10QSB 1 chinadig10qsb093005.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From _________ to _________ 0-12536 (Commission File Number) CHINA DIGITAL WIRELESS, INC. (Exact name of registrant as specified in its charter) Nevada 90-0093373 (State or other jurisdiction of (IRS Employer Identification No.) Incorporation) 429 Guangdong Road Shanghai, People's Republic of China 200001 (Address of principal executive offices) (Zip Code) Issuer telephone number, including area code: (86 21) 6336-8686 Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. [X]Yes [ ]No Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ]Yes [X]No As of October 13, 2005, 17,147,268 of the Issuer's $.001 par value common stock were outstanding. Transitional Small Business Disclosure Format: [ ]Yes [X] No - TABLE OF CONTENTS PART I - FINANCIAL INFORMATION PAGE ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS Consolidated Balance Sheets as of December 31, 2004 (Audited) and September 30, 2005 (Unaudited) 3 Consolidated Statements of Income and Comprehensive Income (Unaudited) For the Three and Nine Months Ended September 30, 2004 and 2005 (Unaudited) 4 Consolidated Statements of Shareholders' Equity for the Year Ended December 31, 2004 (Audited) and the Nine Months Ended September 30, 2005 (Unaudited) 5 Consolidated Statements of Cash Flows for the Nine Months 6 Ended September 30, 2004 and 2005 (Unaudited) Notes to Consolidated Financial Statements 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION 19 ITEM 3. CONTROLS AND PROCEDURES 28 PART II - OTHER INFORMATION ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 28 ITEM 6. EXHIBITS 28 SIGNATURES 29
CHINA DIGITAL WIRELESS INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, September 30, 2004 2005 ------------- ------------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 75,511 $ 1,021,697 Accounts receivable, net of allowance for doubtful accounts of $47,922 and $17,242 (including $1,583,512 and $1,464,904 due from a related party) 4,619,809 2,223,489 Inventories 101,696 510,253 Deferred tax assets 28,772 10,000 Common stock proceeds held in escrow 1,500,000 -- Amounts due from related parties 4,987,956 6,786,313 Advances & deposits to suppliers 150,412 3,560,710 ------------- ------------- Total current assets 11,464,156 14,112,462 Property and equipment, net 1,198,509 1,156,153 ------------- ------------- Total assets $ 12,662,665 $ 15,268,615 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 55,839 $ 898,728 Advance from customer -- 430,990 Deferred revenue 617,694 449,524 VAT payable 213,535 39,750 Income tax payable 312,763 211,521 Due to related parties 100,260 -- Other liabilities 287,025 239,355 ------------- ------------- Total current liabilities 1,587,116 2,269,868 ------------- ------------- Shareholders' equity: Common stock - $0.001 par value, 100,000,000 shares authorized, 17,018,692 shares issued and outstanding at December 31, 2004 and 17,147,268 shares issued and outstanding at September 30, 2005 17,019 17,148 Additional paid-in capital 4,229,974 4,229,845 Retained earnings 6,828,281 8,505,148 Accumulated other comprehensive income 275 246,606 ------------- ------------- Total shareholders' equity 11,075,549 12,998,747 ------------- ------------- Total liabilities and shareholders' equity $ 12,662,665 $ 15,268,615 ============= =============
See accompanying notes to consolidated financial statements. 3
CHINA DIGITAL WIRELESS INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME Three Months ended September 30 Nine Months ended September 30 ------------------------------- ------------------------------- 2004 2005 2004 2005 -------------- -------------- -------------- -------------- (unaudited) (unaudited) (unaudited) (unaudited) Revenues: Product sales $ -- $ 2,843,538 $ 4,914,465 $ 4,316,422 Product sales to related parties 6,239,802 2,048,309 10,512,821 9,856,854 Information service revenue, net 779,719 190,132 2,438,750 1,149,821 Advertising service revenue, net -- 614,136 -- 1,738,878 -------------- -------------- -------------- -------------- Total revenues 7,019,521 5,696,115 17,866,036 17,061,975 Cost of goods sold -- 2,799,693 4,526,396 4,221,241 Cost of goods sold to related parties 6,126,537 2,022,961 10,132,267 9,600,145 Cost of service 234,973 166,732 739,219 495,921 -------------- -------------- -------------- -------------- 6,361,510 4,989,386 15,397,882 14,317,307 Gross profit 658,011 706,729 2,468,154 2,744,668 Operating expenses: Selling 42,748 33,132 127,833 128,157 General and administrative 139,584 263,023 1,354,836 665,390 -------------- -------------- -------------- -------------- Total operating expenses 182,332 296,155 1,482,669 793,547 -------------- -------------- -------------- -------------- Income from operations 475,679 410,574 985,485 1,951,121 Other revenue 130,060 7,089 130,060 7,216 Governmental subsidy -- 108,476 -- 108,476 Interest income (expense) 18,339 (6,179) 31,931 (9,844) -------------- -------------- -------------- -------------- Income before income taxes 624,078 519,960 1,147,476 2,056,969 Income tax provision 54,306 111,042 169,643 380,102 -------------- -------------- -------------- -------------- Net income $ 569,772 $ 408,918 $ 977,833 $ 1,676,867 ============== ============== ============== ============== Other comprehensive income : Foreign currency translation adjustment $ 3 $ 246,335 $ 155 $ 246,331 -------------- -------------- -------------- -------------- Comprehensive income $ 569,775 $ 655,253 $ 977,988 $ 1,923,198 ============== ============== ============== ============== Basic and diluted earnings per share $ 0.03 $ 0.02 $ 0.07 $ 0.10 Weighted average common shares outstanding 17,018,692 17,031,408 14,932,053 17,022,946
See accompanying notes to consolidated financial statements. 4
CHINA DIGITAL WIRELESS INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Accumulated Additional Other Total Common Stock Paid-in Retained Comprehensive Shareholders Shares Amount Capital Earnings Income Equity ------------ ------------ ------------ ------------ ------------- ------------ Balance at December 31, 2003 13,782,636 $ 13,783 $ 1,436,217 $ 5,233,652 $ 12 $ 6,683,664 Recapitalization and reorganization 1,585,705 1,586 308,465 -- -- 310,051 Shares issued for consulting services 167,895 168 604,254 -- -- 604,422 Shares issued for proceeds of $190,000 and consulting services 166,667 167 599,834 -- -- 600,001 Shares issued for net proceeds of $1.5 million 1,315,789 1,315 1,498,685 -- -- 1,500,000 Offset by issuing cost -- -- (217,481) -- -- (217,481) Net income -- -- -- 1,594,629 -- 1,594,629 Foreign currency translation adjustment -- -- -- -- 263 263 ------------ ------------ ------------ ------------ ------------- ------------ Balance at December 31, 2004 17,018,692 $ 17,019 $ 4,229,974 $ 6,828,281 $ 275 $ 11,075,549 Issuance of common stock in exchange of lock up agreements 128,576 129 (129) -- -- -- Net income (unaudited) -- -- -- 1,676,867 -- 1,676,867 Foreign currency translation adjustment (unaudited) -- -- -- -- 246,331 246,331 ------------ ------------ ------------ ------------ ------------- ------------ Balance at September 30, 2005 17,147,268 $ 17,148 $ 4,229,845 $ 8,505,148 $ 246,606 $ 12,998,747 ============ ============ ============ ============ ============= ============
See accompanying notes to consolidated financial statements. 5
CHINA DIGITAL WIRELESS INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months ended September 30, ------------------------------- 2004 2005 ------------- ------------- (unaudited) (unaudited) Cash flows from operating activities: Net income $ 977,833 $ 1,676,867 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 138,851 185,279 Bad debt expenses 4,257 (30,680) Issuance of common stock to consultants for services 1,014,423 -- Deferred tax assets (4,069) 18,772 Gain on disposal of property and equipment -- (7,368) Changes in assets and liabilities: Accounts receivable (1,891,866) 2,427,000 Inventories 521,815 (408,557) Other current assets (543,822) (3,410,298) Accounts payable (105,043) 842,889 Advance from customer -- 430,990 Deferred revenue 42,950 (168,170) VAT recoverable and payable 11,445 (173,785) Income tax payable -- (101,242) Due to related parties -- (100,260) Other liabilities 123,588 (47,670) ------------- ------------- Net cash flows provided by operating activities 290,362 1,133,767 ------------- ------------- Cash flows from investing activities: Purchase of property and equipment (19,162) (332,650) Proceeds on disposal of property and equipment -- 221,210 Amounts due from related parties (2,140,607) (1,798,357) ------------- ------------- Net cash flows used in investing activities (2,159,769) (1,909,797) ------------- ------------- Cash flows from financing activities: Recapitalization and reorganization 310,051 -- Proceeds from issuing redeemable common stock 1,690,000 -- Issuing cost (217,481) -- Escrow receivable (1,500,000) 1,500,000 ------------- ------------- Net cash flows provided by financing activities 282,570 1,500,000 ------------- ------------- Foreign currency translation adjustment 155 222,216 ------------- ------------- Net increase (decrease) in cash and cash equivalents (1,586,682) 946,186 Cash and cash equivalents, beginning of the period 1,713,748 75,511 ------------- ------------- Cash and cash equivalents, end of the period $ 127,066 $ 1,021,697 ============= ============= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ -- $ -- Income taxes $ -- $ 467,509 Issuance of common stock in exchange of lock up agreements $ -- $ 129
