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TELESTONE TECHNOLOGIES CORP - 10-Q/A - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) The following is management's discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. This report includes forward-looking statements. Generally, the words "believe," "anticipate," "may," "will," "should," "expect," "intend," "estimate," "continue," and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents we file with the SEC from time to time, which could cause actual results or outcomes to differ materially from those projected. Undue reliance should not be place on these forward-looking statements which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements, except to the extent required by law. The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Quarterly Report on Form 10-Q. Overview We are a leading access-network solution provider serving the Chinese market. Since 1997, we have operated in the Chinese market and in 2006, we expanded our marketing efforts to include Vietnam, Indonesia, Malaysia, Thailand and India. In 2007, Beijing Telestone Communication Technology Corporation was established as one of our subsidiaries focusing on developing and managing our overseas businesses. Currently, our marketing efforts have expanded to 29 countries around the world, including the U.S., Vietnam, Mexico, Brazil, Russia, India, the Philippines, Thailand, Ireland, Ecuador, Mongolia, South Africa, Turkey, Indonesia, Colombia, Costa Rica, Argentina, Ukraine, Kazakhstan, Singapore, South Korea, Hong Kong (SAR), Saudi Arabia, New Zealand, Bangladesh, the UAE, Canada and Iceland. Continued expansion outside of China is one of our core strategies. We believe that the quality of our products and services will allow Telestone to be increasingly competitive internationally. Our access-network solutions include the research and development ("R&D") and application of access-network technology. In addition to our homegrown access-network equipment, which includes repeaters, antennas and radio-frequency peripherals, we also offer project design, project management, installation, maintenance and other after-sales services to our customers. Our access-network solutions are designed to further enhance the coverage of mobile telecommunications networks, which in turn improves the quality of reception for mobile phone users. The solutions we provide to the telecommunications industry can be used in indoor and outdoor environments, including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels. In 2008, we launched WFDS (as defined below), a next generation wireless distribution system. WFDS is an all-optical network that combines the technologies of both wireless and optical telecommunications. This system supports all mobile telecom networks and various other networks, including WLAN, FTTH, traditional telephone, and video surveillance systems. In 2010, we began generating revenues from WFDS installations. For the six months ended June 30, 2012, we have completed 332 WFDS installations. In addition, our WFDS technology provides several important benefits to Telestone and its investors: WFDS offers an opportunity for us to diversify our customer base; WFDS generates 40.85% of the gross margin of the company; WFDS also targets a different customer base - property developers and managers - rather than the large telecom carriers targeted by some of our other products, and these customers tend to make payments more quickly, which should reduce our accounts-receivable days' sales outstanding ("DSOs") over time. Finally, WFDS is a technology platform, and we have a pipeline of WFDS technologies slated for launch over the next several years. While we expanded our sales from purely consisting of a RF-based wireless product portfolio to one including sales from our Unified Local-Access Solution ("WFDS") products, our traditional RF-based products still remain a strong growth driver for Telestone and we received more than 68.57% of our revenues from RF-based products in the second quarter of 2012. We are committed to the research and development of wireless communication related technology. Over 90% of our technology is developed in-house at our R&D center. We employ an experienced and highly trained professional staff of scientists and engineers that concentrate on the invention and further advancement of wireless communication technology. We have over 100 R&D specialists, many of whom are industry experts in telecommunications - all have at least a bachelor's degree, and 40% have a master's degree or above. As a result of our commitment to R&D, our innovative WFDS technology, since its introduction, has received recognition in the telecommunications industry and has won awards and praise from several telecommunications carriers. Page 24 of 40 Also, in order to provide fast and high quality service to our customers, we have established more than 30 locations throughout China. These locations offer sales, project survey, design, project management and installation and maintenance services. We believe that this sales and service strategy enhances our ability to increase our existing customer base in the PRC and enables us to provide timely responses to customers' inquires as well as technical and maintenance service upon our customers' requests. Our sales efforts are not focused in nor dependent upon any particular region or province of the PRC. As the mobile market in China has matured, mobile operators have been continuing to invest for the future. For example, since 2011, the Chinese telecommunications industry has witnessed accelerated development in the form of a rapid rollout of 3G network investments as well as commitments to introduce 4G technology. Such was also evidenced by China Mobile, China Telecom, and China Unicom's €1.178 billion ($1.625 billion) purchase of network and application solutions, and integration and maintenance services from Alcatel-Lucent on November 5, 2010 during the visit of Chinese President Hu Jintao to France. We also believe that disparate technologies used by mobile carriers in the United States, and the continued roll-out of 3G and 4G also provide a conducive environment for creating potential demand for our equipment and solutions in the United States. Telecom Carriers' Layout for Next-generation Communications Market The industry trend amongst international mainstream telecom carriers is to accelerate the shift towards the construction of next-generation communications networks, such as LTE. At the 2012 World Mobile Communications Conference, held in Barcelona, China Mobile and its partners jointly published plans to construct more than 500,000 TD-LTE base stations over the next three years. These base stations will service up to 2 billion people. In China, nine cities, including Shenzhen and Hangzhou, and over 20,000 base stations will be involved in commercial testing of this plan. Also, in Hong Kong, China Mobile will begin to provide LTE-TD/FDD services. China Unicom also has plans to build a LTE Trial Network. These investments are