The accompanying unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America.
The condensed consolidated financial statements include the financial statements of the Company, its subsidiaries and the variable interest entity (VIE), Yinglin Jinduren. Yinglin Jinduren is considered a VIE because the Company is deemed to be its primary beneficiary by virtue of the contractual arrangements between HK Dong Rong and Yinglin Jinduren. Because the Company and Yinglin Jinduren are under common control, the initial measurement of the assets and liabilities of Yinglin Jinduren for the purpose of consolidation by the Company is at book value. All significant inter-company transactions and balances between the Company, its subsidiaries and the VIE are eliminated upon consolidation. As of September 30, 2012, Yinglin Jinduren has no operations.
In the opinion of management, the accompanying unaudited consolidated financial statements of the Company contain all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the consolidated balance sheets as of September 30, 2012 and December 31, 2011, the consolidated statements of operations and comprehensive income for the three and nine months ended September 30, 2012 and 2011, and the consolidated statements of cash flows for the nine months ended September 30, 2012 and 2011. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results of operations to be expected for the full fiscal year. These financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
(c) Use of estimates
The preparation of consolidated financial statements in conformity with GAAP requires the Company’s management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. The reported amounts of revenues and expenses during the reporting period may be affected by the estimates and assumptions that the management is required to make. Estimates that are critical to the accompanying consolidated financial statements relate primarily to returns, sales allowances and customer chargebacks, the identification and valuation of derivative instruments, and the recoverability of the carrying amounts of property, plant and equipment and goodwill. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the period that they are determined to be necessary. Actual results could differ from these estimates.
(d) Revenue recognition
Sales of goods - distributors
All of the Company’s products sold to its distributor customers are manufactured on its behalf by third parties, based on orders for the Company’s products received from such customers. The Company is responsible for product design, product specification, pricing to such customers, the choice of third-party manufacturer, product quality and credit risk associated with such customers’ receivable. As such, the Company acts as a principal and records revenue from its distributors on a gross basis.
The Company recognizes revenue when (a) the price to the customer is fixed or determinable, (b) persuasive evidence of an arrangement exists, (c) delivery has occurred and (d) collectability of the resulting receivable is reasonably assured. Revenue from the sales of goods is recognized on the transfer of significant risks and rewards of ownership, which generally coincides with the time when the goods are delivered and the title has passed to the customer. Revenue excludes value-added tax (“VAT”) and is stated after deduction of trade discounts and allowances.
Sales of goods - retail
In July 2011, the Company began operating retail stores selling its products. Revenue from retail sales is recognized at each point of sale. During the three and nine months ended September 30, 2012, such sales accounted for 4.6% and 4.8% of the Company’s total revenue, respectively. During the three and nine months ended September 30, 2011, such sales accounted for 8.1% and 2.2% of the Company’s total revenue, respectively.
The Company’s retail revenue is net of VAT collected on behalf of PRC tax authorities in respect of the sale of merchandise. VAT collected from customers, net of VAT paid for purchases, is recorded as a liability in the accompanying consolidated balance sheets until it is paid to the relevant PRC tax authorities.
Retail sales returns within seven days of purchase are accepted only for quality reasons. The Company has not yet had the experience to estimate and provide for such returns at the time of sale, and returns have been minimal to date.
(e) Cash and cash equivalents
For purposes of the statement of cash flows, the Company considers all highly liquid instruments with original maturities of three months or less to be cash equivalents. Cash and cash equivalents comprise cash at bank and on hand and demand deposits with banks.
(f) Accounts receivable
Accounts receivable, including associated VATs, are unsecured, and are stated at the amount the Company expects to collect. The Company may maintain allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company evaluates the collectability of its accounts receivable based on a combination of factors, including customer credit-worthiness and historical collection experience. Management reviews the receivable aging and adjusts the allowance based on historical experience, financial condition of the customer and other relevant current economic factors. Interest is not normally charged on accounts receivable. As of November 1, 2012, there were $3,390 in accounts receivable aged over 120 days from September 30, 2012 that had not been collected. However, management believes that these accounts receivable are collectable and has therefore determined that no allowance for uncollectible amounts is necessary.
(g) Trade deposits
The Company places trade deposits with new third-party manufacturers in order to secure its ability to order production. The trade deposits are recorded at the amount paid to the manufacturers. Trade deposits are applied against the manufacturers’ invoices for inventory purchases. Inventory is recorded when received or when title transfers to the Company.
(h) Inventories
Inventories are stated at the lower of cost or market value, determined by the weighted average method. The Company performs physical inventory counts on a monthly basis to ensure that the amounts reflected in the consolidated financial statements at each reporting period are properly stated and valued. The Company records write-downs to inventories for shrinkage losses and damaged merchandise that are identified during the inventory counts. To date, such amounts have not been material to the consolidated financial statements.
(i) Property, plant and equipment
Property, plant and equipment are stated at cost less accumulated depreciation and impairment losses. Depreciation of property, plant and equipment is computed using the straight-line method based on the following estimated useful lives:
| Motor vehicles | | 5 years |
| Office equipment | | 3 to 5 years |
| Leasehold improvements | | 1 to 4 years (amortized over the shorter of their economic lives or the remaining lease terms) |
(j) Long-lived assets
The Company estimates the future undiscounted cash flows to be derived from an asset to assess whether or not a potential impairment exists when events or circumstances indicate the carrying value of a long-lived asset may be impaired. If the carrying value exceeds the Company’s estimate of future undiscounted cash flows, the Company then calculates the impairment as the excess of the carrying value of the asset over the Company’s estimate of its fair market value.
