Viewtran Group, Inc. 10-Q 2006
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended March 31, 2006.
For the transition period from to .
Commission File Number 0-27436
Comtech Group, Inc.
(Exact name of registrant as specified in its charter)
Room 1001, Tower C, Skyworth Building
High-Tech Industrial Park
Nanshan, Shenzhen 5180, PRC
(Address of Principal Executive Offices including zip code)
(Registrants Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 filler ¨ Non-accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act). Yes ¨ No x
There were 31,991,213 shares of the Registrants Common Stock issued and outstanding on May 12, 2006.
Index to Form 10-Q
PART I - FINANCIAL INFORMATION
Unaudited Condensed Consolidated Balance Sheet
As of March 31, 2006 and December 31, 2005
See notes to condensed consolidated financial statements.
Unaudited Condensed Consolidated Statements of Operations
Three months ended March 31, 2006 and 2005
See notes to condensed consolidated financial statements.
Unaudited Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 2006 and 2005
See notes to condensed consolidated financial statements.
Note 1 - Basis Of Presentation
The accompanying unaudited condensed consolidated financial statements of Comtech Group, Inc., (formerly Trident Rowan Group Inc, (the Parent or the Registrant)) and its subsidiaries (together, we, us or our)) have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles have been condensed or omitted. For a summary of our accounting principles, and other footnote information, reference is made to the Registrants audited consolidated financial statements for the years ended December 31, 2003, 2004 and 2005 included in our Annual Report on Form 10-K (the 10-K) filed with the Securities and Exchange Commission on March 28, 2006. The accompanying unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes included in the 10-K. All adjustments necessary for the fair presentation of the results of operations for the interim periods covered by this report have been included. All such adjustments are of a normal and recurring nature. The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the operating results for the full year.
The accompanying unaudited condensed consolidated financial statements are expressed in Renminbi (RMB), the national currency of the Peoples Republic of China (the PRC). Solely for the convenience of the reader, the March 31, 2006 unaudited condensed consolidated financial statements have been translated into United States dollars (USD or $) at the closing rate in New York City on March 31, 2006 for cable transfers in RMB as certified for customers purposes by the Federal Reserve Bank of New York of USD 1.00 = RMB 8.0167. No representation is made that the RMB could have been, or could be, converted into USD at that rate or at any other certain rate on March 31, 2006, or at any other certain date.
The value of the RMB is subject to changes in the PRCs central government policies and to international economic and political developments affecting supply and demand in the China Foreign Exchange Trading System market. Since 1994, the conversion of RMB into foreign currencies, including USD, has been based on rates set by the Peoples Bank of China, which are set daily based on the previous days interbank foreign exchange market rates and current exchange rates on the world financial markets. Since 1994, the official exchange rate generally has been stable, but the Chinese government recently announced in July 2005 that it will no longer peg its currency exclusively to the USD but will switch to a managed floating exchange rate based on market supply and demand with reference to a basket of currencies yet to be named by the Peoples Bank of China, which will likely increase the volatility of RMB as compared to USD.
Note 2 - Organization And Nature Of Business
The Company provides over 500 customized module design solutions and product lines integrating components from many suppliers to various manufacturers in the mobile handset and telecommunications equipment industries in the PRC and other overseas countries.
Mr. Jeffrey Kang, our principal shareholder and chief executive officer, directly or through entities he controls, currently has a controlling interest in us. Mr. Kang thus has the ability to control the outcome of all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets.
Acquisitions and Newly Formed Subsidiaries
On January 11, 2006, we entered into an agreement to invest in 51.12% of Huameng Engineering Services Ltd. (Huameng BVI), a British Virgin Islands investment holding company, for a cash consideration of RMB44 thousand ($5 thousand). In connection with our investment in Huameng BVI, Huameng BVI subsequently acquired 100% in Huameng Software (Shenzhen) Co, Ltd. (Huameng PRC), a PRC company, for RMB6,769 thousand ($844 thousand) payable in cash. Huameng PRC is engaged in the provision of technology and engineering services, business process outsourcing, network system integration and related training and maintenance services.
The table below summarizes the preliminary purchase price allocation of the aggregate assets acquired and liabilities assumed in connection with the acquisition of Huameng PRC that was consummated during the three months ended March 31, 2006.
Note 3 - Summary Of Principal Accounting Policies
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP).
Sales of components
Sales of components for telecommunication system equipment, mobile handset, network protection devices and data storage are recognized when title transfers, the risks and rewards of ownership have been transferred to the customer, the fee is fixed and determinable, and collection of the related receivable is probable, which is generally at the time of shipment.
Sales of services
Provision of technology and engineering services, business process outsourcing, network system integration and related training and maintenance services are recognized as revenue when the services are rendered.
Revenue is recorded net of value added tax incurred. Such value added taxes amounted to RMB14,822 thousand ($1,849 thousand) and RMB21,594 thousand, for the quarter ended March 31, 2006 and 2005, respectively.
Recently Issued Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R), which addresses the accounting for transactions in which an entity exchanges its equity instruments for goods or services, with a primary focus on transactions in which an entity obtains employee services in share-based payment transactions. This Statement is a revision to Statement 123 and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. This Statement will require measurement of the cost of employee services received in exchange for stock compensation based on the grant-date fair value of the employee stock options. Incremental compensation cost arising from subsequent modifications of awards after the grant date must be recognized. We adopted this Statement with effect from January 1, 2006 under the modified prospective method of application (see note 5). Under that method, we recognize compensation costs for new grants of share-based awards, awards modified after the effect date, and the remaining portion of the fair value of the unvested awards at the adoption date.
