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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______ TO ______
Commission File Number 001-15713
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ASIAINFO HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 752506390
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
4TH FLOOR, ZHONGDIAN INFORMATION TOWER
6 ZHONGGUANCUN SOUTH STREET, HAIDIAN DISTRICT
BEIJING 100086, CHINA
(Address of principal executive office, including zip code)
+8610 6250 1658
(Registrant's telephone number, including area code)
(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
----------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes [X] No [_]
The number of shares outstanding of the Registrant's common stock as of
November 11, 2003 was 44,761,698
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ASIAINFO HOLDINGS, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited) ................................. 3
a) Condensed Consolidated Statements of Operations for the three
and nine months ended September 30, 2002 and 2003 ................ 3
b) Condensed Consolidated Balance Sheets as of December 31, 2002
and September 30, 2003 ........................................... 5
c) Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 2002 and 2003 ......................... 6
d) Notes to Condensed Consolidated Financial Statements for the
three and nine months ended September 30, 2002 and 2003 .......... 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ........................................ 22
Item 3. Quantitative and Qualitative Disclosures About Market Risk ....... 41
Item 4. Controls and Procedures .......................................... 41
PART II. OTHER INFORMATION ................................................ 41
Item 1. Legal Proceedings ................................................ 41
Item 2. Changes in Securities and Use of Proceeds ........................ 42
Item 5. Other Information ................................................ 43
Item 6. Exhibits and Reports on Form 8-K ................................. 43
SIGNATURE
CERTIFICATIONS
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ASIAINFO HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
(In US Dollars thousands, except per share amounts)
Three Months Ended September 30,
--------------------------------
2002 2003
--------------- --------------
(unaudited)
Revenues:
Network solutions........................................................ 23,171 19,543
Software revenue......................................................... 9,400 8,441
--------------- --------------
Total revenues........................................................... 32,571 27,984
--------------- --------------
Cost of revenues:
Network solutions........................................................ 20,019 13,890
Software revenue......................................................... 4,052 4,098
--------------- --------------
Total cost of revenues................................................... 24,071 17,988
--------------- --------------
Gross profit................................................................ 8,500 9,996
--------------- --------------
Operating expenses:
Sales and marketing (excluding stock-based compensation: 2002: $31;
2003: nil and amortization of acquired intangible assets: 2002: $238;
2003: nil).............................................................. 3,082 2,820
General and administrative (excluding stock-based compensation: 2002:
$41; 2003: nil and amortization of acquired intangible assets: 2002:
$147; 2003: $41)........................................................ 2,719 3,116
Research and development (excluding stock-based compensation: 2002: $10;
2003: nil and amortization of acquired intangible assets: 2002: $92;
2003:nil)............................................................... 2,097 2,037
Amortization of deferred stock compensation.............................. 82 --
Amortization of acquired intangible assets............................... 477 41
--------------- --------------
Total operating expenses................................................. 8,457 8,014
--------------- --------------
Income from operations...................................................... 43 1,982
--------------- --------------
Other income (expense):
Interest income.......................................................... 523 362
Interest expense......................................................... (1) --
Other income (expense), net.............................................. 6 (1)
--------------- --------------
Total other income, net.................................................. 528 361
--------------- --------------
Income before income taxes, minority interests and equity in loss of
affiliate.................................................................. 571 2,343
Income tax expense ......................................................... 74 --
--------------- --------------
Income before minority interests............................................ 497 2,343
Minority interests in income of consolidated subsidiaries................... 73 --
Equity in loss of affiliate................................................. (102) (94)
--------------- --------------
Net income ................................................................. $ 468 $ 2,249
=============== ==============
Net income per share:
Basic.................................................................... $ 0.01 $ 0.05
=============== ==============
Diluted.................................................................. $ 0.01 $ 0.05
=============== ==============
Shares used in computation:
Basic.................................................................... 44,081,170 44,521,025
=============== ==============
Diluted.................................................................. 44,835,907 46,971,126
=============== ==============
See notes to condensed consolidated financial statements.
3
ASIAINFO HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
(In US Dollars thousands, except per share amounts)
Nine Months Ended September 30,
--------------------------------
2002 2003
--------------- --------------
(unaudited)
Revenues:
Network solutions ....................................................... 71,900 63,605
Software revenue ........................................................ 25,767 21,956
--------------- --------------
Total revenues .......................................................... 97,667 85,561
--------------- --------------
Cost of revenues:
Network solutions ....................................................... 55,835 50,354
Software revenue ........................................................ 9,006 10,505
--------------- --------------
Total cost of revenues .................................................. 64,841 60,859
--------------- --------------
Gross profit ............................................................... 32,826 24,702
--------------- --------------
Operating expenses:
Sales and marketing (excluding stock-based compensation: 2002: $66;
2003: $43 and amortization of acquired intangible assets: 2002: $513;
2003: $6) .............................................................. 11,460 8,265
General and administrative (excluding stock-based compensation: 2002:
$206; 2003: $51 and amortization of acquired intangible assets: 2002:
$515; 2003: $122) ...................................................... 7,736 8,399
Research and development (excluding stock-based compensation: 2002: $60;
2003: $11 and amortization of acquired intangible assets: 2002: $244;
2003: nil) ............................................................. 6,706 7,248
Amortization of deferred stock compensation ............................. 332 105
In-process research and development ..................................... 350 --
Impairment of goodwill and acquired intangible assets ................... -- 30,221
Amortization of acquired intangible assets .............................. 1,272 128
--------------- --------------
Total operating expenses ................................................ 27,856 54,366
--------------- --------------
Income (loss) from operations .............................................. 4,970 (29,664)
--------------- --------------
Other income (expense):
Interest income ......................................................... 1,757 1,182
Interest expense ........................................................ (75) (2)
Other income (expense), net ............................................. 43 (32)
--------------- --------------
Total other income, net ................................................. 1,725 1,148
--------------- --------------
Income (loss) before income taxes, minority interests and equity in loss
of affiliate .............................................................. 6,695 (28,516)
Income tax expense (benefit) ............................................... 870 (958)
--------------- --------------
Income (loss) before minority interests .................................... 5,825 (27,558)
Minority interests in income (loss) of consolidated subsidiaries ........... 63 (12)
Equity in loss of affiliate ................................................ (383) (281)
--------------- --------------
Net income (loss) .......................................................... $ 5,505 (27,851)
=============== ==============
Net income (loss) per share:
Basic ................................................................... $ 0.13 $ (0.63)
=============== ==============
Diluted ................................................................. $ 0.12 $ (0.63)
=============== ==============
Shares used in computation:
Basic ................................................................... 43,387,643 44,329,684
=============== ==============
Diluted ................................................................. 45,765,340 44,329,684
=============== ==============
See notes to condensed consolidated financial statements.
4
ASIAINFO HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(In US Dollars thousands, except per share amounts)
December 31, September 30,
--------------- --------------
2002 (1) 2003
--------------- --------------
(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents ............................................... $ 115,153 $ 116,351
Restricted cash ......................................................... 14,458 16,074
Short-term investments .................................................. 11,260 11,319
Notes receivable ........................................................ 64 2,776
Accounts receivable, trade (net of allowance for doubtful accounts of
$1,133 and $3,367 at December 31, 2002 and September 30, 2003,
respectively) .......................................................... 49,373 55,938
Inventories ............................................................. 10,934 3,535
Other receivables ....................................................... 8,758 12,797
Deferred income taxes - current ......................................... 1,653 1,627
Prepaid expenses and other current assets ............................... 3,441 3,466
--------------- --------------
Total current assets ................................................. 215,094 223,883
Property and equipment - net ............................................... 4,046 2,802
Goodwill ................................................................... 37,255 11,255
Other acquired intangibles - net ........................................... 4,031 68
Investment in affiliate .................................................... 2,808 2,527
Deferred income taxes ...................................................... 196 41
--------------- --------------
Total Assets ......................................................... $ 263,430 240,576
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Short-term bank loans ................................................... $ 60 $ 60
Notes payable ........................................................... 2,447 4,117
Accounts payable ........................................................ 19,261 23,807
Other payables .......................................................... 2,483 1,344
Deferred revenue ........................................................ 5,056 7,548
Accrued employee benefits ............................................... 5,083 6,718
Other accrued expenses .................................................. 13,226 11,105
Income taxes payable .................................................... 2,760 526
Other taxes payable ..................................................... 2,579 1,179
--------------- --------------
Total current liabilities ............................................ 52,955 56,404
Minority interest .......................................................... 317 --
--------------- --------------
Stockholders' Equity:
Common stock, 100,000,000 shares authorized, $0.01 par value, shares
issued and outstanding: 2002: 44,193,474; 2003: 44,711,045 ............. 442 447
Additional paid-in capital .............................................. 200,649 202,405
Deferred stock compensation ............................................. (105) --
Retained earnings (accumulated deficit) ................................. 9,110 (18,741)
Accumulated other comprehensive income .................................. 62 61
--------------- --------------
Total stockholders' equity ........................................... 210,158 184,172
--------------- --------------
Total Liabilities and Stockholders' Equity ........................... $ 263,430 $ 240,576
=============== ==============
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(1) December 31, 2002 balances were obtained from audited financial statements.
See notes to condensed consolidated financial statements.
5
ASIAINFO HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(In US Dollars thousands, except per share amounts)
Nine Months Ended September 30,
--------------------------------
2002 2003
--------------- --------------
(unaudited)
Cash flows from operating activities:
Net income (loss) ....................................................... $ 5,505 $ (27,851)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Depreciation ............................................................ 2,219 1,551
Amortization of other acquired intangible assets ........................ 1,272 128
Impairment of goodwill and acquired intangible assets ................... -- 30,221
In-process research and development ..................................... 350 --
Amortization of deferred stock compensation ............................. 332 105
Deferred income taxes ................................................... (275) 181
Minority interest in loss of consolidated subsidiaries .................. (63) 12
Equity in loss of an affiliate .......................................... 383 281
Loss on disposal of property and equipment .............................. 56 24
Bad debt expense ........................................................ 553 2,155
Stocks issued for services and other .................................... -- 179
Changes in operating assets and liabilities, net of effects of
business acquired:
Restricted cash ...................................................... 3,544 (1,616)
Notes receivable ..................................................... -- (2,712)
Accounts receivable .................................................. 14,792 (8,722)
Inventories .......................................................... (1,946) 7,399
Other receivables .................................................... (1,571) (4,056)
Prepaid expenses and other current assets ............................ (381) (23)
Notes payable ........................................................ -- 1,670
Accounts payable ..................................................... (4,106) 4,546
Other payables ....................................................... 6 (1,084)
Deferred revenue ..................................................... (121) 2,492
Accrued employee benefits ............................................ (2,544) 1,635
Other accrued expenses ............................................... 1,599 (2,121)
Income taxes payable ................................................. (589) (1,796)
--------------- --------------
Other taxes payable .................................................. (1,764) (1,400)
--------------- --------------
Net cash provided by operating activities .................................. 17,211 1,198
Cash flows from investing activities:
Decrease (increase) in short-term investments ........................... 23,174 (59)
Purchases of property and equipment ..................................... (885) (351)
Proceeds from disposal of fixed assets .................................. 29 19
Increase in loan receivable ............................................. (3,572) --
Purchase of a subsidiary, net of cash acquired .......................... (26,063) (205)
--------------- --------------
Net cash used in investing activities ...................................... (7,317) (596)
--------------- --------------
6
ASIAINFO HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)--(CONTINUED) (In US
Dollars thousands, except per share amounts)
Nine Months Ended September 30,
--------------------------------
2002 2003
--------------- --------------
(unaudited)
Cash flows from financing activities:
Increase in short-term bank loans ....................................... $ 2,924 --
Repayment of short-term bank loans ...................................... (7,636) --
Proceeds on exercise of stock options ................................... 2,628 1,022
Distribution to minority shareholder of consolidated subsidiaries ....... (218) (427)
--------------- --------------
Net cash (used in) provided by financing activities ..................... (2,302) 595
--------------- --------------
Net increase in cash and cash equivalents: .............................. 7,592 1,197
Cash and cash equivalents at beginning of period ........................... 110,635 115,153
Effect of exchange rate changes on cash and cash equivalents ............... 38 1
--------------- --------------
Cash and cash equivalents at end of period ................................. $ 118,265 116,351
=============== ==============
Supplemental cash flow information: Cash paid during the period:
Interest ................................................................ $ 55 --
=============== ==============
Income taxes ............................................................ $ 1,102 $ 481
=============== ==============
Non-cash investing activity:
In February 2002, the Company acquired 100% of the outstanding equity shares of
Bonson for 1.031,686 shares of common stock ($18,003) and cash of $33,387, of
which $624 represented acquisition costs. $20,433 was paid in cash on April 4,
2002. In connection with the acquisition, the Company acquired assets with a
fair value of $28,364 and assumed liabilities of $17,737.
See notes to condensed consolidated financial statements.
7
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited) Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
1. GENERAL AND BASIS OF PREPARATION
AsiaInfo Holdings, Inc. (the "Company") is incorporated in the State of
Delaware, in the United States of America (the "US"). The Company principally
operates through the following directly owned subsidiaries, or their respective
subsidiaries: AsiaInfo Technologies (China), Inc. ("AsiaInfo Technologies")
(100% owned), incorporated in the People's Republic of China ("China" or the
"PRC"), Marsec System, Inc. ("Marsec System"), the former wholly-owned
subsidiary of Marsec Holdings, Inc. ("Marsec") (100% owned), and Bonson
Information Technology Holdings Limited, ("Bonson") (100% owned), both
incorporated in the Cayman Islands.
On March 2, 2000, the Company completed an initial public offering of 5,750,000
shares of its common stock, raising net proceeds of $126,610. The Company's
common stock is traded on The Nasdaq National Market in the United States.
The Company acts as a holding company and, through certain subsidiaries, sources
network-related equipment in the United States for sale to customers in the PRC.
AsiaInfo Technologies was established as a wholly foreign owned enterprise with
an initial operating term of 15 years commencing May 2, 1995 (date of
establishment). Its principal activities are conducted in the PRC and comprise
the provision of telecommunications-related information technology professional
services and software products. In November 2001, the Company merged its
wholly-owned subsidiary, Zhejiang AsiaInfo Telecommunication Technology Co.,
Ltd. ("AI Zhejiang"), into AsiaInfo Technologies. AI Zhejiang's activities were
performed in the PRC and comprised the development and sale of communication
hardware and software as well as providing related technology services.
