Quarterly Report
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 JUNE 30, 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
incorporation
or organization)
|
|
(I.R.S.
Employer
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
ý
NO
o
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 o
Accelerated
Filer o
Non-accelerated filer ý
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). YES o
NO ý
As
of
August 10, 2006, there were 11,369,336 shares of the issuer’s common stock, par
value $0.01 per share, outstanding.
PACIFICNET
INC.
Form 10-Q
for the Quarterly Period Ended June 30, 2006
TABLE
OF CONTENTS
|
|
|
PART I.
|
FINANCIAL
INFORMATION
|
|
Item
1.
|
Financial
Statements (Unaudited)
|
3
|
|
Condensed
Consolidated Balance Sheets
|
3
|
|
Condensed
Consolidated Income Statements
|
4
|
|
Condensed
Consolidated Statements of Cash Flows
|
6
|
|
Notes
to Condensed Consolidated Financial Statements
|
7
|
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
19
|
Item
3.
|
Quantitative
and Qualitative Disclosures about Market Risk
|
28
|
Item
4.
|
Controls
and Procedures
|
29
|
PART II.
|
OTHER
INFORMATION
|
|
Item
1.
|
Legal
Proceedings
|
33
|
Item
1A.
|
Risk
Factors
|
33
|
Item
2.
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
34
|
Item
3.
|
Defaults
upon Senior Securities
|
34
|
Item
4.
|
Submission
of Matters to a Vote of Security Holders
|
34
|
Item
5.
|
Other
Information
|
34
|
Item
6.
|
Exhibits
|
34
|
Signatures
|
|
35
|
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)
|
|
June
30, 2006
(Unaudited)
|
|
December
31, 2005
(Audited)
|
|
ASSETS
|
|
|
|
|
|
Current
Assets:
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
5,935
|
|
$
|
9,579
|
|
Restricted
cash - pledged bank deposit
|
|
|
230
|
|
|
1,652
|
|
Accounts
receivables
|
|
|
16,112
|
|
|
5,998
|
|
Inventories
|
|
|
2,368
|
|
|
1,836
|
|
Loan
receivable from related parties
|
|
|
4,753
|
|
|
2,520
|
|
Loan
receivable from third parties
|
|
|
1,010
|
|
|
1,572
|
|
Other
current assets
|
|
|
8,444
|
|
|
7,973
|
|
Total
Current Assets
|
|
|
38,852
|
|
|
31,130
|
|
Property
and equipment, net
|
|
|
8,361
|
|
|
4,300
|
|
Investments
in affiliated companies and subsidiaries
|
|
|
463
|
|
|
410
|
|
Marketable
equity securities - available for sale
|
|
|
539
|
|
|
539
|
|
Goodwill
|
|
|
16,688
|
|
|
14,227
|
|
Other
assets - debt issuance costs (net)
|
|
|
957
|
|
|
-
|
|
TOTAL
ASSETS
|
|
$
|
65,860
|
|
$
|
50,606
|
|
|
|
|
|
|
|
|
|
LIABILITIES
AND STOCKHOLDERS' EQUITY
|
|
|
|
|
|
|
|
Current
Liabilities:
|
|
|
|
|
|
|
|
Bank
line of Credit
|
|
|
889
|
|
|
1,060
|
|
Bank
loans-current portion
|
|
|
401
|
|
|
188
|
|
Capital
lease obligations - current portion
|
|
|
88
|
|
|
126
|
|
Accounts
payable
|
|
|
4,101
|
|
|
3,186
|
|
Accrued
expenses and other payables
|
|
|
2,558
|
|
|
4,620
|
|
Income
tax payable
|
|
|
33
|
|
|
296
|
|
Subscription
payable
|
|
|
390
|
|
|
775
|
|
Loan
payable to related party
|
|
|
570
|
|
|
369
|
|
Total
Current Liabilities
|
|
|
9,030
|
|
|
10,620
|
|
Long-term
liabilities:
|
|
|
|
|
|
|
|
Bank
loans - non current portion
|
|
|
1,498
|
|
|
6
|
|
Capital
lease obligations - non current portion
|
|
|
43
|
|
|
78
|
|
Convertible
Debenture
|
|
|
|
|
|
|
|
Warrant
Liability
|
|
|
615
|
|
|
|
|
Compound
Embedded Derivatives Liability
|
|
|
7,177
|
|
|
|
|
Total
long-term liabilities
|
|
|
9,333
|
|
|
84
|
|
Total
liabilities
|
|
|
18,363
|
|
|
10,704
|
|
Minority
interest in consolidated subsidiaries
|
|
|
11,898
|
|
|
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:
|
|
|
|
|
|
|
|
June
30, 2006 - 13,483,497 shares issued, 11,369,336
outstanding
|
|
|
|
|
|
|
|
December
31, 2005 - 12,000,687 issued, 10,831,024 outstanding
|
|
|
1
|
|
|
1
|
|
Treasury
stock, at cost (2006 Q2: 2,114,161 shares, 2005: 1,169,663 shares)
|
|
|
(243
|
)
|
|
(119
|
)
|
Additional
paid-in capital
|
|
|
60,678
|
|
|
57,690
|
|
Cumulative
other comprehensive income (loss)
|
|
|
399
|
|
|
247
|
|
Accumulated
deficit
|
|
|
(24,714
|
)
|
|
(26,587
|
)
|
Less
stock subscription receivable
|
|
|
(522
|
)
|
|
(44
|
)
|
Total
Stockholders' Equity
|
|
|
35,599
|
|
|
31,188
|
|
TOTAL
LIABILITIES AND STOCKHOLDERS' EQUITY
|
|
$
|
65,860
|
|
$
|
50,606
|
|
PACIFICNET
INC. AND SUBSIDIARIES
CONSOLIDATED
INCOME STATEMENTS
(Unaudited.
In thousands of United States dollars, except loss per share and share
amounts)
|
|
THREE
MONTHS ENDED JUNE 30
|
|
SIX
MONTHS ENDED JUNE 30
|
|
|
|
2006
|
|
2005
(as
restated)
|
|
2006
|
|
2005
(as
restated)
|
|
Revenues
|
|
$
|
19,330
|
|
$
|
12,280
|
|
$
|
34,364
|
|
$
|
21,492
|
|
Services
|
|
|
7,812
|
|
|
6,060
|
|
|
16,700
|
|
|
9,324
|
|
Product
sales
|
|
|
11,518
|
|
|
6,220
|
|
|
17,664
|
|
|
12,168
|
|
Cost
of revenues
|
|
|
(14,407
|
)
|
|
(9,613
|
)
|
|
(22,960
|
)
|
|
(17,127
|
)
|
Services
|
|
|
(4,027
|
)
|
|
(3,880
|
)
|
|
(7,283
|
)
|
|
(6,201
|
)
|
Product
sales
|
|
|
(10,380
|
)
|
|
(5,733
|
)
|
|
(15,677
|
)
|
|
(10,926
|
)
|
Gross
margin
|
|
|
4,923
|
|
|
2,667
|
|
|
11,404
|
|
|
4,365
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Selling,
general and administrative expenses
|
|
|
(3,177
|
)
|
|
(1,376
|
)
|
|
(7,500
|
)
|
|
(2,257
|
)
|
Depreciation
and amortization
|
|
|
(161
|
)
|
|
(99
|
)
|
|
(219
|
)
|
|
(142
|
)
|
Interest
expense
|
|
|
(214
|
)
|
|
-
|
|
|
(302
|
)
|
|
-
|
|
EARNINGS
FROM OPERATIONS
|
|
|
1,371
|
|
|
1,192
|
|
|
3,383
|
|
|
1,966
|
|
Interest
income
|
|
|
49
|
|
|
-
|
|
|
81
|
|
|
-
|
|
Change
in fair value of derivatives
|
|
|
208
|
|
|
|
|
|
208
|
|
|
|
|
Sundry
income
|
|
|
161
|
|
|
313
|
|
|
286
|
|
|
406
|
|
Earnings
before Income Taxes and Minority Interest
|
|
|
1,789
|
|
|
1,505
|
|
|
3,958
|
|
|
2,372
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision
for income taxes
|
|
|
(85
|
)
|
|
(37
|
)
|
|
(200
|
)
|
|
(64
|
)
|
Share
of earnings of associated companies
|
|
|
52
|
|
|
12
|
|
|
49
|
|
|
4
|
|
Minority
interests
|
|
|
(804
|
)
|
|
(887
|
)
|
|
(1,934
|
)
|
|
(1,304
|
)
|
Net
Earnings Available to Common Stockholders
|
|
$
|
952
|
|
$
|
593
|
|
$
|
1,873
|
|
$
|
1,008
|
|
BASIC
EARNINGS PER SHARE
|
|
$
|
0.09
|
|
$
|
0.06
|
|
$
|
0.17
|
|
$
|
0.10
|
|
DILUTED
EARNINGS PER SHARE
|
|
$
|
0.08
|
|
$
|
0.06
|
|
$
|
0.16
|
|
$
|
0.10
|
|
The
accompanying condensed notes are an integral part of these consolidated
financial statements.