In December 2004, the FASB issued FASB Statement No. 151, Inventory Costs An Amendment of ARB No. 43, Chapter 4 (SFAS No. 151). SFAS No. 151 clarifies that abnormal amounts of idle facility expenses, freight, handling costs and spoilage should be expensed as incurred and not included in inventory cost as a component of overhead. Further, SFAS No. 151 requires that the allocation of fixed and production facilities overhead to conversion costs should be based on normal capacity of the production facilities. The provisions in SFAS No. 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 had no significant impact on our financial position or results of operations.
In May 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections (SFAS No. 143). SFAS No. 154 establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to a newly adopted accounting principle. This statement will be effective for us for all accounting changes and any error corrections occurring after January 1, 2006. The Company did not have any changes in accounting principle other than the adoption of SFAS No. 123R discussed above, which has its own adoption transition provision and is therefore not in the scope of SFAS No. 154. As a result, the adoption of SFAS No. 154 does not have a material impact on our financial position or results of operations. The impact on the consolidated financial statements will depend on new pronouncements that are subsequently issued.
Note 4 - Financing Arrangements
Certain of our customers enter into arrangements with their respective banks for purposes of settling their bills. Under such arrangements, we are entitled to collect the amounts owed directly from the customers banks when the invoice becomes due. These amounts are recorded as bills receivable on the consolidated balance sheets. We, in certain circumstances, have arranged to transfer with recourse certain of our bills receivable to our bank. Under this discounting arrangement, the bank pays in advance a discounted amount to us and collects the amounts owed from the customers banks on the due date. The discount typically ranges between 0.6% to 0.9% of the balance transferred, which is recorded as interest expense. As of March 31, 2006 and 2005, we had discounted bills receivable amounting to approximately RMB4,829 thousand ($602 thousand) and RMB10,878 thousand, respectively.
Note 5 - Stock-Based Compensation
In 1995, the Parent Board of Directors adopted, and the stockholders approved, the 1995 Stock Option Plan for Outside Directors (the Directors Plan), pursuant to which 5 thousand options would be granted annually to each non-employee director of Parent for each full fiscal year of service on the Board. As part of the share exchange transaction with Parent in July 2004, the Company assumed fully vested options under the Directors Plan to purchase 115 thousand shares of the Companys common stock. In addition to the options under the Directors Plan, the Company also assumed 925,417 fully exercisable common stock warrants. Each warrant represents the right to receive 1 share of the Companys common stock. The Directors Plan expired on December 31, 2005 while the options exercisable under the Directors Plan will terminate on July 1 2009. The Company does not intend to issue any additional options under the Directors Plan.
On August 3, 2004, the Board of Directors adopted the Comtech Group, Inc. 2004 Stock Incentive Plan (the Incentive Plan) pursuant to which 2,500 thousand shares of common stock are reserved for issuance upon exercise of stock options, and for the issuance of stock appreciation rights, restricted stock awards and performance shares. As at March 31, 2006, 142 thousand shares (December 31, 2005: 142 thousand shares) of common stock are remaining available for future issuance under the Incentive Plan. The purpose of the Incentive Plan is to provide additional incentive to employees, directors, advisors and consultants by facilitating their acquisition of the Companys common stock. The Incentive Plan provides for a term of 10 years from the date of its adoption by the Board of Directors, after which no awards may be made, unless the Incentive Plan is early terminated by the Board. Options granted under the Incentive Plan are either incentive stock options (i.e. options that afford favorable tax treatment to recipients upon compliance with certain restriction pursuant to Section 422 of the Internal Revenue Code and that do not result in tax deductions to participants unless they fail to comply with Section 422 of the Internal Revenue Code) or options that do no so qualify.
The Directors Plan and the Incentive Plan are administered by the Compensation Committee of the Board of Directors. The Compensation Committee selects the employees to whom awards are to be granted, the number of shares to be subject to such awards, and the terms and conditions of such awards (provided that any discretion exercised by the Compensation Committee must be consistent with resolutions adopted by the Board of Directors and the terms of the Incentive Plan).
Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment (SFAS No. 123R). SFAS No.123R supersedes our previous accounting under Accounting Principles Board Opinion No.25, Accounting for Stock issued to Employees (APB 25), for periods beginning in fiscal 2006. Under APB 25, we accounted for stock options under the intrinsic value method. Accordingly, we did not recognize expense related to employee stock options because the exercise price of such options equaled the fair value of the underlying stock on the grant date. We previously disclosed the fair value of its stock options under the provisions of Statement of Financial Accounting Standards No. 23, Accounting for Stock Based Compensation (SFAS No. 123).
We adopted SFAS No. 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day our fiscal year 2006.
The following table presents details of stock-based compensation expense by functional line item:
The amounts included in the three months ended March 31, 2006 reflect the adoption of SFAS No. 123R. In accordance with the modified prospective transition method, our unaudited condensed consolidated statements of operations for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123R.
Under SFAS No. 123R, we recognized RMB2,151 thousand ($268 thousand) of compensation expense related to stock options in the three months ended March 31, 2006. No options were granted in the three months March 31, 2006.
Stock options activity for the three months ended March 31, 2006 was as follows:
At March 31, 2006, 142 thousand shares were available for future grants under the terms of these plans.