On December 31, 2001, AsiaInfo Technologies formed a wholly-owned subsidiary,
AsiaInfo Technologies (Chengdu), Inc. ("AI Chengdu"), with an initial operating
term of 15 years to provide operational support for systems integration
projects.
Marsec System provides network security consulting and services in the PRC and
is currently in the process of merging with and into AsiaInfo Technologies.
8
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
1. GENERAL AND BASIS OF PREPARATION - CONTINUED
On April 27, 2001, the Company invested approximately $6,157 to acquire a 14.25%
interest (in the form of voting preferred shares) in Intrinsic Technology
(Holdings), Ltd. ("Intrinsic"), a Cayman Islands company engaged in wireless
infrastructure solutions development through two wholly owned subsidiaries in
the PRC. As of September 30, 2003, the Company's interest in Intrinsic had been
diluted from 14.25% to 14.22% due to another shareholder's exercise of warrants
to purchase 37,770 shares of Intrinsic's stock.
In February 2002, the Company acquired 100% of the outstanding equity shares of
Bonson, a leading developer of wireless telecommunications software and
solutions, operating through its subsidiary AsiaInfo Management Software, Inc.
(formerly Guangzhou Bonson Technology Limited) ("AsiaInfo Management"), based in
Guangzhou, China, for $32,763 in cash, including a holdback of $105 which was
paid in June 2003, and the issuance of 1,031,686 shares of the Company's common
stock.
The consolidated financial statements include the financial statements of the
Company and its subsidiaries. All significant inter-company transactions and
balances are eliminated in consolidation. Investments in 50% or less owned
affiliates over which the Company exercises significant influence, but not
control, are accounted for using the equity method. The Company's share of
earnings (losses) of these companies is included in the accompanying
consolidated statement of operations.
All adjustments necessary for a fair presentation of the unaudited results of
operations for the three months and nine months ended September 30, 2002 and
2003 are included in the accompanying condensed financial statements. All such
adjustments are of a normal and recurring nature. The results of operations for
the periods are not necessarily indicative of the results of operations for the
full year. The financial statements are unaudited.
The Company's revenue is derived from the procurement of hardware on behalf of
customers, software license fees, and professional services for systems design,
planning, consulting, and systems integration, and is recognized based on the
percentage of completion method. Revenues from customer orders requiring
significant production, modifications, or customization of the software are
recognized over the installation and customization period. Labor costs and
direct project expenses are used to determine the stage of completion, except
for revenues associated with the procurement of hardware. Such hardware-related
revenues are recognized upon delivery. Estimates of hardware warranty costs are
included in determining project costs. Revenue from packaged software license
fees through reseller arrangements is recorded when the related products are
shipped and installed. Costs related to insignificant obligations for a period
of up to one year, which include telephone support, are accrued at the time the
revenue is recorded.
9
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
1. GENERAL AND BASIS OF PREPARATION - CONTINUED
Software revenue includes the benefit of the rebate of value added taxes on
sales of software received from the Chinese tax authorities as part of the PRC
government's policy of encouragement of software development in the PRC. The
rebate was $550 and $499 for the three months ended September 30, 2002 and 2003,
respectively, and $1,813 and $1,347 for the nine months ended September 30, 2002
and 2003, respectively.
Revisions in estimated contract profits are made in the period in which the
circumstances requiring the revision become known. Provisions, if any, are made
currently for anticipated losses on uncompleted contracts. Revenue in excess of
billings is recorded as unbilled receivables and included in trade accounts
receivable, and amounted to $28,767 at December 31, 2002 and $34,530 at
September 30, 2003. Billings in excess of revenues recognized are recorded as
deferred income. Billings are rendered based on agreed milestones included in
the contracts with customers.
At December 31, 2002 and September 30, 2003, the balance of trade accounts
receivable of $20,606 and $21,408, respectively, represented amounts billed but
not yet collected. All billed and unbilled amounts are expected to be collected
within 1 year.
These financial statements of the Company and its subsidiaries are prepared in
accordance with accounting principles generally accepted in the United States of
America (" U.S. GAAP" ). This basis of accounting differs from that used in the
statutory financial statements of the PRC subsidiaries which are prepared in
accordance with the accounting principles and the relevant financial regulations
applicable to enterprises with foreign investment as established by China' s
Ministry of Finance. The principal adjustments made to conform the statutory
financial statements of these subsidiaries to U.S. GAAP included an adjustment
to record goodwill from business acquisitions and the related impairment
provisions, and an adjustment to recognize compensation expense on the issuance
of stock options.
The preparation of financial statements in conformity with U.S. GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosures of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
The financial records of the Company's PRC subsidiaries are maintained in
Renminbi ("RMB"), their functional currency and the currency of the PRC. Their
balance sheets are translated into United States dollars based on the rates of
exchange ruling at the balance sheet date. Their statements of operations are
translated using a weighted average rate for the period. Translation adjustments
are reflected as cumulative translation adjustments in stockholders' equity. The
Renminbi is not fully convertible into United States dollars or other foreign
currencies. The rate of exchange quoted by the People's Bank of China on
September 30, 2003 was US$1.00=RMB8.2770.
10
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
1. GENERAL AND BASIS OF PREPARATION - CONTINUED
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an Amendment of FASB Statement No.
123," which provides alternative methods of transition for a voluntary change to
the fair value based method of accounting for stock-based employee compensation.
In addition, this Statement amends the disclosure requirements of SFAS No. 123
to require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The amended disclosure
requirements of SFAS No. 148 are effective for years ending after December 15,
2002 and are reflected in the Company's condensed consolidated financial
statements.
In November 2002, the Emerging Issues Task Force (the "EITF") reached a
consensus on Issue No. 00-21 ("EITF 00-21"), "Revenue Arrangements with Multiple
Deliverables". EITF 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which the vendor will perform multiple revenue
generating activities. EITF 00-21 is effective for fiscal periods beginning
after June 15, 2003. The adoption of EITF 00-21 did not have a material impact
on the Company's financial statements.
Reclassifications - Certain comparative figures have been reclassified to
conform to the current period's presentation.
2. CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, demand deposits and highly
liquid investments, which are unrestricted as to withdrawal or use, and which
have maturities of three months or less when purchased.
3. SHORT-TERM INVESTMENTS
Short-term investments are classified as available for sale and consist
principally of certificates of deposit issued by major financial institutions
that have maturities of between 6 and 12 months. As there are no significant
market price movements for such investments, they are held at cost and accrued
interest. There were no realized or unrealized gains or losses on such
investments as of September 30, 2003.
4. NOTES RECEIVABLE
At December 31, 2002 and September 30, 2003, the balances of notes receivable of
$64 and $2,776, respectively, represented bank acceptance drafts that are
non-interest bearing and due within six months.
11
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
5. COMPREHENSIVE INCOME
The components of comprehensive income for the periods presented are as follows:
Three Months
Ended September 30,
-------------------------
2002 2003
----------- -----------
Net income................................... $ 468 $ 2,249
Change in cumulative translation adjustment.. 6 2
----------- -----------
Comprehensive income......................... $ 474 $ 2,251
=========== ===========
Nine Months
Ended September 30,
-------------------------
2002 2003
----------- -----------
Net income (loss)............................ $ 5,505 $ (27,851)
Change in cumulative translation adjustment.. 43 (1)
----------- -----------
Comprehensive income (loss).................. $ 5,548 $ (27,852)
=========== ===========
6. SHORT-TERM BANK LOANS
As of December 31, 2002 and September 30, 2003, the Company had total short-term
credit facilities for working capital purposes totaling $20,000 and $32,081,
expiring by October 2003 and June 2004, respectively. The facilities were
secured by bank deposits of $10,000 as of December 31, 2002 and September 30,
2003, respectively. At December 31, 2002, unused short-term credit facilities
were $18,574 and used facilities totaled $1,426. The used facilities were
pledged as security for standby letters of credit issued to hardware suppliers
and customers. Additional bank deposits of $4,458 were used for issuing standby
letters of credit and guarantees as of December 31, 2002. At September 30, 2003,
unused short-term credit facilities were $27,726 and used facilities totaled
$4,355. The used facilities are pledged as security for standby letters of
credit issued to hardware suppliers and customers. Additional bank deposits of
$6,074 were used for issuing standby letters of credit and guarantees as of
September 30, 2003. Bank deposits pledged as security for these credit
facilities totaled $14,458 and $16,074 as of December 31, 2002 and September 30,
2003, respectively, and are presented as restricted cash in the consolidated
balance sheets.
In addition, as of December 31, 2002 and September 30, 2003, the Company had
short-term borrowings of $60 in RMB, the currency of the PRC, bearing an
interest rate of 4.8% and secured by AsiaInfo Management's assets.
7. NOTES PAYABLE
At December 31, 2002 and September 30, 2003, the balances of notes payable of
$2,447 and $4,117, respectively, represented commercial notes of $1,245 and
$1,273, and bank acceptance drafts of $1,202 and $2,844, respectively, that are
non-interest bearing and due within six months.
12
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
8. INCOME TAXES
The Company is subject to US federal and state income taxes. The Company's
subsidiaries incorporated in the PRC are subject to PRC income taxes.
A reconciliation between the provision for income taxes computed by applying the
US federal tax rate to income (loss) before income taxes, minority interests and
equity in loss of affiliate and the actual provision for income taxes is as
follows:
Three Months
Ended September 30,
----------------------
2002 2003
--------- ---------
US federal rate................................ 35% 35%
Difference between statutory
rate and foreign effective tax rate.......... (23) (33)
Change in valuation allowance.................. -- --
Expenses not deductible
for tax purposes-deferred
stock compensation expense .................. 4 --
Other ......................................... (3) (2)
--------- ---------
13% --
========= =========
Nine Months
Ended September 30,
----------------------
2002 2003
--------- ---------
US federal rate................................ 35% (35%)
Difference between statutory rate
and foreign effective tax rate............... (23) 24
Change in valuation allowance.................. -- 3
Benefit of stock option deduction ............. -- (3)
Non-deductible goodwill and
intangible expenses ......................... -- 8
Expenses not deductible for tax
purposes-deferred stock
compensation expense ........................ 4 --
Other ......................................... (3) --
--------- ---------
13% (3%)
========= =========
13
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
9. CAPITAL STOCK
Option activity in the Company's stock option plans is summarized as follows:
Outstanding options
weighted average
exercise price
Number of shares per share
---------------- -------------------
Outstanding, January 1, 2003: 9,885,565 $ 8.14
Granted............................... 80,750 5.25
Cancelled............................. (404,524) 10.61
Exercised............................. (3,100) 3.83
---------------- -------------------
Outstanding, March 31, 2003........... 9,558,691 $ 8.01
================ ===================
807,000 4.20
Granted...............................
Cancelled............................. (454,957) 9.92
Exercised............................. (6,650) 3.11
---------------- -------------------
Outstanding, June 30, 2003............ 9,904,084 $ 7.62
================ ===================
1,130,495 7.17
Granted...............................
Cancelled............................. (413,618) 10.46
Exercised............................. (445,599) 2.22
---------------- -------------------
Outstanding, September 30, 2003....... 10,175,362 $ 7.69
================ ===================
The exercise price of all options granted during the three months and the nine
months ended September 30, 2003 was equal to the fair market value of the
Company's common stock on the dates of grant.
10. ACCOUNTING FOR STOCK-BASED COMPENSATION
The following table summarizes relevant information as to reported results under
the Company's intrinsic value method of accounting for stock awards, with
supplemental information as if the fair value recognition provisions of FASB
Statement 123 had been applied:
Three Months
Ended September 30,
------------------------
2002 2003
---------- ----------
Net income as reported........................... $ 468 $ 2,249
Add: Stock-based compensation
included in reported net income................ 82 --
Deduct: Total stock-based
compensation expense
Under SFAS 123, net of tax effect.............. (4,783) (2,508)
------------------------
$ (4,233) $ (259)
Pro forma net loss ..............................
========================
Basic and diluted net income per share: ......... $ 0.01 $ 0.05
Reported basic net income per common share....
========================
Reported diluted net income per common share .. $ 0.01 $ 0.05
========== ==========
Pro forma net loss per common share ........... $ (0.10) $ (0.01)
========== ==========
14
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
10. ACCOUNTING FOR STOCK-BASED COMPENSATION - CONTINUED
Nine Months
Ended September 30,
------------------------
2002 2003
---------- ----------
Net income (loss) as reported.................. $ 5,505 $ (27,851)
Add: Stock-based compensation
included in reported net income
(loss) ...................................... 332 105
Deduct: Total stock-based
compensation expense
Under SFAS 123, net of tax effect............ (12,778) (13,411)
------------------------
Pro forma net loss ............................ $ (6,941) $ (41,157)
========================
Basic and diluted net income
(loss) per share:
Reported basic net income
(loss) per share............................. $ 0.13 $ (0.63)
========================
Reported diluted net income
(loss) per share............................. $ 0.12 $ (0.63)
========================
Pro forma net loss per common share ........... $ (0.16) $ (0.93)
========== ==========
11. NET INCOME (LOSS) PER SHARE
The following is a reconciliation of the numerators and denominators of the
basic and diluted net income (loss) per share computations:
Three Months
Ended September 30,
-----------------------------
2002 2003
------------- -------------
Net income (numerator):
Net income
Basic and diluted........................ $ 468 $ 2,249
============= ============
Shares (denominator):
Weighted average
Common Stock Outstanding................. 44,081,170 44,521,025
------------- -------------
Basic....................................... 44,081,170 44,521,025
Options (Treasury Method)................... 754,737 2,450,101
------------- -------------
Diluted..................................... 44,835,907 46,971,126
============= =============
Net income per share:
Basic....................................... $ 0.01 $ 0.05
============= =============
Diluted..................................... $ 0.01 $ 0.05
============= =============
Nine Months
Ended September 30,
-----------------------------
2002 2003
------------- -------------
Net income (numerator):
Net income (loss)
Basic and diluted.......................... $ 5,505 $ (27,851)
============= =============
Shares (denominator):
Weighted average
Common Stock Outstanding................... 43,387,643 44,329,684
------------- -------------
Basic...................................... 43,387,643 44,329,684
Options (Treasury Method).................. 2,377,697 --
------------- -------------
Diluted.................................... 45,765,340 44,329,684
============= =============
Net income (loss) per share:
Basic...................................... $ 0.13 $ (0.63)
============= =============
Diluted.................................... $ 0.12 $ (0.63)
============= =============
15
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
11. NET INCOME (LOSS) PER SHARE - CONTINUED
As of September 30, 2002, the Company had 8,100,297 options outstanding that
could have potentially diluted earnings per share ("EPS") in the future, but
which were excluded in the computation of diluted EPS in these periods, as their
exercise prices were above the average market values in such periods.