(k) Goodwill
In September 2011, the Financial Accounting Standards Board (“FASB”) issued an authoritative pronouncement related to testing goodwill for impairment. The guidance permits the Company to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. The Company adopted this pronouncement as of the first quarter of 2012. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, goodwill is then tested following a two-step process. The first step compares the fair value of each reporting unit to its carrying amount, including goodwill. If the fair value of each reporting unit exceeds its carrying amount, goodwill is not considered to be impaired and the second step will not be required. If the carrying amount of a reporting unit exceeds its fair value, the second step compares the implied fair value of goodwill to the carrying value of a reporting unit’s goodwill. The implied fair value of goodwill is determined in a manner similar to accounting for a business combination with the allocation of the assessed fair value determined in the first step to the assets and liabilities of the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to the assets and liabilities is the implied fair value of goodwill. An impairment loss is recognized for any excess in the carrying value of goodwill over the implied fair value of goodwill.
Management has performed an assessment and determined that there was no indication of impairment to goodwill during the three and nine months ended September 30, 2012.
(l) Foreign currency translation
The Company’s functional currency is the Renminbi (“RMB”), China’s currency. The accompanying unaudited consolidated financial statements are translated from RMB into U.S. Dollars (“US$” or “$”). Accordingly, all assets and liabilities are translated at the exchange rates prevailing at the balance sheet dates, all income and expenditure items are translated at the average rates for each of the periods and equity accounts, except for retained earnings, are translated at the rate at the transaction date. Retained earnings reflect the cumulative net income (loss) translated at the average rates for the respective periods since inception, less dividends translated at the rate at the transaction date.
RMB is not a fully convertible currency. All foreign exchange transactions involving RMB must take place either through the People's Bank of China (the “PBOC”) or other institutions authorized to buy and sell foreign exchange. The exchange rates adopted for the foreign exchange transactions are the rates of exchange quoted by the PBOC, which are determined largely by supply and demand. The rates of exchange quoted by the PBOC on September 30, 2012 and December 31, 2011 were US$1.00 to RMB6.33 and RMB6.36, respectively. The average translation rates of US$1.00 to RMB6.33 and RMB6.40 were applied to the income statement accounts for the three months ended September 30, 2012 and 2011, respectively. The average translation rates of US$1.00 to RMB6.32 and RMB6.49 were applied to the income statement accounts for the nine months ended September 30, 2012 and 2011, respectively.
Translation adjustments are recorded as other comprehensive income in the consolidated statement of income and comprehensive income and as a separate component of stockholders' equity.
Commencing from July 21, 2005, China adopted a managed floating exchange rate regime based on market demand and supply with reference to a basket of currencies. Since then, the PBOC administers and regulates the exchange rate of US$ against RMB taking into account the demand and supply of RMB, as well as domestic and foreign economic and financial conditions.
(m) Comprehensive income
The Company’s only component of other comprehensive income is foreign currency translation gains and losses. The foreign currency translation gain (loss) for the three months ended September 30, 2012 and 2011 were ($105,000) and $547,000 respectively. The foreign currency translation gains for the nine months ended September 30, 2012 and 2011 were $274,000 and $1,374,000 respectively. Accumulated other comprehensive income is recorded as a separate component of stockholders’ equity.
(n) Income taxes
The Company accounts for income taxes under the liability method. Deferred income taxes are recognized for the estimated tax consequences in future years, as differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted tax laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established to reduce deferred tax assets to the amount expected to be realized when, in management’s opinion, it is more likely than not that some portion of the deferred tax assets will not be realized. The provision for income taxes represents current taxes payable net of the change during the period in deferred tax assets and liabilities.
The Company’s income tax returns are subject to examination by the Internal Revenue Service (“IRS”) and other tax authorities in the locations where it operates. The Company assesses potentially unfavorable outcomes of such examinations based on the criteria of FASB ASC 740-10-25-5 through 740-10-25-7 and 740-10-25-13. The interpretation prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return. This interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods and income tax disclosures.
According to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational or other errors made by the taxpayer or the withholding agent. The statute of limitations extends to five years under special circumstances. In the case of transfer pricing issues, the statute of limitations is ten years. There is no statute of limitations in the case of tax evasion. Accordingly, the income tax returns of the Company’s PRC operating subsidiaries for the years ended December 31, 2009 through 2011 are open to examination by the PRC state and local tax authorities. The Company records interest and penalties as other expense on the consolidated income and other comprehensive income statements. During the three and nine months ended September 30, 2012 and 2011, the Company did not recognize any amount in interest and penalties.
(o) Advertising costs
Advertising costs are expensed and reflected in selling expenses on the consolidated statements of income and comprehensive income in the period in which the advertisements are first run. Advertising expense for the three months ended September 30, 2012 and 2011 was approximately $1.47 million and $1.45 million, respectively. Advertising expense for the nine months ended September 30, 2012 and 2011 was approximately $4.48 million and $4.30 million, respectively.
(p) Shipping and handling costs
Shipping and handling costs are expensed as incurred and included in selling expenses. Shipping and handling costs for the three and nine months ended September 30, 2012 and 2011 were insignificant.
(q) Research and development costs
The Company charges all product design and development costs to expense when incurred, and such costs are reflected in general and administrative expenses on the consolidated statements of income and comprehensive income. Such costs were approximately $0.76 million and $0.94 million for the three months ended September 30, 2012 and 2011, respectively, and approximately $2.26 million and $2.14 million for the nine months ended September 30, 2012 and 2011, respectively.