See accompanying notes to consolidated financial statements. 6 NOTE 1 - ORGANIZATION AND BUSINESS BACKGROUND China Digital Wireless, Inc. (("CDW") formerly known as Boulder Acquisitions, Inc.) sells mobile phones to retailers, distributors, and related parties and provides information services to users of mobile phones and pagers. Substantially all of China Digital Wireless, Inc. operations are in Shanghai, People's Republic of China (PRC). In order to meet ownership requirements under Chinese law that restrict a foreign company from operating in certain industries such as value-added telecommunication and Internet services, CDW's subsidiary has entered into information service and cooperation agreements with two of CDW's affiliates that are incorporated in China: Sifang Information and Tianci. CDW holds no ownership interest in Sifang Information or Tianci. Sifang Information and Tianci contract with China Mobile Communications Corporation, or China Mobile, and China United Telecommunications Corporation, or China Unicom, respectively, to provide wireless value-added information services to wireless receiver customers in China via China Mobile and China Unicom. Sifang Information transmits those services to customers of China Mobile and China Unicom on behalf of itself and Tianci pursuant to a signed agreement between Sifang Information and Tianci. Recapitalization and Reorganization On June 23, 2004, Boulder Acquisitions, Inc. ("Boulder Acquisitions") entered into a stock exchange agreement with Sifang Holdings Co. Ltd. ("Sifang Holdings") and certain shareholders. Pursuant to the stock exchange agreement, Boulder Acquisitions issued 13,782,636 shares of its common stock in exchange for a 100% equity interest in Sifang Holdings, making Sifang Holdings a wholly owned subsidiary of Boulder Acquisitions. Boulder Acquisitions was incorporated under the laws of the State of Colorado on May 8, 1980 as Boulder Brewing Company ("Boulder Brewing"). Boulder Brewing was the successor to a general partnership formed in 1979. From the initial inception of the original partnership through 1990, Boulder Brewing was in the business of operating a microbrewery in Boulder, Colorado. During 1990, as a result of various debt defaults, Boulder Brewing's assets were foreclosed upon and all business operations were ceased. Boulder Brewing has effectively had no operations, assets or liabilities since its fiscal year ended December 31, 1990. In September 2001, Boulder Brewing changed its state of incorporation from Colorado to Nevada by means of a merger with and into Boulder Acquisitions, a Nevada corporation formed on September 6, 2001 solely for the purpose of effecting the reincorporation. The Articles of Incorporation and Bylaws of the Nevada corporation are the Articles of Incorporation and Bylaws of the surviving corporation. Such Articles of Incorporation eliminated the provision for Boulder Acquisitions to issue preferred stock. The above stock exchange transaction resulted in those shareholders of Sifang Holdings obtaining a majority voting interest in Boulder Acquisitions. Generally accepted accounting principles in the United States of America require that the company whose shareholders retain the majority interest in a combined business be treated as the acquirer for accounting purposes. Consequently, the stock exchange transaction has been accounted for as a recapitalization of Sifang Holdings as Sifang Holdings acquired a controlling equity interest in Boulder Acquisitions, as of June 23, 2004. The reverse acquisition process utilizes the capital structure of Boulder Acquisitions and the assets and liabilities of Sifang Holdings are recorded at historical cost. Sifang Holdings is the continuing operating entity for financial reporting purposes, and the financial statements prior to June 23, 2004 represent Sifang Holdings' financial position and results of operations. As of June 23, 2004, Boulder Acquisitions had only cash of $310,051, and shareholders' equity of $310,051 with 1,585,705 shares of common stock outstanding, all of which were included in the consolidated financial statements of Sifang Holdings. Please see the shareholders' equity statement for the period from January 1, 2004 to September 30, 2005. Although Sifang Holdings is deemed to be the acquiring corporation for financial accounting and reporting purposes, the legal status of Boulder Acquisitions as the surviving corporation did not change. Subsequent to September 30, 2004, Boulder Acquisitions changed its name to China Digital Wireless, Inc. 7 Business History CDW's business is primarily conducted through its wholly-owned subsidiary Sifang Holdings Co., Ltd., (Sifang Holdings) and its wholly-owned subsidiary TCH Data Technology Co., Ltd. (TCH, and collectively with CDW and Sifang Holdings known as the Company). Sifang Holdings was established under the laws of the Cayman Islands on February 9, 2004 for the purpose of acquiring a 100% equity interest in TCH. TCH was established as a foreign investment enterprise in Shanghai under the laws of the PRC on May 25, 2004, with registered capital of $7.2 million. CDW's current operations were originally a business division of Shanghai Sifang Information Technology Co. (Sifang Information or Shanghai SFT Co., Ltd.). Sifang Information is a Shanghai-based privately owned enterprise established under the laws of the PRC on August 14, 1998. Sifang Information is engaged in the business of pager and mobile phone distribution and provides value-added information services to the customers in the Shanghai metropolitan area. In March 2004, Sifang Information spun off its mobile phone distribution business and the majority of its value added information services business to TCH. As the acquiring entity under common control, TCH initially recognized all the assets and liabilities transferred at their carrying amounts in the accounts of Sifang Information at the date of transfer under the guidance of SFAS No. 141, Appendix D. On May 26, 2004, Sifang Information exchanged 100% of the equity interest in TCH for 100% of the equity interest in Sifang Holdings. Since the ultimate owners of the three entities were the same owners and the three entities remained under common control, the ownership exchange transaction was accounted for at historical costs under the guidance of SFAS No. 141, Appendix D. Prior to May 26, 2004, there were no activities in Sifang Holdings. As a result of the exchange of ownership between TCH and Sifang Holdings, TCH's historical financial statements became the historical financial statements of Sifang Holdings. As a result of the spin-off, the Company engages in the business of mobile phone distribution and provides pager and mobile phone users with access to certain value-added information reformatted by TCH. TCH purchases mobile phones from first tier distributors and sells them to retailers and distributors with a mark-up. In the process of providing value-added information services through entering into monthly subscription agreements with various users, TCH purchases trading activity information from stock exchanges, comments and analyses on PRC stock markets provided by certain reputable security and investment companies, lottery information, weather forecast, and other value-added products and reformats the aforementioned information through decoding and recoding and then has the reformatted information transmitted by Sifang Information, via service contracts, to pager users. The value-added information is constantly saved on the Company's server in order for mobile phone users to dial in via China Mobile or China Unicom. By signing a monthly subscription agreement, wireless receiver users agree to make advance payments for its services for either three or six-month subscription periods. In the spin-off process, the cost of sales included in the Company's financial statements is directly related to the product revenue and the cost of services is directly related to different types of service. The business taxes (similar to sales taxes in the U.S.) are related only to service revenue at a tax rate of approximately 3.3%. The selling expenses are allocated based on the relationship between expense and revenue (such as commission) and payroll records. The general and administrative expenses are allocated based on management hours spent and payroll records. The income tax provision has been calculated on a separate company basis and is in line with the historical actual income tax provision at the Sifang Information level assuming that all income taxes had been paid by Sifang Information and no income tax liability was in existence in the periods reported in the accompanying financial statements. Management believes that the costs, operating expenses, interest expense, and income tax provision included in the Company's financial statements are a reasonable representation of the costs and expenses that would have been incurred if the Company had performed these functions as a stand-alone company. 8 NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation These unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the Company's financial condition and results of operations for the interim periods presented in this Form 10-Q have been included. Operating results for the interim periods are not necessarily indicative of financial results for the full year. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. The Company's consolidated financial statements for the nine months ended September 30, 2004 have been derived from the historical financial statements and accounting records of Sifang Information using the historical operating results and the historical basis of the assets and liabilities transferred to the Company in accordance with accounting principles generally accepted in the United States of America. Management believes that the assumptions underlying the accompanying financial statements are reasonable. However, the financial statements that are derived from Sifang Information's financial records may not necessarily reflect the Company's results of operations and cash flows had the Company been a stand-alone company. Principles of Consolidation The consolidated financial statements for the nine months ended September 30, 2005 include the accounts of CDW, its wholly owned subsidiary Sifang Holdings, and its wholly-owned subsidiary TCH. Substantially all of CDW's revenues are derived from the operations of TCH, which represents substantially all of CDW's consolidated assets and liabilities as of September 30, 2005. All significant intercompany accounts and transactions have been eliminated. Foreign Currency Translations and Transactions The Renminbi ("RMB"), the national currency of the PRC, is the primary currency of the economic environment in which the operations of the Company are conducted. The Company uses the United States dollar ("U.S. dollars") for financial reporting purposes. The Company translates its financial statements into U.S. dollars in accordance with SFAS No. 52, "Foreign Currency Translation." All asset and liability accounts have been translated using the rate of exchange prevailing at the balance sheet date (at September 30, 2005, the prevailing exchange rate of the US dollar against the RMB was 8.0930), and the statement of income is translated at average rates during the reporting period (the average rates of the US dollar against the RMB, during the reporting period, were 8.2322). Equity items are translated at historical rates. Adjustments resulting from the translation of the Company's financial statements from RMB into U.S. dollars are recorded in shareholders' equity as part of