As of September 30, 2003, the Company had 10,175,362 options outstanding that
could have potentially diluted EPS in the future, but which were excluded in the
computation of diluted EPS in these periods, as their effect would have been
antidilutive due to the net loss reported in these periods.
12. ACQUISITION
On January 22, 2003, the Company entered into an agreement to acquire the
250,000 common shares, or 21% stake, of Marsec it did not already own, in
exchange for 14,375 shares of the Company's common stock and approximately $150
in cash. The aggregate acquisition price consisted of. The total consideration
was recorded as goodwill on the date of the transaction but management believed
such goodwill was impaired on that date. As a result, the full amount was
charged to the impairment of goodwill and acquired intangible assets in the
condensed consolidated statements of operations.
On February 6, 2002 (the "date of acquisition"), the Company acquired all of the
outstanding common shares of Bonson, a provider of operation support system
solutions and other services in China. The results of Bonson's operations have
been included in the consolidated financial statements since that date.
The aggregate purchase price was $51,390, including $32,763 in cash, $624 of
acquisition costs and common stock valued at $18,003. The value of the 1,031,686
common shares issued was determined based on the average market price of the
Company's common shares over the 5-day period before and after the terms of the
acquisition were agreed to and announced.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition:
At February 6,2002
------------------
Current assets.......................................... $ 27,517
Property, plant, and equipment.......................... 843
Intangible assets....................................... 6,130
Goodwill................................................ 35,067
Deferred tax assets..................................... 4
------------------
Total assets acquired................................ 69,561
Current liabilities..................................... (17,737)
Deferred tax liabilities................................ (434)
------------------
Total liabilities assumed............................ (18,171)
------------------
Net assets acquired.................................. $ 51,390
==================
The total purchase price had been allocated to the assets acquired and
liabilities assumed based on their respective fair values as follows:
Purchase Price Allocation:
Fair market value of net tangible assets
acquired at February 6, 2002................ $ 10,627
Intangible assets acquired: Economic Life
-------------
Core technology.............................. 1,280 3.5 years
Trade name................................... 700 Indefinite
Indefinite contract backlog.................. 2,700 2 years
Favorable lease.............................. 400 2.1 years
License...................................... 700 Indefinite
In-process technology........................ 350
Goodwill..................................... 35,067 Indefinite
Deferred tax liabilities..................... (434)
------------
Total..................................... $ 51,390
============
16
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
12. ACQUISITION - CONTINUED
The Company recorded a charge of $350 at the date of acquisition in accordance
with FASB Interpretation No. 4, "Applicability of FASB Statement No. 2 to
Business Combinations Accounted for by the Purchase Method," for purchased
in-process technology related to a development project that had not reached
technological feasibility, had no alternative future use, and for which
successful development was uncertain. The conclusion that the in-process
development effort, or any material sub-component, had no alternative future use
was reached in consultation with the Company's management and Bonson's
management.
The goodwill of $35,067 arising from the acquisition was assigned to the
operation support system segment and is not expected to be deductible for tax
purposes.
During the quarter ended March 31, 2003, the Company completed an annual
impairment test for the goodwill and other acquired intangible assets of Bonson
and concluded that an impairment of $29,836 of the recorded goodwill and other
acquired intangible assets of Bonson was necessary due to industry-wide equity
devaluations of the past year. Both an income (discounted cash flow) approach
and a market (guideline company) approach were employed to determine the fair
value of the net assets of Bonson. The fair value was then allocated among all
the assets of Bonson at their fair values, including previously unrecognized
intangible assets. The residual value after the allocation was then compared to
the carrying value of goodwill to determine the amount of impairment loss. The
goodwill of $26,000 and other acquired intangible assets of $3,836 impaired are
related to the operation support system solutions segment. After the impairment
is recorded, the remaining goodwill and other acquired intangible assets of
Bonson are $9,067 and $148, respectively.
The following selected unaudited pro forma combined results of operations for
the three months and nine months ended September 30, 2002 of the Company and
Bonson have been prepared assuming that the acquisitions occurred at the
beginning of that period. The following pro forma financial information is not
necessarily indicative of the results that would have occurred had the
acquisition been completed at the beginning of the period indicated, nor is it
indicative of future operating results:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
2002 2002
------------------ -----------------
Total revenue........................ $ 32,571 $ 98,198
Net income........................... 468 5,184
Net income per share
- Basic........................... $ 0.01 $ 0.12
- Diluted......................... $ 0.01 $ 0.11
Shares used in calculation of net
income per share
- Basic........................... 44,081,170 43,669,661
- Diluted......................... 44,835,907 46,047,359
17
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
12. ACQUISITION - CONTINUED
The pro forma results of operations give effect to certain adjustments,
including amortization of purchased intangibles with definite lives, associated
with the acquisition. The charge for purchased in-process research and
development of $350 has been excluded from the pro forma results, as it is a
material non-recurring charge.
13. SEGMENT AND GEOGRAPHIC OPERATING INFORMATION
During the third quarter of 2003, the Company reorganized its operations
structure so that its business operations focus on specific customers rather
than product lines. Instead of selling its products and services through its two
former strategic business units, Communications Solutions (CS) and Operation
Support Systems Solutions (OSS), the Company now has had one point of sales
contact for its major customers, streamlining the relationship and interaction
with its customers.
The new customer based structure is designed to offer customers a "one window"
shopping solution for all of their needs, including all the business lines from
the Company such as network solutions, software license and services, service
applications solutions and network security solutions. The new structure
benefits from cost efficiencies gained from combined sales and marketing as well
as research and development staff and offers more integrated quality services to
the Company's customers. In order to aid investors' understanding of the
Company's business, the Company has adopted a financial reporting structure that
is based on network solutions and software revenue.
Three Months Ended September
30,
----------------------------
2002 2003
------------ -----------
(unaudited)
Revenues net of hardware cost:
Network solutions ................................ $ 5,287 $ 7,399
Software revenue ................................. 9,400 8,441
------------ -----------
Consolidated revenues net of hardware cost ....... 14,687 15,840
------------ -----------
Consolidated cost of sales net of hardware cost .. 6,187 5,844
------------ -----------
Consolidated gross profit ........................ $ 8,500 $ 9,996
============ ===========
Nine Months Ended September
30,
----------------------------
2002 2003
------------ -----------
(unaudited)
Revenues net of hardware cost:
Network solutions................................. $ 25,607 $ 19,358
Software revenue.................................. 25,767 21,956
------------ -----------
Consolidated revenues net of hardware cost........ 51,374 41,314
------------ -----------
Consolidated cost of sales net of hardware cost... 18,548 16,612
------------ -----------
Consolidated gross profit......................... $ 32,826 $ 24,702
============ ===========
18
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
13. SEGMENT AND GEOGRAPHIC OPERATING INFORMATION - CONTINUED
The 2002 information has been reclassified to conform to the current operating
segments.
For the nine months ended September 30, 2002 and 2003, almost all of the
Company's revenues have been derived from sales to customers in the People's
Republic of China. Revenues are attributed to the country based on the country
of installation of hardware, software and performance of system integration work
and software related services. As of December 31, 2002 and September 30, 2003,
99% of the Company's long-lived assets are located in the People's Republic of
China.
14. COMMITMENTS AND CONTINGENCIES
IPO Litigation
On December 4, 2001, a securities class action case was filed in New York City
against the Company, certain of its current officers and directors and the
underwriters of the Company's initial public offering, or IPO. The lawsuit
alleged violations of the federal securities laws and was docketed in the United
States District Court for the Southern District of New York, or the Court, as
Hassan v. AsiaInfo Holdings, Inc., et al. The lawsuit alleged, among other
things, that the underwriters of the Company's IPO improperly required their
customers to pay the underwriters excessive commissions and to agree to buy
additional shares of the Company's common stock in the aftermarket as conditions
to their purchasing shares in the Company's IPO. The lawsuit further claimed
that these supposed practices of the underwriters should have been disclosed in
the Company's IPO prospectus and registration statement. The suit seeks
rescission of the plaintiffs' alleged purchases of the Company's common stock as
well as unspecified damages. In addition to the case against the Company,
various other plaintiffs have filed approximately 1,000 other, substantially
similar class action cases against approximately 300 other publicly traded
companies and their IPO underwriters in New York City, which along with the case
against the Company have all been transferred to a single federal district judge
for purposes of case management.
On July 15, 2002, together with the other issuer defendants, the Company filed a
collective motion to dismiss the consolidated, amended complaints against the
issuers on various legal grounds common to all or most of the issuer defendants.
The underwriters also filed separate motions to dismiss the claims against them.
On October 9, 2002, the Court dismissed without prejudice all claims against the
individual defendants in the litigation. The dismissals were based on
stipulations signed by those defendants and the plaintiffs' representatives. On
February 19, 2003, the Court issued its ruling on the motions to dismiss filed
by the underwriter and issuer defendants. In that ruling the Court granted in
part and denied in part those motions. As to the claims brought against the
Company under the anti-fraud provisions of the securities laws, the Court
dismissed all such claims without prejudice. As to the claims brought under the
registration provisions of the securities laws, which do not require that intent
to defraud be pleaded, the Court denied the motion to dismiss such claims as to
the Company and as to substantially all of the other issuer defendants. The
Court also denied the underwriter defendants' motion to dismiss in all respects.
19
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
14. COMMITMENTS AND CONTINGENCIES - CONTINUED
In June 2003, the Company elected to participate in a proposed settlement
agreement with the plaintiffs in this litigation. If ultimately approved by the
Court, this proposed settlement would result in a dismissal, with prejudice, of
all claims in the litigation against the Company and against any of the other
issuer defendants who elect to participate in the proposed settlement, together
with the current or former officers and directors of participating issuers who
were named as individual defendants. The proposed settlement does not provide
for the resolution of any claims against the underwriter defendants, and the
litigation against those defendants is continuing. The proposed settlement
provides that the class members in the class action cases brought against the
participating issuer defendants will be guaranteed a recovery of $1 billion by
insurers of the participating issuer defendants. If recoveries totaling $1
billion or more are obtained by the class members from the underwriter
defendants, however, the monetary obligations to the class members under the
proposed settlement will be satisfied. In addition, all participating issuer
defendants will be required to assign to the class members certain claims that
the Company may have against the underwriters.
The proposed settlement contemplates that any amounts necessary to fund the
settlement or settlement-related expenses would come from participating issuers'
directors and officers liability insurance policy proceeds as opposed to funds
of the participating issuer defendants themselves. A participating issuer
defendant could be required to contribute to the costs of the settlement if that
issuer's insurance coverage were insufficient to pay that issuer's allocable
share of the settlement costs. The Company expects that its insurance proceeds
will be sufficient for these purposes and that it will not otherwise be required
to contribute to the proposed settlement. Consummation of the proposed
settlement is conditioned upon, among other things, negotiating, executing, and
filing with the Court final settlement documents, and final approval by the
Court. If the proposed settlement described above is not consummated, the
Company intends to continue to defend the litigation vigorously. Moreover, if
the proposed settlement is not consummated, the Company believes that the
underwriters may have an obligation to indemnify the Company for the legal fees
and other costs of defending this suit and that the Company's directors' and
officers' liability insurance policies would also cover the defense and
potential exposure in the suit. While the Company cannot guarantee the outcome
of these proceedings, the Company believes that the final result of these
actions will have no material effect on the Company's consolidated financial
condition, results of operations or cash flows.
Warranty Costs
The Company's product warranty accrual reflects management's best estimate of
probable liability under its product warranties. Management determines the
warranty based on historical experience and other currently available evidence.
Changes in the product warranty accrual for the 9 months ended September 30,
2003 were as follows:
Balance, beginning of period ...................................... $ 2,229
Payments made ..................................................... (59)
Change in liability for warranties issued during the period ....... (232)
----------
Balance, end of period ............................................ $ 1,938
==========
20
ASIAINFO HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Three and Nine Months Ended September 30, 2002 and 2003
(In US dollars thousands, except per share amounts)
15. RELATED PARTY TRANSACTION
The change in liability for warranties issued includes the reversal of
warranties of $530 related to projects of warranty period that had expired
during the period.
On May 16, 2002, China Merchants Bank, Beijing Branch ("Merchants Bank") entered
into an agreement to provide a revolving credit facility to China Netcom of up
to approximately $9,061 in connection with China Netcom's past and future
purchases of network solutions from AsiaInfo Technologies. China Netcom may draw
on the facility to fund amounts that will become payable to AsiaInfo
Technologies under bankers' acceptances and the amount drawn down by China
Netcom was nil as of September 30, 2003. AsiaInfo Technologies has guaranteed
China Netcom's obligations to Merchants Bank under the facility and agreed to
pay principal and interest on the drawn loan if China Netcom defaulted. The
agreement expired on May 16, 2003.
16. SUBSEQUENT EVENT
On October 20, 2003, the Company entered into an agreement to acquire certain
net assets of Pacific Software (China) Limited, a provider of human resource
management and business intelligence software solutions. The aggregate
acquisition price is expected to consist of shares of the Company's common stock
and approximately $6,450 in cash, subject to adjustment.
