CDC Corporation 20-F 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2007.
Commission file number: 000-30134
(Exact name of Registrant as specified in its charter)
(Jurisdiction of incorporation or organization)
c/o CDC Corporation Limited
33/F Citicorp Centre
18 Whitfield Road
Causeway Bay, Hong Kong
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act:
Class A common shares
Indicate the number of outstanding shares of each of the Issuers class of capital or common stock as of the close of the period covered by this Annual Report:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes ¨ No x
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 preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing.
U.S. GAAP x International Financial Reporting Standards ¨ Other ¨
If Other has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.
¨ Item 17 ¨ Item 18
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
TABLE OF CONTENTS
In April 2005, we changed our name from chinadotcom corporation to CDC Corporation. Concurrently, in April 2005, our then 81%-owned subsidiary listed on the Growth Enterprise Market of The Stock Exchange of Hong Kong Limited, changed its name from hongkong.com Corporation to China.com Inc. Throughout this Annual Report, we use the new names of these companies.
Several of our affiliated entities and subsidiaries have been organized under the laws of the Peoples Republic of China (the PRC or Greater China) with Chinese names and do not have official English names. Some of these entities which are organized under the laws of the PRC are referred to in this Annual Report with their English names, such as Beijing Newpalm Technology Co., Ltd., Beijing Wisecom Technology Co., Ltd., Beijing China.com Technology Services Co., Ltd., Beijing He He Technology Co., Ltd., and Shenzhen KK Technology Ltd. and Beijing TimeHeart Information Technology Limited for Timeheart. We have occasionally referred to these entities in our contracts, other arrangements and audited financial statements as Beijing Newpalm Information Technology Co., Ltd., or Beijing Newpalm, Beijing Wisecom Information Technology Co., Ltd., or Beijing Wisecom, Beijing China Net Communication Technology Service Ltd,, or Beijing China.com, Beijing He He Technology Co., Ltd., or Beijing He He, Shenzhen KK Technology Ltd. and Beijing TimeHeart Information Technology Limited, or Beijing TimeHeart.
References in this Annual Report to Xinhua are to Xinhua News Agency.
CDC Software Factory, CDC Global Services, CDC MarketFirst, CDC Supply Chain, Respond Centerpoint®, Saratoga CRM, and The Customer Driven Company are trademarks of CDC Corporation and/or its subsidiaries or affiliates. All other trade names, trademarks or service marks appearing in this Annual Report are the property of their respective owners and not the property of CDC Corporation or any of its subsidiaries or affiliates.
This Annual Report contains certain forward-looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, and Section 21E of the Securities Exchange Act of 1934, as amended, about us and our subsidiaries that are subject to risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, are forward looking statements. Forward looking statements may be identified by the use of words such as may, will, expect, anticipate, intend, estimate, plan, continue, or believe or other words of similar meaning or future or conditional verbs such as should, would and could. Forward-looking statements include, among other things, discussions of our expected business outlook, future operations, financial performance, pending acquisitions, financial strategies, future working capital needs and projected industry trends, as well as our strategies for growth, product development, regulatory approvals and compliance, market position and expenditures.
Forward-looking statements are only predictions and are not guarantees of performance. Forward-looking statements are based on current expectations of future events and are based on our current views and
assumptions regarding future events and operating performance. These assumptions could prove inaccurate, or unknown risks or uncertainties could materialize, which could cause our actual results to differ materially from our expectations or predictions. Many of these factors are beyond our ability to control or predict.
We have made forward-looking statements concerning the following, among others:
These statements are based on managements current expectations and are subject to risks and uncertainties and changes in circumstances. Factors that could cause actual results to differ materially from those anticipated in the forward looking statements include, but are not limited to, risks associated with the following:
Factors Relating to our Overall Business and International Operations
Factors Relating to our Enterprise Software and Global Services Businesses
Factors Relating to our Online Games Business
Factors Relating to our China.com Businesses
Factors Relating to our Online Games and China.com Segments as a Result of Conducting Operations in the Peoples Republic of China
Factors Relating to our Intellectual Property, Personnel, Technology and Network
Factors Relating to our Class A Common Shares
All forward looking statements contained in this Annual Report are based upon information available to management as of the date of this Annual Report, and you are cautioned not to place undue reliance on any forward looking statements which speak only as of the date of this Annual Report. We assume no obligation to update or alter the forward-looking statements made herein whether as a result of new information, future events or otherwise. You should read these statements in conjunction with the risk factors disclosed under in Item 3.D., Key Information, Risk Factors in this Annual Report.
The following selected consolidated financial data of CDC and our subsidiaries should be read in conjunction with our consolidated balance sheets as of December 31, 2006 and 2007, and the related consolidated statements of operations, cash flows and shareholders equity for the three years ended December 31, 2005, 2006 and 2007 and the notes thereto, together referred to as the Consolidated Financial Statements, included in Item 18, Financial Statements, and the information included in Item 5, Operating and Financial Review and Prospects. The Consolidated Financial Statements have been prepared and presented in accordance with US GAAP.
For the year ended December 31, 2007, we reported operating results in five business segments, Software, Global Services, CDC Games, China.com, and Mobile Services and Applications. During 2005 we reorganized our business into two core business units, CDC Software and China.com, and during 2006 we further reorganized our business to add a third core business unit, CDC Games. The operations of Software and Global Services are included in the CDC Software business unit, the operations of CDC Games are included in the CDC Games business unit, and the operations of Mobile Services and Applications and China.com are included in the China.com business unit in all years presented. See Note 22 Segment Information in Item 18, Financial Statements for additional disclosure of segment information.
During 2004 and 2005, we discontinued the operations of certain of our subsidiaries. The operating results of the discontinued operating units were retroactively reclassified as a loss from operations of discontinued subsidiaries, net of tax, in all periods presented in this Annual Report.
The following selected consolidated financial data of CDC and our subsidiaries is derived from our audited financial data, after adjustment for the reclassification of discontinued operations and segment reporting for the years ended December 31, 2005, 2006 and 2007.
Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below together with other information included or incorporated by reference in this Annual Report in your decision as to whether or not to invest in our common stock. If any of the following risks or uncertainties actually occurs, our business, financial condition or results of operations would likely suffer. In that case, the trading price of our common stock could fall, and you may lose all or part of the money you paid to buy our common stock.
Risks Relating to Our Overall Business
Because our business model and strategy have evolved, we lack experience and have a limited operating history in our new markets and we may not be successful in meeting the needs of customers in these markets. Our operating results could fall below expectations, resulting in a decrease in our stock price.
We began in June 1997 as a pan-Asian integrated Internet company. Our business model and strategy have evolved with a new focus and goal to be a global company focused on enterprise software and business services through our CDC Software business unit, on online games through our CDC Games business unit and on internet and media services through our China.com business unit. You will not be able to evaluate our prospects solely by reviewing our past businesses and results, but should consider our prospects in light of the changes in our business focus. Each of our targeted markets is rapidly changing, and we may not successfully address the challenges in our new lines of business or adapt our business model and strategy to meet the needs of customers in these markets. If we fail to modify our business model or strategy to adapt to these markets, our business could suffer.
We have incurred losses in prior periods, may incur losses in the future and cannot provide any assurance that we can achieve or sustain profitability.
We have incurred operating losses in three of our last 5 fiscal years and net losses in three of our last 5 fiscal years as follows:
Our operating losses and net losses may increase in the future, and we may not achieve or sustain operating profitability or net profitability. We may continue to incur operating losses and post net losses in the future due to several factors, including:
In addition, while, from time to time, we have experienced sequential quarterly increases in revenues, we cannot be certain that revenue growth will occur or continue in the future. We may see a reversal of any sequential growth in quarterly revenues due to several factors, including:
These factors could also adversely affect our ability to achieve or sustain profitability. We may not generate sufficient revenue to achieve or sustain profitability, or that we can sustain or increase profitability on a quarterly or annual basis. Even though our revenue is difficult to predict, we base our decisions regarding our operating expenses on anticipated revenue trends. Many of our expenses are relatively fixed, and we may not be able to quickly reduce spending in response to lower than expected revenue growth. As a result, revenue shortfalls could result in significantly lower income or result in a greater loss than anticipated for any given period, which could result in a decrease in our stock price. If revenue does not meet our expectations, or if operating expenses exceed what we anticipate or cannot be reduced accordingly, our business, results of operations and financial condition will be materially and adversely affected.
Our strategy of expansion through acquisitions or investments has been and will continue to be costly, may not be effective, and we may realize losses on our investments.
As a key component of our business and growth strategy, we have acquired and invested in, and may continue to acquire and invest in, companies and assets that we believe will enhance our business model, revenue base, operations and profitability, particularly relating to our strategy in enterprise software, global services and online games. Our acquisitions and investments have resulted in, and will continue to result in, the use of significant amounts of cash, the incurrence of debt, dilutive issuances of our common shares and amortization expenses related to certain intangible assets, each of which could materially and adversely affect our business, results of operations and financial condition.
Our continued international acquisitions and investments may expose us to additional regulatory and political risks, and could negatively impact our business prospects.
Our expansion throughout international markets exposes us to the following risks, any of which could negatively impact our business prospects:
During each of 2003, 2004, 2006 and 2007, we depended more on acquisitions for our increase in revenues than the organic growth of our businesses. We may not be successful in increasing our revenues through organic growth or through acquisitions and may lose our investment if we do not successfully integrate the businesses we acquire.
Between 2003 and 2004, our consolidated net revenues increased 134%, or approximately $104.6 million, from $77.9 million in 2003 to $182.5 million in 2004 primarily due to the acquisitions of Ross, Pivotal, and Go2joy, as well as the inclusion of a full year of results from acquisitions made in 2003. Between 2004 and 2005, our consolidated net revenues increased 34%, or approximately $62.4 million,
from $182.5 million in 2004 to $244.9 million primarily from the inclusion of Ross, Pivotal and Go2joy for the full year in 2005 and increased sales volumes in certain key products as discussed under the section entitled Results of Operations in Item 5, Operating Financial Review and Prospects. Between 2005 and 2006, our consolidated net revenues increased 26.4% or approximately $64.6 million, from $244.9 million in 2005 to $309.5 million in 2006, primarily as a result of acquisition related activities. Between 2006 and 2007, our consolidated net revenues increased 30% to, or approximately $92.9 million, from $309.5 million to $402.3 million, primarily as a result of acquisition-related activities.
Our ability to achieve organic growth in our businesses is subject to a number of risks and uncertainties, including the following:
Although we have experienced revenue growth in the past, primarily due to acquisitions, if we are unable to achieve organic growth in our businesses, there will be a material and adverse effect on our business, results of operations and financial condition. We cannot assure you that we will be able to achieve organic growth in our business.
As discussed above, from 2004 to 2007, we expanded our operations rapidly, both in size and scope, and during 2008 and in the future need to integrate, manage and protect our interests in the businesses we acquire. We may experience difficulties in integrating, assimilating and managing the operations, technologies, intellectual property, products and personnel of our acquired businesses individually and cumulatively, and may need to reorganize or restructure our operations to achieve our operating goals. This may include creating or retaining separate units or entities within each of our operating segments. Our failure to integrate and manage our acquired businesses successfully could delay the contribution to profit that we anticipate from these acquisitions, and could have a material adverse effect on our business, results of operations and financial condition.
We intend to continue to evaluate and pursue strategic acquisitions. We may incur significant costs in our efforts to engage in strategic transactions and these expenditures may not result in successful acquisitions. Furthermore, we may be unable to integrate our past or future acquisitions successfully, which could result in increased costs, divert managements attention and materially and adversely affect our business, results of operations and financial condition.
We intend to continue to evaluate and pursue strategic acquisitions that can, among other things, broaden our customer base, provide enhanced geographic presence and provide complementary technical and commercial capabilities.
We believe that attractive acquisition candidates currently exist in our target markets for each of our business segments, and we continuously consider a number of transactions, some of which would be material to our operations and financial condition if consummated. Our ability to complete future acquisitions depends upon a number of factors that are not entirely within our control, including our ability
to identify suitable acquisition candidates, negotiate acceptable terms, conclude satisfactory agreements and secure financing. We may incur significant costs arising from our efforts to engage in strategic transactions and these expenditures may not result in the successful completion of acquisitions.
We also may be unable to integrate our past or future acquisitions successfully. In order to realize the benefits anticipated from each acquisition, we need to conform the operational, managerial and financial controls, procedures and policies between our corporate headquarters and the businesses we have acquired, which may divert managements attention, increase transaction costs and reduce employee morale. Our ability to integrate past and future acquisitions is subject to a number of risks, including:
We could be prevented from, or significantly delayed in, achieving our strategic goals if we are unable to complete strategic transactions or successfully integrate acquired businesses. Our failure to complete strategic transactions or to integrate and manage acquired businesses successfully may materially and adversely affect our business, results of operations and financial condition.
The process of integrating our acquisitions has required, and will continue to require, significant resources, particularly in light of potential regulatory requirements and operational demands. Integrating these acquisitions in the past has been time-consuming, expensive and disruptive to our business. This integration process has strained our managerial resources, resulting in the diversion of these resources from our core business objectives and may do so in the future. Failure to achieve the anticipated benefits of these acquisitions or to successfully integrate the operations of these entities has harmed and could potentially harm our business, results of operations and cash flows in future periods. Furthermore, we may face other unanticipated costs from our acquisitions, such as disputes involving earn-out and incentive compensation amounts.
We may make additional acquisitions of complementary companies, products or technologies in the future. In addition, we periodically evaluate the performance of all our products and services and may sell or discontinue current products and services. Failure to achieve the anticipated benefits of any acquisition or divestiture could harm our business, results of operations and cash flows. Furthermore, we may have to incur debt, write off investments, infrastructure costs or other assets, incur severance liabilities, write off impaired goodwill or other intangible assets or issue equity securities to pay for any future acquisitions.
Rapid growth and a rapidly changing operating environment strain our limited resources.
We have limited operational, administrative and financial resources, which may be inadequate to sustain the growth we want to achieve. As the demands of our customers change and if our business continues to expand, we will need to increase our investment in our network infrastructure, facilities and other areas of operations. If we are unable to manage our growth and expansion effectively, the quality of our products and services could deteriorate and our business may suffer. Our future success will depend on, among other things, our ability to:
Several of the products and services we offer are quite disparate and have very different uses and functionalities, and it is difficult to discern significant synergies between and among them, which limits the amount of integration, cost savings and cross-selling we may be able to achieve among our business segments.
We are a global company focused on enterprise software through our CDC Software business unit, on online games through our CDC Games business unit and on internet and media services through our China.com business unit. Several of our products and services are quite disparate and have very different uses and functionalities. As such, it is difficult to discern significant synergies between and among some of our business segments. For example, our Software segment focuses on delivering enterprise software applications and related services around the world for enterprise resource planning, supply chain management, customer relationship management, order management systems, human resource management and business intelligence. Our online Games segment primarily focuses on operating online games for the China market. Because our segments are quite distinct, there may be limits to the amount of integration, cost savings and cross-selling we may be able to achieve among our business segments.
While as of December 31, 2007, we had cash and cash equivalents of $142.2 million and total available-for-sale securities of $107.0 million, much of this cash balance is held at our China.com subsidiary, and we have limited ability to use these funds for our benefit or our other subsidiaries outside of the China.com chain of subsidiaries.
As of December 31, 2007, we had cash and cash equivalents of $142.2 million and total available-for-sale securities of $107.0 million. Of such amounts, $92.9 million of the cash and cash equivalents and $63.1 million of the total investments held for trading and available for sale were held at China.com. China.com is a 77% owned subsidiary of ours listed on the Growth Enterprise Market of the Hong Kong Stock Exchange. Although we have the ability to appoint a majority of the board of directors of China.com, the board of directors of China.com owes fiduciary duties to all of the shareholders of China.com to act in the best interests of and use the assets of China.com, including the cash and cash equivalents balance and debt securities, for the benefit of such shareholders. As a result, aside from the board of directors of China.com declaring a dividend to its shareholders for which we would receive a pro rata portion as a 77% shareholder of China.com or a related party inter-company loan or similar transaction from China.com which would likely require the approval of the minority shareholders of China.com, we have limited ability to transfer or move the cash, cash equivalents, held-for-trading investments and available-for-sale investments balance to us at the parent entity level, or to use the amounts of cash, cash equivalents and held-for-trading investments and available-for-sale investments balance for the benefit of entities other than China.com and its subsidiaries. Any inability to access funds at China.com may have a material adverse effect on our financial condition.
We have significant fixed operating expenses, which may be difficult to adjust in response to unanticipated fluctuations in revenues, and therefore could have a material adverse effect on our operations.
A significant part of our operating expenses, particularly personnel, rent, depreciation and amortization, are fixed in advance of any particular quarter. As a result, an unanticipated decrease in the
number or average size of, or an unanticipated delay in the scheduling for, our engagements may cause significant variations in operating results in any particular quarter and could have a material adverse effect on operations for that quarter. In the near-term, we believe our costs and operating expenses may increase in certain areas as we fund new initiatives and continue to pay for costs related to compliance with the Sarbanes-Oxley Act of 2002, mergers and acquisitions and other corporate initiatives we may undertake. Although we intend to strive to keep our costs and operating expenses in the near-term to a level that is in line with our expected revenue, we may not be able to increase our revenue sufficiently to keep pace with any growth in expenditures.
Because we rely on local management for many of our localized CDC Software, CDC Games and China.com businesses, our business may be adversely affected if we cannot effectively manage local officers or prevent them from acting in a manner contrary to our interests or failing to act at our direction.
In connection with our strategy to develop our enterprise software products and services through our CDC Software business unit, online games through our CDC Games business unit and internet and media services through our China.com subsidiary, we have interests in companies in local markets where we may have limited experience with operating assets and businesses in such jurisdictions, including enterprise software companies in the United States, Canada and Europe, global services companies in Australia, Korea and the U.S. and online games companies in the U.S., Japan and the PRC. As a result, we rely on our local management and have limited oversight over these persons. If we cannot effectively manage our local officers and management, or prevent them from acting in a manner contrary to our interests or failing to act at our direction, these problems could have a material adverse effect on our business, financial condition, results of operations and share price.
We have identified material weaknesses in our internal control over financial reporting as of December 31, 2006 and 2007. If we are unable to remediate the material weaknesses in our internal control over financial reporting, our ability to report timely and accurate financial information could be materially and adversely affected.
In connection with the audit of our consolidated financial statements, we and our independent registered public accounting firm have concluded that material weaknesses existed in our internal control over financial reporting at December 31, 2007. A material weakness is defined as a deficiency or combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the companys annual or interim financial statements would not be prevented or detected on a timely basis. The material weaknesses that existed at December 31, 2007 were noted in the financial statement close and reporting processes, income taxes and treasury management. The primary cause of the material weaknesses was lack of sufficient personnel in each of these areas with appropriate expertise to ensure proper accounting and treatment in accordance with generally accepted accounting principles.
We cannot be certain that our material weaknesses will be fully remediated by December 31, 2008 because we have not yet fully completed the implementation or testing of our planned remedial actions and measures. Furthermore, we cannot assure you if or when we will be able to remedy these control deficiencies, that our independent registered public accounting firm will agree with our assessment that such deficiencies have been fully remediated, or that additional material weaknesses or significant deficiencies in our internal control over financial reporting will not be identified in the future. If the control deficiencies we have identified recur, or if we identify additional deficiencies or fail to implement new or improved controls successfully in a timely manner, we may be unable to issue timely and accurate financial reports and investors could lose confidence in the reliability of our consolidated financial statements, and such conclusion could negatively impact the trading price of our class A common shares.
If we need to raise additional capital in the future, it may not be available to us on favorable terms, if at all.
We may require additional capital in the future to pursue potential acquisitions or grow our business organically. We intend to meet our capital requirements through a variety of sources, including accessing the capital markets. If we are unable to obtain capital on favorable terms, or if we are unable to obtain capital at all, it could have a material and adverse effect on our business, results of operations and financial condition.
Risks Relating to Our International Operations
A large part of our business is international and, as a result, there are a number of factors beyond our control associated with international operations that could materially and adversely affect our business, results of operations and financial condition.
Approximately 57% and 49% of our total revenues in 2006 and 2007, respectively, were derived from customers outside of North America. We anticipate that revenues from customers outside the United States will continue to account for a significant portion of our total revenues in the future, particularly as we intend to expand into targeted emerging markets, such as the PRC. Our operations outside the United States are subject to additional risks, including:
The 2008 Summer Olympics May Impact Our Ability to Provide our Online Games in China.
In preparation for, or in relation to, the upcoming 2008 Summer Olympics to be held in Beijing, regulations may be implemented in China that may affect our ability to provide our online games and other
products and services to customers in China. For example, we or our customers may, at times, experience difficulty in accessing the internet. This may make certain of our operations more difficult and time consuming, and could result in our customers not having access to our games. Additionally, the hours of operation for internet cafes, a significant point of access for customers to our online games, may be limited or restricted. We cannot be sure of that there will not be disruptions to internet connectivity, distribution systems, transportation, communications or other infrastructure systems in China as a result of the 2008 Summer Olympics. Additionally, the length and substance of any regulations imposed may vary from province to province and the presence of a large number of foreign visitors in China may also disrupt the conduct of business in China. These factors could have a material adverse effect on our business, financial position and results of operations.
A change in currency exchange rates could increase our costs relative to our revenues.
Our revenues, expenses and liabilities are denominated in a number of currencies, including Australian dollars, British pounds, Canadian dollars, Euros, Chinese Renminbi, South Korean won, Swedish Kronas and U.S. dollars. However, our financial results are reported in U.S. dollars. In the future, we may also conduct business in additional foreign countries and generate revenues, expenses and liabilities in other foreign currencies. As a result, we are subject to the effects of exchange rate fluctuations with respect to any of these currencies and the related interest rate fluctuations. We have not entered into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future.
Global events beyond our control may disrupt our operations and harm our business, results of operations and financial condition.
Our business may be materially and adversely affected by a war, terrorist attack, third-party acts, natural disaster or other catastrophe. Such a catastrophic event could have a direct negative impact on us, our customers, the financial markets or the overall economy. It is impossible to fully anticipate and protect against all potential catastrophes. A security breach, criminal act, military action, power or communication failure, flood, hurricane, severe storm or the like could lead to service interruptions, data losses for customers, disruptions to our operations, or damage to our facilities, and could reduce acceptance and reliance on our products. Any of these could have a material and adverse effect on our business, results of operations and financial condition. In addition, we may incur costs in repairing any damage or other liabilities beyond our applicable insurance coverage.
Risks Relating to Our Software Group
Our strategy of developing and acquiring products for specific industry segments, or targeted vertical industries, may not be successful, which could materially and adversely affect our business, results of operations and financial condition.
Our strategy focuses on the development of industry-specific enterprise software applications. This strategy may not be successful due to numerous risks and uncertainties, including the following:
If our strategy of developing products for specific vertical industries is not successful, our business, results of operations and financial condition could be materially and adversely affected.
Our failure to successfully develop, market or sell new products or adopt new technology platforms could have a material and adverse effect on our ability to generate revenues and sustain our profitability.
Our enterprise software applications compete in a market characterized by rapid technological advances in hardware and software development, evolving standards in computer hardware and software technology and frequent new product introductions and enhancements that may render existing products and services obsolete. While we continually seek to expand and refresh our product offerings to include newer features, products, technologies and standards, and enter into agreements allowing the integration of third-party technology into our products, we cannot assure you that we will be able to compete effectively or respond to rapid technological changes in our industry. In addition, the introduction of new products or updated versions of existing products has inherent risks, including, but not limited to, risks concerning:
In addition, we may need to adopt newer technology platforms for our enterprise software products as older technologies become obsolete. We cannot assure you that we will be successful in making the transition to new technology platforms for our products in the future. We may be unable to adapt to the new technology, may encounter errors resulting from a significant rewrite of the software code for our products or may be unable to complete the transition in a timely manner. In addition, as we transition to newer technology platforms for our products, our customers may encounter difficulties in the upgrade process, delay decisions about upgrading our products or review their alternatives with another supplier or competitor. Any of these risks could materially and adversely affect our business, results of operations and financial condition.
Because we commit substantial resources to developing new software products and services, if the markets for these new products or services do not develop as anticipated, or demand for our products and services in these markets does not materialize or materializes later than we expect, we will have expended substantial resources and capital without realizing sufficient offsetting or resulting revenues, and our business and operating results could be materially and adversely affected. In 2006, our research and development expense was $20.0 million, or approximately 6.5% of our total consolidated net revenues and in 2007, our research and development expense was $23.8 million, or approximately 5.9% of our total net revenues. In addition, as we or our competitors introduce new or enhanced products, the demand for our older products and older versions of such products is likely to decline. If we are unable to provide continued improvements in the functionality of our older products or move customers with our older products to our newer products, maintenance and license revenues from older products may decline, which could have a material and adverse effect on our business, results of operations and financial condition.
We dedicate a significant amount of resources to research and development activities and we may not realize significant revenues from these efforts for several years.
Developing, enhancing and localizing software is expensive, and the investment in product development may involve a long payback cycle. Our future plans include significant additional investments in software research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. However, we do not expect to receive significant revenues from these investments for several years, if at all.
Revenues from our Software segment fluctuate significantly from quarter to quarter, which may cause volatility in the trading price of our class A common shares.
Many factors have caused, and may continue to cause, revenues from our Software segment to fluctuate significantly, including:
In addition, we expect that a substantial portion of our enterprise software application revenues will continue to be derived from renewals of maintenance contracts from customers of our software applications. These maintenance contracts typically expire on an annual basis, and if they are not renewed, the timing of cash collections from related revenues will vary from quarter to quarter, which could adversely affect our business and results of operations.
Some customers are reluctant to make large purchases before they have had the opportunity to evaluate the performance of our software applications in their business and opt to purchase our products in stages or subject to certain conditions. Additional purchases, if any, may follow only if the software performs as expected. To the extent the number of customers who opt to purchase in stages or subject to conditions remains significant or increases, our revenues could be materially and adversely affected.
We have been increasingly moving software development capabilities for our enterprise software applications to India and China which subjects us to risks that may result in certain staffing and management difficulties, which, if not effectively addressed, could delay development of upgrades and new products that, in turn, could reduce revenues and net income and increase research and development costs.
We have established a CRM-focused software development center in Bangalore, India and an ERP and SCM-focused software development center in Shanghai, China and Nanjing. Such off-shoring subjects us to various risks, including the following:
Our future revenues depend in part on our installed customer base continuing to license additional products, renew customer support agreements and purchase additional services.
Recently, our installed customer base has generated increasing proportions of our license and support and service revenues. In addition, the success of our strategic plan depends on our ability to cross-sell products to our installed base of customers. Our ability to cross-sell new products may depend in part on the degree to which new products have been integrated with our existing applications, which may vary with the timing of new product acquisitions or releases. In future periods, customers may not necessarily license additional products or contract for additional support or other services. Customer support agreements are generally renewable annually at a customers option, and there are generally no mandatory payment obligations or obligations to license additional software. Customer support revenues are primarily influenced by the number and size of new support contracts sold in connection with software licenses and the renewal rate (both pricing and participation) of existing support contracts. If our customers decide to cancel their support agreements or fail to license additional products or contract for additional services, or if they reduce the scope of their support agreements, revenues could decrease and our operating results could be adversely affected.
The market for enterprise software applications and services is highly competitive, and any failure by us to compete effectively in such a market could result in price reductions, reduced margins or loss of market share, which may have an adverse effect on our revenues and profitability.
The business information systems industry in general, and the enterprise software industry in particular, are highly competitive and subject to rapid technological change. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical and marketing resources, greater name recognition, larger technical staffs and a larger installed customer base than we do. A number of companies offer products that are similar to our products and target the same markets as we do. In addition, many of these competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, and devote greater resources to the development, promotion and sale of their products than we can. Furthermore, because there are relatively low barriers to entry in the software industry, we expect additional competition from other established and emerging companies. Such competitors may develop products and services that compete with our products and services or may acquire companies, businesses and product lines that compete with us. It is also possible that competitors may create alliances and rapidly acquire significant market share. Accordingly, our current or potential competitors may develop or acquire products or services comparable or superior to those that we develop, combine or merge to form significant competitors or adapt more quickly than we can to new technologies, evolving industry trends and changing customer requirements. Competition could result in price reductions, reduced margins or loss of market share, any of which could materially and adversely affect our strategy in this market. If we are unable to compete effectively, our business, results of operations and financial condition could be materially and adversely affected.
Our ability to sell our products is highly dependent on the quality of our service and support offerings, and our failure to offer high quality service could have a material adverse effect on our ability to market and sell our products.
Our customers depend upon our customer service and support staff to resolve issues relating to our products. High-quality support services are critical for the successful marketing and sale of our products. If we fail to provide high-quality support on an ongoing basis, our customers may react negatively and we may be materially and adversely affected in our ability to sell additional products to these customers. This could also damage our reputation and prospects with potential customers. Our failure to maintain high-quality support services could have a material and adverse effect on our business, results of operations and financial condition.
