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
October 31, 2006, there were 11,671,836 shares of the issuer’s common stock, par
value $0.0001 per share, outstanding.
PACIFICNET
INC.
Form 10-Q
for the Quarterly Period Ended September 30, 2006
TABLE
OF CONTENTS
PART I.
|
FINANCIAL
INFORMATION
|
|
|
|
|
Item
1.
|
Financial
Statements (Unaudited)
|
3-4
|
|
|
|
|
Condensed
Consolidated Balance Sheets
|
5
|
|
|
|
|
Condensed
Consolidated Statements of Operations
|
6
|
|
|
|
|
Condensed
Consolidated Statements of Cash Flows
|
7-8
|
|
|
|
|
Notes
to Condensed Consolidated Financial Statements
|
9
|
|
|
|
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
25
|
|
|
|
Item
3.
|
Quantitative
and Qualitative Disclosures about Market Risk
|
37
|
|
|
|
Item
4.
|
Controls
and Procedures
|
38
|
|
|
|
PART II.
|
OTHER
INFORMATION
|
|
|
|
|
Item
1.
|
Legal
Proceedings
|
42
|
|
|
|
Item
1A.
|
Risk
Factors
|
42
|
|
|
|
Item
2.
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
42
|
|
|
|
Item
3.
|
Defaults
upon Senior Securities
|
42
|
|
|
|
Item
4.
|
Submission
of Matters to a Vote of Security Holders
|
42
|
|
|
|
Item
5.
|
Other
Information
|
42
|
|
|
|
Item
6.
|
Exhibits
|
42
|
|
|
|
Signatures
|
|
43
|
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)
ASSETS
|
|
September
30,
2006
(Unaudited)
|
|
December
31,
2005
(Audited)
|
|
Current
Assets:
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
7,439
|
|
$
|
9,579
|
|
Restricted
cash - pledged bank deposit
|
|
|
232
|
|
|
1,652
|
|
Accounts
receivables, net of allowances for doubtful accounts of $622 and
$5
|
|
|
13,116
|
|
|
5,998
|
|
Inventories
|
|
|
2,039
|
|
|
1,836
|
|
Loan
receivable from related parties
|
|
|
4,879
|
|
|
2,520
|
|
Loan
receivable from third parties
|
|
|
1,219
|
|
|
1,572
|
|
Other
current assets
|
|
|
8,782
|
|
|
7,973
|
|
Total
Current Assets
|
|
|
37,706
|
|
|
31,130
|
|
Property
and equipment, net
|
|
|
8,731
|
|
|
4,300
|
|
Investments
in affiliated companies and subsidiaries
|
|
|
776
|
|
|
410
|
|
Marketable
equity securities - available for sale
|
|
|
545
|
|
|
539
|
|
Goodwill
|
|
|
18,385
|
|
|
14,824
|
|
Other
assets - debt issuance costs (net)
|
|
|
927
|
|
|
-
|
|
TOTAL
ASSETS
|
|
$
|
67,070
|
|
$
|
51,203
|
|
|
|
|
|
|
|
|
|
LIABILITIES
AND STOCKHOLDERS' EQUITY
|
|
|
|
|
|
|
|
Current
Liabilities:
|
|
|
|
|
|
|
|
Bank
line of Credit
|
|
|
1,082
|
|
|
1,060
|
|
Bank
loans-current portion
|
|
|
992
|
|
|
188
|
|
Capital
lease obligations - current portion
|
|
|
133
|
|
|
126
|
|
Accounts
payable
|
|
|
3,931
|
|
|
3,186
|
|
Accrued
expenses and other payables
|
|
|
2,586
|
|
|
4,620
|
|
Income
tax payable
|
|
|
113
|
|
|
296
|
|
Subscription
payable
|
|
|
390
|
|
|
775
|
|
Loans
payable to related party
|
|
|
373
|
|
|
369
|
|
Total
Current Liabilities
|
|
|
9,600
|
|
|
10,620
|
|
Long-term
liabilities:
|
|
|
|
|
|
|
|
Bank
loans - non current portion
|
|
|
1,436
|
|
|
6
|
|
Capital
lease obligations - non current portion
|
|
|
148
|
|
|
78
|
|
Convertible
Debenture
|
|
|
8,000
|
|
|
-
|
|
Warrant
Liability
|
|
|
268
|
|
|
-
|
|
Compound
Embedded Derivatives Liability
|
|
|
357
|
|
|
-
|
|
Interest
discount
|
|
|
(1,530
|
)
|
|
-
|
|
Liquidated
damages liability
|
|
|
800
|
|
|
-
|
|
Total
long-term liabilities
|
|
|
9,479
|
|
|
84
|
|
Total
liabilities
|
|
|
19,079
|
|
|
10,704
|
|
Minority
interest in consolidated subsidiaries
|
|
|
11,586
|
|
|
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:
|
|
|
|
|
|
|
|
September
30, 2006 - 13,983,497 shares issued, 11,646,836
outstanding
|
|
|
|
|
|
|
|
December
31, 2005 - 12,000,687 issued, 10,831,024 outstanding
|
|
|
1
|
|
|
1
|
|
Treasury
stock, at cost (2006 Q3: 2,336,661 shares, 2005: 1,169,663 shares)
|
|
|
(243
|
)
|
|
(119
|
)
|
Additional
paid-in capital
|
|
|
62,201
|
|
|
57,690
|
|
Cumulative
other comprehensive income (loss)
|
|
|
266
|
|
|
247
|
|
Accumulated
deficit
|
|
|
(25,386
|
)
|
|
(25,990
|
)
|
Less
stock subscription receivable
|
|
|
(434
|
)
|
|
(44
|
)
|
Total
Stockholders' Equity
|
|
|
36,405
|
|
|
31,785
|
|
TOTAL
LIABILITIES AND STOCKHOLDERS' EQUITY
|
|
$
|
67,070
|
|
$
|
51,203
|
|
The
accompanying condensed notes are an integral part of these consolidated
financial statements.
PACIFICNET
INC. AND SUBSIDIARIES
CONSOLIDATED
STATEMENTS OF OPERATIONS
(Unaudited.
