FOR THE TRANSITION PERIOD FROM __________ TO __________

 

COMMISSION FILE NUMBER: 000-24985

 

 

PACIFICNET INC.

(Exact name of small business issuer in its charter)

 

 

DELAWARE	91-2118007
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
23/F, TOWER A, TIMECOURT, NO.6 SHUGUANG XILI,  CHAOYANG DISTRICT, BEIJING, CHINA 100028	N/A
(Address of principal executive offices)	(Zip Code)

 

Registrant's Telephone Number: 0086-10-59225000

601 New Bright Building, 11 Sheung Yuet Road, Kowloon Bay, Kowloon, Hong Kong.

(Former Name and Address)

 

Securities Registered under Section 12(b) of the Exchange Act: NONE

 

Securities Registered under Section 12(g) of the Exchange Act: Common Stock, par value $0.0001

 

Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act o

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

 

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12(b) of the Exchange Act). Yes o No x

 

Issuer's revenues for its most recent fiscal year: $44,341,000. The aggregate market value of the common stock held by non-affiliates of the registrant as of March 31, 2006 was approximately $66,627,235, based upon the closing sale price of $7.39 per share as reported by The NASDAQ National Market on such date. There were 13,238,497 shares of the Company's common stock outstanding on March 31, 2006.

 

Transitional Small Business Disclosure Format (check one): Yes o No x

 

DOCUMENTS INCORPORATED BY REFERENCE - NONE

 

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Explanatory Note:

 

This Annual Report on Form 10-KSB/A (“Form 10-KSB”) is being filed as Amendment No. 1 to our Annual Report on Form 10-KSB/A for the year ended December 31, 2005, which was originally filed with the Securities and Exchange Commission (“SEC) on April 28, 2006 (the “Original Filing”). We are amending and restating the following specific items in this Amendment No. 1:

 

(i)	Part II. Item 6. Management’s Discussion and Analysis or Plan of Operation- to expand disclosures as a result of amendments to the financial statements.

 

(ii)

Part II. Item 7. Financial Statements- to restate the financial statements, including certain adjustments made to the Company’s 203 financial statements regarding the recording of business acquisitions and to expand disclosures for goodwill, property and equipment, subscription payable, income taxes and segment information.

 

(iii)

Part III. Item 9. Directors, Executive Officer, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act to update officer information for our recently appointed CFO.

 

(iv)	Part III. Item 13. Exhibits and Reports on Form 8-k- to reflect inclusion of updated officer certifications in Exhibits 31 and 32 for this amended filing.

 

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PART I		4
ITEM 1. DESCRIPTION OF BUSINESS		4
ITEM 2. DESCRIPTION OF PROPERTY		26
ITEM 3. LEGAL PROCEEDINGS		27
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		27
PART II		28
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS		28
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION		29
ITEM 7. FINANCIAL STATEMENTS		37
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		37
ITEM 8A. CONTROLS AND PROCEDURES		37
ITEM 8B. OTHER INFORMATION		38
PART III		39
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT		39
ITEM 10. EXECUTIVE COMPENSATION		44
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.		45
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.		46
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K.		46
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES		47

 

 

This annual report contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as "anticipate," "expect," "intend," "plan," "will," "we believe," "the Company believes," "management believes" and similar language. The forward-looking statements are based on our 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." Our actual results may differ materially from results anticipated in these forward-looking statements. We base our forward-looking statements on information currently available to us, and we assume no obligation to update them.

 

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PART I

 

ITEM 1. DESCRIPTION OF BUSINESS

 

As used in this report, "we", "us," "our," "Company", "PacificNet" or "PACT" refers to PacificNet Inc., a Delaware corporation.

 

OVERVIEW

 

We were incorporated in the state of Delaware in 1987. Our business consists of four groups, all of which operate within the outsourcing and telecommunications industries in Asia, primarily Greater China, which includes the People's Republic of China (PRC), or mainland China, Hong Kong Special Administrative Region (HKSAR), Macau Special Administrative Region, and Taiwan. Through our subsidiaries we invest in and operate companies that provide outsourcing services, value-added telecom services (VAS) and communication products distribution services. Our business process outsourcing (BPO) services include call centers, providing customer relationship management (CRM), and telemarketing services, and our information technology outsourcing (ITO) includes software programming and development. We are value-added resellers and providers of telecom VAS, which comprises interactive voice response (IVR) systems, call center management systems and voice over internet protocol (VOIP), as well as mobile phone VAS, such as short messaging services (SMS) and multimedia messaging services (MMS). Our communication products distribution services include the wholesale and retail sale and distribution of calling cards in China, multimedia interactive self-service kiosk distribution and online mobile phone distribution. We also have a number of subsidiaries that we use primarily for administration, internal control and acquisition purposes. 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 revenues from call center services, call center management software sales, and training and consulting. We invoice our call center clients monthly at per seat monthly rates, a base price plus commission per call, or a per hour charge rate, depending on the client's preference. Our call center software clients pay per license, for which there is usually a one-time charge on sale of the software and annual maintenance fees for service. We charge per project for our consulting and training services and for our telecom VAS, which are invoiced throughout the project. Our telecom VAS often includes a post-sale service contract for systems integration and consulting services for which we bill separately. Our communication products such as calling cards, kiosks and cell phones are sold cash-on-delivery.

 

Our clients include the leading telecom operators, banks, insurance, travel, marketing, and service companies, as well as telecom consumers, in Greater China. Clients include China Telecom, China Netcom, China Mobile, China Unicom, PCCW, Hutchison Telecom, CSL, SmarTone, Sunday, Swire Travel, Coca-Cola, SONY, Samsung, Motorola, Nokia, TNT Express, Huawei, TCL, Dun & Bradstreet, American Express, Bank of China, DBS, Hong Kong Government, and Hongkong Post. PacificNet employs over 2,000 staff in our various subsidiaries in China with offices in Hong Kong, Beijing, Shanghai, Shenzhen, and Guangzhou.

 

PacificNet's operations include the following four groups:

 

(1) Outsourcing Services: including Business Process Outsourcing (BPO), call center, IT Outsourcing (ITO) and software development services.

 

(2) Value-Added Telecom Services (VAS): including Content Providing (CP), Interactive Voice Response (IVR), Platform Providing (PP) and Service Providing (SP).

 

(3) Communication Products Distribution Services: including calling cards, GSM/ CDMA/ XiaoLingTong products, and multimedia self-service kiosks.

 

(4) Other Business: including internal administrative matters and other related corporate items.

 

CORPORATE STRUCTURE

 

The chart attached herein as Exhibit 99.1, sets forth our corporate and share ownership structure as of the date of this annual report.

 

We conduct our business operations through the following business units and subsidiaries:

 

(I) OUTSOURCING SERVICES GROUP

 

1) PACIFICNET EPRO HOLDINGS LIMITED (FORMERLY KNOWN AS: EPRO TELECOM HOLDINGS LIMITED)

 

PacificNet Epro Holdings Limited (referred to herein as "Epro"), a company incorporated in the Hong Kong Special Administrative Region of the PRC, is engaged in the business of providing call center and customer relationship management (CRM) services, mobile marketing and promotion services, call center training, management and consulting services, call center software, IVR systems, mobile payment and mobile point of sale (POS) solutions, Internet e-commerce and mobile commerce, mobile applications based on short messaging services (SMS), multimedia messaging services (MMS), outsourced telemarketing and customer support services, and other mobile value-added services (VAS). Epro's business serves Hong Kong and the PRC's telecom operators, banks, insurance, and other financial services companies in the PRC. Epro's clients include major telecom operators, banks, insurance and financial services companies in Greater China, such as China Telecom (NYSE: CHA), China Unicom (NYSE: CHU), PCCW (NYSE: PCW), CSL, SmarTone Telecom, Sunday Communications (NASDAQ: SDAY), Hutchison Whampoa Limited (HKSE: 0013.HK), Swire Coca-Cola, Samsung, Dun & Bradstreet, DBS, Dao Heng Insurance, Shenzhen Development Bank, Hong Kong Government Housing Authority and Hong Kong Post.

 

 

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2) PACIFIC SMARTIME SOLUTIONS LIMITED / PACIFIC SOLUTIONS TECHNOLOGY (SHENZHEN) CO. LTD.

 

Pacific Smartime Solutions Limited (referred to herein as "Smartime") is an IT outsourcing company incorporated in Hong Kong that operates through its China subsidiary Pacific Solutions Technology ( Shenzhen ) Co. Ltd. (referred to herein as: Soluteck Shenzhen), which is a leading provider of outsourcing services including software development, R&D, and project management services in China. Smartime employs over 280 staff and provides outsourcing services to the leading telecom, banking and financial services companies in China, including Huawei, IBM, Bank of East Asia. In December 2004, Smartime launched a new software development outsourcing center in Shenzhen, located in a Grade A office building, currently occupying two floors (total 26,000 square feet) with the capacity to expand to two additional floors. Each of the two floors will have the capacity to house about 200 employees. The new outsourcing development center will serve its existing clients, which includes some of the world's leading telecom and IT companies.

 

3) PACIFICNET SOLUTIONS LIMITED (Incorporated in Hong Kong)

 

PacificNet Solutions Ltd. (referred to herein as "PacSo"), incorporated in Hong Kong is a subsidiary that specializes in systems integration, software application, and e-business solutions services in Hong Kong and Greater China. The scope of PacSo's products and services includes smart card solutions, web based front-end applications and web based connections to backend enterprise planning systems.

 

(II) VALUE-ADDED TELECOM SERVICES (VAS) GROUP

 

CONTENT PROVIDER COMPANY

 

CHINAGOHI/LION ZONE (SPECIAL PURPOSE VEHICLE (SPV)), HOLDING COMPANY FOR CHINAGOHI

 

In December, 2005, we acquired a controlling interest in Shenzhen GuHaiGuanChao Investment Consultant Company Limited ("ChinaGoHi"), a wholly owned foreign enterprise (WOFE) registered in China, through the purchase of a 51% interest of ChinaGoHi's parent, GoHi Holdings Limited (referred to herein as "Lion Zone"), a British Virgin Islands company. Lion Zone is an investment holding company principally engaged in providing investment advisory consulting services and direct response television (DRTV) telemarketing services. Through ChinaGoHi, we provide infomercial marketing services and telemarketing services and financial advisory services in China, including Direct Response Television (DRTV) infomercials through satellite and cable TV broadcasting, web portals, and subscription-based value-added services including Internet email, short message services (SMS), mobile WAP services, and interactive voice response (IVR) services via fixed and mobile phones. ChinaGoHi ("ChinaGoHi", http://www.ChinaGoHi.cn) is a leading information content provider of Chinese stock market information, analysis, and investment advisory services via DRTV infomercials through satellite and cable TV broadcasting, IVR, SMS and WAP based mobile value-added services, web portals and subscription based audio-video streaming via the Internet.

 

PLATFORM PROVIDING COMPANY

 

BEIJING LINKHEAD TECHNOLOGIES COMPANY LIMITED (Incorporated in the PRC)

 

Beijing Linkhead Technologies Company Limited, (referred to herein as "Linkhead"), a PRC limited liability corporation, is engaged in the business of providing value-added services (VAS), interactive voice response (IVR) system development and integration, voice Internet portals, computer telephony integration (CTI), VoIP, Internet and mobile application development, telecom customer relationship management (CRM) services for China's telecom operators, telecom related management and consulting services, mobile consumer analytics, mobile data-mining, Internet e-commerce and mobile commerce, mobile applications based on WAP, K-Java, BREW, EMS, short messaging services (SMS), multimedia messaging services (MMS), outsourced software development, and other mobile value-added services (VAS) in the PRC. Linkhead's major clients and profit-sharing partners include some of the leading telecom operators such as China Telecom, China Mobile, China Unicom. Linkhead is also channel partner, or a master reseller, of NMS Communications (NASDAQ: NMSS), a leading provider of communications technologies and solutions which enable new enhanced services and efficient networks that help customers grow their profits and revenue.

