ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
Overview
The Company believes that the People's Republic of China represents a dynamic emerging world market whose role in the global economy is increasing steadily. China's economic growth rate, measured by its gross domestic product, has consistently been higher than 7% over the past 10 years. This economic growth is attributable to many factors, including investment in the country's infrastructure, increased privatization of businesses and an abundant source of labor.
Currently, the Company offers products and services to businesses and consumers located primarily in China. The Company's plan is to take advantage of China's economic growth to expand its existing businesses and, possibly, in the future, to sell its products and services outside of China. The Company also has begun to acquire diverse businesses that are not dependent on, or directly related to, each other. During the past two years, the Company has acquired a digital imaging system business, a property rights exchange business, a security system business and a business that provides "smart cards", which are credit card sized cards that are able to be programmed to perform tasks and store information. The Company has used its technological expertise to enhance the products and services provided by these businesses. The diversification of the Company's business has resulted in an overall improvement in the Company's financial condition. Currently, over 90% of the Company's revenues are generated by its subsidiaries, Shenzhen Golden Anke Technology Ltd. ("Shenzhen Golden Anke"), which sells digital security imaging systems, and Shanghai Newray Photographic Equipment Co., Ltd. ("Shanghai Newray"), which sells digital photographic equipment. The balance of the Company's revenues are generated primarily by other subsidiaries, China E.com Information Technology Ltd. ("China E.com"), which distributes licenses for Chinese language translation software and offers web design and hosting services, and Hainan Concord Financial Products Development Co. Ltd., ("Hainan Development"), which provide financial institutions with research and development services for their financial products and instruments.
We will further develop our business in property rights exchange industry by using our technical expertise to develop an electronic platform for trading of private property rights exchange in China. Through our acquisition in the business in Shanghai, Xi'an, Hainan and Shenzhen, we have enhanced our market presence in various major property rights exchange centre in PRC, and after the electronic trading platform is in operation, we will then have another major stream of revenue from the property rights exchange industry.
Risks Associated with Doing Business in China
There are significant risks in operating in the Peoples' Republic of China (the "PRC"). These include risks associated with the political and economic environment, foreign currency exchange and the legal system in the PRC. The economy of PRC differs significantly from the economies of the industrialized nations of the west in such respects as structure, level of development, gross national product, growth rate, capital reinvestment, resource allocation, self-sufficiency, rate of inflation and balance of payments position, among others. Only recently has the PRC government encouraged substantial private economic activities. The Chinese economy has experienced significant growth in the past several years, but such growth has been uneven among various sectors of the economy and geographic regions. Actions by the PRC government to control inflation have significantly restrained economic expansion in the recent past. Similar actions by the PRC government in the future could have a significant adverse effect on economic conditions there.
Many laws and regulations dealing with economic matters in general and foreign investment in particular have been enacted in the PRC. However, the PRC still does not have a comprehensive system of laws, and enforcement of existing laws may be uncertain and sporadic. Our primary sources of revenues and cash flows are derived from our business operations in the PRC. The PRC economy has, for many years, been a centrally-planned economy, operating on the basis of annual, five-year and ten-year state plans adopted by central PRC governmental authorities, which set out national production and development targets. The PRC government has been pursuing economic reforms since it first adopted its "open-door" policy in 1978. There is no assurance that the PRC government will continue to pursue economic reforms or that there will not be any significant change in its economic or other policies, particularly in the event of any change in the political leadership of, or the political, economic or social conditions in, the PRC. There is also no assurance that the Company will not be adversely affected by any such change in governmental policies or any unfavorable change in the political, economic or social conditions, the laws or regulations, or the rate or method of taxation in the PRC.
As many of the economic reforms that have been or are being implemented by the PRC government are unprecedented or experimental, they may be subject to adjustment or refinement, which may have adverse effects on the Company. Further, through state plans and other economic and fiscal measures such as the leverage of exchange rate, it remains possible for the PRC government to exert significant influence on the PRC economy. The Company's financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents. Cash and cash equivalents are maintained with government-owned banks in the PRC with high credit ratings.