In thousands of United States dollars, except loss per share and share
amounts)
|
|
THREE
MONTHS ENDED
SEPTEMBER
30
|
|
NINE
MONTHS ENDED
SEPTEMBER
30
|
|
|
|
2006
|
|
2005
(as
restated)
|
|
2006
|
|
2005
(as
restated)
|
|
Revenues
|
|
$
|
12,875
|
|
$
|
11,047
|
|
$
|
47,239
|
|
$
|
32,539
|
|
Services
|
|
|
5,445
|
|
|
4,908
|
|
|
22,145
|
|
|
14,232
|
|
Product
sales
|
|
|
7,430
|
|
|
6,139
|
|
|
25,094
|
|
|
18,307
|
|
Cost
of revenues
|
|
|
(10,392
|
)
|
|
(8,852
|
)
|
|
(33,352
|
)
|
|
(25,979
|
)
|
Services
|
|
|
(3,352
|
)
|
|
(3,113
|
)
|
|
(10,635
|
)
|
|
(9,314
|
)
|
Product
sales
|
|
|
(7,040
|
)
|
|
(5,739
|
)
|
|
(22,717
|
)
|
|
(16,665
|
)
|
Gross
margin
|
|
|
2,483
|
|
|
2,195
|
|
|
13,887
|
|
|
6,560
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Selling,
general and administrative expenses
|
|
|
(2,482
|
)
|
|
(1,004
|
)
|
|
(9,982
|
)
|
|
(3,261
|
)
|
Inventory
write-down charge
|
|
|
(486
|
)
|
|
-
|
|
|
(486
|
)
|
|
-
|
|
Bad
debt expense
|
|
|
(657
|
)
|
|
-
|
|
|
(657
|
)
|
|
-
|
|
Depreciation
and amortization
|
|
|
(255
|
)
|
|
(133
|
)
|
|
(474
|
)
|
|
(275
|
)
|
Interest
expense
|
|
|
(395
|
)
|
|
(182
|
)
|
|
(851
|
)
|
|
(182
|
)
|
EARNINGS/(LOSS)
FROM OPERATIONS
|
|
|
(1,792
|
)
|
|
876
|
|
|
1,437
|
|
|
2,842
|
|
Interest
income
|
|
|
96
|
|
|
155
|
|
|
177
|
|
|
155
|
|
Gain
in change in fair value of derivatives
|
|
|
1,004
|
|
|
-
|
|
|
1,212
|
|
|
-
|
|
Liquidated
damages expense
|
|
|
(800
|
)
|
|
-
|
|
|
(800
|
)
|
|
-
|
|
Sundry
income, net
|
|
|
(113
|
)
|
|
171
|
|
|
173
|
|
|
577
|
|
Earnings/(Loss)
before Income Taxes and Minority Interest
|
|
|
(1,605
|
)
|
|
1,202
|
|
|
2,199
|
|
|
3,574
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision
for income taxes
|
|
|
(119
|
)
|
|
13
|
|
|
(319
|
)
|
|
(51
|
)
|
Share
of earnings of associated companies
|
|
|
80
|
|
|
8
|
|
|
129
|
|
|
12
|
|
Minority
interests
|
|
|
529
|
)
|
|
(612
|
)
|
|
(1,405
|
)
|
|
(1,916
|
)
|
Net
Earnings/(Loss) Available to Common Stockholders
|
|
$
|
(1,115
|
)
|
$
|
611
|
|
$
|
604
|
|
$
|
1,619
|
|
BASIC
EARNINGS PER SHARE
|
|
$
|
(0.10
|
)
|
$
|
0.06
|
|
$
|
0.05
|
|
$
|
0.16
|
|
DILUTED
EARNINGS PER SHARE
|
|
$
|
(0.10
|
)
|
$
|
0.05
|
|
$
|
0.05
|
|
$
|
0.15
|
|
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
|
|
|
($25,990
|
)
|
|
($119
|
)
|
$
|
31,785
|
|
Net
earnings/(loss)
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
604
|
|
|
|
|
|
604
|
|
Exercise
of stock options for cash and receivable (369,000 shares)
|
|
|
--
|
|
|
|
|
|
784
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
784
|
|
Issuance
of common stock for acquisition of subsidiaries (471,012
shares)
|
|
|
--
|
|
|
|
|
|
3,578
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3,578
|
|
PIPE
related expenses
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Repurchase
of common shares (less 24,200 shares)
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(124
|
)
|
|
(124
|
)
|
Cumulative
foreign exchange gain/(loss)
|
|
|
--
|
|
|
|
|
|
|
|
|
|
|
|
19
|
|
|
|
|
|
|
|
|
19
|
|
Stock-based
compensation
|
|
|
|
|
|
|
|
|
120
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
120
|
|
Issuance
of warrants for fees of issuing convertible debt (16,000
warrants)
|
|
|
|
|
|
|
|
|
29
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
29
|
|
Less
stock subscription receivable
|
|
|
--
|
|
|
|
|
|
|
|
|
(390
|
)
|
|
|
|
|
|
|
|
|
|
|
(390
|
)
|
BALANCE
AT SEPTEMBER 30, 2006
(11,646,836
SHARES)
|
|
|
--
|
|
$
|
1
|
|
$
|
62,201
|
|
$
|
(434
|
)
|
$
|
266
|
|
$
|
(25,386
|
)
|
$
|
(243
|
)
|
$
|
36,405
|
|
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)
|
|
NINE
MONTHS ENDED
SEPTEMBER
30
|
|
|
|
2006
|
|
2005
|
|
Cash
Flows from operating activities
|
|
|
|
|
|
|
|
Net
earnings / (loss)
|
|
$
|
604
|
|
$
|
1,619
|
|
Adjustment
to reconcile net earnings/(loss) to net cash provided by (used
in)
operating activities:
|
|
|
|
|
|
|
|
Equity
loss of associated company
|
|
|
(129
|
)
|
|
(12
|
)
|
Provision
for income taxes
|
|
|
(183
|
)
|
|
51
|
|
Provision
for allowance for doubtful accounts
|
|
|
657
|
|
|
-
|
|
Minority
Interest
|
|
|
1,405
|
|
|
1,916
|
|
Depreciation
and amortization
|
|
|
1,173
|
|
|
274
|
|
Inventory
write-down charge
|
|
|
486
|
|
|
-
|
|
Stock-based
compensation
|
|
|
120
|
|
|
-
|
|
Change
in fair value of derivatives
|
|
|
(1,212
|
)
|
|
-
|
|
Amortization
of interest discount
|
|
|
307
|
|
|
-
|
|
Liquidated
damages expense
|
|
|
800
|
|
|
-
|
|
Changes
in current assets and liabilities net of effects from purchase
of
subsidiaries:
|
|
|
|
|
|
|
|
Accounts
receivable and other current assets
|
|
|
(8,281
|
)
|
|
(3,029
|
)
|
Inventories
|
|
|
(572
|
)
|
|
(452
|
)
|
Accounts
payable and other accrued expenses
|
|
|
(1,591
|
)
|
|
(234
|
)
|
Net
cash provided by (used in) operating activities
|
|
|
(6,416
|
)
|
|
133
|
|
Cash
flows from investing activities
|
|
|
|
|
|
|
|
Decrease
in restricted cash
|
|
|
1,420
|
|
|
3,132
|
|
Increase
in purchase of marketable securities
|
|
|
-
|
|
|
(409
|
)
|
Acquisition
of property and equipment
|
|
|
(3,806
|
)
|
|
(1,844
|
)
|
Acquisition
of subsidiaries and affiliated companies
|
|
|
(419
|
)
|
|
(1,183
|
)
|
Loans
receivable from third parties
|
|
|
353
|
|
|
(1,597
|
)
|
Loans
receivable from related party
|
|
|
(2,359
|
)
|
|
(1,349
|
)
|
Net
cash used in investing activities
|
|
|
(4,811
|
)
|
|
(3,250
|
)
|
|
|
|
|
|
|
|
|
CASH
FLOWS FROM FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
Loan
payable to related party
|
|
|
4
|
|
|
513
|
|
Advances
(repayments) under bank line of credit
|
|
|
22
|
|
|
(7
|
)
|
Increase
(repayments) of amount borrowed under capital lease obligations
|
|
|
77
|
|
|
29
|
|
Repurchase
of treasury shares
|
|
|
(124
|
)
|
|
-
|
|
Proceeds
from exercise of stock options and warrants
|
|
|
174
|
|
|
981
|
|
Net
proceeds from issuance of convertible debenture
|
|
|
7,500
|
|
|
-
|
|
Advances
under bank loans
|
|
|
1,152
|
|
|
5
|
|
Net
cash provided by financing activities
|
|
|
8,805
|
|
|
1,521
|
|
|
|
|
|
|
|
|
|
Effect
of exchange rate change on cash and cash
equivalents
|
|
|
282
|
|
|
-
|
|
NET
DECREASE IN CASH AND CASH EQUIVALENTS
|
|
|
(2,140
|
)
|
|
(1,596
|
)
|
CASH
AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD
|
|
|
9,579
|
|
|
6,764
|
|
CASH
AND CASH EQUIVALENTS, END OF THE PERIOD
|
|
$
|
7,439
|
|
$
|
5,168
|
|
CASH
PAID FOR:
|
|
|
|
|
|
|
|
Interest
|
|
$
|
744
|
|
$
|
182
|
|
Income
taxes
|
|
$
|
502
|
|
$
|
34
|
|
NON-CASH
INVESTING AND FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
Fixed
assets acquired under banking loan
|
|
|
1,082
|
|
|
-
|
|
Options
exercised for shares receivable
|
|
|
434
|
|
|
-
|
|
Investments
in subsidiaries acquired through the issuance of common stock
|
|
$
|
3,578
|
|
$
|
2,871
|
|
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") a leading provider
of
CRM and telecom services, ecommerce and gaming technology in Hong Kong, Macao,
and China. Through our subsidiaries, PacificNet provides outsourcing services,
telecom (VAS) services, products (telecom & gaming) 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 also a provider of value-added telecom
services in China, which is comprised of interactive voice response (IVR)
systems, call center management systems, and voice over Internet protocol
(VOIP), short messaging services (SMS), multimedia messaging services (MMS),
wireless application protocol (WAP), mobile internet and 3G services. The
Company's operations are primarily based in China, including Hong Kong and
Macau
Special Administrative Region and Asian 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, as amended, 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, as amended, 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 September 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 6 for further details.