(r) Operating leases
Leases where substantially all the risks and rewards of ownership of assets remain with the lessor are accounted for as operating leases. Annual rentals applicable to such operating leases are charged to expense on a straight-line basis over the lease terms except where an alternative basis is more representative of the pattern of benefits to be derived from the leased assets. Lease incentives received are recognized as an integral part of the aggregate net lease payments made. Contingent rentals are charged to expense in the accounting period in which they are incurred.
(s) Derivative financial instruments
The Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks.
The Company reviews the terms of convertible debt or convertible preferred stock that it issues to determine whether there are embedded derivative instruments, including the embedded conversion option, that are required to be bifurcated and accounted for separately as a derivative financial instrument. Also, in connection with the sale of convertible debt or equity instruments, the Company may issue freestanding warrants that may, depending on their terms, be accounted for as derivative instrument liabilities, rather than as equity.
Derivative financial instruments are initially measured at their fair value. For derivative financial instruments that are accounted for as liabilities, each such derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported as charges or credits to income. For option-based derivative financial instruments, the Company uses a binomial option pricing model to value the derivative instruments.
(t) Fair value of financial instruments
The carrying amounts of the Company’s financial instruments, which principally include cash and cash equivalents, time deposits, accounts receivable and accounts payable, approximate their fair values due to the relatively short maturity of such instruments.
Warrants that are recorded as derivative instrument liabilities are carried at their fair value, with changes in the fair value reported as charges or credits to income each period.
(u) Earnings per share
Basic net income per share is computed by dividing net income attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is calculated by dividing net income by the weighted-average number of common shares used in the basic earnings per share calculation plus the number of common shares that would be issued assuming exercise or conversion of all potentially dilutive common stock equivalents outstanding. Equity instruments are excluded from the calculation of diluted earnings per share if the effect of including such instruments is anti-dilutive.
(v) Recent accounting pronouncements
In July 2012, the FASB issued ASU No. 2012-02 Intangibles — Goodwill and Other (Topic 350). The amendments in this update will allow an entity to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. Under these amendments, an entity would not be required to calculate the fair value of an indefinite-lived intangible asset unless the entity determines, based on qualitative assessment, that it is not more likely than not, the indefinite-lived intangible asset is impaired. The amendments include a number of events and circumstances for an entity to consider in conducting the qualitative assessment. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued. The adoption of the provisions in this update is not expected to have a significant impact on the Company’s consolidated financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s consolidated financial statements upon adoption.
(2) INVENTORIES
Inventories consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
| | September 30, | | December 31, | |
| | 2012 | | 2011 | |
| | (unaudited) | | | |
| Finished goods | | $ | 9,624 | | | $ | 1,880 | |
| | | | | | | | | |
| | | $ | 9,624 | | | $ | 1,880 | |
(3) TRADE DEPOSITS
Trade deposits consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
| | September 30, | | December 31, | |
| | 2012 | | 2011 | |
| | (unaudited) | | | |
| Trade deposits | | $ | - | | | $ | 3,482 | |
| | | | | | | | | |
| | | $ | - | | | $ | 3,482 | |
Trade deposits consist of deposits made to third-party manufacturers in order for them to manufacture on behalf of the Company. As of December 31, 2011, the Company had trade deposits with 16 manufacturers. 86.0% of the balance as of December 31, 2011 was with the top seven manufacturers.
(4) BUSINESS COMBINATION
In May 2011, the Company entered into an agreement with its Fujian distributor to acquire the distributor’s retail network of 13 stores for $6,684,000 (RMB 44,100,000) in cash. The Company believes that operating certain points of sale directly can facilitate the promotion of its brand and brand image, and the Company can benefit at the same time from the higher margins for retail sales. The Company believes that the Fujian distributor’s retail network is ideal as the Company is headquartered in, and operates from, the same province. The Company completed this acquisition on June 30, 2011 and has reported its retail operations since July 1, 2011. This acquisition resulted in a new segment, “company stores,” as further disclosed in Note 15. Pro forma results of operations that include the acquired business for the three and nine months ended September 30, 2012 are not presented because the effects of the acquisition were not material to the Company’s financial results. The following table summarizes the fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):
| Total purchase price: | | $ | 6,684 | |
| | | | | |
| Allocation of the purchase price to assets and liabilities at fair value: | | | | |
| Inventories | | | 151 | |
| Prepaid rent | | | 98 | |
| Leasehold improvements | | | 469 | |
| Property, plant and equipment | | | 17 | |
| Net assets acquired at fair value | | | 735 | |
| | | | | |
| Pre-existing distribution agreement | | | 919 | |
| Goodwill | | | 5,030 | |
| Total intangible assets acquired | | $ | 5,949 | |
The pre-existing distribution agreement recognized in conjunction with the acquisition on June 30, 2011 represents the intangible value of the reacquisition of the distribution license that was granted by the Company to its Fujian distributor. The value assigned to the pre-existing distribution agreement has been fully amortized as of December 31, 2011.
The goodwill recognized in conjunction with the acquisition on June 30, 2011 represents intangible values of the acquired store locations for their future profit potential that do not qualify for separate recognition, or other factors.
(5) PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
| | | September 30, 2012 | | | December 31, 2011 | |
| | | (unaudited) | | | | |
| Leasehold improvements | | $ | 2,396 | | | $ | 2,826 | |
| Motor vehicles | | | 56 | | | | 56 | |
| Office equipment | | | 67 | | | | 66 | |
| | | | | | | | | |
| Total property, plant and equipment | | | 2,519 | | | | 2,948 | |
| Less: accumulated depreciation | | | (1,119 | ) | | | (751) | |
| | | | | | | | | |
| Property, plant and equipment, net | | $ | 1,400 | | | $ | 2,197 | |
Depreciation expense was $206 and $312 for the three months ended September 30, 2012 and 2011, respectively, and $852 and $336 for the nine months ended September 30, 2012 and 2011, respectively.