Risks Relating to Our Global Services Group and the Customer Services Provided by Our Software Group
Because most of our global services contracts can be cancelled with limited notice and without significant penalty, we could suffer a significant loss of business service revenues if our clients were to unexpectedly terminate their contracts.
The standard terms for many of our global service contracts do not require any payments or only include an up-front payment of a relatively low percentage of the total fee of the contract with the balance of the payments subject to our achieving specific milestones and deliverables. We generally do not require collateral for accounts receivable and generally, final payments are not due until completion of successful user acceptance testing. However, most of our business services contracts can be cancelled by the client with limited advance notice and without significant penalty. Termination by any client of a contract for our services could result in a loss of expected revenues, additional expenses for redeployment of staff and resources that were allocated to the terminated engagement, and underutilized employees and resources. Any unexpected cancellations or significant reductions in the scope of any of our large global services projects could have a material and adverse effect on the business of our global services companies, particularly those companies that depend upon a relatively small number of key clients for a substantial portion of their revenues. Should any of those key clients unexpectedly terminate their contracts for our services, we may suffer a significant loss of revenues for such companies which, in turn, could have a material and adverse effect on our business, results of operations and financial condition.
If our Global Services Group fails to compete effectively, our business, results of operations and financial condition could be materially and adversely affected.
Our Global Services Group, which consists primarily of many smaller, regionally-focused subsidiaries that operate primarily in Australia and parts of the United States, faces intense competition. Many of our existing competitors, as well as a number of potential new competitors, have longer operating histories, greater name recognition, larger customer bases and greater financial, technical and marketing resources than we do. We also face competition from many of the large Asia Pacific based outsourcing firms. Any of our present or future competitors may provide services that provide significant performance, price, creative or other advantages over those offered by our Global Services Group. We may not be able to compete successfully against our current or future competitors, particularly as markets continue to consolidate, change or mature.
If we fail to accurately estimate the resources and time required for any engagements we enter into on a fixed-price basis, we could experience cost overruns and be subjected to penalties.
Several of our Global Services Groups engagements consist of individual, non-recurring, short-term projects billed on a fixed-price basis, as distinguished from billing on a time and materials basis. In addition, while most of our professional services engagements associated with the sale and implementation of our enterprise software applications are billed on a time and materials basis, some of our engagements are also contracted on a fixed-price basis. These fixed-price engagements require us at times to commit unanticipated additional resources to complete these engagements, which may result, and has in the past resulted, in losses on certain engagements. Clients may also change the scope of the projects on which we are engaged. Our failure to accurately estimate the resources and time required for a particular engagement or to effectively manage client expectations and changes regarding the timing and scope of the services to be delivered could expose us to risks associated with cost overruns and penalties, any of which could have a material and adverse effect on our business, results of operations and financial condition.
Because some of our Global Services contracts do not have disclaimers of, or limitations on, liability for special, consequential and incidental damages, we may be exposed to potential litigation and liabilities.
A large portion of our service agreements with customers of our Global Services Group do not have disclaimers or limitations on liability for special, consequential and incidental damages, and/or do not have caps on liabilities or have relatively high caps on the amounts our customers can recover for damages. In addition, some of our subsidiaries do not carry professional indemnity or other insurance against liability for any claims or breaches under our customer contracts. If a dispute were to arise with respect to one of these agreements, we would likely be held liable for the obligations of these subsidiaries that do not carry insurance.
Claims relating to our Global Services contracts have arisen and may arise in the future. Any claim under customer contracts could subject us to litigation and give rise to substantial liability for damages, including special, consequential or incidental damages that could materially and adversely affect our business, results of operations and financial condition.
Each of our Global Services Group businesses faces intense competition. If we fail to compete effectively, our failure could have a material adverse effect on our business, financial condition and results of operations.
Each of our Global Services Group businesses, many of which are smaller in size and operate in localized regional markets (such as Australia, Korea, and various regions in the United States) faces intense competition. A significant portion of the revenues from some of our Global Services companies is obtained through the resale of software developed by third party software and hardware vendors who use our businesses as channel partners on a non-exclusive basis. Also, we rely on the referrals of these third parties to introduce us to new business opportunities. Should any of those third party software and hardware vendors decide to sell their software and hardware or provide services directly into our market, or use other service providers, this could result in a loss of expected revenues. In addition, many of our existing competitors, as well as a number of potential new competitors, have longer operating histories in each of our
target global services markets, greater name recognition, larger customer bases and greater financial, technical and marketing resources when compared to us. For example, as our business evolves to place greater emphasis on outsourced software development and support services, we will face competition from many of the large Asia Pacific based outsourcing firms, such as Infosys Technologies Ltd and Wipro Ltd. Any of our present or future competitors may provide products and services that provide significant performance, price, creative or other advantages over those offered by us. We can provide no assurance that we will be able to compete successfully against our current or future competitors, particularly as markets continue to consolidate, change or mature.
Risks Related to Our Online Games Business
Our limited operating history and the unproven long-term potential of our online games business model make evaluating our business and prospects difficult.
We commenced the commercial distribution and operation of our most popular game, Yulgang, in July 2005. We commercially introduced our second major online game, Special Force, in June 2007. In December 2007 we launched our first game in Japan, Minna de Battle and in February 2008, we launched Lunia, our first MMORPG commercially available in North America. Our limited operating history makes evaluating our business very difficult. It is also difficult to evaluate our prospective business because we may lack sufficient experience to adequately address risks frequently encountered by early-stage companies that use new and unproven business models and enter into rapidly evolving markets like the online games market. Our operating results will depend on numerous factors, that, in certain cases, we have limited or no ability to control. These factors include but are not limited to:
Due to these factors, as well as others, we may be unable to maintain or grow our business, which may harm our financial results and our stock price.
Our operating results may fluctuate significantly because we currently depend on three online games for substantially all of our online games revenues and have launched, and anticipate launching, several new online games in the future.
We currently derive substantially all of our online games revenues from three online games: Yulgang, Special Force and Shaiya. The commercial lifespan of online games is highly uncertain due to factors such as game quality, business model and competition. If the popularity of Yulgang, Special Force or Shaiya diminish materially, our revenues and profitability may decline. Furthermore, we commercially launched new games in 2007, such as Minna de Battle, in December 2007, and we intend to launch several new games in the future. If revenues from Minna de Battle or other games fail to offset any revenue declines from Yulgang, Special Force or Shaiya, our revenues will decline, which may harm our stock price. The costs associated with launching each new online game are substantial. The typical cost to commercially launch a new online game in the PRC, the United States or Japan varies greatly and can cost several million dollars, exclusive of prepaid licensing fees and royalties, with the substantial majority of these costs being incurred prior to meaningful revenue generation from the online game. Because we incur costs for licensing a new game prior to recognizing any related revenues, we may experience increased expenses and lower margins without the benefit of revenues from that game during this period. The combination of our current reliance on a few online games, the significant costs associated with commercializing each new online game and our expected launch of several new online games in the future may cause our results of operations to fluctuate significantly. Poor operating results for any one game or a delay in the planned launch of a new game could materially affect us, making the investment risks related to any one online game larger than those associated with competitors that have a more broadly established online game portfolio.
If we are unable to consistently license or acquire new online games that have a high likelihood of commercial success, our business will be harmed.
Because we do not have an internal development group, our business strategy requires us to license or acquire new online games that have a high likelihood of commercial success. We typically acquire rights to games either through licensing agreements or by making financial investments in developers in exchange for game publishing and other rights. When we first acquire rights to a game, the game may not have been developed, or if developed, may not have been proven successful in China or another target market. Accordingly, we typically make a significant financial commitment to a game without any guarantee it will be commercially successful. In addition, we have and may continue to enter into licenses with, and make investments in, developers with limited or no history of developing successful games. We may be unable to fully recover upfront and minimum royalty licensing or investment costs if a game is not commercially successful.
For example, during 2007 we entered into several license agreements pursuant to which we were granted rights to distribute online games. Subsequently, however, it became apparent that we would not be able to successfully launch several of these games, and as such, we have taken losses on the license fees we paid for these games. Furthermore, despite our losses, the developers of these games may insist that our obligations under the license agreements continue. Therefore, we may become subject to litigation with the developers of some or all of these online games in the event that we are unable to negotiate an amicable termination of these license agreements.
Furthermore, our ability to successfully license online games that are attractive to users depends in part on our ability to establish relationships with online game developers and to identify games that will be commercially successful and developers capable of producing popular content. It may be difficult to determine whether an online game will appeal to the users in a targeted market, even if it has been successful in other markets. For instance, many games from developers in other markets were not
specifically designed for Chinas online games market, further complicating the task of identifying games that will appeal to our users in China. Moreover, due to increased competition among online game operators in China and other markets, upfront license fees, royalties and investment costs for licensed games have increased, which we expect will continue, and some developers are demanding guaranteed minimum royalty payments.
If we are not able to consistently license, acquire or develop additional attractive online games with lasting appeal to users, our financial condition and results of operations would be significantly harmed.
If we are unable to maintain stable relationships with the licensors of our online games, our licenses may be terminated or we may experience difficulties with the operation of our existing licensed games, the extension of existing licenses, obtaining licenses for new games and our ability to deliver games to our sublicensees.
We must maintain stable and productive working relationships with our licensors to help ensure that we are able to obtain necessary consents for our subsidiaries to operate games we have licensed, and to help ensure cooperation to operate our games effectively, deliver our games to our sublicensees and access to game upgrades and new online games licenses. For certain of our games, the licensors consent is required to permit our subsidiaries to publish the games. Furthermore, many times, an internet content provider license is required to operate an Internet portal under PRC laws and regulations. In such cases the licensors consent is necessary to release and operate the game. In addition, we depend on our licensors to provide necessary technical support for the operation of our licensed games as well as expansion packs and upgrades that help to sustain user interest in our online games. For certain of our games, we have granted sublicenses to games distributors. We depend on our licensors to deliver the games to us so that we may fulfill our obligations under our sublicense agreements. Further, in-game marketing activities and gift promotions often require our licensors consent. Moreover, some of our licenses may be terminated upon the occurrence of certain events, such as failure to commence beta testing or commercially launch the game in a timely manner, failure to make royalty payments, failure to meet certain operating or financial benchmarks, or in the event of a change in control of the licensee. If any of these termination rights are triggered, we may lose rights to a game even if we have expended considerable time and financial resources in developing, marketing and operating that game. If a licensed game is successful during its initial term of operation, we may be unable to obtain an extension of that term on reasonable terms, or at all. If a game license is terminated or we are unable to extend the term of a successful game, the licensor could offer the game itself or enter into a license with one of our competitors. Because most of our licenses only cover one game, we must maintain a stable and productive working relationship with our licensors and continue to offer them competitive terms in order to obtain rights to future games they develop. If we are unable to maintain these relationships, our financial condition and results of operations will be harmed.
For example, on October 17, 2007, Mgame, the licensor of Yulgang, unilaterally announced that they terminated their agreements with CDC Games, alleging breach of contract for non-payment. In October 2007 we filed two lawsuits against Mgame. The first lawsuit alleged breach of contract and that Mgame was not providing adequate technical support for Yulgang, and that Mgame was not supporting CDC Games in its efforts to combat pirate servers. We subsequently filed a second lawsuit alleging that Mgame breached contractual obligations owed to us by failing to provide certain financial and operating data and other information which Mgame is required to provide to us as a shareholder of Mgame. Although we subsequently settled our dispute with Mgame, we cannot assure you that we will not experience disputes with our game developers in the future, which could have a material adverse effect on our financial condition and results of operations.
If we are unable to successfully implement our growth strategies or if we are unable to continue our operations in Japan or the United States, our competitiveness may be harmed and our business, financial condition and results of operations may be materially and adversely affected.
We are currently pursuing or plan to pursue a number of growth strategies, including offering new genres of games and further expanding into international markets. Some of these strategies relate to new products for which there are no established markets in China or are in areas where we lack experience and expertise. Moreover, the development cycle for online games is long, generally ranging from two to four years. The creative process inherent in online games development also makes the length of the development cycle difficult to predict, especially in connection with online games involving new technologies. As a result, we may experience delays in online game introductions from our game developer partners. If the release of an online game is delayed, we may miss an important marketing window, our competitors may be first to introduce a game that competes with our game, we may not achieve anticipated revenues for that game, or we may be required to spend more to accelerate completion of the game, each of which would increase our costs and lower our margins. We may be unable to deliver new products or services in markets where we have no prior experience. Establishing operations in these markets will require meaningful investment and we may be unsuccessful in our efforts. We face several obstacles in our efforts to expand into new markets. Some of these markets, including Japan and the United States where we have recently launched online games, have immature online game markets, or consumers in such markets may prefer playing games on game consoles. This means that online games may not be widely accepted and that the cost to launch games in these markets is higher. If we are unable to successfully implement our growth strategies or if we are unable to continue our operations in Japan or the United States, our competitiveness may be harmed and our business, financial condition and results of operations may be materially and adversely affected.
If consumer tastes and preferences move away from online games or the games that we offer, particularly MMORPGs, our revenues and profitability will likely decline.
Our ability to successfully plan for product licensing, distribution and promotional activities depends significantly on our ability to anticipate and adapt to changes in consumer tastes and preferences in the rapidly evolving online games market. MMORPGs are currently one of the most popular genres of online games in China and we expect to continue to rely on MMORPGs, particularly Yulgang, for a significant portion of our revenues in the near future. The popularity of MMORPGs in China may decline, and their current popularity in China may be replaced by new and different types of online or other games. We may be unable to anticipate or adapt to changes in consumer preferences or obtain rights to or market the genres or styles of games that appeal to evolving consumer preferences. A decline in the popularity of online games in general or the games that we offer, particularly MMORPGs, would likely adversely affect our revenues and profitability.
Moreover, we believe casual games are becoming increasingly popular in China. Casual games tend to have shorter commercial lifespans than MMORPGs, thereby increasing the importance of maintaining a consistent pipeline of new games and lowering our ability to leverage successful games over the longer term. We have little experience offering casual games and we cannot assure you that the casual games in our pipeline will be commercially successful.
If we are unable to successfully launch and operate our new online game genres or adapt to new revenue models, our future results of operations will be adversely affected and we may not generate sufficient revenues to consistently introduce new online games.
Our online games currently scheduled for launch in 2008 include fantasy role-playing, action, martial arts and others. We have invested significant financial resources in obtaining rights to these games and plan to invest a significant amount of financial and personnel resources in launching and operating these and other new games. These game genres have limited or no operating history in China and we have no experience offering certain of these game genres. Accordingly, if these games fail to achieve commercial success, our revenues and profitability would be harmed and we may not generate sufficient revenues to consistently introduce new online games, which is critical to our games business.
We were a pioneer of the free-to-play, pay for virtual merchandise, revenue model and substantially all of our online games continue to utilize this model. This type of revenue model requires us to expend significant resources to track consumer tastes and preferences, especially in-game spending trends in order
to attract users to play and encourage them to purchase in-game merchandise. If new revenue models develop and attain commercial success in the online games industry in China or in future overseas markets, our current revenue model may be less successful and we may be unable to launch new games or retool our current games to adapt to these new models in a cost-effective manner or at all. This could harm our business and financial results.
Moreover, we anticipate that newly introduced games may result in a portion of our existing customers reducing their spending on our current games or switching to these new games altogether. These effects may be magnified as we attempt to unify our log-in and billing system, which is intended to allow users to use a single account to play and pay for all of our games, and lowers the barriers to shifting among different games on our platform. If this reduction in play or switching of players from our existing games exceeds our expectations, we may have to adjust our marketing, pricing and other business plans. Any revenues generated by new online games may be offset, at least in part, by loss of revenues from our current online games, which may harm our financial condition and results of operations.
We compete with other forms of entertainment, including offline games, television, movies, sports, and the Internet.
There are alternative choices of entertainment in the markets in which we operate such as offline games, television, movies, sports and the Internet, which may be perceived by our target users to offer greater variety, affordability, interactivity and enjoyment. These other forms of entertainment compete for the discretionary income of our target customers. Our target customers may prefer entertainment activities that are conducted at a group or communal setting and our online games, while offering a virtual community, may be unsuccessful in competing against other forms of entertainment that allow for greater human interaction. If we are unable to sustain sufficient interest in our products in comparison to other forms of entertainment, including new forms of entertainment, our business model may no longer be viable.
Undetected programming defects and unsatisfactory customer service could harm our reputation or decrease demand for our online games, which would harm our business.
The online games we operate may contain errors or flaws. This risk may be significantly heightened if we launch a significantly higher number of games in 2008 and 2009 than we have to date. Undetected programming errors, game defects and unsatisfactory customer service can disrupt our operations, adversely affect the game experience of our users, harm our reputation, divert our resources and delay market acceptance of our online games, any of which would harm our business. If our online games contain programming errors or other flaws, our users may stop playing them, may not recommend them to other potential users, and may switch to a competitors games.
Unexpected network interruptions, security breaches or computer virus attacks could significantly harm our business, reputation and ability to attract and retain users.
If we fail to maintain satisfactory performance, reliability, security and availability of our network infrastructure, our business, reputation and ability to attract and retain users could be significantly harmed. Major risks involving our network infrastructure include:
Any network interruption or inadequacy that causes interruptions in the availability of, or deterioration in the quality of, our online games services could reduce user satisfaction and our number of
users. In addition, any security breach caused by hacking, which involve efforts to gain unauthorized access to information or systems, or to cause intentional malfunctions or loss or corruption of data, software, hardware or other computer equipment could disrupt our services, harm our reputation and cause users to move to our competitors. Inadvertent transmission of computer viruses could expose us to a material risk of loss or litigation and possible liability as well as damage to our reputation. Moreover, we may incur significant costs to protect our systems and equipment against the threat of, and to repair any damage caused by, computer viruses and hacking. Moreover, if hacking or a computer virus affects our systems and is highly publicized, our reputation and brand names could be materially damaged, which could cause us to lose customers and revenues.
Furthermore, increases in user activity could strain our computer systems capacity, leading to slower response times or system failures. This could result in a reduced number of users and could have an adverse effect on our business, financial condition, results of operations and reputation. We may need to incur additional costs to upgrade our computer systems in order to accommodate increased demand. As of December 31, 2007, our servers were co-located at 25 different Internet data center sites in mainland China, and do not have back-up systems located in different cities from our co-location sites.
We primarily depend upon few printing companies to produce our physical prepaid game point cards. If these companies mishandle our cards or the related passcodes or if there are production defects or delays, our reputation and business would be harmed.
Because of the relatively limited availability of online payment systems in China, we depend upon physical prepaid point cards for a significant portion of our revenues. For 2007, physical prepaid point cards accounted for approximately 30% of the total value of prepaid point cards delivered to users. We rely on a limited number of third-party printing companies to produce our physical prepaid point cards. These cards are generally produced in batches of hundreds of thousands with each card having an individual passcode that enables the purchaser to deposit the points on the card into their online user account. If our printers mishandle our cards or the related passcodes, or if there are production defects or delays, our reputation and business would be harmed.
We could be liable for breaches of security in connection with operating our games.
For 2007, virtual point cards accounted for approximately 55% of the total value of prepaid point cards delivered to users. Currently a substantial portion of our virtual point card sales are conducted through the internet. Secure transmission of confidential information over public networks is essential to maintain consumer confidence. This information includes customer credit or bank card numbers, personal information and billing addresses. Our current security measures may be inadequate to protect such information. Security breaches could expose us to litigation and potential liability for failing to secure confidential user information and could harm our reputation and ability to attract users.
We rely on third parties to provide us with distribution and server hosting services and any disruption or deterioration of these services could adversely affect our business, financial condition and results of operations.
Our users are located throughout China, and because of the limited forms of payment available in China, we rely largely on local distributors to deliver our physical prepaid game point cards to users. For the year ended December 31, 2007, our top five and top 10 distributors accounted for 50% and 80%, respectively, of our total prepaid game point card sales. We do not prohibit our regional distributors from distributing other online game operators prepaid cards and we do not have long-term agreements with any of our distributors. Although we endeavor to seek reputable and reliable distributors, we cannot monitor all of our distributors and their distribution activities. Moreover, these distributors may mishandle our cards or related pass codes, or encounter difficulties in delivery that are beyond their or our control. The occurrence of any of these events may harm our reputation and business.
Moreover, we principally rely on China Telecom and China Netcom to provide us with data communications capacity primarily through telecommunications access and Internet data centers to host our servers. We do not have access to alternative services in the event of disruptions, failures or other problems
with the fixed telecommunications networks of China Telecom and China Netcom, or if China Telecom or China Netcom otherwise fail to provide such services. Any unscheduled service interruption or performance issues could disrupt our operations, damage our reputation and result in a decrease in our revenues. Furthermore, we have no control over the costs of the services provided by China Telecom and China Netcom. If the prices that we pay for telecommunications and Internet services rise significantly, our business, financial condition and results of operations could be adversely affected. In addition, if Internet access fees or other charges to Internet users increase, our user traffic may decrease, which in turn may harm our revenues.
Illegal game servers could materially and adversely affect the business, reputation, financial condition and results of operations of our online games segment.
We increasingly face the risks of illegal game servers at our CDC Games business unit. Some Internet cafés have misappropriated our game server installation software. Several competitors have reported instances of Internet cafés installing illegal copies of competitors games on the cafés servers and letting their customers play such games on illegal servers without paying for game playing time. Although we have made efforts to shut down illegal game servers across China, we have not been completely successful in our efforts. Also, the intellectual property enforcement regime in China is not as robust as that of the United States, and we continue to face considerable challenges to enforcing our intellectual property rights. Enforcement actions generally require cooperation from local authorities, which are sometimes unwilling to use their limited resources to enforce the intellectual property rights of national corporations against individuals or companies in their districts. In addition, litigation proceedings are often necessary to enforce intellectual property rights, which can be very expensive. Despite our efforts to shut down illegal game servers, we believe that a significant number of illegal game servers may continue to operate unauthorized copies of our online games. The continued operation of our online games by illegal game servers, or the operation of any new games that we may introduce by illegal game servers, may materially and adversely affect our business, reputation, financial condition and adversely affect our results of operations. We cannot assure you that we will be able to identify and eliminate new illegal game servers and unauthorized character enhancements in a timely manner, or at all.
If our licensors fail to protect, enforce or maintain their intellectual property rights, our results of operations may be materially and adversely affected.
We expect to derive substantially all of our online games revenues and profits from Yulgang, Special Force, Shaiya and other licensed online games in 2008. The licensors of these games may be subject to intellectual property rights claims with respect to the online games licensed to us. In addition, the license by which these licensors obtained their rights may be terminated or expire. If intellectual property rights claims brought against our licensors are successful and our licensors are precluded from continuing to offer a game we license, or if one of our licensors loses its license to a game, we may be unable to continue offering that game, causing us to lose our investment in, and potential revenues from, that game. We may also be liable for damages to the third-party owner of the game. In certain licensing agreements, we are also responsible for indemnifying our licensors for costs or liabilities resulting from claims of infringement of trademark, copyright or intellectual property. If we lose rights to one or more games, our business financial condition and our results of operations could be harmed.
Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.
We regard our copyrights, trademarks, trade secrets, domain names and other intellectual property as important to our business. Unauthorized use of intellectual property, whether owned by us or licensed to us, may reduce our revenues, devalue our brands and property, and harm our reputation. We rely on intellectual property laws and contractual arrangements with our key employees and certain of our licensors, partners, manufacturers, distributors and others to protect our intellectual property rights. Policing unauthorized use of intellectual property is difficult and expensive. Despite our precautions, it may be possible for third parties to obtain and use the intellectual property used in our business without authorization. The validity, enforceability and scope of protection of intellectual property in Internet-related industries in China and certain other countries are uncertain and still evolving and may not protect intellectual property rights to the same extent as do the laws and enforcement procedures in the United States. Moreover, we may not prevail in any litigation that we undertake to enforce our intellectual property rights, and such litigation could result in substantial costs and diversion of our management resources.
We may be subject to intellectual property infringement claims, which may force us to incur substantial legal expenses and, if determined adversely against us, may materially and adversely affect our business and results of operations.
Our products and services could be found to infringe on the patents, copyrights or other intellectual property rights of others. We may incur substantial expenses in investigating and defending against third-party infringement claims, regardless of their merit. Litigation or other dispute resolution proceedings may be necessary to retain our ability to offer our current and future games, which could result in substantial costs and diversion of our financial and management resources. Furthermore, if we are found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property rights, incur additional costs to license or develop alternative games, characters or features and be forced to pay fines and damages, any of which could harm our business and results of operations.
We experience significant seasonality and our quarterly financial results may not be representative of annual financial performance.
The PRC online games market is characterized by increased user activity during seasonal periods primarily related to student examination schedules and the Lunar New Year holidays in China. We normally experience our highest online games sales volumes in March and September, when many of our users increase their playing after commencement of the school term. Correspondingly, our online games sales tend to be lower during holiday periods such as Lunar New Year, which falls in January or February, as well as immediately preceding and during school examination periods, which typically fall in June. As a result of this seasonality, our quarterly financial results may substantially fluctuate and our interim financial performance may not be indicative due to the seasonality of our revenues. We believe the seasonal variability in our financial results will continue in the future.
Negative publicity in China regarding online games could lead to additional government regulations that may have a material and adverse impact on our business, financial condition and results of operations.
The media in China has reported incidents of violent crimes allegedly inspired by online games, as well as incidents of theft of online game virtual items among users. In addition, incidents of excessive online game playing and allegations that online games distract students and interfere with their education have also been reported in the media. This negative publicity has contributed to several regulatory initiatives, such as:
Anti-addiction laws and regulations in China could have a material and adverse impact on our business, financial condition and results of operations.
On April 5, 2007, eight PRC governmental agencies, including the Ministry of Education, Ministry of Information Industry, the General Administration of Press and Publication and the Ministry of Public Security jointly promulgated the Notice on the Implementation of Online Game Anti-Addiction System to Protect the Physical and Psychological Health of Minors. Under this anti-addiction notice, all online game operators, including us, are required to develop a system according to the Online Game Anti-addiction System Development Standard, which was released as an attachment to the notice, and the corresponding Identity Authentication Scheme of the anti-addiction system developed for our online games is aimed to reduce fatigue time and unhealthy time such that, when a user under the age of 18 has been playing an online game for more than three consecutive hours, he or she will automatically be sent periodic warnings within the game environment prompting him or her to leave the game and rest. Such warnings will become more frequent as the user accumulates more playing time. In addition, this system will cause the rate at which the game user can obtain experience points and other virtual items such as special equipment to decrease to half the normal levels during the fatigue time period and to zero during the unhealthy time period. In addition, anti-addiction laws and regulations may apply or may develop in certain overseas markets in which we conduct our business and could have a material and adverse impact on our business, financial condition and results of operations in such markets.
Also, in March 2006, the Chinese government announced an authentication system which requires all players to enter their identification card numbers before being allowed to play online games. This authentication system as well as the new anti-addiction regulations could have a material adverse effect on our business, financial conditional and results of operations.
Acquisitions and investments may have an adverse effect on our ability to manage our business.
Our growth strategy involves the acquisition of, and investments in, new technologies, businesses, products and services, or the creation of strategic alliances in areas which we do not currently operate. We have limited experience in evaluating investments in gaming companies and integrating acquired companies or assets into our business. Accordingly, we believe that investment, acquisition and integration will require significant attention from our management and could require that our management develop expertise in new areas and manage new business relationships. The diversion of our managements attention and any difficulties encountered in the integration process could have an adverse effect on our ability to manage our business.
Acquisitions and investments will also expose us to potential risks, including risks associated with:
Our ability to grow through acquisitions or investments will depend on the availability of suitable acquisition and investment candidates at an acceptable cost, our ability to compete effectively to attract these candidates, and the availability of financing to complete larger acquisitions or investments. The benefits of an acquisition or investment may also take considerable time to develop and we cannot assure you that any particular acquisition or investment will produce the intended benefits, if any.
We may be unable to compete successfully against new entrants and established industry competitors.
We face intense competition in the online games market in China. We believe there are currently over 150 online game operators in China operating over 400 games and given that the growth prospects of the online game market in China are very high, we expect many more companies to enter the market. Our competitors vary in size and include large companies such as Shanda Interactive Entertainment Limited, Netease.com, Inc., The9 Limited, Perfect World Co., Ltd., Giant Group and Tencent, many of which have significantly greater financial, marketing and game development resources and name recognition than we have. As a result, we may be unable to devote adequate resources to developing, licensing or acquiring new games, undertaking extensive marketing campaigns, adopting aggressive pricing policies, paying high compensation to game developers or compensating independent game developers to the same degree as some of our competitors. Any of our competitors may offer online games with better game performance, more attractive pricing, more developed storylines or other improvements over the games offered or to be offered by us. In addition, the increased competition we anticipate in the online game industry may also reduce the number of our users or growth rate of our user base, reduce the average revenues generated by our users, or cause us to reduce our fees. All of these competitive factors could adversely affect our business and results of operations.