accumulated comprehensive income. Gains or losses resulting from transactions in currencies other than RMB are reflected in the statement of income for the reporting periods. Revenue Recognition The Company derives revenues from the sale of mobile phones, advertisement designing service and the provision of wireless information services that are used on cell phones, pagers and prepaid phone cards. The Company additionally earns commission income ("Agency Income") from the sale of CDMA mobile phones on the behalf of a related party. The Company recognizes its revenues net of related business taxes and value-added taxes. Mobile Phone Sales: Revenues generated from the sale of mobile phones are recognized when the products are shipped to the distributor or retailer and when persuasive evidence 9 of an arrangement exists, delivery of the products has occurred, customer acceptance has been obtained, which means the significant risks and rewards of ownership have been transferred to the customer, the price is fixed or determinable and collectibility is reasonably assured. Advertising Servicing Revenue, Net: Advertising revenues are derived from advertisement designing, masterminding and producing services. The Company recognizes service revenues over the term of the noted agreement at the time of completion of the services. The Company records the revenue from Shanghai Sifang Media Co., Ltd. on a net basis in compliance with EITF 99-19, "Reporting Revenue Gross as a Principle versus Net as an Agent" because the Company is not the primary obligor in the arrangement and they receive a fixed fee from Shanghai Sifang Media Co., Ltd. and they have no latitude in determining prices. Information Services: The Company recognizes service revenues over the term of the noted agreement and/or when the services have been provided to the end user. i) Information Services - TCH: By signing a subscription agreement, wireless receiver users agree to make payments for three to six-month subscriptions in advance. TCH records the proceeds as deferred revenue and amortizes the deferred revenue over the subscription period. When customers buy a pre-charged service card, the Company records the proceeds as deferred revenue. When a customer starts to use this card to access the Company's server and starts to use a pager to access the aforementioned information, the Company identifies the subscription period and amortizes the deferred revenue over the subscription period. ii) Information Services - Installing Agent: In response to a retailer's request, the Company has an installing agent install the Company's software on mobile phones, which are owned by the retailer. The retailer sells these phones for a premium covering a fee to be paid to the installing agent and pre-charged six-month subscription fee to be paid to the Company. After a customer using such a phone dials into the server to access the desired information, the server records a unique identification number installed on the mobile phone, which indicates that a specific phone user starts his or her subscription period. After the Company receives a detailed list from the installing agent regarding the number of phones that have been installed with the Company's software, the Company matches this information with a detailed list from the retailer setting forth how many such phones have been sold. Based on the number of such phones sold, the Company records accounts receivable and deferred revenue correspondingly. At the date on which a customer starts to dial into the server, the six-month subscription period begins and the Company amortizes deferred revenue accordingly. iii) Information Services - China Mobile and/or Unicom: Since April 2004, the revenue generated from selling pre-charged cards has gradually decreased while the revenue generated through monthly subscriptions with China Mobile and/or China Unicom (collectively, "Mobile Operators") has gradually increased as the Mobile Operators' billing systems have been enhanced. The Company's affiliates, Sifang Information and Shanghai Tianci Industrial Group Co., Ltd. ("Tianci"), contract with the Mobile Operators for the transmission of the Company's value-added information services. The Mobile Operators bill and collect from customers and then pass those fees (net of billing and collection service fees charged by the Mobile Operators) to Sifang Information and Tianci who in turn pass those fees to the Company. The Company recognizes net revenues based on the total amount paid by its customers, for which the Mobile Operators bill and collect on behalf of the Company. There is a time lag ranging from 10 days to 45 days between the end of the service period and the date the Mobile Operators send out their billing statements due to the segregated billing systems of each of the provincial subsidiaries of the Mobile Operators. The Company has not recognized service revenue based on the records provided by its own server but has performed a reconciliation on a monthly basis of the revenues recognized by the Company's server to the Mobile Operator's billing statement. In addition, the Mobile Operators charge a network usage fee based on a fixed per message fee multiplied by the excess of messages sent over messages received. (This type of service is not covered by a monthly service 10 subscription and the Company has no control over whether it will occur or not.) Network usage fees charged by the Mobile Operators are reduced for messages received by the Company because the Mobile Operators separately charge the sender a fee for these transmissions. The Company records the revenue from China Mobile / China Unicom on a net basis in compliance with EITF 99-19, "Reporting Revenues Gross as a Principle versus Net as an Agent" because the Company: o Is not the primary obligor in the arrangement, as it relies on Sifang Information to transmit the information services to the end user, o Has limited ability to adjust the cost of services by adjusting the design or marketing of the service, o Has limited ability to determine prices, the Company must follow the price policy within ranges prescribed by Mobile Operators, and o Has limited ability to assume risk of non-payment by customers. The Company's dependence on the substance and timing of the billing systems of the mobile telecommunications operators may require us to estimate portions of our reported revenue for wireless Internet services from time to time. As a result, subsequent adjustments may have to be made to our wireless Internet service revenue in our financial statements. As we do not bill our wireless Internet services users directly, we depend on the billing systems and records of the mobile telecommunications operators to record the volume of our wireless Internet services provided, charge our users through mobile telephone bills and collect payments from our users and pay us. Cash and Cash Equivalents The Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains its cash accounts at credit worthy financial institutions. Accounts Receivable and Concentration of Credit Risk During the normal course of business, the Company extends unsecured credit to retailers and distributors who are mainly located in the Shanghai metropolitan area. Typically, for mobile phone distributors, credit terms require payment to be made within 30 days of the sale. The Company does not require collateral from its customers. The Company's policy is to provide for an allowance for doubtful accounts that is based on 5% of total trade accounts receivable less amounts due from related parties and from the installing agent. The Company regularly evaluates and monitors the creditworthiness of each customer on a case-by-case basis. The Company includes any account balances that are determined to be uncollectible in the overall allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. The Company believes that its allowance for doubtful accounts was adequate as of September 30, 2004 and 2005. However, actual write-offs might exceed the recorded allowance. The following table presents activities in the allowance for doubtful accounts. December 31, September 30, ------------- ------------- 2004 2005 ------------- ------------- (Unaudited) Beginning balance $ 28,158 $ 47,922 Additions charged to expense 19,764 -- Recovered -- (30,680) Actual write off -- -- ------------- ------------- Ending balance $ 47,922 $ 17,242 ============= ============= Inventories Inventories consist principally of mobile phones manufactured by name brand manufacturers with various features and are stated at the lower of cost (weighted-average) or market. 11 Rebates and Credits Receivable In 2004, the Company's major vendor began providing rebates and credits if the Company meets certain sales volume levels prescribed by the vendor. As a result, the Company is entitled to receive certain rebates and credits for the inventory held and sold by the Company within the specified period of time as defined by its vendor through submitting the necessary application forms. In general, once the vendor approves the applications the amounts of these rebates and credits will be deducted from the Company's accounts payable to its vendor and decrease the cost of goods sold or inventory held correspondingly. Capitalization of Software Costs The Company's software is developed by an independent third party to enable pager users to accept certain recoded information which is transmitted by the Company, through affiliates, and enables mobile phone users to dial into the Company's server. The software is for internal use and gives the Company the ability to provide value-added information services. In accordance with SOP 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," the Company capitalizes the external cost incurred to develop this internal-use software by an engineering company at the application development stage and amortizes that cost over the estimated economic life of the software (two or three years) which is consistent with the expected life of a particular type of mobile phone. Property and equipment Property and equipment are recorded at cost and are stated net of accumulated depreciation. Depreciation expense is determined using the straight-line method over the estimated useful lives of the assets as follows: Buildings 20 years Software 2-3 years Vehicles and other equipment 2-5 years Maintenance and repairs are charged directly to expense as incurred, whereas betterment and renewals are generally capitalized in their respective property accounts. Impairment of Long-Lived Assets The Company applies the provisions of Statement of Financial Accounting Standard No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"), issued by the Financial Accounting Standards Board ("FASB"). SFAS No. 144 requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets. Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value. There was no impairment of long-lived assets in the nine months ended September 30, 2004 and 2005. Fair Value of Financial Instruments The carrying amount of cash and cash equivalents, accounts receivable, advances and deposits to supplier, accounts payable and other current liabilities are reasonable estimates of their fair value because of the short maturity of these items. Stock Based Compensation The Company utilizes SFAS No. 123 "Accounting for Stock-Based Compensation," when accounting for stock based compensation and recognizes the fair value impact of the compensation granted to employees and consultants as a charge to net income in the period that the services associated with the compensation are incurred. The Company does not currently have a stock option plan. 12 Value Added Tax TCH is subject to value-added tax ("VAT") imposed by the PRC on TCH's domestic product sales. The output VAT is charged to customers who purchase mobile phones from TCH and the input VAT is paid when TCH purchases mobile phones from its vendors. The VAT rate ranges from 13% to 17%, depending on the types of products purchased and sold. The input VAT can be offset against the output VAT. Income Taxes The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No 109, "Accounting for Income Taxes" ("SFAS No. 109"). SFAS No. 109 requires an entity to recognize deferred tax liabilities and assets for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company establishes a valuation when it is more likely than not that that the assets will not be recovered. The Company's Chinese subsidiary TCH is registered at Pudong District in Shanghai and subject to a favorable income tax rate of 15% compared to a normal income tax rate of 33% (30% for the central government and 3% for the local government) under current PRC tax laws. However, Sifang Information is registered in the Shanghai downtown and the area has been treated by the Shanghai Municipal Administration of Labor as an enterprise that provides unemployed and handicapped people with jobs. Accordingly, Sifang Information is entitled to a favorable income tax rate of 15% and qualifies for an income tax exemption for three years from January 1, 2000 to December 31, 2002, and a 50% income tax reduction for three years from January 1, 2003 to December 31, 2005. The income tax provisions presented in the Company's financial statements are based on the historical actual income tax rates of SFT at 7.5% for the nine months ended September 30, 2004. The income tax provision presented for the nine months ended September 30, 2005 is based on 15%. The deferred tax assets are determined based on the historical income tax rates applicable at the TCH level. There is no income tax for companies domiciled in the Cayman Islands. Accordingly, the Company's financial statements do not present any income tax provisions related to Cayman Islands tax jurisdiction. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. Comprehensive (Loss) Income The Company has adopted Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"), issued by the FASB. SFAS No. 130 establishes standards for reporting and presentation of comprehensive income (loss) and its components in a full set of general-purpose financial statements. The Company has chosen to report comprehensive income (loss) in the statements of income and comprehensive income. Comprehensive income (loss) is comprised of net income and all changes to stockholders' equity except those due to investments by owners and distributions to owners. Earnings Per Share The Company presents earnings per share in accordance with the Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS No. 128"). Basic earnings (loss) per share includes no dilution and is computed by dividing 13 net income (loss) available to common shareholders by the weighted average number of shares outstanding during the period. Diluted earnings (loss) per share reflect the potential dilution of securities that could share in the earnings of an entity if they were converted. The Company did not have any potentially dilutive common share equivalents as of September 30, 2004 and 2005. NOTE 3 - EQUITY TRANSACTIONS On June 23, 2004, the Company issued 167,895 shares of its common stock to a consultant for services relating to the reverse merger that was completed in fiscal 2004. The trading price of the Company's common stock on June 23, 2004 was $3.60 per share; accordingly, the fair value of 167,895 shares was $604,422. On June 23, 2004, the Company issued 166,667 shares of its common stock in exchange for services performed by an existing major shareholder of Boulder Acquisitions for his consulting services involved with the reverse merger. The common stock was issued at a price of $1.14 per share in exchange for gross proceeds of $190,000 based on a stock purchase agreement. The $1.14 per share price was pre-negotiated between the Company and the shareholder before the reverse merger had been completed. Pursuant to the stock purchase agreement, the Company granted the existing shareholder an option which required the Company to purchase up to the aforementioned 166,667 shares of common stock at a price of $1.14 per share, such option being exercisable at any time after the date that is nine months after the Company files a registration statement on Form SB-2 with the SEC, registering the shares purchased by the existing shareholder, up to and including the earlier of the date that such registration statement is declared effective by the SEC or the existing shareholder's shares are eligible for resale under Rule 144 under the Securities Act of 1933. According to Topic D-98 from the SEC, "Classification and Measurement of Redeemable Securities," these shares should be presented outside the permanent equity section. However, on November 12, 2004, the Company filed a Registration Statement on Form SB-2 with the SEC, for registration of these securities to be sold to the public by small business issuers. On February 8, 2005, the SEC approved the registration filing and accordingly, the Company has recorded these shares in shareholders' equity as the contingency surrounding these shares expired as of February 8, 2005. On June 23, 2004, the trading price at the end of the day was $3.60 per share. Due to the relationship between the parties, the difference between the price of $1.14 per share and the price of $3.60 per share was recorded as compensation by presenting $410,001 in additional paid-in capital and in general and administrative expenses. On June 28, 2004, the Company issued, in aggregate, 1,315,789 shares of its common stock to three investors at a price of $1.14 per share in exchange for gross proceeds of $1,500,000 based on a stock purchase agreement. The $1.14 per share price was pre-negotiated between the Company and the investor before the reverse merger had been completed. Pursuant to the signed stock purchase agreement, the Company granted to each of the three investors an option which requires the Company to purchase up to the aforementioned 1,315,789 shares, in aggregate, of common stock at a price of $1.14 per share, such option being exercisable at any time after the date that is nine months after the Company files a Registration Statement on Form SB-2 with the SEC, registering the shares purchased by the existing stockholder, up to and including the earlier of the date that such registration statement is declared effective by the SEC or the existing shareholder's shares are eligible for resale under Rule 144 under the Securities Act of 1933. As of December 31, 2004, the proceeds of $1.5 million were held in an escrow account with an agent who is related to a shareholder. As of December 31, 2004, the Company has treated the proceeds held in escrow as a current asset as the entire amount was released from escrow in March 2005 and paid to the Company. According to Topic D-98 from SEC, "Classification and Measurement of Redeemable Securities," these shares should be presented outside the permanent equity section. However, on November 12, 2004, the Company filed a Registration Statement on Form SB-2 with the SEC, for registration of these securities to be sold to the public by small business issuers. On February 8, 2005, the SEC declared the registration statement effective. Accordingly, the Company has recorded these shares in shareholders' equity as the contingency surrounding these shares expired as of February 8, 2005. In connection with the June 28, 2004, issuance of common stock, the Company incurred share issue costs of $217,481 and accounted for it as a reduction of additional paid-in capital. On August 9, 2005, the Company announced its intent to apply for listing on the American Stock Exchange ("AMEX"). In connection with the AMEX application, certain persons who hold more than 200,000 shares of the Company's common stock entered in lockup agreements with the Company where they generally agreed to not offer, sell, assign or otherwise transfer a portion of their stock or other equity securities of the Company without prior written consent of the Company until the earlier of (i) 180 days after the date of the lockup agreements or (ii) the date that AMEX has approved the Company's listing 14
application. The lockup agreements became effective on September 21, 2005, and were executed by ten of the Company's officers and directors and three additional stockholders. Under the lockup agreements with the non-officer/director stockholders, the Company issued an aggregate of 128,576 shares of common stock in consideration thereof. NOTE 4 - RELATED PARTY TRANSACTIONS Related Party Relationships The following related parties are related through common ownership with the major shareholder of the Company. Merchandise Sold to Related Parties Three months Ended September 30, 2004 2005 -------------- -------------- (Unaudited) (Unaudited) Shanghai Shantian Telecommunication Co. Ltd. ("Shantian") $ -- $ 2,048,309 -------------- -------------- $ -- $ 2,048,309 ============== ============== During the three months ended September 30, 2005, TCH sold Samsung GSM mobile phones valued at $2,048,309 at a 3% gross profit margin to Shantian. There was no Samsung GSM mobile phone sales to Shantian during the three months ended September 30, 2004. Nine months Ended September 30, 2004 2005 -------------- -------------- (Unaudited) (Unaudited) Shanghai Shantian Telecommunication Co. Ltd. ("Shantian") $ 4,273,019 $ 9,856,854 -------------- -------------- $ 4,273,019 $ 9,856,854 ============== ============== During the Nine months Ended September 30, 2005, TCH sold Samsung GSM mobile phones valued at $9,856,854 (2004 - $4,273,019) at a 3% (2004 - 6%) gross profit margin to Shantian. Accounts receivable include $1,464,904 (2004 $812,550) due from Shantian. Advertising Services Rendered to Related Party Three months Ended September 30, 2004 2005 -------------- -------------- (Unaudited) (Unaudited) Shanghai Tianci Real Estate Co. Ltd. $ -- $ 614,136 -------------- -------------- $ -- $ 614,136 ============== ============== Nine months Ended September 30, 2004 2005 -------------- -------------- (Unaudited) (Unaudited) Shanghai Tianci Real Estate Co. Ltd. $ -- $ 1,738,878 -------------- -------------- $ -- $ 738,878 ============== ==============
