ITEM 1. BUSINESS.
Overview of Our Business
We are a leading provider of integrated solutions for the Geographic Information Systems, or GIS, Digital Public Security Technology, or DPST and the Digital Hospital Information Systems, or DHIS markets, in the PRC. We provide a broad portfolio of fully integrated solutions and services, encompassing both software development and display technologies.
We were founded in 1993 and are headquartered in Shenzhen, China. As of December 31, 2010, we had 1,453 employees and 27 sales offices nationwide.
Our customers are mostly public sector entities that use our products and services to improve the service quality and management level and efficiency of public security, traffic control, fire control, medical rescue, border control, surveying and mapping as well as healthcare management. Our typical customers include some of the most important governmental departments in China, including the Ministry of Public Security, the State Bureau of Surveying and Mapping, the State Grid Corporation, the public security, fire fighting, traffic and police departments of several provinces, the Shenzhen General Station of Exit and Entry Frontier Inspection, and several provincial personnel, urban planning, civil administration, land resource, and mapping and surveying bureaus. Over the past several years, we have diversified our customer base beyond our local reach. In the future, we expect to continually expand our market and product offerings in the public and private sectors, through geographic expansion and enhancement of our technical capabilities.
We generate revenues through the sale of our integrated hardware and software products and through the provision of related support services. A significant portion of our operations are conducted through iASPEC, our variable interest entity. iASPEC is a PRC domestic company owned by Jiang Huai Lin, our Chairman and Chief Executive Officer, who is a PRC citizen and resident. iASPEC is able to obtain governmental licenses that are restricted to PRC entities that have no foreign ownership. These licenses allow iASPEC to perform Police-use Geographic Information Systems, or PGIS, services for PRC governmental customers. Under our Amended and Restated Management Services Agreement among our subsidiary, IST, iASPEC and Mr. Lin, IST is entitled to receive 95% of the net received profit of iASPEC during the term of the Agreement, less costs and expenses related to sales and operations, and accrued but uncollected accounts receivable. In fiscal years 2010, 2009 and 2008, 39.1%, 48.6% and 48% of our revenues, respectively, were generated under this exclusive commercial arrangement with iASPEC.
Our History and Background
We were originally organized under the laws of the State of Florida on September 19, 1979 under the name Mark Thomas Publishing Inc. and on April 29, 2003 we changed our name to Irish Mag, Inc. From our inception through October 8, 2006, we provided consulting services in the offset printing industry, targeting individual retail consumers as well as small to mid-size companies. However, as a result of the reverse merger transaction described below, our business operations changed to the provision of integrated GIS services. On January 26, 2007, we changed our name to China Public Security Technology, Inc. to more accurately reflect our new business and commercial objectives.
On April 7, 2008, we reincorporated to the State of Nevada by merging into China Information Security Technology, Inc., a subsidiary that we established in Nevada to effect the reincorporation. As a result, our name changed to China Information Security Technology, Inc. and we became a Nevada corporation.
On August 26, 2010, we changed our name to China Information Technology, Inc. to be aligned with our strategic direction, our ticker symbol and our trade mark.
Reverse Merger Transaction
Between October 6, 2006 and January 31, 2007, our shareholders approved a series of transactions whereby we purchased all the issued and outstanding stock of CPSH from our current Chairman and Chief Executive Officer Jiang Huai Lin, for 25,500,000 shares of our common stock. As a result of these transactions, CPSH and its wholly-owned subsidiary, IST, became our wholly-owned subsidiaries, and Mr. Lin became the beneficial owner of 25,500,000 shares of our common stock, which, at January 31, 2007, constituted 80.8% of our issued and outstanding common stock.
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Management Service Agreement
From October 9, 2006 through June 30, 2007, we operated under a Business Turnkey Agreement, or Turnkey Agreement, with iASPEC, pursuant to which iASPEC exclusively engaged IST as its subcontractor to provide iASPEC with outsourcing services (to the extent that those services do not violate any special governmental permits held by iASPEC and do not involve the improper transfer of any sensitive confidential governmental or other data).
Effective July 1, 2007, iASPEC and iASPEC’s shareholders, Mr. Lin and Mr. Jin Zhu Cai agreed to terminate the Turnkey Agreement and replaced it on the same day with a Management Service Agreement. Pursuant to the terms of the Management Service Agreement, iASPEC granted IST an exclusive, royalty-free, transferable, worldwide, license to use and install for a ten-year term, certain iASPEC software, along with copies of source and object code relating to such software, in any manner permitted by applicable laws, and IST licensed back to iASPEC a royalty-free, limited, non-exclusive license to the software, without right of sub-license, for the sole purpose of permitting iASPEC to carry out its business as presently conducted. IST will also have the right to designate two Chinese citizens to serve as senior managers of iASPEC, to serve on iASPEC’s Board of Directors and assist in managing the business and operations of iASPEC. In addition, both iASPEC and IST will require the affirmative vote of the majority of our Board of Directors, as well as at least one non-insider director, for certain material actions with respect to iASPEC, including, but not limited to: (a) the nomination, appointment, election or replacement of any board members; (b) the distribution of any dividend or profits; (c) any merger, division, change of corporate form, dissolution or liquidation; (d) any reimbursement of net losses or other payments or transfers of funds from IST to iASPEC; (e) the formation or disposition of a subsidiary or the acquisition or disposition of any interest in any other entity; and (f) the encumbrance of any assets under any lien not in the ordinary course of business. Furthermore, under the Management Service Agreement, IST will receive 100% of the net received profit of iASPEC and will reimburse iASPEC for all net losses incurred by iASPEC. The net profit of iASPEC will be paid to IST, and the net losses of iASPEC will be reimbursed by IST, no later than the last day of the month following the end of each calendar quarter, commencing on July 1, 2007. IST is also obligated to pay iASPEC $180,000 per year, no later than the last day of the month following the end of each calendar year, commencing on July 1, 2007, and this amount may be retained by iASPEC out of any net received profit due and payable to IST as of such payment date. IST may also advance to iASPEC, at IST’s sole discretion, amounts to be credited against IST’s future obligations to iASPEC, but any such advances will be treated as prepayments and not as loans. iASPEC will have no obligation to repay any such advances except by crediting the amount of such advances against IST’s obligation to reimburse net losses, or by adding the amount thereof to net profit when and as requested by IST. If iASPEC or any of the iASPEC shareholders materially breaches the Management Service Agreement and fails to remedy the breach within 60 days after notice from IST of such breach, they will be jointly and severally obligated to pay to IST liquidated damages in an amount equal to the higher of (a) eight times the annualized revenues of IST for the last completed fiscal quarter, or (b) US$50 million.
In connection with the Management Service Agreement, IST also entered into a purchase option agreement, or Option Agreement, with iASPEC and its shareholders, effective as of July 1, 2007, pursuant to which the iASPEC shareholders granted IST, or its designee(s), an exclusive, irrevocable option to purchase from the iASPEC shareholders, from time to time, all or a part of iASPEC’s shares, pursuant to an equity transfer agreement, or all or a part of iASPEC’s assets, pursuant to an asset purchase and transfer agreement. However, according to the Option Agreement, the option may not be exercised by IST if the exercise would violate any applicable laws and regulations in China or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated. Under the terms of the Option Agreement, the option is immediately exercisable at an exercise price of $1,800,000, in the aggregate, subject to regulatory approval. In addition, iASPEC and the iASPEC shareholders agreed to use their best efforts to acquire all necessary government approvals and other consents to complete a share purchase under the Option Agreement. The Option Agreement may be rescinded by IST upon 30 days’ notice and will terminate on the date that we purchase all remaining shares or assets of iASPEC pursuant to the terms of the Option Agreement. If any of the parties breaches the Option Agreement and fails to remedy the breach, the breaching party will pay a penalty of RMB5,000,000 (approximately $683,600) to the non-breaching party or parties, and compensate the non-breaching party or parties for any losses caused by the breach.
As a result of the restructuring of its relationship with iASPEC, iASPEC became a variable interest entity of our Company. A variable interest represents a contractual or ownership interest in another entity that causes the holder to absorb the changes in fair value of the other entity’s net assets. Potential variable interests include: holding economic interests, voting rights, or obligations to an entity; issuing guarantees on behalf of an entity; transferring assets to an entity; managing the assets of an entity; leasing assets from an entity; and providing financing to an entity. In such cases consolidation of the variable interest entity is required by the enterprise that controls the economic risks and rewards of the entity, regardless of ownership. While we have held an economic interest in iASPEC since October 9, 2006, the Management Service Agreement and the Option Agreement have now given us control over the business and operations of iASPEC. As a result, iASPEC’s financial data is subject to consolidation with our financial data, commencing July 1, 2007.
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On July 1, 2008, our Chairman and Chief Executive Officer, Mr. Jiang Huai Lin, entered into an Equity Transfer Agreement with Mr. Jin Zhu Cai, the owner of a 24% minority interest in iASPEC, pursuant to which Mr. Lin purchased Mr. Cai’s minority interest for a total consideration of RMB60 million (approximately $8.72 million). As a result of the Equity Transfer Agreement, Mr. Lin holds 100% of the equity interests of iASPEC.
On December 13, 2009, IST, iASPEC and Mr. Lin, as the sole shareholder of iASPEC, amended and restated the Management Service Agreement, pursuant to which IST will continue to provide management and consulting services to iASPEC, subject to the following changes:
iASPEC agreed that IST will be entitled to receive ninety five percent (95%) of the net received profit of iASPEC during the term of the agreement, to be calculated as follows: accrued accounts receivable plus net turnover (revenue), minus cost of sales, minus operating expenses, and minus accrued but not collected accounts receivable, but only if the result is a positive number. iASPEC is obligated to calculate and pay the net received profit due to IST no later than the last day of the first month following the end of each fiscal quarter;
Mr. Lin agreed to enter into a pledge agreement with IST to pledge all his equity interests in iASPEC as security for his and iASPEC's fulfillment of their respective obligations under the Management Service Agreement, and to register the pledge agreement with the local Administration for Industry and Commerce;
Mr. Lin confirmed his status as the sole shareholder of iASPEC and his assumption of all the obligations of the iASPEC shareholder under the agreement, including a confirmation of his continuing obligation under a written guaranty, dated August 1, 2007, executed by the iASPEC shareholders in connection with the Management Service Agreement;
Based on iASPEC’s needs for its development and operation, IST has the right, from time to time, at its sole discretion, to provide iASPEC with capital support either as an entrustment of funds to iASPEC, or as an advance to Mr. Lin, as iASPEC’s shareholder, for the sole purpose of making a capital contribution to iASPEC for use in the business of iASPEC; provided that, any such advance for capital contribution will be evidenced by an “advance agreement” in the form attached to the Amended and Restated Management Service Agreement; and
IST agreed that it will not interfere in any business of iASPEC covered by iASPEC’s State Secret related Computer Information System Integration Certificate, including but not limited to, seeking access to relevant documents regarding such business; provided, however, that iASPEC agreed that it will cooperate with the requests of the Company as necessary to comply with the Company’s reporting obligations to the SEC.
Acquisitions
On November 7, 2007, we acquired 100% of the equity interests of ISSI, and its PRC operating subsidiary, ISS, for which we paid approximately $7.1 million in cash and issued 883,333 shares of our common stock.
On February 1, 2008, we acquired 100% of the equity interests of ISIID, and its PRC operating subsidiary, Bocom, for a purchase price of approximately $18,000,000. We paid approximately $9,000,000 of the purchase price in cash and the remaining $9,000,000 was paid in 1,125,000 shares of our common stock.
On April 7, 2008, iASPEC acquired Geo, pursuant to (1) a share purchase and increased capital agreement, dated as of February 16, 2008, by and among iASPEC, Wuhan Wuda Venture Capital Co., Ltd., Song Ai Hong and Geo, for the purchase of 46% of Geo for a purchase price of approximately $4,819,000, and (2) a share purchase agreement, dated as of February 16, 2008, between iASPEC and Li Wei, for the purchase of 2.4% of Geo for a purchase price of approximately $666,700. On September 3, 2010, Geo increased its registered capital from RMB 60,000,000 (approximately $8,849,680) to RMB 79,200,000 (approximately $11,681,588). The RMB 19,200,000 (approximately $2,831,900) increase was contributed by iASPEC and a group of new shareholders, comprising of the management teams of both GEO and iASPEC, including Mr. Jianghuai Lin, the Company’s chief executive officer. As a result of the capital increase, the equity interest owned by iASPEC in Geo was reduced from 57% to 52.54%, and the management teams of Geo and iASPEC now hold 11.02% of the equity interest in Geo.
On October 31, 2008, we completed the acquisition of Kwong Tai and its PRC operating subsidiary, Zhongtian, from Wide Peace International Investments Limited, or Wide Peace, for a purchase price of $16,500,000. We paid $9,900,000 (approximately RMB67,617,000) in cash and the remaining $6,600,000 was paid in 1,280,807 shares of our common stock.
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Wide Peace is obligated to return 355,164 of the purchased shares to us if Zhongtian does not attain an audited minimum after tax net income, or ATNI, of $2,200,000 for fiscal year 2009, and an additional 355,164 of the shares if Zhongtian does not attain an audited minimum ATNI of $2,860,000 for fiscal year 2010. The 2009 and 2010 targets were met by Zhongtian.
On October 1, 2009, we completed the acquisition of HPC and its PRC operating subsidiary, Huipu, from Ms. Rita Kwai Fong Leung for a purchase price of $16,000,000. We paid $8,000,000 (approximately RMB54,640,000) of the purchase price in cash and the remaining $4,000,000 in 1,101,930 shares of our common stock. We are also obligated to issue and deliver to Ms. Leung an additional 1,101,930 shares of our common stock in accordance with certain make good provisions agreed to between the parties if HCP attains certain audited consolidated ATNI thresholds for fiscal years 2010 through 2012, as follows:
Corporate Structure
The following chart reflects our current corporate organizational structure:
Industry Overview
General
Over the past two decades, the PRC government has encouraged the development and use of new technologies for information and communication, or ICTs, and their application in all spheres of government, industry, education and culture.
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The term “Informatization” or “xinxihua” has been coined in China to describe the overall process of ICT application in China and has in recent years become a linchpin of central and many local economic development strategies.
As a part of the Informatization process, the PRC government has launched a series of online programs to accelerate its pace of implementing and using information technology. For example, the Golden Shield Program promotes the use of information technology for public security services. The Public GIS platform aims to integrate the functions of multiple government departments by using the GIS technology. The Golden Health Program strives to improve the efficiency of public health management by using digital hospital technologies. All these initiatives are of top priority to the Chinese government and are driving the demand for our product offerings.
Global GIS Industry
The GIS field is a rapidly growing field that identifies data according to location. GIS incorporates geographical features with data in order to assess real world problems. In the strictest sense, a GIS is a computer system capable of capturing, storing, analyzing, and displaying geographically referenced information. The term GIS also includes the procedures, operating personnel, and spatial data that go into the system.
The power of a GIS comes from the ability to relate different information in a spatial context and reach a conclusion about this relationship. Most of the information we have about our world contains a location reference, placing that information at some point on the globe. However, GIS can be used to emphasize objects on a map, their absolute location on the Earth's surface and their spatial relationships, in a series of attribute tables-the “information” part of a GIS. For example, while a computer-aided mapping system may represent a road simply as a line, a GIS may also recognize that road as the boundary between wetland and urban development between two census statistical areas. A GIS, therefore, can reveal important new information (such as whether features intersect or whether they are adjacent) that leads to better decision making or solutions.
Data Capture and Integration - In order to utilize a GIS, data must be directly entered into (or captured by) a GIS in digital form, that is, in a form the computer can recognize. A GIS can also convert existing digital information, which may not yet be in map form, into forms it can recognize and use. Map data may also be created by (1) digitizing maps by hand-tracing with a computer mouse on the screen or on a digitizing tablet to collect the coordinates of features, (2) using electronic scanners to convert maps to digits, or (3) uploading coordinates from Global Positioning System, or GPS, receivers into a GIS. Once a time-consuming process, the data capture process is now made easier by the development in the GIS industry of software tools to automatically extract features from satellite images or aerial photographs and create databases in map form for use in a GIS.
Information Retrieval and Data Output - With a GIS you can “point” at a location, object, or area on the screen and retrieve recorded information about it from off-screen files. For example, using scanned aerial photographs as a visual guide, you can ask a GIS about the location of a fire, analyze the area around the fire and determine conditions of adjacency (what is next to it), containment (what is enclosed by it) and proximity (how close is something to it).
Another critical component of a GIS is its ability to produce graphics on the screen or on paper to convey the results of analyses to the people who make decisions about resources. Wall maps, Internet-ready maps, interactive maps and other graphics can be generated, allowing decision makers to visualize and thereby understand the results of analyses or simulations of potential events.
Components of GIS
Hardware - Hardware comprises the equipment needed to support the many activities ranging from data collection to data analysis. A central piece of the equipment is a workstation, which runs the GIS software and is the attachment point for the equipment. Data collection efforts can also require the use of a digitizer for conversion of hard copy data to digital data and a GPS data logger to collect the field. The use of handheld field technology is also becoming an important tool in GIS. With the advent of web-enabled GIS, web servers have become an important piece of equipment for GIS.
Software - Different software packages are important for GIS. Central to this is the GIS application package. Such software is essential for creating, editing and adding spatial and attributed data, therefore these packages contain a myriad of functions inherent to them. Extensions or add-ons are software that extends capabilities of the GIS software package. Component GIS software is the opposite of application software. Component GIS seeks to build software applications that meet a specific purpose and thus are limited in their spatial analysis capabilities. Utilities are stand-alone programs that perform a specific function. For example, a file format utility that converts from one type of GIS file to another. There is also web-GIS software that helps serve data through Internet browsers.
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Data - Data is the core of any GIS. There are two primary types of data that are used in GIS, data in geodatabases and attribute data. A geodatabase is a database that is in some way referenced to locations on earth. Geodatabases are grouped into two different types: vector and raster. A vector image is stored as geometric objects, such as lines and arcs, which are drawn between specific coordinates. If you magnify a vector image you see the lines more accurately, and the line edges stay smooth. A raster image is made up from pixels, like the picture obtained from a scanner, or the screen image on a computer monitor, and has a finite amount of detail which is dependent upon the image size and resolution. However, the closer you look at a raster image the coarser it appears and you don't see any extra detail. Vector drawings are utilized in GIS and other applications where accuracy is important. Usually coupled with this data is data known as attribute data. Attribute data are data that relate to a specific, precisely defined location. The data are often statistical but may be text, images or multi-media. These are linked in the GIS to spatial data that define the location.
People - Well-trained people knowledgeable in spatial analysis and skilled in using GIS software are essential to the GIS process.
Public Sector Use of GIS
GIS can be used by the public sector in the following ways:
Pubic Safety and Emergency Response Planning - GIS technology gives public safety personnel the ability to manage and analyze large amounts of location-based information. Data (including files from legacy systems) can be stored in a geodatabase and used to visualize spatial relationships and reveal trends critical to public safety response and planning. Computer-generated maps can be shared across a network or the Internet with multiple agencies to coordinate efforts and maximize resources.
Law Enforcement - GIS software uses geography and computer-generated maps as an interface for integrating and accessing massive amounts of location-based information. GIS allows law enforcement and criminal justice personnel to effectively plan for emergency response, determine mitigation priorities, analyze historical events, and predict future events. GIS can also be used to get critical information to emergency responders upon dispatch or while en route to an incident to assist in tactical planning and response. While law enforcement agencies collect vast amounts of data, only a very small part of this information can be absorbed from spreadsheets and database files. GIS provides a visual, spatial means of displaying data, allowing law enforcement agencies to integrate and leverage their data for more informed decision making.
Public Works and Development - Use of GIS software in public works improves efficiency and productivity to better serve citizens. For example, GIS applications are in demand in connection with the construction of the Pan Asia Railway and development of the Meigong River and Tumen River in the Northwest of China. Such public works systems could use GIS to connect all divisions in a public works department from engineering to accounting, which streamlines work flows, asset management, operations, and planning. Using a GIS throughout the department allows all sections to share and easily access geographic data. GIS promotes data integrity and facilitates better communication and decision making throughout the organization.
Economic Development - GIS may be used to foster economic development. Agencies could work to advance the quality of life and strengthen the economic base of their region by retaining and growing existing businesses and attracting new investment.
Urban Planning and Site Selection - Information regarding a proposed site for parcel zoning, transportation planning, waste disposal or other use may be combined and manipulated in a GIS to address planning and natural resource issues (such as the location of a water well near a proposed waste disposal site) to guarantee the quality of life for everyone in livable communities. Planning agencies have realized the power of enterprise GIS to identify problems, respond to them efficiently, and share the results with the public.
Our Growth Strategy
Our objective is to be the leading provider of integrated solutions for GIS, public security information technology, and digital hospital systems in China, as well as related software service operations. Our intelligence solutions can help organizations make more insightful decisions and improve the efficiency of their internal processes. Our strategy for achieving this objective includes the following key elements:
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Expand geographic footprint to cover all major markets in China. We intend to leverage our strengths to expand into new geographic markets. For the fiscal year ended December 31, 2010, approximately 64% of our total revenue was generated through our operations in the Guangdong Province. We manage our nationwide operations in the seven strategic development areas in China including the South, the North, the East, the Central, the Southwest, the Northwest China, as well as the Northeast. We have established offices in Guangzhou, Beijing, Wuhan, Hunan and Xinjiang provinces, and work through representatives in Nanning, Guangxi Provinces, in Dongguan, Guangdong Province, in Chongqing Municipality, in Nanjing, Jiangsu Province, in Xi’an, Shanxi Province, in Chengdu, Sichuan Province, in Baotou, Inner Mongolia, in Lanzhou, Gansu Province, etc.. Our nationwide distribution network in China covers 32 provinces and provincial cities throughout China. We believe that expanding our presence in new geographic areas will allow us to increase our cross-selling opportunities for our product and service offerings.
Strengthen R&D capability to enhance and expand core products and further penetrate customer base. To provide our clients with innovative solutions, we expect to offer additional value-added services and add-ins to our current platform through continuous research and development, to enhance our product and service offerings and to maintain our leadership position in our core areas of focus.
Continue to maintain our leading position in the rapidly growing public security technology market. We plan to leverage our strong brand recognition to obtain new customers and new projects from existing customers.
Expand into the private sector. We are witnessing market readiness to adopt our IT solutions and display technologies that used to serve highly specialized activities of public agencies. As private sector grows in technological sophistication, we plan to penetrate into this new sector of the market with both display technologies and internet solutions.
