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RECON TECHNOLOGY, LTD - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.
(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our company's financial condition and
results of operations should be read in conjunction with our unaudited condensed
consolidated financial statements and the related notes included elsewhere in
this report. This discussion contains forward-looking statements that involve
risks and uncertainties. Actual results and the timing of selected events could
differ materially from those anticipated in these forward-looking statements as
a result of various factors.
Overview
We are a company with limited liability incorporated in 2007 under the laws of
the Cayman Islands. Headquartered in Beijing, we provide products and services
to oil and gas companies and their affiliates through our contractually
controlled affiliates ("variable interest entities" or "VIEs"), Beijing BHD
Petroleum Technology Co. Ltd. ("BHD") and Nanjing Recon Technology Co., Ltd.
("Nanjing Recon," and, together with BHD, the "Domestic Companies"). We are the
center of strategic management, financial control and human resources allocation
for the Domestic Companies. Jining ENI Energy Technology Co., Ltd. ("ENI") was
previously one of our contractually controlled affiliates until December 16,
2010, when we ceased to have the power to direct its activities following a
change of ownership. As a result of such change, ENI ceased to be our VIE
starting December 16, 2010.
Through our contractual relationships with the Domestic Companies, we provide
equipment, tools and other hardware related to oilfield production and
management, and develop and sell our own specialized industrial automation
control and information solutions. However, we do not engage in the production
of petroleum or petroleum products.
Our business is mainly focused on the upstream sectors of the oil and gas
industry. We derive our revenues from the sales and provision of (1) hardware
products, (2) software products and (3) services. Our products and services
involve most of the key procedures of the extraction and production of oil and
gas, and include automation systems, equipment, tools and on-site technical
services. For the six months ended December 31, 2011, 88.95% of our revenues
came from the sales of hardware and 11.05% from software. For the same period of
2010, 96.09% of our revenues came from the sales of hardware and 3.91% from
software.
Our VIEs provide the oil and gas industry with equipment, production
technologies and automation and services.
• Nanjing Recon: Nanjing Recon is a high-tech company that specializes in
automation services for oilfield companies. It mainly focuses on providing
automation solutions to the oil exploration industry, including monitoring
wells, automatic metering to the joint station production, process monitor, and
a variety of oilfield equipment and control systems.
• BHD: BHD is a high-tech company that specializes in transportation equipment
and stimulation productions and services. Possessing proprietary patents and
substantial industry experience, BHD has built up stable and strong working
relationships with the major oilfields in China.
Products and Services
We provide the following three types of integrated products and services for our
customers.
Equipment for Oil and Gas Production and Transportation
High-Efficiency Heating Furnaces. Crude petroleum contains certain impurities
that must be removed before it can be sold, including water and natural gas. To
remove the impurities and to prevent solidification and blockage in transport
pipes, companies employ heating furnaces. BHD researched, implemented and
developed a new oilfield furnace that is advanced, highly automated, reliable,
easily operable, safe and highly heat-efficient (90% efficiency).
Burner. We serve as an agent for the Unigas Burner, which is designed and
manufactured by UNIGAS, a European burning equipment production company. The
burner we provide has the following characteristics: high degree of automation,
energy conservation, high turn-down ratio, high security and environmentalsafety.
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Oil and Gas Production Improvement Techniques
Packers of Fracturing. This utility model is used in concert with the security
joint, hydraulic anchor, and slide brushing of sand spray in the well. It is
used for easy seat sealing and sand-up prevention. The utility model reduces
desilting volume and prevents sand-up, which makes the deblocking processes
easier to realize. The back flushing is sand-stick proof.
Production Packer. At varying withdrawal points, the production packer separates
different oil layers and protects the oil pipe from sand and permeation,
promoting the recovery ratio.
Fissure Shaper. This is our proprietary product that is used along with a
perforating gun to effectively increase perforation depth by between 46% and
80%, shape stratum fissures, improve stratum diversion capability and, as a
result, improve our ability to locate oilfields and increase the output ofoil
wells.