On January 1, 1994, the PRC government introduced a single rate of exchange of Renminbi ("Rmb") against United States Dollar ("US$") as quoted daily by the People's Bank of China (the "Unified Exchange Rate"). On July 21, 2005, Rmb was revalued from Rmb 8.28 to Rmb8.11 for US$1 following the removal of the peg to the US dollar and pressure for the United States. The Peoples Bank of China also announced that the Renminbi would be pegged to a basket of foreign currencies, rather then being strictly tied to the US dollar and would trade within a narrow 0.3% band against this basket of currencies, which is dominated by the US dollar, Euro, Japanese Yen and South Korean Won, with a smaller proportion made up of the British pound, Thai Baht and Russian Ruble. No representation is made that the Rmb amounts have been, or could be, converted into US$ at that rate. This quotation of exchange rates does not imply free convertibility of Rmb to other foreign currencies. All foreign exchange transactions continue to take place either through the Bank of China or other banks authorized to buy and sell foreign currencies at the exchange rate quoted by the People's Bank of China. Approval of foreign currency payments by the People's Bank of China or other institutions requires submitting a payment application form together with suppliers' invoices, shipping documents and signed contracts.
Restriction on the Payment of Dividends - PRC law requires net profits after taxes to be used to set-off any losses carried forward before any distribution of profits may be made. Furthermore, PRC law imposes a Mandatory Provident Reserve on all businesses. Under this law, a business must set aside 10% of its distributable profits as a mandatory reserve before a distribution of profits may occur. Once the business accumulates a mandatory reserve equal to 50% of its capitalization, no further accumulation of the reserve is required.
Certain Factors Affecting Future Operating Results
The Company's operating results have been, and will continue to be, affected by a wide variety of factors that could have a material adverse effect on revenues and profitability during any particular period. Some of these factors include:
o the Company's ability to successfully implement its current business plan;
o whether the Company will be able to obtain additional capital, if necessary, to support its operations;
o whether the Company will be able to find joint venture prospects or acquisition prospects with which to enhance its business;
o whether the Company can successfully integrate acquisitions that it makes into its business;
o the level and rate of acceptance of the Company's products and services by consumers in China;
o continued economic growth in China;
o entry of new competition (including established companies from outside China and companies with substantially greater resources) into the Company's market;
o fluctuations in the level of demand for services or products;
o rescheduling or cancellation of orders by customers;
o competitive pressures on selling prices;
o rapid changes in technology, which could result in the Company's technology becoming obsolete;
o dependence upon key employees, in particular the Company's President, Andy Lin;
o availability and cost of computer technicians;
o loss of any of the Company's major customers, including the Jiuding Group;
o the Company's ability to introduce new products and services on a timely basis;
o new product and service introductions by the Company's competitors;
o fluctuations in exchange rates; and
o adverse changes in the general economic, social or political conditions in the PRC.
Critical Accounting Policies
The Company prepares its consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions.
The following critical accounting policies affect the more significant judgments and estimates used in the preparation of the Company's consolidated financial statements.
Revenue Recognition
The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements". The Company recognizes revenue when the significant risks and rewards of ownership have been transferred to the customer pursuant to PRC law, including factors such as when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, sales and value-added tax laws have been complied with, and collectibility is probable.
Accounts Receivable
The Company typically extends credit to its customers. In order to determine the value of the Company's accounts receivable, the Company records a provision for doubtful accounts to cover estimated credit losses. Management reviews and adjusts this allowance periodically based on historical experience and its evaluation of the collectibility of outstanding accounts receivable. The Company evaluates the credit risk of its customers by analyzing its aged accounts receivable, utilizing historical data, the customer's financial condition, general economic conditions and estimates of future performance.
Long-Lived Assets and Goodwill
The Company periodically evaluates the carrying value of long-lived assets held or used whenever events and circumstances indicate that the carrying value of the asset may no longer be recoverable. An impairment loss, measured on the fair value of the asset, is recognized if expected future undiscounted cash flows are less than the carrying value of the assets.
The Company evaluates the carrying value of investments in associated companies, at a minimum, on an annual basis and whenever events and circumstances indicate that the carrying value of the asset may no longer be recoverable. An impairment loss, measured on the fair value of the asset, is recognized if expected future undiscounted cash flows are less than the carrying value of the assets.
The Company evaluates goodwill, at a minimum, on an annual basis and whenever events and changes in circumstances suggest that the carrying amount may not be recoverable in accordance with SFAS No. 142 "Goodwill and Other Intangible Assets". Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit's carrying amount, including goodwill, to the fair value of the reporting unit. The fair values of the reporting units are estimated using discounted cash flows approach. If the carrying amount of the reporting unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any.
Income Taxes
The Company records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. In the event the Company was to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax assets would be credited to operations in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to operations in the period such determination was made.
Results of Operations - Three Months Ended September 30, 2005 and 2004
All amounts shown below are presented in US$. As used below, the letter "K" appearing immediately after a dollar amount denotes that it has been rounded to the nearest $1,000.