At March 31, 2006, we had approximately RMB15,829 thousand ($1,974 thousand) of total unrecognized compensation expense, net of estimated forfeitures, related to stock option plans that will be recognized over the weighted average period of approximately 1.8 years. Cash received from stock option exercises was approximately RMB11,492 thousand ($1,434 thousand) during the three months ended March 31, 2006.
In addition to the options, warrants were also granted. Each warrant represents the right to receive 1 share of our common stock. Stock warrants activity for the three months ended March 31, 2006 was as follows:
Restricted stock (RS) consists of shares of our common stock which are awarded to employees. The grants are restricted such that they are subject to substantial risk of forfeiture and to restrictions on their sale or other transfer by the employee. Upon the occurrence of a change in control, the restrictions on all shares of RS outstanding on the date on which the change in control occurs will lapse.
A summary of changes in RS balance during the quarter ended March 31, 2006 is presented below:
At March 31, 2006, we had approximately RMB3,965 thousand ($495 thousand) of total unrecognized compensation expense related to RS grants that will be recognized over the weighted average period of 1.2 years. We recognized RMB248 thousand ($31 thousand) of expense related to RS during the quarter ended March 31, 2006.
In accordance with the requirements of the disclosure-only alternative of SFAS No. 123, set forth below is a pro forma illustration of the effect on net income and net income per share computed as if we had valued stock-based awards to employees using the Black-Scholes option pricing model instead of applying the guidelines provided by APB 25 in the three months ended March 31, 2005:
The weighted average fair value of options granted for our common stock in the three month period ended March 31, 2005 were RMB13.41 per share respectively, using the Black-Scholes option-pricing model based on the following assumptions:
We used a blended volatility rate using a combination of historical stock price volatility and market implied volatility in accordance with SFAS No. 123 for purposes of its pro forma information. The risk-free interest rate assumption is based upon the average daily closing rates during the quarter for U.S. treasury notes that have a life which approximates the expected life of the option. The dividend yield assumption is based on our history and expectation of dividend payouts. The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding. These expected life assumptions are established through the review of annual historical employee exercise behavior of option grants with similar vesting periods. Prior to 2006, the Company used the actual forfeiture method allowed under SFAS No. 123, which assumed that all options would vest and pro forma expense was adjusted when options were forfeited prior to the vesting dates. In applying SFAS No. 123R, we estimated that the forfeiture rate approximated zero percent as there were no history of significant forfeiture and we expect our future forfeiture to be minimal. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
Note 6 - Earnings Per Share
Basic earnings per share are computed by dividing net income by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share are computed by dividing net income by the sum of (a) the weighted average number of shares of common stock outstanding during the period
and (b) the dilutive effect of potential common stock equivalents during the period. The weighted average number of shares used for the computation of diluted earnings per share is as follows:
Note 7: Operating Segment Information
As part of our strategy to expand our business from providing customized design solutions and selling components to a more comprehensive organization providing engineering services and business services to our existing customer base, we acquired Huameng PRC in January, 2006 (see note 2). Huameng PRC, is an emerging provider of technology, engineering and business services to established telecommunication equipment vendors in the PRC.
Apart from the previously reported Component Solutions as a reportable operating segment, Engineering Services became a second reportable operating segment in the three month period ended March 31, 2006 due to the acquisition of Huameng PRC.
Component Solutions operating segment products include the sale of mobile handset components, telecommunication system equipment, consumer electronics and other components (such as network protection devices and data storage components). Engineering Services operating segment include the provision of technology and engineering services, business process outsourcing, network system integration and related training and maintenance services. There is no inter-segment revenue during the periods reported.
Segment information is summarized as follows:
Note 8: Comprehensive income
A reconciliation of net income to comprehensive income is presented in the table below.
Portions of the discussion and analysis below contain certain statements that are not descriptions of historical facts, but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. These forward-looking statements may include statements about our plans and objectives for future expansion, including into our new digital consumer electronic and storage solution products; expectations for the domestic wireless handset, telecommunications equipment, consumer electronic and storage solution end-markets in the PRC; anticipated margins for our solutions; general and cyclical economic and business conditions, and, in particular, those in the PRCs wireless handset, telecommunications equipment and consumer electronics industries; our ability to enter into and renew key corporate and strategic relationships with our customers and suppliers; changes in the favorable tax incentives enjoyed by our PRC operating companies; and other statements containing forward looking terminology such as may, expects, believes, anticipates, intends, projects, looking forward or similar terms, variations of such terms or the negative of such terms. Such information is based upon various assumptions made by, and expectations of, our management that were reasonable when made but may prove to be incorrect. All of such assumptions are inherently subject to uncertainties and contingencies beyond our control and upon assumptions with respect to future business decisions which are subject to change. Accordingly, there can be no assurance that actual results will meet expectations and actual results may vary (perhaps materially) from certain of the results anticipated herein. For a further description of these and other risks and uncertainties, see our most recent Annual Report filed with the Securities and Exchange Commission (SEC) on Form 10-K, and our subsequent SEC filings. The following discussion of our financial condition and results of operations
should also be read in conjunction with our unaudited condensed consolidated financial statements and the notes to those financial statements appearing elsewhere in this Form 10-Q.