expected to create new opportunities in our industry. To speed up China's Wireless City, Smart City Construction In recent years Chinese large and medium-sized cities have actively constructed "wireless cities" using a variety of wireless access technologies to provide on-demand anytime, anywhere wireless network access. These networks offer a full range of information, government, business and public services, to promote the development of tourism and other industries and to enhance the image of the city. The "Big 3" carriers have used Wi-Fi to accelerate the development of such wireless cities. At present, the extent to which the Big 3 have publicized the efforts to develop wireless cities clearly demonstrates that wireless cities represent not only a "flagship" product of the carriers but also the future of the telecom industry in China. As a result of the demands of rapid urban population growth and in order to efficiently use resources, a growing number of cities have begun implementing "smart city" building strategies. Such smart cities will focus on the integration of technology into a strategic approach to sustainability, citizen well-being, and economic development. Such integration will enhance the functionality of buildings, the provision of utilities, the convenience of transportation, and the effectiveness of government. It is expected that the telecommunications industry will be a major beneficiary of these activities. In 2012, China will focus on building smart cities. In building smart cities, the government will promote the use of wireless, digital, and intelligent buildings which will inevitably become an important part of such construction. Also, at present, China has hundreds of cities proposing to begin construction of smart cities and/or wireless cities. Growth in Mobile Subscribers Growth in the wireless infrastructure market has also been driven by the significant increase in the number of mobile subscribers and in the amount of data transmitted over wireless networks by smart phones in China. This growth has resulted in increasing burdens being placed on the carriers' wireless infrastructure. Overworked wireless networks result in poor wireless service, slow data transfer rates and dropped calls. In order to alleviate the burdens being put on the wireless infrastructure and to increase wireless network capacity, the Big-3 continue to deploy and upgrade their wireless infrastructure equipment. "The Internet of Things" In Chinese organizations and businesses, a budding phenomenon referred to as "The Internet of Things" has developed. The Internet of Things literally translates into "the connection of things", whether they are products, components or systems, so that individuals can communicate intelligently with one another and can communicate remotely with their home and office computers, home appliances and other electronic devices. Everything from home appliances, public infrastructure and facilities to logistic processes will be assigned an IP address and connected to the Internet of Things through a wired or wireless connection. This demand is expected to increase the need for wireless infrastructure. Increasing and Evolving Need for Indoor Wireless Coverage Historically, "indoor wireless" meant only Wi-Fi enabled laptops, but currently, mobile users in China also rely on mobile phones and smart phones, BlackBerry devices, PDAs, and two-way radios to communicate. All of these devices require indoor wireless coverage to operate effectively. However, while many residential and commercial properties in China may have wireless local-area networks (LAN networks), the vast majority do not have indoor wireless cellular coverage for mobile or smart phones. In order to better serve the needs of their tenants, we expect that property owners will increasingly look to deploy indoor wireless coverage solutions. Page 25 of 40 The state has decided the integration of telecommunications networks, TV and radio broadcasting networks, and the internet to be the next step in the evolution of these industries. Such integration shall include telecommunications, broadcasting, internet communications, broadband, digital TV, next-generation internet, network interoperability and resource sharing, voice, data and broadcasting, etc. This integration does not mean unification of these industries, but rather integration of services provided by players in each of the respective industries. This broad extension of the market space will create more development opportunities. Integration involves systems, management, business and other complex distribution of benefits problems. In order to overcome these integration issues, the potential monopoly issues must be overcome. A comprehensive integration can only be achieved when true peer-to-peer access becomes possible, in other words, true distribution of business content and business interests in order to form an effective mode of operation. It is crucial to break the barriers created by potential monopolies to ensure coordination between the broadcasting businesses and telecommunications services. Users should be able to select networks to access the internet, watch TV, communicate over the phone and use other telecommunications value-added services through the network. As a result, traditional monopolies will be diminished, and gradually new industry standards will be established. We expect this integration will play a significant role in benefitting the ecology of the telecommunications and broadcasting industries. The Broadband Strategy Project will Benefit the Entire Communications Industry The 12th Five-Year National Strategic Emerging Industries Development Plan ("the 12th Five-Year Plan") issued by the State Council, for the first time stated the implementation of the "Broadband Strategy Project" and included it in the "20 major projects". The Broadband Strategy Project demands that by the end of the "12th Five-Year Plan" city and rural households' broadband should have more than 20 megabits and 4 megabits access capability, respectively. It also demands wide promotion of the integration of telecommunications networks, TV and radio broadcasting networks, and the internet. The Broadband Strategy Project will be included in "20 major projects" in strategic emerging industries. It will accelerate the construction of next generation information networks, using ultra-high-speed fiber and wireless communications technology, and therefore be beneficial for both telecommunication and IP network equipment providers. The main methods of the Broadband Strategy Project are to accelerate the construction of the broadband optical access network to promote coverage of the third generation mobile communication (3G) network, and to carry out large-scale commercial demonstrations of TD-LTE. It also promotes the implementation of next-generation internet, full implementation of the radio and television digital transformation, network integration, organization of key technologies, equipment, intelligent terminal research and development and industrialization. 