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 third
quarter
of 2006 exclude the potential dilutive effect of 889,456 warrants because
their
impact would be anti-dilutive based on current market prices. 800,000
convertible debentures are tested by using if-converted method. The result
shows
when convertible debentures are included in the computation, diluted EPS
increases. According to SFAS No.128, those convertible debentures are ignored
in
the computation of diluted EPS. 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 September 30
|
|
Nine
Months Ended September 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/(loss)
|
|
$
|
(1,115
|
)
|
$
|
611.
|
|
$
|
604
|
|
$
|
1,619
|
|
Denominator:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
shares used to compute basic EPS
|
|
|
11,619,010
|
|
|
10,826,983
|
|
|
11,171,608
|
|
|
10,171,224
|
|
Dilutive
potential from assumed exercise of stock options and
warrants
|
|
|
-
|
|
|
918,760
|
|
|
648,881
|
|
|
859,147
|
|
Weighted-average
shares used to compute diluted EPS
|
|
|
11,619,010
|
|
|
11,745,743
|
|
|
11,820,489
|
|
|
11,030,371
|
|
Basic
earnings per common share:
|
|
$
|
(0.10
|
)
|
$
|
0.06
|
|
$
|
0.05
|
|
$
|
0.16
|
|
Diluted
earnings per common share:
|
|
$
|
(0.10
|
)
|
$
|
0.05
|
|
$
|
0.05
|
|
$
|
0.15
|
|
4.
GOODWILL AND BUSINESS ACQUISITIONS
The
changes in the carrying amount of goodwill for the following reporting periods
are summarized below:
(US$000s)
|
|
Group
1.
Outsourcing
Services
|
|
Group
2.
Telecom
Value-Added
Services
|
|
Group
3.
Products
(Gaming and Technology)
|
|
Total
|
|
Balance
as of December 31, 2005
|
|
$
|
3,936
|
|
$
|
9,788
|
|
$
|
1,100
|
|
$
|
14,824
|
|
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
|
|
$
|
3,936
|
|
$
|
10,249
|
|
$
|
1,100
|
|
$
|
15,285
|
|
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
|
|
$
|
3,936
|
|
$
|
11,820
|
|
$
|
1,529
|
|
$
|
17,285
|
|
Goodwill
acquired during the third quarter
|
|
|
--
|
|
|
1,100
|
|
|
|
|
|
1,100
|
|
Impairment
losses
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
Goodwill
written off related to sale of business unit
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
Balance
as of September 30, 2006
|
|
$
|
3,936
|
|
$
|
12,920
|
|
$
|
1,529
|
|
$
|
18,385
|
|
Business
Acquisitions during the three months ended September 30,
2006
Able
Entertainment Technology Ltd by PacificNet Games Limited
On
August
3, 2006, PacificNet’s wholly owned subsidiary PacificNet Games Limited
(“PacGames”, Chinese Company Name [太平洋网络游戏有榰公司])
completed the acquisition of 100% of Able Entertainment Technology Ltd.,
a
leading gaming technology provider based in the Macau Special Administrative
Region of China. Upon completion of this transaction, the Company owned 35%
of
PacificNet Games Limited. Under the purchase agreement, Able Entertainment
Technology Ltd represented that is expects to generate an annual profit of
USD$1,600,000 and will provide for an adjustment to the purchase price if
PacGames does not achieve an annual net profit of USD$1,600,000 during the
first
12-month period ended June 30, 2007, and USD$3,000,000 during the second
12-month period ended June 30, 2008.
The
purchase price consideration is 200,000 restricted PACT shares in exchange
for
100% of the issued and outstanding shares of Able Entertainment Technology
Ltd.
or a 35% ownership interest in PacGames. The company has valued the
consideration at a price of $5.08, representing the closing market price
on
August 3, 2006, the date of acquisition. As of September 30, 2006, 40,000
total
restricted shares of PacificNet had been issued for the acquisition and 160,000
shares were held back as contingent consideration payable upon completion
of
certain earnings criteria pursuant to the purchase agreement. The agreement
also
provides for a loan of up to $1,600,000 on an as-needed basis and as of
September 30, 2006, $128,000 was advanced. (See Note 9)
On
September 22, 2006, PACT acquired another 10% of PacGames in exchange for
57,100
restricted shares of the Company’s common stock. These shares have not been
issued as of September 30, 2006.
5.
STOCKHOLDERS' EQUITY
a)
COMMON
STOCK
For
the
quarter ended September 30, 2006, the Company had the following equity
transactions: (i)100,000 shares of common stock were issued as a result of
the
exercise of stock options for cash and receivable consideration of $220,000
in
the aggregate; (ii) 177,500 shares of common stock were released from escrow
(PACT treasury shares) for acquisition of Able Entertainment and contingent
consideration for ChinaGoHi valued at $1,303,200.
Subscription
receivable of approximately $434,000 represents funds receivable from the
exercise of options and is presented as a contra equity account in the
stockholders’ equity section of the consolidated balance sheet.
b)
STOCK
OPTION PLAN - See Note 6 for further details.
The
status of the Stock Option Plan as of September 30, 2006, is as
follows:
|
|
OPTIONS
|
|
WEIGHTED
AVERAGE
EXERCISE
PRICE
|
|
OUTSTANDING,
DECEMBER 31, 2005
|
|
|
1,575,000
|
|
$
|
4.00
|
|
Granted
|
|
|
-
|
|
|
-
|
|
Cancelled
|
|
|
-
|
|
|
-
|
|
Exercised
|
|
|
(24,000
|
)
|
$
|
1.75
|
|
OUTSTANDING,
MARCH 31, 2006
|
|
|
1,551,000
|
|
$
|
4.
04
|
|
Granted
|
|
|
-
|
|
|
-
|
|
Cancelled
|
|
|
(680,000
|
)
|
$
|
6.57
|
|
Exercised
|
|
|
(245,000
|
)
|
$
|
2.13
|
|
OUTSTANDING,
JUNE 30, 2006
|
|
|
626,000
|
|
$
|
2.03
|
|
Granted
|
|
|
500,000
|
|
$
|
4.75
|
|
Cancelled
|
|
|
-
|
|
$
|
-
|
|
Exercised
|
|
|
(100,000
|
)
|
$
|
2.2
|
|
OUTSTANDING,
SEPTEMBER 30, 2006
|
|
|
1,026,000
|
|
$
|
3.34
|
|
On
May
28, 2006, the board of directors 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.
On
September 21, 2006, the
board
of directors and management approved and authorized the grant to directors,
officers, employees and consultants of the company (including its subsidiaries)
of options to purchase up to an aggregate of 500,000 shares of Common Stock
with
a $4.75 exercise price. Those options will vest 20% per year commencing from
January 1st
2007.