21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Except for historical information, the statements contained in this Quarterly
Report on Form 10-Q are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. The Private Securities Litigation Reform Act of 1995 (the "Reform Act")
contains certain safe harbors regarding forward-looking statements. Certain of
the forward-looking statements include management's expectations, intentions and
beliefs with respect to our growth, our operating results, the nature of the
industry in which we are engaged, our business strategies and plans for future
operations, our needs for capital expenditures, capital resources and liquidity;
and similar expressions concerning matters that are not historical facts. Such
forward-looking statements are subject to risks and uncertainties that could
cause actual results to differ materially from those expressed in the
statements. All forward-looking statements included in this document are based
on information available to us on the date hereof, and we assume no obligation
to update any such forward-looking statements. These cautionary statements are
being made pursuant to the provisions of the Reform Act with the intention of
obtaining the benefits of the safe harbor provisions of the Reform Act. Among
the factors that could cause actual results to differ materially are the factors
discussed below under the heading "Factors Affecting our Operating Results and
our Common Stock."
OVERVIEW
We are a leading provider of telecommunications network solutions and software
solutions in China. Our software products and network services enable our
customers to build, maintain, operate, manage and continuously improve their
telecommunications infrastructure. Our customers are primarily the major
telecommunications carriers in China and their provincial subsidiaries, such as
China Mobile Communications Corporation, or China Mobile, China United
Telecommunication Corporation, or China Unicom, China Network Communications
Group Corporation, or China Netcom Group and China Telecommunications
Corporation, or China Telecom.
We commenced our operations in the United States in 1993 and moved our
operations from the United States to China in 1995. We began generating
significant network solutions revenues in 1996 and significant software revenues
in 1998. We conduct the bulk of our business through our wholly-owned operating
subsidiaries, AsiaInfo Technologies (China) Inc., or AsiaInfo Technologies, and
AsiaInfo Management Software, Inc. (formerly Guangzhou Bonson Technology
Limited), or AsiaInfo Management, which are both Chinese companies.
In recent periods, we have marketed and sold our products and services through
two strategic business units, or SBUs: Communications Solutions, or CS, and
Operation Support System Solutions, or OSS. Communications Solutions offered
network infrastructure solutions, service application solutions and network
security solutions. Operation Support System Solutions offered customer care and
billing, customer relationship management (including business intelligence and
decision support systems) and order fulfillment management solutions for
telecommunications providers. Accordingly, in recent periods we have reported
our revenues by breaking down the results of the two SBUs, CS and OSS. However,
effective July 1, 2003, we reorganized our operating structure so that our
business operations focus on specific customers, rather than product areas. As a
result, and to better reflect our operating results under the current
organization structure, we decided to revert back to a financial reporting
structure that breaks down our revenues into network solutions revenue and
software revenue, as discussed further below under the heading "Revenues".
We believe that there are opportunities for us to expand into new business areas
and to grow our business both organically and through acquisitions. On October
20, 2003, we entered into a definitive agreement to acquire certain human
22
resources management and business intelligence assets valued at approximately $9
million from Pacific Software (China) Limited, a privately held, medium-sized
software solutions company based in Hong Kong, and from its affiliate, New
Century Pacific Software (Beijing) Limited, a wholly-foreign-owned enterprise
based in Beijing, China. We expect the acquisition to help us expand into the
human resources management, or HRM, and business intelligence, or BI, software
market, and expose us to customers in other industries, outside of our
traditional telecommunication customer base. Consummation of the acquisition is
subject to certain conditions and is expected to occur before the end of 2003.
In view of this acquisition, our past acquisitions and potential future
acquisitions we may engage in, our historical operating results may not be an
adequate basis on which to evaluate our prospects.
IMPACT OF SARS OUTBREAK. The outbreak of Severe Acute Respiratory Syndrome, or
SARS, is believed to have started in Guangdong Province, China in late 2002 and
to have later spread to Beijing. The SARS outbreak impacted our second quarter
2003 revenues by disrupting travel throughout China and causing delays in
service delivery to our customers. In addition, the outbreak of SARS interrupted
our collection efforts, causing our accounts receivable and days sales
outstanding to increase. These effects are reflected in our operating results
for the nine months ended September 30, 2003 and are expected to impact our full
year 2003 operating results. Although the spread of SARS in China appears to
have been contained and our business activities resumed normal operations
throughout the third quarter of 2003, the medical community worldwide has not
fully understood the origin of SARS and has not found a well-recognized
effective treatment for SARS. As a consequence, the potential long-term effects
of SARS on economic growth in China are still unknown. Any future re-emergence
or worsening of the SARS epidemic could have an adverse impact on our business.
IMPACT OF GOODWILL IMPAIRMENT. In connection with our acquisition of Bonson
Information Technology Holdings Limited, we paid the former shareholders of that
company $32.76 million (net of acquisition costs) in cash and 1,031,686 shares
of our common stock (which were valued at approximately $18 million at the time
the acquisition was announced). During the first quarter of 2003, we completed
an annual impairment test as required by Statement of Financial Accounting
Standard ("SFAS") No.142 and recorded a non-cash impairment charge of $29.8
million relating to the goodwill and acquired intangible assets attributable to
our acquisition of Bonson. In addition, during the first quarter of 2003 we
recorded a goodwill impairment of $0.38 million in connection with our
acquisition of the minority interest in our subsidiary, Marsec Holdings, Inc.
The impairments resulted primarily from the industry-wide equity devaluations of
the past year. Although we do not presently anticipate any further impairment
charges, any future deterioration of market conditions or other changes may
require us to record additional impairment charges in the future.
IMPACT OF TELECOMMUNICATIONS INDUSTRY RESTRUCTURING. As a result of a
restructuring in China's telecommunications industry that occurred in 2002, new
orders for telecommunications infrastructure expansion and improvement projects
have decreased over the past several quarters, adversely affecting our net
revenue and profitability. According to China's Ministry of Information
Industry, or MII, overall capital expenditure by telecommunications service
providers decreased by 20% to $24.6 billion in 2002. Although we expect that the
restructuring will have a positive impact on growth in the telecommunications
industry in China in the long-term, most of China's telecommunications carriers
have indicated that their capital expenditure in 2003 will not increase
significantly as compared to 2002. Continued delays in capital expenditure
projects could continue to negatively affect our growth in the near-term. At the
same time, however, we believe the investment focus of our customers is shifting
towards value-added products and services, including establishing and enhancing
their management and operation support systems, which we believe will bring
growth opportunities to our business.
REVENUES
23
Although we report our revenues on a gross basis, inclusive of hardware
acquisition costs that are passed through to our customers, we manage our
business internally based on revenues net of hardware costs, which is consistent
with our strategy of providing our customers with high value IT professional
services and, where efficient, outsourcing lower-end services such as hardware
acquisition and installation. This strategy may result in lower growth rates for
total revenues as against prior periods, but will not adversely impact revenues
net of hardware costs. The following table shows our revenue breakdown on this
basis:
NINE MONTHS ENDED
SEPTEMBER 30, YEAR ENDED DECEMBER 31,
----------------- ---------------------------
2003 2002 2002 2001 2000
------- ------- ------- ------- -------
Network Solutions net 47% 50% 49% 61% 61%
of hardware costs
Software revenue 53% 50% 51% 39% 39%
As indicated in the foregoing table, software revenues increased as a percentage
of total net revenues from 39% in 2001 to 51% in 2002, and increased from 50%
for the first three quarters of 2002 to 53% for the first three quarters of
2003. The increase in 2002 was largely attributable to our acquisition of
Bonson, a leading player in China's operations support systems software market,
in February of that year. The continuous increase in 2003 largely resulted from
our on-going efforts to further grow our software business, which we believe
will enhance our revenue generation capability and profitability.
NETWORK SOLUTIONS REVENUE. Network solutions revenue consists of hardware sales
for equipment procured by us on behalf of our customers from hardware vendors,
as well as services for network planning, design, systems integration and
training. We procure for and sell hardware to our customers as part of our total
solutions strategy. We minimize our exposure to hardware risks by sourcing
equipment from hardware vendors against letters of credit from our customers. We
believe that as the telecommunications-related market in China develops our
customers will increasingly purchase hardware directly from hardware vendors and
hire us for our professional services.
SOFTWARE REVENUE. Software revenues include two types of revenues: software
license revenue and software services revenue. Software license revenue consists
of fees received from customers for licenses or sublicense to use our software
products as well as third party software products in perpetuity, typically up to
a specified maximum number of users. In most cases, our customers must purchase
additional user licenses from us when the number of users exceeds the specified
maximum. Our software license revenue also includes the benefit of value added
tax rebates on software license sales, which are part of the Chinese
government's policy of encouraging China's software industry. Software services
revenue consists of revenue from software installation, customization, training
and other services. To date, substantially all of our revenue from both software
licenses and software services has been derived from customer orders for
projects requiring some modifications or customization of our software. We
recognize substantially all software revenue over the installation and
customization periods, based on the percentage of completion of the related
project as measured by labor costs and direct project expenses.
REVENUE RECOGNITION. We generally charge a fixed price for all of our projects
and recognize revenue based on the percentage of completion of the project.
Software revenues from customer orders requiring significant production,
modifications, or customization of the software are recognized over the
installation and customization period. We use labor costs and direct project
24
expenses to determine the stage of completion, except for revenue associated
with the procurement of hardware, which we recognize upon delivery of the
hardware to the customer. Since a large part of the cost of certain projects,
particularly network solutions projects, often relates to hardware, the timing
of hardware delivery can cause our quarterly gross revenue and inventory level
to fluctuate significantly. However, those fluctuations do not significantly
affect our gross profits because hardware-related revenues generally approximate
the costs of the hardware.
Our projects generally have a life of nine to twelve months, during which there
are three key milestones. The first milestone occurs when the hardware is
delivered, which is usually between three and four months after signing the
contract. The second milestone in a project is at primary acceptance, which
usually occurs around three to four months after hardware delivery. At
preliminary acceptance, most of the services and products are delivered. The
third milestone is final acceptance, which occurs when the customer agrees that
we have satisfactorily completed all of our work on the project.
UNBILLED REVENUE. Our revenue recognition policies result in our recognizing
certain revenues even though we are not due to receive the corresponding cash
payment under the relevant contract. In the case of hardware sales, the customer
typically holds back around 10 to 20% of the hardware contract payments at the
time of delivery until final project acceptance. Although we record all hardware
revenue based on the cost of the hardware at the time of delivery, the 10 to 20%
held back by the customer is recorded as unbilled receivables and does not
become billable until final project acceptance. In the case of services and
software license revenues, most of the revenue becomes billable at the time of
preliminary acceptance, but the customer typically holds back around 10 to 20%
of the services and software contract payments until final acceptance. Unpaid
amounts for services and software, as well as for hardware, become payable at
the time of final project acceptance. When we recognize revenue for which
payments are not yet due, we book unbilled accounts receivable until the
corresponding amounts become billable.
REVENUE BACKLOG. Most of our revenues are derived from customers' orders under
contracts for hardware, software and services. Our backlog at any given time
includes the contracts we have signed but have not yet commenced and the portion
of uncompleted contracts for which revenue has not yet been recognized. Revenues
are recognized during the course of the relevant project, as described above. At
September 30, 2003, our revenue backlog net of hardware costs was $42.4 million,
a 5% decrease as compared to the end of the previous quarter and a 3% increase
as compared to the end of the corresponding period one year ago. We believe this
decrease was primarily due to delays in certain major contracts from the third
quarter of 2003 to the fourth quarter of 2003. Beginning from the fourth quarter
of 2003, we will no longer be reporting our net revenue backlog because our
customers are implementing more complicated approval processes that will
eventually make it difficult, if not impossible, for us to provide accurate net
backlog numbers. However, we expect to continue to report quarterly net revenue
guidance, which we believe is a more accurate means of forecasting our future
operating results.
COST OF REVENUES
NETWORK SOLUTIONS COSTS. Network solutions costs consist primarily of third
party hardware costs, compensation and travel expenses for the professionals
involved in designing and implementing projects, and hardware warranty costs. We
recognize hardware costs in full upon delivery of the hardware to our customers.
In order to minimize our working capital requirements, we generally obtain from
our hardware vendors payment terms that are timed to permit us to receive
payment from our customers for the hardware before our payments to hardware
vendors are due. However, in large projects we sometimes obtain less favorable
payment terms from our customers, thereby increasing our working capital
requirements. We accrue hardware warranty costs when hardware revenue is fully
recognized upon final acceptance. We obtain manufacturers' warranties for
hardware we sell, which
25
cover a portion of the warranties that we give to our customers. We currently
accrue 0.5% of hardware sales to cover potential warranty expenses. This
estimate of warranty cost is based on our current experience with contracts for
which the warranty period has expired.
SOFTWARE COSTS. Software costs consist primarily of three components:
.. packaging and written manual expenses for our proprietary software
products;
.. compensation and travel expenses for the professionals involved in
modifying, customizing or installing our software products and in providing
consultation, training and support services; and
.. software license fees paid to third-party software providers for the right
to sublicense their products to our customers as part of our solutions
offerings.
The costs associated with creating and enhancing our proprietary software are
classified as research and development expenses as incurred.
OPERATING EXPENSES
Operating expenses are comprised of sales and marketing expenses, research and
development expenses, general and administrative expenses, and amortization
expenses for intangible assets and deferred stock compensation. Compensation
expenses consistently comprise a significant portion of our total operating
expenses.
Sales and marketing expenses include compensation expenses for employees in our
sales and marketing departments, third party advertising expenses, as well as
sales commissions and sales agency fees.
Research and development expenses relate to the development of new software and
the enhancement and upgrading of existing software. We expense such costs as
they are incurred.
We provide most of our officers, employees and directors with stock options. In
the past, we granted a number of options with exercise prices below the fair
market value of the related shares at the time of grant, resulting in deferred
compensation expenses. Most of the options granted with exercise prices below
fair market value on the date of grant were issued prior to 1997 and we do not
intend to issue options below fair market value in the future. Therefore, our
deferred compensation expenses have been significantly higher historically than
we expect them to be in future years. The difference between the exercise price
and the fair market value of the related shares is amortized over the vesting
period of the options and reflected on our consolidated statement of operations
as amortization of deferred stock compensation. For more information on our
deferred compensation expenses, please see note 10 to our consolidated financial
statements included in this report.
We make bad debt provisions for accounts receivable balances based on
management's assessment of their recoverability. In any event, we make bad debt
provisions for all accounts receivable balances that are aged over one year. We
include those bad debt provisions in general and administrative expenses.