PACIFICNET
INC. AND SUBSIDIARIES
CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
|
|
PREFERRED
STOCK
|
|
COMMON
STOCK
|
|
ADDITIONAL
PAID-IN CAPITAL
|
|
STOCK
SUBSCRIPTION
RECEIVABLE
|
|
CUMULATIVE
OTHER COMPREHENSIVE INCOME
|
|
ACCUMUL
ATED
DEFICIT
|
|
TREASURY
STOCK
|
|
TOTAL
STOCKHOLDERS' EQUITY
|
|
BALANCE
AT DECEMBER 31, 2005
(10,831,024
SHARES)
|
|
|
--
|
|
$
|
1
|
|
$
|
57,690
|
|
$
|
(44
|
)
|
$
|
247
|
|
|
($26,587
|
)
|
|
($119
|
)
|
$
|
31,188
|
|
Net
earnings
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1,873
|
|
|
|
|
|
1,873
|
|
Exercise
of stock options for cash and receivable (269,000 shares)
|
|
|
--
|
|
|
|
|
|
564
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
564
|
|
Issuance
of common stock for acquisition of subsidiaries (293,512
shares)
|
|
|
--
|
|
|
|
|
|
2,275
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,275
|
|
PIPE
related expenses
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Repurchase
of common shares (less
24,200 shares)
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(124
|
)
|
|
(124
|
)
|
Cumulative
foreign exchange gain/(loss)
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
152
|
|
|
|
|
|
|
|
|
152
|
|
Stock-based
compensation
|
|
|
|
|
|
|
|
|
120
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
120
|
|
Issuance
of warrants for fees of issuing convertible debt (16,000
warrants)
|
|
|
|
|
|
|
|
|
29
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
29
|
|
Less
stock subscription receivable
|
|
|
--
|
|
|
|
|
|
|
|
|
(478
|
)
|
|
|
|
|
|
|
|
|
|
|
(478
|
)
|
BALANCE
AT JUNE 30, 2006
(11,369,336
SHARES)
|
|
|
--
|
|
$
|
1
|
|
$
|
60,678
|
|
$
|
(522
|
)
|
$
|
399
|
|
$
|
(24,714
|
)
|
$
|
(243
|
)
|
$
|
35,599
|
|
The
accompanying condensed notes are an integral part of these consolidated
financial statements.
PACIFICNET
INC. AND SUBSIDIARIES
CONSOLIDATED
STATEMENTS OF CASH FLOWS
(Unaudited.
In thousands of United States dollars, except earnings per share and share
amounts)
|
|
SIX
MONTHS ENDED JUNE 30
|
|
|
|
2006
|
|
2005
|
|
Cash
Flows from operating activities
|
|
|
|
|
|
Net
earnings
|
|
$
|
1,873
|
|
$
|
1,008
|
|
Adjustment
to reconcile net earnings to net cash used in operating
activities:
|
|
|
|
|
|
|
|
Equity
loss of associated company
|
|
|
(49
|
)
|
|
(4
|
)
|
Provision
for income taxes
|
|
|
33
|
|
|
64
|
|
Provision
for allowance for doubtful accounts
|
|
|
28
|
|
|
-
|
|
Minority
Interest
|
|
|
1,934
|
|
|
1304
|
|
Depreciation
and amortization
|
|
|
768
|
|
|
141
|
|
Stock-based
compensation
|
|
|
120
|
|
|
-
|
|
Change
in fair value of derivatives
|
|
|
(208
|
)
|
|
-
|
|
Changes
in current assets and liabilities net of effects from purchase of
subsidiaries:
|
|
|
|
|
|
|
|
Accounts
receivable and other current assets
|
|
|
(10,370
|
)
|
|
(2,027
|
)
|
Inventories
|
|
|
(415
|
)
|
|
(891
|
)
|
Accounts
payable and other accrued expenses
|
|
|
(1,745
|
)
|
|
295
|
|
Net
cash used in operating activities
|
|
|
(8,031
|
)
|
|
(110
|
)
|
Cash
flows from investing activities
|
|
|
|
|
|
|
|
Decrease
in restricted cash
|
|
|
1,422
|
|
|
2,796
|
|
Increase
in purchase of marketable securities
|
|
|
-
|
|
|
(421
|
)
|
Acquisition
of property and equipment
|
|
|
(3,124
|
)
|
|
(1,341
|
)
|
Acquisition
of subsidiaries and affiliated companies
|
|
|
(836
|
)
|
|
(1,183
|
)
|
Loans
receivable from third parties
|
|
|
562
|
|
|
(2,081
|
)
|
Loans
receivable from related party
|
|
|
(2,233
|
)
|
|
(1,157
|
)
|
Net
cash used in investing activities
|
|
|
(4,209
|
)
|
|
(3,387
|
)
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
Increase
in loan payable to related party
|
|
|
201
|
|
|
390
|
|
Advances
(repayments) under bank line of credit
|
|
|
(171
|
)
|
|
142
|
|
Advances
under bank loan
|
|
|
623
|
|
|
727
|
|
Increase
(repayments) of amount borrowed under capital lease obligations
|
|
|
(73
|
)
|
|
62
|
|
Repurchase
of treasury shares
|
|
|
(124
|
)
|
|
-
|
|
Proceeds
from exercise of stock options and warrants
|
|
|
86
|
|
|
981
|
|
Proceeds
from issuance of convertible debenture
|
|
|
8,000
|
|
|
-
|
|
Net
cash provided by financing activities
|
|
|
8,542
|
|
|
2,302
|
|
|
|
|
|
|
|
|
|
Effect
of exchange rate change on cash and cash
equivalents
|
|
|
54
|
|
|
-
|
|
NET
DECREASE IN CASH AND CASH EQUIVALENTS
|
|
|
(3,644
|
)
|
|
(1,195
|
)
|
CASH
AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD
|
|
|
9,579
|
|
|
6,764
|
|
CASH
AND CASH EQUIVALENTS, END OF THE PERIOD
|
|
$
|
5,935
|
|
$
|
5,569
|
|
CASH
PAID FOR:
|
|
|
|
|
|
|
|
Interest
|
|
$
|
292
|
|
$
|
127
|
|
Income
taxes
|
|
$
|
463
|
|
$
|
34
|
|
NON-CASH
INVESTING AND FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
Issuance
of option shares through increase in subscription
receivable
|
|
|
522
|
|
|
-
|
|
Investments
in subsidiaries acquired through the issuance of common stock
|
|
|
2,275
|
|
$
|
1,977
|
|
The
accompanying condensed notes are an integral part of these consolidated
financial statements.
PACIFICNET
INC. AND SUBSIDIARIES
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), communication products distribution services and the design and
distribution of entertainment kiosks and gaming machines. Our business process
outsourcing (BPO) services include call centers, providing customer relationship
management (CRM), mail order direct marketing 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 mainland China, Hong
Kong
and Macau Special Administrative Region markets.
Condensed
Consolidated Financial Statements
- The
condensed consolidated financial statements have been prepared in accordance
with U.S. generally accepted accounting principles (“GAAP”) for interim
financial reporting consistent in all material respects with those applied
in
the Company’s Annual Report on Form 10-KSB for the year ended December 31,
2005, but do not include all disclosures required by GAAP. You should read
these
interim condensed consolidated financial statements in conjunction with the
audited financial statements, including the notes thereto, and the other
information set forth in the Company’s Annual Report on Form 10-KSB for the year
ended December 31, 2005. The condensed unaudited consolidated financial
statements include the accounts of Pacificnet Inc. and its subsidiaries and
variable interest entities (“VIEs”) for which the Company is the primary
beneficiary. 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.
Use
of Estimates
- The
preparation of the consolidated financial statements in conformity with GAAP
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 reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates, and such differences may be material to the financial
statements. Certain prior year amounts have been reclassified to conform to
the
current year presentation.
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 June 30, 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.
In
June
2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an
Interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the
accounting for uncertainty in tax positions. This Interpretation requires that
the Company recognize in its financial statements the impact of a tax position
if that position is more likely than not of being sustained on audit, based
on
the technical merits of the position. The provisions of FIN 48 are effective
for
the Company on January 1, 2007, with the cumulative effect of the change in
accounting principle, if any, recorded as an adjustment to opening retained
earnings. The Company is currently evaluating the impact of adopting FIN 48
on
its consolidated financial position, cash flows and results of operations.
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.
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 second
quarter of 2006 exclude the potential dilutive effect of 766,000 warrants and
800,000 convertible debentures 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 was as follows:
|
|
Three
Months Ended June 30
|
|
Six
Months Ended June 30
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
|
|
(IN
THOUSANDS OF UNITED STATES DOLLARS, EXCEPT WEIGHTED SHARES AND PER
SHARE
AMOUNTS)
|
|
(IN
THOUSANDS OF UNITED STATES DOLLARS, EXCEPT WEIGHTED SHARES AND PER
SHARE
AMOUNTS)
|
|
Numerator:
earnings
|
|
$
|
952
|
|
$
|
593
|
|
$
|
1,873
|
|
$
|
1,008
|
|
Denominator:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
shares used to compute basic EPS
|
|
|
11,022,984
|
|
|
9,887,274
|
|
|
10,939,834
|
|
|
9,840,681
|
|
Dilutive
potential from assumed exercise of stock options and
warrants
|
|
|
856,713
|
|
|
731,501
|
|
|
962,185
|
|
|
718,383
|
|
Weighted-average
shares used to compute diluted EPS
|
|
|
11,879,697
|
|
|
10,618,775
|
|
|
11,902,019
|
|
|
10,559,064
|
|
Basic
earnings per common share:
|
|
$
|
0.09
|
|
$
|
0.06
|
|
$
|
0.17
|
|
$
|
0.10
|
|
Diluted
earnings per common share:
|
|
$
|
0.08
|
|
$
|
0.06
|
|
$
|
0.16
|
|
$
|
0.10
|
|
4.