The limited use of personal computers in China and the relatively high cost of Internet access with respect to per capita income may limit the development of the Internet in China and impede our growth.
Although the use of personal computers in China has increased in recent years, the penetration rate for personal computers in China is much lower than that in the United States. In addition, despite a decrease in the cost of Internet access in China due to a decrease in the cost of personal computers and the introduction and expansion of broadband access, the cost of Internet access remains relatively high in comparison to the average per capita income in China. The limited use of personal computers in China and the relatively high cost of Internet access may limit the potential number of users and therefore the growth of our business. Furthermore, any increase in the cost of Internet access or personal computers or a decline or slowdown of the China economy, which could affect our users or potential users disposable income, could reduce the number of users or potential users that play or may play our online games.
The PRC government has announced its intention, and has begun, to intensify its regulation of Internet cafés, which are an important venue for our users to play online games. Intensified government regulation of Internet cafés could restrict our ability to maintain or increase our revenues and expand our customer base.
In April 2001, the PRC government began tightening its regulation and supervision of Internet cafés. In particular, a large number of unlicensed Internet cafés have been closed. In addition, the PRC government has imposed higher capital and facility requirements for the establishment of Internet cafés. Furthermore, the PRC governments policy, which encourages the development of a limited number of national and regional Internet café chains and discourages the establishment of independent Internet cafés, may slow down the growth of Internet cafés. Recently, the State Administration of Industry and Commerce, one of the government agencies in charge of Internet café licensing, issued a notice suspending the issuance of new Internet café licenses. It is unclear when this suspension will be lifted, if at all. So long as Internet cafés are the primary venue for our users to play online games, any reduction in the number, or any slowdown in the growth, of Internet cafés in China could limit our ability to maintain or increase our revenues and expand our customer base, thereby reducing our profitability and growth prospects.
Currently there are no laws or regulations in the PRC specifically governing virtual asset property rights and therefore, it is not clear what liabilities, if any, online game operators may have for virtual assets.
In the course of playing online games, some virtual assets, such as special equipment, player experience grades and other features of our users game characters, are acquired and accumulated. These virtual assets can be important to online game players and in some cases are exchanged between players for monetary value. In practice, virtual assets can be lost for various reasons, often through unauthorized use of the game account of one user by other users and occasionally through data loss caused by a delay of network service or by a network crash. Currently there are no PRC laws and regulations specifically governing virtual asset property rights. As a result, it is unclear who is the legal owner of virtual assets and whether and how the ownership of virtual assets is protected by law. In case of a loss of virtual assets, we may be sued by online game players and may be held liable for damages, which may negatively affect our business, financial condition and results of operations. Due to the lack of laws or regulations in the PRC specifically governing virtual asset property rights we also could face an increase in customer complaints related to loss of virtual assets which could cause a substantial increase in workload for us, loss of customers and our reputation could be tarnished.
We may be unable to respond to future changes in the revenue model for the online games industry in China and in our overseas markets, which could materially and adversely affect our business, financial condition and results of operations.
We pioneered the free-to-play revenue model for online games in China. Our existing games, and many other future games that we intend to release, operate under this revenue model. Under the free-to-play revenue model, users can play our massively multiplayer online games, or MMOGs, for free but have the option to purchase in-game virtual items and value-added services to enhance their overall game playing experience. If any new revenue models develop in the online games industry in China or in our overseas markets, we may be unable to launch new games utilizing such new models in a timely manner or at all. We may also be required to expend significant resources to launch such games. In addition, we may unable to adapt our current games to such new models. Any of these factors could materially and adversely affect our business, financial condition and results of operations.
Acts of cheating by users of online games could lessen the popularity of our online games, adversely affect our reputation and our results of operations.
Cheating in online games may occur through a variety of methods, by which cheaters may be able to modify the rules of our online games during game play in a manner that allows them to gain an unfair advantage over our other online game users, which often has the effect of causing players to stop using the game and shortening the games lifecycle. Although we have taken a number of steps to deter our users from engaging in cheating when playing our online games, we cannot assure you that we or the third parties from whom we license some of our online games will be successful or timely in taking corrective steps necessary to prevent users from modifying the terms of our online games.
Risks Relating to our China.com Segment
The portal markets in China are highly competitive. If we fail to compete effectively, our failure could have a material adverse effect on our business, financial condition and results of operations.
In our portal business, our competition for user traffic, ease of use and functionality include Chinese and/or English language based Web search and retrieval companies, including AltaVista Co., Apple Daily, ChinaByte, FindWhat.com, Lycos, Inc., MSN, Netease.com, Inc., Shanghai Online, Sina Corporation, Sohu.com, Inc., Tom Online Inc. and Yahoo!, Inc., Oak Pacific Interactive, 21CN.com and qianlong.com.
Many of our competitors have more experience and longer operating histories in our target markets than us, as well as greater name recognition, larger customer bases and greater financial, technical and marketing resources. We may not be able to compete successfully in these markets. Our failure to remain competitive may cause us to lose our market share in the portals business, and our business, financial condition and results of operations may suffer.
Our China.com and other portal businesses depend substantially on third party content providers and may be adversely affected if we are unable to maintain existing arrangements with these content providers.
We rely on third parties to create traffic and provide content for our portal network to make it more attractive to advertisers and consumers. Our content providers include Xinhua, a major shareholder of CDC, as well as commercial content providers and our registered community members. If Xinhua or these third parties fail to provide us with high quality content, our portal network could lose viewers, subscribers and advertisers and our revenue from these sources would decrease. Our existing relationships with Xinhua and other commercial content providers are not exclusive and may not result in sustained business partnerships or successful service offerings or sustained traffic on our portal network or future revenues.
Risk Relating to Our Online Games and China.com Segments as a Result of Conducting Operations in the Peoples Republic of China
Chinas economic, political and social conditions, as well as government policies, could affect our business.
While the economy in the PRC has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us.
The economy in the PRC has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the PRC government has implemented measures that emphasize the utilization of market forces for economic reform, reduce the state ownership of productive assets and help establish sound corporate governance in business enterprises, a substantial portion of productive assets in the PRC is still owned by the government. In addition, the PRC government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies.
Our financial results have been, and are expected to continue to be, affected by the growth of the economy and the Internet industry in China. A slowdown of economic growth in China would reduce the growth of the Internet industry and related products and services, which in turn could adversely affect our business, operating results and financial condition.
The PRC economy differs from the economies of most developed countries in many respects, including:
The PRC government has also implemented certain measures to control the pace of economic growth. These measures may cause decreased economic activity in China, including a slowing or decline in consumer spending, which in turn could adversely affect our financial condition and results of operations.
Regulation and censorship of information distribution over the Internet in China may adversely affect our business, and we may be liable for information displayed on, retrieved from, or linked to our website.
The online game and Internet content distribution industries in China are highly regulated by the PRC government. Various regulatory authorities of the central PRC government, such as the State Council, the Ministry of Information Industry, the State Administration of Industry and Commerce, the State Press and Publication Administration, and the Ministry of Public Security, are empowered to issue and implement regulations governing various aspects of each of these industries.
China has enacted laws and regulations governing Internet access and the distribution of news, information or other content, as well as products and services, through the Internet. The PRC government has previously stopped the distribution of information through the Internet that it deems in violation of PRC laws and regulations. Under regulations promulgated by the State Council, the Ministry of Information Industry, the State Press and Publication Administration and the Ministry of Culture, Internet content providers and Internet publishers are prohibited from posting or displaying over the Internet, content that, among other things:
The mobile network operators in the PRC also have their own policies regarding the distribution of inappropriate content by wireless value-added service providers and have recently sanctioned certain providers for distributing inappropriate content, including the imposition of fines and service suspensions.
If any Internet content we offer or will offer through our affiliated PRC entities were deemed by the PRC government or the mobile network operators to violate any of such content restrictions, we would not be able to continue such offerings and could be subject to penalties, including confiscation of income, fines, suspension of business and revocation of required licenses, which could materially and adversely affect our business, financial condition and results of operations. Additionally, we may face liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of information originating from our online games network or portal network.
We may also be subject to potential liability for any unlawful actions of our clients or affiliates or for content we distribute that is deemed inappropriate. It may be difficult to determine the type of content that may result in liability for us, and if we were found to be liable, we may be prevented from operating our online game and internet and media services in China. Such content could include material posted by our registered community members on our message boards, online communities, voting systems, e-mail or chat rooms. By providing technology for hypertext links to third-party websites, we may be held liable for copyright or trademark violations by those third-party sites. Third parties could assert claims against us for losses incurred in reliance on erroneous information distributed by us. Users of our web-based e-mail or SMS, MMS, WAP or IVR products could seek damages for:
We do not carry liability insurance to cover potential claims of these types. In the event such claims are asserted against us, we may incur significant costs in investigating and contesting these claims. Any judgment, fine, damage award or liability imposed on us could significantly increase our costs. Moreover, our reputation may suffer as a result of these claims, which could reduce traffic on our portal network or reduce our revenues.
Because many laws, regulations and legal requirements with regard to the Internet in the PRC are relatively new and untested, their interpretation and enforcement of what is deemed to be socially destabilizing by Chinese authorities may involve significant uncertainty. In addition, the legal system in the PRC is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have little precedential value. As a result, it is difficult to determine the type of content that may result in liability. We cannot predict the effect of further developments in the Chinese legal system, particularly with regard to the Internet and the dissemination of news content, including the creation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the pre-emption of local rules and regulations by national laws.
Violations or perceived violations of laws in China arising from information displayed, retrieved from or linked to our portals could result in significant penalties, including a temporary or permanent cessation of our business in China. The Chinese government agencies have announced restrictions on the transmission of state secrets through the Internet. State secrets have been broadly interpreted by Chinese governmental authorities in the past. We may be liable under these pronouncements for content and materials posted or transmitted by users on our message boards, virtual communities, chat rooms or e-mails. If the Chinese government were to take any action to limit or eliminate the distribution of information through our portal network or to limit or regulate any current or future applications available to users on our portal network, this action could have a material adverse effect on our business, financial condition and results of operations.
Government control of currency conversion may limit our ability to utilize our revenues effectively.
Substantially all of the revenues and operating expenses of our CDC Games and China.com businesses, are denominated in Renminbi. The Renminbi is currently convertible to foreign exchange with respect to current account transactions, but not with respect to capital account transactions. Current account transactions include ordinary course import/export transactions, payments for services rendered and payments of license fees, royalties, interest on loans and dividends. Capital account transactions include cross-border investments and repayments of principal of loans. Currently, our PRC subsidiaries may purchase foreign exchange for settlement of current account transactions, including payment of dividends to us and payment of license fees to content licensors, without the approval of the State Administration for Foreign Exchange, or SAFE. Our PRC subsidiaries may also retain foreign exchange in their current accounts, subject to a ceiling approved by SAFE, to satisfy foreign exchange liabilities or to pay dividends. However, the relevant PRC governmental authorities may limit or eliminate the ability for our PRC subsidiaries to purchase and retain foreign currencies in the future. Foreign exchange transactions under the capital account remain subject to limitations and require approvals from or registration with SAFE. This could affect our PRC subsidiaries ability to obtain debt or equity financing from outside the PRC, including by means of loans or capital contributions from us.
Fluctuations in exchange rates could materially and adversely affect the value of our common shares and result in foreign currency exchange losses.
Because our earnings and cash and cash equivalent assets earned or held in the PRC are denominated in Renminbi, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. In July 2005, the PRC government discontinued pegging the Renminbi to the U.S. dollar. However, the Renminbi exchange rate versus the U.S. dollar is restricted to a rise or fall of no more than 0.3% per day and the Peoples Bank of China regularly intervenes in the foreign
exchange market to prevent significant short-term fluctuations in the exchange rate. Nevertheless, the Renminbi may appreciate or depreciate significantly in value against the U.S. dollar in the medium to long term. Moreover, it is possible that in the future, PRC authorities may lift restrictions on fluctuations in the Renminbi exchange rate and lessen intervention in the foreign exchange market. Fluctuations in the exchange rate will also affect the relative value of any dividend we may issue that will be exchanged into U.S. dollars and earnings from and the value of any future U.S. dollar-denominated investments we make.
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedging transactions may be limited and we may not be able to successfully hedge our exposure at all. In addition, our currency exchange losses may be magnified by Chinese exchange control regulations that restrict our ability to convert Renminbi into foreign currency.
Recent PRC regulations relating to offshore investment activities by PRC residents may increase the administrative burden we face and create regulatory uncertainties that could restrict our overseas and cross-border investment activity, and a failure by our shareholders who are PRC residents to make any required applications and filings pursuant to such regulations may prevent us from being able to distribute profits and could expose us and our PRC resident shareholders to liability under PRC law.
In October 2005, SAFE promulgated regulations that require PRC residents and PRC corporate entities to register with and obtain approvals from relevant PRC government authorities in connection with their direct or indirect offshore investment activities. These regulations apply to our shareholders who are PRC residents in connection with our prior and any future offshore acquisitions.
The SAFE regulation required registration by March 31, 2006 of direct or indirect investments previously made by PRC residents in offshore companies prior to the implementation of the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-Raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies on November 1, 2005. If a PRC shareholder with a direct or indirect stake in an offshore parent company fails to make the required SAFE registration, the PRC subsidiaries of such offshore parent company may be prohibited from making distributions of profit to the offshore parent and from paying the offshore parent proceeds from any reduction in capital, share transfer or liquidation in respect of the PRC subsidiaries. Furthermore, failure to comply with the various SAFE registration requirements described above could result in liability under PRC law for foreign exchange evasion.
These regulations are still relatively new and there is uncertainty concerning the reconciliation of the new regulation with other approval requirements, it is unclear how the regulation, and any future legislation concerning offshore or cross-border transactions, will be interpreted, amended and implemented by the relevant government authorities. Some of our shareholders may not comply with our request to make or obtain any applicable registrations or approvals required by the regulation or other related legislation. The failure or inability of our PRC resident shareholders to obtain any required approvals or make any required registrations may subject us to fines and legal sanctions, prevent us from being able to make distributions or pay dividends, as a result of which our business operations and our ability to distribute profits to you could be materially and adversely affected.
We rely on contractual arrangements, including a voting proxy, with our affiliated PRC entities for the control and operation of our online games and Internet content distribution businesses. These arrangements may be difficult to enforce under the PRC legal system. If any of our affiliated PRC entities fails to perform its obligations under these contractual arrangements, we may have to try to legally enforce such arrangements, and our business, financial condition and results of operations may be materially and adversely affected if these arrangements cannot be enforced.
Foreign ownership in the Internet content distribution and online game businesses is subject to significant restrictions under current PRC laws and regulations. The PRC government regulates Internet access, the distribution of online information, the conduct of online commerce and the provision of online game services through strict business licensing requirements and other government regulations. These laws and regulations also include limitations on foreign ownership in PRC companies that provide Internet content distribution and online game services. Specifically, foreign investors are not allowed to own more than a 50% equity interest in any Internet content provision business.
Because we are a Cayman Islands company, we and our PRC subsidiaries and their branch companies in China are treated as foreign or foreign-invested enterprises under PRC laws and regulations. To comply with PRC laws and regulations, we conduct our operations in China through a series of contractual arrangements entered into among our PRC subsidiaries. These licenses held by our affiliated PRC entities are essential to the operation of our business.
Generally, employees of the respective business units who are Chinese nationals own the shares of the respective domestically registered companies in China which hold the relevant required domestic licenses for operation. These Chinese nationals, in turn, have entered into trust deed arrangements with respect to the domestically registered companies in China and affiliates of the respective business units under which the Chinese nationals serve as trustees of the trusts, and the business units have formed offshore holding vehicles to be 100% beneficiaries of the trusts. For a further description of the corporate structure in China, see Item 4.C., Information on the Company Organizational Structure Corporate Structure in China for our CDC Games and China.com Business Units.
CDC Games and China.com have no ownership interest in our affiliated PRC entities. These contractual arrangements, including the voting proxies granted to us, may not be as effective in providing us with control over these companies as direct ownership. If we were the controlling shareholders of these companies with direct ownership, we would be able to exercise our rights as shareholders to effect changes in the board of directors, which in turn could effect change, subject to any applicable fiduciary obligations, at the management level. However, under the current contractual arrangements, as a legal matter, if any of our affiliated PRC entities fails to perform its obligations under these contractual arrangements, we may have to (i) incur substantial costs and resources to enforce such arrangements, including the voting proxy, and (ii) rely on legal remedies under PRC law, which we cannot be sure would be effective. In the event that CDC Games and China.com are unable to enforce these contractual arrangements, if these contractual arrangements are held to be unenforceable under PRC or Hong Kong laws or regulations or if we suffer significant time delays or other obstacles in the process of enforcing these contractual arrangements, our business, financial condition and results of operations could be materially and adversely affected.
If our past or current business operation structure is found not to comply with PRC laws and regulations, we could be subject to severe penalties, including the shutting down of our servers.
The relevant PRC regulatory authorities have broad discretion in determining whether a particular contractual structure is in violation of law. If our past or current ownership structures, contractual arrangements and businesses, or those of our PRC subsidiaries and our affiliated PRC entities are found to be in violation of PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such violations, including:
Moreover, we could face material and adverse tax consequences if the PRC tax authorities determine that our undocumented or documented arrangements with our affiliated PRC entities were not priced at arms length for purposes of determining tax liability. If the PRC tax authorities determine that these arrangements were not entered into on an arms length basis, they may perform a transfer pricing adjustment. A transfer pricing adjustment could result in a reduction, for PRC tax purposes, of deductions recorded by our affiliated PRC entities, which could adversely affect us by increasing the tax liabilities of our affiliated PRC entities without reducing the tax liabilities of our PRC subsidiaries. This increased tax liability could further result in late payment fees and other penalties to our affiliated PRC entities for under-paid taxes. Any payments we make under these arrangements or adjustments in payments under these arrangements that we may decide to make in the future will be subject to the same risk.
Any of these actions could materially and adversely affect our business, financial condition and results of operations.
If the Chinese government considers our existing licenses to be insufficient in meeting compliance requirements with applicable regulations, or if we fail to comply with changes to these requirements or restrictions, our online games and Internet businesses could be materially adversely affected.
The Chinese government regulates access to the Internet by imposing strict licensing requirements on Internet service providers, or ISPs. Generally, the provision of different types of infrastructure telecommunication services and value-added telecommunication services is subject to different licensing regimes in China.
While we believe that our current operation complies with all existing laws, rules and regulations in China, there are substantial uncertainties regarding the interpretation of current Internet laws and regulations. It is possible the Chinese government may take a view contrary to ours because there are no well established precedents or clear judicial interpretations to support our interpretations and views of the laws, rules and regulations. Issues, risks and uncertainties relating to government regulation of Chinas Internet sector include:
Other aspects of our online operations may be subject to regulation in the future.
In addition to the regulations promulgated by the Chinese national government, some local governments, such as the Beijing local government, have also promulgated local rules applicable to Internet companies operating within their respective jurisdictions. These local rules may also create additional barriers in relation to the operation of our business.
Our ability to use and enjoy assets held by our affiliated PRC entities that are important to the operation of our business may be reduced or lost, particularly if any of these entities goes bankrupt or becomes subject to a dissolution or liquidation proceedings.
As part of our contractual arrangements with our affiliated PRC entities, they are required to hold certain of the assets that are important to the operation of our business.
Our PRC subsidiaries and affiliated PRC entities are required under PRC laws and regulations to provide for certain statutory reserves, such as a general reserve, an enterprise expansion fund and a staff welfare and bonus fund. Our PRC subsidiaries and affiliated PRC entities are required to allocate at least 10% of their after tax profits as reported in their PRC statutory financial statements to the general reserve and have the right to discontinue allocations to the general reserve once the reserve balance has reached 50% of their registered capital. These statutory reserves are not available for distribution to the shareholders of these companies, except in a liquidation, and may not be transferred in the form of loans, advances, or cash dividends.
Further, if any of these entities incurs substantial debt, the instruments governing such debt may restrict their ability to pay dividends or make other distributions to us; and if any of these entities goes bankrupt and all or part of its assets become subject to liens or rights of third-party creditors, we may be unable to continue some or all of our business activities, which could materially and adversely affect our business, financial condition and results of operations. If any of our affiliated PRC entities undergoes a voluntary or involuntary liquidation proceeding, the shareholders or unrelated third-party creditors may claim rights to some or all of these assets. Any of the foregoing, thereby hindering our ability to operate our business, which could materially and adversely affect our business, financial condition and results of operations.
The discontinuation of any of the preferential tax treatments currently available to us in the PRC could materially and adversely affect our business, financial condition and results of operations.
Our subsidiaries incorporated in China are governed by the PRC Enterprise Income Tax Law Concerning Foreign-Invested Enterprises and Foreign Enterprises.
Our subsidiary, Beijing He He Technology Co., Ltd. has enjoyed preferential tax treatment as a new technology enterprise pursuant to which its net income was exempted from enterprise income tax from 2003 to 2005, and will be subject to a 7.5% enterprise income tax rate from 2006 to 2008 and a 15% enterprise income tax rate thereafter so long as it maintains its status as a new technology enterprise. In addition, our subsidiary and our affiliated PRC entity have applied for the same preferential tax treatment as new technology enterprises pursuant to which their net income will be exempt from enterprise income tax from 2006 to 2008, and will be subject to a 7.5% enterprise income tax rate from 2009 to 2011 and a 15% enterprise income tax rate thereafter, if they are approved as new technology enterprises and so long as they maintain their new technology enterprise status.
The financial and non-financial criteria that our subsidiary must meet in order to obtain or maintain preferential tax treatment as new technology enterprises are promulgated by the PRC Ministry of Science and Technology, and are as follows:
While we expect our subsidiaries and affiliated PRC entities to be able to enjoy their respective preferential tax rates or tax exemptions, this preferred tax treatment is subject to review by higher authorities. We cannot assure you that the PRC tax authorities will not, in the future, deny or elect to discontinue any or all of these preferential tax treatments. In the event the preferential tax treatment for any of our subsidiaries or affiliated PRC entities is discontinued, the entity will become subject to a 33% standard enterprise income tax rate. The discontinuation of any of these preferential tax treatments could materially and adversely affect our business, financial condition and results of operations.
The PRC legal system embodies uncertainties, which could limit the legal protections available to you and us.
The PRC legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have limited precedential value. In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general. The overall effect of legislation over the past three decades has significantly enhanced the protections afforded to various forms of foreign investment in mainland China. Our PRC operating subsidiaries include several wholly foreign owned enterprises and are subject to laws and regulations applicable to foreign investment in China as well as laws and regulations applicable to foreign-invested enterprises. In particular, they are subject to the laws and regulations governing foreign companies ownership and operation of Internet content distribution and advertising businesses. These laws and regulations frequently change, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to us and our investors. In addition, we cannot predict the effect of future developments in the PRC legal system, particularly with regard to the Internet, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws.
We have limited insurance coverage in China. Any business disruption, litigation or natural disaster might result in substantial costs and the diversion of our resources.
The insurance industry in China is still at an early stage of development and PRC insurance companies offer limited business insurance products. As a result, we do not maintain insurance policies covering losses relating to our systems and we do not have business liability, interruption or litigation insurance for our operations in China. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers. Any business disruption, litigation or natural disaster might result in our incurring substantial costs and the diversion of our resources.
Concerns about the security of electronic commerce transactions and confidentiality of information on the Internet may reduce use of our network and impede our growth.
A significant barrier to electronic commerce and communications over the Internet in the PRC has been a public concern over security and privacy, especially the transmission of confidential information. If these concerns are not adequately addressed, they may inhibit the growth of the Internet and other online services generally, especially as a means of conducting commercial transactions. If a well-publicized Internet breach of security were to occur, general Internet usage could decline, which could reduce traffic to our destination sites and impede our growth.
Risks Relating to Our Intellectual Property, Personnel, Technology and Network
We may be unable to adequately protect or enforce our intellectual property rights and may be involved in future litigation over our use of technology rights.
We have acquired a significant amount of intellectual property and we are increasingly developing our own intellectual property. We regard the protection of our trademarks, service marks, copyrights, trade secrets, domain names, and other intellectual property rights as crucial to our success. We rely on a combination of copyright, trade secret and trademark laws, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary information and technology. Copyrights or trademarks held by us, however, may be challenged or determined to be invalid. In addition to the protections generally available to unregistered trademarks under the laws of many jurisdictions, we also seek to protect our trademarks through registration, primarily in the United States and Canada, although we do seek such protection elsewhere in selected key markets. However, adequate protection for our intellectual property may not be available in any, or every country, in which our intellectual property and technology is used. Some countries, such as the PRC, may not protect our proprietary rights to the same extent as in the United States and Canada. In particular, software piracy in the PRC has been an issue of significant concern for many software publishers. Policing the unauthorized use of our licensed technology is difficult as are the steps necessary to prevent the misappropriation or infringement of our licensed technology.
Litigation, which may also ultimately prove to be insufficient, may be necessary to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of our proprietary rights. Any of these claims, with or without merit, could result in costly litigation, divert our managements time, attention and resources, delay our product shipments or require us to enter into royalty or license agreements.
As part of our confidentiality procedures, we have policies of entering into non-disclosure and confidentiality agreements with our employees, consultants, corporate alliance members, customers, prospective customers and strategic partners. We also enter into license agreements with respect to our technology, documentation and other proprietary information. These licenses are non-exclusive and generally perpetual. We provide for source code escrow arrangements under some of our license agreements. Despite the efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain the use of our products or technology that we consider proprietary and third parties may attempt to develop similar technology independently.
Most of our products do not contain the functionality to allow us to accurately track the numbers of users of our products at a particular customer site. Because some of our license agreements are for named-user licenses in which only a certain limited number of named individuals are permitted to use the software for which the license is granted, if our customers do not accurately report the number of users using our products or we cannot accurately track the number of users of our products at a customer site, we face the potential of lost revenues if the customer has a greater number of users than for which they have purchased licenses. License agreement provisions, such as those requesting or requiring customers to perform annual self audits of the number of users at a customer site, provide only limited protection and are retrospective.
We also currently sub-license and distribute the intellectual property and technology of third parties. As we continue to develop intellectual property and introduce new products and services that require new technology, we anticipate that we may need to obtain licenses for additional third-party technology. These existing and additional technology licenses may cease to be available to us on commercially reasonable terms, or at all. In addition, it is possible that, in the course of using new technology, we or our agents acting on our behalf may inadvertently breach the technology rights of third parties and face liability for our breach. Our inability to obtain these technology licenses or avoid breaching third-party technology rights
could require us to obtain substitute technologies of lower quality or performance standards or at greater cost which could delay or compromise the introduction of new products and services, and could materially and adversely affect our business, results of operations and financial condition.
Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.
We regard our copyrights, trademarks, trade secrets, domain names and other intellectual property as important to our business. Unauthorized use of such intellectual property, whether owned by us or licensed to us, may adversely affect our business and reputation. We rely on intellectual property laws and contractual arrangements with our key employees and certain of our clients, collaborators and distributors and others to protect our intellectual property rights. Policing unauthorized use of intellectual property is difficult and expensive. Despite our precautions, it may be possible for third parties to obtain and use the intellectual property used in our business without authorization. The validity, enforceability and scope of protection of intellectual property in Internet-related industries in China are uncertain and still evolving. In particular, the laws and enforcement procedures of the PRC and certain other countries are uncertain or do not protect intellectual property rights to the same extent as do the laws and enforcement procedures in the United States. Moreover, we may have to resort to litigation to enforce our intellectual property rights. Any future litigation could result in substantial costs and diversion of our resources, and could significantly disrupt our business, as well as have a material adverse effect on our financial condition and results of operations.
We may be subject to infringement claims, which could be time-consuming and costly to defend, divert managements attention and resources or cause product shipment delays.
We may be subject to an increasing number of infringement claims as the number of products and competitors in our various industry segments grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming and costly to defend, divert managements attention and resources, cause product shipment delays or require us or our subsidiaries to enter into royalty or licensing agreements. Any such royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all, and may require the payment of substantial amounts of money. Furthermore, if we are found to have violated the intellectual property rights of others, or any party which licenses intellectual property to us is found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property rights. In the event of a successful product infringement claim against us or our failure or inability to license the infringed or similar technology, our business, results of operations and financial condition could be materially and adversely affected.
If our licensors cannot prevail on future intellectual property rights claims brought against them by third parties, our results of operations may be materially and adversely affected.
With respect to our online games business, we expect to derive most of our online games revenues and profits from Yulgang, Special Force and Shaiya and online games that we may license and launch in the future. Certain technology that is licensed from third parties may also be present in our software applications and licensed and developed online games. Our licensors may be subject to intellectual property rights claims with respect to the online game or games licensed to us. If any of our licensors cannot prevail on the intellectual property rights claims brought against them, we would lose our license from such licensor and may not be able to obtain the license from the legitimate owner of the game on terms acceptable to us, or at all, and our results of operations could be materially and adversely affected.