 

 

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SERVICE PROVIDER COMPANIES

 

1) PACIFICNET CLICKCOM LIMITED (INCORPORATED IN THE PRC)

 

In December 16, 2004, we entered an agreement to acquire a controlling interest in Guangzhou Clickcom Digit-net Science and Technology Ltd ("Clickcom-WOFE") through the purchase of a 51% interest of Clickcom-WOFE's parent company, PacificNet Clickcom Limited, a British Virgin Islands Company ("Clickcom-BVI"). The deal has been completed on March 28, 2005. Clickcom-WOFE conducts its VAS operations with GuangZhou DianXun Company Limited ("Dianxun-DE"), a PRC registered Domestic Enterprise (DE)., through a series of contractual agreements. Under these agreements, the shareholders of Dianxun-DE are required to transfer their ownership in these entities to our subsidiaries when permitted by PRC laws and regulations and all voting rights are assigned to us. Through Clickcom-WOFE, we have also entered into a consulting and services agreements with Dianxun-DE, under which Clickcom-WOFE provides technical services and other services to Dianxun-DE in exchange for all of the net income of Dianxun-DE. In addition, the shareholders of Dianxun-DE have pledged their shares in Dianxun-DE as collateral for non-payment of fees for the services we provide. Through Clickcom-WOFE we provide directly to China's telecom operators a wide variety of wireless Internet services for mobile phones, such as SMS, Wireless Application Protocol (WAP), which allows users to access information instantly via handheld wireless devices and Java mobile applications. The acquisition of Clickcom-WOFE is our first step in entering the VAS service provider market in which we will be able to design our own mobile phone VAS for distribution directly to telecom operators.

 

2) GUANGZHOU 3G INFORMATION TECHNOLOGY CO. LIMITED (Incorporated in the PRC)

 

In March 2005 we entered an agreement to acquire a controlling interest in Guangzhou 3G Information Technology Co. Ltd. ("Guangzhou3G-WOFE"), a PRC registered wholly owned foreign enterprise (WOFE), through the purchase of a 51% interest in Guangzhou 3G's parent company, Pacific 3G Information & Technology Co. Limited, a British Virgin Islands Company ("Guangzhou3G-BVI"). Guangzhou3G-WOFE conducts it VAS operations with Guangzhou Sunroom Information Industrial Co., Ltd. ("Sunroom-DE"), a PRC registered Domestic Enterprise (DE), through a series of contractual agreements. Under these agreements, the shareholders of Sunroom-DE are required to transfer their ownership in these entities to our subsidiaries when permitted by PRC laws and regulations and all voting rights are assigned to us. Through Guangzhou3G-WOFE, we have also entered into a consulting and services agreements with Sunroom-DE, under which Guangzhou3G-WOFE provides technical services and other services to Sunroom-DE in exchange for all of the net income of Sunroom-DE. In addition, the shareholders of Sunroom-DE have pledged their shares in Sunroom DE as collateral for non-payment of fees for the services we provide. Sunroom-DE is one of the largest value-added telecom and information services providers in China with both voice (IVR and call center) and data (SMS, MMS, WAP, JAVA, GPRS) connection to the four major telecom operators in Asia, China Mobile, China Unicom, China Telecom, and China Netcom, covering both mobile and fixed-line networks. Guangzhou 3G-DE also offers a wide variety of IVR and other wireless and fixed-line, value-added telecom services including color ring back tone (CRBT) services, background music (BGM) services, video ICQ (VICQ) mobile instant messaging services, sports and soccer news, weather forecasts, stock prices, jokes, short stories, dramas, songs and mobile karaoke, mobile TV, games, entertainment, as well as community-oriented services, such as chatline and dating services. Mobile and fixed-line phone users can access Guangzhou 3G-DE's IVR services through one of the four major telecom operators' networks. Guangzhou 3G-DE currently employs 280 staff, and has offices in 26 provinces in China including Guangdong, Guangxi, Hubei, Hunan, Jiangsu, Zhejiang, Shanghai, Henan, Anhui, Yunnan, Gansu, Ningxia, Inner Mongolia, Guizhou, Tianjin, Qinghai, Hainan, Heilongjiang, Shanxi, Shandong, Chongqing, Jiangxi, Beijing, Hebei, Liaoning, and Jilin. Guangzhou 3G's market covers all the major regions of China with over 3 million accumulated fee paying customers.

 

3) GUANGZHOU WANRONG INFORMATION TECHNOLOGY CO., LIMITED (Incorporated in the PRC)

 

On January 31, 2006, we consummated an agreement to acquire a 51% majority interest in Guangzhou Wanrong Information Technology Co., Ltd. ("Guangzhou Wanrong,), one of the leading value-added telecom service providers in China. Since its inception in 2003, Guangzhou Wanrong has achieved strong growth in its VAS including SMS, WAP, JAVA, MMS, IVR, multimedia entertainment download services, media interactive products, mobile email services, life, sports, entertainment, and business information services. Guangzhou Wanrong was granted nationwide SMS service numbers "2388" for China Mobile and "9928" for China Unicom.

 

4) IPACT INTERNATIONAL INVESTMENT LIMITED (Incorporated in the BVI)

 

Our subsidiary, PacificNet Strategic Investment Holdings Limited holds an 80% equity interest in IPACT International Investment Limited ("IPACT"). IPACT is a newly formed business entity in October 2005. Its primary business will be to sign up qualified Voice-VAS and IVR service providers as profit sharing members in China under a unified brand "iPACT". We will provide to qualified VAS-Alliance partners, on a profit sharing basis, all of the hardware, software, application, and content for VAS, including a variety of IVR and other wireless and fixed-line VAS content, including color ring back tone (CRBT) services, background music (BGM) services, VICQ mobile instant messaging services, sports news, weather forecasts, stock market, humor, songs and mobile karaoke, mobile TV, games, entertainment, as well as community-oriented services, such as chatline and dating services. Mobile and fixed-line phone users can access PacificNet's VAS-Alliance services through Guangzhou 3G presence in 26 provinces in China.

 

 

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5) PACIFICNET AD. LIMITED (Incorporated in Hong Kong)

 

PacificNet Ad. Limited was incorporated in Hong Kong in December 2005 and 68% of its outstanding equity shares are held by PacificNet Limited. Its principle business is advertising and media services.

 

(III) COMMUNICATION PRODUCTS DISTRIBUTION GROUP

 

1) PACIFICNET COMMUNICATIONS LIMITED

 

PacificNet Communications Limited (referred to herein as "PacCom"), incorporated in Hong Kong, is a wholly owned subsidiary of PacificNet that specializes in the sales and distribution of mobile communication products, accessories, phone cards and mobile SIM cards, and telecom related services in Hong Kong and Greater China.

 

2) PACIFICNET IMOBILE (BEIJING) TECHNOLOGY CO., LIMITED (Incorporated in the PRC)

 

On February 06, 2006, we entered into an agreement to acquire a 51% majority interest in PacificNet iMobile (Beijing) Technology Co., Ltd ("iMobile"), one of the leading Internet information portal and e-commerce distributors for mobile phone and accessories and mobile related value-added service providers in China. iMobile operates its e-commerce business via two Internet portals, "http://www.iMobile.com.cn" and "http://www.18900.com" and one WAP portal "17wap.com" for mobile phone browsing. In addition, iMobile's 18900.com operation is the designated Internet distributor for Motorola, Nokia, and NEC's mobile products in China. 18900.com is the leading Internet e-commerce distributor of mobile products in China, and provides Internet, email, customer service centers, pre-sale and post-sale services, logistics and cash-on-delivery (COD) services to mobile related products in China. iMobile's 18900.com e-commerce operations combines both online Internet services with its offline customer services network composed of a nationwide chain of logistic and customer centers covering 22 provinces and 40 major cities in China, including Beijing, Shanghai, Chongqing, Tianjin, Chengdu, Dalian, Qingdao, Guangzhou, Shenzhen, Zhuhai, Dongguan, Hangzhou, Suzhou, Ningbo, Wenzhou, Nanjing, Wuhan, Xi'an, Harbin, Qiqihaer, Hunan and Changsha. iIMobile's Internet portal has been one of the top ranked traffic sites and has achieved about 2.3 million registered online users and over 400,000 active users, with 5 million daily page views and 20,000 blog postings per day, which makes iMobile the top ranked site in its category in China. It is expected this acquisition was structured in the same manner as our other acquisitions, with operation and services agreements between Beijing Xing Chang Xin Science and Technology Development Co. Limited Incorporated DE and PacificNet Imobile (Beijing) Technology, Co. Ltd. WOFE.

 

3) SHGNAHAI CLASSIC GROUP LIMITED

 

Shanghai Classic Group Limited ("Shanghai Classic"), is a subsidiary of PacificNet that specializes in the distribution of communication products and services. Shanghai Classic's subsidiary YueShen is a distributor of telecom services including phone cards, mobile SIM cards, prepaid stored-value cards, re-chargeable phone cards, VoIP and IDD calling cards.

 

4) TAKE1 TECHNOLOGIES GROUP LIMITED ("TAKE1" , FORMERLY KNOWN AS: CHEER ERA LIMITED)

 

Take1 (http://www.take1technologies.com/) is a leading designer, developer and manufacturer of multimedia entertainment and communication kiosk products including photo and video entertainment kiosks, digital camera photo development stations, multimedia messaging services (MMS) and mobile content download, payment and delivery stations for mobile phones, and other coin-operated kiosks and kiosk consumables. Take1 markets and distributes its multimedia communication stations around the world including the USA, Canada, Mexico, Europe, Korea, China, India and SE Asia. Take1 is headquartered in Hong Kong with operations in China, Canada, and USA.

 

(IV) OTHER BUSINESS ENTITIES

 

1) PACIFICNET LIMITED (INCORPORATED IN HONG KONG)

 

PacificNet Limited is incorporated in Hong Kong as a wholly owned subsidiary of PacificNet Inc. Its primary purpose is to handle the general administrative operations of PacificNet in Hong Kong.

 

2) PACIFICNET STRATEGIC INVESTMENT HOLDINGS LIMITED (Incorporated in the BVI)

 

PacificNet Strategic Investment Holdings Limited (referred to herein as "PacInvest"), incorporated in the British Virgin Islands (BVI), is a wholly owned subsidiary of PacificNet that specializes in strategic investment, direct investment, mergers and acquisitions, joint venture development, and other financial and investment services in Hong Kong and Greater China. Its primary purpose is to help PacificNet identify strategic investment opportunities, process deal flow, conduct due diligence, negotiate terms and valuation, monitor investment performance and conduct synergy development, with a focus in Chinese investment opportunities related to PacificNet's business.

 

 

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3) PACIFICNET POWER LIMITED (Incorporated in Hong Kong)

 

PacificNet Power Ltd. (referred to herein as "PacPower"), incorporated in Hong Kong, is a subsidiary that specializes in information technology (IT) solutions, systems integration, software application, energy saving and electric power management systems and solutions in Hong Kong and Greater China. PacificNet Power was registered in Hong Kong in January 2005 as a subsidiary of PacificNet Limited with 51% controlling ownership by PacificNet.

 

4) PERPETUAL GROWTH INVESTMENTS LIMITED (Incorporated in the BVI)

 

Perpetual Growth Investments Limited incorporated in the British Virgin Islands (BVI), is a wholly owned subsidiary of PacificNet Communications Limited.

 

5) PACIFIC FINANCIAL SERVICES LIMITED (Incorporated in Hong Kong)

 

Pacific Financial Services Limited incorporated in Hong Kong in November 2005, is a wholly owned subsidiary of PacificNet Inc. Its primary purpose is to provide financial services in Hong Kong.