GOODWILL AND PURCHASED INTANGIBLE ASSETS
The
changes in the carrying amount of goodwill for the following reporting periods
are summarized below:
(US$000s)
|
|
Group
1.
Outsourcing
Services
|
|
Group
2.
Value-Added
Services
|
|
Group
3.
Distribution
of
Communications
|
|
Total
|
|
Balance
as of December 31, 2005
|
|
$
|
3,543
|
|
$
|
9,584
|
|
$
|
1,100
|
|
$
|
14,227
|
|
Goodwill
acquired during the first quarter
|
|
|
--
|
|
|
461
|
|
|
--
|
|
|
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
|
|
Goodwill
acquired during the second quarter
|
|
|
--
|
|
|
1,571
|
|
|
429
|
|
|
2,000
|
|
Impairment
losses
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
Goodwill
written off related to sale of business unit
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
Balance
as of June 30, 2006
|
|
$
|
3,543
|
|
$
|
11,616
|
|
$
|
1,529
|
|
$
|
16,688
|
|
5.
STOCKHOLDERS' EQUITY
a)
COMMON
STOCK
For
the
quarter ended June 30, 2006, the Company had the following equity transactions:
(i) 245,000 shares of common stock were issued as a result of the exercise
of
stock options with cash consideration of $521,700 in the aggregate; (ii) 234,725
shares of common stock were released from escrow (PACT treasury shares) for
acquisition of iMobile and GZ3G valued at $1,877,800.
b)
STOCK
OPTION PLAN - See Note 7 for further details.
The
status of the Stock Option Plan as of June 30, 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
|
|
Granted
|
|
|
-
|
|
|
-
|
|
Cancelled
|
|
|
(680,000
|
)
|
$
|
6.57
|
|
Exercised
|
|
|
(245,000
|
)
|
$
|
2.13
|
|
OUTSTANDING,
JUNE 30, 2006
|
|
|
435,100
|
|
$
|
2.00
|
|
On
May
28, the board of director and management approved and authorized the
cancellation of 680,000 stock options that were previously granted during fiscal
year 2005, that were unvested and unexercised. The option cancellation was
authorized by the board and the management in order to reduce stock compensation
expense due to the implementation of FASB 123R.
c)
WARRANTS
At
June
30, 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 3.88 years and the weighted average price per share is $10.61 per share
as follows:
Shares
of common stock
|
|
EXERCISE
PRICE
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 of 2006, we issued 400,000 warrants to several institutional investors in
connection with a private placement of $8 million in convertible debentures.
On
the same day we issued 16,000 warrants to our placement agent for the
transaction. See Note 7 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 quarterly ended June 30 of 2006:
|
|
Number
of
shares
|
|
Remarks
|
|
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
due
to performance targets not yet met
|
|
|
1,017,723
|
|
|
Including
687,500 shares relating to ChinaGoHi; 138,348 shares to Guangzhou
Wanrong;
191,875 shares to iMobile
|
|
Balance,
March 31, 2006
|
|
|
2,348,886
|
|
|
|
|
Less:
Shares issued to iMobile
|
|
|
(38,375
|
)
|
|
|
|
Shares
issued to Guangzhou 3G
|
|
|
(196,350
|
)
|
|
|
|
Balance,
June 30, 2006
|
|
|
2,114,161
|
|
|
|
|
Shares
outstanding at June 30, 2006
|
|
|
11,369,336
|
|
|
|
|
Shares
issued at June 30, 2006
|
|
|
13,483,497
|
|
|
|
|
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
repurchase of the shares was proposed by Yueshen and was unanimously agreed
by
the both parties.
6.
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
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 June 30, 2006 was $58,334.
During
the quarter ended June 30, 2006, the Company did not grant any new stock
options, 245,000 options were exercised, and 680,000 options were cancelled.
See
note 5 b) for the status of the Company’s stock option plan.
Additional
information on options outstanding as of June 30, 2006 is as
follows:
|
WEIGHTED
AVERAGE
EXERCISE
PRICE
|
OPTIONS
|
AVERAGE
REMAINING
CONTRACTUAL
LIFE
|
Options
outstanding
|
$2.00
|
435,100
|
1.08
years
|
Options
exercisable
|
$2.00
|
435,100
|
1.08
years
|
7.
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 of the registration statement, 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 six months
ended June 30, 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 $1,043,000
of issuance costs, which primarily consisted of investment banker fees, legal
and other professional fees. These costs are being amortized and are recorded
as
additional expense through three years, the scheduled date 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 June 30,
2006 was $86,000. At June 30, 2006, net debt issuance costs associated with
the
debentures was $957,000 and is recorded in other assets, net.
The
gross
proceeds of $8,000,000 are recorded as a liability net of a debt discount of
$8,000,000 consisting of an allocation of the fair values attributed to the
Investors’ warrants and to the embedded conversion feature in accordance with
EITF issue No. 00-19 “Accounting for Derivative Financial Instruments Indexed to
and Potentially Settled in a Company’s Own Stock.” The debt discount consisted
of a $693,278 value related to the Investors’ warrants and a value attributed to
the compound embedded derivatives liability, including embedded options and
registration rights.
In
accordance with recent FASB guidance, due to certain factors, including a
liquidated damages provision in the registration rights agreement and an
indeterminate amount of shares to be issued upon conversion of the debentures,
the Company values and accounts for the embedded conversion feature related
to
the Debentures, the Investors’ warrants, and the registration rights as
derivative liabilities. Accordingly, these derivative liabilities are measured
at fair value with changes in fair value reported in earnings as long as they
remain classified as liabilities. The Company reassesses the classification
at
each balance sheet date. If the classification required under EITF No. 00-19
changes as a result of events during the period, the contract should be
reclassified as of the date of the event that caused the
reclassification.
An
aggregate gain of $207,679 representing the change in fair value of these
derivative liabilities was recognized during the six months ended June 30,
2006.
8.
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.
(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 ChinaGoHi), Linkhead,
Clickcom and Guangzhou 3G.
(3)
Communication Products Distribution Services Group - primarily involves voice
products distribution such as distribution of mobile phones and related software
and accessories, calling cards and other communication products, as well as
gaming machines and entertainment kiosks, which are conducted through our
subsidiaries iMobile, Shanghai Classic, PacificNet Communications Limited,
Take1
and PacificNet Games Limited.
(4)
Other
Business -other administrative, financial and investment services and non-core
businesses such as PacificNet Power Limited (PacPower), Pacific Financial
Services Limited, 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 ended June 30, 2006
|
Group
1.
Outsourcing
Business
($)
|
Group
2.
VAS
Business
($)
|
Group
3.
Communications
Distribution
Business
($)
|
Group
4.
Other
Business
($)
|
Total
($)
|
Revenues
|
3,552,000
|
5,517,000
|
8,914,000
|
1,347,000
|
19,330,000
|
(%
of Total Revenues)
|
18%
|
29%
|
46%
|
7%
|
100%
|
|
|
|
|
|
|
Earnings
/ (Loss) from Operations
|
283,000
|
1,130,000
|
208,000
|
-250,000
|
1,371,000
|
(%
of Total Earnings)
|
21%
|
82%
|
15%
|
-18%
|
100%
|
Total
Assets
(%
of Total Assets)
|
8,503,000
13%
|
20,382,000
31%
|
12,626,000
19%
|
24,349,000
37%
|
65,860,000
100%
|
Goodwill
|
3,543,000
|
11,616,000
|
1,529,000
|
-
|
16,688,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
HK,
PRC
|
HK,PRC,USA
|
|
For
the three months ended June 30, 2005
|
Group
1.
Outsourcing
Business
($)
|
Group
2.
VAS
Business
($)
|
Group
3.
Communications
Distribution
Business
($)
|
Group
4.
Other
Business
($)
|
Total
($)
|
Revenues
|
3,403,000
|
4,744,000
|
4,055,000
|
78,000
|
12,280,000
|
(%
of Total Revenues)
|
28%
|
39%
|
33%
|
1%
|
100%
|
|
|
|
|
|
|
Earnings
/ (Loss) from Operations
|
305,000
|
1,086,000
|
118,000
|
-317,000
|
1,192,000
|
(%
of Total Earnings)
|
26%
|
91%
|
10%
|
-27%
|
100%
|
Total
Assets
(%
of Total Assets)
|
5,468,000
13%
|
11,261,000
27%
|
13,661,000
32%
|
12,030,000
28%
|
42,420,000
100%
|
Goodwill
|
3,543,000
|
8,005,000
|
1,100,000
|
-
|
12,648,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
HK,
PRC
|
HK,PRC,USA
|
|
For
the six months ended June 30, 2006
|
Group
1.