The contract life for those options is 5 years.
c)
WARRANTS
At
September 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 3.59 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, 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 September 30 of 2006:
|
|
|
Number
of
shares
|
|
|
Remarks
|
|
Escrowed
shares returned to treasury in 2003
|
|
|
800,000
|
|
|
|
|
Shares
purchased in the open market
|
|
|
38,154
|
|
|
|
|
Repurchase
of shares from Take 1
|
|
|
149,459
|
|
|
|
|
Cancellation
of former employee shares
|
|
|
45,000
|
|
|
|
|
Holdback
shares as contingent consideration due to performance targets not
yet
met
|
|
|
1,304,048
|
|
|
Includes
shares related to Clickcom (78,000); Yueshen (24,200), ChinaGoHi
(550,000), Guangzho(Wanrong (138,348); iMobile (153,500), Able
Entertainment (160,000), and Allink (200,000)
|
|
Balance,
September 30, 2006
|
|
|
2,336,661
|
|
|
|
|
Shares
outstanding at September 30, 2006
|
|
|
11,646,836
|
|
|
|
|
Shares
issued at September 30, 2006
|
|
|
13,983,497
|
|
|
|
|
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
compensation costs, which approximated $120,000 for the nine months ended
September 30, 2006, are recognized on a straight-line base over the option
vesting term and the amortized cost is included in selling, general and
administrative expenses. PacificNet elected the modified prospective method
and
therefore has not restated results for prior periods. The valuation provisions
of SFAS 123(R) apply to new grants and unvested grants that were outstanding
as
of the effective date.
During
the quarter ended September 30, 2006, the Company granted 500,000 new stock
options, 100,000 options were exercised, and zero options were cancelled.
See
note 5 b) for the status of the Company’s stock option plan.
Additional
information on options outstanding as of September 30, 2006 is as
follows:
|
WEIGHTED
AVERAGE
EXERCISE
PRICE
|
OPTIONS
|
AVERAGE
REMAINING
CONTRACTUAL
LIFE
|
Options
outstanding
|
$3.34
|
1,026,000
|
2.84
years
|
Options
exercisable
|
$2.00
|
526,000
|
0.82
year
|
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.
The
convertible debt obligates the Company to file a registration statement with
respect to the shares issuable under the convertible debt note. Due to various
factors, as of September 30, 2006, the Company had not filed such a registration
statement. Accordingly, the terms of the convertible note obligate the Company
to pay liquidated damages to the convertible debenture investors at the rate
of
2% of the principal amount of the convertible per month, or $160,000.
As
of
September 30, 2006, the Company has determined to accrue five months of
liquidated damages or approximately $800,000, although it is possible that
the
Company may not ultimately need to pay the full amount of liquidated
damages. The amount has been reflected in the consolidated financial
statements as a separate line item on the consolidated balance sheet as
“liquidated damages liability” and as a separate line item on the consolidated
statement of operations as “liquidated damages expense”.
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 nine months
ended September 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 $1,106,000
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 and nine months
ended September 30, 2006 was $93,000 and $179,000, respectively. At September
30, 2006, net debt issuance costs associated with the debentures was $927,000
and is recorded in Other assets, net.
The
gross
proceeds of $8,000,000 are recorded as a debenture liability. In addition,
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” are recorded as liabilities. The debt discount consisted of an initial
$690,642 value related to the Investors’ warrants and a $1,145,640 value
attributed to the compound embedded derivatives liability, as well as the
warrants liability. An aggregate gain of $1,211,583 representing the change
in
fair value of these derivative liabilities was recognized during the nine
months
ended September 30, 2006.
In
accordance with recent FASB guidance, due to certain factors, including a
liquidated damages provision in the registration rights agreement, the Company
values and accounts for the embedded conversion feature and the warrants
related
to the debentures as derivatives. 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.
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)
Telecom Value-Added Services - 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)
Products (Telecom & Gaming) - primarily involves communication and gaming
products, GSM/CDMA/3G Products, Multimedia Communication Kiosks. This Group
includes the following subsidiaries: PacificNet Communications Limited, iMobile,
Allink, Take1 and PacificNet Games. PacificNet Games Limited (PacGames) is
a
leading developer of Asian electronic gaming machines, multi-player electronic
gaming technology solutions and gaming related maintenance, IT, and distribution
services for the leading hotel and casino operators based in the Macau and
other
Asian gaming markets.
(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
September
30, 2006
|
Group
1.
|
Group
2.
|
Group
3.
|
Group
4.
|
Total
|
|
Outsourcing
Services
|
Telecom
Value-Added Services
|
Products
(Telecom
& Gaming)
|
Other
Business
|
|
|
($)
|
($)
|
($)
|
($)
|
($)
|
Revenues
|
3,733,000
|
2,350,000
|
6,411,000
|
381,000
|
12,875,000
|
(%
of Total Revenues)
|
29%
|
18%
|
50%
|
3%
|
100%
|
Earnings
/ (Loss) from Operations
|
113,000
|
(833,000)
|
(191,000)
|
(881,000)
|
(1,792,000)
|
(%
of Total Earnings)
|
-6%
|
46%
|
11%
|
49%
|
100%
|
Total
Assets
|
9,159,000
|
18,939,000
|
12,813,000
|
26,159,000
|
67,070,000
|
(%
of Total Assets)
|
14%
|
28%
|
19%
|
39%
|
100%
|
Goodwill
|
3,936,000
|
12,920,000
|
1,529,000
|
-
|
18,385,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
Macau,
HK, PRC
|
HK,
PRC, USA
|
|
For
the three months ended September 30, 2005
|
Group
1.
|
Group
2.
|
Group
3.
|
Group
4.
|
Total
|
Outsourcing
Services
|
Telecom
Value-Added Services
|
Products
(Telecom
& Gaming)
|
Other
Business
|
|
($)
|
($)
|
($)
|
($)
|
|
Revenues
|
3,368,000
|
2,870,000
|
4,677,000
|
132,000
|
11,047,000
|
(%
of Total Revenues)
|
31%
|
26%
|
42%
|
1%
|
100%
|
Earnings
/ (Loss) from Operations
|
217,000
|
824,000
|
172,000
|
(337,000)
|
876,000
|
(%
of Total Earnings)
|
25%
|
94%
|
20%
|
-39%
|
100%
|
Total
Assets
|
4,939,000
|
9,254,000
|
189,000
|
28,983,000
|
43,365,000
|
(%
of Total Assets)
|
11%
|
21%
|
1%
|
67%
|
100%
|
Goodwill
|
3,542,000
|
8,702,000
|
979,000
|
-
|
13,223,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
Macau,
HK, PRC
|
HK,
PRC, USA
|
|
For
the nine months ended September 30, 2006
|
Group
1.
|
Group
2.
|
Group
3.
|
Group
4.
|
Total
|
Outsourcing
Services
|
Telecom
Value-Added Services
|
Products
(Telecom
& Gaming)
|
Other
Business
|
|
($)
|
($)
|
($)
|
($)
|
($)
|
Revenues
|
10,312,000
|
14,907,000
|
18,262,000
|
3,758,000
|
47,239,000
|
(%
of Total Revenues)
|
22%
|
31%
|
39%
|
8%
|
100%
|
Earnings
/ (Loss) from Operations
|
515,000
|
2,011,000
|
74,000
|
(1,163,000)
|
1,437,000
|
(%
of Total Earnings)
|
36%
|
140%
|
5%
|
-81%
|
100%
|
Total
Assets
|
9,159,000
|
18,939,000
|
12,813,000
|
26,159,000
|
67,070,000
|
(%
of Total Assets)
|
14%
|
28%
|
19%
|
39%
|
100%
|
Goodwill
|
3,936,000
|
12,920,000
|
1,529,000
|
-
|
18,385,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
Macau,
HK, PRC
|
HK,
PRC, USA
|
|
For
the nine months ended September 30, 2005
|
Group
1.
|
Group
2.
|
Group
3.
|
Group
4.