We could be subject to product liability claims, which could be time-consuming and costly to defend, divert managements attention and could have a material and adverse effect on our reputation, business, results of operations and financial condition.
Our complex software products may contain errors that may not be detected until after the delivery of the software. Furthermore, errors may also be present in our online games and software that controls or is related to our various mobile applications and services offerings, Any such errors could result in delayed market acceptance or claims against us by customers, which could lead to increased insurance costs or the payment of damages by us. Any such claims, with or without merit, could be time-consuming and costly to
defend and divert managements attention and resources. Contractual provisions we may include in our agreements with third parties to mitigate this risk may not be enforceable in all jurisdictions, and liability insurance may not be available, or coverage for specific claims may be denied. A successful product liability claim brought against us could materially and adversely affect our reputation, business, results of operations and financial condition.
If we lose the services of key employees, it may be costly and time-consuming for us to locate other personnel with the required skills and experience.
Our success depends on the continued efforts of our board members, our senior management and our technical, research and development, services and support, marketing and sales personnel. These persons may terminate their association or employment with us at any time. We have experienced changes in our senior management for a variety of reasons, including restructuring, medical reasons, retirement, and resignations to pursue other career opportunities. Loss of the services of key members of senior management or experienced personnel can be disruptive and causes uncertainty. In particular, we depend upon the services of Mr. Peter Yip, our chief executive officer. Mr. Yip took a leave of absence for medical reasons between February 2005 and April 2006. During that time, two other people who served as our chief executive officer and president resigned. While Mr. Yip believes that he has recovered enough to serve as our chief executive officer, we cannot assure his continued service.
The process of hiring employees with the combination of skills and attributes required to implement our business strategy can be extremely competitive and time-consuming. We compete for a limited number of qualified individuals with more established companies with greater resources that may offer more attractive compensation or employment conditions. As a result, we may be unable to retain or integrate existing personnel or identify and hire additional qualified personnel.
We have determined that material weaknesses in our internal controls over financial reporting existed during 2005 and 2006 as a result of, among other things, our inability to attract and retain sufficient resources with the appropriate level of expertise in the accounting and finance departments of our organization to ensure appropriate application of GAAP, particularly in the areas of accounting for income taxes, foreign currency translation adjustments related to goodwill and intangible assets and the accounting for certain of our non-routine transactions. These material weaknesses resulted in the restatement of our financial statements for the years ended December 31, 2005, 2004 and 2003.
On July 2, 2007, we filed an amendment to our Annual Report on Form 20-F for the year ended December 31, 2005, to address comments received from the U.S. Securities and Exchange Commission and to provide separate consolidated balance sheets for 17game Group, a company we acquired, as of December 31, 2004 and 2005, and the related consolidated statements of operations, shareholders equity and cash flows for the year ended December 31, 2005 and for the five month period from August 1 to December 31, 2004 and the accompanying audit report of Deloitte Touche Tohmatsu CPA Ltd. Additionally, on June 30, 2008, we amended our Annual Report on Form 20-F for the year ended December 31, 2006 to restate certain amounts presented in the business segment footnote to our consolidated financial statements for the year ended December 31, 2006.
An inability to attract or retain additional qualified senior managers or personnel in a timely manner, or the health, family or other personal problems of key personnel could have a material and adverse effect on our business, results of operations and financial condition.
In the past, we have partially relied on options to compensate our employees. In the event employees do not consider their options as valuable compensation, we may need to provide additional compensation at additional expense.
We have granted, and anticipate we will continue to grant, options to purchase our Class A common shares to some of our employees. In the event our employees do not consider their options to be valuable compensation, we may need to provide additional compensation in the form of additional salary, bonuses or equity, in an effort to retain those existing employees. Our inability to retain the employees in our key revenue producing businesses could have a material and adverse effect on our business, results of operations and financial condition.
The computer networks at our CDC Software, CDC Games and China.com business units are vulnerable to hacking, viruses, spamming and other disruptions by third parties, which may cause those businesses to lose key clients, expose us to liability for our clients losses, or prevent us from securing future business.
Unauthorized or inappropriate use of Internet services or errors or omissions in processing instructions or data available in computer system or databases at our CDC Software, CDC Games and China.com business units could jeopardize the security of confidential information stored in these computer systems, which may cause our CDC Software,CDC Games and China.com business units lose key clients, expose us to liability for our clients losses and prevent us from securing future business, any of which could have a material adverse effect on our business, financial condition, results of operations and share price.
Unauthorized or inappropriate use of the Internet includes attempting to gain unauthorized access to information or systems (commonly known as cracking or hacking) and repeated transmission of unsolicited e-mail messages (commonly known as e-mail bombing or spamming). The current policies, procedures and configurations for managing the systems at our CDC Software, CDC Games and China.com business units, including their computer servers, may not be adequate to protect these facilities and the integrity of user and customer information. Although CDC Software, CDC Games and China.com implement security measures to protect their facilities and the integrity of their user and customer information, such measures could be ineffective or circumvented.
Alleviating problems caused by computer viruses or other inappropriate uses or security breaches may require interruptions, delays or cessation in the services our CDC Software, CDC Games and China.com business units, in addition to the outages that occur in these systems from time to time for various reasons, including power interruptions, errors in instructions, equipment inadequacy, capacity and other technical problems. We do not carry errors and omissions or other insurance covering losses or liabilities caused by computer viruses, security breaches or spamming attacks. Compromises or breaches in the security or integrity of these facilities or customer or user information, or inappropriate use of these Internet services, could subject us, CDC Games and China.com to litigation and could adversely affect our customer base, business, share price, results of operation and financial condition.
We rely on software and hardware systems at our CDC Games and China.com business units that are susceptible to failure, and in the event of service operations or other related problems, the operating efficiency and results of operations of these businesses may be adversely affected.
Any system failure or inadequacy that interrupts the services of our CDC Games and China.com business units or increases the response time of these services could reduce user satisfaction, future traffic and our attractiveness to advertisers and consumers. We also depend on Internet service providers and other Web site operators in the PRC and elsewhere that have experienced significant system failures and electrical outages in the past. Our users have experienced difficulties due to system failures that were unrelated to our systems and services. There can be no assurance that our technologies, services and products will not experience interruptions or other related problems, which could affect our operating efficiency and results of operations of these business units.
Many of our servers and routers, including back up servers, are currently hosted by third-party service providers throughout China. We do not maintain insurance policies covering losses relating to our systems and we do not have business interruption insurance. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers.
We also have limited system redundancy, and do not have a disaster recovery plan in the event of damage from fire, natural disasters, power loss, telecommunications failures, break-ins and similar events.
We may experience a complete system shut-down if any of these events were to occur. To improve performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers or one or more copies of our Web sites to mirror our online resources. Because we carry property insurance with low coverage limits, our coverage may not be adequate to compensate us for our losses. If we do not increase our capacity and our redundancy, these constraints could have a material adverse effect on our business, results of operations and financial condition.
The successful operation of our online game and internet portal businesses depends upon the performance and reliability of the Internet infrastructure and fixed telecommunications networks in China.
Our online game and internet portal businesses depend on the performance and reliability of the Internet infrastructure in China. Almost all access to the Internet is maintained through state-owned telecommunication operators under the administrative control and regulatory supervision of Chinas Ministry of Information Industry. In addition, the national networks in China are connected to the Internet through international gateways controlled by the PRC government. These international gateways are generally the only channels through which a domestic user can connect to the Internet. We cannot assure you that a more sophisticated Internet infrastructure will be developed in China. We may not have access to alternative networks in the event of disruptions, failures or other problems with Chinas Internet infrastructure. In addition, the Internet infrastructure in China may not support the demands associated with continued growth in Internet usage.
Risks Relating to Our Class A Common Shares
Our share price could be adversely affected if our major strategic shareholders materially change their holdings in our shares, particularly if the share holdings are not disposed of in an orderly manner.
As of April 30, 2008, Asia Pacific Online Limited, or APOL, beneficially owned 22,384,648 of our common shares, or approximately 20.9% of our total outstanding share capital, based on 106,992,519 shares outstanding as of March 31, 2008, and Xinhua, through a wholly-owned subsidiary, owned 7,362,734 of our common shares, or approximately 6.9% of our total outstanding share capital. APOL is owned by the spouse of Mr. Peter Yip, our current chief executive officer and Vice Chairman of the Board of Directors, and by a trust established for the benefit of Mr. Yips children. There is no guarantee that APOL or Xinhua will continue to hold our shares going forward for any length of time. If APOL or Xinhua disposes, or if our investors expect Xinhua or APOL to dispose of, a substantial portion of their respective holdings in CDC at any time, it could adversely affect our share price. For more information regarding the shareholdings of APOL, Xinhua and other entities, see Item 7.A., Major Shareholders and Related Party Transactions Major Shareholders.
A small group of our existing shareholders control a significant percentage of our common shares, and their interests may differ from those of our other shareholders.
As of April 30, 2008, APOL owned approximately 20.9% of our common shares, based on 106,992,519 shares outstanding as of March 31, 2008, Xinhua, through a wholly-owned subsidiary, owned approximately 6.9% of our common shares and Jayhawk Capital owned approximately 8.4% of our common shares. Accordingly, these shareholders, particularly if they act together, will have significant influence in determining the outcome of any corporate transaction or other matter submitted to shareholders for approval, including:
As a result, these shareholders, if they act together, may be able to effectively prevent a merger, consolidation or other business combination, elect or not elect directors, prevent removal of a director and prevent amendments to our memorandum and articles of association.
For more information regarding the shareholdings of APOL, Xinhua and Jayhawk, see Item 7.A., Major Shareholders and Related Party Transactions Major Shareholders.
Our share price has been, and may continue to be, extremely volatile, which may not be attractive to investors.
The trading price of our common shares has been, and is likely to continue to be, extremely volatile. During the period from July 12, 1999, the date we completed our initial public offering, or IPO, to December 31, 2002, the closing price of our shares ranged from $1.86 to $73.44, adjusted for our two stock splits. From January 1, 2003 to December 31, 2007, the closing price of our shares ranged from a low of $2.40 per share on April 15, 2005 to a high of $14.46 per share on July 14, 2003. There is no assurance that our share price will not fall below its historic or yearly low.
The trading price of our Class A common shares is subject to significant volatility in response to, among other factors:
In addition, the trading price of our common shares has experienced extreme price and volume fluctuations. These fluctuations often have been unrelated or disproportionate to our operating performance. Broad market, political and industry factors may also decrease the price of our common shares, regardless of our operating performance. Securities class-action litigation and regulatory investigations often have been instituted against companies following steep declines in the market price of their securities.
We issued $168 million of senior exchangeable convertible notes due 2011 which we may not be able to repay in cash, could result in dilution to our current stockholders, dilution of our earnings per share, and which contain negative covenants which may have an adverse effect on our business and financial condition.
In November 2006, we issued an aggregate of $168 million of 3.75% senior exchangeable convertible notes due 2011 to a total of 12 institutional accredited investors in a private placement exempt from registration under the Securities Act. As of December 31, 2007, the face value of outstanding senior exchangeable convertible notes was $168 million.
Upon the occurrence of certain events, we have the right to redeem the notes, and the investors may demand redemption of the notes by us in the event that no qualified initial public offering by either CDC Software or CDC Games has occurred on the third anniversary following the issuance of the notes. The notes may be redeemed at par value plus all accrued and unpaid interest; provided, however, that the interest rate shall increase to 12.5% per annum and apply retroactively from the issue date to the applicable redemption date. However, we cannot assure you that we will have enough cash on hand or the ability to access cash to pay the notes if presented for redemption, on a redemption date referred to above or at maturity.
In addition, in connection with our issuance of the notes, we became subject to various negative covenants. We agreed that we will not incur any debt, other than permitted debt, unless after giving effect to such debt: our leverage ratio is less than 6.0 to 1 as reflected in our consolidated financial statements for the immediately preceding four fiscal quarters; our aggregate debt does not exceed 50% of our total capitalization on a consolidated basis as reflected in our consolidated financial statements for the immediately preceding four fiscal quarters; or our consolidated cash flow exceeds two times the sum of consolidated interest expense and capital expenditures during the immediately preceding four fiscal quarters.
Furthermore, we also may not create, assume or incur any mortgage, pledge lien, or other security interest except for certain permitted liens, which include existing liens, intracompany liens, liens over assets of CDC Software to secure a credit facility to CDC Software in an amount not exceeding $30 million, liens securing assets acquired or constructed after the closing to secure the cost of such acquisition or construction, provided such liens do not exceed 80% of the fair market value of the asset, or any lien resulting from renewing extending or replacing a lien.
Pursuant to the negative covenants we are also prohibited from paying dividends to our common shareholders (other than dividends of our common shares) or repurchase any shares of our capital stock or any of our subsidiaries, provided, however, that we may purchase voting equity in any non-wholly owned subsidiary or make purchases pursuant to a stock repurchase program.
The note investors are also afforded anti-dilution protection, a right of first refusal if we, CDC Software or CDC Games intend to offer or sell any of its equity or equity equivalent securities prior to a qualified initial public offering, and have received registration rights with respect to the common shares deliverable upon an exchange of the notes. The negative covenants set forth above may have the effect of limiting our ability to operate our businesses and financial affairs in certain manners, which may have a material, adverse effect on our business, financial condition and results of operations.
We are a foreign private issuer, and have disclosure obligations that are different than those of other U.S. domestic reporting companies so you should not expect to receive the same information about us at the same time as a U.S. domestic reporting company may provide.
We are a foreign private issuer and, as a result, we are not subject to certain of the requirements imposed upon U.S. domestic issuers by the SEC. For example, we are not required to issue quarterly reports or proxy statements. We are allowed six months to file our annual report with the SEC instead of approximately three, and we are not required to disclose certain detailed information regarding executive compensation that is required from U.S. domestic issuers. Further, our directors and executive officers are not required to report equity holdings under Section 16 of the Securities Act. As a foreign private issuer, we are also exempt from the requirements of Regulation FD (Fair Disclosure) which, generally, are meant to ensure that select groups of investors are not privy to specific information about an issuer before other investors. We are, however, still subject to the anti-fraud and anti-manipulation rules of the SEC, such as Rule 10b-5.
Since many of the disclosure obligations required of us as a foreign private issuer are different than those required by other U.S. domestic reporting companies, our shareholders, potential shareholders and the investing public in general, should not expect to receive information about us in the same amount and at the same time as information is received from, or provided by, other U.S. domestic reporting companies.
We are liable for violations of the rules and regulations of the SEC which do apply to us as a foreign private issuer. Violations of these rules could affect our business, results of operations and financial condition.
We may incur significant costs to avoid being considered an investment company under the Investment Company Act of 1940.
Generally, the Investment Company Act of 1940, or the 1940 Act, provides that a company is not an investment company and is not required to register under the 1940 Act as an investment company if:
We believe that we are engaged primarily and directly in the businesses of providing enterprise software and business services through our CDC Software business unit, on online games through our CDC Games business unit and on mobile applications and internet and media services through our China.com business unit. Also, based upon an analysis of our assets at December 31, 2007 and income for the year ended 2007, during 2007, we do not believe we will be considered an investment company. The determination of whether we will be an investment company will be based primarily upon the composition and value of our assets, which are subject to change, particularly when market conditions are volatile. As a result, we could inadvertently become an investment company.
If we were to become subject to the requirements of the 1940 Act, our operations and results would be negatively impacted, including among other possible effects, our inability to raise capital through the offer and sale of our securities in the United States. We could also be subject to administrative or legal proceedings and, among other things, contracts to which we are a party might be rendered unenforceable or subject to rescission. Additionally, we would be unable to continue operating as we currently do and might need to acquire or sell assets that we would not otherwise acquire or sell in order to avoid becoming and investment company as defined under the 1940 Act. We may incur significant costs and management time to avoid being considered an investment company under the Investment Company Act of 1940, as amended.
We can give no assurances in the future as to our investment company status under the Investment Company Act of 1940.
We believe, although we cannot assure you, that our Class A common shares should not be treated as stock of a passive foreign investment company, or PFIC, for the taxable year ending December 31, 2007. This belief is different than the determinations we have made in previous years, and we cannot assure you that we will not be treated as a PFIC in the future.
We do not believe that we should be treated as a PFIC for U.S. federal income tax purposes for our taxable year ended December 31, 2007, based upon our analysis of our assets held at the end of each quarter of our taxable year ending December 31, 2007, and our income for our taxable year ended December 31, 2007. However, the PFIC determination is inherently factual and there is limited guidance regarding the application of the PFIC rules. Accordingly, we cannot assure you that the IRS will not successfully contend, or that a court would not otherwise conclude, that we are a PFIC. Accordingly, prospective investors are strongly urged to consult with their tax advisor as to the effects of the PFIC rules.
Further, the PFIC determination is made annually, and therefore may be subject to change in future years. Thus, we can provide no assurance that we will not be classified as a PFIC in 2008 and beyond. The determination of whether we would become a PFIC in a future tax year would be principally based upon:
We have limited control over these variables and therefore, cannot assure you of our PFIC status for future years.
Further, we may consider additional capital markets or corporate finance transactions in the future. Should we proceed with such offerings, we cannot, at this stage, specify with certainty the timing, amounts or the particular uses of the net proceeds. Depending on the usage of any such net proceeds, we could possibly become classified as a PFIC as a result of such transactions.
If we become a PFIC, U.S. holders, as such term is defined in Item 10.E., Additional Information Taxation Tax Consequences of U.S. Holder, could be subject to adverse U.S. federal income tax consequences. For further discussion regarding our PFIC status, see Item 10.E., Additional Information Taxation Tax Consequences of U.S. Holders Passive Foreign Investment Company Status. U.S. holders are strongly urged to consult their own tax advisors regarding the application of the PFIC rules to their particular circumstances.
Substantial amounts of our common shares are eligible for future sale, which could adversely affect the market price of our shares.
Sales of substantial amounts of our Class A common shares in the public market could adversely affect the market price for our shares. As of March 31, 2008, we had 117,677,165 Class A common shares issued and outstanding, substantially all of which may be sold pursuant to an effective registration statement under the Securities Act or an applicable exemption from registration thereunder, including Rule 144, which permits resales of securities subject to limitations (including trading volume) depending on the holding period of such securities.
In August 2007, we prepared and filed a shelf registration statement on Form F-3 pursuant to which we could potentially register an indeterminate number of common shares and preferred shares, debt securities, or warrants to purchase any of such securities or units.
Several of the agreements we have entered into with respect to acquisitions we have made, require us pay cash and/or issue earn-out shares, which are shares of our common stock issued to sellers or other persons in those transactions, upon the occurrence of certain milestones or on certain dates. These earn-out obligations may, in some instances, extend for several years past the date of the original agreement. Any such issuance of shares will cause dilution in the interests of our stockholders. Furthermore, many of the amounts payable or issuable under the earn-out provisions are variable, and the number of shares and/or cash that may be payable under these provisions may be significantly more or less than we may expect or have anticipated.
In addition, as we continue to issue and register shares to fulfill our contractual and acquisition-related obligations, and as our employees and other grantees have been or are granted, and subsequently exercise, additional options to purchase our common shares, additional shares will be available-for-sale in the public market. We have also granted options to certain of our shareholders, directors and officers to purchase our shares, the vesting of which options may be accelerated upon an occurrence of a change-of-control event. As a result, additional shares may be available-for-sale in the public market. The availability or perceived availability of additional shares could have a dilutive and negative impact on the market price of our shares.
In the future, we may also issue additional shares, convertible notes or warrants to purchase our shares, in connection with acquisitions and our efforts to expand our business. Shareholders could face further dilution from any such future share issuances.
Anti-takeover provisions in our charter documents may adversely affect the rights of holders of our common shares.
Our memorandum and articles of association include provisions that could limit the ability of others to acquire control of us, modify our structure or cause us to engage in change-of-control transactions. We intend to review and evaluate these provisions periodically and may adopt additional anti-takeover measures in the future. These provisions could have the effect of depriving shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of us, in a tender offer or similar transaction.
For example, our board of directors is divided into three classes, each having a term of three years, with the term of one class expiring each year. These provisions have the effect of delaying the replacement of a majority of our directors and make changes to our board of directors more difficult than if such provisions were not in place. In addition, our board of directors has the authority, without further action by our shareholders, to issue up to 5,000,000 preferred shares in one or more series and to fix their designations, powers, preferences, privileges, relative participating, optional or special rights and the qualifications, limitations or restrictions thereon, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences. Any or all of the foregoing may be superior to the rights afforded to the holders of our Class A common shares. Preferred shares could be issued quickly with terms calculated to delay or prevent a change in control or make removal of management more difficult. If our board of directors issues preferred shares, the price of our Class A common shares may fall and the voting and other rights of the holders of our Class A common shares may be adversely affected.
Our shareholders may face difficulties in protecting their interests because we are incorporated under Cayman Islands law.
Our corporate affairs are governed by our amended and restated memorandum and articles of association, and by the Companies Law and common law of the Cayman Islands. The rights of shareholders to take action against our directors, actions by minority shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law in the Cayman Islands is derived in part from, as compared to the U.S., limited judicial precedent in the Cayman Islands and from English common law. Cayman Islands law in this area may conflict with jurisdictions in the United States. As a result, our public shareholders may face more difficulties in protecting their interests in actions against our management, directors or our controlling shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States. For instance, the ability to bring a class action lawsuit may not be available to our shareholders as a vehicle for litigating securities matters against us in the Cayman Islands. Further, under Cayman Islands law, shareholder derivative actions may generally not be brought by a minority shareholder. In addition, the shareholders of Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States. As a result, our shareholders may have more difficulty in protecting their interests in actions against our management, directors or our shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States, and our ability to protect our interests if we are harmed in a manner that would otherwise enable us to sue in a United States court may be limited.
Additionally, the Cayman Islands have a less developed body of corporate and securities laws than the United States.
The Cayman Islands courts are also unlikely to:
There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will generally recognize and enforce a non-penal judgment of foreign court of competent jurisdiction without retrial on the merits.
As a result of the above, our public shareholders may have more difficulty in protecting their interests than they would as public shareholders of a U.S. company.
You may have difficulty enforcing judgments obtained against us.
We are a Cayman Islands company and a substantial majority of our assets are located outside the United States. A substantial portion of our current operations is conducted outside the United States in countries such as Canada, China, Sweden, Australia, the United Kingdom and other countries and territories, and a majority of our directors and officers are nationals and/or residents of countries other than the United States. A substantial portion of any assets these people may hold is located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon, and gain jurisdiction over, these persons. In addition, there is uncertainty as to whether the courts of Canada, China, Sweden, the United Kingdom and other jurisdictions would recognize or enforce judgments of U.S. courts obtained against us or these persons that may be based upon the civil liability provisions of the securities laws of the United States or any state thereof. Furthermore, the courts of these countries may refuse to hear cases brought in Canada, China, Sweden, the United Kingdom, or other jurisdictions against us or such persons predicated upon the securities laws of the United States or any of its states.
If you are not a registered shareholder and do not hold greater than 10,000 shares, you may not receive our proxy materials or other corporate communications.
We are a Cayman Islands company. As such, we are only required to distribute our proxy materials to our registered shareholders, and not to any shareholders who hold our shares beneficially, through a broker or in a brokerage account. We offer electronic delivery of proxy materials to our registered shareholders, and we mail proxy materials to each registered owner who has not opted to receive materials electronically. You are a registered shareholder if you have an account with our transfer agent, The Bank of New York, and if you hold a stock certificate evidencing your ownership of our common shares. You are a beneficial shareholder if a brokerage firm, bank trustee or other agent holds your common shares. However, your name would not appear anywhere on our records, but rather the name of the broker, bank or other nominee appears on our records as retained by our transfer agent, The Bank of New York. Although we only need to distribute our proxy materials to registered shareholders under Cayman Islands law, we also distribute, but are not required to distribute, proxy materials to beneficial shareholders who hold greater than 10,000 of our shares. In an effort to maintain cost effectiveness, we have, and intend to continue to, mail the proxy materials to those beneficial shareholders who hold greater than 10,000 of our shares. If you are not a registered shareholder and do not hold greater than 10,000 of our shares, you will not receive our proxy materials or other corporate communications. Therefore, if you are a beneficial shareholder and want to ensure that you do receive proxy materials, you are urged to become a registered owner.
We do not intend to pay dividends in the foreseeable future and the holders of our class A common shares may not receive any return on their investment from dividends.
We currently intend to retain any future earnings for funding growth. We do not anticipate paying any dividends in the foreseeable future. The holders of our class A common shares may not receive any return on their investment from dividends.
Our headquarters and principal executive offices are located at 33/F Citicorp Centre, 18 Whitfield Road, Causeway Bay, Hong Kong, and our telephone number is 852-2893-8200. Our contact telephone number in Beijing is 011-8610-5129-8700. Our primary address in the United States is Two Concourse Parkway, Suite 800, Atlanta, GA 230328 and our telephone number in Atlanta is (678) 259-8510. We have a website that you may access at http://www.cdccorporation.net. Information contained on our website does not constitute part of this Annual Report.
We were incorporated in June 1997 as China Information Infrastructure Limited, a company limited by shares under the Companies Law of the Cayman Islands and a wholly-owned subsidiary of China Internet Corporation Limited, or CIC, to operate CICs Internet portal and related businesses.
In June 1999, CIC distributed its entire interest in our predecessor company to CICs shareholders. Upon completion of that transaction, CIC ceased to have any ownership interest in our predecessor company. APOL and a wholly-owned subsidiary of Xinhua provided rights of first refusal to buy the other partys shares in us in the event either party sought to dispose of its shareholdings. Additionally, APOL received rights to place shares of us owned by the Xinhua subsidiary to prospective buyers on behalf of the Xinhua subsidiary in exchange for a commission.
In July 1999, we completed our IPO of the equivalent of 19,320,000 class A common shares on NASDAQ at the equivalent of a public offering price of $5.00 per share on a stock split adjusted basis. All of the shares registered were sold and net proceeds from the IPO totaled $85.6 million.
In December 1999, our shareholders approved a two-for-one share split.
In January 2000, we completed a second public offering of the equivalent of 9,952,884 class A common shares on NASDAQ at the equivalent of a public offering price equal to $42.50 per share on a stock split adjusted basis. Of the 9,952,884 class A common shares sold, 2,325,000 shares were offered by certain of our shareholders. The selling shareholders received an aggregate of $94.1 million in net proceeds for their shares. All of the shares registered were sold and net proceeds to us from the offering totaled $303.9 million.
In March 2000, we listed our subsidiary, hongkong.com Corporation (which has since been renamed to China.com), on the Growth Enterprise Market, or GEM, of the Hong Kong Stock Exchange, by selling approximately 16% of this subsidiary to the public. We received net proceeds of approximately $168.5 million in connection with this listing and sale. We currently continue to own approximately 77% of China.com.
In April 2000, our shareholders approved a second two-for-one share split.
In addition, in April 2000, our shareholders approved the change of our company name to chinadotcom corporation. In April 2005, our shareholders approved a second change of our company name from chinadotcom corporation to CDC Corporation. Concurrently, in April 2005, the shareholders of hongkong.com Corporation approved a change of its name from hongkong.com Corporation to China.com.
Acquisitions and Divestitures
Our goal is to be a global company focused on enterprise software through our CDC Software business unit, online games through our CDC Games business unit, internet and media services through our China.com business unit. The evolution of our business model has been achieved in large part through strategic acquisitions and investments during the past three fiscal years. We have spent a significant amount of cash and have issued a significant number of our common shares in connection with the strategic acquisitions and investments mentioned below.
The following is a summary of our strategic acquisitions and investments completed since September 2003 organized by business unit:
Global Services Group
We continually seek to acquire companies that support and expand our current business models. Our acquisitions are typically financed through a combination of cash and our common shares.
In August 2007, we entered into four separate purchase agreements to sell the principal assets and subsidiaries that comprise our Ion Global business for $9.0 million. Under the terms of the agreements, we agreed to sell: (i) the assets related to the internet consulting services and website design and development of Ion Global (California) Inc.; (ii) substantially all of the assets of Ion Global Limited; (iii) all of the issued and outstanding shares of Ion Global Korea Ltd. held by Ion Global (BVI) Ltd.; and (iv) the Ion Global trademark.
CDC Corporation, with facilities in the PRC, Southeast Asia, North America, Europe and Australia, is a global provider of enterprise software, online games and internet and media services. We report operating results in five business segments, Software, Business Services, Online Games, Mobile Services and Applications and China.com. During 2005, we reorganized these segments into two core business units, CDC Software and China.com., and during 2006, we added a third core business unit, CDC Games. The operations of Software and Business Services are included in the CDC Software business unit, the operations of online games are included in the CDC Games business unit and the operations of Mobile Services and Applications and China.com are included in the China.com business unit. In February 2008 we announced that we would be discontinuing our mobile services and applications operations and we have since discontinued such operations due to the regulatory environment connected with such operations.