Outsourcing
Business
($)
|
Group
2.
VAS
Business
($)
|
Group
3.
Communications
Distribution
Business
($)
|
Group
4.
Other
Business
($)
|
Total
($)
|
Revenues
|
6,579,000
|
12,557,000
|
11,851,000
|
3,377,000
|
34,364,000
|
(%
of Total Revenues)
|
19%
|
37%
|
34%
|
10%
|
100%
|
Earnings
/ (Loss) from
|
|
|
|
|
|
Operations
|
403,000
|
2,844,000
|
265,000
|
-129,000
|
3,383,000
|
(%
of Total Earnings)
|
12%
|
84%
|
8%
|
-4%
|
100%
|
Total
Assets
|
8,503,000
|
20,382,000
|
12,626,000
|
24,349,000
|
65,860,000
|
(%
of Total Assets)
|
13%
|
31%
|
19%
|
37%
|
100%
|
Goodwill
|
3,543,000
|
11,616,000
|
1,529,000
|
-
|
16,688,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
HK,
PRC
|
HK,PRC,USA
|
|
For
the six months ended June 30, 2005
|
Group
1.
Outsourcing
Business
($)
|
Group
2.
VAS
Business
($)
|
Group
3.
Communications
Distribution
Business
($)
|
Group
4.
Other
Business
($)
|
Total
($)
|
Revenues
|
6,492,000
|
6,154,000
|
8,731,000
|
115,000
|
21,492,000
|
(%
of Total Revenues)
|
30%
|
29%
|
41%
|
1%
|
100%
|
Earnings
/ (Loss) from
|
|
|
|
|
|
Operations
|
649,000
|
1,589,000
|
236,000
|
-508,000
|
1,966,000
|
(%
of Total Earnings)
|
33%
|
81%
|
12%
|
-26%
|
100%
|
Total
Assets
|
5,468,000
|
11,261,000
|
13,661,000
|
12,030,000
|
42,420,000
|
(%
of Total Assets)
|
13%
|
27%
|
32%
|
28%
|
100%
|
Goodwill
|
3,543,000
|
8,005,000
|
1,100,000
|
-
|
12,648,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
HK,
PRC
|
HK,PRC,USA
|
|
Product
and service revenues classified by major geographic areas are as follows (in
US$):
For
the three months ended June 30, 2006
|
Hong
Kong
|
PRC
|
United
States
|
Total
|
Product
revenues
|
8,546,000
|
2,972,000
|
-
|
11,518,000
|
Service
revenues
|
3,504,000
|
4,308,000
|
-
|
7,812,000
|
For
the three months ended June 30, 2005
|
Hong
Kong
|
PRC
|
United
States
|
Total
|
Product
revenues
|
4,085,000
|
2,135,000
|
-
|
6,220,000
|
Service
revenues
|
2,452,000
|
3,608,000
|
-
|
6,060,000
|
For
the six months ended June 30, 2006
|
Hong
Kong
|
PRC
|
United
States
|
Total
|
Product
revenues
|
12,094,000
|
5,570,000
|
-
|
17,664,000
|
Service
revenues
|
6,535,000
|
10,165,000
|
-
|
16,700,000
|
For
the six months ended June 30, 2005
|
Hong
Kong
|
PRC
|
United
States
|
Total
|
Product
revenues
|
8,761,000
|
3,407,000
|
-
|
12,168,000
|
Service
revenues
|
4,686,000
|
4,638,000
|
-
|
9,324,000
|
9.
RELATED PARTY TRANSACTIONS
LOAN
DUE TO AND FROM RELATED PARTIES
As
of
June 30, 2006, there was a total loan receivable of approximately $4,753,000
due
from related parties while the loan due to related party was
$570,000.
As
of
June 30, 2006, the related party loan receivables included $1,026,000 due from
Take 1, an affiliated company that is 20% owned by PacificNet, and $3,727,000
due from shareholders and directors of certain of the Company’s subsidiaries.
The loans receivable from shareholders and directors of these subsidiaries
is
comprised of $1,249,000 due from a shareholder of Yueshen, $192,000 due from
a
director of Soluteck, $265,000 due from a director of Clickcom, and $2,021,000
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
(Cheer Era)
Take
1 is
an affiliated company and is 20% owned by PacificNet as of June 30, 2006. A
convertible loan of $1,026,000 is outstanding from Take 1 as of June 30, 2006.
Conversion terms of the convertible loan provide PacificNet an option at any
time during the Term to convert in part or in whole of the then outstanding
loan
principle up to $1,794,000 (or HKD$800,000) into shares of Take 1 to reach
51%
ownership of Take 1. The loan was extended as 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
June 30, 2006, there was a $1,249,000 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
June 30, 2006, there was a loan outstanding of $192,000 receivable from a
director of Soluteck, payable in three equal installments of $72,314 each,
which
includes 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
June 30, 2006, there was a loan of $265,000 receivable from the shareholders
of
Clickcom VIE. The loan was advanced by the Company to Clickcom VIE which in
turn
was 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 and is due on August 30, 2007. The loan
bears
interest at a rate of 2% per annum and is personally and jointly guaranteed
by
all three of the shareholders of Clickcom VIE. As additional collateral,
Clickcom VIE has pledged up to 130,000 PacificNet's shares and all remaining
assets and equity ownership of Clickcom BVI.
LOAN
TO A COMPANY OWNED BY A SHAREHOLDER OF LION ZONE
(CHINAGOHI)
As
of
June 30, 2006, a loan of $2,021,000 was receivable from a company owned by
a
shareholder of Lion Zone (ChinaGoHi). The loan is collateralized with this
company’s real estate.
LOAN
PAYABLE TO RELATED PARTY
As
of
June 30, 2006, a loan of $570,000 was payable to a shareholder of EPRO. The
loan
was advanced to Epro for working capital purposes. The loan is due on August
4,
2010. Interest being charged per annum is at Hong Kong Prime lending rate,
which
was approximately 6.5% per annum in 2005 and 8% in 2006..
10.
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 Q2 amounted to $598,000 (2005 Q2: $191,000).
Future minimum lease payments under non-cancelable operating leases are $819,000
for July 2006 through June 2007 and $986,000 for July 2007 through June
2012.
Restricted
Cash
- The
Company has a $230,000 pledged bank deposit for Epro which represents overdraft
protections with certain financial institutions.
Bank
Line Of Credit:
As of
June 30, 2006, Epro has an overdraft banking facility with certain major
financial institutions in the aggregate amount of $889,000, which is secured
by
a pledge of its fixed deposits of $230,000, 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 PRC authorities to transact business in accordance
with
PRC Telecommunication Rules which require that all telecommunication value
added
service providers n conduct 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 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 management, even though the capital requirement is not currently 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 0.42% and 1.14% respectively. Pursuant to a request by the PRC
authorities, PacificNet 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 June 30, 2006:
Secured
[1]
|
$1,088,000
|
Unsecured
|
$811,000
|
Less:
current portion
|
$401,000
|
Non
current portion
|
$1,498,000
|
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
$230,000 of a subsidiary of the Company.
(Aggregate
future maturities of borrowing for the next five years are as follows: 2006:
$354,000, 2007: $277,000 and 2008: $231,000)
The
remaining bank loans of $1,038,000 are generated by PacificNet Inc. relating
to
a fixed asset bought during the first quarter with total cost of $1,648,000.
The
repayment of the bank loan was $44,000. (Aggregate future maturities of
borrowing for the following period are as follows: Less than 1 year: $47,000,
1-5 year: $217,000 and after 5 years: $774,000)
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:
$88,000; 2007: $41,000; and 2008: $2,000)
11.
OTHER CURRENT ASSETS
Other
current assets consist of the following at June 30, 2006 (in
thousands):
|
|
June
30, 2006
$
(in thousands)
|
|
Deposit
|
|
|
$1,216
|
|
Prepayment
|
|
|
$1,027
|
|
Other
receivables
|
|
|
$5,539
|
|
Prepaid
Expense
|
|
|
$618
|
|
Tax
Receivable
|
|
|
$44
|
|
Total
|
|
|
$8,444
|
|
12.
INVENTORY
Inventories
of approximately $2.4 million consist primarily of finished goods and represent
telecommunication products such as mobile phone, rechargeable phone cards,
smart
chip, and interactive voice response cards and are accounted for using the
first-in, first out (FIFO) method. Most inventories are held by the Company’s
Linkhead subsidiary.
13.
SUBSCRIPTION RECEIVABLE
Subscription
receivable of approximately $522,000 represents funds receivable from the
exercise of options.
14.
INCOME TAXES
The
Company is registered in the Delaware and has operations in primarily three
tax
jurisdictions - the PRC, Hong Kong and the United States. For operations in
the
United States of America, Hong Kong and Taiwan, the Company has incurred net
accumulated operating losses for income tax purposes. The Company believes
that
it is more likely than not that these net accumulated operating losses will
not
be utilized in the future. Therefore, the Company has provided full valuation
allowance for the deferred tax assets arising from the losses at these locations
as of June 30, 2006. Accordingly, the Company has no net deferred tax assets
as
of June 30, 2006.