 

6) PACIFICNET GAMES LIMITED (Incorporated in the BVI)

 

PacificNet Games Limited incorporated in the British Virgin Islands (BVI), is a wholly owned subsidiary of PacificNet Strategic Investment Holdings Limited. Its primary purpose is to design and distribute Internet online games and offline gaming machines.

 

7) PACIFICNET TECHNOLOGY (SHENZHEN) LIMITED (Incorporated in the PRC)

 

PacificNet Technology (Shenzhen) Limited (referred to herein as "PacSZ") is incorporated in the PRC as a wholly owned foreign enterprise (WOFE) , is a wholly owned subsidiary of PacificNet Limited Hong Kong. Its primary purpose is to provide administrative support back-office, IT support and software development services, to support PacificNet's operations in China, and to conduct the general administrative operations of PacificNet in China.

 

8) PACIFICNET BEIJING LIMITED (Incorporated in the PRC)

 

PacificNet Beijing Limited (referred to herein as "PacBJ") incorporated in the PRC as a wholly owned foreign enterprise (WOFE) is a wholly owned subsidiary of PacificNet Limited Hong Kong. Its primary purpose is to provide administrative back-office support, IT support and software development services, to support PacificNet's operations in China, and to conduct the administrative operations of PacificNet in China.

 

 

EMPLOYEES

 

As of December 31, 2005, together with our subsidiaries, we had approximately 2,300 employees and contractors. We have not experienced any labor stoppages. None of our employees are covered by collective bargaining agreements. The breakdown of number of employees for each of the business units of the Company is as follows:

 

COMPANY AND SUBSIDIARIES	NUMBER OF EMPLOYEES
PacificNet Inc.	5
PacificNet Limited (Hong Kong)	12
PacificNet Beijing	16
PacificNet Shenzhen	13
PacificNet Guangzhou	1
PacificNet Solutions Ltd.	1
PacificNet Power Ltd.	4
PacificNet Epro (Epro Telecom Holdings Limited)	750
Beijing Linkhead Technologies Company Limited	60
Shanghai Classic Group Limited (Yueshen)	32
Smartime / Soluteck Technology (Shenzhen) Company Limited	170
Guangzhou 3G (Sunroom)	280
Clickcom (Dianxun)	10
ChinaGoHi (Lion Zone, GuHaiGuanChao)	860
Wanrong	42
iMobile	58
TOTAL	2314

 

 

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RESEARCH AND DEVELOPMENT

 

We place great emphasis on the continued enhancement of our existing products and solutions, including designing, developing and supporting a portfolio of converged voice and data enhanced services, products and solutions to help wireless, fixed-line and Internet service providers offer unprecedented access to communications, information and commerce. We have ongoing research and development activities with respect to the following products and solutions:

 

l	multi-media information on demand systems, which integrates the dynamics of the Internet with voice-based communication applications, including text-to-speech and voice recognition capabilities;
l	web-based multimedia call center/customer relationship management for service providers and corporations;
l	WISE-xb, which is a call center agent performance management and reporting software. It provides intelligent routing, comprehensive ACD/PBX capabilities, Email, IVR, Voice Mail, Messaging, Conference, Recording, Coaching/Supervising, Reporting and Interface.;
l	voice mail systems;
l	color ringback tone systems; and
l	value-added services for mobile users.

 

EXECUTIVE OFFICES

 

Our executive offices are located in Hong Kong, Beijing, Shenzhen, Guangzhou, China, and Minneapolis, USA, at the following addresses:

 

PacificNet Limited 601 New Bright Building, 11 Sheung Yuet Road, Kowloon Bay, Kowloon, Hong Kong.

Tel: 011-852-2876-2900, Fax: 011-852-27930689, HKOffice@PacificNet.com

 

PacificNet Shenzhen Office:

Room 901, Tower A, Tian An High-Tech Plaza, Tian An Cyber Park, Fu Tian District, Shenzhen, China Postal Code: 518040

 

PacificNet Guangzhou Office:

15/F, Building A, Huajian Plaza, No. 233 Tianfu Road, Tianhe District, Guangzhou, China Postal Code: 510630

 

PacificNet Beijing Office:

23/F, Building A, TimeCourt, No.6 Shuguang Xili, Chaoyang District, Beijing, China

Postal Code: 100028     Tel:86-010-59225000

 

PacificNet Inc.

860 Blue Gentian Road, Suite 360, Eagan, MN 55121-1575, USA.

Tel: +1-651-209-3100,   Fax: +1-651-209-3103,   Email: IR@PacificNet.com

 

We maintain a website at www.PacificNet.com.

 

RISK FACTORS

 

Investing in our securities involves a great deal of risk. Careful consideration should be made of the following factors as well as other information included in this prospectus before deciding to purchase our common stock. You should pay particular attention to the fact that we conduct a majority of our operations in China and are governed by a legal and regulatory environment that in some respects differs significantly from the environment that may prevail in other countries. Our business, financial condition or results of operations could be affected materially and adversely by any or all of these risks.

 

THE FOLLOWING MATTERS MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS, FINANCIAL CONDITION, LIQUIDITY, RESULTS OF OPERATIONS OR PROSPECTS, FINANCIAL OR OTHERWISE. REFERENCE TO THIS CAUTIONARY STATEMENT IN THE CONTEXT OF A FORWARD-LOOKING STATEMENT OR STATEMENTS SHALL BE DEEMED TO BE A STATEMENT THAT ANY ONE OR MORE OF THE FOLLOWING FACTORS MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN SUCH FORWARD-LOOKING STATEMENT OR STATEMENTS.

 

RISKS RELATED TO OUR BUSINESS

 

WE HAVE A LIMITED OPERATING HISTORY AND RECENTLY EXPERIENCED A SIGNIFICANT INCREASE IN REVENUE THAT MAY NOT BE SUSTAINED.

 

Our business operations commenced in 1994, and subsequently the business was incorporated as a Delaware corporate entity in 1999. Our operating history may be insufficient to evaluate our business and future prospects. Although our revenues have grown rapidly in the past two years, primarily as a result of our increased acquisition activity, we cannot assure investors that we will maintain our profitability or that we will not incur net losses in the future. We expect that our operating expenses will increase as we expand. Any significant failure to realize anticipated revenue growth could result in significant operating losses. We will continue to encounter risks and difficulties in implementing our business model, including our potential failure to:

 

 

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l	increase awareness of our brands, protect our reputation and develop customer loyalty;
l	manage our expanding operations and service offerings, including the integration of any future acquisitions;
l	maintain adequate control of our expenses; and
l	anticipate and adapt to changing conditions in the markets in which we operate as well as the impact of any changes in government regulation, mergers and acquisitions involving our competitors, technological developments and other significant competitive and market dynamics.

 

If we are not successful in addressing any or all of these risks, our business may be materially and adversely affected.

 

THE ACQUISITION OF NEW BUSINESSES IS COSTLY AND SUCH ACQUISITIONS MAY NOT ENHANCE OUR FINANCIAL CONDITION.

 

Our growth strategy is to acquire companies and identify and acquire assets and technologies from businesses in greater China that have services, products, technologies, industry specializations or geographic coverage that extend or complement our existing business. The process to undertake a potential acquisition is time-consuming and costly. We expend significant resources to undertake business, financial and legal due diligence on our potential acquisition target and there is no guarantee that we will acquire the company after completing due diligence. Any future acquisitions will be subject to a number of challenges, including:

 

l	the diversion of management time and resources and the potential disruption of our ongoing business;
l	difficulties in maintaining uniform standards, controls, procedures and policies;
l	potential unknown liabilities associated with acquired businesses;
l	the difficulty of retaining key alliances on attractive terms with partners and suppliers; and
l	the difficulty of retaining and recruiting key personnel and maintaining employee morale.

 

Our acquisitions could result in the use of substantial amounts of cash, potentially dilutive issuances of equity securities, significant amortization expenses related to goodwill and other intangible assets and exposure to undisclosed or potential liabilities of acquired companies. During the fiscal year ended December 31, 2005, we acquired a controlling interest in Guangzhou 3G Information Technology Co. Ltd. ("Guangzhou3G-WOFE") Click-WOFE and Shenzhen GuHaiGuanChao Investment Consultant Company Limited ("ChinaGoHi"), a wholly owned foreign enterprise (WOFE) registered in China. We expect that acquisitions will strengthen our position as a provider of outsourced call center, VAS and communication products in Asia. Although our agreements provide that the consideration is payable upon the acquired company attaining certain income milestones annually, there is no guarantee that these milestones will be reached. If they are not reached as anticipated, the time, cost and capital to acquire the company may outweigh the anticipated benefits from consolidation of their income. PacificNet recorded approximately $8.88 million of goodwill as a result of several acquisitions that is not subject to amortization in the ordinary course of business. To the extent that the businesses acquired in these transactions do not remain competitive, some or all of the goodwill related to that acquisition could be charged against future earnings.

 

A SUBSTANTIAL PORTION OF OUR BUSINESS DEPENDS ON MOBILE TELECOMMUNICATIONS OPERATORS IN CHINA AND ANY LOSS OR DETERIORATION OF SUCH RELATIONSHIPS MAY RESULT IN SEVERE DISRUPTIONS TO OUR BUSINESS OPERATIONS.

 

We rely entirely on the networks and gateways of China Mobile and China Unicom to provide our wireless value-added services. Thus, we face certain risks in conducting our wireless value-added services business, such as the following:

 

Currently, China Mobile and China Unicom are the only mobile telecommunications operators in China that have platforms for wireless value-added services. Our agreements with them are generally for a period of less than one year and generally do not have automatic renewal provisions. If neither of them is willing to continue to cooperate with us, we will not be able to conduct our existing wireless value-added services business.

 

Our agreements with China Mobile and China Unicom are subject to negotiation upon expiration. If any of the mobile telecommunications operators decides to change its content or transmission fees or its share of revenue, or does not comply with the terms of the agreement, our revenue and profitability could be materially adversely affected.

 

THE MOBILE TELECOMMUNICATIONS OPERATORS MAY LAUNCH AND MAY HAVE ALREADY LAUNCHED COMPETING SERVICES OR COULD DISCONTINUE THE USE OF EXTERNAL CONTENT AGGREGATORS SUCH AS OURSELVES ENTIRELY AT ANY TIME.

 

 

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Due to our reliance on the mobile telecommunications operators for our wireless value-added services, any loss or deterioration of our relationship with any of the mobile telecommunications operators may result in severe disruptions to our VAS business operations and the loss of a significant portion of our revenue.

 

OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS MAY BE MATERIALLY AFFECTED BY THE CHANGES IN POLICIES OR GUIDELINES OF THE MOBILE TELECOMMUNICATIONS OPERATORS.

 

The mobile telecommunications operators in China may, from time to time, issue certain operating policies or guidelines, requesting or stating its preference for certain actions to be taken by all wireless value-added service providers using their platforms. Due to our reliance on the mobile telecommunications operators, a significant change in their policies or guidelines may have a material adverse effect on us. For example, some mobile telecommunications operators recently revised their billing policies to request all wireless value-added service providers to confirm the subscription status of those users who have not been active for three months. Such change in policies or guidelines may result in lower revenue or additional operating costs for us, and we cannot assure investors that our financial condition and results of operations will not be materially adversely affected by any policy or guideline change by the mobile telecommunications operators in the future.

 

WE MAY BE SUBJECT TO ADVERSE ACTIONS FOR ANY BREACH OR PERCEIVED BREACH BY US OF THE POLICIES OR GUIDELINES IMPOSED BY THE MOBILE TELECOMMUNICATIONS OPERATOR WITH RESPECT TO CONTENT PROVIDED ON OR LINKED THROUGH OUR WEBSITES.