During the nine months ended September 30, 2012, the Company closed five company stores. The leasehold improvements for these five store locations were disposed of for no consideration and had an unamortized value of $128 at September 30, 2012, resulting in a loss of $128.
During the three months ended September 30, 2012, the Company entered into a lease agreement for new office space, and expensed the remaining $382 of unamortized leasehold improvement for its old office space as the Company does not expect to receive any consideration from disposing such improvement.
During the nine months ended September 30, 2011, the Company disposed of its manufacturing equipment with a net book value of $145 on December 31, 2010, for $154, resulting in a gain of $9.
During the nine months ended September 30, 2011, the Company disposed of the building that housed its discontinued manufacturing activities and the land use right for the land on which the building sits, which collectively had a net book value of $1,013 on December 31, 2010, for $989, resulting in a loss of $24.
(6) GOODWILL
Goodwill (see Note 4) consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
| | | September 30, 2012 | | | December 31, 2011 | |
| | | (unaudited) | | | | |
| Beginning of period | | $ | 5,219 | | | $ | - | |
| Goodwill on stores acquired | | | - | | | | 5,030 | |
| Exchange realignment | | | 28 | | | | 189 | |
| | | | | | | | | |
| End of period | | $ | 5,247 | | | $ | 5,219 | |
(7) ACCRUED EXPENSES AND OTHER PAYABLES
Accrued expenses and other payables consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
| | | September 30, 2012 | | | December 31, 2011 | |
| | | (unaudited) | | | | |
| Accrued salaries and wages | | $ | 81 | | | $ | 79 | |
| Accrued liquidated damages (Note 9) | | | 987 | | | | 987 | |
| Accrued expenses | | | 570 | | | | 699 | |
| Advertising subsidies payable | | | 203 | | | | 202 | |
| | | $ | 1,841 | | | $ | 1,967 | |
(8) RELATED PARTY TRANSACTIONS
Amount due to related parties consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
| | | September 30, 2012 | | | December 31, 2011 | |
| | | (unaudited) | | | | |
| Mr. Qingqing Wu (1) | | $ | 581 | | | $ | 1,144 | |
| Mr. Bennet Tchaikovsky (2) | | | 28 | | | | 5 | |
| Ms. Ying (Teresa) Zhang (3) | | | 90 | | | | 67 | |
| | | $ | 699 | | | $ | 1,216 | |
| (1) | The amount due to this director is unsecured, interest-free and repayable on demand. |
| (2) | Represents compensation and reimbursable expenses owed. |
| (3) | Represents cash compensation owed. |
Mr. Qingqing Wu currently has four trademarks registered in his name that were intended to be transferred to Yinglin Jinduren for no consideration prior to the closing of the Share Exchange on February 13, 2009. As such transfers could not be timely effected, Mr. Wu entered into trademark license contracts with Yinglin Jinduren on February 12, 2009, pursuant to which he perpetually granted Yinglin Jinduren the rights to use these trademarks for no consideration. Mr. Wu is also in the process of transferring the trademarks to Yinglin Jinduren for no consideration as originally intended, although such transfers have not been completed. To date, Yinglin Jinduren has not utilized these trademarks, and the Company considers the value of these trademarks to be de minimis. Upon completion of the transfer to Yinglin Jinduren, the trademarks will be transferred to China Dong Rong.
(9) SALE OF PREFERRED STOCK, COMMON STOCK AND WARRANTS
On October 27, 2009, the Company entered into a securities purchase agreement (the “Purchase Agreement”) with several accredited investors (collectively the “Purchasers”) pursuant to which the Company agreed to sell to the Purchasers shares of the Company’s series A convertible preferred stock (the “Preferred Shares”) at $2.86 per share and to issue warrants to purchase shares of the Company’s common stock (the “Preferred Shares Financing”). At the initial closing on October 27, 2009, the Company issued 1,446,105 Preferred Shares and Warrants to purchase 96,407 shares of common stock for gross proceeds of approximately $4.1 million. At the final closing on November 17, 2009, the Company issued an additional 1,350,616 Preferred Shares and Warrants to purchase 90,041 shares of common stock for gross proceeds of approximately $3.9 million. The 1,446,105 Preferred Shares issued on October 27, 2009 and the 1,350,616 Preferred Shares issued on November 17, 2009 are convertible into 192,814 common shares and 180,082 common shares, respectively.
The designation, rights, preferences and other terms and provisions of the Preferred Shares are set forth in the Certificate of Designation filed with the Nevada Secretary of State on October 23, 2009 (the “Certificate”). The Preferred Shares are convertible into 0.1333 shares of common stock at $21.45 per share (subject to certain adjustments) at any time at the holder’s option, and will automatically convert when the Company’s common stock is qualified for listing on either the NASDAQ Capital Market or the NYSE Amex Equities. The Preferred Shares are entitled to participate in any dividends declared and paid on the Company’s common stock on an as-converted basis. Holders of the Preferred Shares are also entitled to notice of any stockholders’ meeting and vote together with common stock holders on an as-converted basis. Additionally, as long as any Preferred Shares are outstanding, the Company cannot, without the affirmative vote of the holders of a majority of the then outstanding Preferred Shares, (a) alter or change adversely the powers, preferences, or rights given to the Preferred Shares or alter or amend the Certificate, (b) authorize or create any class of stock ranking as to dividends, redemption or distribution of assets upon a Liquidation (as defined in Section 5 of the Certificate) senior to or otherwise pari passu with the Preferred Shares, (c) amend its charter documents in any manner that adversely affects any rights of the holders of Preferred Shares, (d) increase the number of authorized shares of Preferred Shares, or (e) enter into any agreement with respect to any of the foregoing.