4G development in China The 4G wireless network development is led by the China Mobile TD-LTE. In 2012, China Mobile's TD-LTE scale technology pilot cities have been expanded from 6 cities at the early stage, including Shanghai, Nanjing, Hangzhou, Guangzhou, Shenzhen and Xiamen, to 13 cities, with Beijing, Tianjin, Qingdao, Shenyang, Ningbo, Chengdu and Fuzhou being newly covered. Due to the competitive disadvantage of 3G, China Mobile has been urged to develop TD-LTE, and mobile companies from different cities compete for inclusion in the scale technology pilot cities. The bidding process for TD-LTE terminals will begin in the second half of 2012. China Mobile plans to complete 20,000, 200,000 and 350,000 TD- LTE base stations by the end of 2012, 2013 and 2014, respectively. In early 2012, China Unicom conducted a test of LTE-FDD technology in Shanghai. According to releases from the Ministry of Industry and Information Technology, China 4G licenses will be issued in China within the next two to three years. Our Solution We design, engineer and sell RF-based local-access network solutions for indoor and outdoor wireless coverage and WFDS solutions for unified local access-network coverage. In the past, our focus has been on RF-based local access-network solutions, but in the future we expect to leverage our WFDS technology to transition our customers to a unified local access-network solution. Our WFDS solutions are designed for use by property owners of all types of buildings including enterprises, municipalities, small businesses and homes. Our unified local access-network WFDS solutions integrate multiple access services, have a lower total cost of ownership and provide better wirelesscoverage. Page 26 of 40 We plan to leverage our WFDS technology in order to increase our penetration into the Chinese market and to strengthen our relationships with the Big-3 for whom we believe our WFDS solution is a critical component to remain aligned with industry trends and government-sponsored initiatives. Key benefits of our unified local access-network WFDS solution include: · Compatibility with the Big-3's technologies and integrated services. Our WFDS solution is the industry's first solution capable of providing integrated services on a single integrated platform. Our unified solution approach as well as our commitment to research and development have strategically positioned us to be a beneficiary of the Chinese government's directive for network convergence. · Reduction in capital expenditures. The combination of integrating services along with the use of our patented fiber-optic technology should enable the Big-3 to significantly reduce their wireless infrastructure capital expenditures. · Reduction in space required. Thanks to our WFDS technology, property owners can reduce the installation space required for mobile wireless cable and internet service by consolidating eleven devices into one. In a single compact and completely optical platform, we offer integrated solutions streamlined to meet our customers' requirements. · Easy to install, use and maintain. Our WFDS solution enables a property owner to deploy a single multi-functional platform in a simple and consolidated form. WFDS is easy to install, centrally managed, compatible with 2G and 3G services, and is forward compatible with 4G services. RF-based Local Access Network Solutions We provide RF-based local access-network solutions to the telecommunications industry for various venues and premises including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels. Our suite of products that we deploy as part of these solutions includes base stations and tower mounted amplifiers, antennas, couplers and splitters. Our RF-based products support various 2G and 3G transmission standards, including CDMA, W-CDMA, GSM and TD-SCDMA. We provide the public mobile communication access resident wireless access network U-DAS solution to our customers. U-DAS applications include transportation hubs (airports , railway stations ), large venues (sports stadiums , convention centers), office and commercial buildings (office buildings, hotels, shopping centers), hospitals, campuses, residential quarters, etc., where it provides signal access and coverage for the operators of 2G, 3G, and even LTE-FDD and LTE-TDD networks. TIPS Solutions Telestone Intelligence Premises System ("TIPS") is a groundbreaking technology based on Telestone's WFDS technology. The core of TIPS is Telestone's Unified Premises Information Network System ("UPINS") technology, which, in real-time, distributes all information generated or required at any time and at any location within a premises network. TIPS networks are characterized by ultra-wide bandwidth, long transmission distances, and multi-cascading technology. As of June 30, 2012, we have completed the theoretical research and development of the core technology for TIPS. TIPS is expected to be used in a broad range of applications including municipal projects, airports, railways, highways, streets, communities, buildings, houses, and medical facilities, etc. For internal communications capabilities, the functions of TIPS can be divided into IP fiber optic networks and wireless telephony features, office computing optical networks and wireless access capabilities, and wireless access teleconferencing, etc. For external public communications services, the functions of TIPS can be divided into wireless signal coverage for public communications, WLAN coverage for telecommunications carriers, and cable TV access functions, etc. For network management and maintenance, the functions of TIPS can be divided into network monitoring and traffic management, information security management, and behavior management, etc. For security management, the functions of TIPS can be divided into entrance guard and attendance management, video intercom management, and multimedia publishing, etc. TIPS is closely related to the integration of telecommunications, TV and radio broadcasting and internet access into one unified network, a project initiated by the State Council. TIPS also provides reliable solutions to developing "smart cities" via its comprehensive network integration capabilities, intelligent management, cost-saving materials and unique energy-saving features. Our Competitive Strengths We believe that the following competitive strengths enable us to compete effectively and to take advantage of the growth opportunities in our markets: Page 27 of 40 Strong Research and Development Capabilities Our R&D capabilities rank among the best in the PRC's telecommunications industry. We have a robust engineering project management system and an experienced engineering team. Our research and development center is equipped with the latest equipment and testing facilities, which give our research and development personnel the tools they require to make significant advances in access-network technologies. In addition, we provide our employees with continuing education which is administered through internal programs. Our R&D capabilities are recognized and approved by the PRC government