CDC Software Business Unit
CDC Software is a leading global provider of specialized enterprise software applications and complementary business services to customers in select industries, which we refer to as our targeted vertical industries. Companies in our targeted vertical industries generally have specific and complex business needs and often are subject to specific and extensive regulatory requirements. We believe that our enterprise software applications address our customers critical, industry-specific requirements more reliably and more cost-effectively than conventional enterprise software applications. We also offer a range of complementary business services, including information technology, or IT, and outsourcing services, that span the lifecycle of our customers technology investments.
We conduct our business through our Software Group and our Global Services Group. Through our Software Group, we offer enterprise software applications that are designed to deliver industry-specific functionality. We believe our products help our customers establish and maintain a competitive advantage by allowing them to reduce the cost of their operations, gain visibility needed for continuous business improvement and ensure their regulatory compliance. Our products can typically be rapidly deployed, configured and upgraded easily, and are intuitive to learn and use. We believe these factors lower our customers total cost of ownership and increase their return on investment.
CDC Softwares principal enterprise software applications include:
Through our Global Services Group, we offer IT and business services to help our customers optimize their business processes and maximize the value of their IT expenditures. Our IT and business service offerings include application development, IT infrastructure services, help desk services, business process improvement, implementation and outsourced hosting and application management services. Our customers make significant investments when they purchase enterprise software applications, whether from us or other software vendors, to run many critical business processes for years to come. Our broad range of IT and business services helps our customers protect and extend the value of those investments by offering them ways to improve and enhance their IT systems and business processes. We assist our customers in implementing software and in fine-tuning their IT infrastructure, including processes, systems and personnel management.
As of March 31, 2008, products and services had been purchased by over 6,000 companies worldwide. For the year ended December 31, 2007, the CDC Software Business Unit generated total revenues of $349.0 million and operating income of $21.5 million. Our Software Group and our Global Services Group accounted for 59% and 28%, respectively, of these 2007 revenues.
Our Software Group provides a diverse portfolio of sophisticated enterprise software applications for mid-sized enterprises and divisions of larger enterprises in our targeted vertical industries. Revenues from our Software Group were $238.3 million in 2007, which constituted 59% of our total revenues during that period.
Our integrated suite of enterprise software applications help our customers improve efficiencies and profitability through company-wide integration of business and technical information across multiple divisions and organizational boundaries, such as finance, general manufacturing, logistics, human resources, marketing, sales and customer service. While most of our products are available as licensed applications installed at our customers facilities, some of our products are available on a subscription basis over the Internet. Over time, we intend to make more of our products available in a SaaS format. We complement our products with a range of business services that promote a lower totals cost of ownership and faster return on investment. The following chart summarizes our current vertically focused products and services:
Our products and services are designed to meet the specific needs of our targeted vertical industries by helping to address the unique challenges facing those industries. Some of our industry-specific solutions may help our customers:
Enterprise Software Applications and Services
Our enterprise software applications and services include the following:
Enterprise Resource Planning (ERP). Our ERP products help provide the control and visibility needed throughout a customers operations to improve profitability and fulfill customer demand. For companies that produce and package products through recipe and formula-based processes, our ERP solutions help process manufacturers manage manufacturing operations with dynamic forecasting and scheduling, formula-based production and yield management, quality control, inventory management, complex product costing, and streamlined regulatory compliance.
Supply Chain Management (SCM). Our SCM products help enable process manufacturers to plan and forecast proactively, optimize production schedules for low-cost and high-quality customer service, minimize inventory investments, and streamline distribution operations. We also offer SCM products for distribution intensive companies that support demand-driven fulfillment in multi-company, multi-site, multi-channel environments, such as for retailers (grocery stores, specialty goods and direct merchant retailers), wholesalers (pharmaceutical and over-the-counter drug distributors) and consumer goods manufacturers, which have high volumes of order transactions and fast-moving products.
Manufacturing Operations. Our manufacturing operations applications help companies optimize the efficiency and effectiveness of their factories. These applications are integrated with and complement our ERP and SCM products, and also fill the manufacturing operations void in ERP, SCM and manufacturing execution systems from our competitors. Our manufacturing operations applications combine finite factory scheduling with real-time performance management and business intelligence to enable continuous improvement, optimization of operational resources and change management for manufacturing operators, engineers, technicians and management personnel.
Customer Relationship Management (CRM). Our CRM products help our customers establish and maintain profitable long-term business relationships with their customers by integrating information from the entire enterprise and increasing efficiencies within the sales, marketing and service functions to create one unified business network connecting employees, partners and customers. Our products are highly configurable, enabling companies to cost-effectively adapt and integrate the application to fit their unique business processes.
Enterprise Feedback Management (EFM). Our EFM applications help organizations capture and process customer complaints and feedback and use this information to help deliver cost reductions, increased efficiencies, improved customer satisfaction and increased profitability. These applications help companies maintain customer satisfaction and advocacy, and drive business improvements and competitive advantage as well as providing the ability to help address regulatory compliance requirements.
Human Resource Payroll (HRP). Our HRP solutions, which are currently only offered in China, focus on automating processes to enable an organization to improve business results and increase workforce performance by leveraging technology and applications to manage and mobilize a unified, global workforce. Our HRP solutions streamline the human resource management process, increase work efficiency, and support strategic decision-making. Our customers are able to automate routine daily tasks such as payroll processing, attendance, and benefits tracking, giving them more time and information to implement strategies that align the workforce with their organizations strategic goals.
Business Analytics (BA). Our BA applications help to empower organizations with convenient access to information, reporting and analysis capabilities, and budget and planning systems. These tools help to convert large volumes of data collected and stored by the business into meaningful and multi-dimensional reports and analyses for use in decision-making. These applications are sold as complementary applications to our ERP, SCM, CRM and manufacturing operations solutions.
The following table sets forth the core components of our various solutions:
Our Software Group offers a variety of professional services to customers that use our enterprise software applications. These services cover the full range of business optimization requirements, including industry advisory services, business process improvement services, traditional implementation services, tuning/optimization services and outsourced hosting/application management services.
The following diagram illustrates the range of professional services we are able to offer to match up with the continuum of customer needs.
The Professional Services Continuum
Generally, these customer services are offered on a time and expense reimbursement basis, although there has been an increasing trend to perform such services for a fixed fee.
Other Customer Services Provided by the Software Group
To enable our customers to get the most out of our enterprise software applications, we also offer client support and education services to our customers.
Customer Support. We seek to ensure that our customers quickly and easily find answers to questions or issues related to their enterprise software applications. We provide customer support through a variety of media, including web-based support, e-mail, telephone support, technical publications and product support guides. These media allow our customers to conveniently and effectively acquire the information they desire. Customer support works closely with our customers internal support teams to assist our customers in their use of our solutions. Generally, our customer support is provided under the maintenance provisions in our license agreements for an annual fee, which is based on a percentage of the software license fees. Customers are typically required to purchase customer support for at least one or two years when they enter into a license agreement. Standard maintenance agreements generally entitle a customer to certain product upgrades and product enhancements, as well as access to our staff. In addition to standard support, we continue to expand our offerings to include remote services and extended technical support.
Education Services. We seek to ensure that our customers effectively adopt and use their enterprise software applications by delivering education and training services that fit each customers business needs. Education services are offered to customers as standard or customized classes at our education facilities or at the customers location.
Global Services Group
Our Global Services Group provides many of the same business optimization services offered by our Software Group to customers that do not use our enterprise software applications. The Global Services Group assists customers to achieve the highest value for their IT expenditures by providing our customers with more value-added services than offered by our Software Group. These services are generally offered on a regional basis in the United States and Australia. In order to provide more cost-effective services while maintaining a high quality of service, our Global Services Group utilizes both locally based professional services staff who can interact with a customers staff on-site, as well as off-shore professional services staff typically located in India or China.
Revenues from our Global Services Group were $110.8 million in 2007. As a percentage of total revenues, revenues from our Global Services Group constituted 28% of our total revenues in 2007.
Our enterprise software customers operate in process-intensive industries, such as the food and beverage, consumer products, pharmaceutical and biotechnology, chemicals, metals and natural products industries, and in other industries that are characterized by complex customer relationships, such as the financial services, homebuilding and real estate, general manufacturing and healthcare industries. We believe customers in these industries benefit from vendor solutions that address their industry and business specific needs, such as the ability to make modular purchase decisions, the availability of risk-mitigating implementation services and strong configuration support. As a result, our products often suit mid-sized enterprises and divisions of larger enterprises in our targeted vertical industries. As of December 31, 2007, over 6,000 customers worldwide had purchased our products.
Within the Global Services Group, we target both mid and large companies doing business in many areas including telecommunications, chemical, oil and gas, pharmaceutical, consumer product, utility, insurance, banking and finance, entertainment and IT sectors. Because many of our target customers for business services are also in our targeted industries for enterprise software, we seek to cross-sell both enterprise software applications and business services between the two customer bases in addition to leveraging our industry expertise and knowledge gained between the two lines of business.
During 2007, our top 10 customers accounted for 11% of our total revenues. No customer accounted for more than 10% of our total revenues in 2006 or 2007.
We sell our products and services through a variety of methods, including our direct sales force, our channel partners and distributors, and, for certain products, through our websites. Our direct sales force is organized by vertical industry and is primarily concentrated in the United States and Western Europe. As of December 31, 2007, we had approximately 260 employees engaged in direct sales.
In addition to our direct sales force, we sell our products through partners and distributors. These partners include value-added resellers, original equipment manufacturers, consulting and professional services companies, progressive product development organizations, and regional consulting and sales agents that meet certain criteria. Our partners and distributors pay us royalties on the sales of products and maintenance services. As of December 31, 2007, we had approximately 44 distributors, principally located outside the United States, that distribute our enterprise software products. In addition, we sell add-on products, solutions and tools for the Microsoft Dynamics CRM platform both directly through an online store and through more than 600 authorized reseller partners worldwide.
China Strategy for Leveraging Development Capabilities
We believe that we maintain a low-overhead research and development infrastructure that delivers high-quality, low-cost software development capabilities through our operations in Shanghai and Nanjing. As of March 31, 2008, we maintained a total of 135 employees in these facilities.
While our product development and design decisions are primarily maintained in the United States, software development and quality assurance testing work has been increasingly moved offshore. We now have a significant amount of our global research and development organization in China, and currently intend to increase that amount over time. We believe that this strategy will help further reduce our overall cost structure, as labor costs for information technology professionals are approximately 18% of the typical costs of those paid in the U.S. and 79% of the typical costs paid in India. Furthermore, in China, turnover rates have been relatively low, and we have experienced only modest salary increases relative to other regions, such as India.
Currently, Shanghai is our key development center in China today; however, we have also established a significant presence in Nanjing. Nanjing offers lower operating cost than Shanghai, which helps us maintain a low average cost structure in China. Total operating costs in Nanjing are approximately 20% lower than those in Shanghai, and salaries in Nanjing are approximately 18% lower.
In addition, we also maintain a relationship with one of Chinas leading universities, the Nanjing University. We believe this relationship helps our recruiting efforts by attracting top talent.
We also believe that one of our competitive advantages is our ability to migrate research and development efforts to our China operations. Since many of the companies we typically acquire have research and development expenditures greater than our corporate average, during our integration process, we typically leverage our offshore capabilities to lower that spend level, or accelerate development schedules.
China Strategy for Increasing Software Sales
We also believe we have a strong sales channel in China that may allow us to benefit from positive economic and technology trends in China.
Our total headcount in sales and marketing in China is currently approximately 110 persons, and our locations include Shanghai, Beijing, Nanjing, Guangzhou, and Hong Kong.
Global concern over Chinas food and product safety is a major catalyst for interest in our products in China as our ERP products provide food and product traceability necessary to support brand protection initiatives. Other industry drivers include the need to support complex regulatory and reporting requirements for human resources and payroll, and the need to ensure that supply chain inefficiencies do not negatively affect the low cost of labor.
Furthermore, one example of an emerging market we are targeting in China is CRM in the Financial Services industry of Institutional Asset Management. Approximately 50% of the top 25 global asset management firms use CDC Softwares CRM packages. We hope to leverage that experience into the Asia/Pacific region, initially targeting Hong Kong and Singapore.
We have developed our HRM solutions to specifically address the unique regulatory and reporting requirements found in China, and our HRM products are already established in the manufacturing, business services and financial services industries in China. We intend to take advantage of this customer base to help cross-sell our other enterprise applications to these customers.
Franchise Partner Program and Other Initiatives
We have established a Franchise Partner Program, or FPP, and have allocated an aggregate of up to $20 million for investment in channel partners to establish strategic relationships that we hope will accelerate mutual business expansion. We select participating partners in high-growth geographies including Eastern Europe, the Middle East, Latin America, India and China. For participation in the FPP,
we seek partners with long-standing, successful track records in ERP, SCM and CRM. Additionally, we consider the more than 600 authorized distribution partners of CRM add-on products, industry-specific CRM solutions and CRM development tools for Microsoft Dynamics CRM. Our investments, made through equity investments, lines of credit or a combination of these, are used to help these partners grow their businesses through expanded marketing and sales programs, accelerated product localization and improved local support and services.
To date, we have entered into agreements under the FPP with Business T&G Group, in Spain, CMT Latin America, in Latin America, Desarrollo de Recursos Estratégicos S.A de C.V, in Mexico, Ross Systems Chile Ltda, in Chile and DC Software do Brasil Sistemas S.A., in Brasil, we have also acquired Brilliant Training and Consulting in Australia, and a majority ownership interest in Integrated Solutions Limited a Hong Kong-based vendor of ERP systems designed for small and medium-sized discrete manufacturers in China.
In December 2007, we announced that we had commenced sales of our Pivotal CRM solutions in India through CDC CRM Solutions Private Ltd., a company in which we have taken a 19% ownership stake and that is intended to exclusively sell Pivotal CRM in India.
In addition, in October 2007, we executed a term sheet to enter into a joint venture with FlexSystem Limited to develop, market and sell basic accounting and payroll SaaS products. We intend that the products to be developed by the joint venture will initially be marketed and sold to customers in the Peoples Republic of China. The term sheet provides that each party shall license certain intellectual property rights to the joint venture for use in product development. The completion of the joint venture with FlexSystem remains subject to standard conditions, including, but not limited to, finalizing definitive transaction agreements, completing due diligence to our satisfaction and obtaining the approval of our board of directors.
In support of our sales force, partners and distributors, we conduct a variety of marketing programs, including telemarketing, direct mailings, online and print advertising, seminars, trade shows, public relations and on-going customer communication. We are engaged in a significant marketing effort using online channels including web-based seminars, online newsletters, and electronic direct mail. Additionally, we participate in industry, customer and analyst events, and hold local events to better meet the needs of prospects, partners, distributors and customers around the world. We also hold an annual global users conference as a forum to bring together users of our products to present upcoming products and releases, share success stories and best practices and obtain feedback from our customer base on the quality of our products and services, as well as ideas for improvements and future upgrades.
We also conduct communications programs to establish and maintain relationships with key trade press and industry analysts. We have customer marketing teams targeted at working directly with our customers to obtain feedback and to track ongoing customer success stories. We also hold joint web events with marketing partners and others, co-author business papers, and create and publish other materials that are of value to our customers and partners in making a decision to purchase one of our products.
To meet the increasingly sophisticated needs of our customers in our targeted vertical industries and address potential new markets, we strive to invest in, and enhance the functionality of, our existing product offerings and related services and develop new product solutions. During 2007, we spent $23.8 million on research and development activities.
Our development process involves a system where we obtain product input from a variety of sources, including product and design forums, specialty industry groups, market trends, changes in industry and regulatory requirements and customer surveys. The input is conveyed through internal product boards, made up of technical, sales and marketing personnel, that provide advice to the product manager who then produces a product plan. Generally, under the product plans, specific major new releases are made every 12 to 18 months, with minor product releases on a six-month basis.
Generally, the expert knowledge of the functionality of our products and the needs of our customers is located in Atlanta, Georgia for our enterprise and departmental solutions for process manufacturers, and in Vancouver, British Columbia, Canada, and Campbell, California for our vertical CRM products. Our software development capabilities, however, are located principally in China and India. In addition to our development centers in Shanghai and Nanjing, we have established a software development center in Bangalore, India to develop our vertical CRM products. Our Shanghai and Bangalore centers have achieved Microsoft Gold Certification. As of December 31, 2007, our software development centers in China and India employed approximately 135 and 167 development personnel and 0 and 19 consultant personnel, respectively. This shift has enabled us to expand the breadth of product development and accelerate delivery schedules while reducing overall development costs. By managing our own internal development centers, rather than outsourcing to third parties (as is frequently practiced in the software industry) we believe we have maintained better control over product quality and development schedules.
Development activity during 2006, 2007 and the first quarter of 2008 covered a range of evolving functionality enhancements to present releases of our products, including the following:
OnePlan v5.8, the finite scheduling application within CDC Factory was released. This release includes the introduction of Factory Demand which accepts high level and detailed forecasts and sales history, and allows for adjustment and disaggregation of demand into specific products, demand dates, and quantities, for more focused finite production scheduling. This release is based on B2MML integration standards, for improved import and export of information with external applications.
During the quarter, the CDC Factory product line was launched in Spain, including a first release of CDC Factory translation in Spanish, with related sales information and a Spanish web site also now available.
Pivotal CRM for Financial Services 5.9 French was released to address the French-speaking markets.
The first version of the CDC MarketFirst Deliverability Email Server was release. This addition to CDC MarketFirst resolves e-marketing deliverability issues by adding a high-performance email application server that increases message reception, revenue and campaign ROI.
C360 added four new products and enhanced most of the existing products in its Core Productivity Pack. c360s Core Productivity Pack was released in conjunction with Microsoft CRM version 4.0. The new products were designed using customer and partner feedback with a focus on increasing CRM usability, user productivity, and user adoption.
The first managed software as a service (SaaS) enterprise solution for the Life Sciences (Pharmaceuticals and Biotechnology) vertical industries was launched. This comprehensive, industry-specific solution for life sciences companies may be deployed in a matter of days with, in most instances, no customizations required. This unique combination of industry fit and rapid deployment makes this solution suited to a broad array of emerging and mid-sized pharma and biopharma companies supporting GMP manufacturing, clinical supply operations, chargebacks for wholesaler distribution, and project / service-based organizations (CMO/CRO). These life sciences enterprises can choose an off-site hosted or an on-site managed deployment and they also have the option to choose a monthly subscription fee or traditional software license fee.
Pivotal 5.9 Platform upgrade was released providing compatibility support for key customer environment applications, including Windows Vista, Microsoft Internet Explorer 7, Microsoft Exchange 2007, Microsoft Office 2007 and Crystal Reports XI. Pivotal CRM for Homebuilding version 5.9 was released providing integration to the industry-standard home options system from Envision.
CDC MarketFirst 5.10 French was released to address the French-speaking markets.
CDC Respond was enhanced with the launch of Respond Runner, a new application in the latest release of its CDC Respond 3 XA suite of enterprise applications for customer complaint and feedback management. Respond Runner offers powerful new automation and scheduling features that streamline processing and analysis of business data that also help improve an organizations overall operational efficiency.
Ross EPM v 6.2.101, is an upgrade that provides the addition of pricing and promotional analytics. With this upgrade, Ross EPM customers can now analyze gift promotions, book-only promotions, substitution discounts and multi-level sales order discount calculations, in order to help improve their level of customer service. As part of providing expanded negotiated pricing and discounting terms and conditions of sales, Ross EPM Sales enhancements now provide new dashboards, metrics, and KPIs, based on added analysis dimensions, as part of offering added insight into the impact of promotional costs on Sales and Profit Margin over time.
Ross Supply Chain Planning v6.3 was released, formerly known as the Supply Chain Management suite, and provides significant usability and performance enhancements to Demand Planning (DP), Inventory/Replenishment Planning & VMI, and the Advanced Planning & Scheduling (APS) modules, as well as added interoperability with Ross ERP SCP Integration. Major improvements include APS Labor Planning incorporating graphic displays and dynamic alerts, what-if scenarios and 15 new KPIs in APS Performance Management and a new DP Performance Management that now provides improved Forecast Exception and new Forecast Error measurement tools.
CDC Factory Scheduling upgradeThis release provides significant new scheduling features, usability and performance enhancements to help improve production scheduling and real-time integration between shop floor execution and production schedules. The Enhanced Labor Scheduling feature now offers the ability to define, model and assign labor types to specific production tasks, to further enable the optimization of human capital within the factory.
Pivotal Capital IQ Adapter was released, which delivers a packaged solution that allows financial services institutions to leverage Standard & Poors Capital IQ data within the Pivotal System.
We released an ASR Conversion Tool to assist customers and partners in migrating their existing software to our new Pivotal 6.0 platform.
We released the French version of Pivotal CRM for financial services 5.9 which delivers several key customization, administration and end user enhancements to expand our offerings in the financial services industry.
The enterprise software industry is very competitive and subject to rapid technological change. A number of companies offer products that are similar to our products and target the same vertical industries as us. In addition to competing with the internal IT departments of our customers, our major competitors in each of our targeted vertical industries include:
Global Services Group
The IT services industry is highly competitive and rapidly changing as customers needs are constantly evolving. We compete with firms that range from large global IT consulting firms such as Cambridge Technology Partners, Infosys, Syntel and Wipro, to IT services divisions of large diversified technology companies such as IBM Global Services. In addition, we also compete with the internal IT departments of our customers, as well as several niche services providers that specialize in a geographic market or vertical segments.
CDC Softwares Competitive Strengths
We believe our principal competitive strengths include the following:
We have developed sophisticated products for our targeted vertical industries. We believe that sophisticated buyers seek solutions that are closely tailored to their industry-specific requirements. We believe this demand creates significant advantages for us relative to our competitors that offer generalized enterprise software applications that require significant customization. Our enterprise software applications are industry-specific and allow businesses to immediately benefit because our solutions do not require extensive, costly customizations in order to meet an individual customers industry-specific business needs.
Our products can be implemented rapidly, configured and upgraded easily, and are intuitive to use, which helps lower our customers total cost of ownership and increase their return on investment. Because
our enterprise software applications incorporate the unique functionality required by customers in our targeted vertical industries, they can be implemented without the significant customization that is typically required for conventional enterprise software applications. Our applications often require limited configuration, resulting in significant time and cost savings, particularly for mid-sized companies that do not have large IT staffs or budgets for software customization. Beyond initial implementation, our products provide benefits over the lifespan of our customers IT systems. An enterprise software application typically undergoes four to five major release upgrades during its eight to ten year lifecycle. Conventional enterprise software applications that have been highly customized typically require rebuilding and retesting with each upgrade. The effort and cost of these upgrades for the customer may rival those of the initial implementation. Because our enterprise software applications require less customization during initial implementation, the complexity of subsequent upgrades is greatly reduced, saving time and money for customers and enabling them to take advantage of software updates. Furthermore, because our applications are designed to meet industry-specific requirements, end-user training requires fewer staff and is less expensive and time-consuming. We believe our products are also more intuitive to use than conventional enterprise software applications, which helps to lower start-up training and deployment costs.
Our products are scalable to meet the needs of growing businesses. Many of our customers require products that support growing numbers of employees, customers and partners. Our enterprise software applications are designed to enable our customers to expand their use of our products as their businesses grow by adding servers without having to re-implement software or retrain personnel. This improves product performance, enables our products to support larger numbers of concurrent users at lower cost, thereby protecting our customers original investment in our products, and provides us with ongoing revenue streams as our customers grow.
Our sales and marketing personnel have significant industry expertise in our targeted vertical industries. In the current market environment, we believe buyers are not only seeking tailored solutions, but also long-term business partners who understand and are familiar with the unique and evolving challenges of their industries. In order to address this need and to more effectively develop, enhance and sell our industry-specific solutions, we have sought to attract and retain personnel with substantial experience in the industries we target. Our industry experts understand our customers specific business concerns, resulting in a more effective sales force than those of our competitors who sell their products through a generalist sales force. Additionally, due to our focus on offering industry-specific solutions, we believe that our marketing programs are significantly more cost-effective than those of our generalist competitors.
We have a global, diverse and growing base of highly satisfied customers. Our enterprise software applications have been purchased by over 6,000 companies worldwide as of December 31, 2007, and our customer base is growing. During 2007, approximately 51.0% of our total revenues were generated in North America, approximately 24.9% in Europe, the Middle East and Africa, and approximately 24.1% in the Asia Pacific region, whereas during 2006, approximately 56.4% of CDC Software total revenues were generated in North America, approximately 27.4% in Europe, the Middle East and Africa and approximately 16.2% in the Asia/Pacific region. Our global and diverse customer base helps ensure that we are not dependent on any single customer, industry or geographic region. We expect to continue leveraging our existing customer relationships to support our marketing and sales programs through customer case studies, media interviews, speaking engagements and sales references to generate additional leads and sales.
Our business services address a wide spectrum of IT and business needs, create additional cross-selling opportunities and enable us to become a strategic consultant to our software customers and other companies, which helps to build lasting relationships. Our business services offerings extend beyond software implementation, support and maintenance services typically offered by software companies. In addition to these basic services, we also offer industry advisory services, business process improvement services and outsourcing services, such as help desk support, desktop management, enterprise software application management, asset management and custom software development. We also proactively sell additional IT and business consulting services to them. Through these services, we develop advisory
relationships with our customers, increasing the value we provide and strengthening our competitive position with each account. We also gain early insight into additional software requirements of our customers and create opportunities to cross-sell additional enterprise software applications.
Our Growth Strategy
Our goal is to be an integrated global enterprise solutions company offering a complete range of software products to meet the needs of large and mid-sized enterprises in our targeted vertical industries. We also seek to provide high quality, affordable, value-added services that complement our product offerings and enable our customers to enhance their IT use. The key elements of our growth strategy are to grow our business organically and through selective acquisitions. Specifically, we intend to:
Continue to expand and enhance our industry-specific products and expertise to strengthen our competitive advantages. We intend to continue to focus on offering high-quality solutions to our new and existing customers to address their specialized business, industry and regulatory requirements at an affordable cost. To accomplish this, we intend to:
Capitalize on cross-selling opportunities into CDC Softwares installed customer base. As of December 31, 2007, CDC Softwares enterprise software applications and services had been purchased by over 6,000 companies worldwide. However, because the licensing and implementation of software solutions involves a significant capital investment, many customers may not purchase all of the modules or applications we offer to optimize their business at one time. Therefore, CDC Softwares large, global customer base provides us with a significant opportunity to sell our new software products, upgrades for existing applications and complementary business services. CDC Softwares sales force has specific sales and marketing personnel dedicated to penetrating our installed customer base. In addition, our business services customers include many companies that are not currently customers of our enterprise software applications, which presents opportunities to sell our enterprise software applications to business services customers in our targeted vertical industries. During 2007 and the first quarter of 2008, software sales to our growing base of customers increased as a percentage of our overall software license sales.
Enhance our customer relationships. With the broad range of services offered by our Global Services Group, we seek to enhance our customer relationships. We offer capabilities to address the broader strategic issues our customers face as their industries evolve, such as identifying leading industry practices and designing such processes into their systems. We also offer additional technical capabilities to enhance our customers existing systems or even operate their IT systems on an outsourced basis. We believe this expanded relationship with customers across the spectrum of their IT needs will increasingly become the trend and expectation of purchasers of strategic IT systems.
Selectively pursue acquisitions. We may continue to selectively pursue acquisitions to expand our product and service offerings, extend our geographic reach and grow our customer base. Since 2003, we have consummated over 20 acquisitions many of which have provided additional vertical expertise and solutions in our vertical industry portfolio. For example, in February 2007 we acquired Respond Group Limited, which added complaint and feedback management capabilities to our vertical CRM applications, and in October 2006 we acquired MVI Holdings Limited, which added real-time performance management capabilities to our portfolio of solutions for process manufacturing.
Target emerging markets for enterprise software applications. We believe that lower cost geographies, such as China and India, represent strong growth markets for enterprise software applications as many companies continue to relocate their operations to those regions due to lower overhead and labor costs. We intend to target opportunities in these emerging markets, as well as opportunities in Latin America and Eastern Europe. In particular, we believe we are well positioned to take advantage of the experience and infrastructure of CDC Corporations family of companies in China. We believe our enterprise software applications will have competitive advantages in our targeted vertical industries in these emerging markets.
Expand our in-house software development, services and support centers located in China and India. We perform increasing amounts of our software development, services, and support functions at our in-house development centers located in China and India. While our product development and design decisions are made locally, the actual development work has been increasingly moved offshore. In addition to our development centers in Shanghai and Nanjing, China, we have established a software development center in Bangalore, India to develop our vertical CRM products. Our Shanghai and Bangalore centers have achieved Microsoft Gold Certification. This shift has enabled us to expand the breadth of product development and accelerate delivery schedules while reducing overall development costs. By establishing our own offshore development centers, we believe that we maintain better control over product quality and development schedules than our competitors that have outsourced their development work to third parties. Additionally, locating some of our service and support activities offshore allows us to provide those functions more cost effectively while maintaining quality levels.