Net Revenues
Net revenues for the three months ended September 30, 2005 consisted primarily of the sales of digital security imaging systems by the Company's subsidiary, Shenzhen Golden Anke. The balance of the Company's revenues was derived from other subsidiary, China E.com and ChinaE.com Tech, which provide e-commerce solutions, and Hainan Development, which provide services rendered for provision of information on property right exchange. Net revenues for the three months ended September 30, 2004 consisted primarily of the sales of photographic equipment, sales of digital security imaging systems and e-commerce solutions. The term "e-commerce solutions" includes web-site design and development and web-hosting.
The following table reflects the total net revenues and percentage of net revenues by major category for the periods indicated:
Net Revenues Percent of Net Revenues
-------------------------------- -------------------------------------
Three Months Ended September 30, Three Months Ended September 30,
-------------------------------- -------------------------------------
2004 2005 2004 2005
---- ---- ---- ----
US$ US$
E-commerce solutions 58,787 69,563 3.0% 2.0%
Sales of photographic
equipment 167,790 - 8.5% -
Sales of digital security
imaging system 1,741,786 3,427,890 88.5% 98.0%
Consultancy fee - 462 - 0.0%
----------- ---------------- ----------------- -----------------
Total 1,968,363 3,497,915 100.0% 100.0%
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Total net revenues increased by 78% to $3,498K during the three months ended September 30, 2005, as compared to $1,968K during the three months ended September 30, 2004. The increase in total net revenues was primarily attributable to sales of digital security imaging systems made through the Company's subsidiary, Shenzhen Golden Anke, which the Company acquired in August 2004. Revenues attributable to e-commerce solutions increased by $11K or 18%, to $70K during the three months ended September 30, 2005, as compared to $59K earned during the three months ended September 30,2004. During the three months ended September 30, 2005, the Company provide consultancy services rendered for provision of information on property right exchange through its subsidiary, Hainan Concord which the Company acquired in January 2005.
Approximately 98% of the Company's net revenues for the three months ended September 30, 2005 aggregating $3,428K were attributable to the sales of digital security imaging systems made through Shenzhen Golden Anke. The purchasers of these systems are the subsidiaries of Jiuding Group, which sell the systems to third parties. The major shareholders of Jiuding Group are also the 49% shareholders of Shenzhen Golden Anke.
The sale of the Company's products to a small number of customers may cause net sales and operating results to fluctuate from quarter to quarter based on the customers' requirements and the timing of their orders and shipments. The Company does not have long-term sales contracts with its customers, although the Company believes that its relationships with its customers are satisfactory. The loss of any of the Company's significant customers, in particular the Jiuding Group, would have a material adverse effect on the Company's business, results of operations and financial condition. If the Company were unable to replace its significant customers, either with other major customers or with a significant increase in the orders placed by smaller customers, the Company could be forced to severely curtail, or possibly even cease, its operations.
Cost of Revenues
The following table reflects the principal components of cost of revenues and
the percentage of net revenues represented by each component for the periods
indicated:
22
Cost of Revenues Percent of Net Revenues
-------------------------------------- -------------------------------------
-------------------------------------- -------------------------------------
Three Months Ended September 30, Three Months Ended September 30,
-------------------------------------- -------------------------------------
-------------------------------------- -------------------------------------
2004 2005 2004 2005
---- ---- ---- ----
US$ US$
Engineering/technician
salaries 21,283 20,863 1.1% 0.6%
Cost of photographic
equipment 151,736 - 7.7% -
Cost of digital security
imaging system 1,176,489 2,408,556 59.8% 68.9%
Depreciation 1,233 824 0.1% 0.1%
Other 15,449 15,393 0.7% 0.4%
-------------- ---------------- ----------------- -----------------
-------------- ---------------- ----------------- -----------------
Total 1,366,190 2,445,636 69.4% 70.0%
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Cost of revenues increased by 79% to $2,446K or 70% of net revenues for the three months ended September 30, 2005, as compared to $1,366K or 69.4% of net revenues for the three months ended September 30, 2004.
The principal components of cost of revenues during the three months ended September 30, 2005 were engineer and technician salaries, costs of digital security imaging systems hardware, other costs associated with engineering and technical staff support and depreciation of equipment utilized in connection with the Company's operations.
The increase in costs of revenues in 2005 as compared to 2004 was principally attributable to the increase in sales of the Company's digital security imaging systems.
Selling, General and Administrative Expense
Selling, general and administrative ("SG&A") expense consists principally of
sales commissions, advertising, other marketing expense, rental expense,
salaries for administrative and sales staff, and corporate overhead.