Each warrant entitles its holder to purchase one share of common stock at an exercise price of $25.725 per share (subject to certain adjustments) for a period of three years. The Company is also entitled to redeem the warrants for the then applicable exercise price (currently $25.725) if the volume-weighted average price of the common stock for 20 consecutive days exceeds 200% of the then applicable exercise price.
The conversion price of the Preferred Shares and the exercise price of the warrants are subject to anti-dilution adjustments in the event that the Company issues additional equity, equity linked securities or securities convertible into common stock at a purchase price less than the then applicable conversion or exercise price (other than shares issued to the Company’s officers, directors, employees or consultants pursuant to any stock or option plan duly adopted by a majority of the Company’s non-employee directors, or issued upon the conversion or exercise of any securities outstanding as of the closing date of the Preferred Shares Financing, or for acquisitions or strategic transactions approved by a majority of the Company’s directors). The conversion and exercise prices are also subject to customary adjustments for stock dividends, stock splits, reverse stock splits or other similar transactions.
In connection with the Purchase Agreement, certain of the Company’s shareholders entered into a lock-up agreement (the “Lock-up Agreement”) whereby they agreed not to offer, sell, or other dispose of (a) 50% of their common stock holdings for nine months from the initial closing of the Preferred Shares Financing, and (b) the remaining 50% of their common stock holdings for twelve months from the initial closing.
In connection with the Preferred Shares Financing, the Company agreed to place $150,000 of its gross proceeds and Warrants to purchase up to 40,000 shares of common stock in an escrow account to be expended for investor relations, pursuant to the terms of an escrow agreement.
Gilford Securities, Incorporated acted as the placement agent in connection with the Preferred Shares Financing.
On December 1, 2009, the Company entered into a second securities purchase agreement (the “Second Purchase Agreement”) with several accredited investors, including some of the Purchasers (the “Common Shares Purchasers”) pursuant to which the Company issued to the Common Shares Purchasers 87,138 shares of common stock at $21.45 per share and warrants to purchase 43,569 shares of Common Stock, for gross proceeds of approximately $1.87 million (the “Common Shares Financing”). The terms of the warrants issued in connection with the Second Purchase Agreement are identical to the warrants issued in connection with the Purchase Agreement.
The Company is required to file a registration statement to register the common stock underlying the Preferred Shares and Warrants from the Preferred Shares Financing, and the common stock issued in and underlying the warrants from the Common Shares Financing, for resale on or before December 17, 2009, and have it declared effective within 90 days thereafter (or 150 days if the registration statement receives a full review). If the registration statement is not timely filed or declared effective, the Company is subject to liquidated damages of 1% of the gross proceeds from both financings per month, up to 10%, and pro-rated for partial periods. The registration statement was filed on December 17, 2009, and was declared effective on March 30, 2011. Accordingly, as of September 30, 2012 and December 31, 2011, the Company accrued the full amount of the liquidated damages or $987,000.
Because the warrants contain provisions that would reduce their exercise price in the event that the Company issues additional equity, equity linked securities or securities convertible into common stock at a purchase price less than the then applicable conversion or exercise price, and because the Warrants are denominated in a currency that is different from the Company’s functional currency, they have been accounted for as derivative instrument liabilities (see Note 10).
The Preferred Shares are not subject to redemption (except on liquidation), are entitled to participate in any dividends declared and paid on the Company’s common stock on an as-converted basis, and the holders of the Preferred Shares are entitled to vote together with common stock holders on an as-converted basis. The Preferred Shares, excluding the embedded conversion option, are considered to be an equity instrument and accordingly, the embedded conversion option has not been separated and accounted for as a derivative instrument liability. However, the Company has recognized a beneficial conversion feature related to the Preferred Shares, to the extent that the conversion feature, based on the proceeds allocated to the Preferred Shares, was in-the-money at the time they were issued. Such beneficial conversion feature amounted to approximately $1.973 million and $2.030 million related to the initial closing and the final closing of the Preferred Shares Financing, respectively. Because the Preferred Shares do not have a stated redemption date and may be converted by the holder at any time, the discount recognized by the allocation of proceeds to the beneficial conversion feature has been immediately amortized through retained earnings as a deemed dividend to the holders of the Preferred Shares.
(10) DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses a binomial option pricing model to value the common stock purchase warrants issued in connection with the Preferred Shares Financing and the Common Shares Financing (see Note 9). In valuing these warrants at the time they were issued and at September 30, 2012 and December 31, 2011, the Company used the market price of its common stock on the date of valuation, an expected dividend yield of 0% and the remaining period to the expiration date of the warrants. All of the warrants can be exercised by the holder at any time.
Because of the limited historical trading period of the Company’s common stock, the expected volatility of its common stock over the remaining life of the warrants, which has been estimated between 67% to 80% at September 30, 2012 and 75% at December 31, 2011, respectively, is based on a review of the volatility of entities considered by management as comparable. The risk-free rates of return used of 0.06% to 0.08% at September 30, 2012 and 0.10% to 0.11% at December 31, 2011 are based on constant maturity rates published by the U.S. Federal Reserve, applicable to the remaining life of the warrants. Dividend is estimated at 0% at September 30, 2012 and December 31, 2011.
