U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________
COMMISSION FILE NUMBER: 000-24985
PACIFICNET INC.
---------------
(Exact name of registrant in its charter)
DELAWARE 91-2118007
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
23/F, TOWER A, TIMECOURT, NO.6 SHUGUANG XILI,
CHAOYANG DISTRICT, BEIJING, CHINA 100028 n/a
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: 0086-10-59225000
Indicate by check mark whether the registrant (1) has filed all reports required
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
YES |X| NO |_|
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).
Large Accelerated Filer |_| Accelerated Filer |_| Non-accelerated filer |X|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). YES |_| NO |X|
As of May 1, 2006, there were 10,889,611 shares of the registrant's common
stock, par value $0.0001 per share, outstanding.
1
PACIFICNET INC.
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
------- ---------------------
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets at December 31, 2005 and
March 31, 2006 3
Consolidated Income Statements for the Three Months
Ended March 31, 2005 and the Three Months Ended March 31, 2006 4
Consolidated Statements of Changes in Stockholders' Equity
For the Three Months ended March 31, 2006 5
Consolidated Statements of Cash Flows for the Three
Months Ended March 31, 2005 and the Three Months Ended March
31, 2006 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 17
Item 3. Quantitative and Qualitative Disclosures about Market Risk 24
Item 4. Controls and Procedures 24
PART II. OTHER INFORMATION
-------- -----------------
Item 1. Legal Proceedings 28
Item 1A. Risk Factors 28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29
Item 3. Defaults upon Senior Securities 29
Item 4. Submission of Matters to a Vote of Security Holders 29
Item 5. Other Information 29
Item 6. Exhibits 30
Signatures
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PACIFICNET INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands of United States dollars, except par values and share numbers)
MARCH 31,2006 DECEMBER 31,2005
(UNAUDITED) (AUDITED)
-------------------------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 11,189 $ 9,579
Restricted cash - pledged bank deposit 1,653 1,652
Accounts receivables 12,674 5,998
Inventories 2,479 1,836
Loan receivable from related parties 3,314 2,520
Loan receivable from third parties 1,105 1,572
Other current assets 6,499 7,973
-------- --------
Total Current Assets 38,913 31,130
Property and equipment, net 8,533 4,300
Investments in affiliated companies and subsidiaries 411 410
Marketable equity securities - available for sale 565 539
Goodwill 14,688 14,227
Other assets - debt issuance costs (net) 1,432 --
-------- --------
TOTAL ASSETS $ 64,542 $ 50,606
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Bank line of Credit $ 1,011 $ 1,060
Bank loans-current portion 215 188
Capital lease obligations - current portion 107 126
Accounts payable 5,416 3,186
Accrued expenses and other payables 3,171 4,620
Income tax payable 379 296
Subscription payable 390 775
Loan payable to related party 513 369
-------- --------
Total Current Liabilities 11,202 10,620
-------- --------
Long-term liabilities:
Bank loans - non current portion 1,195 6
Capital lease obligations - non current portion 63 78
Bank loan interest payable 576 --
Convertible Debenture 8,000 --
--------- ---------
Total long-term liabilities 9,834 84
-------- --------
Total liabilities 21,036 10,704
Minority interest in consolidated subsidiaries 11,024 8,714
Commitments and contingencies
Stockholders' Equity:
Preferred stock, par value $0.0001, Authorized - 5,000,000 shares
issued and outstanding - none -- --
Common stock, par value $0.0001, Authorized - 125,000,000 shares
issued and outstanding:
March 31, 2006 - 13,238,497 shares issued, 10,889,611 outstanding
December 31, 2005 - 12,000,687 issued, 10,831,024 outstanding 1 1
Treasury stock, at cost (2006 Q1: 2,348,886 shares, 2005: 1,169,663 shares) (243) (119)
Additional paid-in capital 58,220 57,690
Cumulative other comprehensive income (loss) 227 247
Accumulated deficit (25,666) (26,587)
Less stock subscription receivable (57) (44)
-------- --------
Total Stockholders' Equity 32,482 31,188
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 64,542 $ 50,606
======== ========
The accompanying condensed notes are an integral part of these consolidated financial statements.
3
PACIFICNET INC. AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS
(Unaudited. In thousands of United States dollars, except loss per share and
share amounts)
2006 2005
---- ----
THREE MONTHS ENDED MARCH 31:
Revenues $ 15,034 $ 9,212
Services 8,888 3,264
Product sales 6,146 5,948
-------- --------
Cost of revenues (8,553) (7,514)
Services (3,256) (2,321)
Product sales (5,297) (5,193)
-------- --------
Gross margin 6,481 1,698
Selling, general and administrative expenses (4,323) (882)
Depreciation and amortization (58) (43)
Interest expense (88) --
-------- --------
EARNINGS FROM OPERATIONS 2,012 773
Interest income 32 -
Sundry income 125 93
-------- --------
EARNINGS BEFORE INCOME TAXES AND MINORITY INTEREST 2,169 866
Provision for income taxes (115) (26)
Share of earnings of associated companies (3) (8)
Minority interests (1,130) (417)
-------- --------
NET EARNINGS AVAILABLE TO COMMON STOCKHOLDERS $ 921 $ 415
======== ========
BASIC EARNINGS PER SHARE $ 0.08 $ 0.04
======== ========
DILUTED EARNINGS PER SHARE $ 0.08 $ 0.04
======== ========
The accompanying condensed notes are an integral part of these consolidated
financial statements.
4
PACIFICNET INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
CUMULATIVE
ADDITIONAL STOCK OTHER TOTAL
PREFERRED COMMON PAID-IN SUBSCRIPTION COMPREHENSIVE ACCUMULATED TREASURY STOCKHOLDERS'
STOCK STOCK CAPITAL RECEIVABLE INCOME/(LOSS) DEFICIT STOCK EQUITY
-------- -------- -------- ----------- -------- -------- ------- ------
BALANCE AT DECEMBER 31,
2005
(10,831,024 SHARES) -- $1 $57,690 $(44) $247 ($26,587) ($119) $ 31,188
======== ======= ======== ========== ========= ========= ======= =========
Net earnings -- 921 921
Exercise of stock options
for cash and receivable
(24,000 shares) -- 42 42
Issuance of common stock
for acquisition of
subsidiaries
(58,787 shares) -- 397 397
Repurchase of common
shares (less 24,200 shares) -- (124) (124)
Cumulative foreign
exchange gain/(loss) -- (20) (20)
Stock-based compensation 62 62
Issuance of warrants for fees
of issuing convertible debt
(16,000 warrants) 29 29
Less stock subscription
receivable -- (13) (13)
-------- -------- -------- ----------- -------- -------- ------- --------
BALANCE AT MARCH 31, 2006
(10,889,611 SHARES) -- $ 1 $ 58,220 $(57) $227 $(25,666) $(243) $32,482
======== ======== ======== =========== ======== ======== ======= =========
The accompanying condensed notes are an integral part of these consolidated financial statements.
5
PACIFICNET INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited. In thousands of United States dollars, except earnings per share and
share amounts)
THREE MONTHS ENDED MARCH 31
2006 2005
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net earnings $ 921 $ 415
ADJUSTMENT TO RECONCILE NET EARNINGS TO NET CASH USED IN OPERATING ACTIVITIES:
Equity loss of associated company 3 --
Minority Interest 1,130 417
Unrealized loss/gain) on marketable equity securities (2) --
Exchange gain due to foreign currency translation 20 --
Depreciation and amortization 296 43
Stock-based compensation 62 --
CHANGES IN CURRENT ASSETS AND LIABILITIES NET OF EFFECTS FROM PURCHASE OF
SUBSIDIARIES:
Accounts receivable and other current assets (6,296) (2,153)
Inventories (527) (430)
Accounts payable and other accrued expenses 807 (1,798)
-------- --------
NET CASH USED IN OPERATING ACTIVITIES (3,586) (3,506)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Increase in restricted cash (1) --
Increase in purchase of marketable securities (24) (36)
Acquisition of property and equipment (1,751) 63
Acquisition of subsidiaries and affiliated companies (390) (233)
-------- --------
NET CASH USED IN INVESTING ACTIVITIES (2,166) (206)
-------- --------
CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
Decrease in loan receivables 37 --
Increase in loans receivable from related party (794) --
Increase in loan payable to related party 144 467
Dividend paid to minority interest shareholders -- (339)
Repayments under bank line of credit (49) -
Advances under bank loan 153 (836)
Repayments of amount borrowed under capital lease obligations (34) --
Repurchase of treasury shares (124) -
Proceeds from exercise of stock options and warrants 29 111
Proceeds from issuance of convertible debenture 8,000 -
-------- --------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 7,362 (597)
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,610 (4,309)
CASH AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD 9,579 6,764
-------- --------
CASH AND CASH EQUIVALENTS, END OF THE PERIOD
$ 11,189 $ 2,455
======== ========
CASH PAID FOR:
Interest $ 87 $ 45
Income taxes $ 32 $ 34
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Fixed assets acquired under bank financing agreement 1,082 --
Investments in subsidiaries acquired through the issuance of common stock 397 --
The accompanying condensed notes are an integral part of these consolidated financial statements.
6
PACIFICNET INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts expressed in United States dollars unless otherwise stated)
1. BASIS OF PRESENTATION
DESCRIPTION OF OPERATIONS - PacificNet Inc. (referred to herein as "PacificNet"
or the "Company"), through our subsidiaries, provides outsourcing services,
value-added telecom services (VAS) and communication products distribution
services. Our business process outsourcing (BPO) services include call centers,
providing customer relationship management (CRM), and telemarketing services,
and our information technology outsourcing (ITO) includes software programming
and development. We are value-added resellers and providers of telecom VAS,
which is comprised of interactive voice response (IVR) systems, call center
management systems, and voice over Internet protocol (VOIP), as well as mobile
phone VAS, such as short messaging services (SMS) and multimedia messaging
services (MMS). The Company's operations are primarily targeted in the China and
Hong Kong market.
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --The condensed unaudited
consolidated financial statements include the accounts of PacificNet Inc. and
its subsidiaries. The financial statements have been prepared in accordance with
U.S. generally accepted accounting principles for interim financial reporting.
All significant intercompany balances and transactions have been eliminated in
consolidation. In the opinion of management, all material adjustments considered
necessary for a fair presentation of the Company's interim results have been
reflected. PacificNet's 2005 Annual Report on Form 10-KSB includes certain
definitions and a summary of significant accounting policies and should be read
in conjunction with this report. The results for interim periods are not
necessarily indicative of annual results.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") 123-R, SHARE-BASED PAYMENT
("SFAS 123(R)"). SFAS 123(R) replaces SFAS 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, and supersedes APB Opinion 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES. SFAS 123(R) requires, among other things, that all share-based
payments to employees, including grants of stock options, be measured based on
their grant-date fair value and recognized as expense. Effective January 1,
2006, PacificNet adopted the fair value recognition provisions of SFAS 123(R)
using the modified prospective application method. Under this transition method,
compensation expense recognized for the quarter March 31, 2006, includes the
applicable amounts of: (a) compensation expense of all stock-based payments
granted prior to, but not yet vested as of January 1, 2006 (based on the
grant-date fair value estimated in accordance with the original provisions of
SFAS 123 and previously presented in pro forma footnote disclosures), and (b)
compensation expense for all stock-based payments granted subsequent to January
1, 2006 (based on the grant-date fair value estimated in accordance with the new
provisions of SFAS 123(R)). Results for periods prior to January 1, 2006, have
not been restated. See Note 7.