Expand into new vertical industries. We have been successful by focusing on our targeted vertical industries, and we intend to expand into new vertical industries where we believe we can establish a competitive advantage. We may pursue such expansion either through strategic acquisitions or through internal product development. We expect to target new vertical industries that have characteristics similar to our existing vertical industries, such as those characterized by complex customer and partner relationships, intricate regulatory requirements and/or sophisticated processes and procedures.
CDC Games Business Unit
Our CDC Games business unit pioneered the free-to-play, pay for virtual merchandise business model for online games in China, and is a leading operator of online games in China. CDC Games online game, Yulgang, which was launched in July 2004, was the first free-to-play, pay for virtual merchandise online role playing game in China.
CDC Games has experienced significant revenue and earnings growth since it was formed in the third quarter of 2006. Online game revenues were $33.6 million for the year ended December 31, 2007, compared to $26.8 million for the year ended December 31, 2006, and operating loss from our online games segment was $14.6 million for the year ended December 31, 2007, compared to operating income of $9.5 million for the year ended December 31, 2006. During 2007, and prior to such time, 100% of our games revenues were derived from China.
As a percentage of total revenues, revenues from our online games segment constituted 8.3% of total revenues in 2007.
CDC Games Products
CDC Games offers massive multiplayer online role playing games, or MMORPGs and massive multiplayer online games, or MMOGs, which are online games that allow thousands of users to interact with one another in a virtual world by assuming ongoing roles, or avatars, with different features. In addition to traditional MMORPGs, we also offer more casual games that appeal to a wider audience and enable us to introduce our products to non-gamers through our integrated operating platform. The interactive and group-oriented nature of these games along with the size of our user base helps us retain our current users and attract new users.
Our MMORPGs and MMOGs are action-adventure based, and draw upon fantasy, martial arts and combat themes. Typical features of our games include the following:
Yulgang is a fantasy martial arts based MMORPG based upon a popular comic book series in Korea. The game creates a precise, rich and colorful cartoon-like virtual gaming world for online users using 2.5D graphics. In the game, players become martial artists and journey through a mythical realm learning martial arts, completing tasks and mastering skills. As they progress, players may choose factions to join and participate in massive battles for the honor of their factions. Players select a character class to play among bladesman, swordsman, archer, healer and spearman, and accumulate abilities and skills which can be carried over to the successively higher game levels. The game was awarded the Top 10 Most Popular Games award at the China Game Industry Annual Conference in both 2005 and 2006.
Yulgang can be accessed from any location with an Internet connection. Substantially all of the players in China access the game servers either from PCs at home or Internet cafe outlets equipped with multiple personal computers that have Internet access. Currently, a significant portion of CDC Games users access the game through Internet cafes throughout China.
In April 2008, we announced that we had commercially launched Yulgang 2.0, a significant content update for that game.
Special Force, which was developed by, and which we have licensed from, Dragonfly GF Co., Ltd., is a first person shooter online game that originated in Korea. The game allows players to create their own elite military units with customized weapons and equipment selected from those used by special forces from around the world. Special Force has advanced 3D graphics and advanced special effects, and allows users nationwide to play against each other in teams and compete in competitions.
Shaiya is a fantasy-themed free-to-play, pay-for-merchandise MMORPG developed by and licensed from the Korean entertainment company, SONOKONG. In addition to its advanced graphics, Shaiya also contains music and sound effects produced by a large orchestra and choir. Players can choose to join either the Union of Fury or the Alliance of Light to take part in an epic feud where they can battle monsters or other players, and join with other players to battle for control of the continent.
Other Current Active Games
In addition to Yulgang, Special Force and Shaiya, we currently offer the following games in the following territories:
In addition to our current active games, we license several additional games, which we may launch in the future, including, but not limited to:
We have also entered into license agreements for several games that we have subsequently deemed unlikely to succeed, and, therefore we may never launch. These games include Master of Fantasy, Chaosgem, Xeros Online, Dance Fever and Darkness and Light.
In December 2003, we entered into our original game license agreement with Mgame Corporation for Yulgang. This agreement was subsequently supplemented in June 2004 to extend the term of our license for Yulgang to December 2007 and provide a 21% royalty on our revenue derived from Yulgang to Mgame. Furthermore, in March 2007, we entered into an additional supplementary agreement with Mgame pursuant to which we extended our exclusive license to Yulgang in China (excluding Hong Kong) through 2010.
On October 17, 2007, Mgame unilaterally announced that they terminated their agreements with CDC Games, alleging breach of contract for non-payment. In October 2007, we filed two lawsuits against Mgame. The first lawsuit alleged breach of contract and that Mgame was not providing adequate technical support for Yulgang, and that Mgame was not supporting CDC Games in its efforts to combat pirate servers. We subsequently filed a second lawsuit alleging that Mgame breached contractual obligations owed to us by failing to provide certain financial and operating data and other information which Mgame is required to provide to us as a shareholder of Mgame.
Following the announcement of our disputes with Mgame in October 2007 and until such time as we resolved these disputes in March 2008, revenues generated by Yulgang declined significantly.
In March 2008, we settled our disputes with Mgame by entering into an Amended and Restated Exclusive Game License Agreement and Settlement Agreement. Under these settlement agreements, CDC Games received exclusive distribution rights to Yulgang in China until March 2010 with an option to extend for an additional year. CDC Games also agreed to work together with Mgame to launch a Version 2.0 upgrade to Yulgang as soon as possible following the settlement. In addition, the settlement agreements provided that our license fee payable to Mgame would be increased to $4.5 million of which $4.0 million of would be paid by us in the form of shares of Mgame held by us. Additionally, we agreed to pay royalty payments equal to 25% of revenues in months where revenues are less than $2.0 million and 28% in months where revenues are greater than $2.0 million, and agreed to terminate the game license agreement with Mgame pursuant to which we received the exclusive right to distribute Wind Forest Fire Mountain, or WFFM, a combat MMORPG developed by Mgame.
In April 2008, we announced that we commercially launched Yulgang 2.0, a significant content update for that game. Revenues from Yulgang have continued to recover since the settlement of our disputes with Mgame, but have not reached the levels we experienced before our dispute arose.
Other Licensors and Developers
In addition to our license agreement with Mgame for Yulgang, to date, we have obtained our content through licensing arrangements with developers and other third parties. We have entered into license agreements with each of Dragonfly GF Co., Ltd. and SONOKONG for Special Force and Shaiya, respectively.
We also monitor the markets to identify and source new online games, particularly the markets in South Korea, Japan and the United States. The cost of licensing games from developers generally consists of an upfront licensing fee, which we generally pay in installments, and ongoing licensing fees, which are equal to a percentage of our revenues from the relevant licensed game. The ongoing royalties for games which have been licensed range from 17% to 29% of total sales before distributor discount. Each of these licenses provides us with the exclusive right to operate the game in Mainland China, and in some instances, certain other territories, including India. Generally, the MMORPG developers agree to timely provide, without any additional charge, with updates, enhancements and improvements developed for the games licensed to us. The majority of our game licenses require the licensors to provide technical support.
While we do not currently have an in-house game development capacity, we are considering either internally developing or acquiring a research and development program.
Game Developer Program and CDC Games Studio. In August 2006 we introduced a Game Developer Program which included an aggregate of US$20.0 million allocated for investment in selected strategic online game developer partners globally. Under the program we sought and intend to seek to make investments in developers through direct cash investments, equity investments, lines of credit or a combination of these. The investments are intended to be used to help these partners build China culturally aware titles, and may be complemented by market research and game research from us. In March 2007, we expanded our online games developer program by forming CDC Games Studio. CDC Games Studio seeks to attract talented games development companies around the world that may already have operations in China or are seeking to relocate or expand into China to take advantage of the market demand for new games, talent in China available for games development and tax incentives available to companies developing games for domestic distribution as well as for export. CDC Games Studio looks to fund the creation of new online games, as well as acquire rights to develop game titles in China, with the goal of publishing and distributing them on a global scale. As of March 31, 2008, CDC Games has entered into definitive agreements for three investments under this program:
To date, we have adopted a free-to-play and pay for virtual merchandise business model for most of our currently-offered online games (with the exception of EVE Online) and anticipate that many of the games in our pipeline will operate on a similar business model. Under this model, game players are not charged for time spent in the virtual game world, but rather for purchasing value-added virtual merchandise and services through the online game shop, such as weapons, armor, uniforms and magical power. While such a business model has been previously utilized in Korea, Yulgang represents the first instance of such a business model being adopted for a large scale MMORPG in China.
Setting prices for virtual items is generally formulated as part of the underlying economic model for the game during its development. However, we have the ability to adjust prices for virtual items as part of tuning the game, although care must be taken that we will not upset the underlying economic model. We generally look at pricing curves to set and adjust prices for virtual merchandise offered. Pricing curves are developed primarily based on internal game factors such as the popularity of an item and the nature of the enhancing characteristics the item provides, as well as external game factors such as game cost, user game playing and the pricing of competing games in the market. We attempt to adjust prices of virtual merchandise based on the feedback of users and offer various discounts on merchandise from time to time; however, once pricing of virtual merchandise is set, it can be difficult to make significant adjustments to the prices during the games commercial lifecycle. We have generally maintained stable pricing curves for our games.
While most of our games are free to play, in order to purchase virtual merchandise for the game, users must purchase pre-paid points which are sold in both physical card form or can be purchased electronically online and through mobile sales partners. Each pre-paid card, purchased in physical form or electronically, contains a unique access code and password that enables users to add value to their account for our online games. As users purchase virtual merchandise in the gaming world, charges are deducted against the value in their account.
We distribute pre-paid cards through an offline distribution system of physical pre-paid cards. We generally sell pre-paid cards to a group of regional distributors from whom we generally collect payment on a prepaid basis. These distributors resell the cards to sub-distributors that, in turn, distribute the cards directly to Internet cafes and other retail points of sale, such as software stores and newspaper booths. Our sales policies and distributor incentive systems generally discourage our regional distributors from distributing pre-paid cards of other online game operators. In 2007, we offered sales discounts that averaged between approximately 13% and 15% to our distributors. The sales discount represents the difference between the price at which we sell game cards to distributors and the face value of the game cards. For our physical cards, we estimate that our network reaches over 200,000 retail points of sale throughout China, over 75% of which are Internet cafes, which are one of the primary venues for users to play online games in China.
We have both online and mobile sales partners to distribute points for our games. Our mobile sales partners include China Mobile, China Unicom and China Netcom. Points may also be purchased online through several popular Chinese websites, such as www.cupoo.cn, www.cncard.com and www.996.com.
Since our inception, we have focused on providing excellent customer service in order to retain our existing customers, as well as attract new customers.
Game Masters. We have in-game game masters to constantly monitor our games to maintain an effective and fair gaming environment. Our game masters are responsible for organizing in-game events, troubleshooting and actively and continuously monitoring the online game environment. Game masters are always available to respond to players inquiries, initiate the bug reporting and removal process, as well as identify, record and deal with players inappropriate behavior such as cheating and fighting. We believe that utilizing game masters to monitor the gaming environment is an important element in maintaining customer loyalty and efficiently addressing technical problems as they arise.
Customer Service Center. Our centralized customer service center is located in Beijing, China, and is operated 24 hours a day, seven days a week. Customers may call or e-mail our customer service center any time and receive timely responses. As of December 31, 2007, we employed approximately 229 full time personnel in our call center as customer service specialists. In general, our customer service representatives are able to immediately handle approximately 65% of the inquiries from our customers, and provide solutions within 24 to 48 hours with respect to requests that cannot be resolved at the time of the initial customer call. All of our customer service representatives have participated in a formal training program before commencing work. We have implemented detailed performance measures to monitor our calls to ensure that our customers will receive quality service. We periodically review staffing needs and train our representatives to provide excellent customer service.
We also maintain reception areas in our offices in Beijing and Shanghai that are open to the public for customer service purposes.
Our overall marketing strategy is to rapidly attract new customers and increase revenues from recurring customers.
We employ a variety of traditional and online marketing programs and promotional activities to build our brand and attract new customers, including advertising in many game magazines and online game sites that are updated regularly. In addition, we engage in on-site promotions, such as distributing free game related posters at selected Internet cafes, and in-game marketing from time to time, including player competitions in Internet cafes across the country and online adventures for prizes. We also conduct communications programs to establish and maintain relationships with key trade press and industry analysts.
We aim to build a reliable and secure technology infrastructure to fully support our operations. Our current technology infrastructure consists of the following:
We have direct access to the Internet backbone. CDC Games also has contracts with reputable vendors such as Hewlett-Packard Company and Dell Inc. for warranty services for our hardware platform. As of December 2007 we employed 60 technical support staff to maintain our current technology infrastructure and develop new software features to further enhance the functionality of our membership management and payment system.
CDC Games has a network operation team responsible for stability and security of our network. The team follows the workflow for problem detecting, recording, analyzing and solving. The primary responsibilities of the team members consist of monitoring system performance, troubleshooting, detecting system error, random sample testing on servers, maintaining equipment, and testing, evaluating and installing hardware and software. In addition, we frequently upgrade our game server software to ensure the stability of our operation and reduce hacking risks.
The online game market in China is increasingly competitive. A significant number of competitors have entered the online game business in China and we expect more companies to do the same in the future. Additionally, we expect a wider range of online games to be introduced to the China market. Competition from other online game operators, both based in China as well as overseas, is likely to increase in the future. As the online game industry in China is relatively new and constantly evolving, our current or future competitors may compete more successfully as the industry matures. In particular, any of these competitors may offer products and services that provide significant performance, price, creativity or other advantages over those offered by us. Some of our existing and potential competitors have significantly greater financial and marketing resources than we do.
With respect to our online games business, we compete principally with the following three groups of companies in China:
In addition, we compete for users against various offline games, such as console games, arcade games and handheld games, as well as various other forms of traditional or other online entertainment.
CDC Games Competitive Strengths
We believe CDC Games principal competitive strengths include the following:
Ability to localize games from leading and emerging international developer partners. We have partnered with leading global online game developers and successfully localized their products for the Chinese market. Through our network of relationships we have entered into licensing agreements to distribute, market and operate proven, high-quality titles at low cost, leveraging the significant investments our partners have made in game development. We believe that our localization capabilities, significant distribution network, established user base, and knowledge of the Chinese market make us well-positioned to obtain future licenses for leading online games in China and other rapidly growing Asian markets.
Substantial product pipeline and portfolio across game genres. We have secured a substantial product pipeline across online gaming genres which we believe will offer our community of users one of the most diverse game portfolios of online game operators in China. We believe that a diversified approach allows us to reduce the effect of hit or miss games, particularly as many of our titles have been tested and widely played in other countries. We believe that our diversification of leading titles positions us well to attract users in different genres, which we believe is important to address emerging consumer tastes and evolving PRC regulations.
Pioneer and leader in the Free-to-Play business model in China. As there is no charge to play games in our Free-to-Play business model, we believe that more prospective players are attracted to try our games. When combined with the high quality of the games we offer, we believe that players are often drawn to continue playing the game and to enhance their skill level and maximize their gaming experience by purchasing virtual items. As the pioneer of the free-to-play, pay-for-virtual-merchandise business model, we believe we have developed expertise not easily replicable by understanding both the art and science of the in-game item sales model, which includes understanding what items to sell, when to sell and who to sell to. In addition, through our leadership position in free-to-play games, intend to continue to attract game developers to license high-quality games to us for distribution and operation in China.
Extensive nationwide sales and marketing network. In order to play our online games, users must purchase prepaid points which are sold in physical form or can be purchased electronically online and through mobile sales partners. We have built a nationwide network in China to distribute our prepaid points and market our games through local media and Internet cafés. For our physical prepaid cards, we estimate that our network reaches over 200,000 retail points of sale throughout China, over 75% of which are Internet cafés, which are a key venue for online gamers in China. In addition, we have formed partnerships with China Mobile, China Unicom and China Netcom for mobile points card sales, and numerous Chinese websites, such as 1717gm.com, 51gw.com and 15173.com for online points card sales.
Advanced technology platform. We maintain an extensive national server network to host our online games. Due to the real-time interaction among thousands of users, the stable operation of an online game requires advanced data centers with numerous interconnected servers and continuous connectivity, representing significant capital investment and resources to grow and maintain. As of December 31, 2007, our nationwide server network in China consists of approximately 138 server groups with the capacity to accommodate approximately 800,000 concurrent online users. Due to Chinas large geographical area and technological limitations, we have located servers for our online games in a number of regions throughout China. As a result, we believe that our users can play our games using servers located in their region and without exchanging data across the national network, thereby increasing the speed at which our games operate and enhancing the user experience. Additionally, we have developed and maintained proprietary security software which helps us combat unauthorized access to or use of our games by local hackers.
Scalable, high-margin business model. Our online games business is highly scalable with relatively low incremental operating costs. After incurring initial licensing and localization costs for our online games, we can deliver such products and services to a large online games audience quickly and at a low cost. Additional users can be accommodated and revenues generated without incurring significant costs other than those associated with implementing additional servers.
CDC Games Goals and Strategies
Our goal is to become one of the worlds leading providers of online games. Our strategies for achieving this objective include the following:
Utilizing our strategic investment program to strengthen ties to emerging and leading online game developers which we believe will enhance our game pipeline. We have introduced CDC Games Studio, through which we intend to make investments in selected strategic online game developer partners. We plan to partner with developers that have successful track records in the development of top quality and commercially successful online games. Under the program we seek to make strategic investments in these developers through direct cash investments, equity investments, lines of credit or a combination of these methods. We intend that these investments will be used to help these partners develop titles localized for the Chinese consumer and other markets we plan to target, and will be complemented by market and game research we will provide.
Continue to significantly expand and diversify our user and revenue base by continually adding new content and features to our existing portfolio of games while also introducing different genres of online games. We believe that one of our greatest assets is the large number of registered users we have been able to attract to our games. By releasing new versions of our existing games, updating items available for sale and adding new chapters, we believe that we can keep existing users interested in playing our games and can further expand our user base, thereby improving revenues per user and consequently overall game revenues. For example, in April 2008, we launched the Yulgang version 2.0, which provided gamers with enhanced abilities and content. In addition to the diversification of offerings within our current games, we intend to introduce different genres of online games into the market such as casual as well as different types of MMOGs outside of the traditional fantasy-based role-playing genre in order to reach the broadest audience possible.
Pursue cross-selling opportunities and diversify our sources of revenue. We intend to pursue cross-selling opportunities to expand and diversify our sources of revenues, such as seeking to generate advertising revenue from our online games. We believe the combination of our online games platform, our large registered user base and the large number of concurrent users playing our games will provide an established marketing platform for advertisers. Advertising opportunities include sponsorships, banner advertising, sponsored community events, contests and other activities. While we have not sought to grow our advertising revenues to date, we believe that such diversified sources of revenues represent a significant opportunity for us in the future.
Continue to expand our distribution, sales and marketing capabilities to further support our game offerings. We intend to continue to build our sales, marketing and distribution network in China and other targeted high-growth markets to reach the broadest audience possible. We plan to expand our partnerships with physical-point card distributors providing access to distribution points at software stores, Internet cafés, newspaper booths and other local media outlets while also increasing our partnerships with online and mobile distribution providers to ensure as many users across as many distribution channels as possible have knowledge of and access to our games. We plan to use our own CDC Games local ground marketing teams to complement our distribution partnerships by coordinating on-site promotional activities with administrators of Internet cafés and other locations where gamers spend a significant amount of time and initiate marketing campaigns with local media outlets to introduce our products to potential users. We also intend to develop innovative new marketing campaigns across other forms of media such as television to further promote our online game offerings and attract new users to try our games.
Continue to expand through acquisitions of online game companies in China and overseas markets as such opportunities arise. We intend to pursue this strategy by making a combination of minority-stake investments, joint ventures, acquisitions and organic development. We intend to complement our current content acquisition strategy by evaluating potential strategic acquisitions that we believe will further diversify our product portfolio, secure in-house development expertise and/or accelerate our expansion into foreign markets. We evaluate our product portfolio on a regular basis and will look for opportunities to acquire companies with a portfolio of titles that will broaden our community of users and provide differentiated product offerings for our current user base. For example, we believe casual games such as card games, board games and tile games, have a lower level of complexity and require less time to play, providing less experienced online game players with a means to become familiar with both game playing and the online game culture without making substantial commitments of time and resources. In addition to
genre expertise, we actively research strategic opportunities that will accelerate our international expansion efforts either through the acquisition of a localized product portfolio or an operating platform that will allow for the delivery and management of games in high-growth foreign markets.
Seek to expand our online game offerings into other international markets. In December 2007 we launched Minna de Battle, our first online game to be offered in Japan, and in February 2008, we launched Lunia, our first MMORPG commercially available in North America. We intend to continue our expansion in Japan and North America and expand into other online gaming markets exhibiting similar growth and user base characteristics to China. We hope to accomplish this through leveraging the current portfolio of titles and developer partnerships we have generated and by establishing operations in other territories by sub-licensing titles to proven online game operators in the key markets we have identified as expansion opportunities. We also intend to opportunistically partner with or acquire key developers and/or operators that provide a strong entrée into these targeted online games markets.
China.com Business Unit
During 2007, our China.com business unit was engaged in providing mobile services and applications and internet and medial products and services and was comprised of two segments, Mobile Services and Applications and China.com. In February 2008 we announced that, due to negative effects caused by the regulatory environment surrounding the MVAS industry in China, we decided to discontinue the operations of our Mobile Services and Applications business and currently, our China.com business unit is comprised of a single segment, China.com.
Total revenues for the China.com segment were $11.4 million for the year ended December 31, 2007, compared to $10.0 million for the year ended December 31, 2006. As a percentage of total revenues, revenues from our China.com segment constituted 2.8% of total revenues in 2007 and 3.3% of total revenues in 2006.
Products and Services
Mobile Services and Applications segment. During 2007, and in earlier periods, we offered a suite of mobile data applications, including dating, chatting, entertainment, information-related content and community services to mobile subscribers in China utilizing SMS, MMS, WAP and IVR services.
In June 2006 we were alerted to policy changes for all subscription services on China Mobiles, or CMCCs, Monternet platform, which affected the Companys MVAS subscription services. These changes, which were implemented under the policy directives of Chinas Ministry of Information Industry, aimed to address industry-wide objectives, including reducing customer complaints, increasing customer satisfaction and promoting the healthy development of the MVAS industry and CMCCs Monternet.
As a result of these significant industry-wide directives, for the year ended December 31, 2007, our total mobile services and application revenue for the year ended December 31, 2007 was $8.3 million, compared to $31.9 million for the year ended December 2006, representing a decrease of approximately 73.8%. During 2007, SMS and MMS continued to be our primary revenue generating businesses at China.com, representing approximately 52.1% and 23.6% respectively, of the total mobile services and applications revenue. The remaining revenues were mainly comprised of our WAP and IVR services.
As the regulatory environment for the MVAS industry continued to be difficult we determined that there was no reasonable instance where our MVAS business would be profitable in the foreseeable future. As a result, in February 2008, we announced that we were discontinuing our MVAS business and we have since discontinued these operations.
China.com segment. Our China.com business is focused on online entertainment and Internet products and services that target users in China and Chinese communities worldwide via our portal network ( and ). This segment also includes our Singapore-based travel trade publisher and organizer serving the travel and tourism industry in the Asia Pacific region. The China.com business offers the following products and services:
Portal. The services and products of our portal include online advertisement, search, enterprise service and mail services.
Travel and Trade Services. TTG publishes literature for the travel industry and organizes industry events. It is one of Southeast Asias most established information and access providers to the travel and tourism industry. TTG offers a wide range of travel and tourism media products, including publications, exhibitions, database management and Internet products. TTG also offers integrated marketing solutions and a platform for customers to showcase their products and services in the travel and tourism industry. TTG sells its products and provides services directly to its customers, such as travel associations and government agencies.
Internet Video. In November 2006, we announced that China.com launched a new service, v.china.com, which allows people to watch video clips from that site. We believe the v.china.com site is different from many other video sharing websites because its content comes from self-developed or co-developed video films or authorized pieces provided by contracted partners. We believe this approach helps address certain copyright issues which have long plagued the video sharing industry.
Furthermore, in August 2007, China.com signed a content agreement with Forbes. Under the agreement, Forbes.com will provide the China.com portal with a variety of content in English and in Chinese. In addition, during the third quarter of 2007, the China.com portal established a strategic partnership with www.globalsources.com (NASDAQ: GSOL), a leading business-to-business (B2B) media company and a primary facilitator of two-way trade with Greater China.
Recognizing the growth and potential of the online games sector in China, China.com also intends to expand its current games channel into an informational and interactive games platform and intends to forge strategic partnerships with leading domestic and international game developers to launch browser-based games, many of which are sports games, to help capture a fast growing market and to capture the advertising opportunities created by the 2008 Olympics. The portal is also expanding content on games-related news and information, offering the China.com games channel as an attractive choice for game advertisers. Additionally, in November 2007, China.com signed an advertising contract with Giant Interactive Group Inc. (NYSE: GA), one of the leading online games developers and operators in China.
Our China.com business unit is also focused on launching promotions both through our portals and the general media. Currently, we have approximately 58 sales and marketing personnel who are located throughout China, including in Beijing, Nanjing, Shandong, Guangdong and Hangzhou. Our primary sales and marketing initiatives focus on direct marketing through consumer portals like , which is not part of this Annual Report, and general media advertising in traditional media, including point-of-purchase promotions, newspaper and magazine advertisements, radio and TV advertisements.
Our China.com business unit also operates in an increasingly competitive environment and faces increasing competition for content, user traffic, ease of use and functionality. Such competitors include Chinese and/or English language based Web search and retrieval companies, including AltaVista Co., Apple Daily, ChinaByte, FindWhat.com, HotBot, HotWired Ventures, Lycos, Inc., Mingpao.com, MSN, Netease.com, Inc., Netvigator.com, Overture Services, Inc. (acquired by Yahoo!, Inc.), Shanghai Online, Sina Corporation, Sohu.com, Inc., Tom Online Inc. and Yahoo!, Inc. We also encounter increased competition from Internet service providers, Web site operators and providers of Web browser software, including Microsoft Corporation or Netscape Communications Corporation, that incorporate search and retrieval features in their products.
China.coms Competitive Strengths
We believe that China.com benefits from strong brand recognition in China. As of June 2008, Alexa ranked our domain, www.china.com, in the range between 140 and 160th of all websites globally, and also ranked www.china.com as 14th among all simplified Chinese character websites, as measured by user traffic.
In addition, we believe China.com benefits from the growth of online advertising and its established strategic partnerships with Internet industry leaders in China.
China.coms Goals and Strategy
Our goal for our China.com business is to be a leading portal company in China., and we intend to continue to place emphasis on the development of our portal network. We believe that the portal network will play a critical role in driving synergies among our other related businesses, including our online games business and will serve as a strategic and core business platform.
In addition, we have begun to implement a repositioning strategy for the portal network to sharpen its vertical focus, and extend the depth of its product offerings in selected channels which includes Automobile channel and Webgames channel.
China.com and CDC Mobile Strategic Partnerships, Agreements and Investments
Google. In July 2006, China.com and Google formed a strategic partnership, which was expanded in July 2007 to improve search experiences for Internet users in China. Under the agreement, Googles WebSearch service will be embedded in China.coms search box, allowing users to switch between online content and web page search. In addition, China.com intends to utilize Google AdSense program to deliver relevant advertisements that generate revenue and enhance the user experience.
Soufun. In 2005, China.com formed a strategic relationship with Soufun, one of Chinas leading real estate websites. We believe this partnership has enriched our content in those channels and improve users experiences. The China.com portal will continue to broaden its partnership with leading websites in various vertical sectors.
Our Intellectual Property
We have acquired a significant amount of intellectual property and we are increasingly developing our own intellectual property. We regard the protection of our trademarks, service marks, copyrights, trade secrets, domain names, and other intellectual property rights as crucial to our success. We rely on a combination of copyright, trade secret and trademark laws, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary information and technology. Copyrights or trademarks held by us, however, may be challenged or determined to be invalid. In addition to the protection generally available to unregistered trademarks under the laws of many jurisdictions, we also protect our trademarks through registration primarily in the United States and Canada, although we do seek such protection elsewhere in selected key markets. However, protection may not be available in every country in which our intellectual property and technology is used. Some countries, such as China, may not protect our proprietary rights to the same extent as in the United States and Canada. In particular, software piracy has been an issue in China for many software publishers. Policing the unauthorized use of our licensed technology is difficult as are the steps necessary to prevent the misappropriation or infringement of our licensed technology. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of our proprietary rights. Any of these claims, with or without merit, could result in costly litigation, divert our managements time, attention and resources, delay our product shipments or require us to enter into royalty or license agreements.