TAXES
Except for certain of our hardware procurement and resale transactions, we
conduct substantially all of our business through our Chinese operating
subsidiaries. Our Chinese subsidiaries are generally subject to a 30% state
corporate income tax and a 3% local income tax.
Pursuant to the income tax laws of China, foreign invested enterprises meeting
certain criteria set out by the relevant tax authorities can enjoy various
preferential tax treatments. AsiaInfo Technologies is registered and operates in
26
the Beijing Zhongguancun Science Park, and is classified as a "new technology
enterprise." The effective income tax rate for "new technology enterprises"
registered and operating in the Beijing Zhongguancun Science Park is 15%, and
there is an exemption from local income tax as long as the enterprise holds the
"new technology enterprise" status. "New technology enterprises" are exempted
from Chinese state corporate income tax for three years, beginning with their
first year of operations, and are entitled to a 50% tax reduction at the rate of
7.5% for the subsequent three years. The tax exemption for AsiaInfo Technologies
expired on December 31, 1997 and the 50% tax reduction expired on December 31,
2000. However, AsiaInfo Technologies received a continuation of its preferential
tax treatment as an "advanced technology enterprise" for a three-year period
from January 1, 2001 to December 31, 2003, resulting in an effective income tax
rate of 10%. Beginning from January 1, 2004, as a "new technology enterprise"
set up in Beijing Zhongguancun Science Park, the effective income tax rate for
AsiaInfo Technologies will be 15%. Under current law, as long as AsiaInfo
Technologies maintains the "new technology enterprise" status, it will be
exempted from Chinese local corporate income tax.
AsiaInfo Management is registered and operates in the High and New Technology
Industry Development Zone in Guangzhou, China, and is classified as a "high and
new technology enterprise." The effective income tax rate, subject to the
approval of the relevant tax authorities, for "high and new technology
enterprises" registered in High and New Technology Industry Development Zones is
15%. "High and new technology enterprises" are also exempt from Chinese state
and local corporate income tax for two years, beginning with their first
profitable year of operations, and are entitled to a 50% tax reduction at the
rate of 7.5% for the subsequent three years. The tax exemption for AsiaInfo
Management expired on December 31, 2001 and the 50% tax reduction will expire on
December 31, 2004.
AsiaInfo Technologies (Chengdu), Inc., or AsiaInfo Chengdu, is registered in the
High and New Technology Industry Development Zone in Chengdu and is classified
as a "high and new technology enterprise." Subject to the approval of the
relevant tax authorities, "high and new technology enterprises" registered in
the Chengdu High and New Technology Industry Development Zone are exempt from
Chinese state and local corporate income tax for two years, beginning with their
first year of operations (which was year 2002 for AsiaInfo Chengdu), and are
entitled to a tax reduction at the rate of 15% in subsequent years.
Sales of hardware procured in China are subject to a 17% value added tax. Most
of our sales of hardware procured outside China are made through our U.S. parent
company, AsiaInfo Holdings, Inc., and thus are not subject to the value added
tax. We effectively pass value-added taxes on hardware sales through to our
customers and do not include them in revenues reported in our financial
statements. Although sales of software in China are subject to a 17% value added
tax, companies that develop their own software and have the software registered
with the relevant authorities in China are generally entitled to a value added
tax refund. If the net amount of the value added tax payable exceeds 3% of
software sales, the excess portion of the value added tax is refundable
immediately. This policy is effective until 2010. Changes in Chinese tax laws
may adversely affect our future operations.
We are also subject to U.S. income taxes on revenues generated in the United
States, including revenues from our limited hardware procurement activities
through our U.S. parent company, AsiaInfo Holdings, Inc., and interest income
earned in the United States.
FOREIGN EXCHANGE
A majority of our revenues and expenses relating to hardware sales are
denominated in U.S. dollars, and substantially all of our revenues and expenses
relating to the software and service components of our business are denominated
in Renminbi. Although, in general, our exposure to foreign exchange risks should
be limited, the value of our shares will be affected by the foreign exchange
rate between U.S. dollars and Renminbi because the value of our business is
27
effectively denominated in Renminbi, while our shares are traded in U.S.
dollars. Furthermore, a decline in the value of Renminbi could reduce the U.S.
dollar equivalent of the value of the earnings from, and our investment in, our
subsidiaries in China.
CONSOLIDATED RESULTS OF OPERATIONS
REVENUES. Our gross revenues were $28.0 million and $85.6 million, respectively,
in the three- and nine-month periods ended September 30, 2003, representing
decreases of 14% and 12% against the comparable periods in 2002. These decreases
in gross revenues were primarily attributable to the impact of the SARS outbreak
in China, which caused delays in our service delivery to our customers and
corresponding delays in revenue recognition. In addition, gross revenues have
been decreasing as a result of the change in the nature of telecommunications
spending in China, which is shifting from large infrastructure projects (with
high levels of hardware pass through), to value-added software-related project
and other forms of network enhancement.
Revenues net of hardware costs were $15.8 million and $41.3 million,
respectively, in the three- and nine-month periods ended September 30, 2003,
representing an increase of 8% and a decrease of 20% against the comparable
periods in 2002. Software revenues were $8.4 million and $22.0 million,
respectively, in the three- and nine-month periods ended September 30, 2003,
representing decreases of 10% and 15% against the comparable periods in 2002.
The decrease on software revenue was attributable to decreased spending on
internet-protocol, or IP, network software products. Network Solutions net
revenues were $7.4 million and $19.4 million, respectively, in the three- and
nine-month periods ended September 30, 2003, representing an increase of 40%
against the comparable quarter in 2002 and a decrease of 24% against the
comparable nine month period. The quarter to quarter increase was primarily
related to our delivery of network solutions related services under certain
major projects during the quarter.
COST OF REVENUES. Our cost of revenues decreased 25% to $18.0 million, as
compared to the same period in 2002. This decrease in costs of revenues was
attributable to the overall decrease in revenues.
GROSS PROFIT. Our gross profit was $10.0 million and $24.7 million,
respectively, in the three- and nine-month periods ended September 30, 2003,
representing an increase of 18% and a decrease of 25% against the comparable
periods in 2002. Gross profit as a percentage of net revenue increased to 63%
and decreased to 60%, respectively, in the three- and nine-month periods ended
September 30, 2003, as compared to 58% and 64% in the comparable periods of
2002. The improvement in gross margins during the third quarter of 2003 was
attributable to the sequential increase in our net revenue, as well as
improvements in our operational efficiency.
OPERATING EXPENSES. Total operating expenses decreased 5% to $8.0 million in the
three-month period ended September 30, 2003, from $8.5 million in the comparable
period in 2002. This decrease resulted largely from a decrease in sales and
marketing expenses.
Sales and marketing expenses decreased 9% and 28%, respectively, to $2.8 million
and $8.3 million in the three- and nine-month periods ended September 30, 2003,
against the comparable periods in 2002, reflecting our continued efforts to
consolidate our sales force and increase operating efficiency.
Research and development expenses decreased 3% and increased 8%, respectively,
to $2.0 million and $7.2 million, in the three- and nine-month periods ended
September 30, 2003. The quarter to quarter decrease is attributable to the
consolidation of our research and development resources (which were formerly
split between two SBUs).
General and administrative expenses increased 15% and 9%, respectively, to $3.1
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million and $8.4 million, in the three- and nine-month periods ended September
30, 2003, against the comparable periods in 2002. The year-over-year increase
for the third quarter of 2003 was due largely to increases in bad debt
provisions, with the amount of $1.02 million for the third quarter of 2003.
OTHER INCOME (EXPENSE). Other income and expenses, consisting primarily of net
interest income and expense, decreased from income of approximately $0.5 million
and $1.8 million, respectively, in the three- and nine-month periods ended
September 30, 2002 to income of $0.4 million and $1.2 million in the three- and
nine-month periods ended September 30, 2003, primarily due to a decrease in
interest rates and our having less cash invested in interest bearing
investments.
EQUITY IN LOSS OF AFFILIATE. In the three- and nine-month periods ended
September 30, 2003, equity in loss of affiliate of approximately $0.09 million
and $0.28 million, respectively, represented our proportionate share of losses
incurred by Intrinsic, in which we hold a minority stake.
NET INCOME (LOSS). We recorded net income of $2.2 million, or $0.05 basic income
per share, for the quarter ended September 30, 2003. We expect net revenue for
the fourth quarter of 2003 to be between $15 and $16 million, or $0.04 to $0.05
per basic share.
LIQUIDITY AND CAPITAL RESOURCES
Our capital requirements are primarily working capital requirements related to
hardware sales and costs associated with the expansion of our business, such as
research and development and sales and marketing expenses. We recognize hardware
costs in full upon delivery of the hardware to our customers. In order to
minimize our working capital requirements, we generally obtain from our hardware
vendors payment terms that are timed to permit us to receive payment from our
customers for the hardware before our payments to hardware vendors are due.
However, we sometimes obtain less favorable payment terms from our customers,
thereby increasing our working capital requirements. We have historically
financed our working capital and other financing requirements through careful
management of our billing cycle, private placements of equity securities, our
initial public offering in March of 2000 and, to a limited extent, bank loans.
Our accounts receivable balance at September 30, 2003 was $55.9 million,
consisting of $ 21.4 million in billed receivables and $ 34.5 million in
unbilled receivables. Our billed receivables are based on revenue we have booked
and billed. Our unbilled receivables are based on revenue we have booked through
the percentage completion method, but for which we have not yet billed the
customer. For example, we recognize revenues for hardware pass-through at the
time the hardware is accepted by the customer, based on the cost of the
underlying hardware. However, our contracts with our customers will often allow
the customers to withhold 10-20% of the total contract payments until final
project acceptance, which on average is eight to nine months after hardware
delivery. As a result, revenues from hardware pass-through generally represent a
significant portion of our unbilled receivables and can cause the aging of those
receivables to be relatively long.
At the end of the third quarter, our days sales outstanding were 177 days, as
compared to 219 days at the end of the second quarter of 2003. Our billed
receivables were 68 days sales outstanding and our unbilled receivables were 109
days sales outstanding. The lower day sales outstanding were caused by our
enhanced collection abilities. We had positive operating cash flow of $11.6
million in the third quarter of 2003, also primarily attributable to our
enhanced collection abilities.
As of September 30, 2003, we had total short-term credit facilities totaling
$32.1 million, expiring by June 2004, for working capital purposes, of which
unused short-term credit facilities were $27.7 million at that date. At
September 30, 2003, $4.4 million had been used to issue letters of credit and
bank guarantees. Additional borrowings of approximately $0.06 million were
secured by
29
AsiaInfo Management's net assets. All the borrowings were in Renminbi. The loans
carry interest at a rate of 4.8% per annum and are repayable within one year.
Bank deposits pledged as security for those bank loans and short-term credit
facilities totaled $16.1 million as of September 30, 2003, and are presented as
restricted cash in our consolidated balance sheets.
We ended the quarter with a cash position of $143.7 million, of which $11.3
million was in short term investments, $16.1 million was in restricted cash, and
$116.3 million was in cash and cash equivalents. Restricted cash consisted of
$10 million used to secure our $32.1 million credit facility, $5.7 million
pledged as security for issuing standby letters of credit and $0.4 million held
by AsiaInfo Management and pledged as security for guarantees. Our short-term
investments feature fixed income, liquidity and low risk. The cash equivalents
include investments in cash management accounts to enhance our interest income.
As of September 30, 2003, our inventory position was $3.5 million, down from
$4.7 million at the end of the second quarter of 2003. This decrease was
attributable to equipment deliveries for several large projects during the third
quarter of 2003.
Our contractual obligations consist of noncancellable operating lease
agreements. As of September 30, 2003, future minimum lease expenses under
noncancellable operating leases are expected to be approximately $3.1 million,
and become due as presented in the table below:
Operating Leases
----------------
Less than 1 year ........................ $ 1.8 million
1 to 3 years ............................ 1.3 million
4 years and thereafter .................. --
----------------
Total minimum lease expenses ............ $ 3.1 million
================
We anticipate that the net proceeds of our initial public offering in March
2000, together with available funds and cash flows generated from operations,
will be sufficient to meet our anticipated needs for working capital, capital
expenditures and business expansion through 2003. We may need to raise
additional funds in the future, however, in order to fund acquisitions, develop
new or enhanced services or products, respond to competitive pressures to
compete successfully for larger projects involving higher levels of hardware
purchases, or if our business otherwise grows more rapidly than we currently
predict. We plan to raise additional funds, if necessary, through new issuances
of shares of our equity securities in one or more public offerings or private
placements, or through credit facilities extended by lending institutions.
In the event that we decide to pay dividends to our shareholders, our ability to
pay dividends will depend in part on our ability to receive dividends from our
operating subsidiaries in China. Foreign exchange and other regulations in China
may restrict our ability to distribute retained earnings from our operating
subsidiaries in China or convert those payments from Renminbi into foreign
currencies.
CRITICAL ACCOUNTING POLICIES
We prepare our consolidated financial statements in accordance with accounting
principles generally accepted in the United States of America. The preparation
of those financial statements requires us to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amount of revenues and expenses during the reporting period. On an
on-going basis, we evaluate our estimates and judgments, including those related
to revenues and cost of revenues under customer contracts, warranty obligations,
bad
30
debts, income taxes, investment in affiliate, goodwill and other intangible
assets, and litigation. We base our estimates and judgments on historical
experience and on various other factors that we believe are reasonable. Actual
results may differ from these estimates under different assumptions or
conditions. We believe the following critical accounting policies affect the
more significant judgments and estimates used in the preparation of our
consolidated financial statements.
REVENUES AND COST OF REVENUES. We derive a significant portion of our revenue
from fixed-price contracts using the percentage of completion method, which
relies on estimates of total expected contract revenue and costs. We follow this
method since reasonably dependable estimates of the revenue and costs applicable
to various stages of our contracts can be made. Recognized revenues and profit
are subject to revisions as the contract progresses to completion. Accordingly,
changes in our estimates would impact our future operating results.
WARRANTY OBLIGATIONS. We record our estimate of warranty costs at the time of
final project acceptance, when all hardware pass-through revenue has been
recognized. Revisions for estimated warranties may be required in the period in
which actual warranty costs become known, thereby impacting our future operating
results.