In February 2006, the FASB issued SFAS No. 155, ACCOUNTING FOR CERTAIN HYBRID
FINANCIAL INSTRUMENTS--AN AMENDMENT OF FASB STATEMENTS NO. 133 AND 140 ("SFAS
155"). This statement amends SFAS NO. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS
AND HEDGING ACTIVITIES ("SFAS 133"), and SFAS No. 140, ACCOUNTING FOR TRANSFERS
AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES and
resolves issues addressed in SFAS 133 Implementation Issue No. D1, "Application
of Statement 133 to Beneficial Interest in Securitized Financial Assets." This
Statement: (a) permits fair value re-measurement for any hybrid financial
instrument that contains an embedded derivative that otherwise would require
bifurcation; (b) clarifies which interest-only strips and principal-only strips
are not subject to the requirements of SFAS 133; (c) establishes a requirement
to evaluate beneficial interests in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain an embedded derivative requiring bifurcation; (d)
clarifies that concentrations of credit risk in the form of subordination are
not embedded derivatives; and, (e) eliminates restrictions on a qualifying
special-purpose entity's ability to hold passive derivative financial
instruments that pertain to beneficial interests that are or contain a
derivative financial instrument. The standard also requires presentation within
the financial statements that identifies those hybrid financial instruments for
which the fair value election has been applied and information on the income
statement impact of the changes in fair value of those instruments. The Company
is required to apply SFAS 155 to all financial instruments acquired, issued or
subject to a re-measurement event beginning January 1, 2007, although early
adoption is permitted as of the beginning of an entity's fiscal year. The
Company is evaluating the provisions of SFAS 155. The effects of adopting of
SFAS 155 on the Company's financial statements are not known at this time.
Other recent accounting pronouncements issued by the FASB (including its
Emerging Issues Task Force ("EITF")), the American Institute of Certified Public
Accountants ("AICPA"), and the SEC did not or are not believed by management to
have a material impact on the Company's present or future financial statements.
7
3. EARNINGS PER SHARE
Basic and diluted earnings per share (EPS) amounts in the financial statements
are computed in accordance with SFAS No. 128, "Earnings Per Share." Basic EPS is
based on the weighted average number of common shares outstanding. Diluted EPS
is based on the weighted average number of common shares outstanding plus
dilutive common stock equivalents. Basic EPS is computed by dividing net
earnings available to common stockholders (numerator) by the weighted average
number of common shares outstanding (denominator) during the period. Diluted EPS
is calculated by dividing net earnings by the weighted average number of common
shares outstanding and other dilutive securities. Dilutive EPS for first quarter
of 2006 exclude the potential dilutive effect of 766,000 (2005: 400,000)
warrants because their impact would be anti-dilutive based on current market
prices. All per share and per share information are adjusted retroactively to
reflect stock splits and changes in par value.
The reconciliation of the numerators and denominators of the basic and diluted
EPS calculations follows for the three months ended March 31:
2006 2005
-------------------------------------------------------------------------- --------------------------------------------
(IN THOUSANDS OF UNITED STATES DOLLARS,
EXCEPT WEIGHTED SHARES AND PER SHARE
AMOUNTS)
-------------------------------------------------------------------------- --------------------------------------------
Numerator: earnings $921 $415
=== ===
Denominator:
Weighted-average shares used to compute basic EPS 10,855,761 9,794,088
Dilutive potential from assumed exercise of stock options and warrants 671,184 1,034,103
---------- ---------
Weighted-average shares used to compute diluted EPS 11,526,945 10,828,191
========== ==========
Basic earnings per common share: $0.08 $0.04
==== ====
Diluted earnings per common share: $0.08 $0.04
==== ====
4. BUSINESS ACQUISITIONS
During the first quarter of 2006, PacificNet acquired various entities in
accordance with the Company's strategy to grow via mergers and acquisitions. The
entities acquired met various PacificNet acquisition criteria, which include
reasonable expectations for positive earnings and cash flow within two years of
acquisition and reputation for high quality and performance in customer
relationship management, brand name recognition, and well-established
relationships with clients. Several factors contributed to the determination of
the negotiated purchase price and deal structure, including the value of
assets acquired and liabilities assumed, historical EBITDA and projected EBITDA.
The assets acquired and liabilities assumed were recorded at estimated fair
values as determined by the Company's management based on information currently
available and on current assumptions as to future operations.
A summary of business acquisitions for the periods presented follows:
GUANGZHOU WANRONG INFORMATION TECHNOLOGY CO., LIMITED (INCORPORATED IN THE PRC)
On January 31, 2006, the Company, through its subsidiary PacificNet Strategic
Investment Holdings Limited, consummated the acquisition of a 51% controlling
interest in Guangzhou Wanrong Information Technology Co. Limited (Guangzhou
Wanrong), one of the leading value-added telecom service providers in China,
located in PRC Guangzhou. Since its inception in 2003, Guangzhou Wanrong has
achieved strong growth in its VAS including SMS, WAP, JAVA, MMS, IVR, multimedia
entertainment download services, media interactive products, mobile email
services, life, sports, entertainment, and business information services.
Guangzhou Wanrong was granted nationwide SMS service numbers "2388" for China
Mobile and "9928" for China Unicom. Wanrong's integrated value-added mobile
services system is valuable for the implementation of PacificNet's "iPACT
program", a standard service-mark for PacificNet's VAS profit-sharing alliance
partnership program.
The consideration was paid as follows:
(i) The purchase consideration for 51% of the equity interest of Guangzhou
Wanrong was approximately US$1.75million, payable 21% in cash and 79% in
restricted shares of PacificNet common stock valued at $8 per share, or about
173,000 restricted shares.
(ii) Under the purchase agreement, Guangzhou Wanrong has made a guarantee to
generate US$500,000 in annual net income. In the event of a shortfall, the
purchase price will be adjusted accordingly.
8
(iii) PacificNet will also invest approximately RMB 3 million (or about
US$370,000) in Guangzhou Wanrong for general corporate purposes. The purchase
price is payable upon achievement of certain quarterly earn-out targets based on
net income
A summary of the assets acquired and liabilities assumed in the acquisition
follows:
----------------------------------------------------------------------
Estimated fair values:
----------------------------------------------------------------------
Current Assets $185,050
Property Plant and equipment --
Goodwill 461,468
--------
Total Assets Acquired 646,158
Current Liabilities assumed --
--------
Net assets acquired $646,158
========
As of March 31, 2006, goodwill of $461,468 represents the excess of the purchase
price over the fair value of the assets acquired and is not deductible for tax
purposes. The total amount of goodwill by reportable segment for Value-added
Telecom Services was $10,045,253 (see Note 9).
In accordance with SFAS 142, goodwill is not amortized but is tested for
impairment at least annually. The purchase price allocation for Guangzhou
Wanrong acquisition is based on a management's estimates and overall industry
experience. Immediately after the signing of the definitive agreement, the
Company obtained effective control over Guangzhou Wanrong. Accordingly, the
operating results of Guangzhou Wanrong have been consolidated with those of the
Company starting January 31, 2006. Pursuant to SFAS 141 "Business Combinations",
the earn-out consideration was considered contingent consideration and after the
audited combined after-tax profit of US$123,305 for the 3 months ended March 31,
2006 was available. All the contingent consideration has been reflected in the
consolidated financial statements of the Company as of March 31, 2006.
UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION DISCLOSURE FOR THE THREE
MONTHS ENDED MARCH 31, 2006 AND 2005
The following un-audited pro forma consolidated financial information for the
three months ended March 31, 2006 and 2005, as presented below, reflects the
results of operations of the Company assuming the acquisition occurred on
January 1, 2005 and 2006 respectively, and after giving effect to the purchase
accounting adjustments. These pro forma results have been prepared for
information purposes only and do not purport to be indicative of what operating
results would have been had the acquisitions actually taken place on January 1,
2005 and 2006 respectively, and may not be indicative of future operating
results.
------------------------------------------------------------------------------
Quarter ended March Quarter ended March
31, 2006 31, 2005
------------------------------------------------------------------------------
(UN-AUDITED AND IN THOUSANDS OF U.S.
DOLLARS)
------------------------------------------------------------------------------
Revenue $15,289 $9,437
Operating income $2,141 $812
Net earnings $933 $454
Earnings per share - basic (cents) $0.09 $0.04
Earnings per share - diluted (cents) $0.08 $0.04
PacificNet included the financial results of Guangzhou Wanrong in its
consolidated 2006 Q1 financial results from the date of the purchase, January
31, 2006 through March 31, 2006.
9
PACIFICNET IMOBILE (BEIJING) TECHNOLOGY CO., LIMITED (INCORPORATED IN THE PRC)
------------------------------------------------------------------------------
On February 26, 2006, PacificNet acquired a 51% majority interest in PacificNet
iMobile (Beijing) Technology Co., Ltd ("iMobile"), one of the leading Internet
information portal and e-commerce distributors for mobile phone and accessories
and mobile related value-added service providers in China. iMobile operates its
e-commerce business via two Internet portals, "http://www.iMobile.com.cn" and
"http://www.18900.com" and one WAP portal "17wap.com" for mobile phone browsing.
In addition, iMobile's 18900.com operation is the designated Internet
distributor for Motorola, Nokia, and NEC's mobile products in China. iMobile's
Internet portal has been one of the top ranked traffic sites and has achieved
about 2.3 million registered online users and over 400,000 active users, with 5
million daily page views and 20,000 blog postings per day, which makes iMobile
the top ranked site in its category in China. This acquisition was structured in
the same manner as our other acquisitions, that are classified and accounted for
as variable interest entities in accordance with FASB Interpretation No. 46R
"Consolidation of Variable Interest Entities" ("FIN 46R"), an Interpretation of
Accounting Research Bulletin No. 51.), with operation and services agreements
between Beijing Xing Chang Xin Science and Technology Development Co. Limited
Incorporated DE and PacificNet Imobile (Beijing) Technology, Co. Ltd. WOFE. The
results of variable interest entities acquired during the period are included in
the consolidated income statements from the effective date of the acquisition.
The consideration was paid as follows:
(i) The purchase consideration for 51% of the equity interest of iMobile is
approximately US$1.8 million, which represents approximately seven times the
anticipated future annual net income of iMobile.
(ii) The purchase consideration is payable 14% in cash and 86% in restricted
shares of PacificNet valued at $8 per share, or about 191,875 restricted shares.
The purchase price is payable upon achievement of certain quarterly earn-out
targets based on net income.
(iii) Under the purchase agreement, iMobile has committed to generate US$500,000
in annual net income. In the event of a shortfall, the purchase price will be
adjusted accordingly.