 

The mobile telecommunications operators in China may impose policies or guidelines to govern or restrict the content provided by all wireless value-added service providers, including content developed by us or content supplied by others to us. The mobile telecommunications operators from time to time have requested wireless value-added services providers, including us, to remove objectionable content or links to or from websites with certain categories of content, including content that they may deem to be sexually explicit. We aggregate and develop content that we consider attractive to our targeted user base, and we cannot assure investors that the mobile telecommunications operators will not from time to time find certain portions of our content to be objectionable. In the case of a breach or perceived breach of such policies or guidelines, the mobile telecommunications operators may require us to reduce or curtail the content on our Internet portal, which may reduce our portal traffic, and the mobile telecommunications operators may have the right to impose monetary fines upon us, or terminate our cooperation with them. In addition, we would be liable to the mobile telecommunications operators for their economic losses pursuant to our agreements with these operators if we were found to be in breach of the policies or guidelines promulgated by them. As a result of the occurrence of any of the above, our financial condition and results of operations may be materially adversely affected.

 

OUR DEPENDENCE ON THE SUBSTANCE AND TIMING OF THE BILLING SYSTEMS OF THE MOBILE TELECOMMUNICATIONS OPERATORS MAY REQUIRE US TO ESTIMATE PORTIONS OF OUR REPORTED REVENUE FOR WIRELESS VALUE-ADDED SERVICES FROM TIME TO TIME. AS A RESULT, SUBSEQUENT ADJUSTMENTS MAY HAVE TO BE MADE TO OUR WIRELESS VALUE-ADDED SERVICES REVENUE IN OUR FINANCIAL STATEMENTS.

 

As we do not bill our wireless value-added services users directly, we depend on the billing systems and records of the mobile telecommunications operators to record the volume of our wireless value-added services provided, charge our users through mobile telephone bills and collect payments from our users and pay us. In addition, we do not generally have the ability to independently verify or challenge the accuracy of the billing systems of the mobile telecommunications operators. Generally, within 20 to 60 days after the end of each month, a statement from each of the mobile telecommunications operators confirming the value of wireless value-added services they bill to users in that month will be delivered to us, and generally within 60 days after such delivery, we will be paid by the mobile telecommunications operators for the wireless value-added services, net of their revenue share, transmission fees and applicable business taxes, for that month based on such statements.

 

OUR COMMUNICATION PRODUCTS ARE PROVIDED CASH-ON-DELIVERY, WHICH LEAVES US VULNERABLE TO THEFT AND EMPLOYEE EMBEZZLEMENT. The purchase of calling cards, SIM cards and other mobile phone products are made with cash. Although there is a low risk that clients will not pay for these services when delivered, our retail stores maintain large sums of money which might make them robbery targets. We also face the risk that employees who collect the cash and others who may be aware that cash is available at these sites might embezzle the money. Theft or embezzlement could have a material adverse effect on the revenue generated and the financial condition of our business operations.

 

WE INTEND TO OPERATE EACH OF OUR ACQUIRED BUSINESSES ON A STANDALONE BASIS. We do not intend to integrate the information or communications systems, management, or other aspects of the businesses we acquire. If we integrated the businesses, we might be able to reduce expenses by eliminating duplicative personnel, facilities, or technology and other costs. In addition, facilities and technology integration might make inter-company communications and transactions more efficient. By declining to integrate the acquired businesses, we might forego opportunities to operate more profitably. Furthermore, our decision not to integrate these businesses might result in difficulties in evaluating the effectiveness of our internal control over financial reporting, which could complicate compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

 

 

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BECAUSE WE DO NOT HAVE EMPLOYMENT AGREEMENTS WITH MANAGEMENT OF THE ACQUIRED COMPANIES, OUR BUSINESS OPERATIONS MIGHT BE INTERRUPTED IF THEY WERE TO RESIGN AND SEEK EMPLOYMENT WITH COMPETITORS. As part of our acquisition strategy, we do not use our own employees or members of our management team to operate the acquired companies. Key management at these companies has been in place for several years and has established solid relationships with their customers. Competition in our industry for executive-level personnel is strong and we can make no assurance that we will be able to retain the highly effective executive employees. Although we provide incentives to management to stay with the acquired business, we have not entered into employment agreements with them. If such key persons were to resign we might face impairment of relationships with remaining employees or customers, which might result in further resignation by employees, and might cause long-term clients to terminate their relationship with us. Furthermore, we have not entered into any non-competition and confidentiality agreements with these employees and management. Due to the limited enforceability of these types of agreements in China, we face the risk that employees of the acquired subsidiaries might divulge our software and other protected intellectual property secrets to competitors.

 

OUR CUSTOMERS ARE CONCENTRATED IN A LIMITED NUMBER OF INDUSTRIES. Our clients are concentrated primarily in the telecommunications, telemarketing and technology industries, and to a lesser extent, the insurance and financial services industries, where the current trend is to outsource certain CRM and VAS. Our ability to generate revenue depends on the demand for our services in these industries. An economic downturn, or a slowdown or reversal of the tendency in any of these industries to rely on outsourcing could have a material adverse effect on our business, results of operations or financial condition.

 

THE MARKET IN WHICH WE COMPETE IS HIGHLY COMPETITIVE AND FRAGMENTED AND WE MAY NOT BE ABLE TO MAINTAIN MARKET SHARE. We expect competition to persist and intensify in the future. Our competitors are mainly leaders in the CRM services market, such as PCCW Teleservices (Hong Kong) Limited, China Motion Telecom International Limited, and Teletech (Hong Kong) Limited. Our competitors also include small firms offering specific applications, divisions of large entities and other large independent firms. We face the risk that new competitors with greater resources than ours will enter our market. Furthermore, increasing competition among telecom companies in greater China has led to a reduction in telecommunication services fees that can be charged by such companies. If a reduction in telecommunication services fees negatively impacts revenue generated by our clients, they may require us to reduce the price of our services, or seek competitors of ours that charge less. If we must significantly reduce the price of our services, the decrease in revenue could adversely affect our profitability.

 

KEY EMPLOYEES ARE ESSENTIAL TO GROWING OUR BUSINESS. Tony Tong, our Chairman and Chief Executive Officer, and Victor Tong, our President, are essential to our ability to continue to grow through acquisitions. Messrs. Tong and Tong have established relationships within our industry. Their business contacts have been critical in identifying, and negotiating with acquisition candidates. If either of them were to leave our employ, our growth strategy might be hindered, which could limit our ability to increase revenue.

 

THE ESTABLISHMENT AND EXPANSION OF INTERNATIONAL OPERATIONS REQUIRES SIGNIFICANT MANAGEMENT ATTENTION. All of our current, as well as any anticipated future revenue, are or are expected to be derived from Asia. Our international operations are subject to risks, including the following, which, if not planned and managed properly, could materially adversely affect our business, financial condition and operating results:

 

l	legal uncertainties or unanticipated changes regarding regulatory requirements, liability, export and import restrictions, tariffs and other trade barriers;
l	longer customer payment cycles and greater difficulties in collecting accounts receivable;
l	uncertainties of laws and enforcement relating to the protection of intellectual property; and potentially uncertain or adverse tax consequences.

 

OUR OPERATIONS COULD BE CURTAILED IF WE ARE UNABLE TO OBTAIN REQUIRED ADDITIONAL FINANCING. Since inception our investments and operations primarily have been financed through sales of our common stock. During the fiscal year ended December 31, 2005, we completed two private placements of our common stock in which we received approximately $9,300,000 of gross proceeds. In the future we may need to raise additional funds through public or private financing, which may include the sale of equity securities, including securities convertible into our common stock. The issuance of these equity securities could result in dilution to our stockholders. If we are unable to raise capital when needed, our business growth strategy may slow, which could severely limit our ability to increase revenue.

 

 

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EFFORTS TO COMPLY WITH RECENTLY ENACTED CHANGES IN SECURITIES LAWS AND REGULATIONS WILL INCREASE OUR COSTS AND REQUIRE ADDITIONAL MANAGEMENT RESOURCES AND WE STILL MAY FAIL TO COMPLY. As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring public companies to include a report of management on the company's internal controls over financial reporting in their annual reports on Form 10-K. In addition, the independent public accounting firm auditing the company's financial statements must attest to and report on management's assessment of the effectiveness of the company's internal controls over financial reporting. This requirement will first apply to our annual report on Form 10-K for our fiscal year ending December 31, 2007. If we are unable to conclude that we have effective internal controls over financial reporting or, if our independent auditors are unable to provide us with an unqualified report as to the effectiveness of our internal controls over financial reporting beginning with the fiscal year ended December 31, 2007 as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our securities.

 

FLUCTUATIONS IN THE VALUE OF THE HONG KONG DOLLAR OR RMB RELATIVE TO FOREIGN CURRENCIES COULD AFFECT OUR OPERATING RESULTS. We have historically conducted transactions with customers outside the United States in United States dollars. Payroll and other costs of foreign operations are payable in foreign currencies, primarily Hong Kong dollars and Chinese renminbi. To the extent future revenue is denominated in foreign currencies, we would be subject to increased risks relating to foreign currency exchange rate fluctuations that could have a material adverse affect on our business, financial condition and operating results. The value of Hong Kong dollars and Chinese renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions. As our operations are primarily in Asia, any significant revaluation of Hong Kong dollars or the Chinese renminbi may materially and adversely affect our cash flows, revenue and financial condition. For example, to the extent that we need to convert U.S. dollars into Hong Kong dollars or Chinese renminbi for our operations, appreciation of either currency against the U.S. dollar could have a material adverse effect on our business, financial condition and results of operations. Conversely, if we decide to convert our Hong Kong dollars or Chinese renminbi into U.S. dollars for other business purposes and the U.S. dollar appreciates against either currency, the U.S. dollar equivalent of the respective currency we convert would be reduced. To date, we have not engaged in any hedging transactions in connection with our international operations.

 

WE HAVE NEVER PAID CASH DIVIDENDS AND ARE NOT LIKELY TO DO SO IN THE FORESEEABLE FUTURE. We have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings for use in the operation and expansion of our business. We do not expect to pay any cash dividends in the foreseeable future but will review this policy as circumstances dictate.

 

RISKS ASSOCIATED WITH DOING BUSINESS IN GREATER CHINA

 

There are substantial risks associated with doing business in greater China, as set forth in the following risk factors.

 

OUR OPERATIONS AND ASSETS IN GREATER CHINA ARE SUBJECT TO SIGNIFICANT POLITICAL AND ECONOMIC UNCERTAINTIES.

 

Changes in laws and regulations, or their interpretation, or the imposition of confiscatory taxation, restrictions on currency conversion, imports and sources of supply, devaluations of currency or the nationalization or other expropriation of private enterprises could have a material adverse effect on our business, results of operations and financial condition. Under its current leadership, the Chinese government has been pursuing economic reform policies that encourage private economic activity and greater economic decentralization. There is no assurance, however, that the Chinese government will continue to pursue these policies, or that it will not significantly alter these policies from time to time without notice.

 

CURRENCY FLUCTUATIONS AND RESTRICTIONS ON CURRENCY EXCHANGE MAY ADVERSELY AFFECT OUR BUSINESS, INCLUDING LIMITING OUR ABILITY TO CONVERT CHINESE RENMINBI INTO FOREIGN CURRENCIES AND, IF CHINESE RENMINBI WERE TO DECLINE IN VALUE, REDUCING OUR REVENUE IN U.S. DOLLAR TERMS.

 

 

THE PRICE OF OUR STOCK HAS FLUCTUATED IN THE PAST AND MAY CONTINUE TO DO SO.