and have won accolades such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. We focus on increasing our research and development efforts to develop superior and proprietary technologies. Our proprietary WFDS, which is a result of our R&D efforts, is one of the leading indoor access-network products in China. Compared with other traditional wireless distribution systems, our WFDS system has many advantages. Firstly, WFDS uses fiber optic cable to transmit signals. Because of the low signal-loss characteristic of fiber optic cable, signals can be transmitted over long distances, the main unit ("MU") can be placed closer to the signal source and the remote unit ("RU") can be placed closer to the subscribers. Therefore, a micro-power signal source can be used, which reduces interference and noise, generates low electromagnetic interference, and expands the coverage area. Secondly, due to the input port of the MU connecting to the signal combiner, WFDS systems can support multiple signals' access and network integration. WFDS can provide all broadband communication services access in the 500 kHz ~ 3 GHz band for subscribers. Thirdly, due to the fact that each node of the system has the same bandwidth and flow characteristics, WFDS can provide the same communication services for every subscriber. Finally, WFDS systems are easy to manage and flexible for implementing expansion and system upgrades with minimum cost. Broad and Diverse Market Base Our business covers a wide region. We have 30 branches throughout China and our business covers approximately 29 countries worldwide. Experienced Marketing Staff We employ a group of experienced telecommunications experts and an experienced and technologically savvy marketing staff in China. Strong Customer Relations We have maintained long-term relationships with China Unicom, China Mobile, China Telecom and China Netcom as customers for approximately 14 years. Governmental Support As a high-tech enterprise with an established track record, our company enjoys the stimulus plans offered by China's industry governmental authorities and by local authorities, including the Ministry of Science and Technology, the Ministry of Industry and Information Technology, the Beijing municipal government and the Administrative Committee of Z-Park. Our Growth Strategy In order to maintain our position as one of the leading companies in the PRC's access-network solutions sector, and to expand and diversify our revenue streams, we have adopted the following strategies: Continue to Focus on Research and Development We plan to continue to invest in research and development for our key technologies and products to enhance our leading position in the access network technology market and take full advantage of the PRC's investment in 3G and 4G networks. We have dedicated research and development programs to advance access-network solutions for the continuous development of our business. Seek Selective Acquisitions and Strategic Investments In the domestic market, we intend to maintain strong relationships with Chinese mobile telecommunications carriers and potentially make selective acquisitions in major provincial markets where we do not have a leading market share. Our potential targets are companies that enjoy a leading market position and have strong business networks in their provincial markets, have strong production capabilities, own applicable value added products and whose customer network platforms adapt to WFDS. We believe that we will further our penetration into provincial markets and raise our overall market share through selective acquisitions and the promotion of new solutions. Page 28 of 40 Strengthen International Market Presence We plan to focus on increasing our presence in markets outside of the PRC. We will continue to strengthen our presence abroad by leveraging our expertise and our leading access-network products and solutions. In the United States, we plan to seek cooperation with peers that have strong research and development abilities and develop technology and products that are suitable for the PRC market. We also seek partners within the integration business to sell our products. In developing countries, we only seek cooperation with local integration partners to deliver our access network solution technologies. We then work with these partners to set up our local product distribution channels. Description of Products and Engineering Services We design and sell electronic equipment used to provide access-network solutions to our customers. Many of these types of equipment, including WFDS products, RFPA products, passive components and base station antennas as well as engineering supporting fiber optic cable, cable and other auxiliary materials for 2G, 3G, 4G, Broadband access and CATV networks, are highly specialized active microwave components designed to meet the needs of our customers. In addition to designing and selling our products, we also provide systems integration services to our customers. The primary systems integration services provided to our customers are project design and engineering, specifically, the development and design of indoor (living quarters, hospital systems, and hotels) and outdoor (expressways, railways and no coverage zones) wireless signal complementary coverage solutions and their applied products. This includes the design of the required equipment, implementation, project quality evaluation as well as after-sale maintenance and optimization for system integration products, constructive products for engineering design projects and wireless networkoptimization products. Research & Development We maintain a research and development center where the majority of our products are designed by our staff of engineers and scientists. Our research and development center is equipped with the latest equipment and testing facilities, which give our research and development personnel the tools they require to make significant advances in access-network technologies. The center is comprised of three research centers including (i) the Premises Neural Network Research and Development Center, (ii) the Joint Development center, and (iii) the System Product Research Center, and seven professional research departments including: (i) the Resident Neural Network Research and Development Department, (ii) the Radio Station Network Development Department, (iii) the Equipment R&D Department, (iv) the Parts Development Department, (v) the IP Resident Network Research and Development Department, (vi) the Government Intelligent Systems Research and Development Department, and (vii) the Business Intelligent Systems Research Department. We seek to remain at the forefront of current and future technologies, paying close attention to evolving development trends in domestic and international technologies. Our R&D capabilities are recognized and affirmed by the PRC government and have won awards such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. Competition Our main domestic competitors are Guangdong Comba, Wuhan Hongxin and China GrenTech. · Guangdong