Sand Prevention in Oil and Water Well. This technique processes additives that
are resistant to elevated temperatures into "resin sand" which is transported to
the bottom of the well via carrying fluid. The "resin sand" goes through the
borehole, pilling up and compacting at the borehole and oil vacancy layer. An
artificial borehole wall is then formed, functioning as a means of sand
prevention. This sand prevention technique has been adapted to more than 100
wells, including heavy oil wells, light oil wells, water wells and gas wells,
with a 100% success rate and a 98% effective rate.
Water Locating and Plugging Technique. High water cut affects the normal
production of oilfields. Previously, there was no sophisticated method for water
locating and tubular column plugging in China. The mechanical water locating and
tubular column plugging technique we have developed resolves the problem of high
water cut wells. This technique conducts a self-sealing test during multi-stage
usage and is reliable to separate different production sets effectively. The
water location switch forms a complete set by which the water locating and
plugging can be finished in one trip. The tubular column is adaptable to several
oil drilling methods and is available for water locating and plugging in second
and third class layers.
Fracture Acidizing. We inject acid to layers under pressure, which can form or
expand fissures. The treatment process of the acid is defined as fracture
acidizing. The technique is mainly adapted to oil and gas wells that are blocked
up relatively deeply, or the ones in the zones of low permeability.
Electronic Break-Down Service. This service resolves block-up and freezing
problems by generating heat from the electric resistivity of the drive pipe and
utilizing a loop tank composed of an oil pipe and a drive pipe. This technique
saves energy and is environment friendly. It can increase the production of
oilfields that are in the middle and later periods.
Automation System and Services
Pumping Unit Controller. Functions as a monitor to the pumping unit, and also
collects data for load, pressure, voltage, and startup and shutdown control.
RTU Monitor. Collects gas well pressure data.
Wireless Dynamometer and Wireless Pressure Gauge. These products replace wired
technology with cordless displacement sensor technology. They are easy to
install and significantly reduce the work load associated with cable laying.
Electric Multi-way Valve for Oilfield Metering Station Flow Control. This
multi-way valve is used before the test separator to replace the existing three
valve manifolds. It facilitates the electronic control of the connection of the
oil lead pipeline with the separator.
Natural Gas Flow Computer System. The flow computer system is used in natural
gas stations and gas distribution stations to measure flow.
Recon SCADA Oilfield Monitor and Data Acquisition System. Recon SCADA is a
system which applies to the oil well, measurement station, and the union station
for supervision and data collection.
EPC Service of Pipeline SCADA System. A service technique for pipeline
monitoring and data acquisition after crude oil transmission.
EPC Service of Oil and Gas Wells SCADA System. A service technique for
monitoring and data acquisition of oil wells and natural gas wells.
EPC Service of Oilfield Video Surveillance and Control System. A video
surveillance technique for controlling the oil and gas wellhead area and the
measurement station area.
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Technique Service for "Digital Oilfield" Transformation. Includes engineering
technique services such as oil and gas SCADA system, video surveillance and
control system and communication systems.
Factors Affecting Our Business
Business Outlook
The oilfield engineering and technical service industry is generally divided
into five sections: (1) exploration, (2) drilling and completion, (3) testing
and logging, (4) production and (5) oilfield construction. Thus far our
businesses have only been involved in production. Our management plans to expand
our core business, move into new markets, and develop new businesses. Management
anticipates great opportunities both in new markets and our existing markets. We
believe that many existing wells and oilfields need to improve or renew their
equipment and service to maintain production, and techniques and services like
ours will be needed as new oil and gas fields are developed. In the next three
years, we will focus on:
Measuring Equipment and Service. Our priority is the development of our well,
pipeline and oilfield SCADA engineering project contracting service, oilfield
video surveillance and control system, and reforming technical support service.
According to conservative estimates, the potential market for our wireless
indicator and remote monitoring system (SCADA) is approximately ¥5 billion.