In January 2005, Shanghai Sifang Media Co., Ltd and TCH entered into the "Bank Digital TV's Cooperation Agreement", where TCH will assist in the promotion of TV ads for Shanghai Tianci Real Estate Co. Ltd. TCH received a net fee of approximately $1,800,000 for providing the service from January 2005 to September 30, 2005. There is an "Advertisement Agency Contract" between Shanghai Tianci Real Estate Co., Ltd and Shanghai Sifang Media Co., Ltd, which continues until November 2005 and it is expected that TCH will earn additional advertising service revenue during the term of the Advertising Agency Contract. 15 As of September 30, 2005 the balance due from Shanghai Tianci Real Estate Co. Ltd. was $460,275. Service Provided by Related Party Three months Ended September 30, 2004 2005 -------------- -------------- (Unaudited) (Unaudited) Shanghai SFT Co., Ltd. $ 141,980 $ 106,750 -------------- -------------- $ 141,980 $ 106,750 ============== ============== In accordance with terms contained in signed service agreements between TCH and Sifang Information giving TCH the right to use Sifang Information's facility (which may not be owned by foreign investors at the present time) to transmit the reformatted information, the Company paid service fees of approximately $141,980 and $92,081 for the three months ended September 30, 2004 and 2005 respectively. The annual payments for the services have declined from approximately $567,000 to approximately $362,472 since January 1, 2005. During the three months ended September 30, 2005, Sifang Information also provided other management support and marketing services to TCH for $14,669. Nine months Ended September 30, 2004 2005 -------------- -------------- (Unaudited) (Unaudited) Shanghai SFT Co., Ltd. $ 425,900 $ 336,358 -------------- -------------- $ 425,900 $ 336,358 ============== ============== In accordance with terms contained in signed service agreements between TCH and Sifang Information giving TCH the right to use Sifang Information's facility (which may not be owned by foreign investors at the present time) to transmit the reformatted information, the Company paid service fees of approximately $425,900 and $ 273,317 for the nine months ended September 30, 2004 and 2005 respectively. The annual payments for the services have declined from approximately $567,000 to approximately $362,472 since January 1, 2005. During the nine months ended September 30, 2005, Sifang Information also provided other management support and marketing services to TCH for $63,041. Amounts Due from Related Parties December 31, 2004 September 30, 2005 ------------------ ------------------ (unaudited) $ 4,987,956 $ 6,326,038 Shanghai Tianci Real Estate Co. Ltd. -- 460,275 ------------------ ------------------ $ 4,987,956 $ 6,786,313 ================== ================== 16
In order to develop the Company's mobile phone distribution business, the Company is applying to become Nokia's distributor (provincial level) of mobile phones. On March 20, 2005 TCH signed an agreement with Sifang Information for cooperation on Nokia mobile phone's distribution, as TCH will act as an agent to sell Nokia phones on Sifang Information's behalf. In May, the final approval from Nokia was received by Sifang Information. As of September 30, 2005, TCH had advanced $2,407,852 (RMB19,900,000) to Sifang Information in order to help Sifang Information to maintain enough working capital to purchase Nokia mobile phones and to establish marketing for channel distribution. As of September 30, 2005, TCH had also advanced $ to Sifang Information as the working capital to assist Sifang Information for business transformation. Deposit for Business Acquisition In March 2005, TCH signed an agreement with Tianci Group for appointing Tianci Group as an agent for assisting with TCH's proposal to acquire assets and a related business from Shanghai Oriental New Window Company Limited ("Shanghai ONW"), whose main business was digital mobile television and digital media services. To initiate the acquisition, TCH advanced Tianci Group RMB20,000,000 (equivalent to approximately $2,418,000). In June 2005, the acquisition was finalized, and the deposit to Tianci Group was fully collected and all related assets and business was transferred from Tianci Group to TCH with no mark up. Due to Related Parties December 31, 2004 September 30, 2005 ------------------ ------------------ (unaudited) Shanghai Tianci Real Estate Co. Ltd $ 51,350 $ -- Shanghai Tianci Industry Group Co. Ltd. 48,910 -- ------------------ ------------------ $ 100,260 $ -- ================== ================== NOTE 5 - SEGMENT REPORTING The Company currently operates in four principal business segments. Management believes that the following table presents the useful information to the chief operation decision makers for measuring business performance and financing needs and preparing the corporate budget, etc. As most of the Company's customers are located in the Shanghai metropolitan area and the Company's revenues are generated in Shanghai, no geographical segment information is presented. Advertising Service Mobile Phone Beep Pagers Revenue Phone Sales Service Service Corporate Total ------------ ------------ ------------ ------------ ------------ ------------ Three months ended September 30, 2004 Revenue $ -- $ 6,239,802 $ 748,601 $ 31,118 $ -- $ 7,019,521 Gross profit -- 113,265 736,911 (192,165) -- 658,011 Depreciation -- -- (14,309) -- 14,315 6 Interest income -- -- -- -- 18,339 18,339 Net income (loss) -- 158,493 630,622 (162,389) (56,954) 569,772 Expenditures for long-lived assets -- -- (23,171) -- -- (23,171) 17 Three months ended September 30, 2005 Revenue $ 614,136 $ 4,891,847 $ 2,468 $ 187,664 $ -- $ 5,696,115 Gross profit 614,136 69,193 (55,496) 78,896 -- 706,729 Depreciation -- -- 49,043 -- 14,544 129,904 Interest (expense) -- -- -- -- (6,179) (6,179) Net income (loss) 489,704 12,061 (90,782) 33,574 (35,639) 408,918 Expenditures for long-lived assets (157,264) -- 68,285 -- -- (88,979) Nine months ended September 30, 2004 Revenue $ -- $ 15,427,286 $ 1,798,801 $ 639,949 $ -- $ 17,866,036 Gross profit 768,623 1,569,473 130,058 -- 2,468,154 Depreciation -- -- 95,911 -- 42,940 138,851 Interest income -- -- -- -- 31,931 31,931 Net income (loss) -- 584,076 1,247,446 (16,449) (837,240) 977,833 Expenditures for long-lived assets -- -- 19,162 -- -- 19,162 Total Assets,as of December 31, 2004 -- 2,721,741 2,443,657 -- 7,497,267 12,662,665 Nine months ended September 30, 2005 Revenue $ 1,738,878 $ 14,173,276 $ 623,074 $ 526,747 $ -- $ 17,061,975 Gross profit 1,738,878 351,890 349,974 303,926 -- 2,744,668 Depreciation -- -- 142,108 -- 43,171 185,279 Interest (expense) -- -- -- -- (9,844) (9,844) Net income (loss) 1,417,555 172,609 171,047 185,745 (270,089) 1,676,867 Expenditures for long-lived assets -- -- 142,923 -- -- 142,923 Total Assets, as of September 30, 2005 -- 5,839,005 274,814 -- 8,723,806 14,837,625
NOTE 6 -GOVERNMENTAL SUBSIDY During the third quarter of 2005, the Company received a general government subsidy from the local bureau, which is equivalent to 7% of the taxable income of TCH throughout the period from September 2004 to December 2004. The subsidy is non-recurring and subject to government approval. NOTE 7 -EMPLOYEE WELFARE AND RETIREMENT BENEFITS The PRC has been undergoing significant reforms with regard to its employee welfare and fringe benefits administration. Any enterprise operating in the PRC is subject to government-mandated employee welfare and retirement benefit contributions. In accordance with PRC laws and regulations, TCH participates in a multi-employer defined contribution plan pursuant to which TCH is required to provide employees with certain retirement, medical and other fringe benefits. PRC regulations require TCH to pay the local labor administration bureau a monthly contribution at a stated contribution rate based on the monthly basic compensation of qualified employees. The local labor administration bureau, which manages various investment funds, will take care of employee retirement, medical and other fringe benefits. TCH has no further commitments beyond its monthly contribution. TCH contributed a total of $29,743 and $41,745 to these funds as part of selling, general and administrative expenses for the nine months ended September 30, 2004 and 2005, respectively. 18 ITEM 3. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION This report contains certain forward-looking statements that involve risks and uncertainties. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "could," "expect," "plan," "intend," "anticipate," "believe," "estimate," "predict," "potential," or "continue," or the negative of such terms or other comparable terminology. These statements are only predictions and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein. The following discussion should be read in conjunction with our financial statements and the notes thereto and the other financial information appearing elsewhere in this document. We do not undertake to publicly update or revise any of its forward-looking statements even if experience or future changes show that the indicated results or events will not be realized. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Overview of Business Background Sifang Holdings was formed under the laws of the Cayman Islands on February 9, 2004 for the purpose of holding a 100% equity interest in TCH. TCH was established as a foreign investment enterprise in Shanghai under the laws of the PRC on May 25, 2004, with registered capital of $7.2 million. Sifang Information is a Shanghai-based privately owned enterprise established under the laws of the PRC on August 14, 1998. Sifang Information is engaged in the business of pager and mobile phone distribution and provides value added information services to customers in the Shanghai metropolitan area. In March 2004, Sifang Information spun off its mobile phone distribution business and the majority of its value added information services business by presenting a set of carve-out financial statements for the years ended December 31, 2002 and 2003 and six months ended June 30, 2004 as if the spun-off business had been a stand-alone company for two years and one quarter. On June 30, 2004, Sifang Information transferred the spun-off business into TCH. Being a receiving entity under common control, TCH initially recognized all the assets and liabilities transferred at their carrying amounts in the accounts of Sifang Information at the date of transfer under the guidance of SFAS No. 141, Appendix D. On May 26, 2004 Sifang Information exchanged 100% of its equity interest in TCH for a 100% equity interest in Sifang Holdings. Since the ultimate owners of the three entities were the same owners and the three entities remained under common control, the ownership exchange transaction was accounted for at historical costs under the guidance of SFAS No. 141, Appendix D. Prior to May 26, 2004, there were no activities in Sifang Holdings. As a result of exchanging the ownership between TCH and Sifang Holdings, TCH's historical financial statements become the historical financial statements of Sifang Holdings. Sifang Information operates in a business segment that is subject to certain restrictions imposed by the government of the PRC. For example, paging facilities, radio transmitting stations and transmitting equipment owned by Sifang Information are not allowed to be owned by foreign investment enterprises in accordance with PRC government regulations. Therefore, Sifang Information still maintains a small part of its business and paging facilities in order to stay in compliance with relevant regulations and laws in PRC. As a result of the spin-off, TCH engages in the business of mobile phone distribution and provides pager and mobile phone (collectively "wireless receiver") users with access to certain information reformatted by TCH. TCH purchases mobile phones from first tier distributors and sells them to retailers with a mark-up. In the process of providing value-added information services through entering into monthly subscription agreements with various users, TCH purchases trading activity information from stock exchanges, comments and analysis on PRC stock markets provided by certain reputable security and investment companies, lottery information, weather forecast, and other value-added products and reformats the aforementioned information through decoding and recoding and then has the reformatted information transmitted by Sifang Information, via service contracts, to pager users. The information is constantly saved in TCH's server in order for mobile phone users to dial in via China Mobile or China Unicom. By signing a monthly subscription agreement, wireless users agree to make advance payments for either three or six-month subscription periods. 19 We launched a new digital media project to move into the media market in China in 2005. In conjunction with charitable organizations, we have installed donation boxes with digital TV incorporated on top of them in the main lobbies of commercial banks, hotels, malls and other public locations to call the public's attention to the charity and broadcast commercial advertisements. Discussion and Analysis of Operating Results Nine months Ended September 30, 2005 Compared to Nine months Ended September 30, 2004 Revenue Total Revenues Total sales revenues consist of product sales, product sales to related parties, and net information and advertising service revenue. Total sales revenues for the nine months ended September 30, 2005 decreased by $804,061, representing a 4.5% decrease, to $17,061,975 as compared to $17,866,036 for the same period of the prior year. The decrease was mainly due to the decline of mobile phone sales and gross profit margins thereon. The demand for mobile phones in the Chinese telecommunication market is gradually becoming saturated. In the nine months ended September 30, 2005, Samsung's mobile phones accounted for about 97% of our total product sales and other name brand mobile phones accounted for the remaining 3%, compared to the same period of the prior year, in which Samsung and Nokia's mobile phones accounted for 93% and 4% of our total product sales and other brands accounted for the balance. During 2005, market competition for mobile phone sales intensified, causing us to decrease our overall mark-up ratio to 2.5% in order to maintain our market position, in comparison with a mark-up ratio of 5.0% for the same period of the prior year. Product Sales Revenue for product sales in the nine months ended September 30, 2005 decreased by $598,043, representing a 12.2% decrease, to $4,316,422 as compared to $4,914,465 for the same period of the prior year. The decrease was mainly due to the market factors. The demand for mobile phones in Chinese market is becoming saturated along with the intensified competition for the mobile phone distributors. We entered an agreement to distribute select Nokia mobile phones exclusively in the Shanghai region of China in May 2005 and now have obtained the right to distribute two popular models of Nokia's mobile phones . We believe that this agreement will enhance both our market share and profitability. Since June, we distributed approximately $627,876 worth of Nokia mobile phones to our customers with a superior mark-up of approximately 8% compared to the other brands we have been selling. We continue to strengthen our relationship with Nokia and to diversify the mobile phone portfolio to be responsive to market changes and product innovation. The relationship will allow us to benefit from Nokia's position as the leading manufacturer of mobile phones worldwide and Nokia's leadership in the rapidly growing mobile phone market in China. Product sales to a related party We distributed Samsung mobile phones to our related party, Shantian, in which Sifang Information holds a 51% equity interest, for its retail market channel and facility. During the nine month ended September 30, 2005, we sold $9,856,854 worth of mobile phones to Shantian, with an average mark-up of approximately 2.6%, which represents a $665,967 decrease compared to the same period of the prior year. The decrease was also attributable to the market factors mentioned above. 20 Information service revenue, net Total information service revenue net of related business tax and surcharge for the nine months ended September 30, 2005 decreased by $1,288,929 representing a 52.9% decrease, to $1,149,821 compared to $2,438,750 for the same period of the prior year. Value-added service revenue from mobile phone users for the nine months ended September 30, 2005 decreased by $1,175,727 representing a 65.4% decrease, to $623,074 compared to $1,798,801 for the same period of the prior year. The decrease was mainly due to the decline of our financial value-added service. The sluggish Chinese stock market along with inactive stock exchanges hindered our growth in this segment of business. In addition, service revenue from pager users for the nine months ended September 30, 2005 dropped by $113,202 to $ 526,747 compared to $639,949 for the same period of the prior year, representing a 17.7% decrease. We believe that service revenue from pager users will continue to decrease given the increased popularity of mobile phones over beepers and pagers. We project that the decrease in service revenue from pager users will likely plateau at a certain level as most lower income pager users still like to use pagers to access our information services. Advertising service revenue, net We launched a new digital media project to move into the media market in China in 2005. In conjunction with charitable organizations, we have installed donation boxes with digital TV incorporated on top of them in the main lobbies of commercial banks, hotels, malls and other public locations to call the public's attention to the charity and broadcast commercial advertisements. We reached an agreement with China Charity Foundation ("CCF"), a national non-profit charitable organization, which enables the Company to install donation boxes for CCF in banks and other commercial locations throughout China that will also have the Company's out-of-home digital television advertising media platform attached. The completion of this agreement enables us to accelerate the placement of out-of-home digital television platforms, particularly in banks across China. The Company negotiates placement of the donation boxes and digital television media platform with banks and other commercial entities that wish to support the national charity. The China Banking Regulatory Commission ("CBRC") has previously agreed, pending completion of the agreement with CCF, to support and coordinate this effort with respect to approvals of donation box placements in banks throughout China. This agreement facilitates the continued placement of platforms with little or no direct costs. We believe that such costs may constitute as much as 30% of the direct costs of its competitors based upon an analysis of publicly available information. We have placed more than 670 multimedia donation boxes in the inbound area of Shanghai and other arranged spots will be rolled out in the public places with high traffic flow. Based on Shanghai, our strategy is to expand our network to penetrate other large and mid-sized developed cities throughout China. We believe the earnings potential from the advertising service will be a new source of profit in view of the upcoming Special Olympic World Summer Games in 2007 and World Exposition in 2010 to be held in Shanghai. In addition, during the nine months ended September 30, 2005, TCH rendered advertisement designing and producing services to Shanghai Tianci Real Estate Co. Ltd. ("Tianci Real Estate") for publicity and promoting its apartment. Net service revenue of $1,738,878 was derived from this service. Cost of goods sold The cost of goods sold for the nine months ended September 30, 2005 decreased by $837,277 to $13,821,386 compared to $14,658,663 for the same period of the prior year, representing a 5.7 % decrease. The decrease was consistent with the decrease of revenue from product sales. 21