Comba was one of the first Chinese domestic telecom manufacturers. The company is listed on the Hong Kong Stock Exchange under the stock symbol 2342.HK. · Wuhan Hongxin, originally a state-owned enterprise under the management of Wuhan Post & Telecom Academy, has a strong technical background and sales network. Wuhan Hongxin is a large company with a diverse group of products that extend beyond the wireless coverage sector. · China GrenTech, formerly known as Powercom Holdings Limited, was founded in 1999 and is based in Shenzhen. China GrenTech is a leading China based wireless coverage products and services provider, and a leading developer of radio frequency technology and products. Our potential international competitors include Powerwave Technologies and Andrew Corporation. We believe that our overseas competitors are not key threats to Telestone because they have no competitive advantage with respect to product costs and are not accustomed to the marketplace of the PRC. · Powerwave Technologies, Inc. is a global provider of end-to-end wireless infrastructure solutions for use in wireless communications networks. They offer original equipment manufacturers ("OEMs"), operators and network providers in the wireless communications industry a portfolio of antenna systems, base station systems and coverage systems. Page 29 of 40 · Andrew Corporation ("Andrew") is a global designer, manufacturer, and supplier of communications equipment, services and systems. Andrew's products and expertise are found in communications systems throughout the world, including devices for wireless and distributed communications, land mobile radio, cellular and personal communications, broadcast, radar and navigation. Government Regulation The following is a summary of the principal governmental laws and regulations that are or may be applicable to our operations in the PRC. The scope and enforcement of many of the laws and regulations described below are uncertain. We cannot predict the effect of further developments in the Chinese legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement of laws. The telecommunications industry, including certain access-network solution provider services, is highly regulated in the PRC. Regulations issued or implemented by the State-owned Assets Supervision and Administration Commission of the State Council, Ministry of Information Industry of PRC and other relevant government authorities cover many aspects of telecommunications network operations, including entry into the telecommunications industry, the scope of permissible business activities, interconnection and transmission line arrangements, tariff policies and foreign investment. The principal regulations governing the telecommunications services business in the PRC include: · Telecommunications Regulations (2000), (the "Telecom Regulations"). The Telecom Regulations categorize all telecommunications businesses in the PRC as either infrastructure telecommunications businesses or value-added telecommunications businesses. Under the Telecom Regulations, certain services are classified as being of a value-added nature, including telecommunication information services, online data processing and translation processing, call centers and internet access providers, and require the commercial operator of such services to obtain an operating license. The Telecom Regulations also set forth extensive guidelines with respect to different aspects of telecommunications operations in the PRC. · Regulations for the Administration of Foreign-Invested Telecommunications Enterprises (2002), (the "FI Telecom Regulations"). The FI Telecom Regulations set forth detailed requirements with respect to capitalization, investor qualifications and application procedures in connection with the establishment of a foreign-invested telecom enterprise. · Foreign Exchange Controls. The principal regulations governing foreign exchange in the PRC are the Foreign Exchange Control Regulations (1996) and the Administration of Settlement, Sale and Payment of Foreign Exchange Regulations (1996), ("the Foreign Exchange Regulations"). Under the Foreign Exchange Regulations, Renminbi ("RMB") is freely convertible into foreign currency for current account items, including the distribution of dividends. Conversion of RMB for capital account items, such as direct investment, loans and security investment, however, is still subject to the approval of the State Administration of Foreign Exchange ("SAFE"). Under the Foreign Exchange Regulations, foreign-invested enterprises are required to open and maintain separate foreign exchange accounts for capital account items. In addition, foreign-invested enterprises may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from SAFE. Gross Margin Our gross margin has been, and will continue to be, affected by a variety of factors, including: · product mix and average selling prices; · new product introductions and enhancements both by us and by our competitors; · demand for our products and services; · our ability to attain volume manufacturing pricing from our manufacturers or other component suppliers; · losses associated with excess and obsolete inventory; and · growth in our headcount and other related costs incurred in our professional services organization. Page 30 of 40 Operating Expenses Operating expenses consist of sales and marketing expenses, general and administrative expenses, and research and development expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, benefits and other compensation for our employees. We had approximately 1410 full-time employees as of June 30, 2012. Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of sales and marketing expenses and compensation for sales personnel and travel expenses related to sales of products and market development. We expense sales and marketing expenses as incurred. We plan to continue to invest strategically in sales and marketing with the intent of adding new customers and increasing penetration within our existing customer base, expanding our domestic and international sales and marketing activities, building brand awareness and sponsoring additional marketing events. We expect future sales and marketing expenses to continue to be our most significant operating expenses. General and administrative expenses primarily consist of compensation for personnel, travel expenses, materials expenses related to ordinary administration, fees for professional services, and provisions for doubtful accounts. Research and development expenses primarily consist of compensation for research and development staff, material expenses, travel expenses and facility expenses. We are devoting substantial resources to the continuous development of additional functionality for existing products and the development of new products. We intend to continue to invest in our research and development efforts because we believe they are essential for maintaining our competitive edge. The amount invested in our research and development activities will increase as we continue to increase our revenue. However, as