chip” customers and their payment cycles are comparatively long.
Our inventory turnover period for the three months ended March 31, 2012 was 344 days.
In 2012, Our cash and bank balances are mainly denominated in RMB and U.S. Dollars, while our bank borrowings are mainly denominated in RMB. Our revenue, expenses, assets and liabilities are mainly denominated in RMB and U.S. Dollars.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.
We recognize our revenue upon the completion of contracts and have made full tax provision in accordance with relevant national and local laws and regulations of the PRC. A contract is considered completed upon completion of all essential contract work and when installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. We follow the practice of reporting our revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. Despite the fact that we have made full tax provision in our financial statements, we may be subject to surcharge and penalty for the deferred reporting of tax obligations. The Board of Directors considers it is unlikely that the tax surcharge and penalty will be imposed.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not required for smaller reporting company.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures
Under supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”); and whether any change has occurred in the Company’s internal control over financial reporting pursuant to Exchange Act Rules 13a-15(d) and 15d-15(d). Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. This information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were not effective due to the fact that the material weaknesses in the Company’s internal control over financial reporting described in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011 have not been remediated as of the Evaluation Date, although steps have been taken toward remediation during the quarter ended March 31, 2012.
It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
(b) Changes in internal control over financial reporting
During the quarter ended March 31, 2012, there were no changes to our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 1. Legal Proceedings.
Item 1A. Risk Factors.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Item 3. Defaults Upon Senior Securities.
Item 4. Mine Safety Disclosures.
Item 5. Other Information.
Item 6. Exhibits.
The following documents are filed or furnished as part of this report:
In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.