(iv) PacificNet will also invest approximately RMB2 million (about US$250,000)
in iMobile for general corporate and working capital purposes to support growth.
The purchase price is payable upon achievement of certain quarterly earn-out
targets based on net income.
10
5. GOODWILL AND PURCHASED INTANGIBLE ASSETS
The changes in the carrying amount of goodwill for the following reporting
periods are summarized below:
----------------------------------------------------------- ---------------- --------------- ----------------- ------------------
Group 1.
Outsourcing Group 2. Group 3. Total
Services Value-Added Distribution of
(US$000s) Products Services Communications
----------------------------------------------------------- ---------------- --------------- ----------------- ------------------
Balance as of December 31, 2005 $3,543 $9,584 $1,100 $14,227
========== ========== ========== ==========
Goodwill acquired during the first quarter -- 461 -- --
Impairment losses -- -- -- --
Goodwill written off related to sale of business unit -- -- -- --
Balance as of March 31, 2006 $3,543 $10,045 $1,100 $14,688
========== ========== ========== ==========
6. STOCKHOLDERS' EQUITY
a) COMMON STOCK
For the quarter ended March 31, 2006, the Company had the following equity
transactions: (i) 24,000 shares of common stock were issued as a result of the
exercise of stock options with cash consideration of $42,000 in the aggregate
and (ii) 58,787 shares of common stock were issued for acquisition of
subsidiaries valued at $397,000.
b) STOCK OPTION PLAN - See Note 7 for further details.
The status of the Stock Option Plan as of March 31, 2006, is as follows:
-------------------------------- ------------------ ----------------------------
OPTIONS WEIGHTED
AVERAGE
EXERCISE PRICE
-------------------------------- ------------------ ----------------------------
OUTSTANDING, DECEMBER 31, 2005 1,384,100 $3.99
Granted - -
Cancelled - -
Exercised (24,000) $1.75
-----------------------------------------------
OUTSTANDING, MARCH 31, 2006 1,360,100 $4.17
============== ==============
-------------------------------- ------------------ ----------------------------
11
c) WARRANTS
At March 31, 2006, the Company had outstanding and exercisable warrants to
purchase an aggregate of 1,007,138 shares of common stock. The weighted average
remaining life is 4.10 years and the weighted average price per share is $10.61
per share as follows:
--------------------------- ----------------------- ----------------------------
EXERCISE PRICE
Shares of common stock PER SHARE EXPIRATION DATE OF WARRANTS
--------------------------- ----------------------- ----------------------------
123,456 $7.15 January 15, 2009
117,682 $3.89 November 15, 2009
350,000 $12.21 December 9, 2009
400,000 $12.20 March 13, 2011
16,000 $12.20 March 13, 2011
---------
1,007,138
=========
On March 13, 2006, we issued 400,000 warrants to several institutional
investors. On the same day we issued 16,000 warrants to our placement agent for
the transaction. See Note 8 for further details.
d) TREASURY STOCK
The following is a summary of the movement of the Company's shares held as
treasury stock for the quarter ended March 31, 2006:
----------------------------------------------------------------------------------------------------------------
Number of Remarks
shares
----------------------------------------------------------------------------------------------------------------
Balance, December 31, 2005: 1,169,663
Plus: options exercised and issued during Q1 24,000
Share consideration for acquisition of Chinagohi issued
during Q1 under Sale and Purchase Agreement 137,500
Less: Shares issued to Shanghai Classic (24,200)
Plus: Repurchase of shares from Shanghai Classic 24,200
Holdback shares as contingent consideration 1,017,723 Including 687,500 shares relating
due to performance targets not yet met to Chinagohi; 138,348 shares to
Guangzhou Wanrong; 191,875 shares
to iMobile
----------
Balance, March 31, 2006 2,348,886
Shares outstanding at March 31, 2006 10,889,611
----------
Shares issued at March 31, 2006 13,238,497
==========
On March 13, 2006, we repurchased 24,200 restricted shares of our common stock
from Yueshen, a subsidiary of Shanghai Classic for a repurchase price of
RMB1,000,000 (approximately USD$124,223 using exchange rate of 1USD= 8.05 RMB).
The shares repurchased was proposed by Yueshen and has been unanimously agreed
by both parties.
7. STOCK-BASED COMPENSATION
Prior to January 1, 2006, PacificNet accounted for awards granted under
stock-based compensation plans following the recognition and measurement
principles of APB 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related
interpretations. Accordingly, compensation expense was recognized for awards
granted at an exercise price less than fair market value of the underlying
common stock on the date of grant. Effective January 1, 2006, PacificNet adopted
the fair value recognition provisions of SFAS 123(R). See Note 2 for a
description of the Company's adoption of SFAS 123R. The fair value of stock
options is determined using the Black-Scholes option pricing model, which is
consistent with the valuation techniques previously utilized for options in
12
footnote disclosures required under SFAS 123, as amended by FASB Statement No.
148, "Accounting for Stock-Based Compensation--Transition and Disclosure." The
determination of the fair value of stock-based compensation awards on the date
of grant using an option-pricing model is affected by the Company's stock price
as well as assumptions regarding a number of complex and subjective variables,
including the expected volatility of the Company's stock price over the term of
the awards, actual and projected employee stock option exercise behaviors,
risk-free interest rate and expected dividends. The amount of stock-based
compensation expense recognized during the three months ended March 31, 2006 was
$61,709.
During the quarter ended March 31, 2006, the Company did not grant any new stock
options and 24,000 options were exercised. No options were canceled or
forfeited.
Additional information on options outstanding as of March 31, 2006 is as
follows:
-------------------------- ----------------- --------------- -------------------
WEIGHTED OPTIONS AVERAGE
AVERAGE REMAINING
EXERCISE CONTRACTUAL
PRICE LIFE
-------------------------- ----------------- --------------- -------------------
Options outstanding $4.17 1,360,100 1.99 years
Options exercisable $3.31 1,027,500 1.51 years
-------------------------- ----------------- --------------- -------------------
8. CONVERTIBLE DEBENTURES
On March 13, 2006, we completed a private placement in which we sold $8,000,000
in convertible debentures and issued warrants to purchase up to an aggregate of
400,000 shares of common stock. The debentures are convertible at any time into
shares of our common stock at an initial fixed conversion price of $10.00 per
share, subject to adjustments for certain dilutive events. The debentures are
due March 13, 2009. The warrants are exercisable for a period of five years at
an exercise price of $12.20 per share. At the closing of the private placement,
we prepaid the first year's interest on debentures equal to 5% of the aggregate
principal amount of debentures. We will pay interest in cash or shares, provided
that certain conditions are met, at the rate of 6% for the second year the
debentures are outstanding and then 7% for the third. Beginning January 1, 2007,
we are obligated to redeem up to $320,000 every month, plus accrued, but unpaid
interest, liquidated damages and penalties. We also have the option to prepay
the debentures at any time, provided that certain conditions have been met,
after the 12 month anniversary of the effective date of the registration
statement that has been filed with the Securities and Exchange Commission with
respect to the common stock issuable upon conversion of the debentures, some or
all of the outstanding debentures for cash in an amount equal to 120% of the
principal amount outstanding, plus accrued, but unpaid interest, liquidated
damages and penalties outstanding. At any time after the six month anniversary
of the effective date, we may force the holders to convert up to 50% of the then
outstanding principal amount of the debentures, subject to certain trading
conditions being met. If any event of default occurs under the debentures or
other related documents, the holders may elect to accelerate the payment of the
outstanding principal amount of the debenture, plus accrued, but unpaid
interest, liquidated damages and penalties, which shall become immediately due
and payable.
C.E. Unterberg, Towbin L.L.C. acted as Placement Agent and received a negotiated
cash fee in the amount of $449,500 and a warrant to purchase up to 16,000 shares
at an exercise price of $12.20 per share, which expire five years from the date
of issuance. The fair value of these warrants totaled $28,952 and such amount
was charged to other assets, net, and will be amortized over the life of the
debentures, and credited to additional paid-in capital during the three months
ended March 31, 2006. Maxim Group also acted as Placement Agent and received a
cash fee in the amount of $50,000.
In connection with the issuance of the debentures, the Company incurred
$1,432,000 of issuance costs, which primarily consisted of investment banker
fees, legal and other professional fees, and prepaid interest. These costs are
being amortized and are recorded as additional expense over three years, the
scheduled life of the debentures on which holders have the option to require the
Company to repurchase the debentures. Amortization expense related to the
issuance costs during the three months ended March 31, 2006 was immaterial. At
March 31, 2006, net debt issuance costs associated with the debentures was
$1,432,000 and is recorded in other assets, net.
9. SEGMENT INFORMATION
The Company determines and classified its operating segments in accordance with
SFAS No. 131 "DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED
INFORMATION. "The Company identifies and classifies its operating segments based
on reporting entities that exhibit similar long-term financial performance based
on the nature of the products and services with similar economic characteristics
such as margins, business practices and target market. The operating segments
are classified into four major segments which are summarized as follows:
(1) Outsourcing Services - involves human voice services such as
Business Process Outsourcing, CRM, call center, IT Outsourcing and
software development services. These types of services are conducted
through our subsidiaries EPRO, Smartime/Soluteck and PacificNet
Solution Ltd.
13
(2) Value-Added Telecom Services (VAS) - primarily involves machine
voice services such as Interactive Voice Response, SMS and related VAS,
which are conducted through our subsidiaries such as ChinaGoHi (Lion
Zone, aka GoHi), Linkhead, Clickcom and Guangzhou 3G.
(3) Communication Products Distribution Services Group - primarily
involves voice products distribution such as distribution of calling
cards and other products, which are conducted through our subsidiaries
iMobile, Shanghai Classic and PacificNet Communication.
(4) Other Business -other administrative, financial and investment
services and non-core businesses such as PacificNet Power Limited
(PacPower), Pacific Financial Services Limited, PacificNet Games, etc.
The Company's reportable segments are operating units, which represent the
operations of the Company's significant business operations. Summarized
financial information concerning the Company's reportable segments is shown in
the following table. The "Other" column includes the Company's other
insignificant services and corporate related items, and, as it relates to
segment earnings (loss), income and expense not allocated to reportable
segments.