We operate primarily in two distinct business segments: (i) providing customized module design solutions in the PRC (Component Solutions) and (ii) providing technology and engineering services, business process outsourcing, network system integration and related training and maintenance services (Engineering Services). We historically have focused our Component Solutions business on the mobile handset and telecommunications equipment end-markets, but have recently expanded our market scope to include the consumer electronics end-market. We work closely with leading manufacturers in these end-markets to develop solutions to meet their needs for customized module designs. Our customized module design solutions allow our customers to use enabling technology components from established technology component suppliers in a timely and cost-effective manner, reducing their time-to-market and lowering their overall costs. Over the last three years, we have worked with over 200 customers, including a majority of the largest and best-known manufacturers in the mobile handset and telecommunications equipment end-markets in the PRC. In addition to these original equipment manufacturers (OEMs), our other customers include industry participants which support these OEMs, such as subsystem designers and manufacturers. In developing customized module design solutions for use in our customers products, we work closely with over 30 suppliers of enabling technology components, including many large multinational companies such as Broadcom, JDS Uniphase and Matsushita. On January 11, 2006, our wholly owned subsidiary Comtech Cayman acquired a 51.12% interest in Huameng Engineering Services Co. Ltd., which in turn subsequently acquired Shenzhen Huameng Software Co. Ltd. (Huameng PRC). As a result of this acquisition, we have entered and expect to expand our Engineering Services business in the provision of technology and engineering services, business process outsourcing, network system integration and related training and maintenance services.
Principal Factors Affecting Our Results Of Operations
The major factors affecting our results of operations and financial condition include:
Revenue mix. Our net revenue and gross profit are affected by our product mix. Over the last two years, consumer electronics module related sales, which have higher profit margins than our mobile handset and telecom equipment modules related sales, have increasingly constituted a significantly greater portion of our total net revenue. Starting from the first quarter of 2006 after the acquisition of Huameng PRC, total net revenue will be expected to continuously grow and total gross margin will be expected to increase.
Growth in end-market industries. The rapid growth of the domestic mobile handset, telecommunications equipment and consumer electronics products end-markets have been important drivers of growth of the PRCs electronics manufacturing industries. Specific business areas that we expect to continue growing are data communications, consisting of asymmetric digital subscriber line (ADSL) modems and Voice over Internet Protocol (VoIP) equipment; the routers and network security equipment segments; the optical transmission systems; and the line telecommunications network. The growth in these markets have driven, and we believe will continue to drive, growth in the electronics manufacturing businesses supporting hardware OEMs, including those engaged in the customized design of module solutions such as ourselves. However, these industries and the respective domestic manufacturers that operate in these industries may not continue to grow their sales at historical levels, if at all. The stagnation or reduction in overall demand for mobile handset and telecommunications equipment products would materially affect our results of operations.
Increase in exports. We believe that the development of a highly-skilled, low-cost manufacturing base has also enabled the PRCs domestic mobile handset and telecommunications equipment manufacturers to be competitive in the global marketplace. As an example, Huawei has become a major supplier of telecommunications equipment to international customers, while ZTE, a major manufacturer of mobile handset and telecommunications equipment in the PRC, as well as other telecommunications equipment and mobile handset manufacturers, have also begun to expand overseas. We believe that growth in the export market will likely have a positive effect on our results of operations and financial condition, as it should increase the demand for our solutions, particularly among our mobile handset clients.
Growth by entering new end-markets, strengthening in-house capabilities and leveraging our customer base. We recently began targeting the consumer electronics end-market and, over time, we intend to develop integrated circuit and application software design capabilities and provide solutions based on our own proprietary technology. We anticipate that sales related to the consumer electronics end-market that we recently entered will initially have higher profit margins than our mobile handset and telecommunications equipment modules related sales, though such higher margins may decline over time as the industry matures. Our success in the consumer electronics end-market will depend, in significant part, on our ability to leverage our existing customer base. We expect to incur significant research and development expenses, through hiring additional engineering personnel to develop new solutions and expanding our intellectual property and technological capabilities, to meet the needs of our customers that have expanded into or are expected to expand into the consumer electronics end-market.
Demand for engineering services. We have begun providing engineering services to our customers and generating recurring engineering service revenue. Many of our existing customers have been outsourcing engineering functions, we expect to build and expand our engineering services platform to capitalize on this potential market, both in technical areas such as wireless business services and geographic regions such as southeast Asia countries to accommodate this growth.
We provide module design solutions to our customers free of charge and generate revenue when our customers purchase from us certain specific components required in our module designs. Our net revenue is revenue net of a 17% value-added tax, or VAT.
Over the last three years, we have worked with over 200 customers. In addition to many of the largest China-based manufacturers of mobile handsets, telecommunications equipment and consumer electronics products, our customers include industry participants supporting these OEMs, such as subsystem designers and manufacturers in China, as well as international manufacturers who have begun to manufacture end-products in China for the domestic and international market.
We provide technology and engineering services, business process outsourcing, network system integration and related training and maintenance services to our customers and generate revenue when our services are rendered and acknowledged by our customers.
Cost Of Revenue
Cost of revenue for sales of component solutions primarily consists of the purchase of components from suppliers. We develop our customized module design solutions based on specific enabling technology components purchased from key and other suppliers in our target end-markets. Our list of over 30 key suppliers includes Broadcom (DTV), JDS Uniphase (optoelectronic components), M-Systems (Flash memory, DiskOnChip), Matsushita (switches), NAIS (connectors, Relay) and Sambu (speakers). We typically issue purchase orders to our suppliers only after we receive customer orders, enabling us to maintain low inventory levels and, in turn, minimize risks typically associated with holding inventory. If we lose a key supplier, or a supplier reduces the quantity of products it sells to us, does not maintain a sufficient inventory level of products required by us or is otherwise unable to meet our demands for its components, we may have to expend significant time, effort and other resources to locate a suitable alternative supplier and secure replacement components. Even if we are able to find a replacement supplier, we may be required to redevelop the customized module design solution to effectively incorporate the replacement components.