The
components of income before income taxes are as follows:
United
States of America
The
components of earnings before income taxes separating U.S. and non U.S.
operations are as follows:
As
of
June 30, 2006, the Company’s subsidiary in the United States of America had net
operating loss carryforwards available to offset future taxable income. Federal
net operating losses can generally be carried forward 20 years. The Tax Reform
Act of 1986 limits the use of net operating loss and tax credit carryforwards
in
certain situations when changes occur in the stock ownership of a company.
In
the event the Company has a change in ownership, utilization of carryforwards
could be restricted. The deferred tax assets for the United States subsidiary
at
June 30, 2006 consists mainly of net operating loss carryforwards and were
fully
reserved as the management believes it is more likely than not that these assets
will not be realized in the future.
Hong
Kong
As
of
June 30, 2006, the Company’s Hong Kong subsidiary had net operating loss
carryforwards which can be carried forward indefinitely to offset future taxable
income. The deferred tax assets for the Hong Kong subsidiary at June 30, 2006
consists mainly of net operating loss carryforwards and were fully reserved
as
the management believes it is more likely than not that these assets will not
be
realized in the future.
China
Pursuant
to the PRC Income Tax Laws, the Company’s subsidiaries and VIEs are generally
subject to Enterprise Income Taxes (“EIT”) at a statutory rate of 33%, which
comprises 30% national income tax and 3% local income tax. Some of these
subsidiaries and VIEs are qualified new technology enterprises and under PRC
Income Tax Laws, they are subject to preferential tax rates.
Composition
of income tax expenses for China operation
The
following table sets forth current and deferred portion of income tax expenses
of the Company’s China subsidiaries and VIEs, which were included in the
consolidated statements for the periods presented:
Deferred
Tax Assets
Net
Operating Loss Carry forwards
|
|
$
|
86,000
|
|
Total
deferred tax assets
|
|
|
86,000
|
|
Less:
Valuation Allowance
|
|
|
(86,000
|
)
|
Deferred
Tax Assets
|
|
$
|
-
|
|
Income
tax payable was approximately $33,000 at June 30, 2006, a decrease from $296,000
at December 31, 2005. The decrease was primarily attributed to the settling
of a
tax liability by Lion Zone (ChinaGoHi).
15.
SUBSEQUENT EVENTS
Stock
Option Exercise
On
July
1, 2006, PacificNet issued 100,000 shares of common stock as a result of stock
option exercise in accordance to PacificNet’s stock option plan.
Business
Acquisitions
Able
Entertainment Technology Ltd by PacificNet Games Limited
On
August
3, 2006, PacificNet’s wholly owned subsidiary PacificNet Games Limited
(“PacGames”, Chinese Company Name [__________])
completed the acquisition of 100% of Able Entertainment Technology Ltd., a
leading gaming technology provider based in the Macau Special Administrative
Region of China, by exchanging 65% of the share ownership of PacificNet Games
Limited and the issuance of 200,000 restricted shares of PacificNet Inc.
Upon completion of this transaction, PacificNet Inc. owns 35% of PacificNet
Games Limited (Chinese Company Name [__________]).
Under
the purchase agreement, Able Entertainment Technology Ltd has committed to
generate an annual profit of USD$1,600,000 and will provide for an adjustment
to
the purchase price if the PacGames does not achieve an annual net profit of
USD$1,600,000 during the first 12-month period and USD$3,000,000 during the
second 12-month period.
The
consideration was paid as follows:
The
purchase consideration for the entire Issued Shares of 100,000 shares
(representing 100%) of the equity interest of Able Entertainment Technology
Ltd.
is 650 shares (representing 65%) of the ownership interest in PacificNet Games
Limited, a Special Purpose Vehicle (SPV) company registered in the BVI, plus
200,000 restricted PACT shares. Able Entertainment Technology Ltd. has
represented it expects to generate USD$1,600,000, and will provide for an
adjustment to the purchase price if the Company does not achieve an annual
net
profit of USD$1,600,000 during the first 12-month period and USD$3,000,000
during the second 12-month period. The purchase consideration is payable 100%
in
restricted shares of PACT, equivalent to 200,000 restricted PACT
shares.
Allink
Hong Kong Limited
On
August
11, 2006, PacificNet’s wholly owned subsidiary PacificNet Communications Limited
(“PacCom”) completed the acquisition of 80% of Allink Hong Kong Limited (Allink,
Chinese name “[__________]”),
a
leading provider of security and surveillance technology and services based
in
the Hong Kong Special Administrative Region of China, through the issuance
of
200,000 restricted shares of PacificNet Inc. Upon completion of this
transaction, PacificNet Inc. owns 80% of Allink. Under the purchase agreement,
Allink has committed to generate an annual profit of HKD$3,000,000 (approx
USD$385,000) and will provide for an adjustment to the purchase price if the
Allink does not achieve an annual net profit of HKD$3,000,000. Allink
operates one of the leading CCTV communication and security surveillance
technology and services provider utilizing extra low voltage technology for
property management companies in Hong Kong and Macau, China.
The
consideration was paid as follows:
(1) |
The
purchase consideration for 80% of the equity interest of the Company
is
payable entirely (100%) in restricted shares of PACT, equivalent
to
200,000 restricted PACT shares.
|
(2) |
The
purchase price is payable upon achievement of certain quarterly earn-out
targets based on net profits.
|
In
July
2006, PacificNet opened an office in Macau in order to serve the growing needs
of many large clients in the gaming, entertainment, hotel, casino and real
estate development industries in the region. PacificNet’s new Macau office
is 1400 sq. ft. and is located at Av. Do Dr. R. Rodrigues No. 600E, Edif, First
International Commercial Centre, P906, Macau Special Administrative Region,
China. In addition, PacificNet opened a second office in Zhuhai, a city in
the PRC adjacent to Macau, as an R&D center and a back office support center
to provide product design, development, manufacturing, and customer and
technical support services for the growing Macau market.
In
July
2006, PacificNet was selected by NASDAQ to become a member of the newly
established NASDAQ Global Market. PacificNet's trading symbol will be
NasdaqGM:PACT. The NASDAQ Global Market consists of over 1,450 companies
that
have applied for listing, having met and continued to meet stringent financial
and liquidity requirements and agreed to meet specific corporate governance
standards. Formerly called The NASDAQ National Market, this market was renamed
in 2006 to reflect the global leadership and international reach of this
market
and the companies whose securities are listed here. For more information
on the
requirements to be included on The NASDAQ Global Market, please see Listing
Standards & Fees at http://www.nasdaq.com/about/nasdaq_listing_req_fees.pdf.
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:
l |
the
impact of competitive products;
|
l |
changes
in laws and regulations;
|
l |
adequacy
and availability of insurance
coverage;
|
l |
limitations
on future financing;
|
l |
increases
in the cost of borrowings and unavailability of debt or equity
capital;
|
l |
the
inability of the Company to gain and/or hold market
share;
|
l |
exposure
to and expense of resolving and defending liability claims and other
litigation;
|
l |
consumer
acceptance of the Company's
products;
|
l |
managing
and maintaining growth;
|
l |
market
and industry conditions,
|
l |
the
success of product development and new product introductions into
the
marketplace;
|
l |
the
departure of key members of management,
and
|
l |
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 15 years of field experience
in Hong Kong and China. The factors that could affect current and future results
are as follows:
l |
insufficient
sales forces for business development & account
servicing;
|
l |
lack
of PRC management team in
operation;
|
l |
less
familiarity on partners' product
knowledge;
|
l |
deployment
costs of a new HR application and the costs to upgrade the call center
computer system;
|
l |
increasing
operations costs (cost of salaries, rent, interest rates & inflation)
under rising economy in Hong Kong;
|
l |
insufficient
brand awareness initiatives in the
market;
|
l |
salary
increases due to an active labor market in Hong Kong and GuangZhou;
and
|
l |
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 historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form
the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ
from
these estimates under different assumptions or conditions.
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.
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.
Convertible
Debt
In
accordance with recent FASB accounting guidance, due to certain factors,
including a liquidated damages provision in the registration rights agreement
and an indeterminate amount of shares to be issued upon conversion of the
debentures, the Company values and accounts for the embedded conversion feature
related to the Debentures, the Investors’ warrants, and the registration rights
as derivative liabilities. Accordingly, these derivative liabilities are
measured at fair value with changes in fair value reported in earnings as long
as they remain classified as liabilities. The Company reassesses the
classification at each balance sheet date. If the classification required under
EITF No. 00-19 changes as a result of events during the period, the contract
should be reclassified as of the date of the event that caused the
reclassification.
The
fair
value of these derivative instruments, as determined by applying the
Black-Scholes valuation model, is adjusted quarterly. The Black-Scholes
valuation model requires the input of highly subjective assumptions, including
the expected stock price volatility. Additionally, although the
Black-Scholes model meets the requirements of SFAS 133, the fair values
generated by the model may not be indicative of the actual fair values as our
derivative
instruments have characteristics significantly different from traded options.