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
FOR THE THREE MONTHS Group 1. Group 2. Group 3. Group 4. Total
ENDED MARCH 31, 2006 Outsourcing VAS Business Communications Other Business
Business Distribution
($) ($) Business ($) ($) ($)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Revenues 3,027,000 7,040,000 3,355,000 1,612,000 15,034,000
(% of Total Rev) (20.1%) (46.8%) (22.3%) (10.7%) (100%)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Earnings / (Loss) from
Operations 120,000 1,714,000 351,000 (173,000) 2,012,000
(% of Total Earnings) (6.0%) (85.2%) (17.4%) (-8.6%) (100%)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Total Assets 7,446,000 20,637,000 14,011,000 22,448,000 64,542,000
(% of Total Assets) (11.5%) (32.0%) (21.7%) (34.8%) (100%)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Goodwill 3,543,000 10,045,000 1,100,000 - 14,688,000
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Geographic Area HK,PRC HK,PRC HK,PRC HK,PRC
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
For the three months 1.Outsourcing 2. VAS 3. Communications 4. Other Business Total
ended Business Business Distribution
March 31, 2005 ($) ($) Business($) ($) ($)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Revenues 3,064,000 1,409,000 4,676,000 63,000 9,212,000
(% of Total Rev) (33.3%) (15.3%) (50.8%) (0.7%) (100%)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Earnings / (Loss) from
Operations 239,000 556,000 129,000 (151,000) 773,000
(% of Total Earnings) (30.9%) (71.9%) (16.7%) (-19.5%) (100%)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Total Assets 4,476,000 4,200,000 8,388,000 14,266,000 31,330,000
(% of Total Assets) (14.3%) (13.4%) (26.8%) (45.5%) (100%)
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Goodwill 3,543,000 4,489,000 1,100,000 - 9,132,000
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Geographic Area HK,PRC HK,PRC HK,PRC HK,PRC
-------------------------- ------------------ ------------------- ------------------- ------------------ ----------------
Product and service revenues classified by major geographic areas are as follows
(in US$):
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
March 31, 2006 Hong Kong PRC United States Total
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
Product revenues $4,517,000 $1,629,000 $0- $6,146,000
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
Service revenues $3,031,000 $5,857,000 $0 $8,888,000
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
March 31, 2005 Hong Kong PRC United States Total
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
Product revenues $508,000 $5,440,000 $0- $5,948,000
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
Service revenues $2,232,000 $1,032,000 $0 $3,264,000
-------------------------------------- ----------------------- ------------------ ------------------ ---------------------
14
10. RELATED PARTY TRANSACTIONS
LOAN DUE TO AND FROM RELATED PARTIES
------------------------------------
As of March 31, 2006, there was a total loan receivable of approximately
$3,314,000 due from related parties while the loan due to related party was
$513,000.
As of March 31, 2006, the related party loan receivables included $1,026,000 due
from Take 1, an affiliated company that is 20% owned by PacificNet, $2,288,000
due from shareholder and directors of PacificNet's subsidiaries. The loans
receivable from shareholders and directors of PacificNet's subsidiaries
comprised of $1,251,000 due from a shareholder of Yueshen, $86,000 due from a
shareholder of EPRO, $196,000 due from a director of Soluteck, $257,000 due from
a director of Clickcom, and $498,000 due from a company owned by a shareholder
of Lion zone (ChinaGohi).The terms of these related parties loan receivables and
payables are summarized below:
LOAN TO TAKE 1
--------------
Take 1 is an affiliated company, 20% owned by PacificNet as of March 31, 2006. A
Convertible Loan of $1,026,000 is outstanding from Take 1 as of March 31, 2006,
the purpose of which was a working capital loan to finance the expansion of Take
1's business in Europe and North America.
LOAN TO YUESHEN'S SHAREHOLDER
-----------------------------
As of March 31, 2006, there was $1,251,000 loan receivable due from the
shareholder of Yueshen, a subsidiary of the Company. The purpose of the loan was
to repay the working capital loan owed by the predecessor of Yueshen prior to
PacificNet's acquisition and to finance Yueshen shareholder's other projects.
This loan is collateralized with 106,240 PacificNet shares owned by the
shareholder of Yueshen.
LOAN TO SOLUTEK'S DIRECTOR
--------------------------
As of March 31, 2006, there was a loan receivable of $196,000 due from a
director of Soluteck, payable in three equal installments of $72,314 each, being
principal plus interest, due on December 14 for three consecutive years ending
2007. The interest rate for the loan is 8% per annum plus 5% penalty interest in
case it has not been timely paid. The loan is collateralized with 100,000
PacificNet's shares owned by the borrowing director and Ms Iris Lo, and the
remaining assets of Smartime Holding Ltd.
LOAN TO DIRECTOR OF CLICKCOM
----------------------------
As of March 31, 2006, there was a loan of $257,000 receivable from the
shareholders of Clickcom VIE. The loan was advanced by the Company to Clickcom
VIE which in turn loaned to the shareholders of Clickcom VIE to finance the
development of new projects. Pursuant to the loan agreement signed between the
Company and Clickcom VIE, this loan has a two year term due on August 30, 2007
and bears a 2% interest rate and is personally and jointly guaranteed by all the
three shareholders of Clickcom VIE on top of the pledged shares up to 130,000
PacificNet's shares and all remaining assets and equity ownership of Clickcom
BVI.
LOAN TO SHAREHOLDER OF EPRO
---------------------------
As of March 31, 2006, a loan receivable of $86,000 was due from a shareholder of
Epro. The loan is unsecured, interest-free and repayable on demand.
LOAN TO A COMPANY OWNED BY A SHAREHOLDER OF LION ZONE (CHINAGOHI)
------------------------------------------------------------
Aa of March 31, 2006, a loan receivable of $498,000 was due from a company owned
by a shareholder of Lion Zone (ChinaGohi). The loan is collateralized by this
company's real estate.
LOAN PAYABLE TO RELATED PARTY
-----------------------------
As of March 31, 2006, a loan of $513,000 was payable to a shareholder of EPRO.
The loan was advanced to Epro for working capital purposes expiring August 4,
2010, bearing interest at the Hong Kong Prime lending rate of approximately 6.5%
interest per annum prevailing in the year 2005.
15
11. COMMITMENTS AND CONTINGENCIES
OPERATING LEASES. The Company leases warehouse and office space under operating
leases with fixed monthly rentals. None of the leases included contingent
rentals. Lease expense charged to operations for 2006 Q1 amounted to $320,000
(2005 Q1: $153,000). Future minimum lease payments under non-cancelable
operating leases are as follows: 2006: $815,000 and 2007: $806,000.
RESTRICTED CASH - The Company has a $164,000 pledged bank deposit for Epro which
represents overdraft protections with certain financial institutions and a fixed
deposit of $1,489,000 for Lion Zone (ChinaGoHi) utilized to provide guarantee
for a related party.
BANK LINE OF CREDIT (2006 Q1): As of March 31, 2006, Epro has an overdraft
banking facility with certain major financial institutions in the aggregate
amount of $1,011,000, which is secured by a pledge of its fixed deposits of
$164,000, pursuant to the following terms: interest will be charged at the Hong
Kong Prime Rate per annum and payable at the end of each calendar month or the
date of settlement, whichever is earlier.
MINIMUM STATED CAPITAL REQUIREMENTS. Guangzhou Dianxun Co, Limited (DE)
("Dianxun"), a subsidiary of the Group, is carrying on business as a
telecommunication value added service provider in the People's Republic of China
("PRC"). Initially, Dianxun obtained a certificate (the "Certificate") from the
PRC authority to transact business and according to the PRC Telecommunication
Rules, all telecommunication value added service providers can only carry on
business if the Certificate is granted and if the Company maintains a minimum
capital requirement of at least RMB10,000,000.
In order to satisfy the capital requirement of RMB 10,000,000, the shareholders
of Dianxun had contributed relevant assets equivalent to RMB9,000,000 on behalf
of Dianxun and such assets were verified by an independent professional
accountant. Subsequently, such assets were returned back to the shareholders. In
the opinion of the directors, even though the capital requirement is not
fulfilled, Dianxun can continue to carry on business. No provision for any loss
arising from the consequential actions that may be taken by the authority in the
PRC and any potential penalties or claims for the Company not maintaining the
minimum stated capital requirements of the PRC have been made in these financial
statements.
Dianxun's contribution to consolidated revenues and net earnings for 2006 was
approximately 0.50% and 1.39%, respectively. Upon demand by the PRC authorities,
PacificNet has agreed to loan Clickcom the remaining balance of the registration
capital to provide the stated capital in accordance with PRC laws.
BANK LOANS. Bank loans represent the following at March 31, 2006 (in thousands):
-------------------------------------- ---------------------
Secured [1] 1,380
-------------------------------------- ---------------------
Unsecured 30
-------------------------------------- ---------------------
Less: current portion 215
-------------------------------------- ---------------------
Non current portion 1,195
-------------------------------------- ---------------------
Bank Loans are generated by two of the Company's subsidiaries. One of the
subsidiaries is Pacificnet Epro Holdings Limited, a company incorporated in the
Hong Kong Special Administrative Region of the PRC, primarily engaged in the
business of providing call center and customer relationship management (CRM)
services as well as other business outsourcing services.
[1] The loans were secured by the following: joint and several personal
guarantees executed by certain directors of the subsidiary of the Company;
corporate guarantee executed by a subsidiary of the Company; second legal charge
over a property owned by a subsidiary of the Company; and pledged bank deposits
of $164,000 (2005:$163,000) of a subsidiary of the Company.
(Aggregate future maturities of borrowing for the next five years are as
follows: 2006: $169,000, 2007: $100,000 and 2008: $78,000)
The remaining bank loans of $1,063,000 are generated by PacificNet Inc. relating
to a fixed asset of $1,082,000 bought during the first quarter with a total cost
of $2,255,000. The repayment of the bank loan was $19,000. (Aggregate future
maturities of borrowing for the following period are as follows: Less than 1
year: $46,000, 1-5year: $274,000 and after 5 years: $743,000)
CAPITAL LEASE OBLIGATIONS. The Company leases various equipments under capital
leases expiring in various years through 2008. Aggregate minimum future lease
payments under capital leases for each of the next five years are as follows:
(2006: $107,000; 2007: $57,000; and 2008: $6,000)
16
12. OTHER CURRENT ASSETS
Other current assets consists of the following at March 31, 2006 (in thousands):
Deposit $1,011
Prepayment for future service 1,613
Other current assets 766
Other receivables 3,109
------
Total $6,499
======
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE INFORMATION
CONTAINED IN THE FINANCIAL STATEMENTS OF THE COMPANY AND THE NOTES THERETO
APPEARING ELSEWHERE HEREIN AND IN CONJUNCTION WITH THE MANAGEMENT'S DISCUSSION
AND ANALYSIS SET FORTH IN THE COMPANY'S ANNUAL REPORT ON FORM 10-KSB FOR THE
YEAR ENDED DECEMBER 31, 2005.
PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
The statements contained in this Form 10-Q that are not purely historical are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These include statements about the Company's expectations, beliefs,
intentions or strategies for the future, which are indicated by words or phrases
such as "anticipate," "expect," "intend," "plan," "will," "the Company
believes," "management believes" and similar words or phrases. The
forward-looking statements are based on the Company's current expectations and
are subject to certain risks, uncertainties and assumptions, including those set
forth in the discussion under "Description of Business," including the "Risk
Factors" described in that section, and "Management's Discussion and Analysis or
Plan of Operation." The Company's actual results could differ materially from
results anticipated in these forward-looking statements. All forward-looking
statements included in this document are based on information available to the
Company on the date hereof, and the Company assumes no obligation to update any
such forward-looking statements.