BAD DEBTS. We maintain allowances for doubtful accounts for estimated losses
resulting from the aging of accounts receivables or the inability of our
customers to make required payments. If the financial condition of our customers
were to change, changes to these allowances may be required, which would impact
our future operating results.
INCOME TAXES. We record a valuation allowance to reduce our deferred tax assets
to the amount that we believe is more likely than not to be realized. In the
event we were to determine that we would be able to realize our deferred tax
assets in the future in excess of their recorded amount, an adjustment to the
deferred tax asset would increase income in the period such determination was
made. Likewise, should we determine that we would not be able to realize all or
part of our net deferred tax asset in the future, an adjustment to the deferred
tax asset would be charged to income in the period such determination was made.
GOODWILL AND OTHER INTANGIBLE ASSETS. We make assumptions regarding estimated
future cash flows and other factors to determine the fair value of goodwill and
other intangible assets. If these estimates or their related assumptions change
in the future, we may be required to record an impairment charge if the
estimated fair value of goodwill and other intangible assets is less than its
recorded amount. As required under SFAS No.142, during the first quarter of 2003
we completed an annual goodwill impairment test and recorded a one-time,
non-cash impairment charge of $29.8 million relating to the goodwill and
acquired intangible assets attributable to our acquisition of Bonson in February
of 2002, as well as a $0.38 million impairment charge relating to the goodwill
arising from our acquisition of the minority interest of Marsec. The impairments
resulted primarily from the industry-wide equity devaluations of the past year.
Continued deterioration of market conditions may require us to record additional
impairment charges in the future.
INVESTMENT IN AFFILIATE. We account for our minority interest in Intrinsic
Technology (Holdings), Ltd., or Intrinsic, using the equity method. Intrinsic
has incurred operating losses since our investment in April 2001. We conducted
an asset impairment test during the fourth quarter of 2002 in connection with
our private equity investments, including our 14.22% interest in Intrinsic,
which is recorded on our balance sheet as an "investment in affiliate". As a
result of this test, we recorded an impairment charge of approximately $2.0
million in investments in affiliates. Sustained operating losses of this
affiliate or other adverse events could result in our inability to recover the
carrying value of the investment, which may require us to record an additional
impairment charge in the future.
31
LITIGATION. We record contingent liabilities relating to litigation or other
loss contingencies when we believe that the likelihood of loss is probable and
the amount of the loss can reasonably be estimated. Changes in judgments of
outcome and estimated losses are recorded, as necessary, in the period such
changes are determined or become known. Any changes in estimates would impact
our future operating results. Significant contingent liabilities, which we
believe are at least possible, are disclosed in the notes to our consolidated
financial statements.
ACCOUNTING PRONOUNCEMENTS RECENTLY ADOPTED
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an Amendment of FASB Statement No.
123," which provides alternative methods of transition for a voluntary change to
the fair value based method of accounting for stock-based employee compensation.
In addition, this Statement amends the disclosure requirements of SFAS No. 123
to require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The amended disclosure
requirements of SFAS No. 148 are effective for years ending after December 15,
2002 and are reflected in our condensed consolidated financial statements.
In November 2002, the Emerging Issues Task Force (the "EITF") reached a
consensus on Issue No. 00-21 ("EITF 00-21"), "Revenue Arrangements with Multiple
Deliverables." EITF No. 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which the vendor will perform multiple revenue
generating activities. EITF No. 00-21 is effective for fiscal periods beginning
after June 15, 2003. The adoption of EITF 00-21 did not have a material impact
on our financial statements.
FACTORS AFFECTING OUR OPERATING RESULTS AND OUR COMMON STOCK
In addition to the other information in this report, the following factors
should be considered in evaluating our business and our future prospects:
THE GROWTH OF OUR BUSINESS IS DEPENDENT ON GOVERNMENT TELECOMMUNICATIONS
INFRASTRUCTURE AND BUDGETARY POLICY, PARTICULARLY THE ALLOCATION OF FUNDS TO
SUSTAIN THE GROWTH OF THE TELECOMMUNICATIONS INDUSTRY IN CHINA.
Most of our large customers are directly or indirectly owned or controlled by
the government of China. Accordingly, their business strategies, capital
expenditure budgets and spending plans are largely decided in accordance with
government policies, which, in turn, are determined on a centralized basis at
the highest level by the National Development and Reform Commission of China. As
a result, the growth of our business is heavily dependent on government policies
for telecommunications and Internet infrastructure. Insufficient government
allocation of funds to sustain the growth of China's telecommunications
industries in the future could reduce the demand for our products and services
and have a material adverse effect on our ability to grow our business.
On December 11, 2001, in an effort to increase the efficiency of
telecommunications service providers through competition, the State Council of
China announced that it would split China Telecom geographically into a northern
division (comprising ten provinces) and a southern division (comprising 21
provinces). Under the State Council's plan, the northern division of China
Telecom has merged with China Netcom and Jitong Communication, and has been
renamed China Network Communications Group Corporation, or China Netcom Group,
while the southern division operates under the China Telecom name. As a result
of the restructuring, new orders for telecommunications infrastructure expansion
and improvement projects have decreased over the past several quarters,
adversely affecting our backlog and our net revenue. Although we expect that the
restructuring will have a positive impact on growth in the telecommunications
industry in China in the long-term, most of China's telecommunications carriers
32
have indicated that their capital expenditures in 2003 will not increase
significantly as compared to 2002. Continued delays in capital expenditure
projects could continue to negatively affect our growth in the near-term. In
addition, similar restructurings of this nature could cause our operating
results to vary unexpectedly from quarter to quarter in the future.
OUR CUSTOMER BASE IS CONCENTRATED AND THE LOSS OF ONE OR MORE OF OUR CUSTOMERS
COULD CAUSE OUR BUSINESS TO SUFFER SIGNIFICANTLY.
We have derived, and believe that we will continue to derive, a significant
portion of our revenues from a limited number of large customers, such as China
Telecom, China Unicom, China Mobile and China Netcom Group. China Mobile
accounted for 46% of our revenues net of hardware cost in 2002 and for 41% of
our revenue backlog net of hardware cost as of September 30, 2003. The loss,
cancellation or deferral of any large contract by any of our large customers
would have a material adverse effect on our revenues, and consequently our
profits. Our recent acquisition of the HRM and BI assets of Pacific Software is
part of our strategy to further diversify our business and, therefore, gradually
reduce such concentration risk in the future. However, in the near term, the
expected revenue to be generated by our business outside the telecommunications
industry is still limited compared to our overall revenues. Moreover, we can not
provide any assurance that a material proportion of our revenues will be derived
from other industries.
THE LONG AND VARIABLE SALES CYCLES FOR OUR PRODUCTS AND SERVICES CAN CAUSE OUR
REVENUES AND OPERATING RESULTS TO VARY SIGNIFICANTLY FROM PERIOD TO PERIOD AND
MAY ADVERSELY AFFECT THE TRADING PRICE OF OUR COMMON STOCK.
Our revenues and operating results will vary significantly from quarter to
quarter due to a number of factors, many of which are outside of our control and
any of which may cause our stock price to fluctuate. A customer's decision to
purchase our services and products involves a significant commitment of its
resources and an extended evaluation. As a result, our sales cycle tends to be
lengthy. We spend considerable time and expense educating and providing
information to prospective customers about features and applications of our
services and products. Because our major customers operate large and complex
networks, they usually expand their networks and/or apply new features to their
networks in large increments on a sporadic basis. The combination of these
factors can cause our revenues and results of operations to vary significantly
and unexpectedly from quarter to quarter.
A large part of the contract amount of a network solutions project usually
relates to hardware procurement. Since we recognize most of the revenues
relating to hardware plus a portion of contract services revenues at the time of
hardware delivery, the timing of hardware delivery can cause our quarterly gross
revenues and inventory level to fluctuate significantly. Due to the foregoing
factors, we believe that quarter-to-quarter comparisons of our operating results
are not a good indication of our future performance and should not be relied
upon. It is likely that our operating results in some periods may be below the
expectations of public market analysts and investors. In this event, the price
of our common stock will probably decline, perhaps significantly more in
percentage terms than any corresponding decline in our operating results.
OUR WORKING CAPITAL REQUIREMENTS MAY INCREASE SIGNIFICANTLY.
We typically purchase hardware for our customers as part of our turn-key total
solutions services. We generally require our customers to pay 80 to 90% of the
invoice value of the hardware upon delivery. We typically place orders for
hardware against back-to-back orders from customers and seek favorable payment
terms from hardware vendors. This policy has historically minimized our working
capital requirements. However, for certain large and strategically important
projects, we have agreed to payment of less than 80 to 90% of the invoice value
of the hardware upon delivery in order to maintain competitiveness. Wider
adoption of less favorable payment terms or delays in hardware deliveries will
33
require us to increase our working capital needs significantly.
WE HAVE SUSTAINED LOSSES IN PRIOR YEARS AND MAY INCUR SLOWER EARNINGS GROWTH,
EARNINGS DECLINES OR NET LOSSES IN THE FUTURE.
Although we had net income in 1998, 2001 and 2002, we sustained net losses in
1999 and 2000. Recently, we have experienced a decline in earnings growth and
had net losses in the first quarter of 2003 (after impairment charges) and in
the second quarter of the year due to impact of SARS. There are no assurances
that we can sustain profitability or avoid net losses in the future. We continue
to expect that certain of our operating expenses will increase as our business
grows. The level of these expenses will be largely based on anticipated
organizational growth and revenue trends and a high percentage will be fixed. As
a result, any delays in expanding sales volume, generating revenue and
delivering services could result in substantial losses.
OUR HIGH LEVEL OF FIXED COSTS, AS WELL AS INCREASED COMPETITION IN THE SOFTWARE
MARKET, COULD RESULT IN REDUCED OPERATING MARGINS.
We maintain a relatively stable work force of software and network engineers
engaged in all phases of planning and executing projects on behalf of our
customers. As a result, our operating costs are relatively fixed from quarter to
quarter, regardless of fluctuations in our revenues. In recent periods, this has
resulted in our gross profit decreasing as a percentage of our net revenues. For
example, during the second quarter of 2003 our revenues were impacted by the
outbreak of SARS and our gross profit as a percentage of net revenue decreased
to 56% as compared to 66% in the comparable period of 2002. Future fluctuations
in our net revenues could result in similar decreases in our operating margins.
In addition, enhanced competition in the software market and other markets in
which we operate could result in reduced prices, which, together with our
relatively fixed operating costs, could also result in reduced operating
margins.
BUSINESS ACQUISITIONS WE UNDERTAKE MAY BE CHALLENGING, AND WE MAY REALIZE LOSSES
ON OUR INVESTMENTS
In February of 2002, as a key component of our business and growth strategy, we
acquired Bonson, a leading provider of operation support system solutions in
China.
On October 20, 2003, we entered into a definitive agreement to acquire certain
human resources management and business intelligence assets valued at
approximately $9 million from Pacific Software (China) Limited, a privately
held, medium-sized software solutions company based in Hong Kong, and from its
affiliate, New Century Pacific Software (Beijing) Limited, a
wholly-foreign-owned enterprise based in Beijing, China. Consummation of the
acquisition is subject to certain conditions and is expected to occur before the
end of 2003.
In the future, we may acquire other companies or assets that we feel will
enhance our revenue growth, operations and profitability. Such acquisitions
could result in the use of significant amounts of cash, dilutive issuances of
our common stock. Such acquisitions involve other significant risks, including:
.. the difficulties of integrating, assimilating and managing the operations,
technologies, intellectual property, products and personnel of the acquired
business;
.. the diversion of management attention from other business concerns;
.. the additional expense associated with acquired contingent liabilities;
.. the loss of key employees in acquired businesses; and
.. the risk of being sued by terminated employees and contractors.
34
We will need to integrate and manage any businesses we determine to acquire in
the future. Our failure to do so successfully could have a material adverse
effect on our business, results of operations and financial condition.
ASSET IMPAIRMENT REVIEWS MAY RESULT IN FUTURE PERIODIC WRITE-DOWNS.
Effective January 1, 2002, we adopted SFAS No. 142 which requires us, among
other things, to review goodwill and intangible assets for impairment annually.
In connection with our business acquisitions, we make assumptions regarding
estimated future cash flows and other factors to determine the fair value of
goodwill and intangible assets. In assessing the related useful lives of those
assets, we have to make assumptions regarding their fair value, our
recoverability of those assets and our ability to successfully develop and
ultimately commercialize acquired technology. If those assumptions change in the
future when we conduct our periodic reviews in accordance with accounting
standards, we may be required to record impairment charges. We have conducted an
asset impairment test during the fourth quarter of 2002 and recorded an
impairment charge of approximately $2.0 million from our investment in
Intrinsic. We also recorded a one-time, non-cash impairment charge of $30.2
million as a result of an independent valuation during the first quarter of 2003
of the goodwill and acquired intangible assets mainly attributable to our
acquisition of Bonson in February 2002. There is no assurance that future
reviews will not result in further write-downs to goodwill and other intangible
assets.
SEVERE ACUTE RESPIRATORY SYNDROME MAY HAVE AN IMPACT ON OUR BUSINESS
The outbreak of Severe Acute Respiratory Syndrome, or SARS, is believed to have
started in Guangdong Province, China in late 2002 and to have later spread to
Beijing. The SARS outbreak impacted our second quarter revenues by disrupting
travel throughout China and causing serious delays in service delivery to our
customers. The outbreak also interrupted our collection efforts, causing
accounts receivable and days sales outstanding to increase. These effects are
also reflected in our operating results for the nine months ended September 30,
2003 and are expected to impact our full year 2003 operating results. Although
the spread of SARS in China appears to have been contained and our business
activities resumed normal operations throughout the third quarter of 2002, the
medical community worldwide has not fully understood the origin of SARS and has
not found a well-recognized effective treatment for SARS. As a consequence, the
potential long-term effects of SARS on economic growth in China are still
unknown. Any future re-emergence or worsening of the SARS epidemic could have an
adverse impact on our business.
WE ARE HIGHLY DEPENDENT ON OUR EXECUTIVE OFFICERS.