Cost of revenue for the provision of engineering services primarily comprises of direct staff costs and other direct related costs for training.
Selling, general and administrative expenses
Our selling expenses include expenditures to promote our new module solutions and gain a larger customer base, personnel expenses and travel and entertainment costs related to sales and marketing activities, and freight charges. We expense all these expenses as they are incurred. Selling expenses are expected to continue to grow in the future as we diversify by developing and acquiring new design capabilities and expanding into new end-markets.
General and administrative expenses include compensation and benefits for our general and administrative staff, professional fees, and general travel and entertainment costs. We expense all general and administrative expenses as they are incurred. We expect that general and administrative expenses will continue to increase for the foreseeable future as a result of our expected continued growth and the increased costs of complying with U.S. rules and regulations necessary to maintain our listing in the United States and comply with Section 404 of the Sarbanes-Oxley Act of 2002.
Research and development expenses
Research and development expenses consist primarily of salaries and related costs of the employees engaged in research, design and development activities; the costs for design and testing; the cost of parts for prototypes; equipment depreciation; and third party development expenses. We expense research and development expenses as they are incurred. As of March 31, 2006, we had over 300 engineers and other technical employees engaged in research and development related activities to develop new customized module design solutions targeted at the mobile handset, telecommunications equipment and consumer electronics industries. Research and development expenses were significantly higher in the first quarter of 2006 than they were in the same period of 2005, and we expect that our research and development expenses, including those relating to the planned hiring of additional research and development personnel, will increase in the future as we seek to expand our business by developing new customized module design solutions and penetrating new end-markets such as consumer electronics.
We are a holding company incorporated in the State of Maryland and conduct substantially all our operations through our PRC operating companies. Although we are subject to United States taxation, we do not anticipate incurring significant United States income tax liability for the foreseeable future because:
Our subsidiaries that are incorporated in the Cayman Islands and the British Virgin Islands are not subject to income taxes in those jurisdictions.
The usual statutory tax rate applicable to PRC companies is 33%, while the statutory tax rate applicable to PRC companies in the Shenzhen Special Economic Zone in China is 15%. Since three of our PRC operating companies, Shenzhen Comtech, Comtech Communication and Comtech Software, are established in the Shenzhen Special Economic Zone and have agreed to operate for a minimum of ten years in China, Shenzhen Comtech was and Comtech Communication and Comtech Software have been and will continue to be, entitled to preferential income tax treatment under PRC law as follows:
Following expiration of the preferential tax treatment described above, our PRC operating companies located in the Shenzhen Special Economic Zone will be subject to the statutory tax rate of 15%. In addition, Shanghai E&T, our PRC operating company located in the Shanghai Qingpu Zone, has elected to be taxed on a deemed basis at 0.5% of its net revenue in accordance with guidelines issued by the local tax authority in the Shanghai Qingpu Zone in 2004.
As a result of the incentives above, our operations have been subject to relatively low tax liabilities. Our effective tax rate for the first quarter of 2006 was 10.3% whereas that for the same period of 2005 was 8.2%. Our increase in the effective tax rate was mostly due to the passage of the preferential income tax period for Shenzhen Comtech and Comtech Communication, and the profit derived from other non-PRC operating subsidiaries where the statutory tax rates are higher.
Three months ended March 31, 2006 compared to three months ended March 31, 2005
We have two reportable operating segments: Component Solutions, for which we provide customized module design solutions in the PRC focusing primarily on the mobile handset, telecommunications equipment and consumer electronics end-markets, and Engineering Services for which we provide technology and engineering services, business process outsourcing, network system integration and related training and maintenance services.
The following table sets forth information regarding the breakdown of revenues and income from operations between our Component Solutions segment and Engineering Services segment for the three months ended March 31:
Total net revenue increased RMB99,726 thousand, or 58.0% in the first quarter of 2006 when compared to the first quarter of 2005. The increase was mainly contributed by an increase in Component Solutions sales by approximately RMB92 million. Total income from operations increased RMB15,223 thousand, or 82.8% in the first quarter of 2006 when compared to the first quarter of 2005. The increase was mainly due to higher net revenues and gross margins from all business markets, and partly offset by increases in operating expenses.
Overall gross margin amount was RMB52,033 thousand in the first quarter 2006, an increase of RMB25,748 thousand, or 98% when compared to RMB26,285 thousand in the first quarter of 2005. Overall gross margin percentage was 19.1% in the first quarter of 2006, as compared to 15.3% in the first quarter of 2005. The increase in both gross margin amount and percentage is primarily attributed to a change in product mix. Consumer electronics components sales have a higher average margin (20% to 30%) than the mobile handset and telecommunications sales. In addition, the provision for the new engineering services in the first quarter of 2006, in which its gross margin approximated 48%, also contributed to the increase in overall gross margin.
Net revenue and income from operations for Component Solutions for the quarters ended March 31, 2006 and 2005 were as follows:
Component Solutions net revenue increased RMB91,821 thousand, or 53.4% in the first quarter of 2006 when compared to the first quarter of 2005. The increase was primarily due to the higher revenue from the sales of consumer electronics components, which increased more than RMB40 million, as well as the continued growth in the sales of both mobile handset and telecommunications equipment components, which increased revenue by RMB17.6 million and RMB33.5 million respectively
The increase in mobile handset and telecommunications equipment component sales were due to the stable growth in both the customer base and product types in the first quarter of 2006 when compared to the first quarter of 2005. The increase in consumer electronics and other components sales was due to more variety of products introduced since the latter half of 2005, such as digital TV products.