|
Total
|
Outsourcing
Services
|
Telecom
Value-Added Services
|
Products
(Telecom
& Gaming)
|
Other
Business
|
|
($)
|
($)
|
($)
|
($)
|
|
Revenues
|
9,860,000
|
9,024,000
|
13,408,000
|
247,000
|
32,539,000
|
(%
of Total Revenues)
|
30%
|
28%
|
41%
|
1%
|
100%
|
Earnings
/ (Loss) from Operations
|
866,000
|
2,413,000
|
408,000
|
(845,000)
|
2,842,000
|
(%
of Total Earnings)
|
31%
|
85%
|
14%
|
-30%
|
100%
|
Total
Assets
|
4,939,000
|
9,254,000
|
189,000
|
28,983,000
|
43,365,000
|
(%
of Total Assets)
|
11%
|
21%
|
1%
|
67%
|
100%
|
Goodwill
|
3,542,000
|
8,702,000
|
979,000
|
-
|
13,223,000
|
Geographic
Area
|
HK,
PRC
|
PRC
|
Macau,
HK, PRC
|
HK,
PRC, USA
|
|
Product
and service revenues classified by major geographic areas are as follows
(in
US$):
For
the three months ended
September
30, 2006
|
Hong
Kong, Macau
|
PRC
|
United
States
|
Total
|
Product
revenues
|
5,261,000
|
2,169,000
|
-
|
7,430,000
|
Service
revenues
|
3,435,000
|
2,010,000
|
-
|
5,445,000
|
For
the three months ended
September
30, 2005
|
Hong
Kong, Macau
|
PRC
|
United
States
|
Total
|
Product
revenues
|
4,776,000
|
1,363,000
|
-
|
6,139,000
|
Service
revenues
|
2,305,000
|
2,603,000
|
-
|
4,908,000
|
For
the nine months ended
September
30, 2006
|
Hong
Kong
Macau
|
PRC
|
United
States
|
Total
|
Product
revenues
|
17,355,000
|
7,739,000
|
-
|
25,094,000
|
Service
revenues
|
9,970,000
|
12,175,000
|
-
|
22,145,000
|
For
the nine months ended
September
30, 2005
|
Hong
Kong, Macau
|
PRC
|
United
States
|
Total
|
Product
revenues
|
13,538,000
|
4,769,000
|
-
|
18,307,000
|
Service
revenues
|
6,990,000
|
7,242,000
|
-
|
14,232,000
|
9.
RELATED PARTY TRANSACTIONS
LOAN
DUE TO AND FROM RELATED PARTIES
As
of
September 30, 2006, there was a total loan receivable of approximately
$4,879,000 due from related parties while the loan due to related party was
$373,000.
As
of
September 30, 2006, the related party loan receivables included $1,026,000
due
from Take 1, an affiliated company that is 20% owned by PacificNet, $128,000
due
from PacificNet Games, an affiliated company that is 45% owned by PacificNet,
and $3,725,000 due from shareholders and directors of certain of the Company’s
subsidiaries in connection with the acquisition of these 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, and $2,284,000 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 September 30,
2006. A
convertible loan of $1,026,000 is outstanding from Take 1 as of September
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 $1,026,000 (or HKD$8,000,000) 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 PACIFICNET GAMES
PacGames
is an affiliated company that is 45% owned by PacificNet as of September
30,
2006. A loan of approximately $128,000 is outstanding as of September 30,
2006
and is due and payable on July 31, 2007. Payment is due in equal monthly
installments of approximately $11,752 which include principal repayments
and an
implied interest rate of 10%.
LOAN
TO YUESHEN'S SHAREHOLDER
As
of
September 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.
The
Company has been experiencing difficulty recovering the loan receivable due
from
Yueshen’s shareholder. Specifically, the Company and the shareholder disagree
over the outstanding balance owed and are in ongoing discussions about
recovering the loan amount. As the Company still believes that it has a high
probability of recovering the debt, it has continued to record the amount
of the
loan receivable at the full historical cost. Nevertheless, the Company will
continue to closely monitor the repayment of the loan.
LOAN
TO SOLUTEK'S DIRECTOR
As
of
September 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 A COMPANY OWNED BY A SHAREHOLDER OF LION ZONE
(CHINAGOHI)
As
of
September 30, 2006, a loan of $2,284,000 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
September 30, 2006, a loan of $373,000 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 Q3 amounted to $332,000 (2005 Q3: $136,000).
Future minimum lease payments under non-cancelable operating leases are $463,000
for Oct. 2006 through Sep. 2007 and $312,000 for Oct. 2007 through Sep.
2012.
Restricted
Cash-
The
Company has a $232,000 pledged bank deposit for Epro which represents overdraft
protections with certain financial institutions.
Bank
Line of Credit
As of
September 30, 2006, the Company’s outstanding bank lines of credit were as
follows:
|
(i)
|
Epro
has an overdraft banking facility with certain major financial
institutions in the aggregate amount of $949,000, which is secured
by a
pledge of its fixed deposits of $232,000, 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.
|
|
(ii)
|
Smartime
has an overdraft banking facility with a large Hong Kong bank in
the
aggregate amount of $133,000. This overdraft facility is personally
pledged by the deposit account of a director of
Smartime.
|
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 0.17% and -23% 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 September 30, 2006:
Secured
[1]
|
$1,200,000
|
Unsecured
|
1,228,000
|
Less:
current portion
|
992,000
|
Non
current portion
|
$1,436,000
|
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
$232,000 of a subsidiary of the Company.
(Aggregate
future maturities of borrowing for the next five years are as follows: Oct.
2006
to Sep. 2007: $944,000, Oct. 2007 to Sep. 2008: $247,000 and Oct. 2008 to
Sep.
2009: $190,000, thereafter: none.)
The
remaining bank loans of $1,047,000 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 $56,000. (Aggregate future maturities of
borrowing for the following period are as follows: Less than 1 year: $48,000,
1-5 year: $223,000 and after 5 years: $776,000)
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:
$133,000; 2007: $95,000; 2008: $53,000, and thereafter: none.)
Liquidated
damages: Refer to Note 7 re the details behind the liquidating damages
commitment for the Company.
11.
OTHER CURRENT ASSETS
Other
current assets consist of the following at September 30, 2006 (in
thousands):
|
|
September
30, 2006
$
(in thousands)
|
|
Deposit
|
|
$
|
1,814
|
|
Prepayment
|
|
|
1,274
|
|
Other
receivables
|
|
|
5,377
|
|
Prepaid
Expense
|
|
|
376
|
|
Provision
for Bad Debt
|
|
|
(59
|
)
|
Total
|
|
$
|
8,782
|
|
12.
INVENTORY
Inventories
of approximately $2 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.
In
the
beginning of the third quarter of 2006, the Chinese government announced
that it
would implement several new policies regarding mobile phone value-added service
providers effective July 10, 2006. These policies include a “double
confirmation” policy and the requirement that value-added service providers
provide one-month trial subscriptions. By requiring that mobile phone customers
“double-confirm” their intention to purchase services, and by requiring free
subscriptions, the Chinese government has negatively affected value-added
service providers.
Since
the
Company sells hardware to value-added service providers that have been
negatively affected by the new mobile phone policies, during the three months
ended September 30, 2006, we recorded an adjustment to inventory of $486,000.
The
write
down was considered prudent after an assessment by the Company’s internal
control team determined that the inventory was considered not readily saleable
as a result of the recent government policy restrictions.
Although
the Chinese government appeared to lessen restrictions by the end of the
third
quarter, the effect of lesser demand already necessitated a write-down of
inventory.
13.
INCOME TAXES
The
Company is registered in the state of 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 loss for income tax purposes. The
Company
believes that it is more likely than not that these net accumulated operating
loss 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 September 30, 2006. Accordingly, the Company has no
net
deferred tax assets as of September 30, 2006.
14.
SUBSEQUENT EVENTS
Stock
Option Exercise
On
October 1, 2006, PacificNet issued 25,000 shares of common stock as a result
of
stock option exercise in accordance to PacificNet’s stock option
plan.