The following table reflects the principal components of SG&A expense and the
percentage of net sales represented by each component for the periods indicated:
SG&A Expense Percent of Net Revenue
-------------------------------------- -----------------------------------
-------------------------------------- -----------------------------------
Three Months Ended September 30, Three Months Ended September 30,
-------------------------------------- -----------------------------------
-------------------------------------- -----------------------------------
2004 2005 2004 2005
---- ---- ---- ----
US$ US$
Sales and marketing salaries
and commissions 29,443 22,857 1.5% 0.7%
Advertising and other sales
and marketing expenses 13,906 19,150 0.7% 0.5%
Rentals 13,557 14,845 0.7% 0.4%
Administrative salaries 36,445 33,302 1.9% 0.9%
Corporate overhead 198,106 447,215 10.0% 12.8%
------------- ---------------- ----------------- -----------------
Total 291,457 537,369 14.8% 15.3%
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For the three months ended September 30, 2005, SG&A expense increased 84% to $537K, as compared to $291K for the three months ended September 30, 2004.
The increase in SG&A expense in 2005 as compared to 2004 was principally attributable to an increase in corporate overhead, which included expenses of $153K for board management compensation by issuing 1,700,000 shares at $0.09 per share, $234K for commission of 40million shares private placement made in September 2005 by issuing 2,600,000 shares at $0.09 per share and the gain on exchange for the change of exchange rate of Rmb to HK$ and US$ from 1.07 and 8.28 to 1.04 and 8.11respectively from August 11, 2005. The $3K decrease in administrative salaries was mainly attributable to reduce administrative staff. During the three months ended September 30, 2005, the Company reduced its sales team as a result of management's reassessment of the manpower required to generate sales and service to the Company's customers.
Income Taxes
Income taxes for the three months ended September 30, 2005 were $156K and $85K for the three months ended September 30, 2004.
Other Items
Minority interests reflect the minority shareholders' proportionate interests in the net income (loss) of Intermost Focus Advertising, Shanghai Newray, Shenzhen Golden Anke and Hainan Development. Minority interests were $441K for the three months ended September 30, 2005, as compared to minority interests of $239K for the three months ended September 30, 2004.
Equity in earnings of an associated company was $(10K) and $173K for the three months ended September 30, 2005 and 2004 respectively, representing the Company's proportionate share of the earnings (loss) of Shanghai Fortune.
Net Income (Loss)
As a result of the aforementioned factors, the Company had net loss of $(143K) during the three months ended September 30, 2005, as compared to a net profit of $86K during the three months ended September 30, 2004.
Liquidity and Capital Resources -September 30, 2005
At September 30, 2005, the Company had cash and cash equivalents of $930K and working capital of $8,086K, as compared to $138K of cash and cash equivalents and $4,883K of working capital at June 30, 2005.
Net cash used in operating activities was $84K for the three months ended September 30, 2005, as compared to net cash provided by operating activities of $57K for the three months ended September 30, 2004. Net cash used in operating activities in 2005 as compared to 2004 as a result of decrease in accounts receivables. Our use of cash was partially offset by non-cash charges, including the use of our common stock (or the reservation of common stock to be used) in exchange for services in the amount of $660K, depreciation expense in the amount of $4K and amortization of intangible assets in the amount of $147K.
Net cash used in investing activities was $31K for the three months ended September 30, 2005, consisting of $28K of funds from the short-term investment and $3K for the purchase of plant and equipment. Net cash provided by investing activities was $57K for the three months ended September 30, 2004 for the acquisition of a 51% interest in Shenzhen Golden Anke.
Net cash provided by financing activities was $1,051K in net proceeds from the issuance of common stock for the three months ended September 30, 2005. During the three months ended September 30, 2004, net cash used in financing activities was $48K, consisting of $18K for payment due to a director and $30K for amount due from a related company.
The Company has been able to meet its cash requirements by using revenues from the sales of the Company's products, by implementing a stringent cost savings program, and by using funds provided by the private offering of the Company's common stock. The Company has also conserved cash by issuing common stock in exchange for services. The Company's web design projects, sales of digital security imaging systems through Shenzhen Golden Anke, and sales of photographic equipment through Shanghai Newray may provide revenues during the remainder of the fiscal year sufficient to sustain our operations, although there can be no assurances that such revenues will be sufficient to meet the Company's operating cash flow requirements. If the Company's revenues are insufficient to sustain the Company's operations and the Company is unable to borrow money or raise funds by selling securities, the Company may be required to severely curtail, or possibly even cease, its operations. The Company has no commitments for funding and there can be no assurances that funding will be available to the Company in the future on acceptable terms, or at all.
The Company continues to evaluate various opportunities to improve the operating performance of the Company's businesses and to invest in or acquire other types of businesses.
Principal Commitments
At September 30, 2005, the Company does not have any material commitments for operating leases or capital expenditures, or have any transactions, obligations . . .