We expect to execute these key elements of our growth strategy through a combination of investments in internal initiatives. Internal initiatives will focus on expanding capacity and enhancing our technology and services capabilities.
Our Products and Services
Through the operations of our China-based subsidiaries and the subcontracting services provided for in our Management Service Agreement with iASPEC, we are a provider of integrated solutions for the GIS, digital public security as well as digital hospital information markets in China. Our products and services can be separated into four categories: (1) GIS applications and services; (2) Digital Public Security Technology, or DPST; (3) Digital Hospital Information Systems, or DHIS and (4) Other Products and Services or OTHER.
GIS Software Services and Operations
We provide system management and support services in connection with our PGIS platform. The PGIS platform is a set of GIS solutions that was developed by iASPEC and licensed exclusively to us, for use in creating, editing and adding data to our customers’ systems. The PGIS platform allows us to provide our law enforcement customers with different services, including specialized mapping services, positioning services, messaging services and services which monitor access to their GIS by users of different levels. We offer the PGIS platform with a full complement of services, including providing basic map image data from the GIS and specific data in connection with that map image (such as a bus stop), a consolidation of both basic data and specific data services for data inquiry services, and application system services, which is the application of consolidated services to a specific service requirement, such as the position of a police officer in the field.
We also provide application interface services which ensure that our PGIS platform is equipped to interact with other programs to the benefit of our customers. The data from different law enforcement command systems can be integrated with our PGIS platform to provide our law enforcement customers with more robust communication and location information. Typically, our platforms are integrated with the City Emergency Commanding System, the Police Resource Consolidated Management System, the Residence Management System, the Internet Surveillance System, the Traffic Commanding System, the Criminal Investigation System and the City Surveillance System. Our core PGIS technology has been selected for use in the Ministry of Public Security’s PGIS Project, which when complete, is expected to standardize and interconnect all PGIS systems in China. The MPS plans to standardize 100 largest cities over the next three years and then subsequently roll out these systems nationwide.
In the Civil-use GIS sector, we have obtained the highest level of qualifications (some of them are mentioned in the sections under the heading “Competition - High Barriers to Entry” and “Regulation” below) with the widest range of applications, through its affiliation with Geo. In addition, Geo’s copyrighted GIS software, “Geostar,” has been widely applied in many mission-critical projects covering national defense, surveying and mapping, land resource, city planning and electricity. Management believes that these qualifications and intellectual property have positioned the Company to benefit for the next few years from the PRC government’s recent emphasis on and promulgation of favorable policies to encourage more applications of domestic-grown GIS software.
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In January 2010, China’s State Bureau of Surveying and Mapping announced its plan to build a National Geographic Information Public Service Platform. The whole program will include the construction of one national level master node, 31 provincial level nodes, and 333 city level nodes throughout China, and each city level node will centralize approximately 20 local government departments’ different applications. This program aims to improve the capability and efficiency of geographic information public service, and optimize the utilization of national geographic information resources in China. The whole program will be completed in 5 years.
Digital Public Security Technology
First Responder Coordination Platform - The First Responder Coordination Platform is a software program which integrates the contact numbers for general police, fire, traffic and other related government organizations into one contact number and enables these agencies to consolidate and improve their public emergency response. Through this platform, our public security customers are able to command and coordinate joint responses to provide the public with immediate, efficient and reliable assistance. The PRC government, through its “Police Force Technology Reinforcement” initiative, has mandated the adoption of the first responder system to consolidate and improve public emergency response. Approximately 660 cities across China are expected to initiate the deployment of their coordinated emergency response platforms, creating significant opportunities for us.
Intelligent Recognition Systems - Our Intelligent Recognition product is used by the Ministry of Public Security for effective border control management. The Recognition System stores biometric information, such as finger-prints and facial features from passengers in a database and integrates it with infrared and license plate recognition technologies to enable the automation of border control checkpoints for faster and more accurate processing of passengers, while at the same time helping to safeguard borders from stowaways, and greatly improving overall efficiency and the effectiveness of border control management. The rapid development of China in recent years has also led to growing passenger traffic across its borders, which reached 382 million people in 2010. To address the increasing requirement and faster and more accurate checkpoint processing of passenger traffic, Exit and Entry Frontier Stations throughout China are in the process of implementing their own intelligent border control systems. These systems can also be used to strengthen port control and surveillance in China’s 200+ air, sea and land ports and have many alternative private sector applications, including the management and control of stadium attendance, parking lot traffic, work attendance and toll road traffic.
Residence Card Information Management System - This system is designed to apply the latest information technology to automate the Shenzhen Residence Card System, and will integrate with police GIS systems. Through an integrated information transfer platform, the system will facilitate several social programs, including social welfare management, education management, and house rental service management. Various government and functional departments can access information regarding the immigrant population in the system to improve work efficiency and increase managing capability. In the near future, the system may be expanded to be compatible with other applications, such as medical, personal credit history, and driving records. If successful, the system may be extended to 660 cities across China. According to national statistics, there are over 210 million internal immigrants in China. In many mid-to-large cities, the population of recent immigrants from rural areas exceeds the resident population. As a key pilot project for the Ministry of China Public Security, our Residence Card information Management System will be deployed in Shenzhen first for evaluation.
Digital Hospital Information Systems
We provide various hospital information management software and solutions, such as Medical Case Statistics Software and Electronic Medical Case Management System, to help build modern, scientific and digital hospitals. Our products have been widely used to efficiently manage hospital fiscal information, clinic information, medical technologies, equipment and inventory, as well as comprehensive hospital information.
Medical Case Statistics Software serves the growing demand for digital hospital and electronic medical record systems in China. Medical records, including health examinations, medical care, immunity or infectious diseases, will be integrated into one centralized system so that doctors within the network can review a patient’s complete medical history. Such digital hospital systems are expected to reduce medical errors and improve the efficiency of delivering healthcare services, so as to benefit patients, while helping to minimize medical claims fraud. Our Medical Case Statistics Software can also be used to provide public health authorities with an integrated command and decision system for public health and disease control.
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Our Electronic Medical Case Management System is able to integrate Hospital Information System, Laboratory Information System, Picture Archiving & Communication System, Radiology Information System and Corporate Identity System, to digitize all clinic information. The System also provides access interfaces with related agencies such as Social Insurance and Bank.
Other Products and Services
In addition to providing the above-mentioned three main segments of offerings, we assess new market opportunities and develop new solutions such as our display technologies and internet solutions for the private sector. New offerings under market assessment or development outside the existing main business segments are aggregated in this category until a meaningful stand-alone segment is formed, at which point such a new segment will be separated from this category.
Product Warranty
We usually offer a one-year service warranty for our system integration services. The warranty includes support services, minimal updates and system maintenance. In our experience the cost of providing this warranty has been immaterial. We also offer warranties for our hardware sales, but the suppliers of such hardware provide the final warranty services.
Our Intellectual Property
Our success depends, in part, on our ability to maintain and protect our proprietary technology and to conduct our business without infringing on the proprietary rights of others. We rely primarily on a combination of copyrights, patents, trademarks and trade secrets, as well as employee and third-party confidentiality agreements, to safeguard our intellectual property.
As of December 31, 2010, we had 98 registered and copyrighted software products. We also held 16 patents and had 10 patent applications pending. We had 9 trademarks.
We protect our know-how and technologies through confidentiality provisions in the employment contracts we enter into with our employees. In addition, our engineers are generally divided into different project groups, each of which generally handles only a portion of the project. As a result, no one engineer generally has access to the entire design process and documentation for a particular product.
Sales and Marketing
We develop new business by identifying and contacting potential new customers and through referrals, or as a result of new customers contacting us because of our strong brand recognition and reputation in the industry. We strengthen our market presence through various types of marketing campaigns, such as participating in exhibitions, trade fairs and seminars, and presenting solutions to prospective customers. We participate in several domestic and international trade fairs such as the China High-Tech Fair in Shenzhen and the e-Gov China Fair in Beijing. We also participate in seminars held by ESRI, IBM etc. each year, to raise our recognition and promote our products. These trade fairs not only promote our reputation, but also our brand name.
Our main marketing and business development focus is on GIS, public security information technology and hospital information system software services. We have a good reputation and brand recognition in this market. We expect to expand in the market and obtain more market shares through our mature products and quality services.
Our Major Customers
In fiscal years 2010 and 2009, no single customer represented 10% or more of our total revenue. In fiscal 2008, no single customer other than Huipu represented more than 10% of total revenue.
The following tables provide revenue by our major customers for the years ended December 31, 2010, 2009 and 2008.
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Year 2010
Year 2009
Year 2008
Competition
The markets for GIS, digital public security and digital hospital information system sectors in China have developed in recent years but are still in an emerging stage. There are currently only a few key players engaged in each of these fields. In the PGIS area, Beijing Founder Digital Company Limited and Beijing Easymap Information Technology Co., Ltd. are two important competitors. In the GIS platform software business, we consider Environmental Systems Research Institute (“ESRI”), Super Map Software Co., Ltd. (“SuperMap”) and Zondy Cyber Group Co., Ltd. ("Zondy Cyber”) as meaningful competitors. In the digital hospital information system sector, our main competitors include Neusoft Corporation or Neusoft Group Ltd.(“Neusoft”) and DHC Software Company Limited (“DHC Software”).
We believe that we will be able to effectively compete with these companies in the future. We believe that our pioneering solutions, our ongoing customer relationships and our reputation for success in the industry have enabled us to maintain our competitive advantages.
We believe the following are our key competitive strengths.
Broad and Growing Portfolio of Software and Services. We offer our customers a growing portfolio of software and services offerings in each of the 4 segments in which we operate. We are therefore able to provide multiple integrated solutions for our clients. Public entities use our core products to incorporate ever-growing data into their decision-making processes to drive more effective results. Through our platforms, our customers can develop customized applications, which can be extended across their agencies to support a variety of needs and generate more valuable insights. As a complement to these offerings, we offer related services, such as application development, software upgrades, follow-on phases, and systems integration, which help our customers quickly implement and customize our solutions.
Successful Implementation of High Profile Contracts. Our management team has a proven track record of successful implementation of high profile government contracts in China. This track record has enabled us to expand our customer base, which has grown beyond its historical geographic area in the Guangdong province and now includes customers in over 32 provinces throughout China. During 2010, we completed numerous high-profile mission-critical projects related to our core DPST, GIS and DHIS businesses, including the Police-use GIS for 2010 Shanghai Expo, the security system for the 2011 Shenzhen Summer Universiade, the intelligent traffic management system for the 2010 Guangzhou Asian Games, the Police-use GIS for 12 major cities under China’s National PGIS Standardization Project, the exclusive contract with the Guangdong Department of Health for our patented Medical Case Statistics (MCS) software to be rolled out to 2,000 hospitals within the province. Our major accomplishments in 2010 also include: our proprietary Geoglobe and Geostar was selected by China’s State Grid Corporation as the sole domestic GIS software provider for the build-out of the Smart Grid project; China’s newly released state-sponsored online mapping service “Map World” are entirely run on our GIS platform software; in addition, as of Feb 2011, all of the Company’s operating entities have been awarded the National High-Tech Enterprise Status, which allows us to receive significant benefits including lower income tax rate, government subsidies, etc. We were ranked among Deloitte Technology Fast 500 Asia Pacific for the third consecutive year and named 13th among 2010 Forbes China Best SMEs. During the fourth quarter of 2010, we signed new contracts totaling $39.6 million from 25 provinces and provincial cities throughout China, bringing the total contracts amount signed in 2010 to $151.5 million, an increase of 35.8% compared to the year of 2009.
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High Barriers to Entry. We believe our qualifications, our successful contract implementation record, and the high cost of switching to other providers provide us with a “first mover” advantage in the PRC market and pose high barriers to entry for our potential competitors. iASPEC, holds the Computer System Integration Level 1 license from the PRC Ministry of Information, the Information System Security Service qualification from Guangdong Province and a State Secret-related Computer Information Integration Certificate, and Geo holds a Level A Certificate of Surveying and Mapping. As discussed above, we are gaining wider market recognition from our successful contract execution record. In addition, after investing in our systems, our existing customers have a strong incentive to purchase follow-on phases from us in order to expedite implementation and save costs.
Regulation
Because all of our operating entities are located in the PRC, we are regulated by the national and local laws of the PRC. This section summarizes the major PRC regulations relating to our business.
Permits and Certificates
Our PRC subsidiary IST is a Shenzhen City Software Enterprise and holds ISO 9001:2000 Certification, Maturity Level 2 of Capability Maturity Model Integration and National High-Tech Enterprise. However, fulfillment of certain PGIS contracts with PRC Government customers is restricted to entities possessing the necessary government licenses and approvals which IST does not have.
Through our exclusive commercial arrangements with iASPEC, we benefit from the following governmental licenses and permits previously awarded and currently held by iASPEC:
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In addition, our PRC operating subsidiaries hold the following certifications and qualifications:
Taxation
On March 16, 2007, the National People's Congress of China passed a new Enterprise Income Tax Law, or EIT Law, and on November 28, 2007, the State Council of China passed its implementing rules, which took effect on January 1, 2008. Before the implementation of the EIT Law, foreign invested enterprises, or FIEs, established in the PRC, unless granted preferential tax treatments by the PRC government, were generally subject to an earned income tax, or EIT, rate of 33.0%, which included a 30.0% state income tax and a 3.0% local income tax. The EIT Law and its implementing rules impose a unified EIT of 25.0% on all domestic-invested enterprises and FIEs, unless they qualify under certain limited exceptions. However, the EIT Law gives FIEs established before March 16, 2007, or Old FIEs, a five-year grandfather period during which they can continue to enjoy their existing preferential tax treatments. During this five-year grandfather period, Old FIEs that enjoyed tax rates lower than 25% under the original EIT Law can gradually increase their EIT rate by 2% per year until their tax rate reaches 25%. In addition, the Old FIEs that are eligible for the “two-year exemption and three-year half reduction” or “five-year exemption and five-year half-reduction” under the original EIT law, are allowed to continue enjoying their preference until these holidays expire.
In addition to the changes to the current tax structure, under the EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a resident enterprise and will normally be subject to an EIT of 25% on its global income. The implementing rules define the term “de facto management bodies” as “an establishment that exercises, in substance, overall management and control over the production, business, personnel, accounting, etc., of a Chinese enterprise.” If the PRC tax authorities subsequently determine that we should be classified as a resident enterprise, then our organization’s global income will be subject to PRC income tax of 25%. For detailed discussion of PRC tax issues related to resident enterprise status, see Item 1A, “Risk Factors - Risks Related to Doing Business in China - Under the New Enterprise Income Tax Law, we may be classified as a ‘resident enterprise’ of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC stockholders.”
Foreign Currency Exchange
The principal regulation governing foreign currency exchange in China is the Foreign Currency Administration Rules (1996), as amended (2008). Under these Rules, RMB is freely convertible for current account items, such as trade and service-related foreign exchange transactions, but not for capital account items, such as direct investment, loan or investment in securities outside China unless the prior approval of, and/or registration with, the State Administration of Foreign Exchange of the People’s Republic of China, or SAFE, or its local counterparts (as the case may be) is obtained.
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Pursuant to the Foreign Currency Administration Rules, FIEs in China may purchase foreign currency without the approval of SAFE for trade and service-related foreign exchange transactions by providing commercial documents evidencing these transactions. They may also retain foreign exchange (subject to a cap approved by SAFE) to satisfy foreign exchange liabilities or to pay dividends. In addition, if a foreign company acquires a company in China, the acquired company will also become an FIE. However, the relevant PRC government authorities may limit or eliminate the ability of FIEs to purchase and retain foreign currencies in the future. In addition, foreign exchange transactions for direct investment, loan and investment in securities outside China are still subject to limitations and require approvals from, and/or registration with, SAFE.
Dividend Distributions
Under applicable PRC regulations, FIEs in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, a FIE in China is required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserves until the accumulative amount of such reserves reach 50% of its registered capital. These reserves are not distributable as cash dividends. The board of directors of a FIE has the discretion to allocate a portion of its after-tax profits to staff welfare and bonus funds, which may not be distributed to equity owners except in the event of liquidation.
In addition, under the EIT law, the Notice of the State Administration of Taxation on Negotiated Reduction of Dividends and Interest Rates, which was issued on January 29, 2008, the Arrangement between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion, which became effective on December 8, 2006, and the Notice of the State Administration of Taxation Regarding Interpretation and Recognition of Beneficial Owners under Tax Treaties, which became effective on October 27, 2009, dividends from our PRC operating subsidiaries paid to us through our Hong Kong subsidiaries may be subject to a withholding tax at a rate of 10%, or at a rate of 5% if our Hong Kong subsidiaries are considered a “beneficial owner” that is generally engaged in substantial business activities and entitled to treaty benefits under the Arrangement between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion.
Our Employees
As of December 31, 2010, we had approximately 1,453 full-time employees. The following table illustrates the allocation of these employees among the various job functions conducted at our company.
We believe that our relationship with our employees is good. Our Chinese subsidiaries have trade unions which protect employees’ rights, aim to assist in the fulfillment of our economic objectives, encourage employee participation in management decisions and assist in mediating disputes between us and union members. We have not experienced any significant problems or disruption to our operations due to labor disputes, nor have we experienced any difficulties in recruitment and retention of experienced staff. The remuneration payable to employees includes basic salaries and allowances. We also provide training for our staff from time to time to enhance their technical knowledge.
As required by applicable Chinese law, we have entered into employment contracts with all of our officers, managers and employees.
Our employees in China participate in a state pension scheme organized by Chinese municipal and provincial governments. We are required to contribute to the scheme at rates ranging from 13% to 18% of the average monthly salary. As of the date of this report, we have complied with the regulation and have paid the state pension plan as required by law. In addition, we are required by Chinese law to cover employees in China with various types of social insurance. We have purchased social insurance for all of our employees.
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ITEM 1A.
ITEM 1A. RISK FACTORS.
An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below, together with all of the other information included in this report, before making an investment decision. If any of the following risks actually occurs, our business, financial condition or results of operations could suffer. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. You should read the section entitled “Special Note Regarding Forward Looking Statements” above for a discussion of what types of statements are forward-looking statements, as well as the significance of such statements in the context of this report.
RISKS RELATED TO OUR BUSINESS
Unfavorable economic conditions may affect the level of technology spending by our customers which could cause the demand for our products and services to decrease.
The revenue growth and profitability of our business depend on the overall demand for software products and related services, particularly within the private sector. Our strategy involves a sale of our products and services primarily to customers in the private sector, so our business depends on the overall economy and the economic and business conditions within this market. The current stock market decline and the global economic slowdown may affect the demand for our software products and related services and decrease technology spending of many of our customers and potential customers. These events could have a material effect on us in the future, including, without limitation, on our future revenue and earnings.
We are not likely to sustain our recent growth rate.
Our revenues have grown significantly in the last few years, primarily resulting from our strategic acquisitions, including our acquisitions of ISS, Bocom and Huipu, and the acquisition of Geo by our variable interest entity, iASPEC. Specifically, our revenue has grown 157% between fiscal years 2007 and 2006 (including revenue earned by our predecessor in fiscal year 2006), 181% between fiscal years 2008 and 2007, 18% between fiscal years 2008 and 2009 and 62% between fiscal years 2009 and 2010. Additionally, our net income has grown 135% between fiscal years 2007 and 2006 (including revenue earned by our predecessor in fiscal year 2006), 78% between fiscal years 2008 and 2007, 27% between fiscal years 2008 and 2009 and 20% between fiscal years 2009 and 2010. We are not likely to sustain similar growth in revenues or net income in future periods due to a number factors, including, among others, the greater difficulty of growing at sustained rates from a larger revenue base and our ability to identify and consummate strategic acquisitions. Accordingly, you should not rely on the results of any prior period as an indication of our future financial and operating performance.
Our quarterly operating results are difficult to predict and could fall below investor expectations or estimates by securities research analysts, which may cause the trading price of our common stock to decline.
Our revenues and operating results can vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control, such as variations in the volume of business from customers resulting from changes in our customers' operations, the business decisions of our customers regarding the use of our products and services, delays or difficulties in expanding our operational facilities and infrastructure, changes to our pricing structure or that of our competitors, inaccurate estimates of resources and time required to complete ongoing projects and currency fluctuations. As many of our employees take long vacations during the Chinese New Year in the first quarter, our revenues in that quarter are relatively low compared to the other quarters. Moreover, our results may vary depending on our customers' business needs and spending patterns. Due to the annual budget cycles of most of our customers, we may not be able to estimate accurately the demand for our products and services beyond the immediate calendar year, which could adversely affect our business planning and may have a material adverse effect on our business, results of operations and financial condition. In addition, the volume of work performed for specific customers is likely to vary from year to year. Thus, a major customer in one year may not provide the same amount or percentage of our revenues in any subsequent year.
These fluctuations are likely to continue in the future and operating results for any period may not be indicative of our performance in any future period. If our operating results for any quarterly period fall below investor expectations or estimates by securities research analysts, the trading price of our common stock may decline.
We face risks once a business is acquired and the acquired companies may not perform to our expectations, either of which may adversely affect our results of operations.
We face risks when we acquire other businesses. These risks include:
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difficulties in the integration of acquired operations and retention of personnel,
unforeseen or hidden liabilities,
tax, regulatory and accounting issues, and
inability to generate sufficient revenues to offset acquisition costs.
Acquired companies may not perform to our expectations for various reasons, including the loss of key personnel or, as a result, key customers, and our strategic focus may change. As a result, we may not realize the benefits we anticipated. If we fail to integrate acquired businesses or realize the expected benefits, we may lose the return on the investment in these acquisitions, incur transaction costs and our results of operations could be materially and adversely affected as a result.
If we are unable to raise additional financing or identify suitable merger or acquisition targets, we may be unable to implement our long-term business plan, develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures on a timely basis.
Our long-term business plan includes the identification of suitable targets for horizontal or vertical mergers or acquisitions, so as to enhance overall productivity and to benefit from economies of scale. Due to the current global financial crisis, we may not be able to obtain adequate levels of additional financing, whether through equity financing, debt financing or other sources. To raise funds, we may need to issue new equities or bonds which could result in additional dilution to our shareholders, and additional financings could result in significant dilution to our earnings per share or the issuance of securities with rights superior to our current outstanding securities or contain covenants that would restrict our operations and strategy. In addition, we may grant registration rights to investors purchasing our equity or debt securities in the future. If we are unable to raise additional financing, we may be unable to implement our long-term business plan, develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures on a timely basis, if at all. In addition, a lack of additional financing could force us to substantially curtail or cease operations.