FACTORS THAT COULD AFFECT FUTURE RESULTS
Factors that might cause actual results, performance or achievements to differ
materially from those projected or implied in such forward-looking statements
include, among other things:
o the impact of competitive products;
o changes in laws and regulations;
o adequacy and availability of insurance coverage;
o limitations on future financing;
o increases in the cost of borrowings and unavailability of debt or equity
capital;
o the inability of the Company to gain and/or hold market share;
o exposure to and expense of resolving and defending liability claims and
other litigation;
o consumer acceptance of the Company's products;
o managing and maintaining growth;
o customer demands;
o market and industry conditions,
o the success of product development and new product introductions into the
marketplace;
o the departure of key members of management, and
o the effect of the United States War on Terrorism, as well as other risks
and uncertainties that are described from time to time in the Company's
filings with the Securities and Exchange Commission.
Regarding one of our subsidiaries, for example, Epro is engaged in the business
of providing outsourced call center services with over 13 years of field
experience in China. The factors that could affect current and future results
are as follows:
o insufficient sales forces for business development & account servicing;
o lack of PRC management team in operation;
o less familiarity on partners' product knowledge;
o deployment costs of a new HR application and the costs to upgrade the call
center computer system;
17
o increasing operations costs (cost of salaries, rent, interest rates &
inflation) under rising economy in Hong Kong;
o insufficient brand awareness initiatives in the market;
o salary increases due to an active labor market in Hong Kong and GuangZhou;
and
o increasing competition of call center solutions in the Hong Kong and PRC
markets.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis or plan of operations is based upon our consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities.
On an on-going basis, we evaluate our estimates, including those related to
accounts receivable reserves, provisions for impairment losses of affiliated
companies and other intangible assets, income taxes and contingencies. We base
our estimates on historicalexperience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are notreadily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.
Management believes the following critical accounting policies reflect our more
significant estimates and assumptions used in the preparation of our
consolidated financial statements:
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We evaluate the collectibility of our trade receivables based on a combination
of factors. We regularly analyze our significant customer accounts, and, when we
become aware of a specific customer's inability to meet its financial
obligations to us, such as in the case of bankruptcy filings or deterioration in
the customer's operating results or financial position, we record a specific
reserve for bad debt to reduce the related receivable to the amount we
reasonably believe is collectible. We also record reserves for bad debt for all
other customers based on a variety of factors including the length of time the
receivables are past due, the financial health of the customer, macroeconomic
considerations and historical experience. If circumstances related to specific
customers change, our estimates of the recoverability of receivables could be
further adjusted. In the event that our trade receivables become uncollectible,
we would be forced to record additional adjustments to receivables to reflect
the amounts at net realizable value. The accounting effect of this entry would
be a charge to earnings, thereby reducing our net earnings. Although we consider
the likelihood of this occurrence to be remote based on past history and the
current status of our accounts, there is a possibility of this occurrence.
INCOME TAXES
We record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. We have considered future market
growth, forecasted earnings, future taxable income, and the mix of earnings in
the jurisdictions in which we operate and prudent and feasible tax planning
strategies in determining the need for a valuation allowance. We currently have
recorded a full valuation allowance against net deferred tax assets as we
currently believe it is more likely than not that the deferred tax assets will
not be realized. In the event we determine that we would not be able to realize
all or part of our net deferred tax assets in the future, an adjustment to the
deferred tax assets would be charged to earnings in the period such
determination is made. Likewise, if we later determine that it is more likely
than not that the net deferred tax assets would be realized, the previously
provided valuation allowance would be reversed.
CONTINGENCIES
We may be subject to certain asserted and unasserted claims encountered in the
normal course of business. It is our belief that the resolution of these matters
will not have a material adverse effect on our financial position or results of
operations, however, we cannot provide assurance that damages that result in a
material adverse effect on our financial position or results of operations will
not be imposed in these matters. We account for contingent liabilities when it
is probable that future expenditures will be made and such expenditures can be
reasonably estimated.
18
VALUATION OF LONG-LIVED ASSETS INCLUDING GOODWILL AND PURCHASED INTANGIBLE
ASSETS
We review property, plant and equipment, goodwill and purchased intangible
assets for impairment whenever events or changes in circumstances indicate the
carrying value of an asset may not be recoverable. Our asset impairment review
assesses the fair value of the assets based on the future cash flows the assets
are expected to generate. An impairment loss is recognized when estimated
undiscounted future cash flows expected to result from the use of the asset plus
net proceeds expected from disposition of the asset (if any) are less than the
carrying value of the asset. This approach uses our estimates of future market
growth, forecasted revenue and costs, expected periods the assets will be
utilized and appropriate discount rates. Such evaluations of impairment of
long-lived assets including goodwill arising on a business combination and
purchased intangible assets are an integral part of, but not limited to, our
strategic reviews of our business and operations performed in conjunction with
restructuring actions. When an impairment is identified, the carrying amount of
the asset is reduced to its estimated fair value. Deterioration of our business
in a geographic region or within a business segment in the future could also
lead to impairment adjustments as such issues are identified. The accounting
effect of an impairment loss would be a charge to earnings, thereby reducing our
net earnings.
NATURE OF THE OPERATIONS OF THE COMPANY
NATURE OF BUSINESS.
We were incorporated in the state of Delaware in 1987. Our business consists of
three groups, all of which operate within the outsourcing and telecommunications
industries in Asia, primarily greater China, which includes the People's
Republic of China (PRC), or mainland China, Hong Kong Special Administrative
Region (HKSAR), Macau Special Administrative Region, and Taiwan. Through our
subsidiaries we provide outsourcing services, value-added telecom services
(VAS), and communication products distribution services. Our business process
outsourcing (BPO) services include call centers providing customer relationship
management (CRM) and telemarketing services, and our information technology
outsourcing (ITO) includes software programming and development. We are
value-added resellers and providers of telecom VAS, which comprises interactive
voice response (IVR) systems, call center management systems, and VOIP, as well
as mobile phone VAS, such as short messaging services (SMS) and multimedia
messaging services (MMS). Recently, we commenced our communication products
distribution service, through wholesale and, to a lesser extent, retail sale and
distribution of calling cards in China, and we have recently invested in a
company that distributes multimedia interactive self-service kiosks. We intend
to continue to grow our business by acquiring and managing growing technology
and network communications businesses with established products and customers in
Asia.
Our business process outsourcing services generate revenue from call center
services, call center management software sales, and training and consulting. We
invoice our call center clients monthly at per seat monthly rates, a base price
plus commission per call, or a per hour charge rate, depending on the client's
preference. Our call center software clients pay per license, for which there is
usually a one-time charge on sale of the software and annual maintenance fees
for service. We charge per project for our consulting and training services and
for our telecom VAS, which are invoiced throughout the project. Our telecom VAS
often includes a post-sale service contract for systems integration and
consulting services for which we bill separately. Our communication products
such as calling cards, kiosks and cell phones are sold cash-on-delivery.
Our clients include the leading telecom operators, banks, insurance, travel,
marketing, and service companies, as well as telecom consumers, in Greater
China. Clients include China Telecom, China Netcom, China Mobile, China Unicom,
PCCW, Hutchison Telecom, CSL, SmarTone, Sunday, Swire Travel, Coca-Cola, SONY,
Samsung, Motorola, Nokia, TNT Express, Huawei, TCL, Dun & Bradstreet, American
Express, Bank of China, DBS, Hong Kong Government, and Hongkong Post. PacificNet
employs over 2,000 staff in our various subsidiaries in China with offices in
Hong Kong, Beijing, Shanghai, Shenzhen, and Guangzhou.
PacificNet's operations include the following four groups:
(1) Outsourcing Services: including Business Process Outsourcing (BPO), call
center, IT Outsourcing (ITO) and software development services.
(2) Value-Added Telecom Services (VAS): including Content Providing (CP),
Interactive Voice Response (IVR), Platform Providing (PP) and Service Providing
(SP).
(3) Communication Products Distribution Services: including mobile communication
products and accessories, calling cards, GSM/ CDMA/ XiaoLingTong products,
multimedia self-service kiosks and gaming machines.
19
(4) Other Business: including internal administrative matters, other related
corporate items, and other business such as PacificNet Power. PacifiNet Power
Limited (PacPower) has enjoyed significant growth beginning in late 2005 and
early 2006. The following is a more detailed description of PacPower:
PacPower was founded in Hong Kong on January 10, 2005, as a subsidiary of
PacificNet Limited with 51% ownership by PacificNet. Headquartered in Hong Kong,
PacPower invests in, develops, markets, distributes, resells, and manufactures
energy saving products for use in commercial, residential and industrial
settings. PacPower also engages in energy management services (EMS), energy
savings consultation, analysis and solutions implementation, outsourcing energy
management services, energy savings performance contract (ESPC). PacPower's
energy management services include electrical power management for lighting, air
conditioning, elevators and escalators, buildings and roads, and energy related
engineering services.
PacPower recognizes revenue from product sales under the following two types of
contracts:
1) Equipment sale contract - Under the Equipment sale contract, we recognize
revenue when persuasive evidence of an arrangement exists, the sales price to
the buyer is fixed or determinable, collectability is reasonably assured,
delivery has occurred and accepted by the buyers.
2) Energy Management Contract (EMC) or Energy Savings Sharing Contract - Under
this contract, we grant customers extended payment terms under contracts of
sale. These contracts are generally for a period of one to six years at
prevailing interest rates and are collateralized by the related equipment, which
if repossessed, may be less than the receivable balance outstanding. We
recognize revenue under profit sharing agreements when the amounts are fixed and
determinable and collectability is reasonably assured. Amounts received by us in
excess of the original estimated cost savings on the contract is recorded as
interest income.
RESULTS OF OPERATIONS
The following table sets forth selected statement of operations data as a
percentage of revenues for the periods indicated.
------------------------------------------------ ------------------------------
QUARTER ENDED MARCH 31,
------------------------------------------------ ----------------- ------------
2006 (%) 2005 (%)
------------------------------------------------ ----------------- ------------
Revenues 100.00 100.00
Cost of Revenues (56.89) (81.57)
Gross Margin 43.11 18.43
Selling, general and administrative expense (28.75) (9.57)
Depreciation and amortization (0.39) (0.47)
Interest expense (0.59) -
Earnings from operations 13.38 8.39
Interest income 0.21 -
Sundry income 0.83 1.01
Provision for income taxes (0.76) (0.28)
Share of earnings of associated companies (0.02) (0.09)
Minority interest (7.51) (4.53)
Net earnings 6.13 4.50
20
THREE MONTHS ENDED MARCH 31, 2006 COMPARED TO THREE MONTHS ENDED MARCH 31, 2005
REVENUES. Revenues for the three months ended March 31, 2006 were $15,034,000,
an increase of 63% as compared to $9,212,000 for the three months ended March
31, 2005. For the three months ended March 31, 2006, revenues of $3,027,000,
$7,040,000 and $3,355,000 were derived from the services rendered by the
Company's three operating units: Outsourcing Services, Value-Added Services, and
Communications Products Distribution Services, respectively. In the aggregate,
the two newly acquired subsidiaries contributed to 8.41% of the total revenue.