At September 30, 2012 and December 31, 2011, the following derivative liabilities related to the warrants were outstanding (in thousands except price per share and number of warrants):
| Issue Date | | Expiration Date | | # of Warrants | | | Exercise Price Per Share | | | Value - December 31, 2011 | | | Value - September 30, 2012 | |
| | | | | | | | | | | | | | (unaudited) | |
| October 27, 2009 | | October 27, 2012 | | | 96,407 | | | $ | 25.725 | | | $ | 271 | | | $ | 2 | |
| | | | | | | | | | | | | | | | | | | |
| November 17 2009 | | November 17, 2012 | | | 88,941 | | | | 25.725 | | | | 266 | | | | 4 | |
| | | | | | | | | | | | | | | | | | | |
| December 1, 2009 | | December 1, 2012 | | | 43,569 | | | | 25.725 | | | | 136 | | | | 4 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | 228,917 | | | | | | | $ | 673 | | | $ | 10 | |
During the three months ended September 30, 2012 and 2011, the Company recognized gains of $96 and $258, respectively, from the change in fair value of its warrant liability. During the nine months ended September 30, 2012 and 2011, the Company recognized gains of $663 and $837, respectively, from the change in fair value of its warrant liability.
Assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement. The Company’s derivative financial instruments which are required to be measured at fair value on a recurring basis are measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
The following represents a reconciliation of the changes in fair value of financial instruments measured at fair value using Level 3 inputs during the nine months ended September 30, 2012 and 2011 (in thousands):
| | | Warrants | |
| | | | |
| Balance – January 1, 2011 | | $ | 1,312 | |
| Issued | | | - | |
| Exercised | | | - | |
| Fair value adjustments | | | (837 | ) |
| Balance- September 30, 2011 | | | 475 | |
| Issued | | | - | |
| Exercised | | | - | |
| Fair value adjustments | | | 198 | |
| Balance- December 31, 2011 | | | 673 | |
| Issued | | | - | |
| Exercised | | | - | |
| Fair value adjustments | | | (663 | ) |
| Balance- September 30, 2012 | | $ | 10 | |
Estimating the fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, valuation techniques are sensitive to changes in the trading market price of our common stock, which may exhibit significant volatility. Because derivative financial instruments are initially and subsequently carried at fair values, the Company’s income will reflect the volatility in these estimate and assumption changes.
(11) COMMON STOCK
Amounts in the following discussion are in thousands except for share data (shares, par value and price per share):
The Company is authorized to issue 13,333,334 shares of common stock, $0.00001 par value per share. The Company had 193,923 common shares outstanding prior to the Share Exchange with PXPF, and, as described in Note 1, issued 1,941,334 common shares to the shareholders of PXPF in connection with the Share Exchange. For accounting purposes, the shares issued to the shareholders of PXPF are assumed to have been outstanding on January 1, 2008, and the 193,923 shares held by the existing shareholders of the Company prior to the Share Exchange on February 13, 2009 are assumed to have been issued on that date in exchange for the net assets of the Company.
On December 1, 2009, the Company sold 87,138 shares of common stock to certain accredited investors (see Note 9).
During the year ended December 31, 2010, 1,100 warrants were exercised for, and 1,747,962 shares of convertible preferred stock were converted into 1,100 and 233,062 shares of common stock, respectively.
During the year ended December 31, 2011, 415,906 shares of convertible preferred stock were converted into 55,454 shares of common stock.
During the nine months ended September 30, 2012, 209,275 shares of convertible preferred stock were converted into 27,904 shares of common stock.
On March 10, 2010, the Company entered into a service agreement with a non-executive director and agreed to issue 1,334 shares of restricted common stock in four quarterly installments for her annual service. The terms of the service agreement was continued on March 10, 2011 and 2012, with 1,334 shares of restricted common stock to be issued in four quarterly installments accordingly. The trading value of the Company’s common stock on March 10, 2012 and 2011 was $11.91 and $11.79, respectively, and the total to be recognized for each these issuances over the year of service is $16 and $16, respectively. Compensation expense of $3 and $4 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $13 and $20 for the nine months ended September 30, 2012 and 2011, respectively.
On April 27, 2010, the Company entered into an agreement to issue 2,667 shares of restricted common stock to Worldwide Officers Inc. (“WOI”) for the services of its chief financial officer for one year, which would vest as follows: 475 shares on June 30, 2010, 672 shares on September 30, 2010, 672 shares on December 31, 2010, 658 shares on March 31, 2011 and 190 shares on April 26, 2011. The trading value of the granted shares on April 27, 2010 was $37.50 per share for a total value of $100. Compensation expense of $0 and $0 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $0 and $32 for the nine months ended September 30, 2012 and 2011, respectively.
On September 28, 2011, the Company entered into an agreement to issue 2,648 shares of restricted common stock to WOI for the chief financial officer’s services from April 27, 2011 through September 27, 2011. The trading value of the granted shares on September 28, 2011 was $9.75 for a total value of $26. Compensation expense of $0 and $26 was recognized for the three and nine months ended September 30, 2012 and 2011, respectively.