Cost of service The cost of service for the nine months ended September 30, 2005 decreased by $243,298 to $495,921 compared to $739,219 for the same period of the prior year, representing a 32.9% decrease. The decline was mainly due to the decrease of information fees paid to content providers for the value-added service. The breakdown of our service business has changed and the proportion of beep services that are related to financial service has decreased, resulting in a decrease in associated costs pertaining to the securities information fee paid. During 2005, we have continued to maintain current fee structures and establish collaborative relationships or partnerships with Chinese mobile operators and certain information content providers. Gross profit After taking into account the cost of goods sold and cost of service, our gross profit for the nine months ended September 30, 2005 increased by approximately $276,514 to $2,744,668, representing an 11.2% increase, compared to gross profit of $2,468,154 for the same period of the prior year. The increase in gross profit was primarily attributable to the proceeds generated from the new advertising service during the three quarters of 2005. The following table summarizes certain information related to the various components of revenue. Information Advertising Service - Information Service Mobile Service - Revenue Phone Sales Phone Pager Total -------------------------- ----------- ----------- ----------- For nine months ended September 30, 2005 -------------------------- ----------- ----------- ----------- Revenue $ 1,738,878 $14,173,276 $ 623,074 $ 526,747 $17,061,975 -------------------------- ----------- ----------- ----------- Cost -- 13,821,386 292,759 203,162 14,317,307 -------------------------- ----------- ----------- ----------- Gross profit 1,738,878 351,890 330,315 323,585 2,744,668 -------------------------- ----------- ----------- ----------- Gross profit ratio 100% 2.5% 53.0% 61.4% 16.1% -------------------------- ----------- ----------- ----------- For nine months ended September 30, 2004 -------------------------- ----------- ----------- ----------- Revenue $ -- 15,427,286 $ 1,798,801 $ 639,949 $17,866,036 -------------------------- ----------- ----------- ----------- Cost -- 14,658,663 229,328 509,891 15,397,882 -------------------------- ----------- ----------- ----------- Gross profit -- 768,623 1,569,473 130,058 2,468,154 -------------------------- ----------- ----------- ----------- Gross profit ratio -- 5.0% 87.3% 20.3% 13.8% -------------------------- ----------- ----------- -----------
Selling expenses Selling expenses for the nine months ended September 30, 2005 increased by $324 to $128,157 compared to $127,833 for the same period of the prior year, representing a slight increase. The increase was primarily due to the office expenses and fringe benefits attributable to our marketing department. Furthermore, the commission fees paid to the salesmen for mobile phones increased, which was offset by the decline in advertising expenses. 22 General and administrative expenses General and administrative expenses for the nine months ended September 30, 2005 decreased by $689,446 to $665,390 compared to $1,354,836 for the same period of the prior year, representing a 50.9% decrease. The higher expenses in 2004 were mainly due to one time non-cash compensation of $1,014,000 related to the reverse merger that was generated at the parent level, consisting of 167,895 shares issued to a consultant in lieu of a cash payment at a fair market value of $604,000 and the issuance of 166,667 redeemable shares pursuant to a stock purchase agreement resulting in a charge of $410,000 representing the premium between the trading price ($3.60 per share) and the pre-negotiated stock purchase price ($1.14 per share) of the shares. General and administrative expenses incurred at the TCH level for the nine months ended September 30, 2005 decreased from $238,224 to $228,231, representing a 4.2% decrease. The decrease was primarily attributable to the collection of accounts receivable from our clients, resulting in the recovery of provisions for bad debts, and cost control, which lead to the decline of utility expenses and communication fees. The other cash-based expenses incurred at the parent level in the nine months ended September 30, 2005 of $437,159 represented payments for audit fees, retainer fees and other consultant fees. Interest income (expense) During the nine months ended September 30, 2004, interest income derived from bank deposits was $31,931. During the nine months ended September 30, 2004, finance expense incurred in discounting bank drafts net of interest income from bank deposits was $9,844. Income tax The income tax provisions presented in the Company's financial statements are based on the historical actual income tax rates of Sifang Information at 7.5% for the nine months ended September 30, 2004 and 15% for the nine months ended September 30, 2005. For the nine months ended September 30, 2004 and 2005, income tax expense was $169,643 and $380,102, respectively, based on pre-tax income of $1,147,476 (which included the stock compensation of $1,014,000 incurred in the U.S.) and pre-tax income $1,951,121. Because the loss of approximately $1,014,000 incurred in the U.S. cannot offset the taxable income in China, the income tax expense of $169,643 incurred in China was based on the taxable income of approximately $2,162,000 during the nine months end September 30, 2004. Comprehensive income We recorded comprehensive income of $1,923,198 for the nine months ended September 30, 2005, a $945,210 increase in comprehensive income compared to comprehensive income of $977,988 for the same period of the prior year, representing a significant increase. The increase in comprehensive income was attributable to (i) the non-cash expenses that offset the net profit generated in the nine months ended September 30, 2004, (ii) the contribution of our new advertising business that was initiated in the first nine months of 2005, and (iii) the appreciation of Chinese RMB to US dollars. Earnings per share The earnings per share for the nine months ended September 30, 2005 was $0.10 compared to $0.07 for the same period of the prior year. 23 Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004 Revenue Product Sales Revenue from product sales for the three months ended September 30, 2005 was $2,843,538, compared to $0 for the three months ended September 30, 2004. We entered an agreement to distribute select Nokia mobile phones exclusively in Shanghai region of China in May 2005 and have now obtained the right to distribute two popular models of Nokia's mobile phones. We believe that this agreement will enhance both our market share and profitability. In the third quarter, we distributed approximately $627,062 worth of Nokia's mobile phone to our customers with a superior mark-up of approximately 8% compared to the other brands we have been selling, which was around 3%. We will continue to strengthen our relationship with Nokia and to diversify the mobile phone portfolio to be responsive to market changes and product innovation. The relationship will allow us to benefit from Nokia's position as the leading manufacturer of mobile phones worldwide and Nokia's leadership in the rapidly growing mobile phone market in China. Product sales to a related party We distributed Samsung mobile phones to our related party, Shantian, in which Sifang Information holds a 51% equity interest, for its retail market channel and facility. During the three month period ended September 30, 2005, we sold $2,048,309 worth of mobile phones to Shantian, with a mark-up on average of approximately 1.2%, which represents a $4,191,493 decrease compared to the same period of the prior year. The decrease was mainly due to the market factors. The demand for mobile phones in Chinese market is becoming saturated along with intensified competition for mobile phone distributors. Information service revenue, net Total information service revenue net of related business tax and surcharge for the three months ended September 30, 2005 decreased by $589,587 representing a 75.6% decrease, to $190,132 compared to $779,719 for the same period of the prior year. Value-added service revenue from mobile phone users for the three months ended September 30, 2005 decreased by $746,133 to $2,468 compared to $748,601 for the same period of the prior year, representing a material decrease. The decrease was due mainly to the decline of our financial value-added service. The sluggish Chinese stock market along with inactive stock exchanges hindered our growth in this segment of business. The decrease was offset by an increase in service revenue from pager users for the three months ended September 30, 2005 of $156,546 to $ 187,664 compared to $31,118 for the same period of the prior year. The increase was due to the drop of pager service revenue in the third quarter of last year. We believe that service revenue from pager users will continue to decrease given the increased popularity of mobile phones over beepers and pagers. We project that the decrease in service revenue from pager users will likely plateau at a certain level as most lower income pager users still like to use pagers to access our information services. Advertising service revenue, net During the three months ended September 30, 2005, TCH rendered advertisement designing and producing services to Tianci Real Estate for publicity and promoting its apartment. Net advertising service revenue of $614,136 was derived from this source. Cost of goods sold The cost of goods sold for the three months ended September 30, 2005 decreased by $1,303,883 to $4,822,654 compared to $6,126,537 for the same period of the prior year, representing a 21.3% decrease. The decrease was consistent with the decreases in revenue from product sales. 24