The increase in revenue was mainly due to revenue derived from the following
sources:
(a) New acquired subsidiaries in Group (2) Value-added Telecom Services:
Guangzhou Wanrong added approximately $263,000 to three months ended March
31, 2006. We believe that Wanrong's unique and innovative value-added
services will contribute positively to PacificNet's overall revenues.
Wanrong's nationwide VAS licenses and customer service numbers covering
China represent an opportunity to enhance PacificNet's iPACT VAS network in
China;
(b) New acquired subsidiary in Group (3) Communication Products Distribution
Services: iMobile added approximately $1,001,000 to three months ended
March 31, 2006. The acquisition is expected to expand PacificNet's position
as a leading provider of e-commerce, customer services and CRM in China's
mobile distribution market and increase our e-commerce and VAS revenues and
our nationwide CRM service coverage;
(c) In March 2005, we entered an agreement to acquire a controlling interest in
Guangzhou 3G Information Technology Co. Ltd. With China's anticipated 3G
launch, the stakes are high and the opportunities are immense for new 3G
value-added services. Telecom users in China can experience our iPACT VAS
through our broad geographical presence and local VAS offerings in 27
provinces in China through our VAS operating subsidies including Guangzhou
3G and Clickcom. Guangzhou 3G ($2,004,000)contributed $2,004,000 to the
increase in the total revenues for our VAS business during the first
quarter of 2006 and helped us in entering the mobile Internet market in
China.
(d) In December, 2005, we acquired a controlling interest in Shenzhen
GuHaiGuanChao Investment Consultant Company Limited ("ChinaGoHi"), a wholly
owned foreign enterprise (WOFE) registered in China, one of the most widely
recognized brand names in China. We believe that the combination of
ChinaGoHi's online and offline financial content, its innovative
infomercials and publication of a leading weekly magazine on financial
investment and wealth management for the Chinese investors, and ChinaGoHi's
strong brand recognition among China's 80 million B2C retail investors in
China's A-Share Stock Market, along with our growing call center
telemarketing operations will allow us to drive sales from their
information and marketing activities. Lion Zone contributed $3,332,000 to
the increase in the total revenues for our VAS business during the first
quarter of 2006 and helped us in entering the mobile Internet market in
China.
(e) The remaining incremental revenues for three months ended March 31, 2006 as
compared to prior period were derived from growth from existing
subsidiaries such as Epro ($2,576,000), Beijing Linkhead ($1,629,000), and
PacificNet Communications ($2,287,000), respectively.
Several of our businesses experience fluctuations in quarterly performance.
Traditionally, the first quarter from January to March is a low season for our
call center business due to the long Lunar New Year holidays in China. Revenues
from the VAS and IVR segment can vary from quarter to quarter due to new product
launches and the seasonality of certain product lines.
Summarized financial information concerning each of our main operating units is
set forth in the following table. The "Other Business" column included our other
insignificant subsidiaries and corporate related items.
----------------------- -------------------- ------------------ --------------------- ----------------- --------------
FOR THE PERIOD ENDED Group 3.
Group 1 Communications
Outsourcing Group 2. Distribution Group 4
Business VAS Business Business Other Business TOTAL
MARCH 31, 2006 ($) ($) ($) ($) ($)
----------------------- -------------------- ------------------ --------------------- ----------------- --------------
Revenues 3,027,000 7,040,000 3,355,000 1,612,000 15,034,000
----------------------- -------------------- ------------------ --------------------- ----------------- --------------
Earnings / (Loss) from
Operations 120,000 1,714,000 351,000 (173,000) 2,012,000
----------------------- -------------------- ------------------ --------------------- ----------------- --------------
COST OF REVENUES. Cost of revenues for the three months ended March 31, 2006 was
$8,553,000, an increase of $1,039,000 from $7,514,000 for the three months ended
March 31, 2005. The increase is directly associated with the corresponding
increase in revenues. 23.6% of total cost of revenues is generated from Epro. As
a contrast to the same period last year, the increase in cost of revenues for
Epro is mainly due to the increase in software sales of staff cost, rent and
rates etc. Additionally, 15.4% of total cost of revenues was contributed from
PacPower, which resulted from two recent air conditioning projects awarded
during the first quarter of 2006. The total contract sum approximated US$1.8M.
In addition, PacPower received a contract for approximately $250,000 for a
frequency inverter energy saving solution for our client. Approximately, 14.4%
of cost of revenues was generated from the revenues of voice board for Linkhead.
GROSS PROFIT. Gross profit for the three months ended March 31, 2006 was
$6,481,000, a significant increase of 282% as compared to $1,698,000 for the
three months ended March 31, 2005. Gross margin for the three months ended March
31, 2006, was 43.11% of total revenues. As explained above, the improvement on
gross margin for three months periods from the prior periods was primarily due
to higher margin acquisitions added to PACT during the first quarter of 2006,
such as Wanrong. The significant increase in gross margin came primarily
from our phone card business, which has higher gross margins, typical for that
industry. We believe that our overall gross margins approximate the
industry standards and we expect our gross margin percentage to increase
gradually as a result of cost reduction and efficient utilization of assets.
21
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses totaled $4,323,000 for the three months ended March 31,
2006, an increase of 390% from $882,000 for the three months ended March 31,
2005. This increase resulted from the expansion of our operations such as newly
acquired subsidiaries and the expansion of the management team, which included
increased premises costs and staff costs, mainly attributable to the operations
of Epro ($340,000), Linkhead ($107,000) and Lion Zone (ChinaGoHi)($2,707,000).
Our increase in the number of employees to 2,300 and expansion of VAS branch
offices to 26 provinces in China at the end of the first quarter shifted our
expenses to 28.75% of the total revenues.
OPERATING PROFIT. Quarterly operating profit was $2,012,000, an increase of 160%
as compared to $773,000 from Q1 2005. Operating profit of $120,000, $1,714,000,
and $351,000 for the three months ended 2006 were generated from the Company's
three business units: (1) CRM Outsourcing Services, (2) Value Added Services
(VAS), and (3) Telecom Distribution Services, respectively. This compares to
operating profit of $239,000, $580,000 and $129,000 for the three months ended
2005 respectively. We continued to shift our business from our traditional
lower-margin distribution business (B2B services) to higher margin value-added
telecom services and B2C e-commerce which will help drive superior bottom-line
results. We believe that the Company has made substantial progress in a
relatively short period of time which has been demonstrated by our increase in
both gross and operating margins in the first quarter. The acquisitions such as
Clickcom and Guangzhou 3G helped us enter the mobile internet market in China.
Furthermore, the acquisition of iMobile (Beijing) Technology Co., Ltd. during
the first quarter enhances our position in this rapidly growing B2C market in
China. Furthermore, VAS Business expanded as Chinese companies are increasingly
recognizing that we can help building their loyalty and make their products more
competitive. The acquisition of a majority interest in Guangzhou Wanrong is
expected to help support our growth during the second half of fiscal 2006 and
beyond.
INCOME TAXES. Income tax provision was $115,000 for the three months ended March
31, 2006, as compared to $26 for the three months ended March 31, 2005. Interim
income tax provisions are based upon management's estimate of taxable income and
the resulting consolidated effective income tax rate for the full year. As a
result, such interim estimates are subject to change as the year progresses and
more information becomes available.
MINORITY INTERESTS. Minority interests for the three months ended March 31, 2006
totaled $(1,130,000), compared with $(417,000) for the same period in the prior
year, which represents the outside ownership interest in a subsidiary that is
consolidated with the parent for financial reporting purposes.
NET PROFIT. Net profit for the three months ended March 31, 2006 was $921,000
which represented an increase of 122% as compared to $415,000 for the same
period in the prior year. Net profit margin increased to 6.13% for Q1 2006 from
4.5% for Q1 2005. The Company's Q1 results also included a total of $358,000 in
non-cash expenses, including depreciation and amortization expense of $296,000
and $62,000 non-cash stock-based compensation expense recognized during Q1 as a
result of the implementation of SFAS 123(R), which we adopted effective on
January 1, 2006. Each of our subsidiaries and investments, including Epro,
Linkhead, Smartime, 3G, Clickcom and ChinaGoHi, Wangrong, iMobile, PacificNet
Communications, and PacificNet Power were profitable. PacificNet's overall net
profit increased due to (i) the acquisition of Guangzhou Wanrong and iMobile;
(ii) its selection as China Unicom's CRM consulting and training partner, to
help Shangdong Unicom improve its service quality for its "10010" Information
Hotline and Telesales Department, with a goal to generate profit through CRM
services, telemarketing and outbound telesales; (iv) Linkhead's selection by
Eastcom-BUPT (Beijing University of Posts and Telecommunications) to deploy
Color Ring Back Tone ("CRBT") system for value- added telecom services;(v)
Guangzhou 3G's partnering with Chinese Entertainment International (CEI) to
launch the iPACT Mobile Video Services; (vi) its being selected by a leading
property management company to Provide CRM and Direct Marketing Services for
Loyalty Membership Card; and (vii) ChinaGoHi's launching of a stored-value point
card for its financial content services in China.
LIQUIDITY AND CAPITAL RESOURCES
CASH AND CASH EQUIVALENTS.
As of March 31, 2006, cash and cash equivalents were $11,189,000, compared to
$2,323,000 at the end of Q1 2005 as a result of a recently completed private
placement.
WORKING CAPITAL.
The Company's working capital increased to $27,711,000 at March 31, 2006, as
compared to $ 20,510,000 at December 31, 2005. When compared to balances at
December 31, 2005, an increase of 35% in working capital at March 31, 2006 was
primarily due to the overall net increases in the working capital accounts
resulting from significant increases in cash resulting from our $8,000,000
private placement of convertible debentures and increases in accounts
receivables mainly attributable to the newly acquired subsidiaries.
NET CASH FROM OPERATING ACTIVITIES.
Net cash used in operating activities was $3,586,000 for the three months ended
March 31, 2006 as compared to net cash used in operating activities of
$3,506,000 for the three months ended March 31, 2005. Net cash used in operating
activities in the three months ended March 31, 2006 was primarily due to net
earnings offset by the non-cash addition of minority interest of $1,130,000 and
the growth in the business operation for PacificNet power ($1,580,200) and
communication ($1,779,920), which resulted in an increase in accounts receivable
and other current assets ($6,296,000).
NET CASH FROM INVESTING ACTIVITIES.
Net cash used in investing activities was $2,166,000 for the three months ended
March 31, 2006 compared to $206,000 for the comparative prior period. Net cash
used in investing activities in the three months ended March 31, 2006 was
primarily due to the acquisition of property and equipment for $1,751,000 and
the payment for the acquisition of subsidiaries and affiliated companies of
$390,000 (2005: $233,000).
NET CASH FROM FINANCING ACTIVITIES.
Net cash provided by financing activities for the three months ended March 31,
2006 was $7,362,000 primarily representing cash received from the private
placement of $8,000,000 in convertible debentures offset by increases in loans
to related parties of $794,000 and cash paid for the repurchase of treasury
shares of $124,000. Net cash used in financing activities for the three months
ended March 31, 2005 was ($597,000), which was primarily a result of repayment
of Epro's banking facilities of $836,000, dividend paid out of $339,000 to
minority interest shareholders by Linkhead, and cash received of $111,400 from
the exercise of 57,000 share options.
