13-Sep-2005
Annual Report
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
We begin our Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) with a discussion of the Critical Accounting Policies that we believe are important to understanding the assumptions and judgments underlying our financial statements. This is followed by a discussion of our Results of Operations that begins with an Overview followed by a more detailed discussion of our revenue and expenses. We then provide an analysis of our Liquidity and Capital Resources with a discussion of key aspects of our statements of cash flows, changes in our balance sheets, and our financial commitments. Following these discussions is the section entitled Risks That Could Affect Future Results which details some important factors that may significantly impact our future financial performance. You should also note that this MD&A discussion contains forward-looking statements that involve risks and uncertainties. Please see the section entitled "Caution Regarding Forward-Looking Statements" at the end of this Item 7 for important information to consider when evaluating such statements.
You should read this MD&A in conjunction with the Consolidated Financial Statements and Related Notes in Item 8.
Critical Accounting Policies
In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Senior management has discussed the development and selection of these critical accounting policies and their disclosure in this Report with the Audit Committee of our Board of Directors.
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Results of Operations
Our operations for the five months period ended May 31, 2005 consisted of operations of Huaqing (51% indirect ownership interest), Control Tech (Consolidated from March 2005, 90% direct ownership interest), Hartcourt Capital Inc. (100% ownership interest), Hartcourt China, Inc. (100% ownership interest), and Ai-Asia Inc. (100% ownership interest), and Hartcourts investments in other entities located in Hong Kong and China. Our restated operations for the five months period ended May 31, 2004 consisted of the operations of Huaqing (51% indirect ownership interest), Hartcourt China Inc. (100% ownership interest), Ai-Asia Inc. (100% ownership interest), and Hartcourt Capital Inc. (100% ownership interest) and Hartcourt's investments in other entities located in China and Hong Kong.
Operating revenue:
We recorded operating revenue of US$19.7 million for the five months period ended May 31, 2005, compare to US$29.2 million for the same period in 2004, or a 33% decrease. Our sales during the five months period ended May 31, 2005 mainly represented revenues derived from sale of Samsung monitors and notebooks in Shanghai and sales of multimedia products in China, while sales revenue during the five months period ended May 31, 2004 mainly represented revenues derived from sales of Samsung monitors in Zhejiang and Shanghai area.
Samsung monitor sales in Zhejiang province did not sell through Huaqin Shanghai from the beginning of 2005. Huaqin Shanghai disposed of equity interest in Huaqin Hangzhou in August 2004 and Huaqin Hangzhou signed a separate distribution agreement with Samsung at the beginning of 2005. Huaqin Shanghai sales increased 25% compared to same period last year over the same geographic area. The increase comes from the addition of Samsung notebook sales.
Our multi-media products sales were consolidated in our financial statements beginning March 1, 2005.
Our cost of sales amounted to US$18.4 million for the five months period ended May 31, 2005, compare to US$28.6 million for the same period in 2004, excluding the discontinued operations. Cost of sales for the five months ended May 31, 2005 represented the cost of Samsung products and multimedia products. Cost of sales for the five months ended May 31, 2004 represented the costs of Samsung monitors.
Gross profit was US$1.2 million, or 6.3%, for the five months period ended May 31, 2005 compared to US$0.6 million, or 1.9%, for the same period in 2004, an increase of 219%. Overall Samsung gross margin doubled, from last years 2% to this years 4%. Multimedia products are a major gross margin contributor, accounted for nearly 40% of the total gross profit for the five months period ended May 31, 2005.
Selling, general and administrative expenses:
Our selling, general and administrative expenses were US$862 thousand for the five months period ended May 31, 2005 compared to US$985 thousand for the same periods in 2004. a decrease of US$123 thousand , or 12%, due to lower operating expenses.
Depreciation and amortization expenses:
Our depreciation and amortization expenses were US$30 thousand for the five months period ended May 31, 2005 compared to US$23 thousand for the same periods in 2004, a 30% increase. The increase was primarily due to our acquisition of Control Tech assets.
Interest income:
Interest income was US$47 thousand and US$89 thousand for the five month period ended May 31, 2005 and 2004. The US$42 thousand decrease was mainly due to lower cash balances.
Interest expenses:
Interest expenses were US$200 thousand and US$195 thousand for the five months period ended May 31, 2005 and 2004. All the interest expenses were incurred by Huaqing, a 51% owned subsidiary, from short term bank loans to finance the Samsung distribution business.
Other revenue: Other revenue for the five month period ended May 31, 2005 were mainly from Samsung warranty services while in 2004 were resulted from disposal of a real estate property owned by our subsidiary Huaqin.