Accordingly, the results obtained could be significantly different if other
assumptions were used. The effect of this entry would be a charge to net
earnings, thereby either increasing or reducing our net earnings based upon
the
assumptions used and the results obtained,
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). In 2004, we commenced our communication products
distribution service, through wholesale and, to a lesser extent, retail sale
and
distribution of mobile phones, software and hardware, mobile accessories, and
calling cards in Hong Kong and China. Recently, we have also invested in a
company that designs, manufactures, and distributes multimedia interactive
self-service kiosks and gaming machines for the casino and slot machine
operators in Macau Special Administrative Region of China. 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 2,300 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: including mobile communication products
and
accessories, calling cards, GSM/ CDMA/ XiaoLingTong products, multimedia
self-service kiosks and gaming machines.
(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:
PacificNet
Power Limited (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 consolidated income statement data as a
percentage of revenues for the periods indicated.
|
THREE
MONTHS ENDED JUNE 30,
|
SIX
MONTHS ENDED JUNE 30,
|
|
2006
(%)
|
2005
(%)
|
2006
(%)
|
2005
(%)
|
Revenues
|
100
|
100
|
100
|
100
|
Cost
of Revenues
|
(74.53)
|
(78.28)
|
(66.81)
|
(79.69)
|
Gross
Margin
|
25.47
|
21.72
|
33.19
|
20.31
|
Selling,
general and administrative expense
|
(18.38)
|
(12.01)
|
(23.35)
|
(11.16)
|
Earnings
from operations
|
7.09
|
9.71
|
9.84
|
9.15
|
Earnings
before income taxes, minority interest and discontinued
operations
|
9.26
|
12.26
|
11.52
|
11.03
|
NET
EARNINGS
|
4.92
|
4.83
|
5.45
|
4.69
|
THREE
AND SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO THREE AND SIX MONTHS ENDED JUNE
30, 2005
REVENUES.
Revenues for the three and six months ended June 30, 2006 were $19,330,000
and
$34,364,000, an increase of 57% and 60% from $12,280,000 and $21,492,000 for
the
three and six months ended June 30, 2005, respectively. During the second
quarter and first half of 2006, revenues of $3,552,000, $5,517,000, $8,914,000
and $6,579,000, $12,557,000, $11,851,000 were derived from the services rendered
by the Company's three operating units: Outsourcing Services, Value-Added
Services, and Communications Products Distribution Services, respectively.
The
revenues in product sales during the second quarter and first half of 2006
increased by 85.1% and 45.2% compared to the same periods of 2005. The revenues
in services sales during the second quarter and first half of 2006 increased
by
28.9% and 79.1% compared to the same periods of 2005.
The
increase in revenue was mainly due to the following sources:
(1) |
Outsourcing
services: The year-over-year growth in outsourcing services in the
second
quarter and first half of 2006 was primarily due to the higher revenue
from Call Centre business in Hong Kong. For the second quarter of
2006,
Epro’s revenues increased $643,000, or 26.8%, year-over-year, which was
largely due to a 148% increased in revenues from facilities management
services, and a 54% increased in revenue from outbound services.
Its
revenues accounted for 86% and 85% of total outsourcing services
revenues
in the second quarter and first half of 2006, respectively. Due to
rising
labor costs, management believes that Business Process Outsourcing
(BPO)
has become a firmly-entrenched trend in Hong Kong and the PRC. Demand
for
outsourcing services has been steadily increasing, especially in
sectors
such as banking, insurance and telecom, and such demand has lead
to
continued growth in the first half of 2006. The Company’s combined Hong
Kong-China operations expanded total contract center capacity to
host 1000
working positions and to occupy a total of 53,000 square feet. During
the
first half of 2006, the outsourcing contract center in Hong Kong
was at
nearly full utilization. With increasing information technology
expenditures by Hong Kong companies, both the Contact Center (or
Customer
Services Center) System and IT Solutions departments enjoyed revenue
growth. Additionally, EPRO is the Value-added Reseller (VAR) of EPICOR’s
Customer Relationship Management Solution (CRM) and Enterprise Resource
Planning Solution (ERP) which led to additional marketing activities
and
promotional programs in the first half of 2006. Management retains
its
positive outlook on its software operations as companies search for
tools
to streamline or automate their business processes. With an experienced
technical support team, EPRO is able to provide end-to-end solutions
to
meet the increasing IT needs of clients.
|
(2) |
Value-added
Telecom Services: In the aggregate, revenues received through VAS
business
and its subsidiaries accounted for 28.5% and 36.5% of the Company’s total
revenues for the three and six months ended June 30, 2006,
respectively, and 38.6% and 28.6 % of the Company’s total revenues for the
three and six months ended June 30, 2005, respectively. Guangzhou 3G,
Linkhead, Lion Zone contributed 12.8%, 8.9%, and 6.5%, respectively,
of
the total revenues for the three month ended June 30, 2006 and 13.1
%,
9.7% and 13.4%, respectively, for the six month ended June 30, 2006,
respectively. During the second quarter and first half of 2006, China
accounted for 37.5% and 45.8% of the total revenues, respectively,
compared to 46.8 % and 37.4% in the same periods of 2005, respectively.
The significant increase in revenues during the second quarter of
2006 and
a small increase during the first half of 2006 in Guangzhou 3G was
mostly
attributed to providing new 3G services and through the merger of
Guangzhou Wanrong, which added approximately $308,000 and $574,000
to
three and six months ended June 30, 2006, respectively. On
a year-over-year basis, the
Company’s VAS revenue only increased a small percentage, approximately 16%
in the second quarter, which is primarily attributed to the approximate
20% decline in the sales of voice cards from Linkhead. During 2006,
there
was a general market decline for voice cards in Asia, and a 25% decline
in
SMS revenues from Clickcom in which SMS
advertising has been restricted by China Information Industry Department.
However,
voice cards revenues had a slight increase of 5% ($81,000)
quarter-to-quarter. Additionally,
the development of WAP and color ring back tone services had growth
during
the period to partially offset the decline in SMS business.
|
Separately,
stricter guidelines established by the China Securities Regulatory Commission
(CSRC) led to a decrease in the Company’s ability to market its investment
consulting services to retail audiences, which resulted in a revenue
underperformance. Nevertheless, although barriers remain on marketing through
television, the Company has successfully expanded its use of stored-value cards
to maintain its market position. Due to its large loyal retail following, the
Company believes it can work through the current regulatory environment.
Additionally, the Company has shifted its marketing? emphasis to the internet
and magazines.
(3) |
Communication
Products Distribution: iMobile added approximately $1,230,000 and
$2,231,000, or accounted for 13.8% and 18.8% in Communication Products
Distribution revenues for the three and six months ended June 30,
2006,
respectively, in which its major business included internet sales
of
mobile phone and accessories. The revenues from the sales of Motorola
and
Nokia contributed 95% of iMobile’s total revenues during the second
quarter and first half of 2006. Additionally, the completion of a
charging
platform for new services and content information is in process and
is
expected to be rolled out in August of this year. PacCom
revenues accounted for 54 % and 8 % of total revenues in the Communication
Products Distribution business in the first half of 2006 and 2005,
respectively. Revenues
from PacCom increased by 2535% and 811% year-over-year in the second
quarter and first half of 2006, respectively, primarily due to
approximately $1.9million (HK$15million) revenues from providing
LED
lighting technology and solution for Galaxy Starworld Hotel of Macau
and
approximately $0.23million (HK$1.78million) revenues from Dell computer,
Fiber Converter, Mirror Finish Steel, Cabling, DCM player, and others
during the second quarter of 2006.
|
(4) |
The
remaining incremental revenues for the three and six months ended
June 30,
2006 as compared to respective period was derived from organic growth
from
existing subsidiaries, such as PacPower ($894,000 and $2,474,000)
and
PacificNet Limited ($407,000 and $825,000). The Light Eco installation
system project awarded in the second quarter of 2006 posted positive
revenue increases during the second quarter and first half of 2006.
Additionally, projects involving $0.13million (HK$1.04million) of
the
installation of Central Air-Conditioning Chilled-Water Pump Intelligence
Control System at the incorporate owner of Goodrich Garden and
$0.96million (HK$7.50million) of Nan Fung Centre chiller replacement
project strongly help pushed drive revenues. The Company also received
two
services agreements during the second quarter of 2006 including providing
consulting services in the areas of legal, accounting, finance, management
and web site design and construction (HK$1million), and providing
Internet
e-commerce software application and e-commerce web site development
service (HK$1.5million).
|
Acquisitions
during the first quarter of 2006 also expanded PacificNet’s position as a
leading provider of e-commerce, customer services and CRM in China's mobile
distribution market, and increased our e-commerce and VAS revenues and our
nationwide CRM service coverage. Several of our businesses experienced
fluctuations in quarterly performance. Revenues from the VAS and IVR segment
can
vary from quarter to quarter due to new products and services launches and,
the
seasonality of certain product lines.
Summarized
financial information concerning each of our main operating units is set forth
in the following table. The "Other Business" column included our other
insignificant subsidiaries and corporate related items.