Component Solutions income from operations increased RMB11,915 thousand, or 64.8% in the first quarter of 2006 when compared to the first quarter of 2005. The increase was mainly attributed to a significant increase in net revenue from all products in the Component Solutions segment, and the higher gross margin of Component Solutions products. This increase in income from operations was partly offset by an increase in operating expenses, which resulted from an increase in cost for higher sales volumes, and for additional offices and employees.
Net revenue and income from operations for Engineering Services for the quarters ended March 31, 2006 and 2005 were as follows:
Engineering Services net revenue and income from operations were derived from the provision of technology and engineering services, business process outsourcing, network system integration and related training and maintenance services after the acquisition of the Huameng PRC in January 2006.
Selling, R&D, general and administrative expenses
Selling, research and development, and general and administrative expenses of RMB18,459 thousand were RMB10,565 thousand or 133.8% higher than those of the same period last year. The details of the expenses for the three month period ended March 31 are as follows:
The increase in the selling expenses by RMB4,375 thousand or approximately 222.8% was mainly attributed to an increase in sales staff costs of RMB1,051 thousand, additional costs of RMB408 thousand associated with product logistics and transportation, additional bad debt provision of approximately RMB1,200 thousand, and an increase in other indirect selling expenses by approximately RMB1,700 thousand.
Research and development expenses increased by RMB5,815 thousand or approximately 451.8%. The increase was primarily attributable to a significant increase in research and development personnel and engineers, in which the related staff costs were increased by RMB3,381 thousand, an increase in research and development facilities and related costs of RMB993 thousand, and expenditures of approximately RMB1,400 thousand related to research for potential markets.
The increase in general and administrative expenses of RMB375 thousand or approximately 8.1% was mainly attributable to an increase in group professional fees and corporate administrative expenses by RMB2,052 thousand and partly offset by a net exchange gain of approximately RMB1,676 thousand as a result of RMB appreciation against other currencies.
Interest expense in the first quarter of 2006 amounted to RMB412 thousand as compared to RMB393 thousand in the same period of 2005. The slight increase in interest expense was attributable to the increase in the average balance of bank borrowings. The average interest rate applicable to the bank borrowings for the both quarters ended March 31, 2006 and 2005 was approximately 5%.
Interest income in the first quarter of 2006 amounted to RMB2,084 thousand, compared to RMB29 thousand in the same period of 2005. The significant increase was attributed to higher average deposit balances resulting from the proceeds received in the public offering in July 2005 and net cash inflows generated from operations during the period.
The effective tax rate for the three months ended March 31, 2006 was 10.3% compared to 8.2% for the comparable period in 2005. The increase in the effective tax rate is mostly due to the expiration of the preferential tax period for two of our subsidiaries, Shenzhen Comtech and Comtech Communication, and the profit generated from other non-PRC operating subsidiaries where the statutory tax rates are higher.
As a result of the above items, net income for the quarter ended March 31, 2006 was RMB26,225 thousand compared to a net income of RMB15,811 thousand in the corresponding period of 2005. Included in the first quarter 2006 net income was an amount of RMB2,399 thousand ($299 thousand) for share-based compensation cost as a result of the adoption of SFAS 123R, effective January 1, 2006.
Earnings per share
We reported basic per share earnings of RMB0.83 for the first quarter of 2006 based on 31,668,368 outstanding weighted average shares and diluted per share earnings of RMB0.79 based on 33,262,247
outstanding weighted average shares and potential common stock equivalents, compared to basic per share earnings of RMB0.62 for the same period of 2005, based on 25,381,853 outstanding weighted average shares, and diluted per share earnings of RMB0.59 based on 26,871,865 outstanding weighted average shares and potential common stock equivalents.
Liquidity and Capital Resources
Cash flows and working capital
Our accounts payable cycle typically averages approximately one month, whereas our receivables cycle typically averages approximately three months. Accordingly, additional working capital is needed to fund this time difference.
As at March 31, 2006, we had no material commitments for capital expenditures.
We regularly review our cash funding requirements and attempt to meet those requirements through a combination of cash on hand, cash provided by operations, and available borrowings under bank lines of credit and factoring facilities. At times, we may evaluate possible acquisitions of, or investments in, businesses that are complementary to ours, which may require the use of cash. We believe that our existing cash position, operating cash flows and credit facility arrangements, taken together, provide adequate resources to fund our ongoing operating expenditures for the next 12 months. In the event that they do not, we may require additional funds in the future to support our working capital requirements or for other purposes and may seek to raise such additional funds through the sale of public or private equity, as well as from other sources.
As of March 31, 2006, we had working capital of RMB548,436 thousand as compared with working capital of RMB507,349 thousand at December 31, 2005.
Cash used in operating activities of RMB4,416 thousand for the three months ended March 31, 2006 compared to cash provided of RMB22,275 thousand in the corresponding period of 2005. Cash used in operating activities as compared to prior year is primarily due to an increase in trade accounts receivable of RMB25,873 thousand and a decrease in trade accounts payable of RMB30,238 thousand. Trade accounts receivable increased due to a higher proportion of sales occurring at the end of the first quarter of 2006. Trade accounts payable decreased due to the timing of supplier payments. Cash used in operating activities was partly off-set by net income of RMB26,225 thousand and a decrease in inventory of RMB24,709 thousand which was due to tight purchasing control. Cash used in investing activities of RMB4,178 thousand during the first quarter of 2006 was mainly for purchases of fixed assets of RMB2,378 thousand and acquisition of subsidiary, net of cash acquired, of RMB1,847 thousand.