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Income from Continuing Operations:
Income from continuing operations for the five months ended May 31, 2005 was US$345 thousand, compared to a loss of US$443 thousand for the same period a year ago, primarily due to addition of our multimedia business, coupled with lower operating expenses in the five month period ended May 31, 2005.
Minority interest:
Minority interest represented the profit shared by the minority shareholders of Huaqing (49%) and Control Tech (10%).
Income tax:
Overall, our subsidiaries and affiliates are continuing to pay taxes in China that are on average lower than the statutory rate of 33%. Certain of our subsidiaries and affiliates were granted special tax treatment by the local Chinese provincial tax authorities and are exempt from income tax.
Chinese local tax authorities had not yet conducted annual tax audits of our subsidiaries and affiliates in China for the 2004 tax year. Management believes that there are no outstanding tax issues or liabilities at the time of this transition period report. All tax liabilities, if any, prior to the acquisition by us of our various Chinese subsidiaries or affiliates are solely the responsibility of the selling shareholders, as stipulated in each acquisition agreement.
We made provision for PRC income taxes of US$78,378 and US$82,670 for the five months ended May 31, 2005 and 2004, respectively. This provision for taxes relates to the estimated amount of taxes that would be imposed by tax authorities in the PRC. None of our income is subject to taxation by any U.S. governmental authority.
Liquidity and Capital Resources:
Our principal capital requirements during 2005 have been primarily funded by issuance of securities and to a lesser extent, Chinese short term bank loans.
As shown in our accompanying financial statements, we had a net income of US$123,082 for the five months period ended May 31, 2005 as compared to a net income of US$29,262 for the same periods in 2004, helped by one-time gain from discontinued operation in 2004. Our current assets exceeded our current liabilities by US$4,408,610 as of May 31, 2005.
As of May 31, 2005, we had working capital of US$4,408,610. In addition to our working capital on hand, we intend to obtain required capital through a combination of bank loans, staff loans and the sale of our equity securities. However, there are no commitments or agreements on the part of anyone at this time to provide us with additional bank financing or purchase of securities. If we are unable to raise the necessary additional working capital, our operations and financial condition may be adversely affected.
Operating activities:
During the five month period ended May 31, 2005, net cash used in operating activities was US$1.3 million, compared to net cash provided by operating activities of US$1.6 million during the same period in 2004. The decrease in cash generated from operating activities resulted mainly from decrease of deferred revenue.
Investing activities:
Net cash provided by investing activities during the five months ended May 31, 2005, was US$0.8 million compared to net cash used in investing activities US$0.7 million for the same period in 2004. The cash provided by investment activities in the first quarter of 2005 was mostly due to proceeds from disposal of Guowei. The US$0.7 million cash used in investment activities in 2004 was mainly resulted from the net effect of (a) the payment of investment in Guowei of US$0.1 million and (b) payment of 0.6 million for investment in Beijing Challenge, (c) Huaqings payment of dividends to its minority shareholder of US$0.3 million (d) recovery of notes receivable of US$0.3 million.
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Financing activities:
Net cash provided by financing activities during the five months ended May 31, 2005 equaled to US$46 thousand compared to cash provided by financing activities of US$26 thousand during the same period in 2004. Net cash provided by financing activities was mostly due to the net effect of (a) payment of SEC judgment in the amount of US$1.1 million. Please refer to details of the SEC litigation in the Part I, Item 3, Legal Proceedings of this document, (b) bank loans of US$0.2 million borrowed by Huaqing from local bank and (3) funds raised from private offering in the amount of US$1 million. Cash provided by financing activities during same period 2004 was mainly proceeds from sales of our common stock totaling approximately US$1.3 million, net off by payments to related parties, repayment of notes payables and bank loans totally US$1.3 million.
As a result of the above activities, we experienced a net decrease in cash of US$0.3 million for the five months ended May 31, 2005.
Research and Development
Presently the company is not undertaking any significant Research and Development efforts.
Off-Balance Sheet Arrangements
During the transition period ended May 31, 2005, the Company did not engage in any off-balance sheet arrangements as defined in Item 303(a)(4) of the SEC's Regulation S-K.
IMPORTANT FACTORS THAT MAY AFFECT OUR BUSINESS, OUR OPERATING RESULTS AND OUR STOCK PRICE
In addition to the other information contained in this 5-month transitional report, you should carefully read and consider the following risk factors. If any of these risks actually occur, our business, financial condition or operating results could be materially adversely affected and the trading price of our common stock could decline.
WE DEPEND SUBSTANTIALLY ON CARRIE HARTWICK TO MANAGE THE ON-GOING BUSINESS. OUR BUSINESS AND GROWTH PROSPECTS MAY BE SEVERELY DISRUPTED IF WE LOSE HER SERVICES. OUR FUTURE SUCCESS IS HEAVILY DEPENDENT UPON THE CONTINUED SERVICE OF MS. HARTWICK.
Ms. Hartwick serves as our Chief Executive Officer, President and Interim Chief Financial Officer. Our only other executive officer is Mr. Zhou Jing Jing who recently joined Hartcourt as our Vice President of Operations managing the sales operation. If Ms. Hartwick is unable or unwilling to continue in her present positions, we will not be able to easily replace her and will incur additional expenses to recruit and train new personnel and may not be able to efficiently and effectively operate our business in the meantime. Our business could be severely disrupted and our financial condition and results of operations could be materially and adversely affected. Furthermore, since our industry is characterized by high demand and intense competition for talent, we may need to offer higher compensation and other benefits in order to attract and retain key personnel in the future. We cannot assure you that we will be able to attract or retain the key personnel that we will need to achieve our business objectives. Furthermore, we do not maintain key-man life insurance on Ms Hartwick or any of our other personnel.
IF WE CANNOT MAINTAIN DISTRIBUTION AGREEMENTS WITH OUR KEY VENDORS, OUR ON-GOING BUSINESS WILL BE SEVERELY IMPACTED OR FAIL.
Over 90% of our revenue in the transition period from January 1, 2005 through May 31, 2005, was generated from sales of Samsung products. We sign an annual distribution contract with Samsung. There is no guarantee the distribution contract will be renewed. If our relationship with Samsung is severed, we will experience major revenue or profit decline.
WE HAVE INCURRED SIGNIFICANT LOSSES IN THE PAST AND HAVE A HISTORY OF NEGATIVE CASH FLOW FOR OPERATIONS AND MAY NOT ACHIEVE OR SUSTAIN CONSISTENT PROFITABILITY, WHICH COULD RESULT IN A DECLINE IN THE VALUE OF OUR COMMON STOCK OR OUR INABILITY TO SUPPORT OUR OPERATIONS OR FUTURE CAPITAL REQUIREMENTS.
We have received a report from our independent auditors containing an explanatory paragraph that describes doubt about our ability to continue as a going concern due to our historical operating losses and recurring negative working capital. We have incurred net losses and experienced negative cash flows from operations in the last 5 years. As of May 31, 2005, we had an accumulated deficit of approximately US$67 million. As we shift our business from volume driven computer hardware products to more profitable market segments with products low in volume and revenue but high in profit, our revenue will decrease in the near future.
Whether we can achieve cash flow levels sufficient to support our operations, and whether we will then be able to maintain positive cash flow, cannot be accurately predicted. Unless such cash flow levels are achieved, we will need to borrow additional funds or sell debt or equity security, or some combination thereof, to provide funding for our operations. There can be no assurances that any additional debt or equity financing will be available to us on acceptable terms, if at all. The inability to obtain debt or equity financing could have a material adverse effect on our operating results, and as a result we could be required to cease or significantly reduce our operations, seek a merger partner or sell additional securities on terms that may be disadvantageous to shareholders. In addition, irrespective of our revenue, we may not achieve or sustain profitability in future periods as a result of our operating expenses.
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IF WE ARE UNABLE TO COMPETE SUCCESSFULLY IN THE HIGHLY COMPETITIVE MARKETS FOR THE NOTEBOOK COMPUTER AND PRODUCTS FOR ANY REASON, INCLUDING CURRENT OR POTENTIAL COMPETITORS GAIN COMPETITIVE ADVANTAGE THROUGH PARTNERING OR ACQUISITION, OUR BUSINESS WILL FAIL.
Our business is extremely competitive, particularly with respect to prices, quantity and in certain instances, customer relationship. We compete with numerous regional and local distributors of similar products with different brand names. Many of our competitors, as well as certain potential competitors, have longer operating histories in the industry, greater name recognition, larger customer base and significantly greater financial, technical and marketing resources than ours. Any of our present or future competitors may provide services with significant performance, price, creativity or other advantages over those offered by us. We can provide no assurance that we will be able to compete successfully against our current or future competitors.
IF WE ARE UNABLE TO ANTICIPATE THE EVER CHANGING OF TECHNOLOGY TRENDS AND CUSTOMER NEEDS, OUR BUSINESS MAY BECOME OBSOLETE AND IRRELEVANT AND WE WILL FAIL.
The IT industry is subject to rapid technological changes. We may not be able to anticipate the emergence of new technologies and its impact on our existing business. Our products or brands that we sell and market might become unattractive to our customers, thereby limiting our ability to recover our initial investment in acquiring these businesses and potentially adversely affecting our future profitability and growth prospects.
THERE ARE RISKS ASSOCIATED WITH OUR BUSINESS STRATEGY CONTEMPLATING GROWTH THROUGH ACQUISITIONS AND JOINT VENTURES.
As a component of our growth strategy, we intend to continue to enhance our business development by acquiring other businesses. However, our ability to grow through such acquisitions and joint ventures will depend on the availability of suitable acquisition candidates at an acceptable cost or at all, our ability to compete effectively to attract and reach agreement with acquisition candidates or joint venture partners on commercially reasonable terms, the availability of financing to complete larger acquisitions or joint ventures. In addition, the benefits of an acquisition or joint venture transaction may take considerable time to develop and we cannot assure you that any particular acquisition or joint venture will produce the intended benefits. Moreover, the identification and completion of these transactions may require us to expend significant management and other resources.
IF WE ARE ABLE TO EXPAND OUR OPERATIONS PURSUANT TO OUR ACQUISITION STRATEGY, OUR FAILURE TO MANAGE GROWTH COULD HARM OUR BUSINESS AND ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
Our ability to manage growth will not only be dependent on our ability to successfully integrate newly acquired IT businesses, but also on our ability to:
· hire, train and manage additional qualified personnel;
· establish new relationships or expand existing relationships with IT suppliers;
· secure adequate capital;
· identify and acquire or lease suitable premises on competitive terms;
· maintain the supply of IT from IT suppliers; and
· compete successfully in the Chinese IT sector.
Our inability to control or manage these growth factors effectively could have a material adverse effect on our results of operations and financial condition.
THE LIQUIDITY OF OUR COMMON STOCK IS AFFECTED BY ITS LIMITED TRADING ABILITY.
Shares of our common stock are traded on the OTC Bulletin Board under the symbol "HRCT.OB". There is currently no broadly followed established trading market for our common stock. An "established trading market" may never develop or be maintained. Active trading markets generally result in lower price volatility and more efficient execution of buy and sell orders. The absence of an active trading market reduces the liquidity of our shares. The trading volume of our common stock historically has been limited and sporadic. As a result of this trading inactivity and the exchange, the quoted price for our common stock on the OTC Bulletin Board is not necessarily a reliable indicator of its fair market value. Further, if we cease to be quoted, holders would find it more difficult to dispose of, or obtain accurate quotations as to the market value of our common stock, and the market value of our common stock would likely decline.
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THE LACK OF BUSINESS INSURANCE COVERAGE IN CHINA COULD MATERIALLY AND ADVERSELY AFFECT OUR BUSINESS, FINAL CONDITION AND RESULTS OF OPERATION SHOULD ANY MAJOR CATASTROPHIC DISASTER OCCURS.
We have limited business insurance coverage in China. The insurance industry in China is still at an early stage of development. In particular, PRC insurance companies offer limited business insurance products. As a result, we do not have any business liability or disruption insurance coverage for our operations in China. Any business disruption, litigation or natural disaster might result in our incurring substantial costs and the diversion of resources.
OUR CURRENT CAPITAL STRUCTURE MAY NOT BE SUFFICIENT FOR US TO ACQUIRE NEW BUSINESS OR MAINTAIN ON GOING OPERATIONS.
Although we believe that the current capital structure of the Company will be sufficient to allow us to consummate acquisitions, we cannot ascertain the capital requirements for any particular transaction. If the current financial resources prove to be insufficient, either because of the size of the business acquisition or the depletion of the available financial resources in search of acquisitions, we will be required to seek additional financing. We cannot assure you that such financing would be available on acceptable terms, if at all. To the extent that additional financing proves to be unavailable when needed to consummate an acquisition, we would be compelled to restructure the transaction or abandon that particular business acquisition and seek an alternative target business candidate. In addition, if we consummate a business combination, we may require additional financing to fund the operations or growth of the business. The failure to secure additional financing could have a material adverse effect on the continued development or growth of our business. None of our officers, directors or shareholders is required to provide any financing to us in connection with or after an acquisition.
COMPLIANCE WITH NEW RULES AND REGULATIONS CONCERNING CORPORATE GOVERNANCE MAY BE COSTLY AND TIME CONSUMING.
The Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, requires, among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for board and audit committee members and imposes increased civil and criminal penalties for companies, their chief executive officers and chief financial officers for securities law violations. These laws, rules and regulations will increase the scope, complexity and cost of our corporate governance, reporting and disclosure practices, which could harm our results of operations and divert management's attention from business operations. These new rules and regulations may also make it more difficult and more expensive for us to obtain director and officer liability insurance and make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee.