FOR
THE
THREE MONTHS ENDED
|
|
|
|
|
|
Group
3
|
|
|
|
|
|
|
|
Group
1
|
|
|
|
Communications
|
|
|
|
|
|
|
|
Outsourcing
|
|
Group
2.
|
|
Distribution
|
|
Group
4
|
|
|
|
|
|
Business
|
|
VAS
Business
|
|
Business
|
|
Other
Business
|
|
TOTAL
|
|
JUNE
30, 2006
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
Revenues
|
|
|
3,552,000
|
|
|
5,517,000
|
|
|
8,914,000
|
|
|
1,347,000
|
|
|
19,330,000
|
|
Earnings
/ Loss from Operations
|
|
|
283,000
|
|
|
1,130,000
|
|
|
208,000
|
|
|
-250,000
|
|
|
1,371,000
|
|
|
|
|
|
|
|
Group
3
|
|
|
|
|
|
|
|
Group
1
|
|
|
|
Communications
|
|
|
|
|
|
|
|
Outsourcing
|
|
Group
2.
|
|
Distribution
|
|
Group
4
|
|
|
|
|
|
Business
|
|
VAS
Business
|
|
Business
|
|
Other
Business
|
|
TOTAL
|
|
JUNE
30, 2006
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
Revenues
|
|
|
6,579,000
|
|
|
12,557,000
|
|
|
11,851,000
|
|
|
3,377,000
|
|
|
34,364,000
|
|
Earnings
/ Loss from Operations
|
|
|
403,000
|
|
|
2,844,000
|
|
|
265,000
|
|
|
-129,000
|
|
|
3,383,000
|
|
COST
OF
REVENUES. Cost of revenues for the three and six months ended June 30, 2006
was
$14,407,000 and $22,960,000, an increase of 49.9% and 34.1% from $9,613,000
and
$17,127,000 for the three and six months ended June 30, 2005,
respectively. The
cost
of revenues in services and product sales in the second quarter and first half
of 2006 increased by 3.8% and 81.1%, respectively, and 17.4% and 43.5%,
respectively, compared with the respective period in 2005. The increase is
directly associated with the corresponding increase in revenues. In comparison
to the same period last year, the majority of the costs associated with revenues
were from PacCom and Epro. For the second quarter and first half of 2006, PacCom
accounted 34.1% and 26.9% of the total cost of revenues, respectively and
approximately $1.86million (HK$14.5million) cost of revenue from PacCom is
the
IT equipment cost paid for Macau Galaxy Starworld Hotel project during the
second quarter of 2006. Cost of revenues from Epro accounted for 15.7% and
18.7%
of the total cost of revenues in the first half of 2006 and 2005, respectively,
which was mainly related to 27% increase in staff cost related to software
sales, 277% increase in occupancy costs such as rents and electricity and 46%
increase in other operating activity. Additionally, 4% and 8.2% of total cost
of
revenues was contributed from PacPower for the second quarter and first half
of
2006, respectively, which resulted from a Central Air-Conditioning chiller
replacement project and a Light Eco installation system project awarded during
the first and second quarter of 2006 respectively. In addition, PacPower
received a contract for a frequency inverter energy-saving air-conditioning
solution project from a client.
GROSS
PROFIT. Gross profit for the three and six months ended June 30, 2006 was
$4,923,000 and $11,404,000, a significant increase of 84.6% and 161.3 % as
compared to $2,667,000 and $4,365,000 for the three and six months ended June
30, 2005, respectively. Gross margin was 25.5% and 33.2% of total revenues
for
the second quarter and first half of 2006, compared to 21.7% and 20.3% for
the
second quarter and first half of 2005, respectively. As explained above, the
improvement on gross margin for three and six months periods from the prior
periods was primarily due to contributions from higher margin subsidiaries.
The
significant increase in gross margin year-over-year came primarily from our
facilities management and outbound services, and mobile phone sales. One of
our
subsidiaries transformed its operation from a resource outsourcing basis to
more
of a project outsourcing basis. For resource outsourcing, we had high revenue
and low profit margin in the second quarter and first half of 2005. As a result
of the shift in operations, we had lower revenue and higher than normal profit
margin for project outsourcing in the second quarter and first half quarter
of
2006. 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 greater efficiencies in our utilization of
assets.
SELLING,
GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative
expenses totaled $3,177,000 and $7,500,000 for the three and six months ended
June 30, 2006, an increase of 131% and 232% from $1,376,000 and $2,258,000
for
the three and six months ended June 30, 2005, respectively. General and
administrative expenses consist primarily of staff salaries, rent, insurance
and
traveling costs. The year-over-year increase in total general and administrative
expenses in the second quarter and first half of 2006 was mainly due to the
increase of staff cost as well as rent and electricity expenses for the
expansion of call centre. The marketing expenses from the new 3G service and
Wanrong’s services also significantly affected the total expenses during the
second quarter of 2006, increasing approximately 288% compared to the same
period in 2005. Furthermore, the expenses from project outsourcing services
included traveling and training expenses.
The
sharp
increase in the second quarter and first half of 2006 for PACT SZ was primarily
due to 25% and 24 % increase of salary cost from the expansion of accounting,
auditing, SOX internal control and Kingdee software maintenance teams, a 495%
and 292% increase from staff traveling cost resulting from the annual audit
and
the increase in management fees from the regular annual board and audit
committee meetings in SZ. Most of the subsidiaries had representatives attend
the meetings to present their previous one year and current period’s business
financial performance and their forecasts for quarterly financial figures.
Open
and transparent communication is essential as it improves the relationship
between PACT and each subsidiary so that each company can know more about the
others’ business operation. In order to meet the requirements of Sarbanes-Oxley
Act (SOX 404), it is essential to have adequate internal controls and procedure,
and to improve efficiency by using accounting software.
Significant
general expenses from PacificNet Inc. year-over-year in the second quarter
and
first half of 2006 was largely due to $58,334 and $120,043 of vesting option
expense for compensation cost amortization, $27,500 increase in D&O
commercial insurance expense (the total prepayment of $110,000 for its insurance
was from June 2005 to June 2006), $85,996 amortization cost from $8 million
convertible debt issuance cost (3 years amortization) and depreciation cost
from
Beijing Time court (USD1.6m depreciated through 40 years). Additionally, there
is approximately $148,080 financial expense for PacificNet Inc. Such expense
consists of (1) convertible debt interest, in which 5% is prepaid interest
expense, $100,000 is expensed in Q2 2006 and the following three quarters (Q3
2006, Q4 2006 and Q1 2007); and (2) the bank loan interest for Beijing Time
Court ($57,969) in which the total amount of its bank loan is
$1,082,000.
EARNINGS
FROM OPERATIONS. On
a
year-over-year basis, earnings from operations increased 15% and 72% in the
second quarter and first half of 2006, respectively. Operating earnings of
$283,000, $1,130,000, and $208,000 for the three months ended June 30, 2006
were
generated from the Company's three business units: (1) CRM Outsourcing Services,
(2) Value Added Services (VAS), and (3) Communications Distribution Services,
respectively. This compares to operating earnings of $305,000, $1,086,000 and
$118,000 for the three months ended June 30, 2005, respectively. Various factors
affected operating earnings during the second quarter of 2006, including
increased capital expenditures resulting in greater non-cash charges such as
depreciation and amortization expenses. As the Company expanded its call centre
sites in Hong Kong, amortization and depreciation expenses related to the new
leasehold improvement, furniture & fixtures, computer equipment and software
incurred in the second quarter and first half of 2006 also increased. The
increase in fixed assets also included a recorder monitor system, DVCAM,
computer equipment. 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 we believe 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 second quarter. Furthermore, the
acquisition of the majority interest in both iMobile and Guangzhou Wanrong
during the first quarter enhanced our position in this rapidly growing B2C
market in China.
INCOME
TAXES. Income tax provision was $85,000 and $200,000 for the three and six
months ended June 30, 2006, as compared to $37,000 and $64,000 for the three
and
six months ended June 30, 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.
We expect our income taxes to increase as our net earnings increase and the
tax
holidays we have benefited from in Hong Kong and the PRC
expire.
MINORITY
INTERESTS. Minority interests for the second quarter and first half of 2006
totaled $804,000 and $1,934,000 compared with $887,000 and $1,304,000 for the
same period in the prior year, representing outside ownership interests in
subsidiaries that is consolidated with the parent for financial reporting
purposes.
NET
EARNINGS. Overall net earnings year-over-year increased 60.5% and 85.8% in
the
second quarter and first half of 2006, respectively. The Company’s results for
the six months ended June 30, 2006 included a total of $888,000 in non-cash
expenses, including depreciation and amortization expense of $768,000 and
$120,000 non-cash stock-based compensation expense recognized during 2006 as
a
result of the implementation of SFAS 123(R), which we adopted effective on
January 1, 2006, The Company’s quarterly results also included a total of
$530,000 in non-cash expenses, including depreciation and amortization expense
of $472,000 and non-cash stock-based compensation expense $58,000 recognized
during the second quarter 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, Smartime, Guangzhou 3G, Clickcom, ChinaGoHi,
iMobile, PacificNet Communications, PacificNet Limited and PacificNet Power
were
profitable.