We also may not be able to identify merger or acquisition targets or, after a merger or acquisition, may not be able to integrate the target’s business or operations successfully with ours. Such failure to execute our long-term business plan likely will negatively impact our results of operations.
We generally do not have exclusive or long-term agreements with our customers and we may lose their engagement if they are not satisfied with our products and services or for other reasons.
We generally do not have exclusive or long-term agreements with our customers. As a result, we must rely on the quality of our products and services, industry reputation and favorable pricing to attract and retain customers. There is no assurance, however, that we will be able to maintain our relationships with current and/or future customers. Our customers may elect to terminate their relationships with us if they are not satisfied with our services. If a substantial number of our customers choose not to continue to purchase products and services time from us, it would have a material adverse effect on our business and results of operations.
If we are unable to develop competitive new products and service offerings our future results of operations could be adversely affected.
Our future revenue stream depends to a large degree on our ability to utilize our technology in a way that will allow us to offer new types of software applications and services to a broader client base. We will be required to make investments in research and development in order to continue to develop new software applications and related service offerings, enhance our existing software applications and related service offerings and achieve market acceptance of our software applications and service offerings. We may incur problems in the future in innovating and introducing new software applications and service offerings. Our development-stage software applications may not be successfully completed or, if developed, may not achieve significant customer acceptance. If we are unable to successfully define, develop and introduce competitive new software applications, and enhance existing software applications, our future results of operations would be adversely affected. Development schedules for software applications are difficult to predict. The timely availability of new applications and their acceptance by customers are important to our future success. A delay in new the development of new applications could have a significant impact on its results of operations.
If we are unable to keep pace with the rapid technological changes in our industry, demand for our products and services could decline which would adversely affect our revenue.
Our industry is characterized by extremely rapid technological change, evolving industry standards and changing customer demands. These conditions require continuous expenditures on product research and development to enhance existing products, create new products and avoid product obsolescence. We believe that the timely development of new products and continuing enhancements to existing products is essential to maintain our competitive position in the marketplace. Our future success depends in part upon customer and market acceptance of our products and initiatives, which is uncertain. Any failure to achieve increased acceptance of these and other new product offerings could have a material adverse effect on our business and results of operations.
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Our software products may contain defects or errors, which could decrease sales, injure our reputation or delay shipments of our products.
The software products that we develop are complex and must meet the stringent technical requirements of our customers. In addition, to keep pace with the rapid technological change in our industry and to avoid the obsolescence of our software products, we must quickly develop new products and enhancements to existing products. Because of this complexity and rapid development cycle, we cannot assure that our software products are free of errors, especially in newly released software products and new versions of existing software products. If our software is not free of errors, this could result in litigation, fewer sales, increased product returns, damage to our reputation and an increase in service and warranty costs, which would adversely affect our business.
Our technology may become obsolete which could materially adversely affect our ability to sell our products and services.
If our technology, products and services become obsolete, our business operations would be materially adversely affected. The market in which we compete is characterized by rapid technological change, evolving industry standards, introductions of new products, and changes in customer demands that can render existing products obsolete and unmarketable. Our current products will require continuous upgrading or our technology will become obsolete. Our future success will depend upon our ability to address the increasingly sophisticated needs of our customers by supporting existing and emerging hardware, software, database, and networking platforms and by developing and introducing enhancements to our existing products and new products on a timely basis that keep pace with technological developments, evolving industry standards, and changing customer requirements. Research and development expenses were $3,016,693 , $2,705,669 and $2,596,430 for the years ended December 31, 2010, 2009 and 2008, respectively.
We face the risk of systems interruptions and capacity constraints, possibly resulting in adverse publicity, revenue loss and erosion of customer trust.
The satisfactory performance, reliability and availability of our network infrastructure are critical to our reputation and our ability to attract and retain customers and to maintain adequate customer service levels. We may experience temporary service interruptions for a variety of reasons, including telecommunications or power failures, fire, water damage, vandalism, computer bugs or viruses or hardware failures. We may not be able to correct a problem in a timely manner. Any service interruption that results in the unavailability of our system or reduces its capacity could result in real or perceived public safety issues that may affect customer confidence in our services and result in negative publicity that could cause us to lose customer accounts or fail to obtain new accounts. Any inability to scale our systems may cause unanticipated system disruptions, slower response times, degradation in levels of customer service, or impaired quality and speed of transaction processing. We are not certain that we will be able to project the rate or timing of increases, if any, in the use of our services to permit us to upgrade and expand our systems effectively or to integrate smoothly any newly developed or purchased modules with our existing systems.
If we are not able to adequately secure and protect our patent, trademark and other proprietary rights our business may be materially affected.
Under the Management Service Agreement, we license 21 copyrighted software applications from iASPEC on an exclusive basis. To protect the intellectual property underlying these applications and our other intellectual property, we rely on a combination of copyright, trademark, and trade secret laws. We also rely on non-disclosure agreements and other confidentiality procedures and contractual provisions to protect our intellectual property rights. Some of these technologies, other than the iASPEC copyrighted software applications, are very important to our business and are not protected by copyrights or patents. It may be possible for unauthorized third parties to copy or reverse engineer our products, or otherwise obtain and use information that we regard as proprietary. Further, third parties could challenge the scope or enforceability of our copyrights. In certain foreign countries, including China where we operate, the laws do not protect our proprietary rights to the same extent as the laws of the United States. Any misappropriation of our intellectual property could have a material adverse effect on our business and results of operations, and we cannot assure you that the measures we take to protect our proprietary rights are adequate.
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Claims that we infringe the proprietary rights of third parties could result in significant expenses or restrictions on our ability to sell our products and services.
Third parties may claim that our products or services infringe their proprietary rights. Any infringement claim, with or without merit, would be time-consuming and expensive to litigate or settle and could divert our management’s attention from our core business. In the event of a successful infringement claim against us, we may have to pay significant damages, incur substantial legal fees, develop costly non-infringing technology, or enter into license agreements that require us to pay substantial royalties and that may not be available on terms acceptable to us, if at all.
A significant portion of our sales are derived from a limited number of customers, and results from operations could be adversely affected and stockholder value harmed if we lose any of these customers.
Historically, a significant portion of our revenues have been derived from a limited number of customers. For the years ended December 31, 2010, 2009 and 2008, 17%, 25% and 34% of our revenues, respectively, were derived from our five largest customers. The loss of any of these significant customers would adversely affect our revenues and stockholder value.
The digital security, geographic, and hospital information systems markets in China are highly competitive, and we may fail to compete successfully, thereby resulting in loss of customers and decline in our revenues.
The digital security, geographic, and hospital information systems markets in China are intensely competitive and are characterized by frequent technological changes, evolving industry standards and changing customer demands. We have competition from multiple domestic competitors in each segment. Increased competition may result in price reductions, reduced margins and inability to gain or hold market share.
We have limited insurance coverage for our operations in China.
The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited insurance products. We have determined that the risks of disruption or liability from our business, the loss or damage to our property, including our facilities, equipment and office furniture, the cost of insuring for these risks, and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. As a result, we do not have any business liability, disruption, litigation or property insurance coverage for our operations in China except for insurance on some company owned vehicles. Any uninsured occurrence of loss or damage to property, or litigation or business disruption may result in the incurrence of substantial costs and the diversion of resources, which could have an adverse effect on our operating results.
We depend heavily on key personnel, and turnover of key employees and senior management could harm our business.
Our future business and results of operations depend in significant part upon the continued contributions of our key technical and senior management personnel, including Jiang Huai Lin, our Chairman and Chief Executive Officer, Jackie You Kazmerzak, our Chief Financial Officer, Zhi Qiang Zhao, our Chief Operating Officer, Yi Fu Liu, our Chief Marketing Officer and Zhi Xiong Huang, our Chief Technology Officer. They also depend in significant part upon our ability to attract and retain additional qualified management, technical, marketing and sales and support personnel for our operations. If we lose a key employee or if a key employee fails to perform in his or her current position, or if we are not able to attract and retain skilled employees as needed, our business could suffer. Significant turnover in our senior management could significantly deplete our institutional knowledge held by our existing senior management team. We depend on the skills and abilities of these key employees in managing the technical, marketing and sales aspects of our business, any part of which could be harmed by further turnover.
We may be exposed to potential risks relating to our internal controls over financial reporting and our ability to have the operating effectiveness of our internal controls attested to by our independent auditors.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, or SOX 404, the SEC adopted rules requiring public companies to include a report of management on their internal controls over financial reporting in their annual reports, on Form 10-K. We are subject to this requirement commencing with our fiscal year ending December 31, 2008 and a report of our management is included under Item 9A of this Annual Report on Form 10-K. In addition, SOX 404 requires the independent registered public accounting firm auditing a company’s financial statements to also attest to and report on the operating effectiveness of such company’s internal controls. This annual report includes an attestation report since we are deemed to be an accelerated filer. We can provide no assurance that we will comply with all of the requirements imposed thereby. There can be no assurance that we will receive a positive attestation from our independent registered public accountants. In the event we identify significant deficiencies or material weaknesses in our internal controls that we cannot remediate in a timely manner or we are unable to receive a positive attestation from our independent registered public accountants with respect to our internal controls, investors and others may lose confidence in the reliability of our financial statements.
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Our holding company structure may limit the payment of dividends.
We have no direct business operations, other than our ownership of our subsidiaries. While we have no current intention of paying dividends, should we decide in the future to do so, as a holding company, our ability to pay dividends and meet other obligations depends upon the receipt of dividends or other payments from our operating subsidiaries and other holdings and investments. In addition, our operating subsidiaries, from time to time, may be subject to restrictions on their ability to make distributions to us, including as a result of restrictive covenants in loan agreements, restrictions on the conversion of local currency into U.S. dollars or other hard currency and other regulatory restrictions as discussed below. If future dividends are paid in RMB, fluctuations in the exchange rate for the conversion of RMB into U.S. dollars may reduce the amount received by U.S. stockholders upon conversion of the dividend payment into U.S. dollars.
Chinese regulations currently permit the payment of dividends only out of accumulated profits as determined in accordance with Chinese accounting standards and regulations. Our subsidiaries in China are also required to set aside a portion of their after tax profits according to Chinese accounting standards and regulations to fund certain reserve funds. Currently, our subsidiaries in China are the only sources of revenues or investment holdings for the payment of dividends. If they do not accumulate sufficient profits under Chinese accounting standards and regulations to first fund certain reserve funds as required by Chinese accounting standards, we will be unable to pay any dividends.
RISKS RELATING TO OUR COMMERCIAL RELATIONSHIP WITH IASPEC
Jiang Huai Lin’s association with iASPEC could pose a conflict of interest which may result in iASPEC decisions that are adverse to our business.
Jiang Huai Lin, our president and Chief Executive Officer and the beneficial owner of 38.61% of our common stock also beneficially owns 100% of the equity interests in iASPEC, from whom we derived 39.1%, 48.6% and 48% of our revenue in the fiscal years ended December 31, 2010, 2009 and 2008, respectively pursuant to existing commercial arrangements. As a result, conflicts of interest may arise from time to time and these conflicts may result in management decisions that could negatively affect our operations and potentially result in the loss of opportunities.
If iASPEC or its shareholders violate our contractual arrangements with it, our business could be disrupted and we may have to resort to litigation to enforce our rights which may be time consuming and expensive.
Our operations are currently dependent upon our commercial relationship with iASPEC. During the fiscal years ended December 31, 2010, 2009 and 2008, we derived 39.1%, 48.6% and 48% of our revenues, respectively, from the provision of services to iASPEC customers. A significant portion of these revenues have not yet been collected. Amounts owed by iASPEC under the Management Service Agreement for each quarter will be due and payable no later than the last day of the month following the end of each such quarter. If iASPEC or its shareholders are unwilling or unable to perform their obligations under our commercial arrangements with it, including payment of revenues under the Management Service Agreement as they become due each quarter, we will not be able to conduct our operations in the manner currently planned. In addition, iASPEC may seek to renew these agreements on terms that are disadvantageous to us. Although we have entered into a series of agreements that provide us with substantial ability to control iASPEC, we may not succeed in enforcing our rights under them. If we are unable to renew these agreements on favorable terms, or to enter into similar agreements with other parties, our business may not be able to operate or expand, and our operating expenses may significantly increase.
Uncertainties in the PRC legal system may impede our ability to enforce the commercial agreements that we have entered into with iASPEC or any arbitral award thereunder and any inability to enforce these agreements could materially and adversely affect our business and operation.
While disputes under the Management Service Agreement and the Option Agreement with iASPEC are subject to binding arbitration before the Shenzhen Branch of the China International Economic and Trade Arbitration Commission, or CIETAC, in accordance with CIETAC Arbitration Rules, the agreements are governed by PRC law and an arbitration award may be challenged in accordance with PRC law. For example, a claim that the enforcement of an award in our favor will be detrimental to the public interest, or that an issue does not fall within the scope of the arbitration would require us to engage in administrative and judicial proceedings to defend an award. China’s legal system is a civil law system based on written statutes and unlike common law systems, it is a system in which decided legal cases have little value as precedent. As a result, China’s administrative and judicial authorities have significant discretion in interpreting and implementing statutory and contractual terms, and it may be more difficult to evaluate the outcome of administrative and judicial proceedings and the level of legal protection available than in more developed legal systems. These uncertainties may impede our ability to enforce the terms of the Management Service Agreement, the Option Agreement and the other contracts that we may enter into with iASPEC. Any inability to enforce the Management Service Agreement and Option Agreement or an award thereunder could materially and adversely affect our business and operation.
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If iASPEC fails to comply with the confidentiality requirements of certain of its customer contracts, then iASPEC could be subject to sanctions and could lose its business license which in turn would significantly disrupt or shut down our operations.
The business and operations of iASPEC, the owner and licensor to us of the copyrighted software applications and other intellectual property that are essential to the operation of our business, is subject to Chinese contractual obligations and laws and regulations that restrict its use of security information and other information that it obtains from its customers in the public security sector. For some of its contracts with government agencies, iASPEC has agreed to keep confidential all technical and commercial secrets obtained during the performance of services under the contract. iASPEC or its shareholders could violate these contractual obligations and laws and regulations by inadvertently or intentionally disclosing confidential information or by otherwise failing to operate its business in a manner that complies with these contractual and legal obligations. A violation of these agreements could result in the significant disruption or shut down of our business or adversely affect our reputation in the market. If iASPEC or its shareholders violate these contractual and legal obligations, we may have to resort to litigation to enforce our rights under our contractual obligations with iASPEC. This litigation could result in the disruption of our business, diversion of our resources and the incurrence of substantial costs.
All of the share capital of iASPEC is held by our major shareholder, who may cause these agreements to be amended in a manner that is adverse to us.
Our major shareholder, Mr. Jiang Huai Lin, owns and controls iASPEC. As a result, Mr. Lin may be able to cause our commercial arrangements with iASPEC to be amended in a manner that will be adverse to our company, or may be able to cause these agreements not to be renewed, even if their renewal would be beneficial for us. Although we have entered into an agreement that prevents the amendment of these agreements without the approval of the members of our Board other than Mr. Lin, we can provide no assurances that these agreements will not be amended in the future to contain terms that might differ from the terms that are currently in place. These differences may be adverse to our interests.
Our arrangements with iASPEC and its shareholders may be subject to a transfer pricing adjustment by the PRC tax authorities which could have an adverse effect on our income and expenses.
We could face material and adverse tax consequences if the PRC tax authorities determine that our contracts with iASPEC and its shareholders were not entered into based on arm’s length negotiations. Although our contractual arrangements are similar to other companies conducting similar operations in China, if the PRC tax authorities determine that these contracts were not entered into on an arm’s length basis, they may adjust our income and expenses for PRC tax purposes in the form of a transfer pricing adjustment. Such an adjustment may require that we pay additional PRC taxes plus applicable penalties and interest, if any.
The shares purchased by the investors in our 2007 private placement transaction are subject to redemption in the event that the PRC government takes action that unwinds our restructuring transaction. Any such redemption would materially and adversely affect our liquidity and capital resources since we would have to return the funds raised in the private placement.
If any PRC governmental agency takes action that materially and adversely affects the transactions contemplated by the restructuring agreement and we are unable to reverse the adverse governmental action or otherwise address the material adverse effect to the reasonable satisfaction of the investors in the private placement transaction that closed on January 31, 2007 and February 5, 2007, within 60 days of the occurrence of such governmental action, then if asked, we are obligated, as liquidated damages, to redeem the shares purchased by such investors, within 30 days of their demand, for an amount equal to the investor’s entire investment amount without interest. If the PRC government takes action that triggers this redemption right, then our liquidity and capital resources would be materially adversely affected as we would be required to return the funds raised in the private placements. If we are required to return such funds we may required to sell assets or to seek financing on terms that are not favorable, if available at all, and our financial condition could be thereby materially and adversely affected.
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The exercise of our option to purchase part or all of the equity interests in or assets of iASPEC under the Option Agreement might be subject to approval by the PRC government. Our failure to obtain this approval may impair our ability to substantially control iASPEC and could result in actions by iASPEC that conflict with our interests.
Our Option Agreement with iASPEC gives our Chinese operating subsidiary, IST, the option to purchase all or part of the equity interests in or assets of iASPEC, however, the option may not be exercised by IST if the exercise would violate any applicable laws and regulations in China or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated. Under the laws of China, if a foreign entity, through a foreign investment company that it invests in, acquires a domestic related company, China’s regulations regarding Mergers and Acquisitions would technically apply to the transaction. Application of these regulations requires an examination and approval of the transaction by China’s Ministry of Commerce, or MOFCOM, or its local counterparts. Also, an appraisal of the equity or assets to be acquired is mandatory. However, the Zhong Lun Law Firm, our local PRC counsel has advised us that Shenzhen and other local counterparts of MOFCOM hold the view that such a transaction would not require their approval. Therefore, we do not believe at this time that an approval and an appraisal are required for IST to exercise its option to acquire iASPEC in Shenzhen. In light of the different views on this issue, however, it is possible that the central MOFCOM office in Beijing will issue a standardized opinion imposing the approval and appraisal requirement. If we are not able to purchase the equity or assets of iASPEC, then we will lose a substantial portion of our ability to control iASPEC and our ability to ensure that iASPEC will act in our interests.
Our right to elect a majority of the members on iASPEC’s Board of Directors and other provisions of the Management Service Agreement may be viewed by iASPEC’s customers as a change in control of iASPEC, which could subject iASPEC to sanctions and loss of its business license, which in turn would significantly disrupt or possibly terminate our operations.
Our new commercial arrangement with iASPEC gives us the right to designate two Chinese citizens to serve as senior managers of iASPEC, serve on iASPEC’s Board of Directors and assist in managing the business and operations of iASPEC. In addition, iASPEC will require the affirmative vote of the majority of the our Board of Directors, as well as at least one non-insider director, for completing certain material actions with respect to iASPEC, including, but not limited to: (a) the nomination, appointment, election or replacement of any board members; (b) the distribution of any dividend or profits; (c) any merger, division, change of corporate form, dissolution or liquidation; (d) any reimbursement of net losses or other payments or transfers of funds from IST to iASPEC; (e) the formation or disposition of a subsidiary or the acquisition or disposition of any interest in any other entity; and (f) the encumbrance of any assets under any lien not in the ordinary course of business. However, fulfillment of certain PGIS contracts with PRC Government customers is restricted to entities, such as iASPEC, that possess the necessary PRC government licenses and approvals, and any change in control may be viewed under PRC law as creating a new entity. If iASPEC’s government customers view these Management Service Agreement provisions as a change in control of iASPEC or as evidence of iASPEC’s failure to operate its business in a manner that complies with its contractual obligations or with related laws and regulations. Such a perception could result in the cancellation or invalidation of iASPEC’s licenses and permits. A loss by iASPEC of its licenses and permits could result in the significant disruption or possible termination of our business or adversely affect our reputation in the market.
RISKS RELATED TO DOING BUSINESS IN CHINA
Changes in China's political or economic situation could harm us and our operating results.
Economic reforms adopted by the Chinese government have had a positive effect on the economic development of the country, but the government could change these economic reforms or any of the legal systems at any time. This could either benefit or damage our operations and profitability. Some of the things that could have this effect are:
Level of government involvement in the economy;
Control of foreign exchange;
Methods of allocating resources;
Balance of payments position;
International trade restrictions; and
International conflict.
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The Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development, or OECD, in many ways. For example, state-owned enterprises still constitute a large portion of the Chinese economy, and weak corporate governance and the lack of a flexible currency exchange policy still prevail in China. As a result of these differences, we may not develop in the same way or at the same rate as might be expected if the Chinese economy was similar to those of the OECD member countries.
Uncertainties with respect to the PRC legal system could limit the legal protections available to you and us.
We conduct substantially all of our business through our operating subsidiaries in the PRC. Our operating subsidiaries are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to FIEs. The PRC legal system is based on written statutes, and prior court decisions may be cited for reference but have limited precedential value. Since 1979, a series of new PRC laws and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since the PRC legal system continues to evolve rapidly, the interpretations of many laws, regulations, and rules are not always uniform, and enforcement of these laws, regulations, and rules involve uncertainties, which may limit legal protections available to you and us. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention. In addition, most of our executive officers and directors are residents of China and not of the United States, and substantially all the assets of these persons are located outside the United States. As a result, it could be difficult for investors to affect service of process in the United States or to enforce a judgment obtained in the United States against our Chinese operations and subsidiary.
You may have difficulty enforcing judgments against us.
Most of our assets are located outside of the United States and most of our current operations are conducted in the PRC. In addition, most of our directors and officers are nationals and residents of countries other than the United States. A substantial portion of the assets of these persons is located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon these persons. It may also be difficult for you to enforce in U.S. courts judgments on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, most of whom are not residents in the United States and the substantial majority of whose assets are located outside of the United States. In addition, there is uncertainty as to whether the courts of the PRC would recognize or enforce judgments of U.S. courts. Our counsel as to PRC law has advised us that the recognition and enforcement of foreign judgments are provided for under the PRC Civil Procedures Law. Courts in China may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedures Law based on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. China does not have any treaties or other arrangements that provide for the reciprocal recognition and enforcement of foreign judgments with the United States. In addition, according to the PRC Civil Procedures Law, courts in the PRC will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment violates basic principles of PRC law or national sovereignty, security, or the public interest. So it is uncertain whether a PRC court would enforce a judgment rendered by a court in the United States.
The PRC government exerts substantial influence over the manner in which we must conduct our business activities.
The PRC government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to taxation, import and export tariffs, environmental regulations, land use rights, property, and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of the jurisdictions in which we operate may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations.
Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof and could require us to divest ourselves of any interest we then hold in Chinese properties or joint ventures.
If we fail to obtain or maintain all licenses and approvals required to operate our businesses in the PRC, our business and operations may be adversely affected.
Fulfillment of certain PGIS contracts with PRC Government customers is restricted to entities possessing the necessary government licenses and approvals which our subsidiary IST does not have. We currently perform PGIS contracts through iASPEC, which possesses the requisite licenses and approvals, pursuant to our Management Services Agreement with iASPEC, whereby iASPEC exclusively engages IST as its subcontractor to provide iASPEC with outsourcing services (to the extent that those services do not violate any special governmental permits held by iASPEC and do not involve the improper transfer of any sensitive confidential governmental or other data). If the PRC government determines that we are operating without the requisite licenses we may become subject to administrative penalties or an order to discontinue our business operations, both of which could have a material adverse effect on our business and results of operations.
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Future inflation in China may inhibit our ability to conduct business in China.
In recent years, the Chinese economy has experienced periods of rapid expansion and highly fluctuating rates of inflation. During the past ten years, the rate of inflation in China has been as high as 5.9% and as low as -0.8%. These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. High inflation may in the future cause the Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products and our company.
Restrictions on currency exchange may limit our ability to receive and use our sales effectively.
The majority of our sales will be settled in RMB, and any future restrictions on currency exchanges may limit our ability to use revenue generated in RMB to fund any future business activities outside China or to make dividend or other payments in U.S. dollars. Although the Chinese government introduced regulations in 1996 to allow greater convertibility of the RMB for current account transactions, significant restrictions still remain, including primarily the restriction that FIEs may only buy, sell or remit foreign currencies after providing valid commercial documents, at those banks in China authorized to conduct foreign exchange business. In addition, conversion of RMB for capital account items, including direct investment and loans, is subject to governmental approval in China, and companies are required to open and maintain separate foreign exchange accounts for capital account items. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB.
Fluctuations in exchange rates could adversely affect our business and the value of our securities.
The value of our common stock will be indirectly affected by the foreign exchange rate between the U.S. dollar and RMB and between those currencies and other currencies in which our sales may be denominated. Appreciation or depreciation in the value of the RMB relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue that will be exchanged into U.S. dollars, as well as earnings from, and the value of, any U.S. dollar-denominated investments we make in the future.
Since July 2005, the RMB has no longer been pegged to the U.S. dollar. Although the People’s Bank of China regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate, the RMB may appreciate or depreciate significantly in value against the U.S. dollar in the medium to long term. Moreover, it is possible that in the future PRC authorities may lift restrictions on fluctuations in the RMB exchange rate and lessen intervention in the foreign exchange market.
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and we may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert RMB into foreign currencies.
Restrictions under PRC law on our PRC subsidiaries’ ability to make dividends and other distributions could materially and adversely affect our ability to grow, make investments or acquisitions that could benefit our business, pay dividends to you, and otherwise fund and conduct our business.
Substantially all of our sales are earned by our PRC subsidiaries. However, PRC regulations restrict the ability of our PRC subsidiaries to make dividends and other payments to their offshore parent companies. PRC legal restrictions permit payments of dividends by our PRC subsidiaries only out of their accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Our PRC subsidiaries are also required under PRC laws and regulations to allocate at least 10% of their annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in said fund reaches 50% of their registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances, or cash dividends. Any limitations on the ability of our PRC subsidiaries to transfer funds to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.
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Failure to comply with PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident stockholders to personal liability, limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially adversely affect us.
In October 2005, SAFE issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, generally referred to as Circular 75, which required PRC residents to register with the competent local SAFE branch before establishing or acquiring control over an offshore special purpose company, or SPV, for the purpose of engaging in an equity financing outside of China on the strength of domestic PRC assets originally held by those residents. Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations. In the case of an SPV which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, a retroactive SAFE registration was required. Failure to comply with the requirements of Circular 75, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions. Any such failure could also result in the SPV’s affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the SPV, or from engaging in other transfers of funds into or out of China.
We have asked our stockholders who are PRC residents as defined in Circular 75 to register with the relevant branch of SAFE, as currently required, in connection with their equity interests in us and our acquisitions of equity interests in our PRC subsidiaries. However, we cannot provide any assurances that they can obtain the above SAFE registrations required by Circular 75. Moreover, because of uncertainty over how Circular 75 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders.
In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Circular 75. We also have little control over either our present or prospective direct or indirect stockholders or the outcome of such registration procedures. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with Circular 75, if SAFE requires it, could subject these PRC resident beneficial holders to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiaries’ ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.
We may be unable to complete a business combination transaction efficiently or on favorable terms due to complicated merger and acquisition regulations which became effective on September 8, 2006.
On August 9, 2006, six PRC regulatory agencies, including the China Securities Regulatory Commission, or CSRC, promulgated the Regulation on Mergers and Acquisitions of Domestic Companies by Foreign Investors, which became effective on September 8, 2006, and was amended in 2009. This new regulation, among other things, governs the approval process by which a PRC company may participate in an acquisition of assets or equity interests. Depending on the structure of the transaction, the new regulation will require the PRC parties to make a series of applications and supplemental applications to the government agencies. In some instances, the application process may require the presentation of economic data concerning a transaction, including appraisals of the target business and evaluations of the acquirer, which are designed to allow the government to assess the transaction. Government approvals will have expiration dates by which a transaction must be completed and reported to the government agencies. Compliance with the new regulations is likely to be more time consuming and expensive than in the past and the government can now exert more control over the combination of two businesses. Accordingly, due to the new regulation, our ability to engage in business combination transactions has become significantly more complicated, time consuming and expensive, and we may not be able to negotiate a transaction that is acceptable to our stockholders or sufficiently protect their interests in a transaction.
The new regulation allows PRC government agencies to assess the economic terms of a business combination transaction. Parties to a business combination transaction may have to submit to MOFCOM and other relevant government agencies an appraisal report, an evaluation report and the acquisition agreement, all of which form part of the application for approval, depending on the structure of the transaction. The regulations also prohibit a transaction at an acquisition price obviously lower than the appraised value of the PRC business or assets and in certain transaction structures, require that consideration must be paid within defined periods, generally not in excess of a year. The regulation also limits our ability to negotiate various terms of the acquisition, including aspects of the initial consideration, contingent consideration, holdback provisions, indemnification provisions and provisions relating to the assumption and allocation of assets and liabilities. Transaction structures involving trusts, nominees and similar entities are prohibited. Therefore, such regulation may impede our ability to negotiate and complete a business combination transaction on financial terms that satisfy our investors and protect our stockholders’ economic interests.
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Under the New Enterprise Income Tax Law, we may be classified as a “resident enterprise” of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC stockholders.
The EIT Law and its implementing rules became effective on January 1, 2008. Under the EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese enterprise for enterprise income tax purposes. The implementing rules of the EIT Law define de facto management as “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise.
On April 22, 2009, the State Administration of Taxation issued the Notice Concerning Relevant Issues Regarding Cognizance of Chinese Investment Controlled Enterprises Incorporated Offshore as Resident Enterprises pursuant to Criteria of de facto Management Bodies, or the Notice, further interpreting the application of the EIT Law and its implementation non-Chinese enterprise or group controlled offshore entities. Pursuant to the Notice, an enterprise incorporated in an offshore jurisdiction and controlled by a Chinese enterprise or group will be classified as a “non-domestically incorporated resident enterprise” if (i) its senior management in charge of daily operations reside or perform their duties mainly in China; (ii) its financial or personnel decisions are made or approved by bodies or persons in China; (iii) its substantial assets and properties, accounting books, corporate chops, board and shareholder minutes are kept in China; and (iv) at least half of its directors with voting rights or senior management often resident in China. A resident enterprise would be subject to an enterprise income tax rate of 25% on its worldwide income and must pay a withholding tax at a rate of 10% when paying dividends to its non-PRC shareholders. However, it remains unclear as to whether the Notice is applicable to an offshore enterprise incorporated by a Chinese natural person. Nor are detailed measures on imposition of tax from non-domestically incorporated resident enterprises are available. Therefore, it is unclear how tax authorities will determine tax residency based on the facts of each case.
We may be deemed to be a resident enterprise by Chinese tax authorities. If the PRC tax authorities determine that we are a “resident enterprise” for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences could follow. First, we may be subject to the enterprise income tax at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations. In our case, this would mean that income such as interest on financing proceeds and non-China source income would be subject to PRC enterprise income tax at a rate of 25%. Second, although under the EIT Law and its implementing rules dividends paid to us from our PRC subsidiaries would qualify as “tax-exempt income,” we cannot guarantee that such dividends will not be subject to a 10% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes. Finally, it is possible that future guidance issued with respect to the new “resident enterprise” classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC stockholders and with respect to gains derived by our non-PRC stockholders from transferring our shares. We are actively monitoring the possibility of “resident enterprise” treatment for the 2011 tax year and are evaluating appropriate organizational changes to avoid this treatment, to the extent possible.
If we were treated as a “resident enterprise” by PRC tax authorities, we would be subject to taxation in both the U.S. and China, and our PRC tax may not be creditable against our U.S. tax.
We face uncertainty from China’s Circular on Strengthening the Administration of Enterprise Income Tax on Non-Resident Enterprises' Share Transfer that was released in December 2009 with retroactive effect from January 1, 2008.
The Chinese State Administration of Taxation, or SAT, released a circular on December 15, 2009 that addresses the transfer of shares by nonresident companies, generally referred to as Circular 698. Circular 698, which is effective retroactively to January 1, 2008, may have a significant impact on many companies that use offshore holding companies to invest in China.
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Circular 698, which provides parties with a short period of time to comply with its requirements, indirectly taxes foreign companies on gains derived from the indirect sale of a Chinese company. Where a foreign investor indirectly transfers equity interests in a Chinese resident enterprise by selling the shares in an offshore holding company, and the latter is located in a country or jurisdiction where the effective tax burden is less than 12.5% or where the offshore income of his, her, or its residents is not taxable, the foreign investor is required to provide the tax authority in charge of that Chinese resident enterprise with the relevant information within 30 days of the transfers. Moreover, where a foreign investor indirectly transfers equity interests in a Chinese resident enterprise through an abuse of form of organization and there are no reasonable commercial purposes such that the corporate income tax liability is avoided, the PRC tax authority will have the power to re-assess the nature of the equity transfer in accordance with PRC’s “substance-over-form” principle and deny the existence of the offshore holding company that is used for tax planning purposes. There is uncertainty as to the application of Circular 698. For example, while the term “indirectly transfer” is not defined, it is understood that the relevant PRC tax authorities have jurisdiction regarding requests for information over a wide range of foreign entities having no direct contact with China. Moreover, the relevant authority has not yet promulgated any formal provisions or formally declared or stated how to calculate the effective tax in the country or jurisdiction and to what extent and the process of the disclosure to the tax authority in charge of that Chinese resident enterprise. In addition, there are not any formal declarations with regard to how to decide “abuse of form of organization” and “reasonable commercial purpose”, which can be utilized by us to balance if our Company complies with the Circular 698. As a result, we may become at risk of being taxed under Circular 698 and we may be required to expend valuable resources to comply with Circular 698 or to establish that we should not be taxed under Circular 698, which could have a material adverse effect on our financial condition and results of operations.
We may be exposed to liabilities under the Foreign Corrupt Practices Act and Chinese anti-corruption laws, and any determination that we violated these laws could have a material adverse effect on our business.
We are subject to the Foreign Corrupt Practice Act, or FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute, for the purpose of obtaining or retaining business. We have operations, agreements with third parties, and make most of our sales in China. The PRC also strictly prohibits bribery of government officials. Our activities in China create the risk of unauthorized payments or offers of payments by the employees, consultants, sales agents, or distributors of our Company, even though they may not always be subject to our control. It is our policy to implement safeguards to discourage these practices by our employees. However, our existing safeguards and any future improvements may prove to be less than effective, and the employees, consultants, sales agents, or distributors of our Company may engage in conduct for which we might be held responsible. Violations of the FCPA or Chinese anti-corruption laws may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition. In addition, the U.S. government may seek to hold our Company liable for successor liability FCPA violations committed by companies in which we invest or that we acquire.
RISKS RELATED TO THE MARKET FOR OUR STOCK
We may be subject to penny stock regulations and restrictions and you may have difficulty selling shares of our common stock.
The SEC has adopted regulations which generally define so-called “penny stocks” to be an equity security that has a market price less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exemptions. Our common stock may become a “penny stock” and subject to Rule 15g-9 under the Exchange Act, or the Penny Stock Rule. This rule imposes additional sales practice requirements on broker-dealers that sell such securities to persons other than established customers and “accredited investors” (generally, individuals with a net worth in excess of $1,000,000 or annual incomes exceeding $200,000, or $300,000 together with their spouses). For transactions covered by Rule 15g-9, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to sale. As a result, this rule may affect the ability of broker-dealers to sell our securities and may affect the ability of purchasers to sell any of our securities in the secondary market, thus possibly making it more difficult for us to raise additional capital.
For any transaction involving a penny stock, unless exempt, the rules require delivery, prior to any transaction in penny stock, of a disclosure schedule prepared by the SEC relating to the penny stock market. Disclosure is also required to be made about sales commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Finally, monthly statements are required to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stock.
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There can be no assurance that our common stock will qualify for exemption from the Penny Stock Rule. In any event, even if our common stock were exempt from the Penny Stock Rule, we would remain subject to Section 15(b)(6) of the Exchange Act, which gives the SEC the authority to restrict any person from participating in a distribution of penny stock, if the SEC finds that such a restriction would be in the public interest.
The market price of our common stock is volatile, leading to the possibility of its value being depressed at a time when you want to sell your holdings.
The market price of our common stock is volatile, and this volatility may continue. Numerous factors, many of which are beyond our control, may cause the market price of our common stock to fluctuate significantly. These factors include:
our earnings releases, actual or anticipated changes in our earnings, fluctuations in our operating results or our failure to meet the expectations of financial market analysts and investors;
changes in financial estimates by us or by any securities analysts who might cover our stock;
speculation about our business in the press or the investment community;
significant developments relating to our relationships with our customers or suppliers;
stock market price and volume fluctuations of other publicly traded companies and, in particular, those that are in the our industries;
customer demand for our products;
investor perceptions of the our industry in general and our company in particular;
the operating and stock performance of comparable companies;
general economic conditions and trends;
major catastrophic events;
announcements by us or our competitors of new products, significant acquisitions, strategic partnerships or divestitures;
changes in accounting standards, policies, guidance, interpretation or principles;
loss of external funding sources;
sales of our common stock, including sales by our directors, officers or significant stockholders; and
additions or departures of key personnel.
Securities class action litigation is often instituted against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs to us and divert our management’s attention and resources. Moreover, securities markets may from time to time experience significant price and volume fluctuations for reasons unrelated to operating performance of particular companies. For example, in July 2008, the securities markets in the United States, China and other jurisdictions experienced the largest decline in share prices since September 2001. These market fluctuations may adversely affect the price of our common stock and other interests in our company at a time when you want to sell your interest in us.
We do not intend to pay dividends for the foreseeable future.
For the foreseeable future, we intend to retain any earnings to finance the development and expansion of our business, and we do not anticipate paying any cash dividends on our common stock. Accordingly, investors must be prepared to rely on sales of their common stock after price appreciation to earn an investment return, which may never occur. Investors seeking cash dividends should not purchase our common stock. Any determination to pay dividends in the future will be made at the discretion of our board of directors and will depend on our results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law and other factors our board deems relevant.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
We have no outstanding or unresolved comments from the SEC staff.
ITEM 2.
ITEM 2. PROPERTIES.
All land in China is owned by the state or collectives. Individuals and companies are permitted to acquire rights to use land or land use rights for specific purposes. In the case of land used for industrial purposes, the land use rights are granted for a period of 50 years. This period may be renewed at the expiration of the initial and any subsequent terms according to the relevant Chinese laws. Granted land use rights are transferable and may be used as security for borrowings and other obligations.
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Prior to June 2007, our subsidiary IST occupied space in offices pursuant to a six month rental agreement. In June 2007, we moved into our new executive offices located on the 21st Floor of the Everbright Bank Bldg., Zhuzilin, Futian District, Shenzhen, China, for which IST currently has land use rights. Our new executive offices consist of approximately 1,200 square meters, all of which are dedicated to administrative office space. We have fully paid the land use fees. Our other property primarily consists of computer equipment, servers, licensed software, some furniture and fixtures. There is no lien on any of our property and we currently do not have any intention to make large scale improvements or developments with respect to these properties.
iASPEC and Bocom lease offices, employee dormitories and factory space in Shenzhen, Guangzhou, Beijing and Wuhan in the PRC, pursuant to lease agreements that will expire on various dates through November 2011. Rent expense for the years ended December 31, 2010, 2009 and 2008, was approximately $380,000, $386,200 and $337,000, respectively.
We believe that all our properties have been adequately maintained, are generally in good condition, and are suitable and adequate for our business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are currently not aware of any such legal proceedings or claims that we believe will have a material adverse affect on our business, financial condition or operating results.
ITEM 4.
ITEM 4. (REMOVED AND RESERVED).
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Market Information
Our common stock is traded on the Nasdaq Global Select Market under the symbol “CNIT.”
The following table sets forth, for the periods indicated, the high and low closing prices of our common stock. These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
(1) The above table sets forth the range of high and low closing prices per share of our common stock as reported by www.quotemedia.com for the periods indicated.
Approximate Number of Holders of Our Common Stock
As of February 28, 2011, there were approximately 9,372 holders of record of our common stock. This number excludes the shares of our common stock owned by stockholders holding stock under nominee security position listings.
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Dividend Policy
We have never declared dividends or paid cash dividends. Our board of directors will make any future decisions regarding dividends. We currently intend to retain and use any future earnings for the development and expansion of our business and do not anticipate paying any cash dividends in the near future.
Securities Authorized for Issuance Under Equity Compensation Plans
On June 13, 2007, our Board of Directors authorized the establishment of the China Information Security Technology, Inc. Equity Incentive Plan, or Plan, whereby we are authorized to issue shares of our common stock to certain employees, consultants and directors. At that time we reserved 8,000,000 shares of our common stock for issuance under the Plan.
On November 27, 2007, we issued 70,000 shares of common stock to our senior management and an outside consultant as bonus awards.
On March 20, 2008 our Board of Directors approved the grant of 400,000 stock awards to certain employees of the Company. These newly granted shares vested quarterly at 1/4 over a one-year period following the grant.
On February 2, 2009, we granted eligible employees a total of 60,000 shares of our common stock as compensation under the Plan.
On January 12, 2010, we granted eligible employees a total of 213,363 shares of common stock as compensation under the Plan.
On September 25, 2010, the Company granted eligible employees a total of 250,000 shares of the Company's common stoc k as compensation under the Plan.
On February 8, 2011, the Company granted eligible employees a total of 250,000 shares of the Company’s common stock as compensation under Plan.
Recent Sales of Unregistered Securities
We have not sold any equity securities during the fiscal year ended December 31, 2010 that were not previously disclosed in a quarterly report on Form 10-Q or a current report on Form 8-K that was filed during the 2010 fiscal year.
Purchases of Equity Securities
No repurchases of our common stock were made during the fourth quarter of 2010.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated statement of income and comprehensive income data for the years ended December 31, 2010, 2009 and 2008 and the selected balance sheet data as of December 31, 2010 and 2009 are derived from our audited consolidated financial statements included elsewhere in this report. The selected consolidated financial data for the years ended December 31, 2007 and 2006 and the selected balance sheet data as of December 31, 2008 and 2007 are derived from our audited consolidated financial statements not included in this report.
The following selected historical financial information should be read in conjunction with our consolidated financial statements and related notes and the information contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
For business combinations during the years ended December 31, 2008, 2009 and 2010, see Item 1, Acquisitions, in this Report.
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(All amounts, except for share and per share amounts, in U.S. dollars)
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following management’s discussion and analysis should be read in conjunction with our financial statements and the notes thereto and the other financial information appearing elsewhere in this report. In addition to historical information, the following discussion contains certain forward-looking information. See “Special Note Regarding Forward Looking Statements” above for certain information concerning those forward looking statements. Our financial statements are prepared in U.S. dollars and in accordance with U.S. GAAP.
Overview
We are a leading provider of integrated solutions for the Geographic Information Systems, or GIS, Digital Public Security Technology, or DPST and the Digital Hospital Information Systems, or DHIS markets, in the PRC. We provide a broad portfolio of fully integrated solutions and services, encompassing both software development and display technologies.
We were founded in 1993 and are headquartered in Shenzhen, China. As of December 31, 2010, we had 1,453 employees and 27 sales offices nationwide.
Our customers are mostly public sector entities that use our products and services to improve the service quality and management level and efficiency of public security, traffic control, fire control, medical rescue, border control, and surveying and mapping. Our typical customers include some of the most important governmental departments in China, including the State Bureau of Surveying and Mapping, the State Grid Corporation, the Ministry of Public Security, the public security, fire fighting, traffic and police departments of several provinces, the Shenzhen General Station of Exit and Entry Frontier Inspection, and several provincial personnel, urban planning, civil administration, land resource, and mapping and surveying bureaus. Over the past several years, we have diversified our customer base beyond our local reach. In the future, we expect to continually expand our market and product offerings in the public and private sectors, through geographic expansion and enhancement of our technical capabilities.
We generate revenues through the sale of our hardware and software products and through the provision of related support services. A significant portion of our operations are conducted through iASPEC, our variable interest entity. iASPEC is a PRC domestic company owned by Jiang Huai Lin, our Chairman and Chief Executive Officer, who is a PRC citizen and resident. iASPEC is able to obtain governmental licenses that are restricted to PRC entities that have no foreign ownership. These licenses allow iASPEC to perform PGIS services for PRC governmental customers. Under our Amended and Restated Management Services Agreement among our subsidiary, IST, iASPEC and Mr. Lin, IST is entitled to receive 95% of the net received profit of iASPEC during the term of the Agreement, less costs and expenses related to sales and operations, and accrued but uncollected accounts receivable. In fiscal years 2010, 2009 and 2008, 39.1%, 48.6% and 48% of our revenues, respectively, were generated under this exclusive commercial arrangement with iASPEC.
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Fiscal Year 2010 Financial Performance Highlights
We continued to experience strong demand for our products and services during the fiscal year ended December 31, 2010, which resulted in revenue and net income growth. The following are some financial highlights for the year:
Revenue: Revenue increased $62.85 million, or 62.23%, to $163.85 million for the fiscal year ended December 31, 2010, from $101 million for 2009.
Gross profit: Gross profit increased $19.91 million, or 39.31%, to $70.56 million for the fiscal year ended December 31, 2010, from $50.65 million for 2009. Gross margin decrease by 708 basis points to 43.07% in 2010 from 50.15% in 2009.
Income from continuing operations: Income from continuing operations increased $5.34 million, or 17.71%, to $35.47million for the fiscal year ended December 31, 2010, from $30.14 million for 2009. Operating margin (defined as income from continuing operations as a percentage of revenue) decrease by 819 basis points to 21.65% in 2010 from 29.84% in 2009.
Net income attributable to the company: Net income was $34.40 million for the fiscal year ended December 31, 2010, as compared to $30.09 million for 2009, a 14.31% increase. As a result, net margin contracted by 880 basis points to 21 % in 2010 from 29.80% in 2009.
Fully diluted net income per share from continuing operations: Fully diluted net income per share from continuing operations was $0.66 for the fiscal year ended December 31, 2010, as compared to $0.62 for the same period in 2009, representing a growth of 6.45%.
The total value of our backlog of contracts as of December 31, 2010 is estimated to be approximately $28.88 million.
Principal Factors Affecting Our Financial Performance
Demand for Software Products and Services
The revenue growth and profitability of our business depend on the overall market demand for software products and related services. Over the past two decades, the PRC government has encouraged the development and use of new technologies for information and communication and their application in all spheres of government, industry, education and culture. The term “Informatization” or “xinxihua” has been coined in China to describe the overall process of ICT application in China and has in recent years become a linchpin of central and many local economic development strategies.
For example, the Golden Shield Program promotes the use of information technology for public security services. The Digital City Program aims to ultimately integrate the functions of multiple government departments by using the GIS technology. The Golden Health Program strives to improve the efficiency of public health care by using digital hospital technologies. All these initiatives are of top priority to the Chinese government and are driving the demand for our DPST, GIS and DHIS offerings.
Taxation
CNIT is subject to United States tax at a tax rate of 34%. No provision for income taxes in the United States has been made as CNIT has no income taxable in the United States.
CPSH and HPC Intl was incorporated in the BVI, but is not subject to taxation in that jurisdiction.
ISSI, ISIID, Kwong Tai and HPC HK were incorporated in Hong Kong and under the current laws of Hong Kong, are subject to Profits Tax of 16.5%.
Under the EIT Law, Geo, Iaspec, Bocom and Zhongtian, are approved as high-technology enterprises and are subject to EIT at a rate of 15% in 2010. ISS and Huipu are subject to EIT at a rate of 22% in 2010. IST enjoys a two-year tax exemption, followed by a 50% exemption for three years, retroactive to as of January 1, 2007. Year 2010 was the forth year that IST was entitled to the tax holiday and subject to a favorable tax rate of 11%. Since the EIT Law permits companies, such as IST, that were previously exempt from taxes or that had concessional rates to retain their preferences until the original expiration date, the EIT Law does not impact IST’s income tax qualification to enjoy a 50% tax exemption in fiscal year 2010 and will continue to qualify for a 50% tax exemption for the one year thereafter.
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Business Segment Information
Segment information is consistent with how management reviews the businesses, makes investing and resource allocation decisions and assesses operating performance. Transfers and sales between reportable segments, if any, are recorded at cost.
Our segment reporting follows the organizational structure as reflected in our internal management reporting systems, which are the basis for assessing the financial performance of the business segments and for allocating resources to the business segments.
We report financial and operating information in the following four segments:
GIS Segment, which includes the PGIS and Civil-Use GIS sales;
DPST Segment, formerly known as the “Digital Information Security Technology Segment,” which includes revenues from information security related projects;
DHIS Segment, which includes revenues from digital information systems provided to hospitals or medical institutes;
Other Products and Services, which include new offerings under market assessment or development outside the existing main business segments. When a meaningful stand-alone segment is formed, such a new segment will be separated from this category.
We also provide general corporate services to our segments and these costs are reported as “Corporate and others.”
For more information regarding our operating segments, see Note 16 (Consolidated Segment Data) to our audited consolidated financial statements included elsewhere in this report.
Results of Operations
Comparison of Fiscal Years Ended December 31, 2010 and
The following table sets forth key components of our results of operations for fiscal years ended December 31, 2010 and 2009, both in dollars and as a percentage of our revenue.
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Revenue.
Our revenue is generated from our hardware and software products and through the related after-sales services. For the year ended December 31, 2010, our revenue was $163.85 million, compared to $101 million for the year ended December 31, 2009, an increase of $62.85 million, or 62.23%. The total revenue exceeded our plan primarily because progress on a few contracts was accelerated at client’s requests. In addition, our new offering of display technology products turned out faster than expected. Finally, we also liquidated some of HPC’s inventory that is not aligned with the new strategic direction as part of the restructuring process. During the year, Huipu, which was acquired in October 2009, contributed $42.26 million to revenues. Excluding the impact of Huipu, organic revenue growth was 26.23%.
Software sales increased by 41.66% to $90.42 million for the year ended December 31, 2010, from $63.83 million for the year ended December 31, 2009. Software sales constituted 55.19% of our total revenue, as compared to 63.20% during the prior year. Excluding the impact of Huipu, software sales were 74.37% of organic revenues, which reflects our continued commitment to our core competency in software.
Product sales increased by $36.54 million, or 217.72%, for the year ended December 31, 2010, as compared to $16.78 million in 2009 primarily due to the sales of display technology products and the liquidation of HPC’s inventory described earlier. Product sales constituted 32.55% of total revenue during the current period as compared with 16.62% during the prior year. Excluding the impact of Huipu, the percentage of organic product revenues decreased to 11.99% for the year 2010, from 12.35% for the prior year.
Sales of system integration services decreased by 14.40% for the year ended December 31, 2010, as compared to 2009. As a percentage of revenue, it declined from 18.83% during the year ended December 31, 2009 to 9.94% during 2010. Excluding the impact of Huipu, system integration was 13.39% of organic revenues.
Other revenue increased by 179.60%, from $1.37 million in the year ended December 31, 2009 to $3.82 million in 2010. Other revenue mainly derived from maintenance services in the year ended December 31, 2009, while in 2010, other income consisted of both maintenance services and royalty income from Huipu by licensing other manufacturers to use the HPC trademark.
The following table shows our revenue by segment:
GIS accounted for 43.28% of the total revenue while DPST, DHIS and Other Products and Services represented 43.12%,11.09% and 2.51%, respectively. These compared to 36.46%, 53.66%, 9.88% and nil of the total revenue for the year ended December 31, 2009. The shifts in segment weights reflected the GIS and DHIS segments outpacing DPST in their growth momentum. This is the direct result of our focus in the last few years on targeting at areas with the highest barriers-to-entry and developing sustainable competitive advantages in the GIS and DHIS segments, in anticipation of accelerating market growth in the coming years. The addition of Other Products and Services represents our new market developments, primarily in display technology products.
Cost of Revenue and Gross Profit. As indicated in the table below, our cost of revenues increased $42.94 million, or 85.29%, to $93.28 million, for the year ended December 31, 2010, from $50.34 million for the year 2009. As a percentage of revenues, our cost of revenue increased to 56.93% during the year 2010, from 49.89% in 2009. As a result, gross profit as a percentage of revenue was 43.07% for the year ended December 31, 2010, a decrease of 7.08%, from 50.15% in 2009. Huipu yielded a gross margin of 16.81%. Excluding the impact of Huipu, gross margin of organic business was 52.19%, exceeding the organic gross margin of 51.84% in 2009. Such an increase in organic gross margin is primarily due to the increased weight of software business relative to total organic business.
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The decrease in the overall gross margin resulted from a number of factors. First, during the year 2010, our product sales increased in weight relative to total revenues. Such increase was accelerated due to the clearance of HPC’s non-strategic inventory as well as our faster-than expected sales of display technology products. Since the average gross margin of products is lower than the other categories of revenues, the overall gross margin declined. Meanwhile, gross margin of product categories declined by 557 basis points mostly because the clearance of HPC’s non-strategic inventory was done at cost and the sales of the new display technology products did not enjoy economies of scale due to the low volume in the beginning. In addition, we experienced decline of gross margins of software on a year-over-year basis. This is because we were engaged in larger software projects on average than 2009, and larger projects generally offer lower profit margin than smaller ones. The negative impact on gross margin from the above factors was partially mitigated by the improvement in profitability in system integration and increased weight in other revenues.
For the year ended December 31, 2010, approximately $41.70 million of our cost of revenues was attributable to our DPST segment, $39.70 million was attributable to our GIS segment, $8.02 million was attributable to our DHIS segment and $3.86 million was attributable to our Other Products and Services segement, compared to $31.67 million to DPST, $15.41 million to GIS , $3.27 million by DHIS and nil by others, respectively, during 2009.
Administrative Expenses. Administrative expenses consist primarily of compensation and benefits to our general management, finance and administrative staff, professional advisor fees, audit fees and other expenses incurred in connection with general operations. Total administrative expenses increased by $5.97 million, or 47.18%, to $18.62 million for the year ended December 31, 2010, from $12.65 million in the year 2009. As a percentage of revenue, administrative expenses decreased to 11.37% for the year 2010, from 12.53% for the year 2009. Some notable changes that resulted in the increase of administrative expenses are: 1) the increase of stock based compensation expenses of $1.67 million; 2) the increase of depreciation and amortization expenses of $1.85 million partly because the depreciation and amortization expenses of HPC impacted the full year of 2010 whereas they only affected the last three months of fiscal year 2009. Also contributing to the increase was the addition of properties, plants and equipment for future business growth and 3) the addition of provision for long term investment in Tianhe of $0.85 million. 4) the increase of bad debt provision for accounts receivable of $0.89 million. Also contributing to the increase were the expenses incurred in new representative offices.
Research and Development Expenses. Research and development expenses consist primarily of personnel-related expenses as well as costs associated with new software product development and enhancement. For the year ended December 31, 2010, research and development expenses increased to $3.02 million, from $2.71 million in the year 2009, a $0.31 million, or 11.5% increase. As a percentage of revenue, the research and development expenses decreased 0.84% to 1.84% for 2010, from 2.68% in 2009. Such decrease was due to the fact that research and development investments made from prior years are yielding scalable effects in revenue growth.
Selling Expenses. Selling expenses consist primarily of compensation and benefits to our sales and marketing staff, sales and after-sales traveling cost, and other sales related costs. Selling expenses increased $3.22 million for the year ended December 31, 2010, or 102.77%, to $6.36 million, from $3.14 million in 2009. As a percentage of revenue, our selling expenses increased to 3.88% for 2010, from 3.11% in 2009. The selling expenses outpacing revenue growth reflects our heightened efforts in national market expansion.
Subsidy Income. For the year ended December 31, 2010 and 2009, in connection with research and development activities in a designated locale, we received approximately $948,630, $833,429, respectively as a subsidy from the local governmental agency in China.
Income Tax Expense. Income tax expense increased $3.98 million for the year ended December 31, 2010, or 102.28%, to $7.86 million, from $3.89 million in 2009. The increase was mainly due to the increase in pre-tax income and an increase in our effective income tax rate from 11.43% in 2009 to 18.14% in 2010 as a result of the tax unification program in China.
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Non-controlling Interest. Non-controlling interest of $1,071,626 for the year ended December 31, 2010 represents the $893,316 fee retained by iASPEC under the Management Service Agreement and $178,310 of Geo’s profit attributable to its 47.46% non-controlling interest.
Net income attributable to the Company. As a result of the factors described above, net income attributable to the Company increased $4.31 million, or 14.31%, to $34.4 million for the year ended December 31, 2010, from $30.09 million for 2009.
Comparison of Fiscal Years Ended December 31, 2009 and
The following table sets forth key components of our results of operations for fiscal years ended December 31, 2009 and 2008, both in dollars and as a percentage of our revenue.
Revenue. Our revenue is generated from our hardware and software products and through the related after-sales services. For the year ended December 31, 2009, our revenue was $101 million, compared to $85.30 million for the year ended December 31, 2008, an increase of $15.70 million, or 18.40%. Our increase in revenues during 2009 was attributable to an increase in our software sales of 82.58% to $63.83 million, from $34.96 million for the year ended December 31, 2008. Software sales constituted 63.20% of our total revenue.
Sales of hardware products included $4.68 million contributed by Huipu in November and December of 2009. Sales of hardware products and system integration services decreased by 37.42% and 1.61%, respectively, for the year ended December 31, 2009, as compared to 2008.
These changes are reflective of our increased focus on high value-added offerings surrounding our core competency, which warrant higher gross margin
The following table shows our revenue by segment:
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(1) The DHIS segment was started in November 2008, so the full-year comparison is skewed by the difference in time periods that contributed to the consolidated results.
Cost of Revenue and Gross Profit. As indicated in the table below, our cost of revenues increased $4.12 million, or 8.92%, to $50.34 million, for the year ended December 31, 2009, from $46.22 million for the year 2008. As a percentage of revenues, our cost of revenue decreased to 49.85% during the year 2009, from 54.19% in 2008. As a result, gross profit as a percentage of revenue was 50.15% for the year ended December 31, 2009, an increase of 4.34%, from 45.81% in 2008.
The increase is the result of three counter-active factors. First, during the year 2009, we sharpened our focus on high value-added offerings surrounding our core competency, which led to the weight of software contribution to revenue to 63.20% in 2009 from 41.0% in 2008. The gross margin of software is 65.17%, significantly higher than those of hardware of 19.2% and system integration of 25.1%. In the meantime, we experienced decline of gross margins of software and system integration sub-categories on a year-over-year basis. This is because we were engaged in larger projects on average than 2008, and larger projects generally offer lower profit margin than smaller ones. Finally, as we focused our product business on high-end hardware, the gross margin of our product subcategory increased significantly from 2008. In the end, the benefit of the product mix change in favor of software and the improvement in profitability of hardware business out-weighed the decline in profitability of software and system integration business. Consequently, the gross margin improved year-over-year.
For the year ended December 31, 2009, approximately $31.67 million of our cost of revenues was attributable to our DPST segment, $15.41 million was attributable to our GIS segment and $3.27 million was attributable to our DHIS segment, compared to $31.51 million to DPST, $14.68 million to GIS and $35,577 by DHIS, respectively, during the year 2008. Gross margins for all segments improved.
Administrative Expenses. Administrative expenses consist primarily of compensation and benefits to our general management, finance and administrative staff, professional advisor fees, audit fees and other expenses incurred in connection with general operations. Total administrative expenses increased by $2.49 million, or 24.55%, to $12.65 million for the year ended December 31, 2009, from $10.16 million in the year 2008. As a percentage of revenue, administrative expenses increased to 12.53% for the year 2009, from 11.91% for the year 2008. Such a ratio incline reflects our efforts in enhancing managerial capabilities which lead to higher compensation to staff and increased head count. Such investment shall yield managerial efficiency in the long run.
Research and Development Expenses. Research and development expenses consist primarily of R&D personnel-related expenses as well as costs associated with new software product development and enhancement. For the year ended December 31, 2009, research and development expenses increased to $2.71 million, from $2.60 million in the year 2008, a $0.11 million, or 4.21%, increase. As a percentage of revenue, the research and development expenses decreased 0.36% to 2.68% for 2009, from 3.04% in 2008. This ratio decline reflects the revenue scalability of the R&D results.
Selling Expenses. Selling expenses consist primarily of compensation and benefits to our sales and marketing staffs, business travels after-sale support, transportation costs and other sales related costs. Selling expenses increased $0.7 million for the year ended December 31, 2009, or 28.69%, to $3.14 million, from $2.44 million in 2008. As a percentage of revenue, our selling expenses decreased to 2.68% for 2009, from 2.86% in 2008.
Subsidy Income. For the year ended December 31, 2009, in connection with research and development activities in a designated locale, we received approximately $833,429 as a subsidy from the local governmental agency in China.
Income Tax Expense. Income tax expense increased $2.34 million for the year ended December 31, 2009, or 151.21%, to $3.89 million, from $1.55 million in 2008. The increase was mainly due to the increase in pre-tax income and an increase in our effective income tax rate from 6.23% in 2008 to 11.43% in 2009. Our subsidiaries, ISS, Zhongtian and Huipu are subject to EIT at a rate of 20% of assessable profits in 2009, compared to 18% for 2008, an increase of 2%. Our VIE, iASPEC (exclusive of Geo) acquired the high technology enterprise qualification during 2009, and became subject to EIT at a rate of 15%, decrease of 3% compared with 18% in 2008. As a High-Tech Enterprise, Geo is subject to EIT at a rate of 15% of assessable profits. However, after offsetting accumulated losses from prior years, Geo had no assessable profits subject to EIT for the year ended December 31, 2009. As a software company, IST was entitled to a two-year exemption from EIT followed by a 50% tax exemption for the next 3 years. In 2008, IST enjoyed tax exemption. From 2009 through 2011, IST is subject to a favorable tax rate of 10%, 11% and 12%, respectively.
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Non-controlling Interest. Non-controlling interest of $43,076 for the year ended December 31, 2009 represents the $180,000 fee retained by iASPEC under the Management Service Agreement, and $136,926 of Geo’s losses attributable to its 43% non-controlling interest.
Net income attributable to the Company. As a result of the factors described above, net income attributable to the Company increased $6.31 million, or 26.52%, to $30.09 million for the year ended December 31, 2009, from $23.79 million for 2008. During November and December of 2009, Huipu generated a net loss of $197,803. This near break-even result is in line with our expectation, as Huipu is going through significant strategic changes and restructuring upon the close of our acquisition on October 14, 2009. We believe that as Huipu completes the restructuring process, it will realize the economies of scale and optimize efficiency to realize the goals set in the earn-out provisions, which is to earn a minimum of $3.2 million in net profit for 2010.
Liquidity and Capital Resources
As of December 31, 2010, we had cash and cash equivalents of $18.17 million. The following table summarizes the key cash flow components from our condensed consolidated statements of cash flows for the periods indicated.
Cash Flow
(all amounts in U.S. dollars)
Operating Activities
Net cash provided by operating activities was $26.95 million for the year ended December 31, 2010, an increase of $15.47 million or, 134.8%, from $11.48 million net cash provided by operating activities for 2009. This increase far outpaced revenue growth of 62.23%. Such an increase was primarily due to the improvements in working capital turnover, including the speeding up of the turn-over of accounts receivable and inventories.
For fiscal 2009, net cash provided by our operating activities increased by $6.93 million, or 152.4%, as compared to fiscal 2008. Such an increase in net cash provided by operating activities, while revenues expanded by 18.4%, reflected improved operating cash flow management in 2009. The increase was mainly due to the improvement in working capital turnover.
Investing Activities
Net cash used in our investing activities was $62.36 million for the year ended December 31, 2010, as compared to $14.66 million net cash used in investing activities for 2009. Approximately $25.31 million of the total was used as the deposit for purchasing land use rights under local government incentives. Details have been provided in Footnote 10(a), Item 1, Part I of this report and Footnote 17 (Subsequent Event), Item 1, Part I of the Form 10Q/A for the quarterly period ended June 30, 2010. Approximately $32.82 million was used to purchase machineries, equipment and software as an investment for future business expansion.
For fiscal 2009, net cash used by our investing activities decreased by $6.38 million, or 30.3%, as compared to fiscal 2008. The decrease was mainly due to a decrease in cash used for acquisitions of $8.02 million, with Huipu being the only acquisition in 2009, as compared with 3 acquisitions completed in 2008, a decrease in proceeds from investments of $3.45 million and a decrease of capital expenditure of $1.8 million.
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Financing Activities
Net cash provided by our financing activities increased to $38.56 million during the year ended December 31, 2010, as compared to $7.11 million during 2009. The increase was mainly attributable to the net proceeds of $9.38 million raised in issuing of common stock, an increase in net bank borrowings of $22.44 million, and an increase in net borrowings from shareholders’ long-term loan of $5 million. Geo also received capital injection of $1.74 million from minority shareholders.
For fiscal 2009, net cash provided by our financing activities increased by $1.89 million, as compared to fiscal 2008. The increase was mainly due to an increase in net borrowings under short-term bank loans of $1.2 million, a decrease in long-term loan repayment of $734,000 and a purchase of treasury stock in 2009 of $11,500.
Loan Facilities
As of December 31, 2010, the amount, maturity date and duration of each of our loan facilities were as follows:
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Obligations Under Material Contracts
The following table sets forth our material contractual obligations as of December 31, 2010:
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires our management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements, including the notes thereto, and related disclosures of commitments and contingencies, if any. We consider our critical accounting policies to be those that require the more significant judgments and estimates in the preparation of financial statements, including the following:
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Goodwill-ASC 350-30-50, We review goodwill and intangible assets with indefinite lives for impairment on an annual basis and whenever events or circumstances indicate that the carrying value may not be recoverable. Goodwill is assessed for impairment using a two-step test. In the first step, the fair value of each reporting unit is compared to its carrying amount. If the fair value of the reporting unit exceeds the carrying amount, no impairment exists and we are not required to perform further testing. If the carrying amount exceeds its fair value, the second step must be performed to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of the reporting unit’s goodwill exceeds its implied fair value, then an impairment loss is recorded in an amount equal to that excess. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions. Valuation techniques we use to measure fair value is the income approach. It includes discounted cash flow measurements using a market discount rate. Our valuation techniques could yield variable results based on changes in assumptions such as the discount rate and long-term growth rate and forecasted revenue and expense. Our annual impairment analysis indicated a fair value for goodwill that was above its book value. Accordingly, no impairment loss was charged against earnings.
•
Revenue Recognition-Revenues from products are recognized only when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price to the customer is fixed or determinable, and collectability is reasonably assured. Generally, revenue is recognized (1) upon shipment for equipment and software, (2) as work is performed for professional services and (3) in equal periodic amounts over the term of the contract for software and hardware maintenance.
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The majority of revenues are generated from fixed-price contracts, which provide for licenses to software products, and services to customize such software to meet customers' use. Generally, when the services are determined to be essential to the functionality of the delivered software, revenue is recognized using the percentage of completion method of accounting. The percentage of completion for each contract is estimated based on the ratio of direct labor hours incurred to total estimated direct labor hours. We review accounts receivables for allowances whenever events or changes in circumstances indicates that the related carrying amounts may not be recoverable, losses on accounts receivables are provided when they become evident.
•
Accounts Receivable-We regularly evaluates and monitors the creditworthiness of each customer on a case-by-case basis. We include any account balances that are determined to be uncollectible in an allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. The allowance for doubtful accounts at December 31, 2010 and 2009, totaled $6,073,000 and $3,123,000 respectively, representing management’s best estimate.
•
Inventories -We valued inventories at the lower of cost or market. Market is the estimated selling price in the ordinary course of business less the estimated cost of completion and the estimated costs necessary to make the sale. We perform an analysis of slow-moving or obsolete inventory periodically and any necessary valuation reserves, which could potentially be significant, are included in the period in which the evaluations are completed.
•
Income Taxes - Income taxes are provided on an asset and liability approach for financial accounting and reporting of income taxes. Deferred income taxes are recognized for all significant temporary differences at enacted rates and classified as current or non-current based upon the classification of the related asset or liability in the financial statements. A valuation allowance is provided to reduce the amount of deferred tax assets if it is considered more likely than not that some portion of, or all, the deferred tax asset will not be realized. The Company classifies interest and/or penalties related to unrecognized tax benefits, if any, as a component of income tax provisions.
Recent Accounting Pronouncements
In April 2010, the FASB issued Accounting Standards Update No. 2010-17, Revenue Recognition - Milestone Method (Topic 605) - Revenue Recognition (ASU 2010-17). ASU 2010-17 provides guidance on defining the milestone and determining when the use of the milestone method of revenue recognition for research or development transactions is appropriate. It provides criteria for evaluating if the milestone is substantive and clarifies that a vendor can recognize consideration that is contingent upon achievement of a milestone as revenue in the period in which the milestone is achieved, if the milestone meets all the criteria to be considered substantive. ASU 2010-17 is effective for us in fiscal 2011 and should be applied prospectively. The adoption of ASU 2010-17 did not have any effect on the Company’s financial position or results of operations.
In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends ASC Topic 820, Fair Value Measurement and Disclosure (“ASC 820”) to require a number of additional disclosures regarding fair value measurements. In addition to the new disclosure requirements, ASU 2010-06 also amends ASC 820 to clarify that reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities. Prior to the issuance of ASU 2010-06, the guidance in ASC 820 required separate fair value disclosures for each major category of assets and liabilities.
ASU 2010-06 also clarifies the requirement for entities to disclose information about both the valuation techniques and inputs used in estimating Level 2 and Level 3 fair value measurements. Except for the requirement to disclose information about purchases, sales, issuance and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, all of the provisions of ASU 2010-06 are effective for interim and annual reporting periods beginning after December 15, 2009, or January 1, 2010 for the Company. The requirement to separately disclose purchases, sales, issuances and settlements of recurring Level 3 measurements does not become effective until fiscal years beginning after December 15, 2010, or January 1, 2011 for the Company. The adoption of ASU 2010-06 is for disclosure purposes only and did not have any effect on the Company’s financial position or results of operations.
In June 2009, the FASB issued guidance now codified within ASC Topic 810, Consolidation (“ASC 810”). ASC 810 requires entities to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity. This analysis identifies the primary beneficiary of a variable interest entity as one with the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and obligation to absorb losses of the entity that could potentially be significant to the variable interest. The guidance is effective as of the beginning of the annual reporting period commencing after November 15, 2009, or January 1, 2010 for the Company, with early adoption prohibited. The adoption of the guidance codified within ASC 810 did not have any effect on the Company’s financial position or results of operations.
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In October 2009, the FASB issued ASU 2009-13, “Multiple-Deliverable Revenue Arrangements,” (amendments to FASB ASC Topic 605, “Revenue Recognition”) (ASU 2009-13) and ASU 2009-14, “Certain Arrangements That Include Software Elements,” (amendments to FASB ASC Topic 985, “Software”) (ASU 2009-14). ASU 2009-13 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. ASU 2009-14 removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. ASU 2009-13 and ASU 2009-14 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company considered the adoption of ASU 2009-13 or ASU 2009-14 would have no material impact to consolidated results of operations and financial condition.
Seasonality
The first quarter of the calendar year is typically the slowest season of the year due to the Chinese New Year holiday. During this period, accounts receivable collection is very slow and we also need to prepare for upcoming busier seasons by making payments for inventory.
Inflation
Inflationary factors such as increases in the cost of our product and overhead costs may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net revenues if the selling prices of our products do not increase with these increased costs.
Off-Balance Sheet Arrangements
We do not have any off-balance arrangements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Interest Rate Risk
We deposit surplus funds with Chinese banks earning daily interest. We do not invest in any instruments for trading purposes. Most of our outstanding debt instruments carry fixed rates of interest. Our operations generally are not directly sensitive to fluctuations in interest rates. The amount of long-term debt outstanding as of December 31, 2010 and 2009 was $11 million and $2 million, respectively. A hypothetical 1.0% increase in the annual interest rates for all of our credit facilities under which we had outstanding borrowings at December 31, 2010, would decrease net income before provision for income taxes by approximately $235,000, or less than 1% for the fiscal year ended December 31, 2010. Management monitors the banks’ prime rates in conjunction with our cash requirements to determine the appropriate level of debt balances relative to other sources of funds. We have not entered into any hedging transactions in an effort to reduce our exposure to interest rate risk.
Foreign Exchange Risk
While our reporting currency is the U.S. dollars, substantially all of our consolidated revenues and consolidated costs and expenses are denominated in RMB. Substantially all of our assets are denominated in RMB except for cash. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be affected by fluctuations in the exchange rate between U.S. dollars and RMB. If the RMB depreciates against the U.S. dollars, the value of our RMB revenues, earnings and assets as expressed in our U.S. dollars financial statements will decline. Assets and liabilities are translated at exchange rates at the balance sheet dates and revenue and expenses are translated at the average exchange rates and equity is translated at historical exchange rates. Any resulting translation adjustments are not included in determining net income but are included in determining other comprehensive income, a component of equity. An average appreciation (depreciation) of the RMB against the U.S. dollars of 5% would increase (decrease) our comprehensive income by $10.46 million based on our outstanding revenues, costs and expenses, assets and liabilities denominated in RMB as of December 31, 2010. As of December 31, 2010, our accumulated other comprehensive income was $11.33 million. We have not entered into any hedging transactions in an effort to reduce our exposure to foreign exchange risk.
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The value of RMB against the U.S. dollars and other currencies is affected by, among other things, changes in China’s political and economic conditions. Since July 2005, RMB has not been pegged to the U.S. dollars. Although the People’s Bank of China regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate, RMB may appreciate or depreciate significantly in value against the U.S. dollars in the medium to long term. Moreover, it is possible that in the future, PRC authorities may lift restrictions on fluctuations in RMB exchange rate and lessen intervention in the foreign exchange market.
Inflation
Inflationary factors such as increases in the cost of our product and overhead costs may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net revenues if the selling prices of our products do not increase with these increased costs.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Consolidated Financial Statements
The full text of our audited consolidated financial statements as of December 31, 2010 and 2009 begins on page of this report.
Quarterly Financial Results
The following table sets forth certain unaudited financial information for each of the eight quarters ended December 31, 2010. The consolidated financial statements for each of these quarters have been prepared on the same basis as the audited consolidated financial statements included in this annual report and, in the opinion of management, include all adjustments necessary for the fair presentation of the results of operations for these periods. This information should be read together with our audited consolidated financial statements and the related notes included elsewhere in this annual report.
(All amounts in U.S. dollars, except for per share amounts)
Earnings per share are computed independently for each of the quarters presented. Therefore, the sum of the quarterly net earnings per share will not necessarily equal the total for the year.
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ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As required by Rule 13a-15(e), our management has carried out an evaluation, with the participation and under the supervision of our Chief Executive Officer, Mr. Jiang Huai Lin and our Chief Financial Officer, Ms. Jackie You Kazmerzak, of the effectiveness of the design and operation of our disclosure controls and procedures, as of December 31, 2010. Based upon, and as of the date of this evaluation, Mr. Lin and Ms. Kazmerzak, determined that, as of December 31, 2010, and as of the date of this report, our disclosure controls and procedures were effective.
Management’s Annual Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting refers to the process designed by, or under the supervision of, our chief executive officer and chief financial officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP, and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that our receipts and expenditures are being made only in accordance with the authorization of our management and directors; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2010. In making this assessment, management used the framework set forth in the report entitled Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. The COSO framework summarizes each of the components of a company’s internal control system, including (i) the control environment, (ii) risk assessment, (iii) control activities, (iv) information and communication, and (v) monitoring. Based on our assessment, we determined that, as of December 31, 2010, the Company’s internal control over financial reporting was effective based on those criteria.
Our independent registered public accounting firm, BDO Limited, has issued an audit report on our internal control over financial reporting. Their audit report is set forth under Item 8 of this Annual Report on Form 10-K.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting during the fourth quarter of fiscal year 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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ITEM 9B.
ITEM 9B. OTHER INFORMATION.
We have no information to disclose that was required to be disclosed in a report on Form 8-K during fourth quarter of fiscal year 2010, but was not reported.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The information required by Item 10 of Part III is included in our Proxy Statement for our 2010 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 of Part III is included in our Proxy Statement for our 2010 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by Item 12 of Part III is included in our Proxy Statement for our 2010 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The information required by Item 13 of Part III is included in our Proxy Statement for our 2010 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information required by Item 14 of Part III is included in our Proxy Statement for our 2010 Annual Meeting of Stockholders and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
Financial Statements and Schedules
The financial statements are set forth under Item 8 of this annual report on Form 10-K. Financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included.
Exhibit List
The following exhibits are filed as part of this report or incorporated by reference:
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- 49 -
*Filed herewith.
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SIGNATURES
In accordance with section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant caused this Report on Form 10-K to be signed on its behalf by the undersigned, thereto duly authorized individual.
Date: March 8, 2011
CHINA INFORMATION TECHNOLOGY, INC.
By: /s/ Jiang Huai Lin
Jiang Huai Lin
Chief Executive Officer
By: /s/ Jackie You Kazmerzak
Jackie You Kazmerzak
Chief Financial Officer
In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Jiang Huai Lin
Chairman and Chief Executive Officer March 8, 2011
Jiang Huai Lin
(Principal Executive Officer)
/s/ Jackie You Kazmerzak
Chief Financial Officer March 8, 2011
Jackie You Kazmerzak
(Principal Financial and Accounting Officer)
/s/ Zhiqiang Zhao
Director and Chief Operating Officer March 8, 2011
Zhiqiang Zhao
/s/ Yun Sen Huang
Director March 8, 2011
Yun Sen Huang
/s/ Qiang Lin
Director March 8, 2011
Qiang Lin
/s/ Remington Hu
Director March 8, 2011
Remington Hu
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CHINA INFORMATION TECHNOLOGY, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2010 AND 2009
-F- 1 -
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF
CHINA INFORMATION TECHNOLOGY, INC.
We have audited the accompanying consolidated balance sheet of China Information Technology, Inc. and its subsidiaries and variable interest entity (the “Company”) as of December 31, 2010 and the related consolidated statements of income, comprehensive income, changes in equity and cash flows for the year ended December 31, 2010. We have also audited the Company’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A Report of the Company’s Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorisations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2010 and the results of its operation and its cash flows for the year ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
BDO Limited
Hong Kong, March 8, 2011
-F- 2 -
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
China Information Security Technology, Inc.
We have audited the accompanying consolidated balance sheet of China Information Security Technology, Inc. and subsidiaries as of December 31, 2009, and the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the years in the two-year period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of China Information Security Technology, Inc. and subsidiaries as of December 31, 2009, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, during 2009 the provisions of new accounting standards relating to business combinations and non-controlling interests were adopted.
/s/ GHP HORWATH, P.C.
Denver, Colorado
March 5, 2010
-F- 3 -
CHINA INFORMATION TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2010 AND 2009
Expressed in U.S. dollars (Except for share amounts)
-F- 4 -
The accompanying notes are an integral part of these consolidated financial statements
-F- 5 -
CHINA INFORMATION TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008
Expressed in U.S. dollars (Except for share amounts)
-F- 6 -
The accompanying notes are an integral part of these consolidated financial statements
-F- 7 -
CHINA INFORMATION TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008
Expressed in U.S. dollars
The accompanying notes are an integral part of these consolidated financial statements
-F- 8 -
CHINA INFORMATION TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008
Expressed in U.S. dollars (Except for share amounts)
The accompanying notes are an integral part of these consolidated financial statements
-F- 9 -
CHINA INFORMATION TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008
Expressed in U.S. dollars
-F- 10 -
The accompanying notes are an integral part of these consolidated financial statements
-F- 11 -
On February 1, 2008, 1,125,000 shares of common stock were issued and a further 1,280,807 were reserved for issuance for the equity portion of the purchase price of approximately $5,120,000 of Bocom and Zhongtian.
On November 11, 2009, 1,101,930 shares of common stock were issued for the equity portion of the purchase price of approximately $8,462,800 of Huipu.
In 2009, upon achievement of earn out targets by ISS, Bocom and Zhongtian, approximately 905,164 previously issued shares became no longer returnable and resulted in additional equity purchase consideration and goodwill of approximately $5,575,810.
In 2010, upon achievement of earn out target by Zhongtian, 355,164 previously issued shares became no longer returnable and resulted in additional equity purchase consideration and goodwill of $1,850,405. Huipu achieved earn out target in 2010 and 330,578 shares will be issued for equity portion of purchase price of Huipu.
-F- 12 -
CHINA INFORMATION TECHNOLOGY, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 and 2008
1. ORGANIZATION AND PRINCIPAL ACTIVITIES
China Information Technology, Inc. (the "Company" or “CNIT”), and its subsidiaries, is a provider of integrated solutions for Geographic Information Systems (GIS), digital public security technology (DPST), and digital hospital information systems (DHIS), as well as display technologies. These services are provided through the Company’s wholly-owned PRC subsidiaries, Information Security Technology (PRC) Co., Ltd ("IST"), Information Security Software (China) Co., Ltd (formerly, Information Security Development Technology Co., Ltd), or "ISS," Shenzhen Bocom Multimedia Display Technology Co., Ltd ("Bocom"), Shenzhen Zhongtian Development Company Ltd (“Zhongtian”) and Huipu Electronics (Shenzhen) Co., Ltd (“Huipu”), and through the Company’s variable interest entity ("VIE"), iASPEC Software Company Limited ("iASPEC"), and its subsidiary, Wuda Geoinformatics Co., Ltd ("Geo").
On April 2, 2007, China Public Security Technology, Inc. ("CPST") entered into an Agreement and Plan of Merger (the "Merger Agreement") with CNIT, a Nevada corporation and wholly-owned subsidiary of CPST. Pursuant to the Merger Agreement, CPST agreed to merge with and into CNIT, with CNIT being the surviving entity (the "Reincorporation Merger"). The Reincorporation Merger became effective on April 7, 2008. The Reincorporation Merger was effected by an exchange of shares of CPST into shares of CNIT on a one-for-one basis. As a result of the Reincorporation Merger, CPST became domiciled in Nevada and its name was changed to China Information Technology, Inc. All assets, liabilities, contracts and obligations of CPST became the assets, liabilities, contracts and obligations of CNIT. References to the Company are to CNIT as successor to CPST and its subsidiaries.
Business Turnkey Agreement
On October 9, 2006, IST, entered into a Business Turnkey Agreement, as amended (the “Turnkey Agreement”) with iASPEC Software Company Limited, (formerly Shenzhen iASPEC Software Engineering Company Limited) (“iASPEC”), a PRC company controlled by Mr. Lin, the Company’s Chairman and Chief Executive Officer (“Mr Lin”). iASPEC is a software development company that provides public security information technology, Police-Use Geographic Information Systems (“PGIS”) and Civil-Use Geographic Information Systems (“CGIS”) operating services to government and private customers in the PRC. Under the Turnkey Agreement, IST was to pay an annual fee of $180,000 to iASPEC and was to perform all services necessary for iASPEC to fulfill its customer contracts in exchange for 100% or 90% of the revenues from such contracts, depending on the contract. In addition, under the Turnkey Agreement, iASPEC granted IST an exclusive, royalty-free, transferable, worldwide perpetual license to use and install iASPEC’s proprietary software. No other tangible assets or liabilities were transferred to IST under the Turnkey Agreement.
Effective July 1, 2007, IST, iASPEC and iASPEC’s then shareholders, Mr. Lin and Mr. Jin Zhu Cai, terminated the Turnkey Agreement, and replaced it with a Management Service Agreement (“MSA”).
Management Service Agreement
Pursuant to the terms of the MSA, iASPEC granted IST a ten-year, exclusive, royalty-free, transferable worldwide license to use and install certain iASPEC software, along with copies of source and object codes relating to such software. In addition, IST licensed back to iASPEC a royalty-free, limited, non-exclusive license to the software, without right of sub-license, for the sole purpose of permitting iASPEC to carry out its business as presently conducted. IST has the right to designate two Chinese citizens to serve as senior managers of iASPEC, to serve as a majority on iASPEC’s Board of Directors, and to assist in managing the business and operations of iASPEC. In addition, both iASPEC and IST will require the affirmative vote of a majority of the Company’s Board of Directors, including at least one non-insider director, for certain material actions, as defined, with respect to iASPEC.
Under the MSA, IST receives 100% of the net received profit of iASPEC, and reimburses iASPEC for all net losses incurred by iASPEC, as such terms are defined in the MSA, and iASPEC is permitted to retain $180,000 per year out of the net received profits. The MSA also provides that IST may advance to iASPEC, at its sole discretion, amounts to be credited against IST’s future obligations to iASPEC. Any such advances are treated as prepayments and not as loans and iASPEC has no obligation to repay any such advances except by crediting the amount of such advances against IST’s obligation to reimburse net losses, or by adding the amount thereof to net received profit when and as requested by IST. The parties to the MSA also agreed to the calculation of a true-up amount, consisting of the cumulative net profit or net losses of iASPEC from October 9, 2006 to June 30, 2007, when iASPEC commenced its contractual relationship with IST, through the date of the MSA.
-F- 13 -
In connection with the MSA, IST also entered into an immediately exercisable purchase option agreement (“Option Agreement”) with iASPEC and its shareholders, pursuant to which the iASPEC shareholders granted the Company or its designee(s) an exclusive, irrevocable option to purchase, from time to time, all or a part of iASPEC’s shares or iASPEC’s assets from the iASPEC shareholders for $1,800,000 in the aggregate. The option may not be exercised if the exercise would violate any applicable laws and regulations in the PRC or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated.
The substance of the MSA and the Option Agreement is to:
•
Allow the Company to utilize the business licenses, contacts, permits and other resources of iASPEC in order for the Company to be able to expand its operations and business model;
•
Provide the Company with effective control over all of iASPEC's operations;
•
Allow the shareholders of iASPEC an opportunity to monetize a portion of their investment through the $1.8 million purchase option.
As a result of the MSA and the Option Agreement, on July 1, 2007 iASPEC became a Variable Interest Entity (VIE) of the Company. Accordingly, this transaction has been accounted for on a basis similar to reorganization between entities under common control, and iASPEC’s results are consolidated in the Company’s financial statements. To comply with PRC laws and regulations that restrict foreign ownership of companies that provide public security information technology and Geographic Information Systems software operating services to certain government and other customers, the Company operates the restricted aspect of its business through iASPEC.
Amended and Restated MSA
On December 13, 2009, IST, iASPEC and Mr. Lin, as the sole iASPEC shareholder, amended and restated the MSA (the "Amended and Restated MSA"), pursuant to which IST will continue to provide management and consulting services to iASPEC, subject to the following changes:
•
iASPEC agreed that IST will be entitled to receive ninety five percent (95%) of the Net Received Profit, as defined, of iASPEC during the term of the Agreement. iASPEC is obligated to calculate and pay the Net Received Profit due to IST no later than the last day of the first month following the end of each fiscal quarter;
•
Mr. Lin agreed to enter into a pledge agreement with IST to pledge all of his equity interests in iASPEC as security for his and iASPEC's fulfillment of their respective obligations under the MSA, and to register the pledge agreement with the local AIC (Administration for Industry and Commerce);
•
Mr. Lin confirmed his status as the sole iASPEC shareholder and his assumption of all of the obligations of the iASPEC shareholder under the agreement, including a confirmation of his continuing obligation under the written guaranty, dated August 1, 2007, executed by the then iASPEC shareholders in connection with the MSA;
•
Based on iASPEC’s needs for its development and operation, IST has the right, from time to time, at its sole discretion, to provide iASPEC with capital support
•
IST agreed that it will not interfere in any business of iASPEC covered by iASPEC’s PRC State Secret related Computer Information System Integration Certificate, including but not limited to, seeking access to relevant documents regarding such business; provided, however, that iASPEC agreed that it will cooperate with the requests of the Company as necessary to comply with the Company’s reporting obligations to the Securities and Exchange Commission.
The Company has performed a reassessment of its VIE relationship with iASPEC as a result of the Amended and Restated MSA and concluded that iASPEC continues to be the Company’s VIE.
In May 2008, IST entered into a contractual joint venture agreement with Huipu to set up a joint venture project in manufacturing and sales of LCD screens. According to the contract, the Company provided funds to the project for equipment acquisition, repayable by Huipu if certain revenue and income targets were not met. This contractual arrangement resulted in a variable interest, as the Company was the primary beneficiary of the project.
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In May 2008, IST also entered into a contractual joint venture agreement with Lianchengwen Technology (Shenzhen) Co., Ltd. ("LTS"), to set up a joint venture project in leasing LED screens. According to the contract, the Company provided funds to the project for equipment acquisition, repayable by LTS if certain revenue and income targets were not met. This contractual arrangement also resulted in the creation of a variable interest, as the Company was the primary beneficiary of the project.
Effective December 31, 2008, the contractual joint venture agreements were terminated and the cash flows of these two JV’s has been eliminated from IST’s ongoing operations and IST has no continuing involvement in the VIEs. Accordingly, the assets and liabilities and revenues and expenses of the joint ventures are no longer included in the Company’s consolidated financial statements and $718,000, representing IST’s agreed-upon share of the VIEs’ net income from inception through termination, has been recorded as income from discontinued operations. The Company received a refund of its $4.1 million investment in LTS in the second quarter of 2009. During the third quarter of 2009, the Company and Huipu agreed to offset the receivable for the refund of IST’s investment in the joint venture of approximately $4.4 million, with advances made by Huipu to iASPEC. In October 2009, the Company acquired Huipu in a purchase transaction (Note 5).
On September 3, 2010, Wuda Geoinformatics Co., Ltd (“Geo”), a majority-owned subsidiary of iASPEC Software Co, Ltd (“iASPEC”), the variable interest entity of China Information Technology, Inc. (the “Company”), increased its registered capital from RMB 60,000,000 (approximately $8,849,680) to RMB 79,200,000 (approximately $11,681,588). The RMB 19,200,000 (approximately $2,831,900) increase was contributed by iASPEC, the minority shareholders of Geo and a group of new shareholders, comprising of the management teams of both GEO and iASPEC, including Mr. Jianghuai Lin, the Company’s chief executive officer and the sole shareholder of iASPEC.
The board of directors of iASPEC and the Company approved iASPEC’s less than pro rata contribution of RMB 7,410,000 (approximately $1,092,936), and approved the participation of the management teams of Geo and iASPEC in the capital increase as an incentive and to align their interests with the interests of Geo and iASPEC. As a result of the capital increase, the equity interest owned by iASPEC in Geo was reduced from 57% to 52.54%, and the management teams of Geo and iASPEC now hold 11.02% of the equity interest in Geo.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Consolidation
The consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles. The consolidated financial statements include the accounts of the Company, its subsidiaries and its VIE for which the Company is the primary beneficiary. All significant intercompany accounts and transactions have been eliminated in consolidation.
(b) Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Management makes these estimates using the best information available at the time the estimates are made; however actual results could differ from those estimates.
(c) Economic and Political Risks
The majority of the Company’s operations are conducted in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy. The Company's operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.
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(d) Cash and Cash Equivalents
The Company considers all highly liquid investments purchased and cash deposits with financial institutions with original maturities of three months or less to be cash equivalents.
The Company maintains its cash accounts at credit worthy financial institutions and closely monitors the movements of its cash positions. At December 31, 2010 and 2009, approximately $18.17 million and $13.48 million, respectively was held in bank accounts in the PRC.
(e) Restricted Cash
Restricted cash as of December 31, 2010 consists of security deposits in bank accounts in the PRC that serve as collateral for the Company's revolving working capital facility.
(f) Accounts Receivable, Bills Receivable and Concentration of Risk
During the normal course of business, the Company extends unsecured credit to its customers. The Company regularly evaluates and monitors the creditworthiness of each customer on a case-by-case basis. The Company includes any account balances that are determined to be uncollectible in an allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance.
Bills receivable represent bank undertakings that essentially guarantee payment of amounts thereunder. The undertakings are provided by banks upon receipt of collateral deposits from the Company’s customers or debtors. Bills receivable can be sold at a discount before maturity, which is typically within three months.
Accounts receivable include $67.62 million and $47.85 million of unbilled accounts receivable at December 31, 2010 and 2009, respectively. Unbilled accounts receivable consist of estimated future billings for work performed but not yet invoiced to the customer. Unbilled accounts receivable are generally invoiced upon the completion of work orders, which is estimated to be within one year.
The Company’s top five customers accounted for 16% of accounts receivable as of December 31, 2010, of which no single customer accounted for greater than 10% or more of accounts receivable. The Company’s top five customers accounted for 31% of accounts receivable as of December 31, 2009, of which no single customer accounted for greater than 10% or more of accounts receivable.
For the year ended December 31, 2010, no single customer accounted for 10% or more of total revenue. For the year ended December 31, 2009, no single customer accounted for 10% or more of total revenue. For the year ended December 31, 2008, one customers accounted for 13% of the revenue and no other customer contributed greater than 10% of revenue. The allowance for doubtful accounts at December 31, 2010 and 2009, totaled $6,073,000 and $3,123,000 respectively, representing management’s best estimate.
(g) Advances to Suppliers
Advances to suppliers represents cash deposits for the purchase of inventory items from suppliers.
(h) Advances from Customers
Advances from customers represents cash received from customers as advance payments for the purchase of the Company’s products.
(i) Fair Value of Financial Instruments and Fair Value Accounting
Financial Instruments
Management has estimated that the carrying amounts of non-related party financial instruments approximate their fair values due to their short-term maturities. The fair value of the amount due from (to) related parties is not practicable to estimate due to the related party nature of the underlying transactions.
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Fair Value Accounting
Financial Accounting Standards Board Accounting Standards Codification (ASC) No. 820.10 (“FASB ASC 820.10) establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). As required by FASB ASC 820.10, assets are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The three levels of the fair value hierarchy under FASB ASC 820.10 are described below:
During the year ended December 31, 2009, the Company completed a business acquisition in which non-financial assets and liabilities were initially measured at fair value using level 3 inputs.
(g) Inventories
Inventories are valued at the lower of cost or market. Market is the estimated selling price in the ordinary course of business less the estimated cost of completion and the estimated costs necessary to make the sale.
The Company performs an analysis of slow-moving or obsolete inventory periodically and any necessary valuation reserves, which could potentially be significant, are included in the period in which the evaluations are completed.
For the years ended December 31, 2010 and 2009, approximately 40%, 33%, respectively of total inventory purchases were from five unrelated suppliers. One supplier accounted for 10.6% of total inventory purchase in 2010 and no other suppliers accounted for greater than 10% of total inventory purchases. Two suppliers accounted for 11.5% and 10.3% of total inventory purchase in 2009 and no other suppliers accounted for greater than 10% of total inventory purchases.
(k) Long-term Investments
Long-term investments are carried at cost. If a decline in the fair value of a cost method investment is determined to be other than temporary, an impairment charge is recorded and the fair value becomes the new cost basis of the investment. Management evaluates all cost method investments for impairment; however, the fair value of the cost method investments is not required to be determined unless impairment indicators are present. When impairment indicators exist, discounted cash flow analyses are generally used to estimate the fair value.
(l) Property, plant and equipment
Property, plant and equipment are stated at cost less accumulated amortization and depreciation. Amortization and depreciation is provided over the assets' estimated useful lives, using the straight-line method. Estimated useful lives of property, plant and equipment are as follows:
Maintenance and repairs costs are expensed as incurred, whereas significant renewals and betterments are capitalized.
(m) Land use rights
All land in the PRC is owned by the PRC government. The government in the PRC, according to the PRC law, may sell the right to use the land for a specified period of time. Thus, all of the Company’s land purchases in the PRC are considered to be leasehold land under operating lease arrangement and are stated at cost less accumulated amortization and any recognized impairment loss. The cost of the land use right is amortized on a straight-line basis over the beneficial period, 46 years.
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(n) Intangible assets
Intangible assets represent technology-based intangible assets acquired in connection with business acquisitions and software development costs capitalized by the Company’s subsidiaries.
Intangible assets are being amortized using the straight-line method over the following estimated useful lives:
(o) Goodwill
ASC 350-30-50, “Goodwill and Other Intangible Assets”, requires the testing of goodwill and indefinite-lived intangible assets for impairment at least annually. The Company tests goodwill for impairment in the fourth quarter each year.
Under applicable accounting guidance, the goodwill impairment analysis is a two-step test. The first step of the goodwill impairment test involves comparing the fair value of each reporting unit with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value, the second step must be performed to measure potential impairment.
The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated possible impairment. If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of goodwill, an impairment charge is recorded for the excess.
(p) Long-Lived Assets
Long-lived assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. It is reasonably possible that these assets could become impaired as a result of technology or other industry changes. Determination of recoverability of assets to be held and used is determined by comparing the carrying amount of an asset to future net undiscounted cash flows to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets held for disposal, if any, are reported at the lower of the carrying amount or fair value less costs to sell.
(q) Revenue Recognition
The Company generates its revenues primarily from three sources, (1) hardware sales, (2) software sales and (3) system integration services. The Company's revenue recognition policies are in accordance with SEC Staff Accounting Bulletin No. 104, "Revenue Recognition" and Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) No.605.35 ("FASB ASC 605.35") .
Revenues from hardware products are recognized only when persuasive evidence of an arrangement exists, delivery has occurred and upon receipt of customers' acceptance, the price to the customer is fixed or determinable in accordance with the contract, and collectability is reasonably assured.
Software revenues are generated from fixed-price contracts which include the development of software products, and services to customize such software to meet customers' needs. Generally, when the services are determined to be essential to the functionality of the delivered software, revenue is recognized using the percentage of completion method of accounting in accordance with FASB ASC 605.35. The percentage of completion for each contract is estimated based on the ratio of direct labor hours incurred to total estimated direct labor hours. The Company provides post contract support (PCS), which includes telephone technical support, that is not essential to the functionality of the software. Although vendor-specific objective evidence does not exist for PCS, because (1) the PCS fees are included in the total contract amount, (2) the PCS service period is for less than one year, (3) the estimated cost of providing PCS is not significant, and (4) unspecified upgrades/ enhancements offered are minimal and infrequent; the Company recognizes PCS revenue together with the initial fee after delivery and customer acceptance of the software products.
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System integration revenues are generated from fixed-price contracts which provide for software development and hardware integration, which involves more than minor modifications to the functionality of the software and hardware products. Accordingly, system integration revenues are accounted for in accordance with FASB ASC 605.35, using the percentage of completion method of accounting. The percentage of completion for each contract is estimated based on the ratio of costs incurred to total estimated costs. Contract periods are usually less than six months, and typical contract periods for PCS are 12 months.
System integration projects are billed in accordance with contract terms, which typically require partial payment at the signing of the contract, at delivery and customer acceptance dates, with the remainder due within a stated period of time not exceeding 12 months. Occasionally, the Company enters into contracts which allow a percentage of the total contract price to be paid one to three years after completion of the system integration project. Revenues on these extended payments are recognized upon completion of the terms specified in the contract and when collectability is reasonably assured.
No rights of return are allowed except for non-conforming products, which have been insignificant based on historical experiences. If non-conforming products are returned due to software issues, the Company will provide upgrades or additional customization to suit customers' needs. In cases where non-conformity is a result of integrated hardware, the Company returns the hardware to the original vendor for replacement.
Unbilled accounts receivable consist of estimated future billings for work performed but not yet invoiced to the customer. Unbilled accounts receivable are generally invoiced within one year of completion of the work performed. Changes in estimates for revenues, costs and profits are recognized in the period in which they are determinable. When the Company's estimates indicate that the entire contract will be performed at a loss, a provision for the entire loss is recorded in the current accounting period.
(r) Treasury Stock
The Company repurchases its common stock from time to time in the open market and holds such shares as treasury stock. The Company applies the "cost method" and presents the cost to repurchase such shares as a reduction in shareholders' equity. During the years ended December 31, 2010 and 2009, the Company has repurchased 0 and 6,000 shares of common stock.
(s) Retirement Plan
Retirement benefits in the form of contributions under a defined contribution retirement plan to the relevant authorities are charged to earnings as incurred. Retirement benefit expenses for the years ended December 31, 2010, 2009 and 2008 were $820,939, $537,915 and $428,800, respectively.
(t) Stock-based compensation
The Company adopts ASC No. 718, “Compensation - Stock Compensation” (formerly the SFAS No. 123 (revised 2004) “Share-based Payment”), which requires that share-based payment transactions with employees, such as share options, be measured based on the grant-date fair value of the equity instrument issued and recognized as compensation expense over the requisite service period, with a corresponding addition to equity. Under this method, compensation cost related to employee share options or similar equity instruments is measured at the grant date based on the fair value of the award and is recognized over the period during which an employee is required to provide service in exchange for the award, which generally is the vesting period.
During the years ended December 31, 2010, 2009 and 2008, the Company recognized approximately $3,130,000, $1,453,110, $1,604,741, respectively of compensation expenses under the Plan. As of December 31, 2010 there was no unrecognized compensation expense.
(u) Foreign Currency Translation
The functional currency of the US and British Virgin Islands (“BVI”) Companies is the United States dollars. The functional currency of the Company’s Hong Kong subsidiaries is the Hong Kong dollars.
The functional currency of the Company’s wholly-owned PRC subsidiaries and its VIE is the Chinese Renminbi Yuan, (“RMB”). RMB is not freely convertible into foreign currencies. The Company’s PRC subsidiaries’ and their VIE’s financial statements are maintained in the functional currency. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at rates of exchange prevailing at the balance sheet date. Transactions denominated in currencies other than the functional currency are translated into the functional currency at the exchange rates prevailing at the dates of the transactions. Exchange gains or losses arising from foreign currency transactions are included in the determination of net income for the respective periods.
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For financial reporting purposes the financial statements of the Company, have been translated into United States dollars. Assets and liabilities are translated at exchange rates at the balance sheet dates and revenue and expenses are translated at average exchange rates, and equity is translated at historical exchange rates. Any resulting translation adjustments are not included in determining net income but are included in foreign exchange adjustment to other comprehensive income, a component of equity.
The exchange rates adopted are as follows:
No representation is made that the RMB amounts could have been, or could be, converted into United States dollars at the rates used in translation.
(v) Accounting for Computer Software to be Sold, Leased or Otherwise Marketed
The Company accounts for software development costs in accordance with FASB ACS 985-20-Cost of Software to be Sold, Leased, or Marketed. Costs related to establishing the technological feasibility of a software product are expensed as incurred as a part of research and development expenses. Costs that are incurred to produce the finished products after technological feasibility is established are capitalized and amortized over the estimated economic life from 2 to 5 years. The Company performs periodic reviews to ensure that unamortized program costs remain recoverable from future revenue. During the years ended December 31, 2010, 2009 and 2008, $1,466,554, $1,079,148 and $483,849, respectively was capitalized. At December 31, 2010, 2009 and 2008, unamortized capitalized software costs were $1,866,424, $1,240,439, and $845,828, respectively.
(w) Subsidy Income
Subsidy income mainly represents the income we receive from the local governmental agency in China for development and designated activities. We have no continuing obligation under the subsidy provision.
(x) Income Taxes
Income taxes are provided on an asset and liability approach for financial accounting and reporting of income taxes. Deferred income taxes are recognized for all significant temporary differences at enacted rates and classified as current or non-current based upon the classification of the related asset or liability in the financial statements. A valuation allowance is provided to reduce the amount of deferred tax assets if it is considered more likely than not that some portion of, or all, the deferred tax asset will not be realized. The Company classifies interest and/or penalties related to unrecognized tax benefits, if any, as a component of income tax provisions.
The Company adopted the provisions of ASC No. 740 “Income Taxes” (“ASC 740”), which clarifies the accounting for uncertainty in income taxes recognized by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 also provides accounting guidance on de-recognition, classification, interest and penalties, disclosure and transition.
(y) Segment reporting
Segment information is consistent with how management reviews the businesses, makes investing and resource allocation decisions and assesses operating performance. Transfers and sales between reportable segments, if any, are recorded at cost.
In connection with the changes in the Company's business portfolio and realignment of management, management conducted a review of its operating business segments during the first quarter of 2009. The review resulted in adding the Digital Hospital Information System Segment and merging the Product Sales Segment into Digital Information Security Technology Segment.
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The Company's new segment reporting, which has been used for all periods presented, follows the organizational structure as reflected in its internal management reporting systems, which are the basis for assessing the financial performance of the business segments and for allocating resources to the business segments.
The Company reports financial and operating information in the following four segments:
(1)
Digital Public Security Technology Segment (“DPST”, formerly known as “Digital Information Security Technology Segment (“DIST”) ): includes revenues from information security related projects;
(2)
Geographic Information Systems Segment ("GIS"): includes the Police-Use Geographic Information Systems ("PGIS") and Civil-Use GIS sales;
(3)
Digital Hospital Information System Segment ("DHIS"): includes revenues from digital information system provided to hospitals or medical institutes.
(4)
Others Products and Services (“OTHER”): include new offerings under market assessment or development outside the existing main business segments. When a meaningful stand-alone segment is formed, such a new segment will be separated from this category.
The Company also provides general corporate services to its segments and these costs are reported as "Corporate and others."
All of the Company’s revenues are earned in the PRC and substantially all of the Company’s assets are located in the PRC.
(z) Sales, use and other value added tax
Revenue is recorded net of applicable sales, use and value added tax.
(aa) Business combinations and non-controlling interests
In December 2007, the FASB amended its guidance on accounting for business combinations. The new accounting guidance resulted in a change in our accounting policy effective January 1, 2009, and is being applied prospectively to all business combinations subsequent to the effective date. Among other things, the new guidance amends the principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. It also establishes new disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. The adoption of this new accounting policy did not have a significant impact on the Company's consolidated financial statements, and the impact it will have on its consolidated financial statements in future periods will depend on the nature and size of business combinations completed subsequent to the date of adoption.
In December 2007, the FASB issued new accounting and disclosure guidance related to non-controlling interests in subsidiaries (previously referred to as minority interests), which resulted in a change in accounting policy effective January 1, 2009. Among other things, the new guidance requires that a non-controlling interest in a subsidiary be accounted for as a component of equity separate from the parent's equity, rather than as a liability. The new guidance is being applied prospectively, except for the presentation and disclosure requirements, which have been applied retrospectively.
Accordingly, after adoption, non-controlling interests (approximately $18.5 million and $15.4 million at December 31, 2010 and December 31, 2009, respectively) are classified as equity, a change from its previous classification between liabilities and stockholders' equity. Earnings attributable to non-controlling interest (approximately ($1,072,000, $43,000 and $241,000 for 2010, 2009 and 2008, respectively) are included in net income, although such earnings continue to be deducted to measure earnings per share. Purchases and sales of non-controlling interests are reported in equity similar to treasury stock transactions.
(ab) Recently Issued Accounting Guidance
In April 2010, the FASB issued Accounting Standards Update No. 2010-17, Revenue Recognition - Milestone Method (Topic 605) - Revenue Recognition (ASU 2010-17). ASU 2010-17 provides guidance on defining the milestone and determining when the use of the milestone method of revenue recognition for research or development transactions is appropriate. It provides criteria for evaluating if the milestone is substantive and clarifies that a vendor can recognize consideration that is contingent upon achievement of a milestone as revenue in the period in which the milestone is achieved, if the milestone meets all the criteria to be considered substantive. ASU 2010-17 is effective for us in fiscal 2011 and should be applied prospectively. The adoption of ASU 2010-17 did not have any effect on the Company’s financial position or results of operations.
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In January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends ASC Topic 820, Fair Value Measurement and Disclosure (“ASC 820”) to require a number of additional disclosures regarding fair value measurements. In addition to the new disclosure requirements, ASU 2010-06 also amends ASC 820 to clarify that reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities. Prior to the issuance of ASU 2010-06, the guidance in ASC 820 required separate fair value disclosures for each major category of assets and liabilities.
ASU 2010-06 also clarifies the requirement for entities to disclose information about both the valuation techniques and inputs used in estimating Level 2 and Level 3 fair value measurements. Except for the requirement to disclose information about purchases, sales, issuance and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, all of the provisions of ASU 2010-06 are effective for interim and annual reporting periods beginning after December 15, 2009, or January 1, 2010 for the Company. The requirement to separately disclose purchases, sales, issuances and settlements of recurring Level 3 measurements does not become effective until fiscal years beginning after December 15, 2010, or January 1, 2011 for the Company. The adoption of ASU 2010-06 is for disclosure purposes only and did not have any effect on the Company’s financial position or results of operations.
In October 2009, the FASB issued ASU 2009-13, “Multiple-Deliverable Revenue Arrangements,” (amendments to FASB ASC Topic 605, “Revenue Recognition”) (ASU 2009-13) and ASU 2009-14, “Certain Arrangements That Include Software Elements,” (amendments to FASB ASC Topic 985, “Software”) (ASU 2009-14). ASU 2009-13 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. ASU 2009-14 removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. ASU 2009-13 and ASU 2009-14 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company considered the adoption of ASU 2009-13 or ASU 2009-14 would have no material impact to consolidated results of operations and financial condition.
In June 2009, the FASB issued guidance now codified within ASC Topic 810, Consolidation (“ASC 810”). ASC 810 requires entities to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity. This analysis identifies the primary beneficiary of a variable interest entity as one with the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and obligation to absorb losses of the entity that could potentially be significant to the variable interest. The guidance is effective as of the beginning of the annual reporting period commencing after November 15, 2009, or January 1, 2010 for the Company, with early adoption prohibited. The adoption of the guidance codified within ASC 810 did not have any effect on the Company’s financial position or results of operations.
3. VARIABLE INTEREST ENTITY
The Company is the primary beneficiary of iASPEC, pursuant to the MSA, and iASPEC qualifies as a variable interest entity of the Company. Accordingly, the assets and liabilities and revenues and expenses of iASPEC have been included in the accompanying consolidated financial statements.
In order to facilitate iASPEC’s expansion and also to provide financing for iASPEC to complete the acquisition of Geo, the Company advanced RMB38 million (approximately $5.4 million) to iASPEC in two installments on November 20, 2007 and May 8, 2008, respectively, to increase iASPEC’s registered capital. In order to comply with PRC laws and regulations, the advance was made to Mr. Lin, iASPEC’s then majority shareholder, who, upon the authority and direction of the Board of Directors, forwarded the funds to iASPEC. The Company has recorded the advance of these funds as an interest-free loan to iASPEC, which was eliminated against additional capital of iASPEC in consolidation. The increase in iASPEC’s registered capital does not affect IST’s exclusive option to purchase iASPEC’s assets and shares under the MSA.
For the years ended December 31, 2010, 2009 and 2008, $1,071,626 ($893,316 from iASPEC and $178,310 from Geo), $43,076 ($180,000 from iASPEC and loss $136,924 from Geo) and $241,197 ($180,000 from iASPEC and $61,197 from Geo), respectively have been attributed to non-controlling interest in the consolidated statements of income of the Company.
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At December 31, 2010, the consolidation of iASPEC and Geo, resulted in an increase in assets (consisting primarily of cash at bank, accounts and other receivables, inventories and property, plant and equipment) of approximately $72.3 million, an increase in liabilities (consisting primarily of accounts payable and short-term bank loans) of approximately $28.4 million, and an increase in non-controlling interest of approximately $18.5 million. The creditors of these entities do not have recourse to the general credit of the Group. The Group will provide all of the needed financing for the VIEs. For the years ended December 31, 2010, 2009 and 2008, the consolidation resulted in an increase in net income attributable to the Company of approximately $17.0 million, $9.3 million and $10.6 million, respectively.
4. EARNINGS PER SHARE
Basic earnings per share are computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, or resulted in the issuance of common stock that shared in the earnings of the entity. For purposes of the computation of net income per share, shares issued in connection with acquisitions that are returnable are considered contingently returnable shares under FASB ASC 260, although classified as issued and outstanding, are not included in the basic weighted average number of shares until all necessary conditions are met that no longer cause the shares to be contingently returnable. These contingently returnable shares are included in the diluted weighted average number of shares as of the beginning of the period in which the conditions were satisfied (or as of the date of the agreement, if later).
Components of basic and diluted earnings per share were as follows for the years ended December 31, 2010, 2009 and 2008:
Warrants for the purchase of 400,000 shares were not included in 2010, 2009 or 2008 as their effect would have been anti-dilutive.
5. BUSINESS ACQUISITIONS
Goodwill by segment as at December 31, 2010 and 2009 are as follows:
(a) Zhongtian
On October 31, 2008, the Company acquired 100% of the equity interest of Kwong Tai International Technology Limited (“Kwong Tai”), a Hong Kong company and its wholly-owned Chinese subsidiary, Shenzhen Zhongtian Technology Development Company Ltd. (“Zhongtian”). Approximately $9,900,000 (approximately RMB67,617,000) of the purchase price was paid in cash and the balance of the purchase price was paid through the issuance of 1,280,807 shares of the Company’s common stock in February 2009.
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Under the terms of the purchase agreement, 355,164 shares of the Company’s common stock were to be returned if Zhongtian does not meet certain net income targets in 2009, and an additional 355,164 shares of the Company’s common stock are to be returned if Zhongtian does not meet certain income targets in 2010.
Zhongtian met net income targets in 2010 and 2009, resulting in an increase to goodwill of $1,850,405 and $2,187,810 during the fourth quarter of 2010 and 2009, respectively. The following table represents the purchase price allocation of Kwong Tai and Zhongtian (collectively “Zhongtian”) including the additional goodwill.
The operating results of Zhongtian have been included in the consolidated financial statements from November 1, 2008, the acquisition date. Intangible assets include software with an estimated useful life of 10 years. Goodwill, which has been allocated to the Company’s DHIS segment, is not expected to be deductible for tax purposes.
(b) Huipu
On October 14, 2009, the Company, through CPSH, acquired 100% of the equity interests of Topwell Treasure Ltd.("Topwell"), a Hong Kong limited company, for the purchase of Topwell and its wholly-owned Chinese subsidiary, Huipu Electronics (Shenzhen) Co., Ltd. ("Huipu"), for an aggregate purchase price of $16,000,000, pursuant to a Share Purchase Agreement, dated August 28, 2009. Huipu is a leading developer and manufacturer of customized LCD/LED multi-screen display systems in China and the holder of numerous technology patents, trademarks, certifications and licenses. As a result of the acquisition, the Company is expected to penetrate to those markets with the integrated system of the software and LCD/LED multi-screen display.
FASB ASC 805 - Business Combinations, applying to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, requires the consideration transferred shall be measured at the acquisition date fair value.
The total acquisition date fair value of the consideration transferred was estimated at $22.06 million, which included the initial payments totaling approximately $8 million in cash, 1,101,930 shares of the Company’s common stock valued at $7.68 per share, representing the closing market price of the Company’s shares at acquisition date, and the estimated fair value of acquisition-related contingent consideration to be paid to Huipu’s shareholders totaling approximately $5.6 million.
The fair value estimate of the contingent consideration is based on weighted probability (level 3 input) of achievement of After Tax Net Income targets (ATNI) in 2010, 2011 and 2012, which could result in the issuance of up to 1,101,930 additional shares of the Company’s common stock. Actual achievement of ATNI below $3.2 million would reduce the liability to zero and achievement of ATNI of $6.8 million or more would increase the liability to $6.8 million. A change in fair value of the acquisition-related contingent consideration could have a material effect on the statement of operations and financial position in the period of the change in estimate. Due to the change in estimate of the fair value of acquisition-related contingent consideration, a gain of $0.33 million and $1.1 million was recorded under other income, net in 2010 and 2009, respectively. The following table represents the fair value movement changes in the year 2010:
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The following table summarizes the consideration paid for Huipu and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date. Huipu achieved the earn out target in 2010, and 330,578 shares will be issued for the equity portion of the purchase price of Huipu.
None of the goodwill recognized is expected to be deductible for income tax purposes. The operating results of Topwell and Huipu have been included in the consolidated financial statements from the acquisition date. Intangible assets include trade marks and patents with an estimated useful life of 3 years. The goodwill of $18,477,237 arising from the acquisition consists largely of the synergies from combining the operations of the Company and Topwell. The goodwill was assigned to the Company's DPST and GIS segments.
6. RELATED PARTY BALANCES AND TRANSACTIONS
As of December 31, 2010 and 2009, amounts due from (to) related parties consist of:
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Due from related companies, current portion
Approximately 8% of Xiamen Yili Geo Information Technology Co., Ltd. (“Yili”) is owned by Geo. The balance consists of accounts receivable from sales.
Shenzhen Kewen Information Technology Co., Ltd. (“Kewen”) is a private company owned by a member of the senior management of Zhongtian. The balance consists of accounts receivable balances from sales during the year.
Due to related companies, current portion
Approximately 9% of Wuhan Geo Navigation and Communication Technology Co., Ltd. (“Geo Navigation”) is owned by Geo. The balance represents advances from Geo Navigation to Geo. These advances are non-interest bearing and due on demand.
Shenzhen Information Security Investment and Development Co., Ltd. (“ISID”) is a company under the control of Mr Lin. The balance due to ISID represents advances from ISID to Bocom. These advances are non-interest bearing and due on demand.
Due to related party, long-term portion
The balance due to shareholder represents the personal loans from Mr. Jianghuai Lin, the CEO of the Company, to the Company as of December 31, 2010.
On January 14, 2010, Mr. Lin loaned the Company a total of $5 million from the proceeds of the sale of his shares for use for general corporate purposes and working capital. In consideration of the loan from Mr. Lin, the Company's Board of Directors approved the issuance and delivery of a one-year, non-interest bearing, convertible promissory note (“the Original Note”) to Mr. Lin, in the principal amount of $5 million The note is due and payable on January 14, 2011, and is convertible into shares of the Company's common stock at a conversion price of $5.88 per share (the per share closing price on the trading day prior to the delivery date of the Original Note).
On March 25, 2010, Mr. Lin surrendered the Original Note to the Company and have asked the Company to void and rescind the Original Note, and issue a replacement note (“the New Note”), in the principal amount of $6,000,000, to reflect the principal amount of the Original Note as well as an additional loan of $1,000,000 made to the Company on March 25, 2010. The new additional loan of $1,000,000 has been repaid by the Company on 7 April 2010.
The New Note has omitted the conversion feature that was contained in the Original Note and it is non-interest bearing. The maturity date of the New Note is March 5, 2012 and the Company may prepay all or any part of the amounts outstanding under this Note at any time before the maturity date without the express written consent of Mr. Lin. In accounting for the New Note, the Company accrues an interest expense at an interest rate of 5% per annum, which is the market interest rate for USD denominated 2-year loans in China. The imputed interests for the year ended December 31, 2010 is $187,500 and is recognized as capital contribution by the shareholder.
(b) Revenue - related party
Amounts earned from Yili and Kewen during the years ended December 31, 2010 and 2009 were as follows:
(c) Rental expenses- related party
Rental expenses to Mr. Lin during the years ended December 31, 2010, 2009 and 2008 were $110,795, 0, and 0 respectively.
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(d) Guarantees of bank loans
Mr. Lin has provided personal guarantees for certain of the Company’s loans as follows:
7. INVENTORIES
As of December 31, 2010 and 2009, inventories consist of:
8. LONG-TERM INVESTMENTS
As of December 31, 2010 and 2009, long-term investments consist of:
Geo holds a 20% ownership interest in Tianhe Navigation and Communication Technology Co., Ltd. (“Tianhe”). Although Geo owns 20% of Tianhe, Geo’s management does not have the ability to exercise significant influence over operating and financial policies of Tianhe due to the following factors:
a.
The Company and Geo do not participate in the policy making, operations, or financial processes of Tianhe;
b.
There are no intercompany transactions between the Company or Geo and Tianhe;
c.
There is no interchange of managerial personnel
d.
The Company and Geo do not nominate or hold a board position at Tianhe.
e.
There is no technological or financial dependence between the Company or Geo and Tianhe.
As a result of the foregoing factors, the investment in Tianhe is accounted for using the cost method of accounting.
Geo holds a 8% ownership interest in Tianditu which was set up in 2010 to provide online map service.
Long-term investments also include Geo’s investments in Yili. During the years ended December 31, 2010 and 2009, the Company received dividends of RMB 749,700 (approximately $111,000) and RMB 750,000 (approximately $110,000), respectively, in connection with its investment in Yili.
As at December 31, 2009, management determined that there was an other-than temporary impairment in the value of its investment in Tianhe and recorded an impairment loss of approximately $233,000. As at December 31, 2010, the management reassessed the possible impairment to the investment to Tianhe and determined that there was an other-than temporary impairment in the value of its investment in Tianhe and recorded an impairment loss of approximately $855,000.
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9. PROPERTY, PLANT AND EQUIPMENT
As of December 31, 2010 and 2009, property, plant and equipment consists of:
Depreciation expense for the years ended December 31, 2010, 2009, and 2008 was approximately $7,715,000, $4,069,000, and $2,991,000, respectively.
10. LAND USE RIGHTS AND INTANGIBLE ASSETS
(a) Deposits for purchase of land use rights
As of December 31, 2010, deposits for purchase of land use rights represent deposit for purchase of land use rights in Dongguan City of approximately $18.20 million (RMB 119.96 million) by IST, and deposit for expansion of land use rights in Fuyong County of Shenzhen of approximately $8.38 million (RMB 55.16 million) by Huipu.
(b) Land use rights
As of December 31, 2010 and 2009, land use rights consist of:
Amortization expense for the years ended December 31, 2010, 2009, and 2008 was approximately $42,000, $7,000 and $0, respectively.
Estimated amortization for the next five years and thereafter is as follows:
(c) Intangible assets
As of December 31, 2010 and 2009, intangible assets consist of:
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Amortization expense for the years ended December 31, 2010, 2009, and 2008 was approximately $1,752,000, $1,780,000, and $1,355,000, respectively.
Estimated amortization for the next five years and thereafter is as follows:
11. BANK LOANS
(a) Short-term bank loans
At December 31, 2010, the Company has the following bank borrowings due in one year:
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At December 31, 2009, the Company has the following bank borrowings due in one year:
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(b) Long-term bank loans
The total outstanding balance of long-term bank loan as of December 31, 2010 is RMB 38,650,000 ($5,863,205).
On January 1, 2010, Huipu obtained a RMB 27,400,000 ($4,156,580) long-term loan from PingAn Bank. The loan has a fixed interest rate of 7.128% per annum and matures on October 17, 2011. Interest on the loan is payable monthly, and principal is due at maturity.
On September 25, 2010, Huipu obtained an operational loan of RMB 30,000,000 ($4,491,000) from Shenzhen Development Bank. At December 31, 2010, the total outstanding balance of this long-term bank loan is RMB 26,250,000 ($3,982,125).The loan has a fixed interest rate of 5.4% per annum and matures on September 24, 2012. Interest on the loan is payable monthly, and principal of RMB 1,250,000 ($187,000) is payable monthly through the maturity date.
12. BILLS PAYABLE
The Company has total available bills payable facilities of $19.19 million and $16.5 million with various banks, of which $2 million and $3.8 million were unutilized as of December 31, 2010 and 2009 respectively. The funds borrowed under these facilities are generally repayable within 6 months. The bills payable are non-interest bearing and do not have any restrictions or covenants attached.
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13. INCOME TAXES
Pre-tax income for the years ended December 31, 2010, 2009 and 2008 was taxable in the following jurisdictions:
United States
The Company was incorporated in Nevada and is subject to United States of America tax law. It is management's intention to reinvest all the income attributable to the Company earned by its operations outside the United States of America (the "U.S."). Accordingly, no U.S. corporate income taxes are provided in these condensed consolidated financial statements.
BVI
Under the current laws of the BVI, dividends and capital gains arising from the Company's investments in the BVI are not subject to income taxes.
PRC
The income tax provision consists of the following:
The reconciliation of income taxes for income tax computed at the PRC federal statutory rate to income tax expenses is as follows:
The significant components of deferred tax assets and deferred tax liabilities were as follows as at December 31, 2010 and December 31, 2009:
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The breakdown between current and long-term deferred tax assets/(liabilities) was as follows as at December 31, 2010 and 2009:
As at December 31, 2010, deferred tax assets related to loss carry forwards represented HPC’s accumulated losses for prior years of $2,374,000.
FASB ASC 740 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. In accordance with proactive communication with local tax bureau, the management determined that $3,100,000 of the accumulative losses of HPC could not be utilized to deduct against future taxable profit as it had been denied by the local tax bureau. The management derecognized the corresponding deferred tax assets and wrote off the corresponding valuation allowance therefore.
The management expects that there may not be sufficient taxable income in the future to realize this portion of the deferred tax assets, the valuation allowance amounting to approximately $593,600 existed as at December 31, 2010.
Geo, iASPEC, Zhongtian and Bocom are all governed by the Income Tax Laws of the PRC, and are approved as high-technology enterprises subject to the PRC enterprise income tax (“EIT”) at 15% in 2010.
ISS and Huipu are subject to the PRC EIT at 22% in 2010.
The China Unified Corporate Income Tax Law (the “Unified Tax Law”) was released on March 6, 2007 and on November 28, 2007, the State Council of China passed the Implementing Rules for the EIT Law ("Implementing Rules"), both of which became effective on January 1, 2008, resulting in an increase in the PRC federal statutory tax rate to 25%. The Unified Tax Law is to be phased in over five years. Companies that were subject to an income tax of 15% in 2007 will pay 18% in 2008, 20% in 2009, 22% in 2010, 24% in 2011 and 25% from 2012.
As a wholly-owned foreign investment enterprise, IST is entitled to enjoy a two-year tax exemption, followed by a 50% exemption for three years thereafter as approved by PRC tax authorities. Under the EIT Law, companies that were previously exempt from taxes or that had concessional rates are to retain their preferences until the original expiration date. The Unified Tax Law does not impact IST’s income tax qualification to enjoy a tax exemption in fiscal year 2010 and IST will continue to qualify for a 50% tax exemption. Therefore, IST is subjected to the PRC EIT at 11% in 2010, and will continue to qualify for a 50% tax exemption for the one year thereafter. EIT exemptions claimed by IST may become payable if IST were to dissolve within the next 10 years. However, management believes that the PRC tax authorities will not request payment of any such amounts.
The Company recognizes that virtually all tax position in the PRC are not free of some degree of uncertainty due to tax law and policy changes by the State. However, the Company cannot reasonably quantify political risk factors and thus must depend on guidance issued by current State officials.
Based on all known facts and circumstances and current tax law, the Company believes that the total amount of unrecognized tax benefits as of December 31, 2010, is not material to its results of operations, financial condition or cash flows. The Company also believes that the total amount of unrecognized tax benefits as of December 31, 2010, if recognized, would not have a material effect on its effective tax rate. The Company further believes that there are no tax positions for which it is reasonably possible, based on current Chinese tax law and policy, that the unrecognized tax benefits will significantly increase or decrease over 12 months producing, individually or in the aggregate, a material effect on the Company’s results of operations, financial condition or cash flows.
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The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, the Company did not have any accrued interest or penalty associated with any unrecognized tax benefits, nor was any interest expense recognized for the years ended 2010, 2009 and 2008.
Since the Company intends to reinvest its earnings to further expand its businesses in the PRC, PRC subsidiaries do not intend to declare dividends to their immediate parent companies in the foreseeable future. Accordingly, the Company has not recorded any withholding tax on the cumulative amount of distributed and undistributed retained earnings. Should the Company's PRC subsidiaries distribute all of their profits generated after December 31, 2007, the aggregate withholding tax amount would have been approximately $7.71 million and $4.73 million as of December 31, 2010 and December 31, 2009, respectively.
14. RESERVE AND DISTRIBUTION OF PROFIT
In accordance with relevant PRC regulations and the Articles of Association of IST, ISS, iASPEC, Bocom , Zhongtian and HPC SZ, appropriations of net income, as reflected in their PRC statutory financial statements, are to be allocated to statutory reserve, as determined by resolution of the Board of Directors. For the years ended December 31, 2010, 2009, and 2008, $4,623,614, $3,380,774, and $3,209,045, respectively, were appropriated.
15. EQUITY
(a) Issuance of new shares
On February 1, 2008, the Company issued 1,125,000 shares of common stock in connection with the acquisition of Bocom.
On June 11, 2008, the Company issued 298,008 shares of common stock in connection with the exercise of 440,632 warrants.
On June 20, 2008, September 20, 2008 and December 20, 2008, the Company issued 100,000, 100,000 and 200,000 shares of common stock respectively in connection with the Plan. (see (c) below).
On February 2, 2009, the Company issued 60,000 shares of common stock in connection with the Equity Incentive Plan. (see (c) below).
On February 23, 2009, the Company issued 1,280,807 shares of common stock in connection with the acquisition of Zhongtian.
On March 10, 2009, the Company repurchased 6,000 shares of common stock from open market and held such shares as treasury stock.
On November 11, 2009, the Company issued 1,101,930 shares of common stock in connection with the acquisition of Topwell and Huipu.
On January 12, 2010, the Company issued 1,652,033 shares of common stock to certain purchasers at $6.15 per share, for the purpose of funding the Company with working capital. The purchasers also received from the Company additional warrants to purchase an aggregate of 813,008 shares of common stock at an exercise price of $6.15. The warrants expired 45 days after the initial issuance date.
On January 12, 2010 and September 25, 2010, the Company granted 213,363 and 250,000 shares, respectively of the Company’s common stocks as compensation under the Plan. (see (c) below).
On January 21, 2010, the Purchasers exercised the warrants and purchased 41,250 shares of common stock at an exercise price of $6.15.
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(b) Equity Transfer Agreement
On July 1, 2008, Mr. Lin, entered into an equity transfer agreement (the “Equity Transfer Agreement”) with Mr. Jin Zhu Cai (“Mr. Cai”), the owner of the 24% minority interest in iASPEC, pursuant to which, Mr. Lin agreed to purchase Mr. Cai’s Minority Interest in iASPEC from Mr. Cai, for a total consideration of RMB60 million (approximately $8.72 million) (the “Purchase Price”). The Purchase Price was paid in 1,527,855 shares of restricted common stock of the Company owned by Mr. Lin, valued at $5.708 per share (based on a 5-day average of the Company’s share price during the week of June 23, 2008). Mr. Lin delivered the shares in September 2008. As a result of the Equity Transfer Agreement, Mr. Lin now holds 100% of the equity interest of iASPEC.
(c) Stock-based compensation
Effective June 13, 2007, the Board of Directors of the Company adopted the China Information Security Technology, Inc. 2007 Equity Incentive Plan (“The Plan”). The Plan provides for grants of stock options, stock appreciation rights, performance units, restricted stock, restricted stock units and performance shares. A total of 8,000,000 shares of the Company’s common stock may be issued pursuant to Awards granted under the Plan.
On November 30, 2007, subject to ratification of the Plan by the stockholders, the Company issued options to certain employees to purchase 490,000 shares of the Company’s common stock, par value $0.01, with an exercise price of $9.48 per share. The options were to vest on December 5, 2008 and expire on December 5, 2011.
On March 3, 2008, the Company's Board of Directors voided and canceled the grant of the stock options, and on March 20, 2008 approved the grant of 400,000 shares of common stock to the employees. The fair value of the Company’s common stock based on quoted market prices on March 20, 2008 was $4.30 per share. Since the cancellation and grant of the replacement award occurred concurrently, they were treated as a modification of the terms of the cancelled award. 100,000 shares of common stock became vested on June 20, 2008 and September 20, 2008, respectively, and the remaining 200,000 shares of common stock were vested on December 20, 2008.
The Company uses the Black-Scholes option pricing model to measure the fair value of stock options granted. The determination of the fair value of stock-based compensation awards on the date of grant using an option-pricing model is affected by the Company’s stock price, as well as by assumptions regarding a number of complex and subjective variables, including the expected volatility of the Company’s stock price over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. The expected term represents the weighted average period of time that stock-based awards are expected to be outstanding, giving consideration to employees’ expected exercise and post-vesting employment termination behavior. Expected volatilities are based on historical volatilities of the Company’s common stock. The risk-free interest rate is based on the U.S. T-bill with maturity terms similar to the expected term on the stock-based awards. The Company does not anticipate paying any cash dividends in the foreseeable future. Forfeitures are estimated at the time of the grant and revised in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest.
On February 2, 2009, the Company granted eligible employees a total of 60,000 shares of the Company’s common stock as compensation under the Plan.
On January 12, 2010, the Company granted eligible employees a total of 213,363 shares of the Company's common stock as compensation under the Plan. The fair value of these shares of approximately $1.27 million, based on the quoted market price, was accrued as of December 31, 2009 as the compensation was for services provided in 2009.
On September 25, 2010, the Company granted eligible employees a total of 250,000 shares of the Company's common stock as compensation under the Plan. The fair value of these shares of approximately $1.13 million based on quoted market price was recognized as stock-based compensation for the year ended December 31, 2010.
As of December 31, 2010, $2million related to bonus were accrued for stock based compensation and not yet issued.
As of December 31, 2010, there was no unrecognized compensation expenses related to the non-vested options.
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16. CONSOLIDATED SEGMENT DATA
(1) Revenues by operating segments exclude intercompany transactions.
(2) Includes non-cash compensation, professional fees and consultancy fees for the Company.
Non-cash employee compensation by segment for the years ended December 31, 2010, 2009, and 2008 are as follows:
Depreciation and amortization by segment for the years ended December 31, 2010, 2009 and 2008 are as follows:
Total assets by segment as at December 31, 2010 and 2009 are as follows:
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17. COMMITMENTS AND CONTINGENCIES
iASPEC, Bocom, Zhongtian, and HPC lease offices, employee dormitories and factory space in Shenzhen, Guangzhou, Beijing and Dongguan in the PRC, under lease agreements that will expire on various dates through August 2012. Rent expense for the years ended December 31, 2010, 2009 and 2008 was approximately $380,000, $386,200 and $337,000, respectively.
Future minimum lease payments under these lease agreements are as follows:
Years Ending December 31,
On July 9, 2010, the Company entered into an agreement with the municipal government of Dongguan City, to purchase a land use right for a land of 101,764 square meters at a consideration of approximately $23.31 million (RMB 153.63 million) to be paid in cash in installments. As of December 31, 2010, the Company paid deposits of approximately $18.20 million (RMB 119.96 million). The Company will pay the remaining contracted amount within year 2011.
18. SUBSEQUENT EVENTS
We evaluated events that occurred subsequent to December 31, 2010, for recognition or disclosure in our financial statements and notes to our financial statements. No significant events occurred subsequent to the balance sheet date but prior to the filing of this report that would have a material impact on the consolidation financial statements.
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EXHIBIT INDEX
*Filed herewith.