 

Our stock price has fluctuated dramatically. There is a significant risk that the market price of our common stock will decrease in the future in response to any of the following factors, some of which are beyond our control:

 

l	variations in our quarterly operating results;
l	announcements that our revenue or income are below analysts' expectations;
l	general economic slowdowns;
l	changes in market valuations of similar companies;
l	sales of large blocks of our common stock;
l	announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; and
l	fluctuations in stock market prices and volumes, which are particularly common among highly volatile securities of companies with primarily international-based operations.

 

FUTURE SALES OF SHARES COULD HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK

 

As of December 31, 2005, we had 12,000,687 shares of common stock issued, which shares will be available to be sold in the public market in the near future, subject to, with respect to shares of common stock held by affiliates and shares issued between 12 and 24 months ago, the volume restrictions and/or manner of sale requirements of Rule 144 under the Securities Act. On February 4, 2005, a registration statement on Form SB-2 was declared effective with respect to 2,702,230 shares of our common stock. These shares are freely tradable without restriction or further registration, subject to the related prospectus delivery requirements. Sales by our current shareholders of a substantial number of shares could significantly reduce the market price of our common stock.

 

 

ITEM 2. DESCRIPTION OF PROPERTY

 

A description of our property is as follows:

 

HONG KONG - We maintain our corporate headquarters, development center and our Call Center in Hong Kong located at Units 601-603 New Bright Building, 11 Sheung Yuet Road, Kowloon Bay, Kowloon where we lease approximately 17,739 square feet for a monthly fee of $16,365 and our branch office is located at Units 2-3, 17th Floor, Nan Fung Commercial Centre, 19 Lam Lok Street, Kowloon Bay, Hong Kong where we lease approximately 2,359 square feet for a monthly rental fee of $1,815.

 

 

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Locations	Area (Square Feet)
PacificNet Limited, 601 New Bright Building, 11 Sheung Yuet Road, Kowloon Bay, Kowloon, Hong Kong. Tel: 011-852-2876-2900 ,   Fax: 011-852-27930689 ,   HKOffice@PacificNet.com	17,739
PacificNet Shenzhen Office: Room 901, Tower A, Tian An High-Tech Plaza, Tian An Cyber Park, Fu Tian District, Shenzhen, China Postal Code:518040	1,100
No. 30, ShiBaFu North Road, Liwan District, Guangzhou, 510140	2,250
1-2 floor, Yingyuan u, Yingyuan Road, Yuexiu District, Guangzhou, 510410	2,500
PacificNet Beijing Office: 23/F, Building A, TimeCourt, No.6 Shuguang Xili, Chaoyang District, Beijing, China, Postal Code: 100028   Tel:86-010-59225000	14,812

 

 

ITEM 3. LEGAL PROCEEDINGS

 

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

The Company held its annual meeting on December 30, 2005 at the Company's executive offices located at 901,Tower A, Tian An High-Tech Plaza, Tian An Cyber Park, Futian District, Shenzhen, China for the following purposes:

 

1.	To elect seven (7) directors to the Board of Directors of the Company to serve until the next annual meeting of stockholders and until their successors are duly elected and qualified;

 

2.	To ratify the appointment of Clancy and Co., P.L.L.C. as the Company's independent auditors; and

 

3.	To transact any other business as may properly be presented at the Annual Meeting or any adjournment or postponement thereof.

 

At such meeting the followings proposals were voted and resolved:

 

1.

The following directors were elected to the Board of Directors of Company, after each receiving a plurality of the votes cast: 1. Tony Tong (6,079,111 votes or 50.82% voted for), 2. Victor Tong (6,077,611 votes or 50.81% voted for), 3. Joseph Levinson (6,077,581 votes or 50.81% voted for), 4. Tao Jin (6,079,083 votes or 50.82% voted for), 5. Peter Wang (6,078,583 votes or 50.82% voted for), 6. Michael Chun Ha (6,079,683 votes or 50.83% voted for), 7. Jeremy Goodwin (6,079,083 votes or 50.82% voted for).

 

2.

Ratification and approval of the appointment of Clancy and Co., P.L.L.C. as the Company's independent auditors 6,071,479 shares of the Company's common stock, constituting a 50.76% majority of the shares of common stock present in person or by proxy entitled to vote at this meeting have voted in favor of this proposal.

 

 

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ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

 

 

	HIGH	LOW
F FISFISCAL 2004
Quarter Ended March 31, 2004	$7.40	$4.81
Quarter Ended June 30, 2004	$5.65	$2.62
Quarter Ended September 30, 2004	$3.85	$1.91
Quarter Ended December 31, 2004	$14.08	$2.43
FISCAL 2005
Quarter Ended March 31, 2005	$11.34	$6.46
Quarter Ended June 30, 2005	$10.23	$6.71
Quarter Ended September 30, 2005	$9.00	$6.85
Quarter Ended December 31, 2005	$8.48	$6.30
F FISFISCAL 2006
January 1, 2006 - March 31, 2006	$8.88	$6.57

 

HOLDERS OF RECORD

 

As of March 31, 2006, there were 142 record holders of our common stock. However, the total number of beneficial holders is unknown as they hold our common stock in street name.

 

DIVIDENDS

 

We have not paid any cash dividends on our common stock, and we currently intend to retain any future earnings to fund the development and growth of our business.

 

EQUITY COMPENSATION PLAN INFORMATION

 

The following table sets forth aggregate information regarding the Company's equity compensation plans in effect as of December 31, 2005:

 

	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights ($)	Remaining available for further issuance under equity compensation plans
Equity compensation plans approved by security holders (under 1998 Stock Option Plan) (1)	1,360,100	3.99	0
Equity compensation plans approved by security holders (under 2005 Stock Option Plan) (2)	155,600	6.59	1,844,400
Equity compensation plans not approved by security holders	N/A	N/A	N/A

(1) Reflects options granted and available for issuance under the 1998 Stock Option Plan.

(2) Reflects options granted and available for issuance under the 2005 Stock Option Plan.

 

 

RESULTS OF OPERATIONS

 

 

	YEAR ENDED DECEMBER 31,
	2005 (%)	2004 (%)
Revenues	100	100
Cost of Revenues	(75.4)	(81.0)
Gross Margin	24.6	19.0
Selling, general and administrative expense	(13.2)	(11.6)
Depreciation and amortization	(0.7)	(0.3)
Earnings / (loss) from operations	10.3	6.5
Interest (expenses) income, net	0.1	0.3
Sundry income	1.9	1.4
Provision for income taxes	(0.5)	(0.1)
Share of profit of associated companies	(0.00)	0.1
Minority interest	(6.6)	(5.5)
Discontinued operations	-	(0.1)
NET EARNINGS	5.6	2.6

 

 

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YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004

 

For the year ended December 31, 2005	Group 1. Outsourcing Business ($)	Group 2. VAS Business ($)	Group 3. Communications Distribution Business ($)	Group 4. Other Business ($)	Total ($)
Revenues (% of Total)	13,505,000 (30.5%)	13,834,000 (31.2%)	16,201,000 (36.5%)	801,000 (1.8%)	44,341,000 (100%)
Earnings / (Loss) from Operations	1,360,000	3,899,000	558,000	(1,248,000)	4,569,000

 

(1) OUTSOURCING SERVICES

 

Revenues for the year ended December 31, 2005 were $13,505,000, an increase of 44% as compared to $9,385,000 for the year ended December 31, 2004. Outsourcing services revenues made up 26.54% of the Company's total revenues for the fourth quarter of the year due to its subsidiary being selected by China's State Administration of Taxation to provide integrated call center services training for the tax bureau's "123661" customer services center in Shenzhen and it is believed that the contact center expansion in Guangzhou will lead to over 40% annual revenue growth in the coming years. One of the reasons the revenues increased is due to the continuous rapid growth on computer software product and the company provides a seamless solution and multi-media channels for clients to communicate with their customers for building better customer relationship and generating more sales revenue. The combination of its innovative infomercials along with our growing call center operations will allow us to support significant future growth. It is a strong vote of confidence in our future development in China's growing CRM call center market due to our expansion from B2B outsourced call center services into B2C infomercial services market for vertical industries which a growing number of domestic and multinational companies across a number of industries are selecting us to enhance customer services. This demand for CRM services reflects the increasingly competitive nature of the Chinese marketplace where customers choose a provider not solely based upon price, but also on customer services. We believe that our CRM contact center has emerged as the new competitive advantage for the market leaders in China and we are well positioned to benefit from this trend.

 

(2) VALUE-ADDED SERVICES VAS

 

Revenues for the year ended December 31, 2005 was $13,834,000, a significant increase of 142% as compared to $5,724,000 for the year ended December 31, 2004. Our acquisition of 3G, Clikcom and Lion Zone in 2005 contributed to the increase in revenues for this business segment and helped us enter the mobile Internet market in China. VAS revenues made up 49.1% of the Company's total revenues for the fourth quarter of the year. Presently, approximately 80% of mobile phone users use VAS in China. The Company’s revenue in the sales of voice cards continued to grow through Linkhead-generated NMS cards and with the cards increasing use in voice hardware equipment, based on CPCT industry control machines and Media Server which supports access from both PSTN and VoIP, softswitch and 3Gnetworks. These phone cards sold through the VAS segment differ from the calling cards sales in the Communication Distribution Business as described below in that those phone cards are geared towards the end user and include prepaid calling cards, IDD long distance calling cards, internet access cards, bundled cross-selling insurance cards, shopping discount cards, travel and hotel reservation cards, entertainment cards, and customer loyalty membership cards. For example, the Bank of China Shanghai selected PacificNet Epro to provide CRM and call center management training, to enhance agent productivity, to improve call center service quality, and to revise the strategic market positioning for the bank.

 

 

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(3) COMMUNICATION PRODUCTS DISTRIBUTION

 

Revenues for the year ended December 31, 2005 were $16,201,000, an increase of 37% as compared to $11,790,000 for the year ended December 31, 2004. Distribution revenues remained steady growth during the year due to the increasing market growth in communication products distribution services. Communication products distribution revenues made up 20.3% of the Company's total revenues for the fourth quarter of the year. In FY2005, sales mix of high-margin products such as number cards and IP cards increased whereas substantial portion of FY2004 revenues were derived from low-margin prepaid stored-value cards. This improved sales mix was achieved through sales incentive scheme. Furthermore, we believe that our Take1 and My Memory Maker Kiosks are a natural fit in the self-service vending machine, party, amusement, and casino market, and we also believe there are strong opportunities for growth in high-traffic tourist and amusement destinations. Recently, the Company had entered into a definitive agreement to acquire iMobile in order to enhance our position in this rapidly growing B2C market in China.

 

COST OF REVENUES AND GROSS MARGIN

 

Cost of revenues for the year ended December 31, 2005 were $33,439,000 an increase of 38% from $24,074,000 for the year ended December 31, 2004. The slight increase in the cost of revenues was directly associated with the increase in revenue. Cost of revenue, as a percentage of revenue, was 75% for the year ended December 31, 2005 as compared with 81% for the year ended December 31, 2004. The decrease in percentage cost of revenues was attributable to the changes in operations, from supplying systems integration and software applications in 2004 to becoming value-added telecom services and product providers in 2005. Gross profit for the year ended December 31, 2005 was $10,902,000 an increase of 93% as compared to $5,635,000 for the year ended December 31, 2004, resulting from gross margin contributions from our newly acquired subsidiaries in 2005. Gross profit for the fourth quarter of the year was $5,047,000, a significant increase of 265% as compared to $1,379,000 for the same period in 2004; or a significant increase of 153% as compared to the third quarter of 2005.

 

We believe that our gross margin overall approximates the industry standards. The significant increase in gross margin came primarily from, our phone card business, which has higher gross margins, typical for that industry. We expect our gross margin percentage to increase gradually as a result of cost reduction and efficient utilization of assets.