As part of our confidentiality procedures, we have policies of entering into non-disclosure and confidentiality agreements with our employees, consultants, corporate alliance members, customers and prospective customers. We also enter into license agreements with respect to our technology, documentation and other proprietary information. These licenses are non-exclusive and generally perpetual. We provide for source code escrow arrangements under some of our license agreements. Despite the efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain the use of our products or technology that we consider proprietary and third parties may attempt to develop similar technology independently.
Most of our products do not contain the functionality to allow us to accurately track the numbers of users of our products at a customer site. Because some of our license agreements are for named-user licenses in which only a certain limited number of named individuals are permitted to use the software for which the license is granted, if our customers do not accurately report the number of users using our products or we cannot accurately track the number of users of our products at a customer site, we face the potential of lost revenues if the customer has a greater number of users than for which they have purchased licenses. License agreement provisions, such as requesting customers to perform annual self audits of the number of users at a customer site, provide only limited protection and are retrospective.
We currently sub-license and distribute the intellectual property and technology of third parties. As we continue to develop intellectual property and introduce new products and services that require new technology, we anticipate that we may need to obtain licenses for additional third-party technology. These existing and additional technology licenses may cease to be available to us on commercially reasonable terms, or at all. In addition, it is possible that, in the course of using new technology, we or our agents acting on our behalf may inadvertently breach the technology rights of third parties and face liability for our breach. Our inability to obtain these technology licenses or avoid breaching third-party technology rights could require us to obtain substitute technologies of lower quality or performance standards or at greater cost which could delay or compromise the introduction of new products and services, and could materially and adversely affect our business, results of operations and financial condition.
As of June 2008, other than as set forth below, there is no material litigation pending against us. From time to time, we and our subsidiaries are a party to other litigation and claims incident to the ordinary course of business. While the results of such litigation and claims cannot be predicted with certainty, we believe that the final outcome of such other matters will not have a material adverse effect on our financial position, results of operations or cash flows.
Class Action Lawsuit. A class action lawsuit was filed in the United States District Court, Southern District of New York on behalf of purchasers of our securities between July 12, 1999 (the date of our IPO) and December 6, 2000, inclusive. The complaint charges we and the underwriters in our IPO with violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint alleges that the prospectus used in our IPO was materially false and misleading because it failed to disclose, among other things, that (i) the underwriters had solicited and received excessive and undisclosed commissions from certain investors, in exchange for which the underwriters allocated to those investors material portions of the restricted numbers of the Companys shares issued in connection with the IPO; and (ii) the underwriters had entered into agreements with customers whereby the underwriters agreed to allocate our shares to those customers, in exchange for which the customers agreed to purchase additional shares in the aftermarket at pre-determined prices.
In June 2003, the plaintiffs in the consolidated IPO class action lawsuits currently pending against us and over 300 other issuers who went public between 1998 and 2000, announced a proposed settlement with us and the other issuer defendants. The proposed settlement provided that the insurers of all settling issuers would guarantee that the plaintiffs recover $1.0 million from non-settling defendants, including the investment banks that acted as underwriters in those offerings. In the event that the plaintiffs do not recover $1.0 million, the insurers for the settling issuers will make up the difference. Under the proposed settlement, the maximum amount that could be charged to us insurance policy in the event that the plaintiffs recovered nothing from the investment banks would be approximately $3.9 million. We believe that we have sufficient insurance coverage to cover the maximum amount that we may be responsible for under the proposed settlement. The independent members of our Board of Directors approved the proposed settlement at a meeting held in June 2003. As of March 2005, outside counsel advised that the court has granted preliminary approval of the settlement, subject to certain conditions. In August 2005, the court preliminarily approved the settlement. In December 2006, the appellate court overturned the certification of classes in the six test
cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings (the action involving the Company is not one of those test cases). In June 2007, the court entered an order terminating the proposed settlement based on a stipulation among the parties to the settlement. Plaintiffs have filed amended master allegations and amended complaints and moved for class certification in the six test cases, which the defendants in those cases have opposed. In March 2008, the court largely denied the defendants motion to dismiss the amended complaints in the six test cases. It is uncertain whether there will be any revised or future settlement. If the litigation proceeds, we believe that we have meritorious defenses to plaintiffs claims and intends to defend the action vigorously.
ManTech International Corporation and ManTech Australia International Inc. In October 2005, ManTech International Corporation and ManTech Australia International Inc, filed a civil action against our subsidiaries CDC Australia Limited and CDC Australia (Praxa) Pty Ltd (collectively, CDC Australia), alleging that CDC Australia failed to pay AU$5.0 million that was retained as part of the consideration for the acquisition of Praxa Limited. In late 2005, CDC Australia filed and served a request for further and better particulars of the statement of claim and a request for the filing of security of costs. The plaintiffs have answered the requests for further and better particulars, and further directions as to the conduct of the action were given by the Court soon after plaintiff made payment of security for costs in January 2007. The parties are engaging in discovery and interrogatories under a new timetable, and other preliminary procedural steps through early 2008 have been set. At a hearing held in February 2008, plaintiffs filed and served answers to defendants interrogatories and a directions hearing was scheduled for March 2008. Plaintiffs have now requested additional discovery. We believe that the AU$5.0 million was rightfully retained by CDC Australia in accordance with the terms of the acquisition agreement, and the action is without merit. We intend to vigorously defend such action. Management considers the outcome of any judgment on the lawsuit with respect to us to be uncertain and the amount of any expenditure from the lawsuit is not estimable.
Lam, Po Chiu Mark. In December 2003, Mr. Mark Lam filed a civil action in the High Court of Hong Kong against our subsidiary Ion Global (BVI) Limited alleging breach of contract in relation to a put option agreement under a share purchase agreement in an amount of approximately $0.7 million. Pleadings closed in April 2004 when Mr. Lam filed his reply to the defense filed by Ion Global. The case was largely dormant until late 2005 when the plaintiff sought and was granted leave to amend his statement of claim and to join CDC Corporation, our parent company, as a party. CDC Corporation was joined in July 2006. In January 2007, Mr. Lam also joined a member of our board of directors, Mr. Peter Yip, to the proceedings. An amended statement of claim and an amended defense have been filed by the plaintiff and defendants, respectively. Management considers the outcome of any judgment in this matter to be uncertain and the amount of any expenditure from this matter is not estimable. We believe that this action is without merit and intend to vigorously defend such action.
Marjorie Fudali. In June 2003, Majorie Fudali (Fudali) filed a civil action in the United States District Court for the District of Columbia against Pivotal Corporation, alleging that she was owed commission in the amount of $0.4 million plus override commissions under a compensation plan allegedly agreed between her and a former senior executive of Pivotal, and wages under District of Columbia wage laws. In early 2004, Pivotals motion to dismiss the wage law claim was granted. In July 2004, Fudali amended her claim to add a promissory estoppel ground. In August 2004, Pivotal filed a motion for summary judgment, which was denied by the Court, ruling that factual disputes existed, which should be resolved at trial. Shortly before the jury trial which was scheduled to occur in January 2007, Fudali alleged that new facts came into light and amended her damages claim to $2.3 million. As a result, the jury trial was adjourned. The jury trial took place in October 2007, and a verdict against Pivotal was returned. The Court ordered Fudali to provide a calculation of the amount that Fudali believes she may be entitled to based on the verdict. Fudali has provided two alternative calculations, in the amounts of $1.9 million and $1.8 million. Pivotal has challenged those calculations and is awaiting a hearing and the Courts decision on the amount.
Jason Leedy. In August 2002, Mr. Jason Leedy filed a civil action against Vis.align, LLC, which we acquired in December 2006. Mr. Leedy has alleged that his employment with Vis.align had been wrongfully terminated, and severance pay and other amounts were owing to him, and sought damages in the amount of $0.3 million. After a jury trial in which a verdict favorable to Mr. Leedy was returned, the Court entered judgment in the amount of $0.4 million, which included $0.1 million in attorneys fees and costs. Vis.align
has appealed to the Pennsylvania Superior Court. In September 2006, the Superior Court ordered that the judgment below based on the jury verdict be vacated, and that judgment be entered in favor of Vis.align notwithstanding the verdict. In November 2006, the Superior Court granted Mr. Leedys petition for rehearing en banc and withdrew its September 2006 decision. In March 2008, an evenly divided Superior Court issued two opinions, one in support of reversal of the trial court and one in affirmance of the trial court. As the Superior Court was evenly split, the trial courts decision was affirmed by default, leaving the defendants liable for approximately $40.4 million. A petition requesting review by the Pennsylvania Supreme Court was filed in April 2008 and remains pending.
Asian Media Company Limited. Optic Communications Co., Ltd received an arbitration claim of approximately $0.5 million from Asian Media Company Limited claiming damages related to an alleged breach of contract under an undated 3-party agreement among Guangzhou Optic Communications Co., Ltd, Asian Media Company Limited and Changchun YaAo Resources Development Company Limited. We intend to vigorously defend such action. Management considers the outcome of this matter with respect to us to be uncertain and the amount of any expenditure from this matter is not estimable.
Chan. In March 2007, we filed suit against Steven Chan (Chan) and Bing Corporation (Bing), alleging that Chan and Bing illegally obtained option shares in CDC Corporation. In April 2008, Chan and Bing filed a cross-complaint against CDC Corporation and CDC Corporation Ltd. alleging breach of an oral contract and various tortious claims including interference with the exercise of purported options, and defamation. Chan and Bing currently allege damages: (i) in excess of $1.0 million arising from alleged inability to exercise stock options at more favorable dates, (ii) in excess of $0.2 million for various payments alleged to be due to Chan and/or Bing, and (iii) unspecified damages for libel.
Pure Biosciences. In June 2007, Pure Biosciences (Pure) filed a complaint in the Southern District of California asserting claims for breach of contract, breach of express warranty, breach of implied warranty of merchantability, breach of the implied warranty of fitness for a particular purpose, and rejection of goods and/or revocation of acceptance related to a Software License and Professional Services Agreement and related Statement of Work and Master Work Order Pure entered into with Ross in March. In August 2007, Ross filed a motion to dismiss the complaint. Pure did not respond to Rosss motion, but instead filed an amended complaint in October 2007. In November 2007, Ross filed a second motion to dismiss, and in an order dated April 4, 2008, the Court granted Rosss motion without prejudice. Pure filed its Second Amended Complaint In May 2008 asserting claims for breach of contract, breach of express warranty, and rejection of goods/revocation of acceptance and seeking attorneys fees and damages of at least $0.2 million. Ross filed its third motion to dismiss in May 2008, arguing that Pure still failed to adequately allege that the software failed to conform to the terms of the parties License Agreement or the express warranty it contains and that Pure cannot state a claim based on alleged pre-contractual marketing statements because the License Agreement contains a merger clause. Pure filed its response in June 2008, and Rosss reply is due June 23, 2008. The Company cannot predict when the final resolution of this litigation will occur, and it is not possible to evaluate the likelihood of an unfavorable outcome or to estimate the amount or range of potential loss with respect to this matter.
William McKenna (McKenna). In November 2007, McKenna filed a civil action in the District Court of Denver County, Colorado, against the Companys subsidiary, CDC Software, Inc. alleging he was terminated from his position as a sales account executive in violation of public policy, based on his refusal to engage in allegedly improper sales practices. McKenna is seeking compensatory damages in an unspecified amount, damages for emotional distress and exemplary damages. In January 2008, the Company removed the case from the Colorado State Court to the U.S. District Court for the District of Colorado and thereafter filed an answer, defenses and asserted a counterclaim alleging a breach of McKennas Proprietary Information Agreement with the Company. In addition, the Company filed a motion to transfer venue of this case to the United States District Court for the Northern District of Georgia. In February 2008, McKenna filed an answer to the Companys counterclaim, and the Company was notified that McKennas attorney requested permission to withdraw from the case. McKenna hired new counsel, who filed a response in opposition to the Companys motion to transfer and moved to amend the Complaint to add a cause of action for alleged violations of the Colorado Wage Claim Act. The Company filed a reply in support of its motion to transfer in April 2008, and the parties are now waiting for the Court to rule on that motion. Later in April 2008, the Company filed a response in opposition to McKennas motion to
amend, and McKenna filed a reply in early May 2008, and the United States Magistrate Judge issued a written opinion recommending that the District Court Judge grant McKennas motion to amend, and the Company filed Objections later in May 2008. The parties have recently propounded written discovery. The Company cannot predict when the final resolution of this litigation will occur, and it is not possible to evaluate the likelihood of an unfavorable outcome or to estimate the amount or range of potential loss with respect to this matter.
Triton IP LLC. In April 2008, Triton IP, LLC filed a claim in the United States District Court for the Eastern District of Texas against defendants NetSuite, Inc., CDC Corporation and CDC Software Inc. alleging that our MarketFirst software infringed a patent owned by Triton through assignment. The plaintiff is seeking a permanent injunction against defendants, damages, costs, expenses, interest, attorneys fees and other restitutional remedies. The Company intends to vigorously defend such action. Management of the Company considers the outcome of this matter with respect to the Company to be uncertain and the amount of any expenditure from this matter is not estimable.
Vertical Computer Systems, Inc./NOW Solutions LLC (Vertical or NOW). In February 2003, Vertical Computer Systems (on behalf of itself and on behalf of NOW Solutions) filed a civil action in the state court in New York, New York, against the Companys subsidiary Ross Systems, Inc. and others alleging, among other things, breach of contract, claims under contractual indemnifications and fraud arising from the February 2001 sale of assets from Rosss HR/Payroll division to NOW Solutions. The action sought $5.0 million in damages. In April 2003, Ross filed a motion to dismiss the complaint, which was granted in November 2003. The plaintiff appealed and its appeal was granted in October 2004. The matter was remanded to the trial court for adjudication. In May 2006, both Vertical and Ross filed a summary judgment motions against each other. In November 2006, the Court denied these summary motions, finding that factual issues existed to be resolved at trial. In March 2004, the Companys subsidiary Ross filed a separate civil action against NOW in state court in New York, New York seeking payment of the final $0.8 million installment due under a promissory note executed by NOW in connection with the February 2001 HR/Payroll division asset sale. In November 2004, NOW asserted counterclaims against Ross raising the same contractual issues asserted in the Vertical v. Ross action, as well as additional contractual claims related to the 2001 asset sale, seeking a total of approximately $15.0 million in damages. In December 2004, Ross filed a motion to dismiss certain of the counterclaims, which he Court granted in February 2005, thereby reducing the total damages being sought in NOWs counterclaims to approximately $5.0 million. In May 2006, Ross filed a motion for partial summary judgment that was granted in part. A jury trial of both the Vertical v. Ross and Ross v. NOW actions took place in March and April 2007 following which the Court directed certain verdicts in favor of NOW, and certain verdicts in favor of Ross. In September 2007, the Court entered a final judgment against Ross in the amount of $1.3 million in damages, $0.9 million in attorneys fees and costs, and $0.9 million in pre-judgment interest, for a total judgment against Ross of $3.2 million. In November 2007, Ross filed a Notice of Appeal, thereby commencing its appeal from the Courts trial rulings. In February 2007, NOW Solutions, Inc, the alleged successor-by-merger to NOW Solutions, LLC, filed an action in the state court in New York, New York, against Ross, although Ross has yet been served with the Complaint. In this action, NOW Solutions, Inc. asserts claims for breach of contract and attorneys fees based upon facts similar to those in the above action, seeking $4.1 million in damages. The Company believes that this action filed in February 2007 is duplicative of the claims that have already been litigated through trial as referred to above, and is without merit, and the Company intends to vigorously defend the same. The Company accrued $0.3 million, $2.9 million and $3.2 million at December 31, 2005, 2006 and 2007, respectively.
CDC Corporation was incorporated in June 1997. The following table sets forth our significant subsidiaries organized by business unit as of April 30, 2008. Please note that the following table does not include our intermediate holding companies.
Corporate Structure in China for our CDC Games and China.com Business Units
Internal Restructuring. In December 2006, we completed our plans for an internal restructuring of CDC Games pursuant to which CDC Games was moved from within China.com to become a direct business unit of CDC Corporation. The independent shareholders of China.com, present in person or by proxy at China.coms shareholders meeting, approved the restructuring.
In connection with the restructuring, CDC Games entered into a stock purchase agreement whereby it acquired all issued and outstanding shares of its common stock for a purchase price of $110 million. Of such amount, $50 million was paid in cash at closing and $60 million was funded through CDC Games issuance of a note bearing interest at 5% per annum, due June 28, 2008. This note was paid in full on June 27, 2008.
Businesses. As of March 31, 2008, CDC Games operates in the online games business segment in China through 17game and Optic. As of March 31, 2008, China.com, a 77% owned subsidiary of CDC Corporation, operates our China.com business segments in China.
CDC Games and China.com make investments in each of these business units mainly through offshore holding vehicles registered in the British Virgin Islands or Cayman Islands.
Trust Deed Arrangements
To comply with legal and regulatory considerations in China, each of CDC Games and China.com conducts a significant portion of the operations of these business units through domestically registered companies in China, referred as ICPs, which are held under trust deed arrangements. Under these trust deed arrangements, the trustees are employees of CDC Games or China.com who are Chinese nationals and the 100% beneficiaries of the trusts are offshore holding vehicles registered in the British Virgin Islands or Hong Kong.
With respect to our Newpalm business, we have formed two ICPs, Beijing Newpalm Technology Co., Ltd., or Beijing Newpalm, and Beijing Wisecom Technology Co., Ltd., or Beijing Wisecom. Two of China.coms employees, Mr. Wang and Ms. He, each own 50% of Beijing Newpalm and Mr. Wang and Mr. Fang each own 50% of Beijing Wisecom. Beijing Newpalm and Beijing Wisecom are held under trust deed arrangements under which Mr. Wang, Ms. He and Mr. Fang also serve as trustees of the trusts. China.com Corp. Limited is the holding vehicle of China.com incorporated in Hong Kong which is the 100% beneficiary of the trusts.
With respect to our Shenzhen business, the ICP is Shenzhen KK Technology Ltd., or Shenzhen KK. Two of China.coms employees have ownership interests in Shenzhen KK with Mr. Wang and Ms. each owning 50% of Shenzhen KK. Shenzhen KK is held under trust deed arrangements under which Mr. Wang and Ms. He also serve as trustees of the trusts. Unitedcrest Investments Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.
With respect to our TimeHeart business, the ICP is Beijing TimeHeart Information Technology Limited, or Beijing Timeheart. Two of China.coms employees have ownership interests in Beijing TimeHeart with Ms. Huang owning 50% of Beijing TimeHeart and Ms. Zhao owning 50% of Beijing TimeHeart. Beijing TimeHeart is held under trust deed arrangements under which Ms. Huang and Ms. Zhao also serve as trustees of the trusts, and TimeHeart Science Technology Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.
With respect to our China.com Portal business, the ICP is Beijing China.com Technology Services Co., Ltd., or Beijing China.com. Three of China.coms employees have ownership interests in Beijing China.com with Mr. Wang and Mr. Fang each owning 40% of Beijing China.com and Ms. Wu owning 20% of Beijing China.com. Beijing China.com is held under trust deed arrangements under which Mr. Wang, Mr. Fang and Ms. Wu also serve as trustees of the trusts, and chinadotcom Portals Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.
With respect to our Go2joy business, the ICP is Beijing He He Technology Co., Ltd., or Beijing He He. Two of China.coms employees have ownership interests in Beijing He He with Ms. He and Ms. Wu each owning 50% of Beijing He He. Beijing He He is held under trust deed arrangements under which Ms. Wang and Ms. Wu also serve as trustees of the trusts, and Double Keen Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.
With respect to our 17game business, the ICP is Beijing Hulian Jingwei Technology Development Co., Ltd., or Beijing Inter Connected. Two of China.coms employees have ownership interests in Beijing Inter Connected with Mr. Wang owning 70% of Inter Connected and Mr. Xu owning 30% of Inter Connected. Inter Connected is held under trust deed arrangements under which Mr. Wang and Mr. Fan also serve as trustees of the trusts, and Equity Pacific Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.
Licenses and Agreements
The ICPs each hold various types of licenses required by the regulatory authorities in China with respect to operating their respective businesses.
During 2007, Beijing Newpalm continued to serve as the primary ICP within Newpalm. Previously, Beijing Newpalm had entered into agreements with China Mobile to provide services on China Mobiles network and Beijing Wisecom had entered into agreements with China Unicom to provide services on China Unicoms network. As the primary ICP within Newpalm, Beijing Newpalm continues to enter into various agreements with China Mobile to provide services on China Mobiles network, and except for a few provinces, Beijing Newpalm has replaced Beijing Wisecom to renegotiate with China Unicom to provide services on China Unicoms network.
Beijing He He has entered into agreements with China Mobile and China Unicom to provide MVAS services using either China Mobiles or China Unicoms network.
Shenzhen KK has entered into agreements with China Mobile to provide MVAS services using China Mobiles network.
Beijing China.com holds an Internet Content Provider License and has been authorized to operate an Internet portal with the URL www.china.com. Beijing China.com also holds various licenses which are attached to the Internet Content Provider License, such as an Internet advertisement license and an Internet news reporting license.
Beijing Inter Connected holds one Internet content provider license and has been authorized to operate two Internet portals with the URL www.17game.com and the URL for all its online games. Beijing Inter Connected also holds various licenses which are attached to the Internet content provider license which are particularly applied for each game imported into and operated in China.
With respect to our online games business, we also hold various licenses in the PRC for the import and licensing of Yulgang, Travia and Special Force.
Use of Wholly Foreign Owned Enterprises
The ICPs Beijing Newpalm and Beijing Wisecom (for Newpalm), Beijing China.com (for the China.com Portal) and Beijing He He (for Go2joy) and Beijing Timeheart (for TimeHeart) act as the primary revenue generating entities of each business unit. In order to provide, among other things, more effective controls over these ICPs, each of the respective beneficiaries of the trusts, under the trust deed
arrangements for these business units, has formed and invested in a wholly foreign owned enterprise, or WFOE, to act as a long term exclusive partner of the ICP. WFOEs are limited liability companies established under the Chinese Company Law, the shareholders of which are permitted to be 100% foreign (not Chinese nationals).
As the long term exclusive partner of the ICP, the respective WFOE for the ICP provides technical and logistical support for the day to day operations of the ICP, including sales and marketing, billing, and administrative services. To facilitate the delivery of the technical and logistical support, the WFOE owns the physical assets, including servers, switches and computers, and employs the technical, sales and administrative personnel necessary to deliver these services. In exchange for such services, the WFOE charges the ICP a fee.
The WFOE formed to provide services for Beijing Newpalm, Beijing Wisecom and Shenzhen KK is Newpalm (China) Information Technology Co., Limited, and such WFOE charges a fee of approximately 90% of the gross revenue of each of Beijing Newpalm, Beijing Wisecom and Shenzhen KK for its services.
The WFOE formed to provide services for Beijing TimeHeart is TimeHeart (Beijing) Network Technology Limited. This WFOE did not charge Beijing TimeHeart any fees in 2006.
The WFOE formed to provide services for Beijing China.com is Chinadotcom Communications Technology Development (Beijing) Limited This WFOE charged fees averaging approximately 49% and 41% of the gross revenue of Beijing China.com for its services during each of 2005 and 2006, respectively.
The WFOE formed to provide services for Beijing He He is Beijing He He IVR Mobile Technology Ltd. This WFOE did not charge Beijing He He any fees in 2005 or 2006.
The WFOE formed to provide services for Beijing Inter Connected is Beijing 17game Network Technology Co., Ltd. This WFOE is able to directly sell the final online game products to the consumers instead of charging a service fee via Beijing Inter Connected.
As of April 30, 2008, we owned no real estate and our major leased facilities included our:
We and our subsidiaries also lease additional office space in various other locations in the United States, Canada, Europe, Asia and Australia. These locations include:
In December 2006, China.com entered into contracts to acquire approximately 376,740 square feet of land in Nanjing, China for an aggregate of approximately $0.6 million payable in installments. We intend that these premises will be utilized as corporate facilities for us and our subsidiaries.
You should read the following discussion of our financial condition and results of operations together with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 20-F. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from those anticipated in these forward-looking statements as a result of factors including, but not limited to, those set forth under Item 3.D. of this Annual Report, Key Information Risk Factors and Item 11 of this Annual Report, Quantitative and Qualitative Disclosures About Market Risk.
Operating Segments and Discontinued Operations
We report results in five business segments, Software, Global Services, CDC Games, China.com and MVAS. Due to the decision made in the first quarter of 2008 to discontinue the MVAS business, subsequent filings will show the MVAS segment as a discontinued operation.
Products and Services
CDC Corporation is a global provider of enterprise software, mobile services and internet and media services and is also engaged in the development and operation of online games. We offer the following products and services to customers around the world:
During 2006 and 2007, we made the following significant business acquisitions, by business segment, the results of which have been consolidated from the respective dates of acquisition. There were no significant acquisitions during 2005.
For a list of all acquisitions, see Item 4 Information on the Company.
Management performed an assessment of the effectiveness of the Companys internal control over financial reporting as of December 31, 2007, utilizing the criteria described in the Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The objective of this assessment was to determine whether the Companys internal control over financial reporting was effective as of December 31, 2007. That assessment identified the following control deficiencies as of December 31, 2007, that constituted material weaknesses. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the companys annual financial statements will not be prevented or detected on a timely basis.
Financial Statement Close and Reporting
Management has concluded that a material weakness exists in documentation and procedures relating to the financial statement close process that result in a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected.
Specific control deficiencies identified relating to the financial statement close process include:
These control deficiencies related to the financial statement close process affect all of our significant accounts. As a result of these control deficiencies, management recorded material adjustments to the financial statements during the year ended December 31, 2007. These control deficiencies could result in a material misstatement to the annual consolidated financial statements that would not be prevented or detected.
Management has also concluded that a material weakness exists in accounting for income taxes that results in a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected.
Specific control deficiencies identified relating to the accounting for income tax process include:
These control deficiencies could result in a misstatement of the tax provision and deferred tax asset and liability balances that would result in a material misstatement to the annual consolidated financial statements that would not be prevented or detected.
Management has concluded that a material weakness exists in the management of our investments and other treasury related activities that result in a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected. This limits our ability to effectively manage risk in the treasury/capital transactions component of our strategy and could result in unexpected losses and adjustments to the carrying value of investments and derivatives employed by us.
Specific control deficiencies identified relating to the treasury management process include lack of sufficient personnel with appropriate skills and experience to adequately assess and monitor the accounting, economics, performance and risks related to complex treasury transactions.
The above material weakness resulted in the temporary event of default on our $168 million Convertible Notes as disclosed in Footnote 11 of Notes to Consolidated Financial Statements.
Because of the material weaknesses described above, our management concluded that we did not maintain effective internal control over financial reporting as of December 31, 2007, based on the criteria in Internal ControlIntegrated Framework issued by the COSO. The attestation report of our independent registered public accounting firm is included in Part III, Item 18. Financial Statements of this report under the captions entitled Report of Independent Registered Public Accounting Firm.
Change in Internal Control over Financial Reporting
Management has taken the following steps during 2007 to begin the remediation process:
Remediation activities are underway but have not been fully implemented.
Remediation Steps to Address Material Weaknesses
Our executive, regional and financial management are committed to achieving and maintaining a strong control environment. In addition, management remains
committed to the process of developing and implementing improved corporate governance and compliance initiatives. Our management team has been actively working on remediation efforts as discussed above to address the material weaknesses, as well as other identified areas of risk. In 2008, we have taken the following additional steps to remediate our material weaknesses:
Management has applied the above remediation steps and incorporated substantive review procedures during the year end financial statement close process to compensate for the control weaknesses relating to reporting the financial results as of December 31, 2007.
Prospectively, we intend to undertake further efforts to remediate the control weaknesses identified, including:
We intend to continue to monitor our internal controls and our progress on the remediation steps identified above and, if further improvements or enhancements are identified, take steps to implement such improvement or enhancements.
We believe the measures described above, once designed and operating effectively, will remediate the material weaknesses we have identified and strengthen our internal control over
financial reporting. We are committed to continuing to improve our internal control processes and will diligently and vigorously review our financial reporting controls and procedures. As we continue to evaluate and work to improve our internal control over financial reporting, we may determine to take additional remediation measures or determine to modify, or in appropriate circumstances not to complete, certain of the remediation measures described above.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, goodwill and intangible assets, business combinations, valuation of derivative financial instruments, fair value of investments not actively traded, capitalization of software costs, investments, accounts receivable and allowance for doubtful accounts, deferred tax valuation allowance, stock based compensation, and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies are described in Note 2- Summary of Significant Accounting Policies in Item 18- Financial Statements.
We believe the following critical accounting policies are some of the more critical judgment areas in the application of our accounting policies that affect our financial condition and results of operations.