a percentage of revenue, research and development costs are expected to remain relatively low. Interest Expense Interest expense includes interest we pay on our short-term bank loans. Other Income (Expense), Net Other income (expense), net includes interest income on cash balances, gains or losses on disposal of fixed assets, gains or losses on the conversion of non-Renminbi transactions into Renminbi, and gains from governmental subsidies. Cash has historically been invested in highly liquid investments with original maturities of three months or less. Income Tax Expense Income tax expense is computed based on pre-tax income included in the condensed consolidated statement of operations. Income taxes have been provided, using the liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities and their reported amounts. The tax consequences of those differences are classified as current or non-current based upon the classification of the related assets or liabilities in the condensed consolidated financial statements. Critical Accounting Policies Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). These accounting principles require us to make estimates and judgments that affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, foreign currency translation, inventory valuation, allowances for doubtful accounts, and goodwill. Revenue Recognition Our revenue is derived primarily from two sources: (1) product revenue and (2) professional services revenue. Product revenue represents the contracted value of goods, net of value-added tax ("VAT") and returns. The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery occurs, the fee is fixed or determinable, and collectability is probable. Professional service revenue is recognized when the service is performed and accepted by the customer. As part of professional services, the Company provides installation services for certain sales of equipment under fixed-price contracts. Revenues from these fixed-price service contracts are recognized on the completed-contract method. Under the completed-contract method, revenue and costs of individual contracts are included in operations in the year during which they are completed. Losses expected to be incurred on contracts in progress are recognized in the period such losses are determined. This method is used because the contract is completed within a short period of time, and the financial position and results of operations do not vary significantly from those that would result from using the percentage-of-completion method. A contract is considered completed upon completion of all essential contract work and once the installation has been accepted by the customer. Page 31 of 40 Foreign Currency Translation All major subsidiaries of the Company consider Renminbi as their functional currency as a substantial portion of their business activities is conducted in Renminbi. However, the Company has chosen the United States dollar as its reporting currency. Transactions in currencies other than the functional currency during the year are translated into the functional currency at the applicable rates of exchange prevailing at the time of the transactions. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at the applicable rates of exchange in effect on the balance sheet date. Exchange gains and losses are recorded in the condensed consolidated statements of operations. For translation of financial statements into the reporting currency, assets and liabilities are translated at the exchange rate on the balance sheet date, equity accounts are translated at historical exchange rates, and revenue, expenses, gains and losses are translated at the weighted average rates of exchange prevailing during the period. A translation adjustment, when material, resulting from this process is recorded in accumulated other comprehensive income within stockholders' equity. Inventory Valuation Inventory consists of equipment and related component parts and is stated at the lower of weighted average cost or market value. We record inventory write-downs for potential excess inventory based on forecasted demand, economic trends and technological obsolescence of our products. If future demand or market conditions are less favorable than our projections, additional inventory write-downs could be required and would be reflected in cost of product revenue in the period the revision is made. At the time of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Allowances for Doubtful Accounts We record a provision for doubtful accounts based on historical results and a detailed assessment of the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, our management considers, among other factors, (1) the aging of the accounts receivable, including trends within and ratios involving the age of the accounts receivable, (2) our historical write-offs, (3) the credit-worthiness of each customer, (4) the economic conditions of the customer's industry, and (5) general economic conditions. In cases where we are aware of circumstances that may impair a specific customer's ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. Goodwill We apply ASC Topic 350 - Goodwill and Other Intangibles and perform an annual goodwill impairment test, or test more frequently if events or changes in circumstances indicate that the carrying value may be impaired. Goodwill is allocated to cash-generating units for the purpose of the impairment test and determination of gain or loss on disposal. Goodwill on acquisition of businesses, being the excess of the cost of the acquisition over the Company's share of the fair value of the identifiable assets, liabilities and contingent liabilities, is recognized as a separate asset. Goodwill is carried at cost less accumulated impairment losses. An impairment loss on goodwill is not reversed. We did not recognize impairment charges in any of the periods presented. Page 32 of 40 Results of Operations Our operating results are presented for the quarter ended June 30, 2012, as compared to the quarter ended June 30, 2011. The following is the statement of our operations for the three months ended June 30, 2012 and 2011: Item Three Months Ended June 30, 2012 Three Months Ended June 30, 2011 Comparisons $'000 % of revenue $'000 % of revenue $'000 %Revenue 17,866 24,337 -6,471 -26.5 9 % Equipment and services costs 11,246 62.95 % 13,703 56.31 % -2,457 -17.93 % Gross profit 6,620 37.05 % 10,634 43.69 % -4,014 -37.75 % Sales and marketing expenses 3,032 16.97 % 3,026 12.43 % 6 0.20 % General and administrative expenses 3,782 21.17 % 1,360 5.59 % 2,422 178.09 % Research and development expenses 567 3.17 % 620 2.55 % -53 -8.55 % Depreciation and Amortization 192 1.07 % 120 0.49 % 72 60.00 % Interest expenses 259 1.45 % 187 0.77 % 72 38.50 % Other income, net 236 1.32 % 121 0.50 % 115 95.04 % Net (loss)/ Income before income tax (976 ) -5.46 % 5,442 22.36 % -6,418 -117.93 % Income tax 326 1.82 % 918 3.77 % -592 -64.49 % Net(loss)/ income (1,302 ) -7.29 % 4,524 18.59 % -5,826 -128.78 % The following is the statement of our operations for the six