 

(1) OUTSOURCING SERVICES

 

As compared to prior year, cost of revenues for outsourcing services increased by 55% to $10,095,000 (2004: $6,491,000). Gross profit was 4% lower at $3,409,000 (2004: $3,543,000). Gross profit of $1,069,000 for the fourth quarter had a significant increase of 56% as compared to $682,000 for the third quarter of 2005 due to the increasing demand for outsourcing contact center services, especially from the industries of telecom, banking, market research and fast-moving consumer goods, among others. The slightly decline year over year was primarily due to the enhanced Hong Kong market competition. However, from the perspective of high-margin IT Solutions, EPRO enjoyed growth in FY2005 from its self-developed Contact Center System - WISE-xb Contact Center System and TNT Hong Kong selected this contact center solution with customer management capabilities to improve efficiency and enhance customer satisfaction.

 

(2) VALUE-ADDED SERVICES

 

As compared to prior year, cost of revenues for VAS increased by 75% to $7,715,000 (2004: $4,403,000). Gross profit was 262% much higher at $6,119,000 (2004: $1,688,000). Gross profit of $3,241,000 for the fourth quarter also had a significant increase of 471% as compared to the same period in 2004; or an increase of 184% as compared to $1,141,000 for the third quarter of 2005. Throughout the new acquisitions in 2005 such as Lion Zone with higher gross margin, it moved our strategic consolidation in China's CRM and VAS market, and increased our customer base and improved our gross margin. The increasing gross profit is also derived from the continued profitability in the sale of phone cards. Furthermore, Company increased market share in the voice/IVR supplier market.

 

(3) COMMUNICATION PRODUCTS DISTRIBUTION

 

As compared to prior year, cost of revenues for communication products distribution slightly increased by 17% to $15,347,000 (2004: $13,106,000). Gross profit was 194% higher at $854,000 (2004: $290,000). The fourth quarter is normally the strongest due to holiday-related promotions which increase the spending of our customers with us and therefore higher margin was expected. Furthermore, since revenues made up the highest rate of 36.5% of the Company's total revenues and cost of revenues had only slightly increased in 2005, its gross profit relatively increased more to reach our future expectation. As one of its subsidiaries, Shanghai Classic (Yueshen), signed an agreement to become a designated integrated services distributor of China Mobile in 2005, it increased the Company's overall distribution revenues and profit margin. The improved gross margin was mainly due to increased sales mix from higher margin products such as number cards with average gross margin of 8 to 15% and IP calling cards with average gross margin of 30% instead of low-margin prepaid stored-value cards with just around 2% gross margin.

 

 

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(4) OTHER BUSINESS

 

Cost of revenues and gross profit for PacificNet Power for the year ended December 31, 2005 was $269,000 and $67,000. PacificNet Power did not exist in 2004, so no comparison is available for 2004

 

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

 

Selling, General and Administrative expenses totaled $5,811,000 for the year ended December 31, 2005, an increase of 69% from $3,435,000 for the year ended December 31, 2004. As our fourth quarter results included several one-time charges or expenses such as the $103,250 NASDAQ National Market Entry Fee, quarterly SG&A had significant increase of 183% as compared to the third quarter of the year. The increase in selling, general and administrative expenses reflected the expansion of our operations of which expenses were incurred by our newly acquired subsidiaries and the expansion of the management team. In addition to making several key acquisitions in 2005, we laid the foundation for a strong future, by hiring additional personnel in key areas to support our accounting and back-office functions, as well as implemented the systems to allow the Company to better measure the performance of each of its units.

 

(1) OUTSOURCING SERVICES

 

Selling, General and Administrative expenses for outsourcing services were $1,628,000 for the year ended December 31, 2005, a reduction of $502,000 from $2,130,000 for the year ended December 31, 2004. Due to the increase in the demand for telemarketing and call center services, one of the subsidiaries purchased a new 250-seat call center facility in China, to support the rapidly growing business of the company. It caused an increase of 103% to $482,000 for SG&A for the fourth quarter of the year. However, a wide array of supporting services are provided, including professional inbound services, outbound services, facilities management and IVRS support services, to meet clients' diversified needs.

 

(2) VALUE-ADDED SERVICES

 

Selling, General and Administrative expenses for VAS were $2,159,000 for the year ended December 31, 2005, an increase of $2,072,000 as compared to $87,000 in 2004. The increase of SG&A resulted from increasing the size of our operations which included premises costs and staff costs from the three new acquisitions.

 

(3) COMMUNICATION PRODUCTS DISTRIBUTION

 

Selling, General and Administrative expenses for communication products distribution were $271,000 for the year ended December 31, 2005, an increase of 188% as compared to $94 for the year ended December 31, 2004. This business is easily scalable depending on the availability of working capital, since one of the subsidiaries, Shanghai Classic (YueShen), needs to pay the telephone operators/suppliers cash upfront.

 

(4) OTHER BUSINESS

 

Selling, General and Administrative expenses were $167,000 for the year ended December 31, 2005.

 

DEPRECIATION AND AMORTIZATION EXPENSES

 

Depreciation and amortization expenses were $1,126,000 for the year ended December 31, 2005, which represented 1344% increase as compared to the year ended December 31, 2004 of which depreciation and amortization expenses was $78,000.

 

EARNINGS FROM OPERATIONS

 

Operating profit of $4,569,000 for the year ended December 31, 2005, a significant increase of 136% as compared to $1,937,000 from the year ended December 31, 2004. Operating margins nearly doubled to 10.3% from 6.5% in the previous year. Quarterly operating profit was $1,702,000, an increase of 66% as compared to $1,026,000 from Q3 2005. Quarterly operating profit of $380,000, $1,470,000, and $254,000 generated from the Company's three business units: (1) CRM Outsourcing Services, (2) Value-Added Services (VAS) and (3) Telecom Distribution Services, represented an increase of 75%, 50% and 47% respectively. These are compared to $217,000, $974,000, and $172,000 respectively for Q3 2005. Operating profit of $1,360,000, $3,899,000 and $558,000 generated from business units (1), (2) and (3) for the year ended December 31, 2005 represented an increase of 36%, 110% and 556% respectively, as compared to$1,000,000, $1,859,000, and $85,000 respectively for the year ended December 31, 2004. The increase in operating margin reflects Company's continuous shift away from our traditional lower-margin phone card distribution business (B2B services) to higher margin value-added telecom services and B2C e-commerce. We believe that in 2006 this strategy will result in increased profitability. This strategy is beginning to work, as our operating margin increased from 6.5% in 2004 to 10.3% in 2005.

 

INTEREST EXPENSES / INCOME 

 

Interest income was $246,000 for the year ended December 31, 2005, an increase of 211% as compared to $79,000 for the year ended December 31, 2004. The increase is due to 62% of interest income generated from PacificNet Communications. Interest income was mainly generated from $152,000 of PacificNet Communications from lending and fixed-rate bank deposits (62% of total interest income) and $45,000 of PacificNet Strategic Investment Holdings Limited from bank deposits. Interest expenses were $229,000 for the year ended December 31, 2005, an increase of 24% as compared to $185,000 for the year ended December 31, 2004. Most of the interest expenses were attributed to bank loans by PacificNet Strategic Investment Holdings ($34,000) and Linkhead ($26,000), and bank loans and bank overdraft by Epro ($133,000).

 

 

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SUNDRY INCOME/EXPENSE

 

Sundry income known as non-operating income is defined as the external income (miscellaneous income) that results from factors outside of our operating subsidiaries' control and such income does not related to each subsidiaries' core operating business. Income from the sale of various investments is one of the typical examples. (See Note 11 for details)

 

For the year ended December 31, 2004, the non-operating income or sundry income was mainly derived from Linkhead's consulting services income from system integration services totaling $380,000.

 

For the year ended December 31, 2005, the non-operating income or sundry income was $830,000 included in Statement of Operations was mainly derived from the consulting services income of $116,000, software service income of $375,000, investment income of $113,000, leasehold income of $75,000 and various other totaling $151,000.

 

SHARE OF PROFIT OF ASSOCIATED COMPANIES 

 

We recorded the loss of $8,000 for the year ended 2005 with respect to our 20% ownership interest in Take1 Technology (Cheer Era Limited), acquired in April 2004.

 

INCOME TAXES The income taxes expenses for the Company's subsidiaries were $222,000 for the year ended December 31, 2005. The provision of income taxes was the result of the operating profit generated by Guangzhou3G, Clickcom and ChinaGoHi, the subsidiaries we acquired in 2005. Pursuant to the PRC Income Tax Laws, the Company's subsidiaries and VIEs are generally subject to Enterprise Income Taxes ("EIT") at a statutory rate of 33%, which comprises 30% national income tax and 3% local income tax. Some of these subsidiaries and VIEs are qualified new technology enterprises and under PRC Income Tax Laws, they are subjected to a preferential tax rate of 15%. Guangzhou3G-DE as software enterprise comprises 15% tax rate for one year during 2005 and it can continue to apply 15% tax rate after this is expired. In addition, Guangzhou 3G-WOFE, as a new High Technology Foreign Investment Enterprises and under PRC Income Tax Laws, is entitled to a two-year tax exemption in 2005 and 2006. In order to improve the technology market in China, another of our high-tech subsidiaries, Linkhead, is entitled a three-year tax exemption followed by three years with a 50% reduction in the tax rate, commencing the first operating year. Therefore, Linkhead's taxes have been remitted during January 1, 2003 to December 31, 2005 but it pays taxes at 7.5% from January 1, 2006 to December 31, 2008.

 

MINORITY INTERESTS Minority interests for the year ended December 31, 2005 totaled $2,926,000. Minority interests represented the interests of third parties in our subsidiaries' results.

 

 

CONTRACTUAL OBLIGATIONS

 

CONTRACTUAL OBLIGATIONS We have significant cash resources to meet our contractual obligations as of December 31, 2005, as detailed below:

 

Payments Due by Period

 

Contractual Obligations		Total			Less than 1 year			1-5 years			After 5 years
Line of credit		$	1,060,000		$	1,060,000			--			--
Bank Loans		$	194,000		$	188,000		$	6,000			--
Operating leases		$	1,676,000		$	870,000		$	806,000			--
Capital leases		$	204,000		$	126,000		$	78,000			--
Total cash contractual obligations		$	3,134,000		$	2,244,000		$	890,000			--

 

 

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OFF-BALANCE SHEET ARRANGEMENTS We had no outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. We did not engage in trading activities involving non-exchange traded contracts during 2005.

 

LIQUIDITY AND CAPITAL RESOURCES

 

WORKING CAPITAL

 

The Company's working capital increased by 27% to $20,510,000 at December 31, 2005, as compared to $16,185,000 at December 31, 2004. The increase in working capital primarily resulted from proceeds (shown net of offering costs) from our private placement activities that resulted in an increase of $2,815,000 increase in cash balance and time deposit, net of cash expenditures for operations and acquisitions.

 

ISSUANCE OF COMMON STOCK

 

During the year ended December 31, 2005, the Company issued shares of common stock as follows: (i) 700,000 shares of common stock were issued as a result of the exercise of stock options and warrants with cash consideration of $1,014,000 in the aggregate;; (ii) 515,900 for the acquisition of subsidiaries with market value of $3,971,000; and (iii) 20,000 shares of common stock were issued to our investor relations firm for services rendered with a market value of $63,000.

 

FUTURE LIQUIDITY NEEDS

 

As of December 31, 2005, we had approximately $9,579,000 in cash. We regularly review our cash funding requirements and attempt to meet those requirements through a combination of cash on hand, cash provided by operations, available borrowings under bank lines of credit and possible future public or private equity offerings. We evaluate possible acquisitions of, or investments in, businesses that are complementary to ours, which transactions may require the use of cash. We believe that our cash, other liquid assets, operating cash flows, credit arrangements, access to equity capital markets, taken together, provide adequate resources to fund ongoing operating expenditures. In the event that they do not, we may require additional funds in the future to support our working capital requirements or for other purposes and may seek to raise such additional funds through the sale of public or private equity as well as from other sources.