On September 28, 2011, the Company entered into an agreement to grant WOI a restricted stock award of $200 of its common stock for each one-year term of the chief financial officer, $100 of which is calculated based on the closing price of the common stock on the first day of such term, and the other $100 calculated based on the closing price on the first day immediately after the initial 6-month period of such term. In connection therewith, 10,256 shares were granted to WOI for the initial 6-month period term (“First Issuance”), and 8,482 shares for the subsequent 6-month term (“Second Issuance”), calculated based on the closing prices of the Company’s common stock as quoted on the OTC Bulletin Board on September 28, 2011 of $9.75, and on March 28, 2012 of $11.79, respectively. The terms of agreement were continued on September 28, 2012 with 12,049 shares granted to WOI for the 6-month period of the renewal term (“Third Issuance”), calculated based on the closing prices of the Company’s common stock as quoted on the OTC Bulletin Board on September 28, 2012 of $8.30. The First Issuance vested in two installments of 5,128 shares each on December 27, 2011 and March 27, 2012. The Second Issuance vested in two installments of 4,241 shares each on June 27 and September 27, 2012. The Third Issuance will vest in two installments of 6,025 shares on December 27, 2012 and 6,024 shares on March 27, 2013. For the First Issuance and Second Issuance, compensation expense of $48 and $2 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $149 and $2 for the nine months ended September 30, 2012 and 2011, respectively. For the Third Issuance, compensation expense of $2 and $0 was recognized for the three and nine months ended September 30, 2012 and 2011, respectively.
On May 25, 2012, the Company’s Board of Directors ratified an agreement with a consultant to provide one year of strategic public relations services from May 4, 2012 to May 3, 2013 in exchange for 22,334 shares of its common stock to be issued under the Company’s 2012 Stock Plan. The trading value of such shares on May 25, 2012 was $10.20, for a total value of $227. Compensation expense of $0 and $0 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $227 and $0 for the nine months ended September 30, 2012 and 2011, respectively. The shares were issued in July 2012.
On July 25, 2012, the Company’s Board of Directors ratified an agreement with a consultant to provide the Company with general advice and consulting services regarding the Company’s expansion into the Taiwan market from July 20, 2012 to July 19, 2013 in exchange for 11,667 shares of its common stock to be issued under the Company’s 2012 Stock Plan. The trading value of such shares on July 25, 2012 was $6.15, for a total value of $72. Compensation expense of $72 and $0 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $72 and $0 for the nine months ended September 30, 2012 and 2011, respectively. The shares were issued in July 2012.
A summary of the status of the Company’s non-vested shares as of September 30, 2012, and changes during the year ended December 31, 2011, is presented below:
| Non-vested shares | | Shares | | | Weighted- Average Grant Date Fair Value | |
| Non-vested at January 1, 2011 | | | 1,181 | | | $ | 39.96 | |
| Granted | | | 14,237 | | | | 9.98 | |
| Vested | | | (4,495 | ) | | $ | 18.00 | |
| Forfeited | | | - | | | | - | |
| Non-vested at September 30, 2011 | | | 10,923 | | | $ | 9.90 | |
| Granted | | | - | | | $ | - | |
| Vested | | | (5,462 | ) | | $ | 9.87 | |
| Forfeited | | | - | | | | - | |
| Non-vested at December 31, 2011 | | | 5,461 | | | $ | 9.93 | |
| Granted | | | 55,865 | | | | 9.23 | |
| Vested | | | (48,889 | ) | | $ | 9.50 | |
| Forfeited | | | - | | | | - | |
| Non-vested at September 30, 2012 | | | 12,437 | | | $ | 8.47 | |
As of September 30, 2012, there was $105 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted by the board of directors. This cost is expected to be recognized by March 27, 2013. The total fair value of shares vested during the three months ended September 30, 2012 and 2011 was $124 and $31, respectively. The total fair value of shares vested during the nine months ended September 30, 2012 and 2011 was $464 and $79, respectively.
On December 12, 2011, the Company effected a 1-for-2.5 reverse stock split of its issued and outstanding shares of common stock and a proportional reduction of its authorized shares of common stock. On September 24, 2012, the Company effected a 1-for-3 reverse stock split of its issued and outstanding shares of common stock and a proportional reduction of its authorized common stock. All common share and per share amount, and exercise prices of common stock purchase warrants and options disclosed herein and in the accompanying consolidated unaudited financial statements have been retroactively restated to reflect both reverse stock splits.
At September 30, 2012, there were 2,599,321 shares of common stock issued and outstanding.
(12) PREFERRED STOCK
The following amounts are in thousands except for share data (shares, par value and price per share):
The Company is authorized to issue 100,000,000 shares of preferred stock, $0.00001 par value, of which 2,800,000 shares have been designated as series A convertible preferred stock (the “Preferred Share”).
On October 27 and November 17, 2009, the Company sold 1,446,105 and 1,350,616 Preferred Shares to certain accredited investors in connection with the Preferred Shares Financing, respectively (see Note 9). Up to December 31, 2011, 2,163,868 Preferred Shares were converted, and at December 31, 2011, 632,853 Preferred Shares were outstanding, with an aggregate liquidation preference of $1,810. During the nine months ended September 30, 2012, 209,275 Preferred Shares were converted into 27,904 shares of common stock, and at September 30, 2012, 423,578 Preferred Shares were outstanding, with an aggregate liquidation preference of $1,211.