Allink
Hong Kong Limited
On
August
11, 2006, PacificNet’s
wholly
owned subsidiary PacificNet Communications Limited (“PacCom”)
agreed
to the acquisition of 80% of Allink Hong Kong Limited (Allink, Chinese name
“瘺瑑濦晧港有榰公司”),
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. If the transaction is completed,
PacificNet Inc. will own 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 transaction was originally expected
to be completed in the third quarter of 2006, however since the necessary
due
diligence has not been completed, the Company has been unable to consummate
the
merger.
The
consideration to be paid 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.
|
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, AS AMENDED.
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
|
customer
demands;
|
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.
In
the
beginning of the third quarter of 2006, the Chinese government announced
that it
would implement several new policies regarding mobile phone value-added service
providers effective from July 10, 2006. These policies include a “double
confirmation” policy and the requirement that value-added service providers
provide one-month trial subscriptions. By requiring that mobile phone customers
“double-confirm” their intention to purchase services, and by requiring free
subscriptions, the Chinese government has negatively affected value-added
service providers.
Since
the
Company does business with several value-added service providers that have
been
negatively affected by the new mobile phone policies, during the three months
ended September 30, 2006, the Company decided to incur a bad debt charge
of
approximately $657,000. This amount is listed as a separate line item in
the
consolidated statement of operations. The
write
down was considered prudent after an assessment by the Company’s internal
control team that several customer accounts may be uncollectible as a result
of
Chinese government pressure on value-added service providers.
Although
the Chinese government appeared to lessen restrictions by the end of the
third
quarter, the negative affect on the ability of certain of the Company’s
customers to pay on accounts receivable already necessitated a provision
for
uncollectible accounts.
Inventory
Our
inventory purchases and commitments are made in order to build inventory
to meet
forecasted demand for our products. We perform a detailed assessment of
inventory for each period, which includes a review of, among other factors,
demand requirements, product life cycle and development plans, component
cost
trends, product pricing and quality issues. Based on this analysis, we record
adjustments to inventory for excess, obsolescence or impairment, when
appropriate, to reflect inventory at net realizable value. Revisions to our
inventory adjustments may be required if actual demand, component costs or
product life cycles differ from our estimates. In the event we were unable
to
sell our products, the demand for our products diminished, and/or other
competitors offered similar or better products, we would be forced to record
an
adjustment to inventory for impairment or obsolescence to reflect inventory
at
net realizable value. The accounting effect of this entry would be a charge
to
earnings, thereby reducing our net earnings.
In
the
beginning of the third quarter of 2006, the Chinese government announced
that it
would implement several new policies regarding mobile phone value-added service
providers effective July 10, 2006. These policies include a “double
confirmation” policy and the requirement that value-added service providers
provide one-month trial subscriptions. By requiring that mobile phone customers
“double-confirm” their intention to purchase services, and by requiring free
subscriptions, the Chinese government has negatively affected value-added
service providers.
Since
the
Company sells hardware to value-added service providers that have been
negatively affected by the new mobile phone policies, during the three months
ended September 30, 2006, we recorded an adjustment to inventory of $486,000.
The
write
down was considered prudent after an assessment by the Company’s internal
control team determined that the inventory was considered not readily saleable
as a result of the recent government policy restrictions.
Although
the Chinese government appeared to lessen restrictions by the end of the
third
quarter, the effect of lesser demand already necessitated a write-down of
inventory.
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
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.
PacificNet
Inc. is a leading provider of CRM and telecom services, ecommerce and gaming
technology in China. 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 and one group that focuses on primarily administrative and corporate
related matters. Through our subsidiaries we provide outsourcing services,
telecom (VAS) services, and products (telecom & gaming) 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. In 2005, we
invested Take1Technologies (Cheer Era), a company that designs, manufactures,
and distributes multimedia interactive self-service kiosks, bingo and gaming
machines for the casino and slot machine operators Europe and Asia.
In
2006,
we invested in PacificNet Games Limited (PacGames), a leading provider of
Asian
multi-player electronic gaming machines, gaming technology solutions and
gaming
related maintenance, IT and distribution services for the leading hotel,
casino
and slot hall operators based in Macau, China and other Asian gaming markets.
Macau is expected to surpass Las Vegas in total revenues by 2006. Currently,
table games make up the bulk of Macau casino revenues, which is in sharp
contrast to other areas such as Las Vegas. PacGames is a leading developer
of
electronic versions of these popular table games which are less expensive
to run
resulting in higher casino profits with great appeal to the mass market players.
Further, the growing market in Macau is for Asian table games such as Baccarat,
Roulette, Fan Tan, Fish-Prawn-Crab and Sic-Bo Cussec as these games have
wider
acceptance in the Asian market than Western games such as poker or slots.
The
development, manufacturing, maintenance, and service of electronic Asian
table
games are underserved areas which are predicted to grow considerably as Macau's
gaming market matures. PacGames products include multi-play electronic gaming
machines such as Baccarat, Fish-Prawn-Crab, Sib-Bo Cussec, Roulette, and
Video
Lottery Terminals (VLT) such as Keno and Bingo, as well as other traditional
slot machines. 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
gaming
center operations generate revenue through the sale of gaming machines to
casinos, or through resellers who sell to casinos. Currently we do not
consolidate gaming operations as we do not currently hold a controlling interest
in the gaming operations, but a 45% interest.
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)
Telecom Value-added Services: including Content Providing (CP), Interactive
Voice Response (IVR), Platform Providing (PP) and Service Providing
(SP).
(3)
Products (Telecom & Gaming): including communication and gaming products,
GSM/CDMA/3G Products, Multimedia Communication Kiosks. This Group includes
the
following subsidiaries: PacificNet Communications Limited, iMobile, Allink,
Take1 and PacificNet Games. PacificNet Games Limited (PacGames) is a leading
developer of Asian electronic gaming machines, multi-player electronic gaming
technology solutions and gaming related maintenance, IT, and distribution
services for the leading hotel and casino operators based in the Macau and
other
Asian gaming markets.
(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.
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
SEPTEMBER
30,
|
|
NINE
MONTHS ENDED
SEPTEMBER
30,
|
|
|
|
2006
(%)
|
|
2005
(%)
|
|
2006
(%)
|
|
2005
(%)
|
|
Revenues
|
|
|
100
|
|
|
100
|
|
|
100
|
|
|
100
|
|
Cost
of Revenues
|
|
|
(80.7
|
)
|
|
(80.1
|
)
|
|
(70.6
|
)
|
|
(79.8
|
)
|
Gross
Margin
|
|
|
19.3
|
|
|
19.9
|
|
|
29.4
|
|
|
20.2
|
|
Selling,
general and administrative expense
|
|
|
(19.3
|
)
|
|
(9.1
|
)
|
|
(21.1
|
)
|
|
(10.0
|
)
|
Earnings
/ (Loss) from operations
|
|
|
(13.9
|
)
|
|
(7.9
|
)
|
|
3.0
|
|
|
8.7
|
|
Earnings
/ (Loss) before income taxes, minority interest
and
discontinued operations
|
|
|
(12.5
|
)
|
|
(10.9
|
)
|
|
4.7
|
|
|
11.0
|
|
NET
EARNINGS / (LOSS)
|
|
|
(8.7
|
)
|
|
5.5
|
|
|
1.3
|
|
|
5.0
|
|
THREE
AND NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THREE AND NINE MONTHS
ENDED
SEPTEMBER 30, 2005
REVENUES.
Revenues for the three and nine months ended September 30, 2006 were $12,875,000
and $47,239,000, an increase of 17% and 45% from $11,047,000 and $32,539,000
for
the three and nine months ended September 30, 2005, respectively. During
the
third quarter and first nine months of 2006, revenues of $3,733,000, $2,350,000,
$6,411,000 and $10,312,000, $14,907,000, $18,262,000 were derived from the
services rendered by the Company's three operating units: Outsourcing Services,
Telecom Value-Added Services, and Products (Telecom & Gaming), respectively.