months ended June 30, 2012 and 2011: Six Months Ended Six Months Ended Item June 30, 2012 June 30, 2011 Comparisons $'000 % of revenue $'000 % of revenue $'000 % Revenue 34,969 38,809 -3,840 -9.89 % Equipment and services costs 21,809 62.37 % 21,577 55.60 % 232 1.08 % Gross profit 13,160 37.63 % 17,232 44.40 % -4,072 -23.63 % Sales and marketing expenses 6,649 19.01 % 5,157 13.29 % 1,492 28.93 % General and administrative expenses 5,128 14.66 % 3,365 8.67 % 1,763 52.39 % Research and development expenses 1,030 2.95 % 868 2.24 % 162 18.66 % Depreciation and Amortization 393 1.12 % 222 0.57 % 171 77.03 % Interest expenses 530 1.52 % 336 0.87 % 194 57.74 % Other income, net 284 0.81 % 324 0.83 % -40 -12.35 % Net (loss)/Income before income tax (286 ) -0.82 % 7,608 19.60 % -7,894 -103.76 % Income tax 537 1.54 % 1,465 3.77 % -928 -63.34 % Net(loss)/ income (823 ) -2.35 % 6,143 15.83 % -6,966 -113.40 % Page 33 of 40 For the three months ended June 30, 2012: our revenue was $17,866,000, decreased by $6,471,000 or 26.59% when compared to the same period in 2011. For the six months ended June 30, 2012: our revenue was $34,969,000, decreased by $3,840,000 or 9.89% from the same period in 2011. For the three months ended June 30, 2012: the gross profit was $6,620,000, gross profit margin was 37.05%. For the six months ended 2012: our gross profit was $13,160,000, gross profit margin was 37.63%. Our gross profit margin in both three months and six months ended June 30, 2012 decreased when compared to the same periods in 2011. For the three months ended June 30,2012: the net loss was -$1,302,000; the net loss ratio was -7.29%. For the six months ended June 30, 2012: the net loss was -$823,000; the net loss ratio was -2.35%. As a result of the decrease in revenue and the bad debt provision in of approximately $1,870,000 included in general and administrative expenses, our net income in both three months and six months periods decreased when compared to the same periods in 2011. Revenue Three months ended June 30, 2012 and 2011: Three Months Ended Three Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % Product sales 5,953 33.32 % 8,834 36.30 % -2,881 -32.61 % Service sales 11,913 66.68 % 15,503 63.70 % -3,590 -23.16 % Total 17,866 100.00 % 24,337 100.00 % -6,471 -26.59 % Six months ended June 30, 2012 and 2011: Six Months Ended Six Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 %Product sales 9,484 27.12 % 15,826 40.78 % -6,342 -40.07 % Service sales 25,485 72.88 % 22,983 59.22 % 2,502 10.89 % Total 34,969 100.00 % 38,809 100.00 % -3,840 -9.89 % For the three months ended June 30, 2012: revenue generated from product sales was $5,953,000 and accounted for 33.32% of the second quarter's total revenue. For the three months ended June 30, 2012, revenue generated from service sales was $11,913,000 and accounted for 66.68% of the second quarter's total revenue. Changes in product sales and service revenues were subtle when compared to the same period in 2011. For the six months ended June 30, 2012: revenue generated from product sales was $9,484,000 and accounted for 27.12% of the six months total revenue. Revenue generated from service sales was $25,485,000 accounted for 72.88% of the six months total revenue. The main contributors to the contract revenue decrease were: construction of 3G has been completed and 4G Construction has experienced a slow and soft start; the Company strategically controls revenue increases in certain cities where account receivables collecting period is comparatively long and market downsizing has intensified competition. Breakdown by Customers Three months ended June 30, 2012 and 2011: Three Months Ended Three Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % China Mobile 7,750 43.38 % 13,038 53.57 % -5,288 -40.56 % China Unicom 6,048 33.85 % 8,570 35.21 % -2,522 -29.43 % China Telecom 785 4.39 % 1,339 5.50 % -554 -41.37 % Others 3,226 18.06 % 1,363 5.60 % 1,863 136.68 % Overseas 57 0.32 % 27 0.12 % 30 111.11 % Total 17,866 100.0 % 24,337 100.0 % -6,471 -26.59 % Page 34 of 40 Six months ended June 30, 2012 and 2011: Six Months Ended Six Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % China Mobile 17,524 50.11 % 19,298 49.73 % -1,774 -9.19 % China Unicom 10,368 29.65 % 13,979 36.02 % -3,611 -25.83 % China Telecom 2,220 6.35 % 2,234 5.76 % -14 -0.63 % Others 4,800 13.73 % 3,239 8.35 % 1,561 48.19 % Overseas 57 0.16 % 59 0.14 % -2 -3.39 % Total 34,969 100.0 % 38,809 100.0 % -3,840 -9.89 % Revenues from the wireless telecom carriers were the Company's major source of revenue, among which the majority of the revenue was from China Mobile and China Unicom. For the three months ended June 30, 2012, our revenue generated from China Mobile accounted for 43.38% of our total revenue. Our revenue generated from China Unicom over the same period accounted for 33.85% of total revenue. For the six months ended June 20, 2012, our revenue generated from China Mobile accounted for 50.11% of total revenue and revenue from China Unicom accounted for 29.65% of total revenue. Compared with the same period of 2011, there is no significant change in the proportion of revenue generated from the 'Big Three'. Breakdown by Type of Technology Three months ended June 30, 2012 and 2011: Three Months Ended Three Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % WFDS 5,616 31.43 % 5,683 23.35 % -67 -1.18 %Traditional product 12,250 68.57 % 18,654 76.65 % -6,404 -34.33 % Total 17,866 100 % 24,337 100 % -6,471 -26.59 % Six months ended June 30, 2012 and 2011: Six months ended Six months ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % WFDS 7,374 21.09 % 9,013 23.22 % -1,639 -18.18 % Traditional product 27,595 78.91 % 29,796 76.78 % -2,201 -7.39 % Total 34,969 100 % 38,809 100 % -3,840 -9.89 % The revenue from WFDS products was $5,616,000 in the second quarter of 2012, which accounted for 31.43% of total revenue, increased by 13.89% when compared to the same period in 2011. For the six months ended 2012, revenue of WFDS products was $7,374,000, which accounted for 21.09% of total revenue. WFDS revenue increased significantly by $3,858,000 in the second quarter, compared to the first quarter of 2012. Gross Profit For the three months ended June 30, 2011 and 2012, a tabular summary of our gross profit is presented below: Three Months Ended Three Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % Revenue 17,866 24,337 -6,471 -26.59 % Equipment and services costs 11,246 62.95 % 13,703 56.31 % -2,457 -17.93 % Gross profit 6,620 37.05 % 10,634 43.69 % -4,014 -37.75 % For Six months ended June 30, 2012 and 2011: Six Months Ended Six Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % Revenue 34,969 38,809 -3,840 -9.89 % Equipment and services costs 21,809 62.37 % 21,577 55.60 % 232 1.08 % Gross profit 13,160 37.63 % 17,232 44.40 % -4,072 -23.63 % Page 35 of 40 Our gross profit was $6,620,000 in the second quarter of 2012, decreased by $4,014,000 as compared to the second quarter of 2011, The gross profit ratio decreased from 43.69% for the three months ended June 30, 2011 to 37.05% for the same period in 