Each of our executive officers is responsible for an important segment of our
operations. Although we believe that we have significant depth at all levels of
management, the loss of any of our executive officers' services could be
detrimental to our operations. We do not have, and do not plan to obtain, "key
man" life insurance on any of our employees.
WE FACE A COMPETITIVE LABOR MARKET IN CHINA FOR SKILLED PERSONNEL AND THEREFORE
ARE HIGHLY DEPENDENT ON THE SKILLS AND SERVICES OF OUR EXISTING KEY SKILLED
PERSONNEL AND OUR ABILITY TO HIRE ADDITIONAL SKILLED EMPLOYEES.
Competition for highly skilled software design, engineering and sales and
marketing personnel is intense in China. Our failure to attract, assimilate or
retain qualified personnel to fulfill our current or future needs could impair
our growth. Competition for skilled personnel comes primarily from a wide range
of foreign companies active in China, many of which have substantially greater
resources than we have. Limitations on our ability to hire and train a
sufficient number of personnel at all levels would limit our ability to
undertake projects in the future and could cause us to lose market share.
WE EXTEND WARRANTIES TO OUR CUSTOMERS THAT EXPOSE US TO POTENTIAL LIABILITIES.
35
We customarily provide our customers with one to three year warranties, under
which we agree to maintain installed systems at no additional cost to our
customers. The maintenance services cover both hardware and our proprietary and
third party software products. Although we seek to arrange back-to-back
warranties with hardware and software vendors, we have the primary
responsibility to maintain the installed hardware and software. Our contracts do
not have disclaimers or limitations on liability for special, consequential and
incidental damages, nor do we cap the amounts our customers can recover for
damages. In addition, we do not currently maintain any insurance policy with
respect to our exposure to warranty claims. The failure of our installed
projects to operate properly could give rise to substantial liability for
special, consequential or incidental damages, that in turn could materially and
adversely affect us.
WE SELL OUR LARGE SYSTEMS INTEGRATION PROJECTS ON A FIXED-PRICE, FIXED-TIME
BASIS WHICH EXPOSES US TO RISKS ASSOCIATED WITH COST OVERRUNS AND DELAYS.
We sell our large systems integration projects on a fixed-price, fixed-time
basis. In contracts with our customers, we typically agree to pay late
completion fines of up to 5% of the total contract value. In large-scale
telecommunications infrastructure projects, there are many factors beyond our
control which could cause delays or cost overruns. In this event, we would be
exposed to cost overruns and liable for late completion fines.
WE MAY BECOME LESS COMPETITIVE IF WE ARE UNABLE TO DEVELOP OR ACQUIRE NEW
PRODUCTS, OR ENHANCEMENTS TO OUR EXISTING PRODUCTS, THAT ARE MARKETABLE ON A
TIMELY AND COST-EFFECTIVE BASIS.
Our future operating results will depend, to a significant extent, upon our
ability to enhance our existing products and services and to introduce new
products and services to meet the requirements of our customers in a rapidly
developing and evolving market. For example, we continually develop new services
and software products for our customers in the telecommunications market. If we
do not enhance our existing products and services or introduce new successful
products and services in a timely manner, our products and services may become
obsolete, and our revenues and operating results may suffer. Moreover,
unexpected technical, operational, distribution or other problems could delay or
prevent the introduction of any products or services that we may plan to
introduce in the future. We cannot be sure that any of these products and
services will achieve widespread market acceptance or generate incremental
revenues.
OUR PROPRIETARY RIGHTS MAY BE INADEQUATELY PROTECTED AND THERE IS A RISK OF POOR
ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS IN CHINA.
Our success and ability to compete depend substantially upon our intellectual
property rights, which we protect through a combination of confidentiality
agreements and copyright and trademark registration. We have registered some
marks and filed trademark applications for other marks with the United States
Patent and Trademark Office, the Trademark Bureau of the State Administration of
Industry and Commerce in China and the Trade Marks Registry in Hong Kong. We
have also registered copyrights with the State Copyright Bureau in China with
respect to telecommunications-related software products, although we have not
applied for copyright protection elsewhere (including the United States).
Despite these precautions, the legal regime protecting intellectual property
rights in China is weak. Moreover, Bonson, which we acquired in February 2002,
had never registered copyrights for its software products prior to the
acquisition, although we subsequently registered copyrights for all of its
software products. Because the Chinese legal system in general, and the
intellectual property regime in particular, are relatively weak, it is often
difficult to enforce intellectual property rights in China. In addition, there
are other countries where effective copyright, trademark and trade secret
protection may be unavailable or limited.
We do not own any patents and have not filed any patent applications, as we do
36
not believe that the benefits of patent protection outweigh the costs of filing
and updating patents for our software products. We enter into confidentiality
agreements with our employees and consultants, and control access to, and
distribution of, our documentation and other licensed information. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use our licensed services or technology without authorization, or to develop
similar technology independently. Policing unauthorized use of our licensed
technology is difficult and there can be no assurance that the steps we take
will prevent misappropriation or infringement of our proprietary technology. In
addition, litigation may be necessary to enforce our intellectual property
rights, to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others, which could result in substantial costs and
diversion of our resources.
A portion of our business involves the development and customization of software
applications for customers. We generally retain significant ownership or rights
to use and market such software for other customer projects, where possible.
However, our customers sometimes retain co-ownership and rights to use the
applications, processes, and intellectual property so developed. In some cases,
we may have no right or only limited rights to reuse or provide these
developments in projects involving other customers. To the extent that we are
unable to negotiate contracts which permit us to reuse source-codes and
methodologies, or to the extent that we have conflicts with our customers
regarding our ability to do so, we may be unable to provide similar solutions to
our other customers.
WE ARE EXPOSED TO CERTAIN BUSINESS AND LITIGATION RISKS WITH RESPECT TO
TECHNOLOGY RIGHTS HELD BY THIRD PARTIES.
We currently license technology from third parties and intend to do so
increasingly in the future as we introduce services that require new technology.
There can be no assurance that these technology licenses will be available to us
on commercially reasonable terms, if at all. Our inability to obtain any of
these licenses could delay or compromise our ability to introduce new services.
In addition, we may or may allegedly breach the technology rights of others and
incur legal expenses and damages, which could be substantial.
INVESTORS MAY NOT BE ABLE TO ENFORCE JUDGMENTS BY UNITED STATES COURTS AGAINST
US.
We are incorporated in the State of Delaware. However, a majority of our
directors, executive officers and principal shareholders live outside the United
States, principally in Beijing and Hong Kong. As a result, you may not be able
to:
.. effect service of process upon us or those persons within the United
States; or
.. enforce against us or those persons judgments obtained in United States
courts, including judgments relating to the federal securities laws of the
United States.
WE DO NOT INTEND TO PAY AND MAY BE RESTRICTED FROM PAYING DIVIDENDS ON OUR
COMMON STOCK.
We have never declared or paid dividends on our capital stock and we do not
intend to declare any dividends in the foreseeable future. We currently intend
to retain future earnings to fund our growth. Furthermore, if we decide to pay
dividends, foreign exchange and other regulations in China may restrict our
ability to distribute retained earnings from China or convert these payments
from Renminbi, the currency of China, into foreign currencies.
THE FACT THAT OUR BUSINESS IS CONDUCTED IN BOTH U.S. DOLLARS AND RENMINBI MAY
SUBJECT US TO CURRENCY EXCHANGE RATE RISK DUE TO FLUCTUATIONS IN THE EXCHANGE
37
RATE BETWEEN THESE TWO CURRENCIES.
Substantially all of our revenues, expenses and liabilities are denominated in
either U.S. dollars or Renminbi. As a result, we are subject to the effects of
exchange rate fluctuations between these currencies. Because of the unitary
exchange rate system introduced in China on January 1, 1994, the official bank
exchange rate for conversion of Renminbi to U.S. dollars experienced a
devaluation of approximately 50%. We report our financial results in U.S.
dollars, therefore, any future devaluation of the Renminbi against the U.S.
dollar may have an adverse effect on our reported net income.
Substantially all our revenues and expenses relating to hardware sales are
denominated in U.S. dollars, and substantially all our revenues and expenses
relating to the software and services component of our business are denominated
in Renminbi. Although, in general, our exposure to foreign exchange risks should
be limited, the value in our shares may be affected by the foreign exchange rate
between the U.S. dollar and the Renminbi because the value of our business is
effectively denominated in Renminbi, while our shares are traded in U.S.
dollars. Furthermore, a decline in the value of the Renminbi could reduce the
U.S. dollar value of earnings from, and our investments in, our subsidiaries in
China.
THE MARKETS IN WHICH WE SELL OUR SERVICES AND PRODUCTS ARE COMPETITIVE AND WE
MAY NOT BE ABLE TO COMPETE EFFECTIVELY.
The market for network solutions in China is new and rapidly changing. Our
competitors in the network solutions market mainly include domestic systems
integrators such as Zoom Networks and Digital China Holdings Limited. Although
we are a leading player in this market, there are many large multinational
companies with substantial, existing information technology operations in other
markets in China that have significantly greater financial, technological,
marketing and human resources. Should they decide to enter the network solutions
market, this could hurt our profitability and erode our market share.
The service application solutions sector is highly competitive. Our principal
competitors in that sector are Openwave Systems Inc. (formerly Software.com and
Phone.com) and Huawei Technologies. In the network security solutions market, we
mainly compete with Information Security One Limited, Nsfocus Information
Technology Co., Ltd., and 21ViaNet China Inc. An increasing number of companies
are devoting their resources to this sector in developing network security
products.
In the online billing segment, we compete primarily with Portal Software and
Zoom Networks. In the operation support system solutions market, we compete
mainly with Linkage System Integration Co. Ltd. (Nanjing), SI-TECH Computer
System Engineering Ltd. (Beijing) and Powerise Group (Changsha). Currently, due
in part to each telecommunication provider's stringent approval system for
providers of wireless billing software in China and competitive pricing offered
by domestic companies, some multinational information technology companies have
been deterred from entering this market. However, multinational companies have
recently formed alliances with Chinese companies to expand into China's
telecommunications solutions market. For example, CSG Systems, or CSG, has
formed a strategic alliance with a subsidiary of Legend Group Limited to develop
a suite of customer care and billing solutions for China's telecommunications
carriers. In view of the gradual deregulation of the Chinese telecommunications
industry and China's entry into the WTO, we anticipate the entrance of new
competitors into the operation support system market.
In the human resources management and business intelligence software sector,
following the completion of our anticipated acquisition of the HRM and BI assets
of Pacific Software, our competitors will include large international
information technology companies such as SAP, IBM and PeopleSoft and domestic
players such as UFSoft.
Our competitors, some of whom have greater financial, technical and human
38
resources than us, may be able to respond more quickly to new and emerging
technologies and changes in customer requirements or devote greater resources to
the development, promotion and sale of new products or services. It is possible
that competition in the form of new competitors or alliances, joint ventures or
consolidation among existing competitors may decrease our market share.
Increased competition could result in lower personnel utilization rates, billing
rate reductions, fewer customer engagements, reduced gross margins and loss of
market share, any one of which could materially and adversely affect our profits
and overall financial condition.
POLITICAL AND ECONOMIC POLICIES OF THE CHINESE GOVERNMENT COULD AFFECT OUR
INDUSTRY IN GENERAL AND OUR COMPETITIVE POSITION IN PARTICULAR.
Since the establishment of the People's Republic of China in 1949, the Communist
Party has been the governing political party in China. The highest bodies of
leadership are the Politburo of the Communist Party, the Central Committee and
the National People's Congress. The State Council, which is the highest
institution of government administration, reports to the National People's
Congress and has under its supervision various commissions, agencies and
ministries, including The Ministry of Information Industry, the
telecommunications regulatory body of the Chinese government. Since the late
1970s, the Chinese government has been reforming the Chinese economic system.
Although we believe that economic reform and the macroeconomic measures adopted
by the Chinese government have had and will continue to have a positive effect
on economic development in China, there can be no assurance that the economic
reform strategy will not from time to time be modified or revised. Such
modifications or revisions, if any, could have a material adverse effect on the
overall economic growth of China and investment in the Internet and the
telecommunications industry in China. Such developments could reduce, perhaps
significantly, the demand for our products and services. There is no guarantee
that the Chinese government will not impose other economic or regulatory
controls that would have a material adverse effect on our business. Furthermore,
changes in political, economic and social conditions in China, adjustments in
policies of the Chinese government or changes in laws and regulations could
adversely affect our industry in general and our competitive position in
particular.
HIGH TECHNOLOGY AND EMERGING MARKET SHARES HAVE HISTORICALLY EXPERIENCED EXTREME
VOLATILITY AND MAY SUBJECT YOU TO LOSSES.
The trading price of our shares may be subject to significant market volatility
due to investor perceptions of investments relating to China and Asia, as well
as developments in the Internet and telecommunications industries. In addition,
the high technology sector of the stock market frequently experiences extreme
price and volume fluctuations, which have particularly affected the market
prices of many software companies and which have often been unrelated to the
operating performance of these companies.
IF OUR STOCK PRICE IS VOLATILE, WE MAY BECOME SUBJECT TO SECURITIES LITIGATION
WHICH IS EXPENSIVE AND COULD RESULT IN A DIVERSION OF RESOURCES.
In the past, following periods of volatility in the market price of a particular
company's securities, securities class action litigation has often been brought
against that company. Many companies in our industry have been subject to this
type of litigation in the past, and we are currently involved in this type of
litigation as a result of allegedly improper allocation procedures relating to
the sale of our common stock in connection with our initial public offering in
March of 2000. For more information on this litigation, see the discussion under
the heading "Item 1. Legal Proceedings" in Part II of this report. Litigation is
often expensive and diverts management's attention and resources, which could
materially and adversely affect our business.
FUTURE SALES OF SHARES BY OUR COMPANY OR EXISTING SHAREHOLDERS COULD CAUSE THE
MARKET PRICE OF OUR COMMON STOCK TO FALL.
39
If our stockholders sell substantial amounts of our common stock in the public
market, including shares issued upon the exercise of outstanding options, the
market price of our common stock could fall. Such sales also might make it more
difficult for us to sell equity or equity-related securities in the future at a
time and price that we deem appropriate.
A SMALL NUMBER OF SHAREHOLDERS CONTROLS US.