The revenues in product sales during the third quarter of 2006 increased
by 21%
and 37% compared to the same periods of 2005. The revenues in services sales
during the third quarter of 2006 increased by 11% and 56% compared to the
same
periods of 2005.
The
increase in revenue was mainly due to the following:
(1)
|
Outsourcing
services: The
year-over-year increase in outsourcing services for the three and
nine
months ended September 30, 2006 was primarily due to 44% and 30%
growth in
Epro compared to the same period in 2005. During the first nine
months of
2006, the outsourcing contract center in Hong Kong was at nearly
full
utilization. Driven by strong gains in outbound services, insourcing
services and facilities management services, Epro recorded double
digit
gains in revenue. As salaries continue to rise in Hong Kong and
China,
companies are under greater pressure to manage their labor costs.
Outsourcing has become an attractive tool for companies in the
region to
manage these costs. Additionally, the Company signed deals with
several
new clients, including a deal to provide customer service operation
management training for NanJing Airlines. The McDonalds Corporation
selected the Company to provide web-based quality management services
and
supplier quality management
services.
|
(2)
|
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
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 and 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 to magazines.
|
(3)
|
Products
(Telecom & Gaming): iMobile added approximately $863,000 and
$1,326,000, or accounted for 13% and 7% in this segments revenues
for the
three and nine months ended September 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 third quarter of 2006. The Company’s
18900.com website has now become one of the leading Internet e-commerce
distributor of mobile products in China, covering 1,572 cities
throughout
the nation. Additionally, during the third quarter, PacificNet
iMobile
entered into a new agreement with Motorola to become a designated
after-sales service provider for Motorola’s mobile products and
accessories in China.
Continued
strength in the Company’s Hong Kong mobile phone wholesaler subsidiary
drove sales gains. The Company believes its Hong Kong mobile phone
wholesale subsidiary is now one of the top five largest wholesalers
of
mobile phones in Hong Kong, and its position has attracted numerous
overseas wholesale buyers.
|
(4)
|
The
remaining incremental revenues for the three and nine months ended
September 30, 2006 as compared to respective period was derived
from
organic growth from existing subsidiaries, such as PacPower ($176,000
and
$2,650,000) and PacificNet Limited ($124,000 and
$949,000).
|
Acquisitions
during the first nine month of 2006 expanded PacificNet’s position as a leading
provider of e-commerce, customer services and CRM in China's mobile distribution
market, and increased our e-commerce and VAS revenues and our nationwide
CRM
service coverage. Several of our businesses experienced fluctuations in
quarterly performance.
Summarized
financial information concerning each of our main operating units is set
forth
in the following table. The "Other Business" column included our other
insignificant subsidiaries and corporate related items.
FOR
THE
THREE MONTHS ENDED
|
|
Group
1
Outsourcing
Services
|
|
Group
2.
Telecom
Value-Added Services
|
|
Group
3
Products
(Telecom
& Gaming)
|
|
Group
4
Other
Business
|
|
TOTAL
|
|
SEPTEMBER
30, 2006
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
Revenues
|
|
|
3,733,000
|
|
|
2,350,000
|
|
|
6,411,000
|
|
|
381,000
|
|
|
12,875,000
|
|
Earnings
/ (Loss) from Operations
|
|
|
113,000
|
|
|
(833,000
|
)
|
|
(191,000
|
)
|
|
(881,000
|
)
|
|
(1,792,000
|
)
|
FOR
THE
NINE MONTHS ENDED
|
|
|
|
|
|
Group
3
|
|
|
|
|
|
|
|
Group
1
|
|
Group
2
|
|
Products
|
|
Group
4
|
|
|
|
|
|
Outsourcing
Services
|
|
Telecom
Value-Added Services
|
|
(Telecom
& Gaming)
|
|
Other
Business
|
|
TOTAL
|
|
SEPTEMBER
30, 2006
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
($)
|
|
Revenues
|
|
|
10,312,000
|
|
|
14,907,000
|
|
|
18,262,000
|
|
|
3,758,000
|
|
|
47,239,000
|
|
Earnings
/ (Loss) from Operations
|
|
|
515,000
|
|
|
2,011,000
|
|
|
74,000
|
|
|
(1,163,000
|
)
|
|
1,437,000
|
|
COST
OF
REVENUES. Cost of revenues for the three and nine months ended September
30,
2006 was $10,392,000 and $33,352,000, an increase of 17% and 28% from $8,852,000
and $25,979,000 for the three and nine months ended September 30, 2005,
respectively. The cost of revenues in services sales for the three and
nine months ended September 30, 2006 increased by 8% and 14%, respectively,
and cost of revenues in product sales for the three and nine months ended
September 30, 2006 increased by 23% and 36%, respectively, in each case 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 Shanghai Classic,
PacCom and Epro. Cost of goods sold increased as sales at the Company’s mobile
phone subsidiaries increased.
GROSS
PROFIT. Gross profit for the three and nine months ended September 30, 2006
was
$2,483,000 and $13,887,000, a significant increase of 13% and 112% as compared
to $2,195,000 and $6,560,000 for the three and nine months ended September
30,
2005, respectively. Gross margin was 19% and 29% of total revenues for the
three
and nine months ended September 30, 2006, compared to 20% and 20% for the
three
and nine months ended September 30, 2005, respectively. As explained above,
the
improvement in gross margin for three and nine months periods from the prior
periods was primarily due to increased contributions from higher margin
subsidiaries. As a result of the shift in operations, we had lower revenue
and
higher than normal profit margin for project outsourcing during the three
and
nine months ended September 30, 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.
As
part
of its strategy of shifting to higher-margin businesses, the Company is
increasingly focusing on the gaming businesses. Gross profit margins from
the
company’s new PacGames subsidiary are currently more than 50%.
SELLING,
GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative
expenses totaled $2,482,000 and $9,982,000 for the three and nine months
ended
September 30, 2006, an increase of 147% and 206% from $1,004,000 and $3,261,000
for the three and nine months ended September 30, 2005, respectively. Selling,
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 during the three and nine months ended September
30,
2006 was mainly due to the increase in staff costs as well as rent and
electricity expenses for the expansion of its call center (Epro accounted
for
11% of total selling, general and administrative expenses). The marketing
expenses and staff cost from the new 3G service and Wanrong’s services also
significantly affected the total expenses during the third quarter of 2006
accounting for approximately 9% of the total selling, general and administrative
expenses. Additionally, Linkhead accounted for 9% of the total selling, general
and administrative expenses.
The
significant increase for general and administrative expenses from PacificNet
Inc. year-over-year for the first nine months of 2006 was also
partly due to $120,043 of vesting option expense for compensation cost
amortization, $92,740 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 $127,532 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 Q3 2006 and the following three quarters
(Q4
2006 and Q1 2007); and (2) the bank loan interest for Beijing Time Court
($14,347) in which the total amount of its bank loan is
$1,082,000.
EARNINGS/
(LOSS) FROM OPERATIONS. On a year-over-year basis, loss from operations
decreased 304% and 49% for the three months and nine months ended September
30,
2006, respectively. Operating earnings/(loss) of $113,000, $(833,000), and
$(191,000) for the three months ended September 30, 2006 were generated from
the
Company's three business units: (1) CRM Outsourcing Services, (2) Telecom
Value-Added Services, and (3) Products (Telecom & Gaming) Services,
respectively. This compares to operating earnings/(loss) of $217,000, $824,000
and $172,000 for the three months ended September 30, 2005, respectively.
Various factors affected operating earnings during the third 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
center sites in Hong Kong, amortization and depreciation expenses related
to the
new leasehold improvement, furniture & fixtures, computer equipment and
software incurred in the first nine months 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. 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 third quarter. Furthermore,
the acquisition of majority interests in both iMobile and Guangzhou Wanrong
during the first quarter enhanced our position in the rapidly growing B2C
market
in China.