Net cash provided by financing activities was RMB19,950 thousand during the first quarter of 2006. The financing net cash inflows were mainly contributed by net proceeds for exercises of stock options of approximately RMB11,492 thousand and proceeds of net bank borrowings of RMB8,458 thousand.
On October 7, 2005, Comtech Hong Kong entered into a RMB40,084 thousand ($5,000 thousand) U.S. dollar denominated credit facility with Standard Chartered Bank (Hong Kong) Limited (SCB), and a RMB72,150 thousand ($9,000 thousand) U.S. dollar denominated facility with Bank of China (BOC). Both of the SCB and BOC facilities are guaranteed by Comtech Group, Inc. Apart from cash generated from operations, these revolving credit facilities serve as our principal source of liquidity to fund our working capital needs.
As of the date of this filing, there was no outstanding loan balance under the SCB facility. This facility is secured by funds on deposit in an amount of $2,000,000, and bears interest ranging from HIBOR +1.5% to USD Prime per annum, depending on the different kinds of borrowings made. The SCB facility is repayable on demand and SCB may immediately terminate the facility without our consent or that of any third party. Interest on this facility accrues until payment is demanded by SCB.
As of the date of this filing, the outstanding loan balance under the BOC facility was RMB39,113 thousand ($4,879 thousand), leaving RMB33,037 thousand ($4,121 thousand) in availability. This facility is secured by funds on deposit in an amount of $3,000,000, and bears interest from LIBOR plus 2% to 2.25% per annum, depending on the different kinds of borrowings made. The BOC facility is repayable on demand and BOC may increase, reduce and/or cancel the facility by notice to us. Interest on this facility accrues until payment is demanded by BOC.
Bills receivable. Some of our customers enter into arrangements with their respective banks for the purpose of settling their bills. Under such arrangements, we are entitled to collect the amounts owed directly from the customers banks when the invoice becomes due. These amounts are recorded as bills receivable on our consolidated balance sheet. In certain circumstances, we have arranged to transfer with recourse certain of our bills receivable to the bank. Under this discounting arrangement, the bank pays a discounted amount to us and collects the amounts owed from the customers banks. The discount typically ranges from 0.6% to 0.9% of the balance transferred, which is recorded as interest expense. As of March 31, 2006, we had discounted bills receivable amounting to approximately RMB4,829 thousand ($602 thousand).
Future liquidity needs
As of March 31, 2006, the Company had approximately RMB187,073 thousand ($23,336) in cash and cash equivalents. We regularly review our cash funding requirements and attempt to meet those requirements through a combination of cash on hand, cash provided by operations and available borrowings under bank lines of credit. At times, we evaluate possible acquisitions of, or investments in, businesses that are complementary to those of ours, which transactions may require the use of cash. We believe that our cash, other liquid assets, operating cash flows and credit facility arrangements, taken together, provide adequate resources to fund ongoing operating expenditures. In the event that they do not, we may require additional funds in the future to support our working capital requirements or for other purposes and may seek to raise such additional funds through the sale of public or private equity as well as from other sources.
Critical Accounting Policies
The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenue and expenses. These estimates are based on our historical experience and on various other assumptions that we believe to be reasonable. Estimates are evaluated on an ongoing basis, but actual results may differ from these estimates.
Critical accounting policies are those that, in managements view, are most important in the portrayal of our financial condition and results of operations. Those that require significant judgments and estimates include:
Revenue recognition. Revenue, net of VAT, from sales related to our customized module design solutions are recognized when title transfers, the risks and rewards of ownership have been transferred to the
customer, the fee is fixed and determinable, and collection of the related receivable is probable, which is generally at the time of shipment. Provision of technology and engineering services, business process outsourcing, network system integration and related training and maintenance services are recognized as revenue when the services are rendered.
Allowance for doubtful accounts. We establish an allowance for doubtful accounts primarily based upon the age of receivables and factors surrounding the credit risk of specific customers. We generally do not require collateral or other security from our customers. As of March 31, 2006, our accounts receivable balance was RMB299,186 thousand ($37,320 thousand), net of a RMB8,695 thousand ($1,085 thousand) allowance for doubtful accounts. As our business grows, we expect our accounts receivable balances to increase, as could our allowance for doubtful accounts. If the financial condition of our customers deteriorates, our uncollectible account receivables could exceed our current or future allowances.
Foreign exchange risk
The functional currency of our major operating entities is the Renminbi (RMB). Transactions in other currencies are recorded in RMB at the rates of exchange prevailing when the transactions occur. Monetary assets and liabilities denominated in other currencies are remeasured into RMB at rates of exchange in effect at the balance sheet dates. Exchange gains and losses are recorded in our statements of operations as a component of current period earnings.
The PRC State Administration for Foreign Exchange, under the authority of the Peoples Bank of China, controls the conversion of RMB into foreign currencies. The principal regulation governing foreign currency exchange in the PRC is the Foreign Currency Administration Rules (1996), as amended. Under the Rules, once various procedural requirements are met, RMB is convertible for current account transactions, including trade and services, but not for capital account transactions, including direct investment, loan or investment in securities outside the PRC, unless the prior approval of the State Administration of Foreign Exchange of the PRC is obtained. Although the PRC government regulations now allow greater convertibility of RMB for current account transactions, significant restrictions still remain. Currently, our PRC subsidiaries, Comtech Communication and Comtech Software, may purchase foreign exchange for settlement of current account transactions in accordance with certain procedural requirements under PRC law. A portion of our net revenue will need to be converted into other currencies to meet our foreign currency obligations, which primarily include debt service on foreign currency-denominated debt and purchases of imported components.