 

INFLATION

 

Inflation has not had a material impact on the Company's business in recent years.

 

 

ITEM 7. FINANCIAL STATEMENTS

 

The consolidated financial statements and the report and notes, are attached hereto following the signature page beginning on Page F-1.

 

INDEX TO FINANCIAL STATEMENTS

 

	Report of Independent Registered Public Accounting Firm	F-1
	Consolidated Balance Sheets - As of December 31, 2005 and 2004	F-2
	Consolidated Statements of Operations - For the Years Ended December 31, 2005 and December 31, 2004	F-3
	Consolidated Statements of Changes in Stockholders' Equity - For the Years Ended December 31, 2005 and December 31, 2004	F-4
	Consolidated Statements of Cash Flows - For the Years Ended December 31, 2005 and December 31, 2004	F-5
	Notes to Consolidated Financial Statements	F-6

 

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

 

 

ITEM 8A. CONTROLS AND PROCEDURES

 

 

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EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES.

 

We maintain controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures performed as of the period covered by this report, our chief executive officer and the chief financial officer concluded that our disclosure controls and procedures were inadequate, need to be strengthened and are not sufficiently effective to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. The Company has taken various steps to maintain the accuracy of our financial disclosures, and based on these measures and other significant work, management believes there are no material inaccuracies or omissions of material fact in our financial statements and other reports filed with the SEC. However, material weaknesses in our internal controls over financial reporting could further adversely impact our current inability to report timely financial information. Despite the drastic strengthening of our disclosure controls and procedures over the past 12 months, our efforts have been insufficient and delayed due to our significant growth and expansion as described in Item 1 and our recent adoption of FIN46R. We are developing a plan to ensure that all information will be recorded, processed, summarized and reported on a timely basis. This plan is dependent, in part, upon reallocation of responsibilities among various personnel, hiring additional experienced personnel, allocating additional Information Technology spending, and possible raising additional funding. It should also be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

 

In connection with the audit of our financial statements for the year ended December 31, 2005, Clancy and Co., P.L.L.C. ("Clancy"), our independent auditors, informed the Board of Directors on April 27, 2006, of several "significant deficiencies" that collectively constituted a "material weakness" in our internal control over financial reporting under standards established by the Public Company Accounting Oversight Board.

 

A SIGNIFICANT DEFICIENCY is a control deficiency, or combination of control deficiencies, that adversely affects the Company's ability to initiate, authorize, record, process or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the Company's annual or interim financial statements that is more than inconsequential and will not be prevented or detected.

 

A MATERIAL WEAKNESS is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement or the annual or interim financial statements will not be prevented or detected.

 

The following conditions were identified:

 

l	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.
l	Certain key managers in the accounting department do not appear to have the knowledge and experience required for their responsibilities.
l	Substantive matters are not being addressed appropriately by the Board and Audit Committee resulting in inadequate oversight from the Board and Audit Committee.
l	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.
l	There is no adequate means of accurately capturing and recording certain significant and complex business transactions.

 

Accordingly, the Company's internal controls over financial reporting are not effective.

 

 

ITEM 8B. OTHER INFORMATION

 

 

 

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ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;

 

COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

 

Set forth below are the names of the directors, executive officers and significant employees of the Company as of November __, 2006:

 

Name	Age	Title
Tony Tong	38	Chairman and Chief Executive Officer
Victor Tong	35	President, Secretary, and Director
Joseph Levinson	30	Chief Financial Officer
Shaojian (Sean) Wang	41	Director
Peter Wang	51	Independent Director (1)(3)
Michael Ha	36	Independent Director (2)(3)
Jeremy Goodwin	33	Independent Director (1)(3)
Tao Jin	38	Independent Director (1)(2)(3)
Mary Ma	35	Vice President of Finance and Chief Financial Officer for ChinaGoHi Subsidiary
Wenming Wang	44	President of ChinaGoHi Operation
Jingjin Wu	46	Vice President of ChinaGoHi & DRTV Operations
David Lin	39	Vice President of Investment Management
Victor Choy	37	Vice President, Mobile Distribution Services
Brian Lin	41	Vice President, Northern China
Fei Sun	40	Vice President, Southern China
Philip Cheng	42	Vice General Manager
Jack Ou	39	Vice General Manager, Southern China
Mike Fei	38	Company Secretary and General Counsel
Star Mu	37	Regional Manager, Northern China
Shannon Lee	29	Vice President of Investment
Jacob Lakhany	29	Director of Investor Relations and Public Relations
Super Yongchao Wang	32	Vice President of Value Added Services
Telly Wai-Hon Wong	44	Vice President of Call Center Services
Carol Men-Yee Chang	43	Vice President & COO of Call Center Operations
Joyce Mei-Wei Poon	40	Vice President of CRM Services
Fiona Yee-Chong Cheuk	31	Marketing and PR Manager, CRM & Call Center Services

 

(1) Member of Audit Committee

(2) Member of Nominating Committee

(3) Member of Compensation Committee

 

Our executive officers are appointed at the discretion of our board of directors with no fixed term. There are no family relationships between or among any of our executive officers or our directors other than the relationship between Mr. Tony Tong and Mr. Victor Tong.

 

 

MS. FIONA CHEUK, age 31, joined PacificNet Epro in 2004 as Marketing Manager. The major duty of Ms. Cheuk is to drive innovative and effective marketing strategy of exploring more business opportunities for the company. She also takes responsibility for delivering efficient marketing communications of raising brand awareness and revealing value differentiation of our products and services in the competitive market. Prior to joining Epro, Ms. Cheuk gained customer relationship management and marketing experiences while working at SmarTone Telecom (HKSE:0315.HK) and Cisco Systems. Ms. Cheuk holds a MBA Degree in Marketing from Western Sydney University.

 

COMPLIANCE WITH SECTION 16(A) OF EXCHANGE ACT

 

Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires our executive officers, directors and persons who beneficially own more than 10% of a registered class of our equity securities to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of our common stock and other equity securities. Such executive officers, directors, and greater than 10% beneficial owners are required by SEC regulation to furnish us with copies of all Section 16(a) forms filed by such reporting persons.

 

Based solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that the following executive officers and directors failed to timely file Form 4's and 5's: Tony Tong failed to timely file Form 4's, one Form 4 reporting the exercise of a stock option and three Form 4's each reporting the grant of stock options; Victor Tong failed to timely file Form 4's, one Form 4 reporting the exercise of a stock option and four Form 4's each reporting the grant of stock options; Shaojian Wang failed to timely file Form 4's, two Form 4's each reporting the exercise of stock options and three Form 4's each reporting the grant of stock options; Michael Chun Ha failed to timely file Form 4's, one Form 4 reporting the exercise of an option and three Form 4's each reporting the grant of stock options; Peter Wang failed to timely file three Form 4's each reporting the grant of stock options; Jeremy Goodwin failed to timely file three Form 4's each reporting the grant of stock options and Tao Jin failed to timely file three Form 4's each reporting the grant of stock options.

 

AUDIT COMMITTEE OF THE BOARD OF DIRECTORS

 

The Audit Committee is responsible for nominating the Company's independent auditors and reviewing any matters that might impact the auditors' independence from the Company; reviewing plans for audits and related services; reviewing audit results and financial statements; reviewing with management the adequacy of the Company's system of internal accounting controls, including obtaining from independent auditors management letters or summaries on such internal accounting controls; determining the necessity and overseeing the effectiveness of the internal audit function; reviewing compliance with the U.S. Foreign Corrupt Practices Act and the Company's internal policy prohibiting insider trading in its Common Stock; reviewing compliance with the SEC requirements for financial reporting and disclosure of auditors' services and audit committee members and activities; reviewing related-party transactions for potential conflicts of interest; and reviewing with corporate management and internal and independent auditors the policies and procedures with respect to corporate officers' expense accounts and perquisites, including their use of corporate assets.

 

 

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The board of directors has established an audit committee in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. The members of the Audit Committee are Messrs. Peter Wang, Jeremy Goodwin and Tao Jin, each of whom are considered "independent" under the NASDAQ National Market listing standards currently in effect.

 

 

 

SUMMARY COMPENSATION TABLE

 

The following table sets forth all cash compensation paid or to be paid by the Company, as well as certain other compensation paid or accrued, during each of the Company's last three fiscal years to each named executive officer.

 

		Annual Compensation			Long Term Compensation Awards
Name / Principal Position	Fiscal Year	Salary($)	Bonus($)	Other($)	Restricted Stock Award ($)	Stock Options	All Other Comp.($)
Tony Tong, CEO	2005	$70,000	-	-	-	66,000	$8,000
	2004	$70,000	-	$24,000(1)	-	65,000	$4,000
	2003	$100,000	-	-		120,000	$3,000

 

(1) This amount represents a housing allowance.

 

OPTION GRANTS DURING FISCAL YEAR 2005 (INDIVIDUAL GRANTS)

 

The following table sets forth certain information with respect to stock option grants to our named executive officers during the fiscal year ended December 31, 2005.

 

					Potential Realizable Value at Assumed Rates of Stock Price  Appreciation for Option Term (3)
Name	Options Granted (1)	% of Total Options Granted to Employees in 2005 (2)	Exercise or Base Price	Expiration Date	5%	10%
Tony Tong, CEO	66,000	9.7%	$6.50	July 26, 2009	$ 521,452	$ 628,099

 

(1) All options were granted pursuant to our 1999 Stock Plan and as amended in 2002 and 2003. The options have a ten-year term and vest and become exercisable over four years. In the event of a change in control of the Company, the options will be substituted by the successor corporation or will fully vest and become exercisable for a period of fifteen days.

 

(2) Based on an aggregate of 2,000,000 shares subject to options granted to our employees in 2005.

 

 

OPTION EXERCISE AND VALUES

 

Aggregated Option Exercises During Fiscal Year 2005 and Fiscal Year-End Option Values.

 

The following table sets forth information for our executive officers relating to the number and value of securities underlying exercisable and not exercisable options they held at December 31, 2005 and sets forth the number of shares of Common Stock acquired and the value realized upon exercise of stock options held as of December 31, 2005 by our named executive officers.

Name	Shares Acquired On Exercise	Value Realized (1)	No. of Securities Underlying Unexercised Options At 12/31/05		Value ($) of Unexercised In-the-Money Options At 12/31/05 (2)
			Exercisable	Not Exercisable	Exercisable	Not Exercisable
Tony Tong, CEO	6,000	$29,700	145,000	66,000	$677,650	$12,120

 

 

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

 

 

NAME AND ADDRESS OF BENEFICIAL OWNER	NUMBER OF SHARES STOCK BENEFICIALLY OWNED(1)	% OF COMMON STOCK ENEFICIALLY OWNED
Sino Mart Management Ltd. (2) c/o ChoSam Tong 16E, Mei On Industrial Bldg.17 Kung Yip Street, Kwai Chung, NT, Hong Kong	1,835,160	13.86%
ChoSam Tong (3) 16E, Mei On Industrial Bldg. 17 Kung Yip Street, Kwai Chung, NT, Hong Kong	1,839,160	13.89%
Kin Shing Li (4) Rm. 3813, Hong Kong Plaza 188 Connaught Road West, Hong Kong	1,150,000	8.69%
Tony Tong (5)	347,391	2.62%
Victor Tong (6)	175,400	1.32%
ShaoJian (Sean) Wang (7)	88,000	*
Peter Wang (8)	11,000	*
Michael Chun Ha (9)	31,000	*
Tao Jin (10)	6,000	*
Jeremy Goodwin (11)	6,000	*
All directors and officers as a group (7 persons)	664,791	5.02%

 

 

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* Less than one percent.