INCOME
TAXES. Income tax provision was $(119,000) and $(319,000) for the three and
nine
months ended September 30, 2006, as compared to $13,000 and $(51,000) for
the
three and nine months ended September 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 three and nine months ended September
30,
2006 totaled $529,000 and $(1,405,000) compared with $(612,000) and $(1,916,000)
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 / (LOSS). Overall net loss year-over-year increased 282% and 62%
during
the three and nine months ended September 30, 2006, respectively. The Company’s
results for the nine months ended September 30, 2006 included a total of
$2,400,000 in non-cash expenses, including depreciation and amortization
expense
of $994,000 and $179,000 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 $1,341,000 in non-cash expenses, including depreciation and
amortization expense of $388,000. Each of our subsidiaries and investments,
including Epro, Smartime, Guangzhou 3G, Clickcom, ChinaGoHi, iMobile, PacificNet
Communications, PacificNet Limited and PacificNet Power were profitable.
LIQUIDITY
AND CAPITAL RESOURCES
CASH
AND
CASH EQUIVALENTS.
As
of
September 30, 2006, cash and cash equivalents were $7,439,000, compared to
$9,579,000 at December 31, 2005 as a result of the decrease of cash and cash
equivalents of more than $2.3million for Lion Zone. The significant reduction
for Lion Zone was primarily attributed to a loan to a related party of
approximately $2.3million, acquisition of property and equipment, and taxes
paid. The loan for Lion Zone is a related party advance with no fixed maturity
date and captioned under “Loans receivable from related Parties” in the
consolidated balance sheet.
WORKING
CAPITAL.
The
Company’s working capital increased to $28,106,000 at September 30, 2006, as
compared to $20,510,000 at December 31, 2005. When compared to balances at
December 31, 2005, an increase of 37.04% in working capital at September
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 September 30, 2006 was mainly driven from the increase of
$2,020,000 from PacPower (due to the revenues from Light Eco and Pure Air
projects), the increase of $2,224,000 from PacCom, and the increase of $523,000
from Epro.
NET
CASH
FROM OPERATING ACTIVITIES.
Net
cash
(used in) operating activities was $(6,416,000) for the nine months ended
September 30, 2006 as compared to net cash provided by operating activities
of
$133,000 for the nine months ended September 30, 2005. Net cash used in
operating activities in the nine months ended September 30, 2006 was primarily
due to net earnings of $604,000 offset by noncash items such as minority
interest of $1,405,000, depreciation and amortization of $1,173,000, decrease
in
charge in fair value of derivatives of 1,212,000, provision for allowance
for
doubtful accounts of $657,000, inventory write down of $486,000, equity profit
of associated company of $129,000, provision for income tax of $(183,000),
amortization of interest discount of $307,000, and liquidated damages expense
of
$800,000 offset by a net decrease in working capital items of $10,444,000.
The
decrease in working capital was mainly due to a decrease in accounts receivable
and other current assets of $8,281,000 and a decrease in inventories of $572,000
which mainly resulted from higher revenues and a net decrease in account
payables and accrued expenses of $1,591,000 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 $(4,811,000) for the nine months ended
September 30, 2006 compared to $(3,250,000) for the comparative prior period.
Net cash used in investing activities in the nine months ended September
30,
2006 was primarily due to the acquisition of property and equipment from
the
company, PACT strategic and PACT Limited totaling $(3,806,000), and a decrease
in acquisition of subsidiaries and affiliated companies of $419,000, offset
by
the release of the restricted cash of $1,420,000, an increase of $353,000
for
loan receivables from third parties and an decrease of $2,359,000 for loan
receivables from related parties.
NET
CASH
FROM FINANCING ACTIVITIES.
Net
cash
provided by financing activities for the nine months ended September 30,
2006
was $8,805,000, which was mainly due to the proceeds from issuance of
convertible debenture of $7,500,000 and the exercise of the share options
and
warrants of $174,000, an increase in bank loan of $1,152,000 and an increase
in
loans payable to related party of $4,000 and repurchase of treasury shares
of
$(124,000), an increase in amount borrowed under capital lease obligations
of
$77,000 and bank line of credit of $22,000. Net cash provided by financing
activities for the nine months ended September 30, 2005 was $1,521,000 which
was
primarily a result of an increase in proceeds from exercise of stock options
and
warrants of $981,000, increase in loans from related party of $513,000, and
an
increase in amount borrowed under capital lease obligations of
$29,000.
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
The
Company has convertible debt which obligates the Company to file a registration
statement with respect to the shares issuable under the convertible debt
note.
Due to various factors, as of September 30, 2006, the Company had filed the
registration statement, but it has not gone effective. Accordingly, the terms
of
the convertible note obligate the Company to pay liquidated damages to the
convertible debenture investors at the rate of 2% of the principal amount
of the
convertible per month, or $160,000. As of September 30, 2006, the Company
has determined to accrue five months of liquidated damages or approximately
$800,000, although it is possible that the Company may not ultimately need
to
pay the full amount of liquidated damages. The amount has been reflected
in the
consolidated financial statements as a separate line item on the consolidated
balance sheet as “liquidated damages liability” and as a separate line item on
the consolidated statement of operations as “liquidated damages
expense”.
We
have
significant cash resources to meet our contractual obligations as of September
30, 2006, as detailed below:
Payments
Due by Period
Contractual
Obligations
|
|
Total
|
|
Less
than 1 year
|
|
1-5
years
|
|
After
5 years
|
|
Line
of credit
|
|
$
|
1,082,000
|
|
$
|
1,082,000
|
|
|
0
|
|
|
0
|
|
Bank
Loans
|
|
$
|
2,428,000
|
|
$
|
992,000
|
|
$
|
470,000
|
|
$
|
966,000
|
|
Operating
leases
|
|
$
|
775,000
|
|
$
|
463,000
|
|
$
|
312,000
|
|
|
0
|
|
Capital
leases
|
|
$
|
281,000
|
|
$
|
133,000
|
|
$
|
148,000
|
|
|
0
|
|
Total
cash contractual obligations
|
|
$
|
4,566,000
|
|
$
|
2,670,000
|
|
$
|
930,000
|
|
$
|
966,000
|
|
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. The economic environment in China can
often involve dealing with arbitrary regulations, especially with regard
to the
telecommunications sector.. With this exception, 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 CFO concluded that as of September 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 implemented remediation initiatives and interim measures beginning
in
the second quarter and continues to implement such initiatives.
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
continues to reviewe and 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 for China operations, a position which will be permanently stationed
in
China. 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. 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. In May 2006,
the
Company announced the resignation of Mr. ShaoJian Wang as the CFO effective
May
26, 2006, as a result of this new position at Hurray! Holding Co. Ltd.
(Nasdaq:HRAY) as their President and Chief Operating Operator. Mr. Wang has
remained as a director of PacificNet. In September 2006, the Company announced
the hiring of its new CFO, Mr. Joseph Levinson, a former manager at Deloitte
and
Touche in New York.
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 successfully implemented the Kingdee K/3 Software for all its wholly
owned subsidiaries. In the second quarter of 2006, the Company rolled out
the Kingdee K/3 Software for its other partially owned subsidiaries and joint
ventures in China.
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, and in Part II, Item IA Risk
Factors in our Amendment to Quarterly Report on Form 10-Q for the period
ended
June 30, 2006 which could materially affect our business, financial condition
or
future results. The risks described in our Annual Report on Form 10-KSB and
the
Amendment to our Quarterly Report on Form 10-Q 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.
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 (Principal Executive
Officer)
|
31.2
|
Rule
13a-14(a) Certification of Chief Financial Officer (Principal 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: November
17, 2006
|
By:
|
/s/ TONY
TONG
|
|
Tony
Tong
Chief
Executive Officer
(Principal
Executive Officer)
|
|
|
|
|
|
|
Date: November
17, 2006
|
By:
|
/s/ Joseph
Levinson
|
|
Joseph
Levinson
Chief
Financial Officer
(Principal
Financial Officer)
|
43