We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectibility is reasonably assured. If an acceptance period is required, revenue is recognized upon the earlier of customer acceptance or the expiration of the acceptance period. In some circumstances, we recognize revenue on arrangements that contain certain acceptance provisions when we have historical experience that the acceptance provision is perfunctory. Our agreements with our customers, resellers and distributors do not contain product return rights. If the fee is not fixed or determinable due to the existence of extended payment terms, revenue is recognized periodically as payments become due, provided all other conditions for revenue recognition are met. Discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period in which the related revenue is recorded. Such provisions are calculated after considering relevant historical data.
We generate revenue from five primary sources: Software, Global Services, CDC Games, China.com and MVAS. We recognize revenue in accordance with US GAAP. The specific literature that we follow in connection with its revenue recognition policy includes the Securities and Exchange Commissions (SEC) Staff Accounting Bulletin 104, Revenue Recognition (SAB 104), the American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, Software Revenue Recognition (SOP 97-2), as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, Financial Accounting Standards Board (FASB) Emerging Issues Task Force
(EITF) 00-21, Revenue Arrangements with Multiple Deliverables, EITF 00-3, Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entitys Hardware, and in certain instances EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent (EITF 99-19) and SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1). In addition to these basic criteria, the following are the specific revenue recognition policies we follow for each major stream of revenue by reporting segment.
We generate software revenue from the sale of software licenses, and the maintenance and services for such software licenses. Such sales often include a combination of software consulting and integration services, implementation training and maintenance services. We allocate the arrangement fee in these multi-element arrangements to each individual element using its relative fair value as based on vendor specific objective evidence (VSOE). VSOE of fair value is typically determined by the customary price charged for each element when sold separately after the application of any standard approved discount. In the case of an element not yet sold separately, VSOE of fair value is the price established by authorized management if it is probable that the price, once established, will not change before market introduction. Where fair value exists for all undelivered elements of the arrangement but not the delivered elements, we apply the residual method of accounting and defer revenue allocated to the undelivered elements while recognizing the residual revenue allocated to the delivered elements. In the absence of VSOE of fair value for any undelivered element, we defer the entire arrangement fee and recognize revenue when all undelivered elements are delivered assuming all other basic criteria for revenue recognition have been met. We recognize revenue from services separately from license fees revenue because the service arrangements qualify as service transactions as defined by SOP 97-2. The factors considered in determining whether the revenue should be accounted for separately include the nature of the services and whether the services are essential to the functionality of the licensed product, availability of services from other vendors, and the impact of payment timing on the realizability of the software license fee.
Software license revenue is normally generated through licensing with end-users, value-added resellers (VARs) and distributors, and through the sale of the software with or incorporating third-party products. VARs and distributors do not have rights of return, price protections, rotation rights, or other features that would preclude revenue recognition. When software licenses are sold indirectly to end-users through VARs, we recognize as revenue only the net fee receivable upon sell-through to the end-user. License revenue from distributors is calculated at an agreed upon percentage of the distributors net selling price to the end-user. We typically do not earn any portion of fees for services provided by the distributor to the end-user. We earn maintenance fees based on an agreed upon percentage of the maintenance fees that the distributor earns from the end-user.
When software licenses incorporating third-party software products are sold or sold with third-party products that complement our software, we recognize as revenue the gross amount of sales of third-party products. The recognition of gross revenue is in accordance with criteria established in EITF 99-19 because we are ultimately responsible for the fulfillment and acceptability of the products purchased, have full latitude in establishing pricing and assume all credit and general inventory risks.
Revenue related to consulting and integration services and the provision of training services for software products are deferred and recognized as the services are delivered, assuming all other basic criteria for revenue recognition have been met.
Revenue related to maintenance agreements on software products is deferred and recognized ratably over the terms of the agreements which are normally one year.
We make provisions for discounts and rebates to customers and other adjustments in the same period in which the related revenue is recorded. Such provisions are calculated after considering relevant historical data.
Recognition of revenue from the licensing of our software products requires management judgment with respect to determination of fair values and in determining whether to use the gross versus net method of reporting for certain types of revenue. The timing of our revenue recognition could differ materially if we were to incorrectly determine the fair value of the undelivered elements in an arrangement for which we are using the residual method. The composition of revenue and cost of revenue would change if we made a different assessment on the gross versus net method of reporting sales of software licenses which incorporate third-party software products.
We generate global services revenue from information technology services, eBusiness consulting, web development and outsourcing.
We recognize revenue from time and materials outsourcing contracts as the services are delivered assuming all other basic criteria for revenue recognition have been met.
We recognize revenue from the design, development and integration of Internet web sites and mobile phone devices using contract accounting based on either client acceptance of completed milestones or using the cost-to-cost percentage-of-completion method. We use the cost-to-cost method based on hours incurred as a percentage of the total estimated hours to complete the project because our historical experience has demonstrated that it produces a reliable indication of the progress on each engagement. We regularly reevaluate estimates of total projected contract costs and revise them if appropriate. Any adjustments to revenue due to changes in estimates are accounted for in the period of the change in estimate. When estimates indicate that a loss will be incurred on a contract upon completion, a provision for the expected loss is recorded in the period in which the loss becomes evident. Historically, we have not experienced material losses on fixed-price contracts. The majority of our contracts are short term in duration, and the use of the completed contract method would not result in a material difference in the timing of revenue recognition. Some projects include acceptance clauses requiring customers sign-off at the conclusion of the projects. Historically, we have not experienced projects where sign-off or acceptance has been withheld by a customer resulting in a material loss on a project. Recognition of revenue using contract accounting requires judgment with respect to the method used. The timing of our revenue recognition could differ if we were to use a different methodology for estimating progress to completion, such as an output method based on milestones for contracts where we currently use an input method such as hours incurred.
Revenue from Internet web site maintenance agreements is deferred and recognized ratably over the terms of the related agreements, which are usually for periods of six months or one year.
Database and marketing support services include list rental, database development and supply, data analysis and call center services. Revenue is recognized when the service or list has been delivered assuming all other basic criteria for revenue recognition have been met.
Advertising revenue arising from direct mailing or placement of print advertising is recognized when the advertisements are sent or published, assuming all other basic criteria for revenue recognition have been met.
We derive advertising and marketing services revenue from consulting services, marketing database and support services, online and print advertising, and our Internet media business which is focused on online entertainment and Internet products services that target users in China via our portal network.
Advertising and marketing consulting services revenue for fixed price contracts is recognized upon completion of contractual milestones which are specified in the contracts along with pricing, payment terms and project timetable. Revenue from time and materials outsourcing contracts is recognized as the services are delivered, assuming all other basic criteria for revenue recognition have been met.
CDC Games revenue is principally derived from the provision of online game services in China. We operate our MMORPGs under two models. The first revenue model is the traditional subscription based pay-to-play, where users purchase PP-Cards to play for a fixed number of hours. The second revenue model is free-to-play, under which players are able to access the games free of charge but may choose to purchase in-game merchandise or premium features to enhance their game playing experience, such purchases can only be made through the use of PP-Cards.
All PP-Cards are sold to distributors and retailers across the country, from whom the Group collects payment on a prepaid basis. The distributors then resell the cards to end users and other retail points. The Group offered sales discounts primarily ranging from 13%-15% to distributors or retailers. The sales discount represents the difference between the price at which the PP-Cards are sold and the face value of the PP-Cards.
The end users are required to activate their PP-Cards by using access codes and passwords to exchange the value of these cards to game points and deposit into their personal accounts. They consume points for online game services by trading them either for a pre-specified length of game playing time or in-game merchandise or premium features sold at online game stores.
All prepaid fees received from distributors are initially recognized as deferred revenue and revenue is recognized when the registered points are consumed for the our online game services, i.e., when game playing time occurs or in-game merchandise or premium features are delivered, or when the end customers are no longer entitled to access the online game services after the expiration of the PP-Cards. Distributors are permitted to return unsold prepaid cards under certain conditions, including termination of game and disqualification of distributor status. Returns of PP-Cards during 2006 and 2007 were not material.
Revenue from internet and media mainly represents revenue from advertising, which is recognized on a straight-line basis over the period in which the advertisement is displayed, and when collection of the resulting receivable is probable, provided that no significant obligations of the Company remain. Advertising service fees from direct mailings are recognized when each advertisement is sent to a target audience.
We generate mobile services and applications revenue from a comprehensive suite of mobile data applications, including dating, chatting, fortune telling, entertainment, information-related content and community services to mobile subscribers in China utilizing SMS, MMS, WAP and IVR services. We rely on mobile network operators in China to bill mobile phone users for our subscription fees. We have revenue sharing arrangements with China Mobile and China Unicom under which we receive 70% to 85% of the subscription fee collected from a mobile subscriber, with the balance being retained by the mobile operators. In addition to our charges, the mobile operators separately charge their subscribers RMB 0.10 to RMB 1.00 for every SMS, MMS or WAP message sent. These amounts are collected by the mobile operators and are not shared with us.
MVAS revenue is recognized in the month in which the services are performed, provided that all other basic criteria for revenue recognition have been met. The mobile operators provide statements after month-end indicating the amount of fees that were charged to users for mobile services and applications services that we provided during that month and the portion of fees that are due to us in accordance with our contractual arrangements with the mobile operators. We typically receive these statements within 30 to 90 days following month-end, and we typically receive payment within 30 to 90 days following receipt of the statement. We also maintain an internal system that records the number of messages sent to and messages received from mobile users. There are differences between the expected value of delivered messages based on our system records and our portion of the fees confirmed by the mobile operators for the delivered messages. These differences may result from the users phone being turned off, problems with the mobile operators networks or our billing system or other issues which prevent delivery of our services to users. These are known in the industry as billing and transmission failures. We do not recognize revenue for services which result in billing and transmission failures. Billing and transmission failures can vary significantly from month to month, province to province and between mobile operators. At the end of each reporting period, where an operator fails to provide us with a monthly statement confirming the amount of charges billed to their mobile phone users for that month, we use the information generated from our internal system and historical data to make estimates of the billing and transmission failures and accrue as revenue the estimated amount of collectable mobile services and applications fees. If an actual discrepancy varies significantly from our estimate, it could result in an overstatement or understatement of revenue and costs of revenue.
We are also required to pay some of our content providers either monthly fee or a percentage of the revenue received from or confirmed by the mobile operators, with or without a minimum guaranteed payment, with respect to services incorporating the content providers products. In calculating the fees payable to these providers, we reduce the amount of the fee payable by our estimate of account billing and transmission failures which may have been applicable to the services incorporating these products. If we receive confirmation of billing or transmission failures which differ from our estimate after we make payments, we do not ask for refunds, make additional payments, or make adjustments with respect to fees payable for future periods. If the assumptions we use in making such estimates prove inaccurate, we may have paid, and may continue to pay, fees to such providers which are disproportionate to the amount we have been paid for the services.
Recognition of MVAS revenue requires judgment with respect to the estimation of revenue not yet confirmed by the mobile operators at the end of a period, and whether to use the gross versus net method of reporting revenue. We regularly re-evaluate our EITF 99-19 assessment as the mobile services environment continues to evolve with the transition to new platforms and significant changes in the operating practices of the network operators. The
composition of revenue and cost of revenue would change if we made a different assessment on the gross versus net basis of reporting. Our estimates also rely to some extent on our historical experience. We believe we have the ability to make reasonable estimates. However, material differences in the amount and timing of our revenue and cost of revenue could result during any period because of differences between the actual billing and transmission failure rate per the mobile operators statements and our estimates based on our internal records and historical experience, or if we were to use a different methodology for estimating the billing and transmission failure rate applicable to unconfirmed revenue. In the future we may also change our estimation methodology based on future experience or if there are changes in the manner in which the mobile operators confirm revenue.
Goodwill and Intangible Assets
Our long-lived assets include goodwill and other intangible assets. Goodwill represents the excess of cost over the fair value of net intangible assets of businesses acquired. Goodwill and indefinite lived intangible assets are not amortized. All other intangible assets are amortized over their estimated useful lives.
Goodwill is assigned to reporting units based on the reporting unit classification of the entity to which the goodwill is attributable. We have determined our reporting units based on an analysis of our operating segments: (a) the nature of products and services; (b) the nature of the production process; (c) the type and class of customers; (d) the method to distribute products or provide services; and (e) the nature of regulatory environment. In 2007 we reallocated the goodwill from our acquisition of Vis.align from our Software segment to our Global Services segment. Vis.align was originally acquired in December of 2006 and the goodwill was assigned to the Software segment. However, during the integration process, management determined that Vis.aligns product and service offerings were more closely aligned with our Global Services segment, therefore all of the goodwill recognized in connection with this acquisition was reallocated from our Software segment to our Global Services segment.
Our intangible assets represent trademarks and trade names, uniform resource locators (URLs), software applications and programs, customer base and contracts, and business licenses and partnership agreements. Definite-lived intangible assets are carried at cost less accumulated amortization. Amortization is computed using the greater of the straight-line method over the estimated useful life of the respective asset or the undiscounted cash flows method. The estimated useful lives of these intangible assets are as follows:
We test goodwill and intangible assets with an indefinite useful life for impairment on an annual basis as of December 31. This testing, carried out using the guidance and criteria described in SFAS No. 142, Goodwill and Other Intangible Assets, compares carrying values to fair values at the reporting unit level and, when appropriate, the carrying value of these assets is reduced to fair value. Factors that could trigger an impairment charge include, but are not limited to, significant changes in our overall business or in the manner or use of the acquired assets, underperformance against projected future operating results, and significant negative industry or economic trends. Any impairment losses recorded in the future could have a material adverse impact on our financial condition and results of operations for the periods in which such impairments occur.
During 2006 and 2007, we performed the required impairment tests on goodwill and intangibles with an indefinite useful life. Management judgment is required with respect to the identification of reporting units based on our internal reporting structure that reflects the way we manage our business or operations, assigning assets and liabilities to reporting units, and assigning goodwill to reporting units. Significant judgment is also required to estimate the fair value of reporting units including estimating future cash flows, determining appropriate discount rates, estimating the applicable tax rates, projecting future industry trends and market conditions, and making other assumptions. The use of different estimates and assumptions could materially affect the determination of fair value for each reporting unit. If we change our estimates and assumptions in the future based on changes in our overall business or in the manner or use of the acquired assets, underperformance against projected future operating results, or significant negative industry or economic trends, such changes might result in an impairment charge.
During 2006, the regulatory environment for the MVAS industry in China changed, and we believe that market conditions will continue to be challenging for the entire MVAS sector in the future. Since the onset of the regulatory changes, we have significantly reduced headcount and the marketing promotion expenses incurred for the MVAS business. In 2007, we explored various strategies to achieve long term growth. These strategies included: (i) continue to move further upstream into the content provider segment of the business; (ii) continue to launch popular mobile games; and (iii) develop mobile applications for enterprises and government offices in China.
However, as the regulatory environment for the MVAS industry continues to be difficult and we see no reasonable instance where our MVAS business may turn profitable in the foreseeable future, in February 2008, we announced that we were in the process of reducing the MVAS workforce and intended to scale down our emphasis on this business. Later in 2008, we made the determination that we were winding down the operations of the MVAS business and would discontinue this segment.
During 2006, we were not required to record any impairment. During 2007, we determined that all of the goodwill associated with our MVAS segment was impaired. Therefore, we wrote off all of the $71.1 million of goodwill that was assigned to this segment. See the Results of Operations section where this is discussed further.
We also annually review and adjust the carrying value of amortized intangible assets if facts and circumstances suggest they may be impaired. If this review indicates that amortized intangible assets may not be recoverable, as determined based on the undiscounted cash flows of the entity acquired over the remaining amortization period, the carrying value of intangible assets will be reduced by the estimated shortfall in discounted cash flows. Management judgment is required in the assessment of useful lives of amortized intangibles, and our estimates of future cash flows require judgment based on our historical and anticipated results and are subject to many factors including our assessment of the discount rate used and the amounts and timing of future cash flows. We performed the required impairment reviews during 2006 and 2007 and determined that we were required to record Nil and $2.4 million of impairment charges related to our MVAS segment, respectively (see the Results of Operations section where this is discussed further). The use of different estimates and assumptions might have resulted in an impairment charge, or might result in an impairment charge in the future. As of December 31, 2007, $124.7 million of our identifiable intangible assets were subject to amortization.
We have made a number of acquisitions and may make strategically important acquisitions in the future. When recording an acquisition, we allocate the purchase price of the acquired company to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. These allocations require us to make significant estimates and assumptions which include future expected cash flows from license sales and customer contracts and acquired technologies, discount rates, and assumptions regarding the period of time the acquired technology or customer relationships will continue. Such assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions and estimates.
In addition, acquired deferred revenue is recognized at fair value to the extent it represents a legal obligation assumed by us in accordance with EITF 01-03, Accounting in a Business Combination for Deferred Revenue of an Acquiree. We consider service contracts and post-contract customer support contracts to be legal obligations of the acquired entity. We estimate the fair value of acquired deferred revenue based on prices paid by willing participants in recent exchange transactions. Management judgment is also required in determining an appropriate fair value for deferred revenue. If the fair values we determined for deferred revenue acquired in prior years were lower, our revenue for the year would have been lower.
Capitalization of Software Costs
We capitalize computer software product development costs incurred in developing a product once technological feasibility has been established and until the product is available for general release to customers in accordance with SFAS No. 86, Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed. We evaluate realizability of the capitalized amounts based on expected revenue from the product over the remaining product life. Where future revenue streams are not expected to cover remaining unamortized amounts, we either accelerate amortization or expense the remaining capitalized amounts. Amortization of such costs is computed as the greater of the amount calculated based on (1) the ratio of current product revenue to projected current and future product revenue or (2) the straight-line basis over the expected economic life of the product (not to exceed five years). Software costs related to the development of new products incurred prior to establishing technological feasibility or after general release are expensed as incurred. When technological feasibility of the underlying software is not established until substantially all product development is completed, including the development of a working model, we expense the costs of such development because the impact of capitalizing such costs would not be material.
Management judgment is required with respect to the determination of technological feasibility and the determination of the expected product revenue used to assess realizability of the capitalized amounts. If we were to determine that technological feasibility occurs at a different stage of the process, we may capitalize more or less software development costs. If our assumptions about realizability were to change, our reported operating expenses could increase in the short-term by any amounts we write off. As of December 31, 2006 and 2007, capitalized software development costs were $20.9 million and $28.9 million, respectively, and related accumulated amortization totaled $4.5 million and $8.9 million, respectively.
Debt and equity investments designated as available-for-sale are stated at fair value. Unrealized holding gains or losses, net of tax, on available-for-sale securities are reported in accumulated other comprehensive income (loss) and as a separate component of shareholders equity. Realized gains and losses and any declines in fair value judged to be other-than-temporary on available-for-sale securities are included in gain (loss) on disposal and impairment, respectively, in our consolidated statements of operations. Gains or losses on the sale of investments and amounts reclassified from accumulated other comprehensive income (loss) to the statement of operations are computed based upon specific identification. Interest on securities classified as available-for-sale securities is included in interest income.
Debt investments, where we have the positive intent and ability to hold the securities to maturity, are designated as held to maturity securities and are stated at amortized cost.
When determining whether an impairment of investments exists or a decline in value of an available-for-sale security is other-than-temporary, we evaluate evidence to determine whether the realizable value is less than the current market price for the securities. Such information may include the investments financial performance, the near term prospects of the investment, the current and expected future financial condition of the investments issuer and industry, and our investment intent. Management judgment is required in determining fair value of investments, and in determining whether an impairment is other-than-temporary. The use of different estimates and assumptions could affect the determination of fair value for each investment, and could result in an impairment charge. For investments not actively traded, we review a variety of information including financial performance, comparisons to recently traded comparable securities, advice of investment professionals, and financial modeling to determine the fair market value as well as determine in the case of declines in value if the decline is an other than temporary decline in fair value.
All other equity investments for which we do not have the ability to exercise significant influence (generally, when we have an investment of less than 20% ownership and no representation on the companys board of directors) and for which there is not a readily determinable fair value, are accounted for using the cost method. Dividends and other distributions of earnings from equity investees or investments, if any, are included in income when declared. We periodically evaluate the carrying value of our investments accounted for under the cost method of accounting and any other than temporary impairment is included in the consolidated statement of operations. We wrote off $4.5 million of cost investments in 2007.
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), as modified by SFAS No. 149, Amendment of SFAS 133 on Derivative Instruments and Hedging Activities (SFAS 149), requires all contracts which meet the definition of a derivative to be recognized in our consolidated financial statements as either assets or liabilities and recorded at fair value. Changes in the fair value of derivative financial instruments are either recognized periodically in the consolidated statement of operations or in the consolidated statement of shareholders equity as a component of accumulated other comprehensive income (loss), depending on the use of the derivative and whether it qualifies for hedge accounting. Changes in fair values of derivatives not qualified as hedges are reported in the consolidated statement of operations. The estimated fair values of derivative instruments are determined at discrete points in time based on the relevant market information. These estimates are calculated with reference to the market rates using the industry standard valuation techniques.
Deferred Tax Valuation Allowance
We record a valuation allowance on our deferred tax assets in an amount that is sufficient to reduce the deferred tax assets to an amount that is more likely than not to be realized. In reaching this determination, we consider the future reversals of taxable temporary differences, future taxable income, exclusive of taxable temporary differences and carryforwards, taxable income in prior carryback years and tax planning strategies. As of December 31, 2006 and 2007, we have provided a valuation allowance of $59.0 million and $62.7 million against our net deferred tax assets. For our calendar year ended December 31, 2007, the valuation allowance increased by $3.7 million, which is the result of the tax effects of our operations as well as our determination of the amount that will be realized. A maximum of $41.7 million of the valuation allowance for which tax benefits are subsequently recognized will be allocated to reduce the goodwill. The portion of the change in the valuation allowance resulting in a decrease in goodwill principally relates to our recovery of deferred tax assets acquired in business combinations for which a valuation allowance was recorded at the time of acquisition.
On January 1, 2006, we adopted SFAS No. 123(R), Share Based Payment (SFAS 123(R)). Prior to January 1, 2006, we accounted for share-based employee compensation arrangements under the recognition and measurement principles of Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees (APB 25) and related Interpretations, and complied with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under APB 25, share compensation expense was recognized by utilizing the accelerated expense attribution method over the vesting period of the share options based on the difference, if any, between the fair value of the underlying shares at the date of grant and the exercise price of the share options.
Prior to the adoption of SFAS 123(R), cash flows resulting from the tax benefit related to equity-based compensation was required to be presented in the operating cash flows, along with other tax cash flows, in accordance with the provisions of EITF 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option, (EITF 00-15). SFAS 123(R) superseded EITF 00-15, amended SFAS No. 95, Statement of Cash Flows, and requires tax benefits relating to excess equity-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows.
We adopted SFAS 123(R) using the modified prospective method. SFAS 123(R) requires measurement of compensation cost for all share based awards at fair value on the date of grant and recognition of compensation over the service period for awards expected to vest. The recognized expense is net of expected forfeitures and the restatement of prior periods is not required.
The fair value of restricted shares is determined based on the number of shares granted and the quoted market price of our common shares. SFAS 123(R) did not change the accounting guidance for share-based payment transactions with parties other than employees as originally issued by EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (EITF 96-18). The fair value of options is determined using the Black-Scholes valuation model, which is consistent with the our valuation techniques previously utilized for options in footnote disclosures under Statement of SFAS 123, as amended by SFAS No. 148, Accounting for Stock Based Compensation Transition and Disclosure (SFAS 148). On March 29, 2005, the Securities
and Exchange Commission (SEC) published Staff Accounting Bulletin No. 107 (SAB 107), which provides the Staffs views on a variety of matters related to share based payments. SAB 107 requires that share based compensation be classified in the same expense line items as cash compensation.
Equity-based compensation expense recognized under SFAS 123(R) in the consolidated statements of operations for the years ended December 31, 2006 and 2007 was $7.7 million and $8.5 million, respectively. The estimated fair value of the Companys equity-based awards, less expected forfeitures, is amortized over the awards vesting period on a straight-line basis.
We regularly assess the estimated impact and probability of various uncertain events, or contingencies, and account for such events in accordance with SFAS No. 5, Accounting for Contingencies (SFAS 5). Under SFAS 5, contingent losses must be accrued if available information indicates it is probable that the loss has been or will be incurred given the likelihood of the uncertain event, and the amount of the loss can be reasonably estimated.
Management judgment is required in deciding the amount and timing of accrual of a contingency. For example, legal proceedings are inherently uncertain, and in order to determine the amount of any reserves required, we assess the likelihood of any adverse judgments or outcomes in pending and threatened litigation, as well as potential ranges of probable losses. As of December 31, 2007, we had $4.7 million accrued for legal fees and contingencies. A determination of the amount of loss accrual required for these contingencies is made after analysis of each individual matter. The amount of such accruals may change in the future due to changes in approach or new developments in each case.
Impact of Certain Recently Issued Accounting Standards
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments an Amendment of FASB Statements No. 133 and 140 (SFAS 155). SFAS 155 allows financial instruments that have embedded derivatives that otherwise would require bifurcation from the host to be accounted for as a whole, if the holder irrevocably elects to account for the whole instrument on a fair value basis. Subsequent changes in the fair value of the instrument would be recognized in earnings. The standard also clarifies which interest-only strips and principal-only strips are not subject to the requirement of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133); establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a Replacement of FASB Statement No. 125 (SFAS 140) to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued by us after January 1, 2007. SFAS 155 did not have an effect on our financial position or results of operations for the year ended December 31, 2007.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement (SFAS 157). SFAS 157 defines fair value, expands disclosures about fair value measurements, establishes a framework for measuring fair value in generally accepted accounting principles, and establishes a hierarchy that categorizes and prioritizes the sources to be used to estimate fair
value. We are required to adopt SFAS 157 effective January 1, 2008, on a prospective basis. In February, 2008, the FASB issued Financial Statement of Position No. 157-2, Partial Deferral of the Effective Date of Statement 157 (FSP 157-2). FSP 157-2 delays the effective date of SFAS 157, for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. We believe this standard will not have a material impact on our consolidated financial statements.
In September 2006, the SEC issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS 158). SFAS 158 requires the recognition of a plans overfunded or underfunded status as an asset or liability in the consolidated balance sheet and the recognition of changes in that funded status in the year in which the changes occur through comprehensive income. We settled our defined benefit plan obligations during 2006; therefore, SFAS 158 did not have an effect on our financial position, cash flows or results of operations for the year ended December 31, 2006 or 2007.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We believe this standard will not have a material impact on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (SFAS 141R), and SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements (SFAS 160). SFAS 141R requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. This standard also requires the fair value measurement of certain other assets and liabilities related to the acquisition, such as contingencies and research and development. SFAS 160 clarifies that a non-controlling interest in a subsidiary should be reported as equity in the consolidated financial statements. Consolidated net income should include the net income for both the parent and the non-controlling interest with disclosure of both amounts on the consolidated statement of income. The calculation of earnings per share will continue to be based on income amounts attributable to the parent. The effective date for both Statements is the beginning of fiscal year 2009. We have currently not determined the potential effects on our combined and consolidated financial statements.
In April 2007, the FASB issued FSP FIN No. 39-1, which amended FIN No. 39, Offsetting of Amounts Related to Certain Contracts an interpretation of APB Opinion No. 10 and FASB Statement No. 105 (FIN No. 39), to indicate that the following fair value amounts could be offset against each other if certain conditions of FIN No. 39 are otherwise met: (a) those recognized for derivative instruments executed with the same counterparty under a master netting arrangement and (b) those recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from the same master netting arrangement as the derivative instruments. In addition, a reporting entity is not precluded from offsetting the derivative instruments if it determines that the amount recognized upon payment or receipt of cash collateral is not a fair value amount. FSP FIN No. 39-1 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the effects of this statement on our consolidated financial position and results of operations for 2008.
In December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements an amendment of ARB No. 51 (SFAS 160). This statement applies to the accounting for non-controlling interests (previously referred to as minority interest) in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 requires non-controlling interests to be reported as a component of equity, which changes the accounting for transactions with non-controlling interest holders. The effective date for SFAS 160 is the beginning of fiscal year 2009. We have currently not determined the potential effects on our consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (SFAS 161). This statement is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entitys financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Management is currently evaluating the impact of adopting SFAS 161 on our consolidated financial statements.
In April 2008, the FASB issued FASB Staff Position No. 142-3, Determining the Useful Life of Intangible Assets (FSP 142-3). FSP 142-3 amends the factors to be considered in determining the useful life of intangible assets. Its intent is to improve the consistency between the useful life of an intangible asset and the period of expected cash flows used to measure its fair value. FSP 142-3 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the effect the implementation will have on our consolidated financial statements.
Results of Operations
The following table summarizes our historical results of operations in U.S. dollars and as percentages of total revenue for the years ended December 31, 2005, 2006 and 2007: