AI
Saturday, April 16, 2005 2:00:48 AM
Form 10KSB for HARTCOURT COMPANIES INC
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15-Apr-2005
Annual Report
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND THE NOTES THERETO AND THE OTHER FINANCIAL INFORMATION APPEARING ELSEWHERE IN THIS DOCUMENT. IN ADDITION TO HISTORICAL INFORMATION, THE FOLLOWING DISCUSSION AND OTHER PARTS OF THIS DOCUMENT CONTAIN CERTAIN FORWARD-LOOKING INFORMATION. WHEN USED IN THIS DISCUSSION, THE WORDS "BELIEVES," "ANTICIPATES," "EXPECTS," AND SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES, WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED DUE TO A NUMBER OF FACTORS BEYOND OUR CONTROL. WE DO NOT UNDERTAKE TO PUBLICLY UPDATE OR REVISE ANY OF OUR FORWARD-LOOKING STATEMENTS EVEN IF EXPERIENCE OR FUTURE CHANGES SHOW THAT THE INDICATED RESULTS OR EVENTS WILL NOT BE REALIZED. YOU ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH REFLECT ONLY OUR CURRENT VIEWS OF POSSIBLE FUTURE EVENTS.
PRO FORMA CONDENSED AND COMBINED FINANCIAL STATEMENTS
Since we have disposed of all but one of our operating subsidiaries during 2004 a comparison of 2004 operating results to our reported 2003 financial results would not be meaningful. As such, the following discussion is based on the comparison of the full year combined operating results for 2004, with the pro forma operating results of the surviving subsidiaries and continued operations in 2003.
The condensed pro forma financial statements set forth below represent the combined financial statements of the surviving subsidiary Huaqing, which we acquired in February 2003. The combined pro forma financial statements for 2004 accounted for the full year's operating results including the profit/loss on disposals and the results of discontinued operations. The condensed pro forma financial statements for 2004 and 2003 are prepared and audited in accordance with the U.S. GAAP.
In order to make the year-on-year comparison as meaningful as possible, the below pro forma financial statements are based on the full year operating results of the Company and surviving subsidiary for 2004. Since the surviving subsidiary was itself acquired by us in March 2003, the operating results for 2003 only consolidate the surviving subsidiary for the ten-month period following the effective date of acquisition. The below information includes a discussion of the changes in market conditions that affected our operating results and the structure and composition of the Group.
The exclusion of the four subsidiaries that have either been disposed or are pending for sale from our pro forma financial statements reduced our pro forma revenue for the 2004 fiscal year by approximately $165 million. The exclusion of revenue from these subsidiaries from which the Company derived a profit also led to a consolidated operating loss of $0.9 million. All of the subsidiaries that have been divested or are pending for sale were or are to be sold back to the prior owners of the respective businesses.
Due to the decline of the share price of our common stock between the time of issuance (as high as $0.60 per share) pursuant to the transactions in which we acquired the four subsidiaries and the unwinding of the acquisitions and return of the shares used as consideration to Hartcourt (as low as $0.08 per share), the loss of share value is over $12 million with respect to these four subsidiaries. While this is a largely non-cash, one-time accounting loss, it nevertheless reflected a substantial loss in our financial statements.
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The following table sets forth certain selected consolidated financial data and should be read in conjunction with the our consolidated financial statements and related notes appearing elsewhere in this annual report:
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HARTCOURT'S SURVIVING SUBSIDIARIES AND CONTINUED OPERATIONS
PRO FORMA FINANCIAL STATEMENT
FOR THE YEARS ENDED 2004 AND 2003
2004 2003
BALANCE SHEET ------------ ------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents 1,744,852 823,639
Accounts receivable 5,141,892 1,868,729
Inventories 1,229,971 866,331
Notes receivable 1,376,916 608,573
Trade deposits 3,791,927 1,565,018
Deposit, prepayment and other receivables 1,470,508 216,939
Due from related companies 436,155 1,170,150
Assets pending for sale 2,204,260 --
------------ ------------
TOTAL CURRENT ASSETS 17,396,481 7,119,379
------------ ------------
FIXED ASSET-NET 363,849 493,163
INVESTMENTS 60,412 13,980,520
------------ ------------
OTHER ASSETS
Goodwill 2,160,101 2,160,101
Notes receivable -- 1,827,509
------------ ------------
TOTAL OTHER ASSETS 2,160,101 3,987,610
------------ ------------
TOTAL ASSETS $19,980,843 $25,580,672
============ ============
LIABILITIES & SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Bank loan -- 376,048
Bill payable -- 1,553,038
Account payables 632,528 398,599
Deferred revenue -- --
Accrued expenses 2,397,256 81,810
Customers deposit 8,522,065 --
Staff loans 1,052,427 671,402
Due to related parties -- 1,084,026
Due to shareholders 260,807 229,936
------------ ------------
TOTAL CURRENT LIABILITIES 12,865,083 4,394,859
============ ============
TOTAL LIABILITIES $12,865,083 $4,394,859
MINORITY INTERESTS 1,171,779 1,626,052
COMMITMENTS AND CONTINGENCIES -- 1,300,000
Preferred stock -- 10
Common stock 171,659 171,157
Additional paid-in Capital 72,152,129 70,858,036
Subscription receivables -- (1,842,326)
Other comprehensive losses 934,092 933,487
Treasury stock (48,728) (48,728)
(Accumulated losses) (67,264,171) (51,811,875)
------------ ------------
TOTAL SHAREHOLDERS' EQUITY 5,943,981 18,259,761
------------ ------------
TOTAL LIABILITIES AND EQUITY $19,980,843 25,580,672
============ ============
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HARTCOURT'S SURVIVING SUBSIDIARIES AND CONTINUING OPERATIONS
PRO FORMA INCOME STATEMENT
FOR THE YEARS ENDED 2004 AND 2003
2004 2003
----------- -----------
SALES 74,563,459 48,529,401
COST OF SALES (72,847,501) (45,980,047)
----------- -----------
GROSS PROFIT 1,715,958 2,549,354
OTHER REVENUE 215,154 83,771
ADMINISTRATIVE AND SELLING EXPENSES
Selling, general & administrative expenses 2,698,159 1,414,160
Depreciation 57,996 66,526
Impairment on notes receivable 4,083,876 --
----------- -----------
TOTAL ADMINISTRATIVE AND SELLING EXPENSES 6,840,031 1,480,686
----------- -----------
INCOME(LOSS) FROM OPERATIONS (4,908,919) 1,152,439
OTHER INCOME/(EXPENSE)
Interest income 238,282 188,945
Interest expenses (552,547) (84,480)
Gain on disposal of fixed assets 97,888 --
Provision for investments (223,816) (509,294)
Litigation accruals (100,000) (1,300,000)
----------- -----------
TOTAL OTHER INCOME/(EXPENSES) (540,193) (1,704,829)
TOTAL LOSS FROM CONTINUING OPERATIONS (5,449,112) (552,390)
LESS: MINORITY INTEREST (50,288) (582,731)
----------- -----------
LOSS BEFORE DISCONTINUED OPERATIONS (5,499,400) (1,135,121)
DISCONTINUED OPERATIONS:
GAIN/(LOSS) FROM DISCONTINUED OPERATIONS 368,715 364,677
GAIN/(LOSS) ON DISPOSAL OF DISCONTINUED OPERATION (2,968,693) 173,911
PROVISION FOR ASSETS PENDING FOR SALE (7,137,339) --
----------- -----------
LOSS BEFORE TAX (15,236,717) (596,533)
INCOME TAX EXPENSE (215,579) (161,947)
----------- -----------
NET LOSS (15,452,296) (758,480)
=========== ===========
RESULTS OF OPERATIONS
NET SALES
The combined income statement recorded net sales of $74,563,459 and $48,529,401 for the year ended December 31, 2004 and December 31, 2003 (2003 fiscal year), respectively. The revenue for our 2004 fiscal year represented product sales revenue derived from distribution of Samsung monitors and notebooks while revenue for our 2003 fiscal year included $857,286 consulting service income and $47,672,115 products sales revenue derived from distribution of Samsung monitors for ten months ended December 31, 2003. The 56% increase in Samsung product sales is mainly due to the expansion of the sales distribution network of Huaqing. In addition, the SARS epidemic which occurred in the second quarter of 2003 had a negative impact on sales in 2003 due to the impact on consumer confidence in all markets in China during the period.
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OPERATING MARGINS
The operating margin for our 2004 fiscal year was 2.3%, compared with 5.3% for our 2003 fiscal year. Except for the consulting service revenue of $857,286, the operating margin for Samsung products sales was 3.5% for our 2003 fiscal year. The decrease in our operating margin was mainly due to fierce competition during 2004 in the IT retail market. The declining gross margin in the China IT hardware distribution sector has been a broad and continuing trend in the past five years, which we believe will continue over the next several years.
OTHER REVENUE
Other revenue totaled $215,154 during our 2004 fiscal year, a 157% increase compared with other revenue of $83,771 for our 2003 fiscal year. Other revenue mainly represented income from warranty services and other after sales services and the government grants. The increase was mainly due to (1) the receipt of government grants of $58,089 from local authorities and (2) increases in warranty and after-sales service revenue, which was in line with an increase in our sales revenue.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for our 2004 fiscal year were $2,698,159, compared with $1,414,160 for our 2003 fiscal year. The increase of $1.2 million, or 90%, in our selling, general and administrative expenses was mainly due to the increase of Huaqing's operating expenses, such as payroll and sales commission, marketing expenses, rentals and other items totaling $0.5 million, which was in line with the increase in sales revenue. We incurred additional audit and consulting fees of $350,000, legal fees of $200,000 and other office expenditures of $150,000 with respect to the implementation of our new business strategies and internal control system.
DEPRECIATION
Depreciation for our 2004 fiscal year amounted to $57,996, compared with $66,526 for our 2003 fiscal year, representing a decrease of 13%. The decrease was mainly due to the disposition by Huaqing of one of its investment properties in 2004, which also resulted in a gain on disposal of fixed assets.
IMPAIRMENT
The $4,083,876 impairment charge recorded for our 2004 fiscal year was in part the result of a 100% provision for loss on notes receivable from Edda of $1,993,742. As of December 31, 2004, the outstanding notes receivable due from Edda was $1,993,742. Edda has not paid interest or principal on the note since the second quarter of 2004 and has informed us that they were unwilling to pay the remaining balance due to us. We therefore decided to make a 100% loss provision for the remaining balance on the note. The impairment charge also resulted from the provision for loss of $2,026,234 on notes receivable from Shen Zhen Raiser; the notes were received upon the sale of the Company's equity interest in Guangdong New HuaSun. Please refer to the section "Discontinued Operations" below. The impairment charge also includes a provision for the loss of $63,900 on notes receivable from Beijing TSS., which did not have any assets to repay the notes to Hartcourt.
INTEREST EXPENSES
Interest expenses for our 2004 fiscal year totaled $552,547, a 554% increase compared with $84,480 for our 2003 fiscal year. The increase in interest expenses was mainly attributable to our borrowing of funds to finance the expansion of our Samsung distribution business.
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PROVISION FOR INVESTMENTS
Provision for investments was $223,816 for our 2004 fiscal year, a 56% decrease compared to provision for investments totaling $509,294 for our 2003 fiscal year. The provision for investments for 2004 was related to our investment in First information. The decrease in provision for investments was primarily due to having made full provision on two investments in our 2003 fiscal year.
LOCAL PRC 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 have conducted annual tax audits of our subsidiaries and affiliates in China for the 2003 tax year and prior years. There are no outstanding tax issues or liabilities at the time of this annual 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.
None of our income is subject to taxation by any U.S. governmental authority.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The net cash used in operating activities during our 2004 fiscal year amounted to $7.1 million, a 58% increase compared to $4.5 million in our 2003 fiscal year. The net increase was mainly due to an increase in operating funds used by certain of our discontinued operations, including NewHuaSun, GuoWei, Challenger and the funds used in expanding our Samsung distribution business. The funds were primarily used to finance the inventories and receivables.
INVESTING ACTIVITIES. Cash used by investing activities in our 2004 fiscal year amounted to $1.7 million, a 141% decrease compared to $2.4 million provided by investing activities in our 2003 fiscal year. The cash used by investing activities was mainly as a result of excluding $3.5 million cash from the disposition of our under-performing subsidiaries. The $2.4 million cash provided by investing activities in 2003 was mainly derived from consolidation of cash from newly acquired businesses.
FINANCING ACTIVITIES. Net cash provided by financing activities in our 2004 fiscal year amounted to $8 million, an 82% increase compared to $4.4 million in 2003. The increase in financing activities resulted primarily from loans obtained from banks, unrelated parties and employees of Challenger, NewHuaSun and GuoWei. We received $1.4 million in proceeds in 2004 from the sale of our common stock on December 31, 2003 to a group of PRC investors.
DISCONTINUED OPERATIONS
On July 16, 2004, Hartcourt and the minority owners of Wenzhou Zhongnan Group reached an agreement to rescind the original acquisition agreement entered into on June 28, 2003 to purchase a 51% equity ownership of Wenzhou for a total purchase price of $5,011,352. The acquisition was paid for entirely by the issuance of 8,415,370 shares of our common stock. Wenzhou's financial results were consolidated under our operations beginning in October 2003. All of the shares that we issued pursuant to this acquisition have been returned to us and cancelled. We recorded a $2,907,510 loss on the disposition of Wenzhou of $2,854,835, due to our share price decline from $0.5955 per share on the issuance date to $0.25 per share on the cancellation date. Although there was no cash loss in this transaction, we lost time and opportunities to pursue other business acquisitions.
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From October 2003 to June 2004, Wenzhou's revenue and net income results were 79% and 30%, respectively, of the target revenue and net income provided for under the acquisition agreement. The significantly lower profit was due to sharply deteriorating market demand in the Chinese IT retail business, leading to the closing of 5 out of 11 Wenzhou retail stores during the period from October 2003 to June 2004. Fierce price competition in the wholesale hardware business led to steep gross margin erosion and severely impacted our net income.
Based on nine months of actual operating results, the fair market value of Wenzhou's business, using cash flow information and present value in accounting measurements as defined by U.S. GAAP, would be approximately $700,000, and Hartcourt's 51% equity share would be worth approximately $350,000 compared to the acquisition price of $5 million. At the end of June 2004, the fair market value of 8.4 million Hartcourt shares used as consideration for the Wenzhou acquisition was approximately $2.2 million, significantly higher than the $357,000 fair market value of the 51% Wenzhou equity.
The Wenzhou acquisition agreement contained a contingency clause that if Wenzhou failed to attain a certain level of net profit and revenue, we could, at our sole and absolute discretion, request Wenzhou to repurchase the equity interests and return the Hartcourt shares paid as consideration for the acquisition. To protect the Company's interest and prevent unnecessary shareholder dilution, management in June 2004 elected to exercise the contingency clause stipulated in the acquisition agreement that required the sellers to repurchase the equity interests and transfer to us all of our shares of common stock that had been issued to the sellers as consideration should the Wenzhou business not achieve its first year guaranteed profit, which at that time was highly unlikely.
In the fourth quarter of 2004, the IT retail sector experienced a dramatic downturn in sales that we believed was a permanent reduction in the size of the IT retail market in China. The price of low-end branded desktops declined to that of non-branded desktops, taking away a substantial share of market from the non-branded desktop segment. In the meantime, the price of notebooks continued to drop, making notebooks an attractive alternative to desktop computers. As a comparison, GuoWei's 2004 revenue (from January to December 2004) was 156% of the first year (from July 2003 to June 2004) guaranteed turnover as stipulated in the acquisition contract while net income was only 33% of the first year guaranteed profit. Based on sales projections and cash flow estimates, the fair market value of GuoWei is estimated to be $1.03 million and Hartcourt's 50.5% equity share is valued at $519,000. Hartcourt acquired 50.5% of GuoWei equity for a total of $4,647,447, by issuance of 10,863,788 Hartcourt common shares and a cash investment of $301,932
Pursuant to the GuoWei acquisition agreement, both the seller and buyer have the first right to buy back their respective equities in the event that the parties decide not to complete the merge. On March 16, 2005, Hartcourt and the minority shareholders of GuoWei reached an agreement to sell the 50.5% of Hartcourt equity back to its original owners for a total consideration of $1,031,496 in a combination of cash and stock transaction where GuoWei paid cash consideration of $794,914 and returned 2,951,800 shares of Hartcourt common stock.
The difference of the GuoWei carrying value on Hartcourt books versus the disposal consideration is $3.9 million. This is the impairment of GuoWei assets pending for sale at the end of 2004. While the loss on GuoWei can be seen as significant, the value that we realized in disposing the GuoWei assets is still far above the current fair market value of GuoWei.
We acquired the equity interest in NewHuasun on April 24, 2003 for a total consideration of $3,304,597, paid for entirely by the issuance of 13,769,156 shares of our common stock. We also obtained 10% equity voting rights through proxy statements from one of the NewHuaSun's shareholders. The voting rights were returned to the NewHuaSun shareholder at the time of sell of NewHuaSun equity interest to Shenzhen Riser.
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NewHuaSun is an authorized distributor of Samsung monitors and is engaged in the sale and distribution of Samsung monitors in the Guangdong province. Within months of our acquisition, NewHuaSun experienced significant cash flow problems which adversely impacted its sales. It also borrowed heavily to purchase inventory from Samsung in order to fulfill its obligation as an authorized distributor. The interest cost on borrowed funds further depressed net income. The unfavorable operating results led us to sell our equity interest to a third party.
On August 30, 2004, we sold our 45% equity interest in Guangzhou NewHuaSun (NewHuaSun) to ShenZhen Raiser Industrial and Development Co., Ltd. for $3,403,150. The purchase price is being paid to us in twenty-one quarterly interest-bearing installments. We acquired our equity interest in NewHuasun on April 24, 2003 for a total purchase price of $3,304,597, paid for entirely by the issuance of 13,769,156 shares of our common stock. In addition, we obtained voting rights over an additional 10% of the equity of NewHuaSun through voting proxies from one of NewHuaSun's shareholders. We recorded a loss on disposition of NewHuaSun of $118,343.
On March 3, 2005 we entered into agreements with NewHuaSun and Shenzhen Raiser, pursuant to which we redeemed 13,769,156 shares of our common stock held by NewHuaSun, New HuaSun redeemed a 45% equity interest, and we released Shenzhen Raizer of its obligation on a $3,403,150 promissory note payable to us. The fair market value of the 13,769,156 shares of common stock was $1,376,916, and the difference of $2.1 million represents the impairment on the notes receivable at year end. The loss is due to the fact that our common stock was issued at $0.24 per share at the time of acquisition and returned to the Company at $0.10 per share at the time of disposition of the subsidiaries.
On September 16, 2004, Huaqing signed a definitive agreement to sell all of its equity interest in Hangzhou Huaqing to a PRC citizen for $760,870. We recorded a profit on the disposition of Hangzhou of $20,670.
On June 30, 2004, Hartcourt, together with the minority shareholder of Hopeful Internet Technologies Limited (Hopeful), signed an agreement with First Information Technology for the sale of all of our equity interest in Hopeful for $464,472, which was paid by the issuance of 2,179 shares of common stock of First Information Technology at value of $0.01. As a result, we own a 10.5% equity interest in First Information. We recorded a loss on sale of Hopeful of $16,185.
In December 2004, our board of directors authorized the sale of our entire 51% equity interest in Beijing Challenger Group (Challenger) due to on-going adverse market conditions and our declining share price. Our estimation of the proceeds from the sale of Challenger amounts to $1,172,764, including the provision on sale of asset. The difference between the carrying value of Challenger on our books and the sale proceeds represents the impairment on the pending sale of Challenger at year-end 2004, which amounts to $3.2 million.
The purchase price adjustment clause in the Challenger acquisition agreement provides that, if upon expiration of the one year restricted trading period imposed upon the shares of our common stock paid as consideration for the acquisition, the return accrued or derived from the shares is less than 41% of our net profit for our 2004 fiscal year, then the sellers may request the purchaser to either (i) repurchase the shares and transfer to the sellers all beneficial and equitable interest in the registered capital of the Company or
(ii) issue and allot to the sellers such total number of additional shares equal to the difference of the value of the initial shares paid and at $0.556 per share.
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Due to a decline in our share price in 2004, Challenger initially notified us that it would exercise the option of obtaining additional Hartcourt shares to meet the guaranteed purchase price. The share compensation would amount to additional 22 million shares based on the 2004 year-end trading price. In view of the pending sale of IBM worldwide PC business to Lenovo, the dominant Chinese PC maker, and the numerous operating issues faced in managing the Challenger business, we concluded that the business will likely not be able to generate a favorable return on our investment and that we should dispose the Challenger investment. In the meantime, Challenger's minority owners concluded that the cost that it must incur to be a part of a U.S. publicly listed company was greater than the benefit it could reap and notified us that it would exercise the option of requesting Hartcourt to repurchase its consideration shares and transfer all the Challenger equity back to the original owners.
As such, the estimated Challenger disposal would amount to $1.2 million, including the provision on sale of asset. The difference between the acquisition cost of $4.4 million and the estimated disposal price of $1.2 million is the impairment on the pending sale of Challenger assets at year-end 2004, which amounts to $3.2 million. Negotiation with the Challenger minority owner is underway as of this filing date.
CHANGES IN ACCOUNTING PRINCIPLES
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15-Apr-2005
Annual Report
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND THE NOTES THERETO AND THE OTHER FINANCIAL INFORMATION APPEARING ELSEWHERE IN THIS DOCUMENT. IN ADDITION TO HISTORICAL INFORMATION, THE FOLLOWING DISCUSSION AND OTHER PARTS OF THIS DOCUMENT CONTAIN CERTAIN FORWARD-LOOKING INFORMATION. WHEN USED IN THIS DISCUSSION, THE WORDS "BELIEVES," "ANTICIPATES," "EXPECTS," AND SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES, WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED DUE TO A NUMBER OF FACTORS BEYOND OUR CONTROL. WE DO NOT UNDERTAKE TO PUBLICLY UPDATE OR REVISE ANY OF OUR FORWARD-LOOKING STATEMENTS EVEN IF EXPERIENCE OR FUTURE CHANGES SHOW THAT THE INDICATED RESULTS OR EVENTS WILL NOT BE REALIZED. YOU ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH REFLECT ONLY OUR CURRENT VIEWS OF POSSIBLE FUTURE EVENTS.
PRO FORMA CONDENSED AND COMBINED FINANCIAL STATEMENTS
Since we have disposed of all but one of our operating subsidiaries during 2004 a comparison of 2004 operating results to our reported 2003 financial results would not be meaningful. As such, the following discussion is based on the comparison of the full year combined operating results for 2004, with the pro forma operating results of the surviving subsidiaries and continued operations in 2003.
The condensed pro forma financial statements set forth below represent the combined financial statements of the surviving subsidiary Huaqing, which we acquired in February 2003. The combined pro forma financial statements for 2004 accounted for the full year's operating results including the profit/loss on disposals and the results of discontinued operations. The condensed pro forma financial statements for 2004 and 2003 are prepared and audited in accordance with the U.S. GAAP.
In order to make the year-on-year comparison as meaningful as possible, the below pro forma financial statements are based on the full year operating results of the Company and surviving subsidiary for 2004. Since the surviving subsidiary was itself acquired by us in March 2003, the operating results for 2003 only consolidate the surviving subsidiary for the ten-month period following the effective date of acquisition. The below information includes a discussion of the changes in market conditions that affected our operating results and the structure and composition of the Group.
The exclusion of the four subsidiaries that have either been disposed or are pending for sale from our pro forma financial statements reduced our pro forma revenue for the 2004 fiscal year by approximately $165 million. The exclusion of revenue from these subsidiaries from which the Company derived a profit also led to a consolidated operating loss of $0.9 million. All of the subsidiaries that have been divested or are pending for sale were or are to be sold back to the prior owners of the respective businesses.
Due to the decline of the share price of our common stock between the time of issuance (as high as $0.60 per share) pursuant to the transactions in which we acquired the four subsidiaries and the unwinding of the acquisitions and return of the shares used as consideration to Hartcourt (as low as $0.08 per share), the loss of share value is over $12 million with respect to these four subsidiaries. While this is a largely non-cash, one-time accounting loss, it nevertheless reflected a substantial loss in our financial statements.
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The following table sets forth certain selected consolidated financial data and should be read in conjunction with the our consolidated financial statements and related notes appearing elsewhere in this annual report:
-15-
HARTCOURT'S SURVIVING SUBSIDIARIES AND CONTINUED OPERATIONS
PRO FORMA FINANCIAL STATEMENT
FOR THE YEARS ENDED 2004 AND 2003
2004 2003
BALANCE SHEET ------------ ------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents 1,744,852 823,639
Accounts receivable 5,141,892 1,868,729
Inventories 1,229,971 866,331
Notes receivable 1,376,916 608,573
Trade deposits 3,791,927 1,565,018
Deposit, prepayment and other receivables 1,470,508 216,939
Due from related companies 436,155 1,170,150
Assets pending for sale 2,204,260 --
------------ ------------
TOTAL CURRENT ASSETS 17,396,481 7,119,379
------------ ------------
FIXED ASSET-NET 363,849 493,163
INVESTMENTS 60,412 13,980,520
------------ ------------
OTHER ASSETS
Goodwill 2,160,101 2,160,101
Notes receivable -- 1,827,509
------------ ------------
TOTAL OTHER ASSETS 2,160,101 3,987,610
------------ ------------
TOTAL ASSETS $19,980,843 $25,580,672
============ ============
LIABILITIES & SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Bank loan -- 376,048
Bill payable -- 1,553,038
Account payables 632,528 398,599
Deferred revenue -- --
Accrued expenses 2,397,256 81,810
Customers deposit 8,522,065 --
Staff loans 1,052,427 671,402
Due to related parties -- 1,084,026
Due to shareholders 260,807 229,936
------------ ------------
TOTAL CURRENT LIABILITIES 12,865,083 4,394,859
============ ============
TOTAL LIABILITIES $12,865,083 $4,394,859
MINORITY INTERESTS 1,171,779 1,626,052
COMMITMENTS AND CONTINGENCIES -- 1,300,000
Preferred stock -- 10
Common stock 171,659 171,157
Additional paid-in Capital 72,152,129 70,858,036
Subscription receivables -- (1,842,326)
Other comprehensive losses 934,092 933,487
Treasury stock (48,728) (48,728)
(Accumulated losses) (67,264,171) (51,811,875)
------------ ------------
TOTAL SHAREHOLDERS' EQUITY 5,943,981 18,259,761
------------ ------------
TOTAL LIABILITIES AND EQUITY $19,980,843 25,580,672
============ ============
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HARTCOURT'S SURVIVING SUBSIDIARIES AND CONTINUING OPERATIONS
PRO FORMA INCOME STATEMENT
FOR THE YEARS ENDED 2004 AND 2003
2004 2003
----------- -----------
SALES 74,563,459 48,529,401
COST OF SALES (72,847,501) (45,980,047)
----------- -----------
GROSS PROFIT 1,715,958 2,549,354
OTHER REVENUE 215,154 83,771
ADMINISTRATIVE AND SELLING EXPENSES
Selling, general & administrative expenses 2,698,159 1,414,160
Depreciation 57,996 66,526
Impairment on notes receivable 4,083,876 --
----------- -----------
TOTAL ADMINISTRATIVE AND SELLING EXPENSES 6,840,031 1,480,686
----------- -----------
INCOME(LOSS) FROM OPERATIONS (4,908,919) 1,152,439
OTHER INCOME/(EXPENSE)
Interest income 238,282 188,945
Interest expenses (552,547) (84,480)
Gain on disposal of fixed assets 97,888 --
Provision for investments (223,816) (509,294)
Litigation accruals (100,000) (1,300,000)
----------- -----------
TOTAL OTHER INCOME/(EXPENSES) (540,193) (1,704,829)
TOTAL LOSS FROM CONTINUING OPERATIONS (5,449,112) (552,390)
LESS: MINORITY INTEREST (50,288) (582,731)
----------- -----------
LOSS BEFORE DISCONTINUED OPERATIONS (5,499,400) (1,135,121)
DISCONTINUED OPERATIONS:
GAIN/(LOSS) FROM DISCONTINUED OPERATIONS 368,715 364,677
GAIN/(LOSS) ON DISPOSAL OF DISCONTINUED OPERATION (2,968,693) 173,911
PROVISION FOR ASSETS PENDING FOR SALE (7,137,339) --
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LOSS BEFORE TAX (15,236,717) (596,533)
INCOME TAX EXPENSE (215,579) (161,947)
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NET LOSS (15,452,296) (758,480)
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RESULTS OF OPERATIONS
NET SALES
The combined income statement recorded net sales of $74,563,459 and $48,529,401 for the year ended December 31, 2004 and December 31, 2003 (2003 fiscal year), respectively. The revenue for our 2004 fiscal year represented product sales revenue derived from distribution of Samsung monitors and notebooks while revenue for our 2003 fiscal year included $857,286 consulting service income and $47,672,115 products sales revenue derived from distribution of Samsung monitors for ten months ended December 31, 2003. The 56% increase in Samsung product sales is mainly due to the expansion of the sales distribution network of Huaqing. In addition, the SARS epidemic which occurred in the second quarter of 2003 had a negative impact on sales in 2003 due to the impact on consumer confidence in all markets in China during the period.
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OPERATING MARGINS
The operating margin for our 2004 fiscal year was 2.3%, compared with 5.3% for our 2003 fiscal year. Except for the consulting service revenue of $857,286, the operating margin for Samsung products sales was 3.5% for our 2003 fiscal year. The decrease in our operating margin was mainly due to fierce competition during 2004 in the IT retail market. The declining gross margin in the China IT hardware distribution sector has been a broad and continuing trend in the past five years, which we believe will continue over the next several years.
OTHER REVENUE
Other revenue totaled $215,154 during our 2004 fiscal year, a 157% increase compared with other revenue of $83,771 for our 2003 fiscal year. Other revenue mainly represented income from warranty services and other after sales services and the government grants. The increase was mainly due to (1) the receipt of government grants of $58,089 from local authorities and (2) increases in warranty and after-sales service revenue, which was in line with an increase in our sales revenue.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for our 2004 fiscal year were $2,698,159, compared with $1,414,160 for our 2003 fiscal year. The increase of $1.2 million, or 90%, in our selling, general and administrative expenses was mainly due to the increase of Huaqing's operating expenses, such as payroll and sales commission, marketing expenses, rentals and other items totaling $0.5 million, which was in line with the increase in sales revenue. We incurred additional audit and consulting fees of $350,000, legal fees of $200,000 and other office expenditures of $150,000 with respect to the implementation of our new business strategies and internal control system.
DEPRECIATION
Depreciation for our 2004 fiscal year amounted to $57,996, compared with $66,526 for our 2003 fiscal year, representing a decrease of 13%. The decrease was mainly due to the disposition by Huaqing of one of its investment properties in 2004, which also resulted in a gain on disposal of fixed assets.
IMPAIRMENT
The $4,083,876 impairment charge recorded for our 2004 fiscal year was in part the result of a 100% provision for loss on notes receivable from Edda of $1,993,742. As of December 31, 2004, the outstanding notes receivable due from Edda was $1,993,742. Edda has not paid interest or principal on the note since the second quarter of 2004 and has informed us that they were unwilling to pay the remaining balance due to us. We therefore decided to make a 100% loss provision for the remaining balance on the note. The impairment charge also resulted from the provision for loss of $2,026,234 on notes receivable from Shen Zhen Raiser; the notes were received upon the sale of the Company's equity interest in Guangdong New HuaSun. Please refer to the section "Discontinued Operations" below. The impairment charge also includes a provision for the loss of $63,900 on notes receivable from Beijing TSS., which did not have any assets to repay the notes to Hartcourt.
INTEREST EXPENSES
Interest expenses for our 2004 fiscal year totaled $552,547, a 554% increase compared with $84,480 for our 2003 fiscal year. The increase in interest expenses was mainly attributable to our borrowing of funds to finance the expansion of our Samsung distribution business.
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PROVISION FOR INVESTMENTS
Provision for investments was $223,816 for our 2004 fiscal year, a 56% decrease compared to provision for investments totaling $509,294 for our 2003 fiscal year. The provision for investments for 2004 was related to our investment in First information. The decrease in provision for investments was primarily due to having made full provision on two investments in our 2003 fiscal year.
LOCAL PRC 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 have conducted annual tax audits of our subsidiaries and affiliates in China for the 2003 tax year and prior years. There are no outstanding tax issues or liabilities at the time of this annual 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.
None of our income is subject to taxation by any U.S. governmental authority.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The net cash used in operating activities during our 2004 fiscal year amounted to $7.1 million, a 58% increase compared to $4.5 million in our 2003 fiscal year. The net increase was mainly due to an increase in operating funds used by certain of our discontinued operations, including NewHuaSun, GuoWei, Challenger and the funds used in expanding our Samsung distribution business. The funds were primarily used to finance the inventories and receivables.
INVESTING ACTIVITIES. Cash used by investing activities in our 2004 fiscal year amounted to $1.7 million, a 141% decrease compared to $2.4 million provided by investing activities in our 2003 fiscal year. The cash used by investing activities was mainly as a result of excluding $3.5 million cash from the disposition of our under-performing subsidiaries. The $2.4 million cash provided by investing activities in 2003 was mainly derived from consolidation of cash from newly acquired businesses.
FINANCING ACTIVITIES. Net cash provided by financing activities in our 2004 fiscal year amounted to $8 million, an 82% increase compared to $4.4 million in 2003. The increase in financing activities resulted primarily from loans obtained from banks, unrelated parties and employees of Challenger, NewHuaSun and GuoWei. We received $1.4 million in proceeds in 2004 from the sale of our common stock on December 31, 2003 to a group of PRC investors.
DISCONTINUED OPERATIONS
On July 16, 2004, Hartcourt and the minority owners of Wenzhou Zhongnan Group reached an agreement to rescind the original acquisition agreement entered into on June 28, 2003 to purchase a 51% equity ownership of Wenzhou for a total purchase price of $5,011,352. The acquisition was paid for entirely by the issuance of 8,415,370 shares of our common stock. Wenzhou's financial results were consolidated under our operations beginning in October 2003. All of the shares that we issued pursuant to this acquisition have been returned to us and cancelled. We recorded a $2,907,510 loss on the disposition of Wenzhou of $2,854,835, due to our share price decline from $0.5955 per share on the issuance date to $0.25 per share on the cancellation date. Although there was no cash loss in this transaction, we lost time and opportunities to pursue other business acquisitions.
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From October 2003 to June 2004, Wenzhou's revenue and net income results were 79% and 30%, respectively, of the target revenue and net income provided for under the acquisition agreement. The significantly lower profit was due to sharply deteriorating market demand in the Chinese IT retail business, leading to the closing of 5 out of 11 Wenzhou retail stores during the period from October 2003 to June 2004. Fierce price competition in the wholesale hardware business led to steep gross margin erosion and severely impacted our net income.
Based on nine months of actual operating results, the fair market value of Wenzhou's business, using cash flow information and present value in accounting measurements as defined by U.S. GAAP, would be approximately $700,000, and Hartcourt's 51% equity share would be worth approximately $350,000 compared to the acquisition price of $5 million. At the end of June 2004, the fair market value of 8.4 million Hartcourt shares used as consideration for the Wenzhou acquisition was approximately $2.2 million, significantly higher than the $357,000 fair market value of the 51% Wenzhou equity.
The Wenzhou acquisition agreement contained a contingency clause that if Wenzhou failed to attain a certain level of net profit and revenue, we could, at our sole and absolute discretion, request Wenzhou to repurchase the equity interests and return the Hartcourt shares paid as consideration for the acquisition. To protect the Company's interest and prevent unnecessary shareholder dilution, management in June 2004 elected to exercise the contingency clause stipulated in the acquisition agreement that required the sellers to repurchase the equity interests and transfer to us all of our shares of common stock that had been issued to the sellers as consideration should the Wenzhou business not achieve its first year guaranteed profit, which at that time was highly unlikely.
In the fourth quarter of 2004, the IT retail sector experienced a dramatic downturn in sales that we believed was a permanent reduction in the size of the IT retail market in China. The price of low-end branded desktops declined to that of non-branded desktops, taking away a substantial share of market from the non-branded desktop segment. In the meantime, the price of notebooks continued to drop, making notebooks an attractive alternative to desktop computers. As a comparison, GuoWei's 2004 revenue (from January to December 2004) was 156% of the first year (from July 2003 to June 2004) guaranteed turnover as stipulated in the acquisition contract while net income was only 33% of the first year guaranteed profit. Based on sales projections and cash flow estimates, the fair market value of GuoWei is estimated to be $1.03 million and Hartcourt's 50.5% equity share is valued at $519,000. Hartcourt acquired 50.5% of GuoWei equity for a total of $4,647,447, by issuance of 10,863,788 Hartcourt common shares and a cash investment of $301,932
Pursuant to the GuoWei acquisition agreement, both the seller and buyer have the first right to buy back their respective equities in the event that the parties decide not to complete the merge. On March 16, 2005, Hartcourt and the minority shareholders of GuoWei reached an agreement to sell the 50.5% of Hartcourt equity back to its original owners for a total consideration of $1,031,496 in a combination of cash and stock transaction where GuoWei paid cash consideration of $794,914 and returned 2,951,800 shares of Hartcourt common stock.
The difference of the GuoWei carrying value on Hartcourt books versus the disposal consideration is $3.9 million. This is the impairment of GuoWei assets pending for sale at the end of 2004. While the loss on GuoWei can be seen as significant, the value that we realized in disposing the GuoWei assets is still far above the current fair market value of GuoWei.
We acquired the equity interest in NewHuasun on April 24, 2003 for a total consideration of $3,304,597, paid for entirely by the issuance of 13,769,156 shares of our common stock. We also obtained 10% equity voting rights through proxy statements from one of the NewHuaSun's shareholders. The voting rights were returned to the NewHuaSun shareholder at the time of sell of NewHuaSun equity interest to Shenzhen Riser.
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NewHuaSun is an authorized distributor of Samsung monitors and is engaged in the sale and distribution of Samsung monitors in the Guangdong province. Within months of our acquisition, NewHuaSun experienced significant cash flow problems which adversely impacted its sales. It also borrowed heavily to purchase inventory from Samsung in order to fulfill its obligation as an authorized distributor. The interest cost on borrowed funds further depressed net income. The unfavorable operating results led us to sell our equity interest to a third party.
On August 30, 2004, we sold our 45% equity interest in Guangzhou NewHuaSun (NewHuaSun) to ShenZhen Raiser Industrial and Development Co., Ltd. for $3,403,150. The purchase price is being paid to us in twenty-one quarterly interest-bearing installments. We acquired our equity interest in NewHuasun on April 24, 2003 for a total purchase price of $3,304,597, paid for entirely by the issuance of 13,769,156 shares of our common stock. In addition, we obtained voting rights over an additional 10% of the equity of NewHuaSun through voting proxies from one of NewHuaSun's shareholders. We recorded a loss on disposition of NewHuaSun of $118,343.
On March 3, 2005 we entered into agreements with NewHuaSun and Shenzhen Raiser, pursuant to which we redeemed 13,769,156 shares of our common stock held by NewHuaSun, New HuaSun redeemed a 45% equity interest, and we released Shenzhen Raizer of its obligation on a $3,403,150 promissory note payable to us. The fair market value of the 13,769,156 shares of common stock was $1,376,916, and the difference of $2.1 million represents the impairment on the notes receivable at year end. The loss is due to the fact that our common stock was issued at $0.24 per share at the time of acquisition and returned to the Company at $0.10 per share at the time of disposition of the subsidiaries.
On September 16, 2004, Huaqing signed a definitive agreement to sell all of its equity interest in Hangzhou Huaqing to a PRC citizen for $760,870. We recorded a profit on the disposition of Hangzhou of $20,670.
On June 30, 2004, Hartcourt, together with the minority shareholder of Hopeful Internet Technologies Limited (Hopeful), signed an agreement with First Information Technology for the sale of all of our equity interest in Hopeful for $464,472, which was paid by the issuance of 2,179 shares of common stock of First Information Technology at value of $0.01. As a result, we own a 10.5% equity interest in First Information. We recorded a loss on sale of Hopeful of $16,185.
In December 2004, our board of directors authorized the sale of our entire 51% equity interest in Beijing Challenger Group (Challenger) due to on-going adverse market conditions and our declining share price. Our estimation of the proceeds from the sale of Challenger amounts to $1,172,764, including the provision on sale of asset. The difference between the carrying value of Challenger on our books and the sale proceeds represents the impairment on the pending sale of Challenger at year-end 2004, which amounts to $3.2 million.
The purchase price adjustment clause in the Challenger acquisition agreement provides that, if upon expiration of the one year restricted trading period imposed upon the shares of our common stock paid as consideration for the acquisition, the return accrued or derived from the shares is less than 41% of our net profit for our 2004 fiscal year, then the sellers may request the purchaser to either (i) repurchase the shares and transfer to the sellers all beneficial and equitable interest in the registered capital of the Company or
(ii) issue and allot to the sellers such total number of additional shares equal to the difference of the value of the initial shares paid and at $0.556 per share.
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Due to a decline in our share price in 2004, Challenger initially notified us that it would exercise the option of obtaining additional Hartcourt shares to meet the guaranteed purchase price. The share compensation would amount to additional 22 million shares based on the 2004 year-end trading price. In view of the pending sale of IBM worldwide PC business to Lenovo, the dominant Chinese PC maker, and the numerous operating issues faced in managing the Challenger business, we concluded that the business will likely not be able to generate a favorable return on our investment and that we should dispose the Challenger investment. In the meantime, Challenger's minority owners concluded that the cost that it must incur to be a part of a U.S. publicly listed company was greater than the benefit it could reap and notified us that it would exercise the option of requesting Hartcourt to repurchase its consideration shares and transfer all the Challenger equity back to the original owners.
As such, the estimated Challenger disposal would amount to $1.2 million, including the provision on sale of asset. The difference between the acquisition cost of $4.4 million and the estimated disposal price of $1.2 million is the impairment on the pending sale of Challenger assets at year-end 2004, which amounts to $3.2 million. Negotiation with the Challenger minority owner is underway as of this filing date.
CHANGES IN ACCOUNTING PRINCIPLES
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