Cost of service The cost of service for the three months ended September 30, 2005 decreased by $68,241 to $166,732 compared to $234,973 for the same period of the prior year, representing a 29% decrease. The costs of service consist of value-added service costs and advertising service costs. The decline was due mainly to the decrease of information fees paid to content providers for the value-added service. The breakdown of our service business has changed and the proportion of beep services that are related to financial service has decreased, resulting in a decrease in associated costs pertaining to the securities information fee paid. During 2005, we have continued to maintain current fee structures and establish collaborative relationships or partnerships with Chinese mobile operators and certain information content providers. Gross profit After taking into account the cost of goods sold and cost of service, our gross profit for the three months ended September 30, 2005 increased by $48,718 to $706,729, representing a 7.4% increase, compared to gross profit of $658,011 for the same period of the prior year. The increase in gross profit was primarily attributable to the proceeds generated by the new advertising service which offset the decrease in information service during the third quarter of 2005. The following table summarizes certain information related to the various components of revenue. Information Advertising Service - Information Service Mobile Service - Revenue Phone Sales Phone Pager Total -------------------------- ----------- ----------- ----------- For three months ended September 30, 2005 -------------------------- ----------- ----------- ----------- Revenue $ 614,136 $ 4,891,847 $ 2,468 $ 187,664 $ 5,696,115 -------------------------- ----------- ----------- ----------- Cost -- 4,822,654 77,623 89,109 4,989,386 -------------------------- ----------- ----------- ----------- Gross profit (loss) 614,136 69,193 (75,155) 98,555 706,729 -------------------------- ----------- ----------- ----------- Gross profit ratio 100% 1.4% (3045.2)% 52.5% 12.4% -------------------------- ----------- ----------- ----------- For three months ended September 30, 2004 -------------------------- ----------- ----------- ----------- Revenue $ -- 6,239,802 $ 748,601 $ 31,118 $ 7,019,521 -------------------------- ----------- ----------- ----------- Cost -- 6,126,537 11,690 223,283 6,361,510 -------------------------- ----------- ----------- ----------- Gross profit (loss) -- 113,265 736,911 (192,165) 658,011 -------------------------- ----------- ----------- ----------- Gross profit ratio -- 1.8% 98.4% (617.5)% 9.4% -------------------------- ----------- ----------- -----------
Selling expenses Selling expenses for the three months ended September 30, 2005 decreased by $9,616 to $33,132 compared to $42,748 for the same period of the prior year, representing a 22.5% decrease. The decrease was mainly due to the decrease of commission fees paid to the salesmen for mobile phones which was partly offset by the increase in advertising expense. 25 General and administrative expenses General and administrative expenses for the three months ended September 30, 2005 increased by $123,439 to $263,023 compared to $139,584 for the same period of the prior year, representing an 88.4% increase. The increase was mainly due to the expense incurred in our parent company. General and administrative expenses incurred at the TCH level in the three months ended September 30, 2005 increased from $37,395 to $41,583, representing a slight increase. At the parent level, we incurred an aggregate of $221,440 for audit fees, service fees for Investor Relations and Public Relations and application fees for Amex listing in the three months ended September 30, 2005, compared to consulting fees of $102,189 incurred in the prior year. Interest income (expense) During the three months ended September 30, 2004, interest income derived from deposits in banks was $18,339. During the three months ended September 30, 2005, finance expenses incurred in discounting the bank draft net of interest income from deposits were $6,179. Income tax The income tax provisions presented in the Company's financial statements are based on the historical actual income tax rates of Sifang Information at 7.5% for the three months ended September 30, 2004 and 15% for the three months ended September 30, 2005. In the three months ended September 30, 2004 and 2005, income tax expense was $54,306 and $111,042, respectively, based on pre-tax income of $624,078 and $519,960. Comprehensive income We recorded comprehensive income of $655,253 for the three months ended September 30, 2005 compared to $ 569,772 for the same period of the prior year, representing a 15% increase. The increase in comprehensive income was attributable to (i) contribution of our new advertising business, and (ii) the appreciation of Chinese RMB to US dollars. Earnings per share The earnings per share for the nine months ended September 30, 2005 was $0.02 compared to $0.03 for the same period of the prior year Liquidity and Capital Resources Our net cash generated during the nine months ended September 30, 2005 increased from $127,066 to approximately $1,021,697 as of September 30, 2005. Net cash flows generated in operating activities was $1,133,767 during the nine months ended by September 30, 2005 compared to $290,362 during the same period of the prior year. The increase in cash provided was due to the collection of accounts receivable and increase in accounts payable offset by the cash used in other current assets and the increase in inventories. Net cash flows used in investing activities for the nine months ended September 30, 2005 reached $1,909,797 compared to $2,159,769 for the same period of the prior year. The cash used in investing activities was mainly due to the amount due from related parties. As of September 30, 2005, the amounts due from Tianci Real Estate and Sifang Information represent $460,275 and $6,326,038, respectively. 26 Net cash provided by financing activities for the nine months ended September 30, 2005 was $1,500,000 compared to $282,570 for the same period of the prior year. The $1,500,000 relates to proceeds for shares that were issued in fiscal 2004 but were held in escrow until the Company filed a Registration Statement on Form SB-2 with the SEC. The Company treated the proceeds held in escrow as a current asset as the entire amount was released from escrow in March 2005 and paid to the Company. On August 9, 2005, the Company announced its intent to apply for listing on the AMEX. In connection with the AMEX application, certain persons who hold more than 200,000 shares of the Company's common stock entered in lockup agreements with the Company where they generally agreed to not offer, sell, assign or otherwise transfer a portion of their stock or other equity securities of the Company without prior written consent of the Company until the earlier of (i) 180 days after the date of the lockup agreements or (ii) the date that AMEX has approved the Company's listing application. The lockup agreements became effective on September 21, 2005, and were executed by ten of the Company's officers and directors and three additional stockholders. Under the lockup agreements with the non-officer/director stockholders, the Company issued an aggregate of 128,576 shares of common stock in consideration thereof. We believe that current cash balance and cash flows from operations, if any, will be sufficient to meet present growth strategies and related working capital. In regards to the capital expenditures, we have sufficient funds to expand our operations. We plan to utilize a combination of internally generated funds from operations with potential debt and/or equity financings to fund its longer-term growth over a period of two to five years. The availability of future financings will depend on market conditions. There is no assurance that the future funding will be available. The forecast of the period of time through which our financial resources will be adequate to support operations is a forward-looking statement that involves risks and uncertainties. Recent Accounting Pronouncements In November 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material impact on our consolidated financial statements. In December 2004, the FASB issued SFAS No. 123-R, "Share Based Payments", which requires that the compensation cost relating to share-based payment transactions (including the cost of all employee stock options) be recognized in the financial statements. The cost will be measured based on the estimated fair value of the equity or liability instruments issued. SFAS 123-R covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Management believes the adoption of this pronouncement will not have a material effect on our consolidated financial statements. Also, in December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions." The amendments made by SFAS No. 153 are based on the principle that the exchange of nonmonetary assets, which should be measured using the estimated fair market value of the assets exchanged. SFAS No. 153 eliminates the narrow exception for nonmonetary exchanges of similar productive assets, and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has "commercial substance" if the future cash flows of the entity are expected to change significantly as a result of the transaction. This pronouncement is effective for monetary exchanges in fiscal periods beginning after June 15, 2005. Management believes the adoption of this pronouncement will not have a material effect on our consolidated financial statements. Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements. 27 Item 3. Controls and Procedures Prior to the conclusion of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13(a)-14(c). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic SEC filings. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date we carried out this evaluation. PART II OTHER INFORMATION Item 2. Unregistered sales of equity securities and use of proceeds As previously reported in the Company's Current Report on Form 8-K filed on September 27, 2005, the Company entered into lockup agreements with ten of the Company's officers and directors and three additional stockholders in connection with the Company's intended AMEX listing. The lockup agreements became effective on September 21, 2005. Under the lockup agreements with the non-officer/director stockholders, the Company issued an aggregate of 128,576 shares of common stock in consideration thereof in reliance on an exemption from registration under Section 4(2) under the Securities Act. Item 6. Exhibits The following documents are filed as part of this report: 31.1 Chief Executive Officer Certification furnished pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Chief Financial Officer Certification furnished pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Chief Executive Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Chief Financial Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 28 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CHINA DIGITAL WIRELESS, INC. (Registrant) Date: November 21, 2005 /s/ Fu Sixing ---------------------------------- Fu Sixing, Chief Executive Officer Date: November 21, 2005 /s/ Qian Fang ---------------------------------- Qian Fang, Chief Financial Officer 29