** The address for each beneficial owner not otherwise specified is: c/o PacificNet Inc., 860 Blue Gentian Rd., Suite 360, Eagan, MN 55121. USA.

(1)

Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to the shares shown. Except as indicated by footnote and subject to community property laws where applicable, to our knowledge, the stockholders named in the table have sole voting and investment power with respect to all common stock shares shown as beneficially owned by them. A person is deemed to be the beneficial owner of securities that can be acquired by such person within 60 days upon the exercise of options, warrants or convertible securities (in any case, the "Currently Exercisable Options"). Each beneficial owner's percentage ownership is determined by assuming that the Currently Exercisable Options that are held by such person (but not those held by any other person) have been exercised and converted.

(2)	Sino Mart Management Ltd. is owned by Mr. ChoSam Tong, the father of Messrs. Tony Tong and Victor Tong.

(3)	Includes shares of common stock of Sino Mart Management Ltd., which is owned by Mr. ChoSamTong.

(4)	Information obtained from the Schedule 13D/A filed by Mr. Kin Shing Li on October 14, 2003.

(5)	Includes Currently Exercisable Options to acquire 163,000 shares of common stock.

(6)	Includes Currently Exercisable Options to acquire 153,000 shares of common stock.

(7)	Includes 69,000 shares issuable upon exercise of Currently Exercisable Options.

(8)	Represents shares issuable upon exercise of Currently Exercisable Options.

(9)	Includes 6,000 shares issuable upon exercise of Currently Exercisable Options.

(10)	Represents shares issuable upon exercise of Currently Exercisable Options.

(11)	Represents shares issuable upon exercise of Currently Exercisable Options.

 

 

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

 

 

 

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K.

 

EXHIBITS

 

The following exhibits are filed as part of this report:

 

EXHIBIT NUMBER	DESCRIPTION
2.1	Share Exchange Agreement by and among Davin Enterprises, Inc., Carl Tong, Leo Kwok and Acma Strategic Holdings Limited dated December 15, 1997. (1)
2.2	Share Exchange Agreement dated February 17, 2000, between Registrant and holders of membership interests in PacificNet.com LLC.(2)
2.3	Supplement to Share Exchange Agreement dated April 29, 2000, between Registrant and holders of membership interests in PacificNet.com LLC. (2)
2.4	Agreement dated September 30, 2000, among the Company and the "Purchasers" named therein. (3)
2.5	Supplemental Agreement dated October 3, 2000, among the Company and the "Purchasers" named therein. (3)
2.6	Deed of Waiver, dated October 3, 2000, by Creative Master Limited in favor of the Company. (3)
3.1	Certificate of Incorporation, as amended. (4)
3.2	Form of Amended By Laws of the Company. (4) Specimen Stock Certificate of the Company.
4.1	Securities Purchase Agreement, dated as of January 15, 2004, among PacificNet Inc. and the purchasers identified therein (5)
4.2	Form of Common Stock Warrant issued to each of the purchasers (5)
4.3	Form of Common Stock Warrant issued to each of the purchasers, dated December 9, 2004 (10)
4.4	Form of Common Stock Warrant issued to each of the purchasers, dated November 17, 2004 (10)
4.5	Securities Purchase Agreement, dated February 28, 2006, among PacificNet Inc. and the Holders identified therein (12)
4.6	Form of Variable Rate Convertible Debenture due March 2009 issued to each of the Holders (12)
4.7	Form of Common Stock Purchase Warrant issued to each of the holders (12)
4.8+	Form of Registration Rights Agreement, dated February 28, 2006
10.1	Form of Indemnification Agreement with officers and directors. (1)
10.2	Amendment to 1998 Stock Option Plan. (8)
10.3	Form of Notice of Stock Option Grant and Stock Option Agreement under the 1998 Stock Option Plan. (2)
10.4	Amendment dated January 31, 2002 to the Subscription Agreement by and between the Company and Sino Mart Management Ltd., dated as of December 9, 2001 (6)
10.6	Sub-Lease Agreement dated August 30, 2002.(8)
10.7	Agreement dated on December 1, 2003 for the Sale and Purchase and Subscription of Shares in Epro Telecom Holdings Limited (9)

 

 

46

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EXHIBIT NUMBER

DESCRIPTION

10.8	Agreement dated on December 15, 2003 for the Sale and Purchase of Shares in Beijing Linkhead Technologies Co., Ltd. (9)
10.9	Securities Purchase Agreement, dated as of December 9, 2004, among PacificNet Inc. and the purchasers identified therein (10)
10.10	Securities Purchase Agreement, dated as of November 17, 2004, among PacificNet Inc. and the purchasers identified therein (10)
10.11	Agreement for the Sale and Purchase of Shares in Shanghai Classic Group Limited (4)
10.12	Agreement for the Sale and Purchase of Shares of Cheer Era Limited (11)
10.13	Agreement for the Sale and Purchase of Shares in Pacific Smartime Solutions Limited
10.14	Agreement for the Sale and Purchase of Shares in Guangzhou Clickcom Digit-net Science and Technology Ltd. (16)
10.15	PacificNet Inc. 2005 Stock Option Plan (15)
10.16	Agreement for the Sale and Purchase of Shares in GuangZhou 3G Information Technology Co., Ltd. (16)
10.17	Agreements of Consulting, Pledge, and Power of Attorney of Clickcom and Sunroom (14)
10.18	Agreement for the Sale and Purchase of Shares in Lion Zone Holdings (13)
10.19+	Form of Lock-Up Agreement, dated March 13, 2006
10.20+	Form of Voting Agreement, dated March 13, 2006
14	Code of Ethics (9)
21	List of Subsidiaries (Included in Exhibit 99.1)
23.1+	Consent of Clancy & Co. P.L.L.C
99.1	Corporate structure chart of our corporate and share ownership structure (14)
99.2	Subscription Agreement by and between the Company and Sino Mart Management Ltd., dated as of December 9, 2001 (6)
99.3	19.9% Private Placement Agreement and Amendments between Ho Shu-Jen and PacificNet.com Inc. (7)

 

+ Filed herewith.

(1)    Incorporated by reference to the Company's Form SB-2 filed on October 21, 1998.

(2)    Incorporated by reference to the Company's Form 8-K filed on August 11, 2000.

(3)    Incorporated by reference to the Company's Form 8-K filed on October 17, 2000.

(4)    Incorporated by reference to the Amendment to Registration Statement on Form S-3 on Form SB-2/A

 (Registration No. 333-113209) filed on April 21, 2004.

(5)    Incorporated by reference to the Registration Statement on Form S-3 filed on March 2, 2004

(6)    Incorporated by reference to the Company's Form 8-K filed on March 20, 2002.

(7)    Incorporated by reference to the Company's Form 10-KSB filed on April 16, 2002.

(8)    Incorporated by reference to the Company's 10-KSB filed on March 31, 2003.

(9)    Incorporated by referenced to the Company's Form 10-KSB filed on April 2, 2004.

(10)  Previously filed as an exhibit to the Form SB-2 Registration Statement filed on December 30, 2004.

(11)  Incorporated by reference to the Company's Form 8-K filed on April 19, 2004.

(12)  Incorporated by reference to the Company's Form 8-K filed on March 6, 2006

(13)  Incorporated by reference to the Company's Form 8-K filed on December 20, 2005.

(14)  Incorporated by reference to the Company's Form 10-KSB filed on April 28, 2006.

(15)  Incorporated by reference to the Company’s Definitive Proxy Statement filed on November 19, 2004.

(16)  Incorporated by reference to the Company’s Form 10-KSB filed on April 19, 2005.

 

 

EXHIBITS

 

EXHIBIT NUMBER	DESCRIPTION
2.1	Share Exchange Agreement by and among Davin Enterprises, Inc., Carl Tong, Leo Kwok and Acma Strategic Holdings Limited dated December 15, 1997. (1)
2.2	Share Exchange Agreement dated February 17, 2000, between Registrant and holders of membership interests in PacificNet.com LLC.(2)
2.3	Supplement to Share Exchange Agreement dated April 29, 2000, between Registrant and holders of membership interests in PacificNet.com LLC. (2)
2.4	Agreement dated September 30, 2000, among the Company and the "Purchasers" named therein. (3)
2.5	Supplemental Agreement dated October 3, 2000, among the Company and the "Purchasers" named therein. (3)
2.6	Deed of Waiver, dated October 3, 2000, by Creative Master Limited in favor of the Company. (3)
3.1	Certificate of Incorporation, as amended. (4)
3.2	Form of Amended By Laws of the Company. (4) Specimen Stock Certificate of the Company.
4.1	Securities Purchase Agreement, dated as of January 15, 2004, among PacificNet Inc. and the purchasers identified therein (5)
4.2	Form of Common Stock Warrant issued to each of the purchasers (5)
4.3	Form of Common Stock Warrant issued to each of the purchasers, dated December 9, 2004 (10)
4.4	Form of Common Stock Warrant issued to each of the purchasers, dated November 17, 2004 (10)
4.5	Securities Purchase Agreement, dated February 28, 2006, among PacificNet Inc. and the Holders identified therein (12)
4.6	Form of Variable Rate Convertible Debenture due March 2009 issued to each of the Holders (12)
4.7	Form of Common Stock Purchase Warrant issued to each of the holders (12)
4.8+	Form of Registration Rights Agreement, dated February 28, 2006

 

 

48

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EXHIBIT NUMBER

DESCRIPTION

10.1	Form of Indemnification Agreement with officers and directors. (1)
10.2	Amendment to 1998 Stock Option Plan. (8)
10.3	Form of Notice of Stock Option Grant and Stock Option Agreement under the 1998 Stock Option Plan. (2)
10.4	Amendment dated January 31, 2002 to the Subscription Agreement by and between the Company and Sino Mart Management Ltd., dated as of December 9, 2001 (6)
10.6	Sub-Lease Agreement dated August 30, 2002. (8)
10.7	Agreement dated on December 1, 2003 for the Sale and Purchase and Subscription of Shares in Epro Telecom Holdings Limited (9)
10.8	Agreement dated on December 15, 2003 for the Sale and Purchase of Shares in Beijing Linkhead Technologies Co., Ltd. (9)
10.9	Securities Purchase Agreement, dated as of December 9, 2004, among PacificNet Inc. and the purchasers identified therein (10)
10.10	Securities Purchase Agreement, dated as of November 17, 2004, among PacificNet Inc. and the purchasers identified therein (10)
10.11	Agreement for the Sale and Purchase of Shares in Shanghai Classic Group Limited (4)
10.12	Agreement for the Sale and Purchase of Shares of Cheer Era Limited (11)
10.13	Agreement for the Sale and Purchase of Shares in Pacific Smartime Solutions Limited
10.14	Agreement for the Sale and Purchase of Shares in Guangzhou Clickcom Digit-net Science and Technology Ltd. (16)
10.15	PacificNet Inc. 2005 Stock Option Plan (15)
10.16	Agreement for the Sale and Purchase of Shares in GuangZhou 3G Information Technology Co., Ltd. (16)
10.17	Agreements of Consulting, Pledge, and Power of Attorney of Clickcom and Sunroom (14)
10.18	Agreement for the Sale and Purchase of Shares in Lion Zone Holdings (13)
10.19+	Form of Lock-Up Agreement, dated March 13, 2006
10.20+	Form of Voting Agreement, dated March 13, 2006
14	Code of Ethics (9)
21	List of Subsidiaries (Included in Exhibit 99.1)
23.1+	Consent of Clancy & Co. P.L.L.C
99.1	Corporate structure chart of our corporate and share ownership structure (14)
99.2	Subscription Agreement by and between the Company and Sino Mart Management Ltd., dated as of December 9, 2001 (6)
99.3	19.9% Private Placement Agreement and Amendments between Ho Shu-Jen and PacificNet.com Inc. (7)