2012. For the six months ended June 30, 2012, our gross profit was $13,160,000, decreased by $4,072,000, as compared to the same period in 2011. The gross profit ratio decreased from 44.40% for six months ended June 30, 2011 to 37.63% for the same period in 2012. Intense market competition and shrinkage of our profit margin resulted in the low gross profit ratio. Operating Expenses Three months ended June 30, 2012 and 2011: Three Months Ended Three Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 %Sales and Marketing expenses 3,032 16.97 % 3,026 12.43 % 6 0.20 % General and Administrative expenses 3,782 21.17 % 1,360 5.59 % 2,422 178.09 % Research and Development expenses 567 3.17 % 620 2.55 % -53 -8.55 % Depreciation and Amortization 192 1.08 % 120 0.49 % 72 -60.00 % Total 7,573 42.39 % 5,126 21.06 % 2,447 47.73 % Six months ended June 30, 2012 and 2011: Six Months Ended Six Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % Sales and Marketing expenses 6,649 19.02 % 5,157 13.29 % 1,492 28.93 % General and Administrative expense 5,128 14.66 % 3,365 8.67 % 1,763 52.39 % Research and Development Expense 1,030 2.95 % 868 2.24 % 162 18.66 % Depreciation and Amortization 393 1.12 % 222 0.57 % 171 77.03 % Total 13,200 37.75 % 9,612 24.77 % 3,588 37.33 % Sales and Marketing Expenses Sales and marketing expenses were $3,032,000 or 16.97% of our revenue for the three months ended June 30, 2012, as compared to $3,026,000, or 12.43% of our revenue for the same period in 2011. Sales and marketing expenses were $6,649,000, or 19.01% of our revenue for the six months ended June 30, 2012, as compared to $5,157,000 or 13.29% of our revenue for the same period in 2011. The slight increase in sales and marketing expenses for the six months ended June 30, 2012 was mainly due to the increase in the number of staff at the branch offices of the Company. General and Administrative Expenses General and administrative expenses were $3,782,000 or 21.17% of our revenue for the three months ended June 30, 2012, as compared to $1,360,000 or 5.59% of revenue for the same period in 2011. For the six months ended June 30, 2012, general and administrative expenses were $5,128,000 or 14.66% of our revenue, as compared to $3,365,000 or 8.67% of revenue for the same period in 2011. The increase in General and Administrative expenses for the six months ended June 30, 2012 was mainly due to a provision for bad debts of accounts receivable of $1,870,000 made during the three months ended June 30, 2012. Page 36 of 40 Research and Development Expenses Research and development expenses were $567,000 or 3.17% of revenues for the three months ended June 30, 2012, as compared to $620,000, or 2.55% of revenues for the same period in 2011. For the six months ended June 30, 2012 the R&D expenses were $1,030,000 or 2.95% of revenues, as compared to $868,000 or 2.24% of revenues for the same period in 2011. There were no significant changes to R&D expenses except for a slight increase due to additional R&D staff. Interest Expense Three months ended June 30, 2012 and 2011: Three Months Ended Three Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 % Interest expenses 259 1.45 % 187 0.77 % 72 38.50 % Six months ended June 30, 2012 and 2011: Six Months Ended Six Months Ended June 30, 2012 June 30, 2011 Growth $'000 % of revenue $'000 % of revenue $'000 %Interest expenses 530 1.52 % 336 0.87 % 194 57.74 % Interest expenses Interest expenses were $259,000 for the three months ended June 30, 2012, an increase of 38.50% as compared to $187,000 for the same period in 2011. For the six months ended June 30, 2011, interest expenses were $530,000, an increase of $194,000 or 57.74% as compared to $336,000 for the same period in 2011. The increase in the interest expense in 2012 was due to more interest paid on short-term loans. The Company's short-term loans increased to $11,232,000 when compared with same period of 2011 and the associated interest expenses increased accordingly. Liquidity and Capital Resources We generally finance our operations from internally generated cash flow and short-term bank loans. As of June 30, 2012, we had current assets of $285,782,000. Our current assets were mainly comprised of: inventories of $10,707,000, accounts receivable of $259,562,000, prepayments of $2,351,000, other current assets of $3,945,000 and cash and cash equivalents of $7,674,000. Current liabilities were $159,546,000 and were mainly comprised of accounts payable of $51,481,000, income tax payables of $19,204,000, short-term loans of $11,232,000, customer deposits for sales of equipment of $2,501,000, amounts due to related parties of $1,821,000, service cost payable of $40,115,000 and other payables and accruals amounting to $33,192,000. Our net cash flow used in operating activities was $7,527,000 for the six months ended June 30, 2012. Current assets were $285,782,000 and current liabilities were $159,546,000, reflecting a current ratio (current assets/current liabilities) of 1.79:1. Our trading terms with our customers are mainly on credit. The accounts receivable turnover period for the three months ended June 30, 2012 was 1232 days. The long accounts receivable turnover period is due to the rapid-growth in revenue in 2010, which resulted in an increase in accounts receivable, and also to the fact that the trading terms with our customers are mainly credit based. We have experienced a long accounts receivable turnover period. This is due to the fact that most of our projects are integrated projects and the accounts receivable turnover period for these kinds of sales is usually longer. Most of our major competitors focus on pure equipment sales, which lead to shorter accounts receivable turnover periods. In addition, most of our customers are the "Big Three", which are known as "blue chip" customers and their payment cycles are comparatively long. That said, our inventory turnover period for the three months ended June 30, 2012 was 264 days. Also, our inventory turnover period for the six months ended June 30,2012 was 278 days. In 2012, our cash and bank balances are mainly denominated in RMB and U.S. Dollars, while our bank borrowings are mainly denominated in RMB. Our revenue, expenses, assets and liabilities are mainly denominated in RMB and U.S. Dollars. OFF-BALANCE SHEET ARRANGEMENTS We do not have any off-balance sheet arrangements. CONTINGENT LIABILITIES We recognize our revenue upon the completion of contracts and have made full tax provision in accordance with relevant national and local laws and regulations of the PRC. A contract is considered completed upon completion of all essential contract work and when installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. We follow the practice of reporting our revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. Despite the fact that we have made full tax provision in our financial statements, we may be subject to surcharge and penalty for the deferred reporting of tax obligations. The Board of Directors considers it is unlikely that the tax surcharge and penalty will be imposed. Page 37 of 40 |