A small number of shareholders, including Warburg-Pincus Ventures, and their
affiliates, as well as Edward Tian, one of our directors, James Ding, our
Chairman, and several of our other directors and officers control approximately
50% of our voting stock. As a result, these shareholders collectively are able
to control all matters requiring shareholder approval, including election of
directors and approval of significant corporate transactions, such as a sale of
our assets and the terms of future equity financings. The combined voting power
of our large shareholders could have the effect of delaying or preventing a
change in control.
WE ARE SUBJECT TO ANTI-TAKEOVER PROVISIONS THAT COULD PREVENT A CHANGE OF
CONTROL AND PREVENT OUR SHAREHOLDERS FROM REALIZING A PREMIUM ON THEIR COMMON
STOCK.
Our board of directors has the authority to issue up to 10,000,000 shares of our
preferred stock. Without any further vote or action on the part of our
stockholders, the board of directors has the authority to determine the price,
rights, preferences, privileges and restrictions of the preferred stock. This
preferred stock, if it is ever issued, may have preference over and harm the
rights of the holders of our common stock. Although the issuance of this
preferred stock will provide us with flexibility in connection with possible
acquisitions and other corporate purposes, this issuance may make it more
difficult for a third party to acquire a majority of our outstanding voting
stock.
We currently have authorized the size of our board of directors to be not less
than three nor more than nine directors. The terms of the office of the
nine-member board of directors have been divided into three classes: Class I,
whose term will expire at the annual meeting of the stockholders to be held in
2006; Class II, whose term will expire at the annual meeting of stockholders to
be held in 2004; and Class III, whose term will expire at the annual meeting of
stockholders to be held in 2005. This classification of the board of directors
may have the effect of delaying or preventing changes in our control or
management.
We are subject to the provisions of Section 203 of the Delaware General
Corporation Law. In general, the statute prohibits a publicly-held Delaware
corporation from engaging in a "business combination" with an "interested
stockholder" for a period of three years after the date when the person became
an interested stockholder unless, subject to exceptions, the business
combination or the transaction in which the person became an interested
stockholder is approved in a prescribed manner. Generally, a "business
combination" includes a merger, asset or stock sale, or other transaction
resulting in a financial benefit to the stockholder.
OUR CHANGE OF CONTROL SEVERANCE AGREEMENTS WITH EXECUTIVE OFFICERS MAY
DISCOURAGE A CHANGE OF CONTROL
Recently we have entered into change of control severance agreements with
several of our executive officers. These agreements provide, among other things,
that the executive officers would be entitled to various benefits upon the
occurrence of either a covered termination (as defined therein) or a change of
control (as defined therein), including payment of one year of base salary and
bonus, immediate vesting of 50% of any outstanding unvested stock options held
by the executive officer and provisions of medical benefits and housing
allowance. The potential obligations to pay the executive officers the above
amounts may
40
discourage a potential acquirer from effecting a change of control.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest-rate risk primarily associated with our cash, short-
term investments and short-term bank loans. To date, we have not entered into
any types of derivatives to hedge against interest-rate changes, nor do we
speculate in foreign currency. However, we do maintain a significant portion of
our cash deposits in U.S. dollars to avoid currency risk related to Renminbi. A
portion of these U.S. dollar deposits are used to collateralize Renminbi-
denominated loans from Chinese banks.
Because substantially all of our revenues and expenses relating to hardware
sales are denominated in U.S. dollars, and substantially all of our revenues and
expenses relating to the service component of our network solutions business and
software business are denominated in Renminbi, we do not have significant
exposure to either the U.S. dollar or Renminbi. Thus, we do not believe that it
is necessary to enter into derivatives contracts to hedge our exposures to
either currency.
There have been no significant changes in our exposure to changes in either
interest rates or foreign currency exchange rates for the quarter ended
September 30, 2003. Our exposure to interest rates is limited as we do not have
variable rate and long-term borrowings. We are subject to variable interest
rates on our bank deposits that are cash and short-term investments. As there
are no significant market price movements, such investments are held at cost. As
of September 30, 2003, a hypothetical 10% immediate increase or decrease in
interest rates would increase our annual interest expense by approximately $190
and decrease our annual interest income by approximately $118,000, respectively.
The effect of changes in exchange rates on our results of operations has been
insignificant.
ITEM 4. CONTROLS AND PROCEDURES
Within 90 days prior to the filing date of this quarterly report, we carried out
an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as
amended. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures are
effective. There were no significant changes in our internal controls or in
other factors that could significantly affect those controls subsequent to the
date of our evaluation.
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
On December 4, 2001, a securities class action case was filed in New York City
against us, certain of our current officers and directors and the underwriters
of our initial public offering, or IPO. The lawsuit alleged violations of the
federal securities laws and was docketed in the United States District Court for
the Southern District of New York, or the Court, as Hassan v. AsiaInfo Holdings,
Inc., et al. The lawsuit alleged, among other things, that the underwriters of
our IPO improperly required their customers to pay the underwriters excessive
commissions and to agree to buy additional shares of our common stock in the
aftermarket as conditions to their purchasing shares in our IPO. The lawsuit
further claimed that these supposed practices of the underwriters should have
been disclosed in our IPO prospectus and registration statement. The suit seeks
rescission of the plaintiffs' alleged purchases of our common stock as well as
unspecified damages. In addition to the case against us, various other
plaintiffs have filed approximately 1,000 other, substantially similar class
action cases against approximately 300 other publicly traded companies and their
IPO
41
underwriters in New York City, which along with the case against us have all
been transferred to a single federal district judge for purposes of case
management. On July 15, 2002, together with the other issuer defendants, we
filed a collective motion to dismiss the consolidated, amended complaints
against the issuers on various legal grounds common to all or most of the issuer
defendants. The underwriters also filed separate motions to dismiss the claims
against them. On October 9, 2002, the Court dismissed without prejudice all
claims against the individual defendants in the litigation. The dismissals were
based on stipulations signed by those defendants and the plaintiffs'
representatives. On February 19, 2003, the Court issued its ruling on the
motions to dismiss filed by the underwriter and issuer defendants. In that
ruling the Court granted in part and denied in part those motions. As to the
claims brought against us under the anti-fraud provisions of the securities
laws, the Court dismissed all such claims without prejudice. As to the claims
brought under the registration provisions of the securities laws, which do not
require that intent to defraud be pleaded, the Court denied the motion to
dismiss such claims as to us and as to substantially all of the other issuer
defendants. The Court also denied the underwriter defendants' motion to dismiss
in all respects.
In June 2003, based on a decision made by a special independent committee of our
board of directors, we elected to participate in a proposed settlement agreement
with the plaintiffs in this litigation. If ultimately approved by the Court,
this proposed settlement would result in a dismissal, with prejudice, of all
claims in the litigation against us and against any of the other issuer
defendants who elect to participate in the proposed settlement, together with
the current or former officers and directors of participating issuers who were
named as individual defendants. The proposed settlement does not provide for the
resolution of any claims against the underwriter defendants, and the litigation
against those defendants is continuing. The proposed settlement provides that
the class members in the class action cases brought against the participating
issuer defendants will be guaranteed a recovery of $1 billion by insurers of the
participating issuer defendants. If recoveries totaling $1 billion or more are
obtained by the class members from the underwriter defendants, however, the
monetary obligations to the class members under the proposed settlement will be
satisfied. In addition, all participating issuer defendants will be required to
assign to the class members certain claims that we may have against the
underwriters.
The proposed settlement contemplates that any amounts necessary to fund the
settlement or settlement-related expenses would come from participating issuers'
directors and officers liability insurance policy proceeds as opposed to funds
of the participating issuer defendants themselves. A participating issuer
defendant could be required to contribute to the costs of the settlement if that
issuer's insurance coverage were insufficient to pay that issuer's allocable
share of the settlement costs. We expect that our insurance proceeds will be
sufficient for these purposes and that we will not otherwise be required to
contribute to the proposed settlement. Consummation of the proposed settlement
is conditioned upon, among other things, negotiating, executing, and filing with
the Court final settlement documents, and final approval by the Court. If the
proposed settlement described above is not consummated, we intend to continue to
defend the litigation vigorously. Moreover, if the proposed settlement is not
consummated, we believe that the underwriters may have an obligation to
indemnify us for the legal fees and other costs of defending this suit and that
our directors' and officers' liability insurance policies would also cover the
defense and potential exposure in the suit. While we cannot guarantee the
outcome of these proceedings, we believe that the final result of these actions
will have no material effect on our consolidated financial condition, results of
operations or cash flows.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On March 2, 2000, our Registration Statement on Form S-1 covering the offering
of 5,000,000 shares of our common stock (No.333-93199) was declared effective.
The underwriters in the offering exercised an over-allotment option to purchase
an additional 750,000 shares of our common stock. The total price to the public
for
42
the shares offered and sold was $138,000,000. The net proceeds of the offering
(after deducting expenses) was approximately $126,610,000. From the effective
date of the Registration Statement through September 30, 2003, the net proceeds
have been used for the following purposes:
Purchase and installation of machinery and equipment ............. $ 7,460,000
Temporary investments, including cash and cash equivalents ....... 25,230,000
Investments in subsidiaries ...................................... 51,110,000
Research and development and sales and marketing expenses ........ 42,810,000
-------------
$ 126,610,000
=============
The net proceeds will continue to be used for general corporate purposes,
including working capital, and expenses such as research and development and
sales and marketing. A portion of the net proceeds may also continue to be used
to acquire or invest in complementary businesses or products. None of the net
proceeds of the offering have been paid directly or indirectly to our directors,
officers or their associates, to persons owning ten percent or more of our
common stock, or to our affiliates.
ITEM 5. OTHER INFORMATION
NEW BOARD MEMBER
Effective October 17, 2003, we appointed Weiying Zhang to our board of directors
as an independent director. A highly respected economic and management expert in
China, Mr. Zhang is a Professor of Economics and the First Associate Dean of
Guanghua School of Management at Peking University. Mr. Zhang is also a member
of the Advisory Board of the State Informatization Committee of China. Mr. Zhang
holds a doctorate degree in economics from Oxford University. Mr. Zhang replaced
Steven Chang, who had been a member of AsiaInfo's board of directors since 2001.
Mr. Chang's resignation from the board and Mr. Zhang's appointment became
effective on the same date, October 17, 2003.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following exhibits are filed as a part of this Report.
Exhibit Number Description Exhibits
-------------- --------------------
2.1 Share Purchase Agreement for the acquisition of Bonson Information
Technology Holdings Limited/***/
3.1 Certificate of Incorporation of AsiaInfo Holdings, Inc., dated June 8,
1998/*/
3.2 Certificate of Amendment to Certificate of Incorporation of AsiaInfo
Holdings, Inc., dated August 27, 1999/*/
3.3 Certificate of Amendment to Certificate of Incorporation of AsiaInfo
Holdings, Inc., dated November 15, 2000/**/
3.4 Certificate of Correction to Certificate of Amendment to Certificate of
Incorporation of AsiaInfo Holdings, Inc., dated January 18, 2001/**/
3.5 By-Laws of AsiaInfo Holdings, Inc., dated December 19, 2000/**/
4.1 Specimen Share Certificate representing AsiaInfo Holdings, Inc. shares of
common stock/*/
10.1 2002 Stock Option Plan, approved and adopted as of April 18, 2003 /****/
10.2 Lease of AsiaInfo's headquarters at 6 Zhongguancun South Street, Beijing,
China, dated August 31, 1999/*/
10.3 Agreement for the Establishment of a Limited Liability Company (Guangdong
43
Wangying Communications Technology Company Limited) and Capital
Contribution /**/
10.4 Employment Agreement between AsiaInfo Holdings, Inc. and Xingsheng Zhang
dated January 27, 2003/#/
10.5 Change of Control Severance Agreement between AsiaInfo Holdings, Inc. and
Xingsheng Zhang dated May 30, 2003/#/
10.6 Master Executive Employment Agreement between AsiaInfo Holdings, Inc. and
Ying Han dated May 30, 2003/#/
10.7 Change of Control Severance Agreement between AsiaInfo Holdings, Inc. and
Ying Han dated May 30, 2003/#/
10.8 Master Executive Employment Agreement between AsiaInfo Holdings, Inc. and
James Li dated May 30, 2003/#/
10.9 Change of Control Severance Agreement between AsiaInfo Holdings, Inc. and
James Li dated May 30, 2003/#/
11.1 Statement regarding computation of per share earnings (included in note 9
to condensed consolidated financial statements)
31.1 Certification of Principal Executive Officer required by Rule 13a-14(a)
or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
31.2 Certification of Principal Financial Officer required by Rules 13a-14(a)
or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
/*/ Incorporated by reference to our Registration Statement on Form
S-1 (No.333-93199).
/**/ Incorporated by reference to our Annual Report on Form 10-K for the
fiscal year ended December 31, 2000.
/***/ Incorporated by reference to our Current Report on Form 8-K filed on
February 21, 2002.
/****/ Incorporated by reference to our Proxy Statement for the 2003 Annual
Meeting of Stockholders filed on March 21, 2003.
/#/ Incorporated by reference to our Quarterly Report on Form 10-Q filed on
August 14, 2003.
(b) Reports on form 8-K
We furnished a Current Report on Form 8-K on October 21, 2003 relating to our
quarterly earnings announcement for the quarter ended September 30, 2003. On the
same Form 8-K, we also reported the signing of a definitive agreement to acquire
certain human resources management and business intelligence assets valued at
approximately $9 million from Pacific Software (China) Limited, a privately
held, medium-sized software solutions company based in Hong Kong, and from its
affiliate New Century Pacific Software (Beijing) Limited, a wholly-foreign-owned
enterprises based in Beijing, China.
Pursuant to the requirements of Item 9 of Form 8-K as mandated by Regulation FD,
we furnished a Current Report on Form 8-K on October 22,2003 relating to certain
presentation slides delivered at an investment community day held at our
headquarters in Beijing, China.
44
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, AsiaInfo
Holdings, Inc. has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
AsiaInfo Holdings, Inc.
Date: November 14, 2003 By: /s/ Ying Han
----------------------------------------
Name: Ying Han
Title: Chief Financial Officer
(duly authorized officer
and principal financial officer)