The value of the RMB is subject to changes in the PRCs central government policies and to international economic and political developments affecting supply and demand in the China Foreign Exchange Trading System market. Since 1994, the conversion of RMB into foreign currencies, including USD, has been based on rates set by the Peoples Bank of China, which are set daily based on the previous days interbank foreign exchange market rates and current exchange rates on the world financial markets. Since 1994, the official exchange rate generally has been stable, but in July 2005 the PRC government announced that it will no longer peg its currency exclusively to the USD but will switch to a managed floating exchange rate based on market supply and demand with reference to a basket of currencies yet to be named by the Peoples Bank of China, which will likely increase the volatility of RMB as compared to USD. As of March 31, 2006, the exchange rate is RMB8.0167 to $1.
We conduct substantially all of our operations through our PRC operating companies, and their financial performance and position are measured in terms of RMB. Our solutions are primarily procured, sold and delivered in the PRC for RMB. The majority of our net revenue is denominated in RMB.
Any devaluation of the RMB against the USD would consequently have an adverse effect on our financial performance and asset values when measured in terms of USD. On the other hand, the appreciation of the RMB could make our customers products more expensive to purchase because many of our customers are involved in the export of goods, which may have an adverse impact on their sales. A decrease in sales by our customers could have an adverse effect on our operating results. In addition, from time to time we may have USD denominated borrowings, and therefore a decoupling of the RMB many affect our financial performance in the future.
In the past, we have experienced minimal foreign exchange gain and losses to date due to the relative stability of the RMB. We had a comprehensive loss of RMB1,988 thousand ($248 thousand) due to foreign exchange translation during the quarter ended March 31, 2006. We do not know what further effect the decoupling of the RMB from the USD will have on our financial statements and results of operations. We do not currently engage in hedging activities to reduce our exposure to exchange rate fluctuations.
Interest rate risk
We are exposed to interest rate risk arising from having short-term variable rate borrowings from time to time. Our future interest expense would fluctuate in line with any change in our borrowing rates. We do not have any derivative financial instruments and believe our exposure to interest rate risk and other relevant market risks is not material. Our bank borrowings amounted to RMB43,942 thousand ($5,481 thousand) as of March 31, 2006. Based on a variable rate of return, the bank borrowings approximated fair value at that date.
If there was a hypothetical 1% change in interest rates, the net impact to earnings and cash flows would be approximately RMB439 thousand ($55 thousand). The potential change in cash flows and earnings is calculated based on the change in the net interest expense over a one year period due to an immediate 1% change in rates.
In recent years, the PRC has not experienced significant inflation, and thus inflation has not had a material impact on our results of operations in recent years. According to the National Bureau of Statistics of China, the change in Consumer Price Index in the PRC was 1.2%, 3.9% and 1.8% in 2003, 2004 and 2005, respectively.
Our most liquid assets are cash, cash equivalents and short-term investments. Because of their liquidity, these assets are not directly affected by inflation. Because we intend to retain and continue to use our equipment, furniture and fixtures and leasehold improvements, we believe that the incremental inflation related to replacement costs of such items will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and contract services, which could increase our level of expenses and the rate at which we use our resources.
Based on their evaluation as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms relating to us, including our consolidating subsidiaries.
We have only recently begun assessing our readiness for compliance with Section 404 of the Sarbanes-Oxley Act of 2002. Given the status of our efforts, substantial uncertainty exists regarding our ability to comply with the regulations by applicable deadlines. If we are unable to conclude that we have effective internal controls over financial reporting, or if our independent auditors are unable to provide us with an unqualified report as to the effectiveness of our internal controls over financial reporting as of December 31, 2006 and future year ends, as required by Section 404 of the Sarbanes-Oxley Act, we could experience delays in our reporting of financial information, or non-compliance with SEC reporting and other regulatory requirements. This could subject us to regulatory scrutiny and result in a loss of public confidence in our management, which could, among other things, adversely affect our stock price.
PART II - OTHER INFORMATION
We have received a draft complaint threatening an action for damages arising from alleged breaches of fiduciary duties in connection with transactions involving Centerpoint Corporation and Bion Environmental Technologies, Inc. The transactions took place before the consummation of our share exchange agreement with Trident, at a time when Trident and our subsidiary, OAM, owned a majority of the shares of Centerpoint. We are named as a potential defendant in the draft complaint, together with OAM, and Mark Hauser and Mark Segall, who are current members of our board of directors, and other individuals and entities associated with Trident. The draft complaint is said to be on behalf of Centerpoint and a class of Bion shareholders, and alleges that the potential defendants controlled the affairs of Centerpoint, and used their positions, among other things, to divert Centerpoint assets to themselves. We are investigating the allegations made in the draft complaint, which seeks damages in an unspecified amount. Should any formal legal proceedings be instituted, we intend to vigorously defend ourselves, although we cannot predict the outcome of any possible legal proceedings.
Except as described above, we are not currently involved in any material litigation. From time to time, we may be also involved in litigation arising in the normal course of our business.
Item 1A. RISK FACTORS
There have been no material changes in the Companys risk factors from those previously disclosed in the Companys Form 10-K for the year ended December 31, 2005.
In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.