22
INFLATION. Inflation has not had a material impact on the Company's business in
recent years.
CURRENCY EXCHANGE FLUCTUATIONS.
All of the Company's revenues are denominated either in U.S. dollars or Hong
Kong dollars, while its expenses are denominated primarily in Hong Kong dollars
and Renminbi ("RMB"), the currency of the People's Republic of China. The value
of the RMB-to-U.S. dollar or Hong Kong dollar-to-United States dollar and other
currencies may fluctuate and is affected by, among other things, changes in
political and economic conditions. Since 1994, the conversion of Renminbi into
foreign currencies, including U.S. dollars, has been based on rates set by the
People's Bank of China, which are set daily based on the previous day's
interbank foreign exchange market rates and current exchange rates on the world
financial markets. Since 1994, the official exchange rate generally has been
stable. Recently there has been increased political pressure on the Chinese
government to decouple the RMB from the United States dollar. Although a
devaluation of the Hong Kong dollar or RMB relative to the United States dollar
would likely reduce the Company's expenses (as expressed in United States
dollars), any material increase in the value of the Hong Kong dollar or RMB
relative to the United States dollar would increase the Company's expenses, and
could have a material adverse effect on the Company's business, financial
condition and results of operations. The Company has never engaged in currency
hedging operations and has no present intention to do so.
OFF-BALANCE SHEET ARRANGEMENTS.
We had no outstanding derivative financial instruments, off-balance sheet
guarantees, interest rate swap transactions or foreign currency forward
contracts. We did not engage in trading activities involving non-exchange traded
contracts during the first quarter of 2006.
CONTRACTUAL OBLIGATIONS
We have significant cash resources to meet our contractual obligations as of
March 31, 2006, as detailed below:
PAYMENTS DUE BY PERIOD
------------------------------------------- ------------------ -------------------- --------------- ----------------
Contractual Obligations Total Less than 1 year 1-5 years After 5 years
------------------------------------------- ------------------ -------------------- --------------- ----------------
Line of credit $ 1,011,000 $ 1,011,000 -- --
Bank Loans $ 1,410,000 $ 215,000 $ 374,000 $ 821,000
Bank Loan interest payable $ 576,000 $ 57,000 $ 242,000 $ 277,000
Operating leases $ 1,621,000 $ 815,000 $ 806,000 --
Capital leases $ 170,000 $ 107,000 $ 63,000 --
------------ ------------ ------------ -----------
Total cash contractual obligations $ 4,788,000 $ 2,205,000 $ 1,485,000 $1,098,000
------------------------------------------- ------------------ -------------------- --------------- ----------------
CONCENTRATION OF CREDIT RISK
All of the Company's revenues are derived in Asia and Greater China. The Company
does not have any single customer that accounts for more than 10% of its
revenues or 10% of its purchases. If the Company was unable to derive any
revenue from Asia and Greater China, it would have a significant, financially
disruptive effect on the normal operations of the Company. Based on the current
economic environment in China, the Company does not expect any material adverse
impact to its business, financial condition and results of operations.
SEASONALITY AND QUARTERLY FLUCTUATIONS
Several of our businesses experience fluctuations in quarterly performance.
Traditionally, the first quarter from January to March is a low season for our
call center business due to the long Lunar New Year holidays in China. Revenues
and income from operations for the call center and VAS tend to be higher in the
fourth quarter due to special holiday promotions. Internet/Direct Commerce
revenues also tend to be higher in the fourth quarter due to increased consumer
spending during that period. Revenues from the VAS and IVR segment can vary from
quarter to quarter due to new product launches and the seasonality of certain
product lines.
23
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risks arising from adverse changes in market
rates and prices, such as foreign exchange fluctuations and interest rates,
which could impact our results of operations and financial position. We do not
currently engage in any hedging or other market risk management tools, and we do
not enter into derivatives or other financial instruments for trading or
speculative purposes.
FOREIGN CURRENCY EXCHANGE RATE RISK.
Fluctuations in the rate of exchange between the U.S. dollar and foreign
currencies, primarily the Hong Dollar and the Chinese Renminbi, could adversely
affect our financial results. During the quarter ended March 31, 2006,
approximately all of our sales are denominated in foreign currencies. We expect
that foreign currencies will continue to represent a similarly significant
percentage of our sales in the future. Selling, marketing and administrative
costs related to these sales are largely denominated in the same respective
currency, thereby mitigating our transaction risk exposure. We therefore believe
that the risk of a significant impact on our operating income from foreign
currency fluctuations is not substantial. However, for sales not denominated in
U.S. dollars, if there is an increase in the rate at which a foreign currency is
exchanged for U.S. dollars, it will require more of the foreign currency to
equal a specified amount of U.S. dollars than before the rate increase. In such
cases and if we price our products in the foreign currency, we will receive less
in U.S. dollars than we did before the rate increase went into effect. If we
price our products in U.S. dollars and competitors price their products in local
currency, an increase in the relative strength of the U.S. dollar could result
in our price not being competitive in a market where business is transacted in
the local currency. All of our sales denominated in foreign currencies are
denominated in the Hong Dollar and the Chinese Renminbi. Our principal exchange
rate risk therefore exists between the U.S. dollar and these two currencies.
Fluctuations from the beginning to the end of any given reporting period result
in the re-measurement of our foreign currency-denominated receivables and
payables, generating currency transaction gains or losses that impact our
non-operating income/expense levels in the respective period and are reported in
other (income) expense, net in our combined consolidated financial statements.
We do not currently hedge our exposure to foreign currency exchange rate
fluctuations. We may, however, hedge such exposure to foreign currency exchange
rate fluctuations in the future.
All of our sales denominated in foreign currencies are denominated in the Hong
Dollar and the Chinese Renminbi. Our principal exchange rate risk therefore
exists between the U.S. dollar and these two currencies. Fluctuations from the
beginning to the end of any given reporting period result in the re-measurement
of our foreign currency-denominated receivables and payables, generating
currency transaction gains or losses that impact our non-operating
income/expense levels in the respective period and are reported in other
(income) expense, net in our combined consolidated financial statements. We do
not currently hedge our exposure to foreign currency exchange rate fluctuations.
We may, however, hedge such exposure to foreign currency exchange rate
fluctuations in the future.
INTEREST RATE RISK.
Changes in interest rates may affect the interest paid (or earned) and therefore
affect our cash flows and results of operations. We are exposed to interest rate
change risk with respect to Epros' (one of our subsidiaries) credit facility
with a commercial lender. However, we do not believe that this interest rate
change risk is significant.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
PacificNet Inc. (the "Company") maintains disclosure controls and
procedures that are designed to ensure that information required to be disclosed
in the reports the Company files or submits under the Securities Exchange Act of
1934, as amended (the "Exchange Act"), is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commission's rules and forms, and that such information is accumulated and
communicated to the Company's management, including its Chief Executive Officer
("CEO") and Chief Financial Officer ("CFO"), as appropriate, to allow timely
decisions regarding required financial disclosure.
In connection with the preparation of this Quarterly Report on Form
10-Q, the Company carried out an evaluation under the supervision and with the
participation of the Company's management, including the CEO and CFO, as of end
of the period covered by this report of the effectiveness of the design and
operation of the Company's disclosure controls and procedures, as such term is
defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon this
evaluation The CEO and CFO concluded that as of March 31, 2006 the Company's
disclosure controls and procedures contained significant deficiencies and
material weaknesses. Also, as previously reported in our Annual Report on Form
10-KSB for the year ended December 31, 2005 (the "2005 Form 10-KSB"), as of the
end of the period covered by this report, significant deficiencies and material
weaknesses with respect to the Company's internal controls over financial
reporting were identified and communicated to us by our independent auditors.
The Company has implemented and continues to implement remediation initiatives
and interim measures during the quarter ended March 31, 2006 and through the
current date.
24
In the absence of full implementation of the remediation initiatives in
the first quarter of 2006, the Company has undertaken additional measures
described below in the interim to ensure that the Company's consolidated
financial statements included in this Quarterly Report on Form 10-Q were
prepared in accordance with accounting principles generally accepted in the
United States. Accordingly, the Company's management believes that the
consolidated financial statements included in this Quarterly Report on Form 10-Q
fairly present in all material respects the Company's financial condition,
results of operations and cash flows for the periods presented and that this
Quarterly Report on Form 10-Q does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report.
MANAGEMENT'S REMEDIATION INITIATIVES AND INTERIM MEASURES
Management has reviewed and begun to implement changes to the overall
design of the Company's control environment, which includes formalizing the
roles, duties and responsibilities of each functional group within the
organization and putting in place a process by which each subsidiary's
accounting staff must report and communicate required financial disclosures to
the Company's primary accounting groups for review and oversight, as well as new
procedures to monitor internal controls over financial reporting, which the CEO
and CFO believe will greatly improve the current process.
The following is a description of the Company's remediation initiatives
with respect to each deficiency identified in the 2005 Form 10-KSB and at the
end of the period covered by this report:
1. THE CURRENT ORGANIZATION OF THE ACCOUNTING DEPARTMENT DOES NOT PROVIDE
PACIFICNET WITH THE ADEQUATE SKILLS TO ACCURATELY ACCOUNT FOR AND DISCLOSE
SIGNIFICANT TRANSACTIONS OR DISCLOSURES.
REMEDIATION INITIATIVES
Beginning in Q1 2006, the Company streamlined its reporting procedures
by requiring all accounting groups within each subsidiary, which includes tax,
treasury, financial planning and analysis groups, to directly report information
and communicate to their respective accounting group at the Company's financial
accounting headquarters in Shenzhen. Each accounting group at Shenzhen is now
responsible for overseeing the reporting results delivered for each subsidiary
within their group to ensure that the material transactions and financial
disclosures provided by such group are accurate, complete and correct and do not
contain any material misstatements or omit material information.
The Company plans to retain the services of outside consultants, other
than the Company's independent registered public accounting firm, with relevant
accounting experience, skills and knowledge, working under the supervision and
direction of the Company's management, to supplement the Company's existing
accounting personnel.
The Company plans to expand the size of its internal audit group, and
has determined to retain an outside independent consulting firm with relevant
accounting experience. In connection with this expansion the Company will give
the internal audit group the added responsibility to monitor its wholly owned
subsidiaries and partially owned subsidiaries and joint venture operations
through reviews and audits at such locations a minimum of three times a quarter.
The Company believes that this new responsibility of the internal audit group is
critical upon each new acquisition, as the newly acquired subsidiary must
quickly become familiar with the Company's policies and procedures for
processing, summarizing, reporting and disclosing material information and
ensuring that financial information about the new subsidiary is properly
accounted for and communicated to management.
2. CERTAIN KEY MANAGERS IN THE ACCOUNTING DEPARTMENT DO NOT APPEAR TO HAVE THE
KNOWLEDGE AND EXPERIENCE REQUIRED FOR THEIR RESPONSIBILITIES.