In
the
outsourcing business, Smartime signed an outsourcing contract with a local
Bank
in Hong Kong, Wing Lung Bank, in May which will help drive growth in the
outsourcing business, and provide a platform for further penetrating this market
in the region. Smartime provided some senior engineers for the Bank and will
also jointly recruit some recently-graduated students and train them.
Furthermore, the Company is constantly seeking new channels to provide lower
prices for resources, leading to lower operating costs.
Two
recently acquired subsidiaries, iMobile and Wanrong, also added approximately
$2
million and $268,000 net profit, respectively, to the total amount of net profit
during the second quarter of 2006. With the new operation of 2, 2.5 and 3G
VAS
services, net profit has rapidly increased. PacificNet Limited and PacificNet
Power also added approximately $214,000 and $296,000 net profit, respectively,
to the Company due to newly obtained projects during the second quarter of
2006.
Overall, management is optimistic in our ability to drive revenue and profits
quarter-to-quarter as a result of cost reductions and efficient utilization
of
assets.
LIQUIDITY
AND CAPITAL RESOURCES
CASH
AND
CASH EQUIVALENTS.
As
of
June 30, 2006, cash and cash equivalents were $5,935,000, compared to $9,579,000
at December 31, 2005 as a result of the decrease of cash and cash equivalents
of
more than $3.2million for Lion Zone. The significant reduction for Lion Zone
was
primarily attributed to a loan to a related party of approximately $2.1million,
acquisition of property and equipment, and taxes paid.
WORKING
CAPITAL.
The
Company’s working capital increased to $29,822,000 at June 30, 2006, as compared
to $20,510,000 at December 31, 2005. When compared to balances at December
31,
2005, an increase of 45.4% in working capital at June 30, 2006 was primarily
due
to the increases in current assets and the decrease in current liabilities
accounts. The increase of current assets was mainly the result of significant
increase in accounts receivable which was attributable to our existing
subsidiaries and a significant increase in loan receivable from related parties.
The decrease of current liabilities was primarily due to the decrease of accrual
expense and other payable. The increase of accounts receivable at June 30,
2006
was mainly driven from the increase of $2,070,000 from PacPower (due to the
installation of Central Air-Conditioning and chiller replacement project, and
two services agreements - see revenues (4) above), the increase of $2,575,000
from PacCom (see revenues (3) above), the increase of $839,000 from 3G (due
to
the expansion of 3G services) and the increase of $574,000 from Epro. The two
recently acquired subsidiaries, Wanrong and iMobile also added $255,000 and
$587,000 to accounts receivable at June 30, 2006, respectively.
NET
CASH
FROM OPERATING ACTIVITIES.
Net
cash
used in operating activities was $8,031,000 for the six months ended June 30,
2006 as compared to net cash used in operating activities of $110,000 for the
six months ended June 30, 2005. Net cash used in operating activities in the
six
months ended June 30, 2006 was primarily due to net earnings of $1,873,000
offset by minority interest of $1,934,000, non-cash related expenses of
$900,000, $208,000 for the change in fair value of our derivatives as of the
balance sheet date, and a net increase in working capital items of $12,530,000.
The increase in working capital was mainly due to an increase in accounts
receivable of $10,370,000 and an increase in inventories of $415,000 which
mainly resulted from higher revenues and a net decrease in account payables
and
accrued expenses of $1,745,000 which was primarily due to the decrease in
accrued expenses and income tax payable.
NET
CASH
FROM INVESTING ACTIVITIES.
Net
cash
used in investing activities was $4,209,000 for the six months ended June 30,
2006 compared to $3,387,000 for the comparative prior period. Net cash used
in
investing activities in the six months ended June 30, 2006 was primarily due
to
the acquisition of property and equipment from the company, Dragon Roar, Lion
Zone and Epro totaling $3,124,000, and cash payment totaling $836,000 related
to
the ChinaGoHi, Wanrong and iMobile acquisitions, and an increase of $2,233,000
in loan receivable from related parties, offset by the release of the restricted
cash of $1,422,000 from ChinaGoHi and an decrease of $562,000 for loan
receivables from third parties.
NET
CASH
FROM FINANCING ACTIVITIES.
Net
cash
provided by financing activities for the six months ended June 30, 2006 was
$8,542,000, which was mainly due to the proceeds from issuance of convertible
debenture of $8,000,000 and the exercise of the share options and warrants
of
$86,000, an increase in bank loan of $623,000 which was due to the purchase
of
our Beijing office, and an increase in loans payable to related party of
$201,000 by Epro. The amount was partially offset by the repayment of banking
facilities of $171,000 from Epro and Smartime, the repayment of amount borrowed
under capital lease of $73,000, and repurchase of treasury shares of $124,000.
Net cash provided by financing activities for the six months ended June 30,
2005
was $2,302,000, which was primarily a result of an increase in loans payable
to
related party of $390,000, an increase in advances from banking facilities
of
$142,000 primarily by EPRO, an increase in bank loan of $727,000, and an
increase from the exercise of share options and warrants of
$981,000.
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
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 second quarter of 2006.
CONTRACTUAL
OBLIGATIONS
We
have
significant cash resources to meet our contractual obligations as of June 30,
2006, as detailed below:
Payments
Due by Period
Contractual
Obligations
|
Total
|
Less
than 1 year
|
1-5
years
|
After
5 years
|
Link
of credit
|
$889,000
|
$889,000
|
0
|
0
|
Bank
Loans
|
$1,899,000
|
$401,000
|
$725,000
|
$773,000
|
Operating
leases
|
$1,805,000
|
$819,000
|
$986,000
|
0
|
Capital
leases
|
$131,000
|
$88,000
|
$43,000
|
0
|
Total
cash contractual obligations
|
$4,724,000
|
$2,197,000
|
$1,754,000
|
$773,000
|
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 sales, telemarketing
and direct marketing 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.
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 June 30, 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 Interim
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 Interim 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 Interim CFO concluded that as of June 30, 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") and
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 June 30, 2006 and through the current
date.
In
the
absence of full implementation of the remediation initiatives in the second
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 Interim 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 the first quarter of 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
As
indicated in the Company’s 10-K filed on April 28, 2006, PacificNet has greatly
expanded its Finance and Accounting staff in China in the last six months.
In
January, the Company promoted Mary Ma to the new position of Vice President
of
Finance, a position which will be permanently stationed in China. The Company
has gradually transitioned the roles, responsibilities and job function of
the
CFO role to Mary May, the new VP of Finance. In May 2006, the Company announced
the resignation of Mr. ShaoJian Wang as the CFO effective May 26, 2006.
Concurrently, Mr. Wang announced that he had accepted a new position at Hurray!
Holding Co. Ltd. (Nasdaq:HRAY) as their President and Chief Operating Operator.
Mr. Victor Tong, PacificNet’s President, has taken the position of Interim CFO
during the Company’s search for a permanent CFO. PacificNet has been actively
seeking a new permanent CFO through job ads and headhunting firms.
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. Joe Levinson, the
Company's outside financial advisor, 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.
The
Company has plans to hire managers experienced in several key areas of
accounting, including primarily persons with experience in US GAAP consolidation
requirements, SEC financial reporting requirements and international tax skills,
who will include the following:
· |
a
consolidation manager with relevant accounting experience, skills
and
knowledge;
|
· |
several
senior managers familiar with SEC financial reporting requirements
with
relevant accounting experience, skills and knowledge;
and
|
· |
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.
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.
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:
• |
the
burden of complying with a variety of foreign laws and regulations;
|
• |
the
burden of complying with United States laws and regulations for foreign
operations, including the Foreign Corrupt Practices Act;
|
• |
difficulty
complying with continually evolving and changing global product and
communications standards and regulations for both our end products
and
their component technology;
|
• |
market
acceptance of our new products, including longer product acceptance
periods in new markets into which we enter;
|
• |
reliance
on local original equipment manufacturers (“OEMs”), third party
distributors and agents to effectively market and sell our products;
|
• |
unusual
contract terms required by customers in developing markets;
|
• |
changes
in local governmental control or influence over our customers;
|
• |
changes
to import and export regulations, including quotas, tariffs, licensing
restrictions and other trade barriers;
|
• |
evolving
and unpredictable nature of the economic, regulatory, competitive
and
political environments;
|
• |
reduced
protection for intellectual property rights in some countries;
|
• |
unproven
business operation models developed or operated in specific countries
or
regions;
|
• |
longer
accounts receivable collection periods; and
|
• |
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
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.
None.
ITEM
3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
ITEM
5. OTHER INFORMATION.
None.
ITEM
6. EXHIBITS
The
following exhibits are filed as part of this report:
EXHIBIT
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
|
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: August
15, 2006 |
By: |
/s/ TONY
TONG |
|
|
|
Tony
Tong
Chief
Executive Officer
(Principal
Executive Officer)
|
|
|
|
|
|
|
Date: August
15, 2006 |
By: |
/s/ VICTOR
TONG |
|
|
|
Victor
Tong
President
and Interim Chief Financial Officer
(Principal
Financial Officer)
|
35