(13) EARNINGS PER SHARE
The following amounts are in thousands except for share data (shares and earnings per share):
(a) Basic
“Basic earnings per share - common” is calculated by dividing the net income attributable to common shareholders of the Company by the weighted average number of common shares. Using the two class method pursuant to ASC 260-10-45, the Company allocated its net income to preferred and common shareholders during the three and nine months ended September 30, 2012 and 2011, based on the number of common shares outstanding during the periods shown (taking into account the number of preferred shares converted into common shares at the end of such periods on a 1-for-0.1333 common share basis), and participating preferred shares outstanding during the periods shown.
| | | Three Months Ended September 30, | | | Nine months Ended September 30, | |
| | | 2012 | | | 2011 | | | 2012 | | | 2011 | |
| Income attributable to common shareholders of the Company | | | 2,987 | | | | 1,549 | | | | 10,191 | | | | 9,450 | |
| Income attributable to preferred shareholders of the Company | | | 65 | | | | 59 | | | | 221 | | | | 360 | |
| Net income | | $ | 3,052 | | | $ | 1,608 | | | $ | 10,412 | | | $ | 9,810 | |
| Weighted average number of common shares outstanding | | | 2,583,841 | | | | 2,485,057 | | | | 2,552,524 | | | | 2,478,231 | |
(b) Diluted
Diluted earnings per share is calculated by adjusting the weighted average number of common shares outstanding to assume conversion of all dilutive potential common shares. The Company has two categories of dilutive potential common shares: the Preferred Shares issued in October and November 2009 in connection with the Preferred Shares Financing, and the Warrants issued in connection with both the Preferred Shares Financing and the Common Shares Financing in December 2009. The Warrants are assumed to have been converted into common shares and the calculation is done to determine the number of shares that could have been acquired at fair value (determined as the average annual market share price of the Company’s common stock) based on the monetary value of the subscription rights attached to outstanding Warrants. The Preferred Shares that were outstanding at the end of the respective periods are assumed to have been converted into common shares on a 1-for-0.1333 basis. Since the Preferred Shares are included in the diluted calculation, net income (attributable to both common and preferred shareholders) is used. The number of shares calculated as above is compared with the number of shares that would have been issued assuming the exercise of the Warrants.
| | | Three Months Ended September 30, | | | Nine months Ended September 30, | |
| | | 2012 | | | 2011 | | | 2012 | | | 2011 | |
| Net income | | $ | 3,052 | | | $ | 1,608 | | | $ | 10,412 | | | $ | 9,810 | |
| Weighted average number of common shares outstanding | | | 2,583,841 | | | | 2,485,057 | | | | 2,552,524 | | | | 2,478,231 | |
| | | | | | | | | | | | | | | | | |
| Adjustment for: | | | | | | | | | | | | | | | | |
| Preferred stock | | | 67,426 | | | | 115,334 | | | | 75,378 | | | | 121,665 | |
| | | | 2,651,267 | | | | 2,600,391 | | | | 2,627,902 | | | | 2,599,896 | |
For the three and nine months ended September 30, 2012 and 2011, 228,917 common stock purchase warrants are excluded from the calculation of diluted earnings per share as they are anti-dilutive.
(14) INCOME TAXES
The provisions for income tax expense were as follows (in thousands):
| | | Three Months Ended September 30, | | | Nine months Ended September 30, | |
| | | 2012 | | | 2011 | | | 2012 | | | 2011 | |
| PRC enterprise income tax- current | | $ | 1,295 | | | $ | 400 | | | $ | 5,327 | | | $ | 2,950 | |
As of September 30, 2012 and December 31, 2011, the Company did not have any significant temporary differences and carry forwards that may result in deferred tax.
The applicable rate of Hong Kong profits tax for 2012 and 2011 is 16.5%. No provision for Hong Kong profits tax has been made, however, as the Company does not carry on any business that generates profits chargeable to Hong Kong profits tax.
PXPF is a company incorporated in the BVI and is fully exempt from Domestic Corporate Tax of the BVI.
The Company’s subsidiary and VIE in China are subject to a statutory income tax rate of 25% in the PRC.
The Company has analyzed the tax positions taken or expected to be taken in its tax filings and has concluded it has no material liability related to uncertain tax positions or unrecognized tax benefits as of September 30, 2012.
The following table reconciles the theoretical tax expense calculated at the statutory rates to the Company’s effective tax expense for the three and nine months ended September 30, 2012 and 2011, respectively (in thousands):
| | | Three Months Ended September 30, | | | Nine months Ended September 30, | |
| | | 2012 | | | 2011 | | | 2012 | | | 2011 | |
| Theoretical tax expense calculated at PRC statutory Enterprise income tax rate of 25% | | | 1,087 | | | | 502 | | | | 3,935 | | | | 3,190 | |
| Tax adjustment for prior year | | | - | | | | - | | | | 1,056 | | | | - | |
| Tax effect of non-deductible expenses | | | 232 | | | | (38) | | | | 553 | | | | (31 | ) |
| Other | | | (24 | ) | | | (64) | | | | (217 | ) | | | (209 | ) |
| Effective tax expense | | $ | 1,295 | | | $ | 400 | | | $ | 5,327 | | | $ | 2,950 | |
The tax adjustment for the prior year represents a change in management’s estimate of the prior year income tax provision. Certain expenses that the Company believed were deductible were deemed non-deductible by the PRC tax bureau subsequent to the Company's filing of its annual report on Form 10-K on April 12, 2012. A provision was therefore made for the additional income tax during 2012. Non-deductible expenses for the three and nine months ended September 30, 2012 and 2011 primarily consisted of expenses incurred outside of the PRC which are not deductible in computing the income tax for the PRC.
The New Tax Law imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China for distribution of earnings generated after January 1, 2008. Under the New Tax Law, the distribution of earnings generated prior to January 1, 2008 is exempt from the withholding tax. As management does not anticipate that the subsidiaries in the PRC will distribute their earnings to the Company for the year ending December 31, 2012, and no dividends were distributed in the years ended December 31, 2011 and 2010, no deferred tax liability has been recognized for the undistributed earnings of these PRC subsidiaries through September 30, 2012. Total undistributed earnings of these PRC subsidiaries at September 30, 2012 was RMB340,477,569 ($53,829,595).