REMEDIATION INITIATIVES
The Company created a new position, Vice President of Finance for China
Operations, and has appointed Mary Ma to fill the position. Ms. Ma has the prior
business experience required to act in a supervisory capacity for the Company,
including experience with Chinese Accounting Standards, IAS and US GAAP,
corporate finance, finance analysis and operation. Ms. Ma and Mr. Wang, the
Company's CFO, with assistance from other senior members of the financial staff,
have reviewed and will continue to review and adapt the overall design of the
Company's financial reporting structure, including the roles and
responsibilities of each functional group within the Company.
25
The Company has plans to hire managers experienced in several key areas of
accounting, including persons with experience in US GAAP consolidation
requirements, SEC financial reporting requirements and international tax skills,
who will include the following:
o a consolidation manager with relevant accounting experience, skills
and knowledge;
o several senior managers familiar with SEC financial reporting
requirements with relevant accounting experience, skills and
knowledge; and
o a senior manager with relevant PRC and international tax and
accounting skills, experience and knowledge.
In September 2005, the Company implemented a formal training process to train
its accounting and financial staff and plans to continue this process to ensure
that personnel have the necessary competency, training and supervision for their
assigned level of responsibility and the nature and complexity of the Company's
business. The Company plans to conduct a training seminar regarding revenue
recognition, including identification of non-standard contracts in China.
The Company has allocated resources to continue to hire additional accounting
personnel in the U.S., Hong Kong and China, in the areas of tax, external
financial reporting, revenue recognition, treasury, financial planning and
analysis and corporate accounting with relevant accounting experience, skills
and knowledge.
3. SUBSTANTIVE MATTERS ARE NOT BEING ADDRESSED APPROPRIATELY BY THE BOARD AND
AUDIT COMMITTEE RESULTING IN INADEQUATE OVERSIGHT FROM THE BOARD AND AUDIT
COMMITTEE.
REMEDIATION INITIATIVES
The Company has proposed to set forth a schedule and increase the frequency of
Board of Director meetings and Audit Committee meetings. The Company, its Board
of Directors and the Audit Committee have recognized that communication is
required earlier and more frequently to ensure that substantive matters are
addressed as early as possible in both the review and audit process and to allow
for more detailed financial accounting reports and findings to be prepared and
presented to the Audit Committee in a timely manner.
4. THE PROCESS THAT PACIFICNET IS CURRENTLY USING TO MONITOR THE ONGOING
QUALITY OF INTERNAL CONTROLS PERFORMANCE, IDENTIFY DEFICIENCIES AND TRIGGER
TIMELY CORRECTIVE ACTION IS NOT WORKING EFFECTIVELY.
REMEDIATION INITIATIVES
Utilization of Computerized Automated Controls:
Beginning in the third quarter of 2005, the Company started to deploy a
company-wide unified financial accounting system using the Kingdee K/3 Financial
Accounting & ERP Software, provided by Kingdee International Software Group
Company Limited (www.Kingdee.com), one of the top two financial accounting and
ERP system providers in China. From Q3 2005 through Q1 2006, the Company rolled
out and has successfully implemented the Kingdee K/3 Software for all its wholly
owned subsidiaries. Commencing in the second quarter of 2006, the Company plans
to roll out the Kingdee K/3 Software for its other partially owned subsidiaries
and joint ventures in China.
When fully operational, the Kingdee Software allows the Company and its
subsidiaries to easily manage and monitor all financial and accounting processes
within the group, which will assist the Company in collecting all material
information necessary for its financial reports easily and accurately. During
the first quarter of 2006, the Company implemented, and plans to continue to
enhance, its month-end closing procedures, including reconciliations and
controls over spreadsheets, and standardized checklists to ensure such
procedures are consistently and effectively applied throughout the organization
in order to improve the financial review time and quality to ensure that U.S.
GAAP reviewers monitor financial information from non-U.S. locations in a
consistent manner, through such measures as use of standardized reporting
packages and review procedures.
26
The Company plans to deploy a document management system with secured
intranet access during the third quarter of 2006 to ensure that all material
contracts are collected, retained and available for review by all at one site.
5. THERE IS NO ADEQUATE MEANS OF ACCURATELY CAPTURING AND RECORDING CERTAIN
SIGNIFICANT AND COMPLEX BUSINESS TRANSACTIONS:
REMEDIATION INITIATIVES
In 2006 the Company began requiring centralized retention of documentation
evidencing proof of delivery of products and services and final acceptance for
revenue recognition purposes. The Company believes the document management
system it plans to deploy as described above will be the primary tool to ensure
that its business transactions are accurately recorded and evaluated for the
purposes of legal and financial disclosure. The Company plans to design a
contract review process in China requiring financial and legal staff to provide
input during the contract negotiation process to ensure timely identification
and accurate accounting treatment of non-standard contracts and to ensure proper
revenue recognition with adequate documentation.
27
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
None.
ITEM 1A. RISK FACTORS.
In addition to the other information set forth in this report, you should
carefully consider the factors discussed in "Risk Factors" in our Annual Report
on Form 10-KSB for the year ended December 31, 2005, which could materially
affect our business, financial condition or future results. The risks described
in our Annual Report on Form 10-KSB are not the only risks facing us. Additional
risks and uncertainties not currently known to us or that we currently deem to
be immaterial also may materially adversely affect our business, financial
condition and/or operating results.
SINCE THE FILING OF OUR ANNUAL REPORT ON FORM 10-KSB, WE HAVE IDENTIFIED THE
FOLLOWING ADDITIONAL RISKS:
OUR MULTINATIONAL OPERATIONS SUBJECT US TO VARIOUS ECONOMIC, POLITICAL,
REGULATORY AND LEGAL RISKS. We market and sell our products globally, with
significant portion of our sales historically made in China. The expansion of
our existing multinational operations and entry into new markets will require
significant management attention and financial resources. Multinational
operations are subject to a variety of risks, such as:
o the burden of complying with a variety of foreign laws and regulations;
o the burden of complying with United States laws and regulations for foreign
operations, including the Foreign Corrupt Practices Act;
o difficulty complying with continually evolving and changing global product
and communications standards and regulations for both our end products and
their component technology;
o market acceptance of our new products, including longer product acceptance
periods in new markets into which we enter;
o reliance on local original equipment manufacturers ("OEMs"), third party
distributors and agents to effectively market and sell our products;
o unusual contract terms required by customers in developing markets;
o changes in local governmental control or influence over our customers;
o changes to import and export regulations, including quotas, tariffs,
licensing restrictions and other trade barriers;
o evolving and unpredictable nature of the economic, regulatory, competitive
and political environments;
o reduced protection for intellectual property rights in some countries;
o unproven business operation models developed or operated in specific
countries or regions;
o longer accounts receivable collection periods; and
o difficulties and costs of staffing and managing multinational operations,
including but not limited to internal controls and compliance.
FAILURE TO ACHIEVE AND MAINTAIN EFFECTIVE INTERNAL CONTROLS IN ACCORDANCE WITH
SECTION 404 OF THE SARBANES-OXLEY ACT OF 2002 COULD HAVE A MATERIAL ADVERSE
EFFECT ON OUR BUSINESS AND STOCK PRICE.
Section 404 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act")
requires that we establish and maintain an adequate internal control structure
and procedures for financial reporting and include a report of management on our
internal control over financial reporting in our annual report on Form 10-K.
That report must contain an assessment by management of the effectiveness of our
internal control over financial reporting and must include disclosure of any
material weaknesses in internal control over financial reporting that we have
identified. In addition, our independent registered public accounting firm must
attest to and report on management's assessment of the effectiveness of our
internal control over financial reporting.
We have identified material weaknesses in our internal control over financial
reporting. See "Item 8A--Controls and Procedures--Management's Report on
Internal Control Over Financial Reporting" in our Annual report on Form 10-KSB
for the year ended December 31, 2005 for a discussion of these material
weaknesses. As of the date of the filing of this quarterly report on Form 10-Q,
we are still in the process of implementing remedial measures related to the
material weaknesses identified. If our efforts to remedy the weaknesses we
identified are not successful, our business and operating results could be
harmed and the
28
reliability of our financial statements could be impaired, which could adversely
affect our stock price. The requirements of Section 404 of the Sarbanes-Oxley
Act are ongoing and also apply to future years. We expect that our internal
control over financial reporting will continue to evolve as we continue in our
efforts to transform our business. Although we are committed to continue to
improve our internal control processes and we will continue to diligently and
vigorously review our internal control over financial reporting in order to
ensure compliance with the Section 404 requirements, any control system,
regardless of how well designed, operated and evaluated, can provide only
reasonable, not absolute, assurance that its objectives will be met. Therefore,
we cannot be certain that in the future additional material weaknesses or
significant deficiencies will not exist or otherwise be discovered.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
The information required to be disclosed under this Item 2 with respect to our
private placement of convertible debentures and warrants was previously included
on a Current Report on Form 8-K filed with the SEC under Items 1.01 (Entry into
a Material Definitive Agreement) and 9.01 (Exhibits) on March 6, 2006 and on a
Current Report on 8-K filed with the SEC under Item 3.02 (Unregistered Sales of
Equity Securities) on March 13, 2006.
REPURCHASES OF COMPANY COMMON STOCK
-----------------------------------
---------------------------- -------------------------- ------------------------- -------------------------- -----------------------
Period (a) Total Number of (b) Average Price Paid (c) Total Number of (d) Maximum Number (or
Shares Purchased Per Share Shares Purchased as Part Approximate Dollar
of Publicly Announced Value) of Shares That
Plans of Programs May Yet Be Purchased
Under the Plans or
Programs
---------------------------- -------------------------- ------------------------- -------------------------- -----------------------
January 1 - January 31 NONE NONE NONE $686,608
---------------------------- -------------------------- ------------------------- -------------------------- -----------------------
February 1 - February 28 NONE NONE NONE $686,608
---------------------------- -------------------------- ------------------------- -------------------------- -----------------------
March 1 - March 31 24,200 (1) $5.13 NONE $686,608
---------------------------- -------------------------- ------------------------- -------------------------- -----------------------
(1) On March 13, 2006, the Company repurchased 24,200 restricted shares of our
common stock from Yueshen, as subsidiary of Shanghai Classic for an aggregate
repurchase price of RMB1,000,000 (approximately USD124,223 using an exchange rat
of USD1 = RMB8.05). The share repurchase was proposed to the Company by Yueshen
and was unanimously agreed by both parties.. This repurchase was not part of the
Company's repurchase plan.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
ITEM 5. OTHER INFORMATION.
None.
29
ITEM 6. EXHIBITS
The following exhibits are filed as part of this report:
EXHIBIT
NUMBER DESCRIPTION
------ -----------
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32.1 18 U.S.C. Section 1350 Certifications
30
SIGNATURES
In accordance with the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
PACIFICNET INC.
Date: May 22, 2006 By: /s/ TONY TONG
-------------------
Tony Tong
Chief Executive Officer
(Principal Executive Officer)
Date: May 22, 2006 By: /s/ WANG SHAO JIAN
-------------------
Wang Shao Jian
Chief Financial Officer
(Principal Financial Officer)
31