WHILE WE BELIEVE THAT WE CURRENTLY HAVE ADEQUATE INTERNAL CONTROL PROCEDURES IN PLACE, WE ARE STILL EXPOSED TO POTENTIAL RISKS FROM RECENT LEGISLATION REQUIRING COMPANIES TO EVALUATE INTERNAL CONTROLS UNDER SECTION 404 OF THE SARBANES-OXLEY.
We are evaluating our internal controls systems in order to allow management to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting, as required by this legislation. We will be performing the system and process evaluation and testing (and any necessary remediation) required in an effort to allow our management to assess the effectiveness of our system of internal control as of the end of the transition period ended May 31, 2005, the end of our current fiscal year. Our independent auditors must then attest to and report on that assessment by our management to comply with the management certification and auditor attestation requirements of Section 404 of Sarbanes-Oxley (Section 404). As a result, we have and expect to continue to incur significant additional expenses and diversion of management's time. We may fail to timely complete our evaluation, testing and remediation actions in order to allow for this assessment by our management or our independent auditors may not be able to timely attest to our management's assessment. If we are not able to implement the requirements of
Section 404 in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by regulatory authorities, such as the Securities Exchange Commission. Further, if our independent auditors are not satisfied with our internal control over financial reporting or with the level at which it is documented, designed, operated or reviewed, they may decline to attest to management's assessment or may issue a qualified report identifying a material weakness in our internal controls. Any such action could adversely affect our financial results and could cause our stock price to decline.]
IF THE PRC GOVERNMENT FINDS THAT THE STRUCTURE FOR OPERATING OUR CHINA BUSINESS DOES NOT COMPLY WITH PRC GOVERNMENT RESTRICTIONS ON FOREIGN INVESTMENT IN THE IT DISTRIBUTION INDUSTRY, WE COULD BE COMPELLED TO RESTRUCTURE OUR INVESTMENT OR ABANDON OUR INVESTMENT.
We are a U.S. registered company and we conduct our operations solely in China through our directly owned subsidiaries and indirectly majority-owned subsidiary. In order to comply with foreign ownership restrictions, we operate our business in China through a subsidiary which is majority owned by Kang Bin, our financial controller, and Ni Ting Ting, our investment associate, both of whom are PRC citizens (our nominees). We have entered into a series of contractual arrangements with our indirectly owned subsidiary, its shareholders and our nominees. As a result of these contractual arrangements, we are considered the majority beneficiary of all of our subsidiaries and accordingly we consolidate all of our subsidiaries' results of operations in our financial statements.
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In the opinion of Zhonglun Law Firm (Shanghai), our PRC legal counsel: (1) the ownership structures of our subsidiaries is in compliance with existing PRC laws and regulations; (2) our contractual arrangements with each of our subsidiaries, our nominees and its shareholders are valid and binding, and will not result in any violation of PRC laws or regulations currently in effect; (3) the business operations of our subsidiaries are in compliance with existing PRC laws and regulations in all material aspects and (4) the enforcement of foreign judgments made by courts outside the PRC has no direct and automatic operation in the PRC, but these judgments may be recognized and enforced by a PRC court in accordance with a bilateral or international treaty to which PRC is a party, or subject to the principles of reciprocity upon a finding that the judgment does not conflict with fundamental principles, sovereignty, security and public interests of the PRC after review of the judgment.
There are, however, substantial uncertainties regarding the interpretation and application of current or future PRC laws and regulations. Accordingly, we cannot assure you that the PRC regulatory authorities will not ultimately take a view that is contrary to the opinion of our PRC legal counsel.
RISKS RELATING TO THE PEOPLE'S REPUBLIC OF CHINA
SUBSTANTIALLY ALL OF OUR ASSETS ARE LOCATED IN CHINA AND SUBSTANTIALLY ALL OF OUR REVENUES ARE DERIVED FROM OUR OPERATIONS IN CHINA. ACCORDINGLY, THE CHINESE LAWS, RULES AND REGULATIONS WHICH CAN BE DIFFERENT FROM THE US LAWS, ARE PREVALENT IN GOVERNING OUR BUSINESS ACTIVITIES IN CHINA.
Chinese law and regulations strictly limit the repatriation of assets of Chinese companies. Payments to parties outside of the PRC are governed by the Foreign Exchange Bureau and its Regulation on Foreign Exchange Control. Pursuant to the Regulation, a Chinese enterprise may make overseas payments from their foreign . . .
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