Market Demand for Gathering and Transferring Equipment. (1) Furnace. We estimate
the total market demand in China for furnaces like ours at about 2,000 units per
year, of which 500 are expected to come from new wells and 1,500 are expected to
come from reconstruction of old wells. The potential market is estimated at ¥800
million (approximately $121 million) based on an average price of ¥400,000
(approximately $60,498) per furnace. (2) Oil/water separator. We estimate the
total market demand in China at about 800 units per year, of which 300 are
expected to come from new wells and 500 are expected to come from reconstruction
of old wells. The potential market is about ¥400 million (approximately $60
million) based on an average price of ¥500,000 (approximately $75,622). (3)
Burner. We estimate the total market demand in China at about 5,000 units per
year, of which 1,000 are expected to come from new wells and 4,000 are expected
to come from reconstruction of old wells. The potential market is about ¥300
million (approximately $45 million) based on an average unit price of ¥60,000
(approximately $9,075).
New Business of Proprietary Oil/Water Separators and Horizontal Well Fracturing
Technology. Among the products and services we provide to private oilfield
companies, we are now offering our proprietary oil/water separators and
horizontal well fracturing technology by establishing our own work team in this
area. Our new business of proprietary oil/water separators and horizontal well
fracturing technology has generated approximately ¥9 million revenues during the
three months ended December 31, 2011.
Growth Strategy
As a smaller domestic company, it is our basic strategy to focus on developing
our onshore oilfield business, that is, the upstream of the industry. Due to the
remote location and difficult environments of China's oil and gas fields,
foreign competitors rarely enter those areas.
Large domestic oil companies prefer to focus on their exploration and
development businesses to earn higher margins and keep their competitive
advantage. With regard to private oilfield service companies, we estimate that
approximately 90% specialize in the manufacture of drilling and production
equipment. Thus, the market for technical support and project service is still
in its early stage. Our management insists on providing high quality products
and service in the oilfield where we have a geographical advantage. This allows
us to avoid conflicts of interest with bigger suppliers of drilling equipment
and keep our position within the market segment. Our mission is to increase the
automation and safety levels of industrial petroleum production in China, and
improve the underdeveloped working process and management mode by using advanced
technologies. At the same time, we are always looking to improve our business
and to increase our earning capability.
Industry and Recent Developments
Oilfield drilling and production equipment and engineering technique services
are applied in the process of oil and gas extraction. Therefore, the exploration
and exploitation activities of petroleum companies directly influences demand
for oilfield technical services and corresponding equipment. The number of new
oil and gas wells each year is a key indicator of the market and reflects the
prosperity of the oilfield service industry. China is the world's second-largest
petroleum producing country, with nearly 30,000 wells drilled and annual drill
depths of 49,000,000 meters. In the long run, factors affecting the development
of petroleum companies include prices of oil and gas, and China's national
energy strategy. In the short to medium term, petroleum companies plan their
development activities according to the level of demand.
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Thus, the level of demand for oil and gas in the short- to medium-term affects
the number of oil and gas wells. Meanwhile, well prospecting is done to ensure
the supply of oil and gas in the medium to long term. At present, China is in
shortage of oil and gas. The difference between supply and demand is growing.
For the three state-owned petroleum companies, the top priority is to ensure the
nation supply and to promote stable and increased oilfield production. The
capital expenditures are determined by the national energy strategy to a large
extent. Under such circumstances, despite the adverse domestic and international
market conditions influencing the Chinese oil market in 2010 and 2011, the
investment by petroleum companies to upstream prospecting and development
continues to increase. Advanced oilfield drill equipment and technique services
are in greater demand, as petroleum companies make efforts to promote
effectiveness and reduce costs.
Recently, China's dependence on imported oil exceeded 50%, and an increasingly
serious "gas shortage" also put stress on China's energy supply. The government
has decided to invest more in the construction of gas storage and long-distance
natural gas transportation pipeline. Our management believes our current product
lines and experience in pipeline transportation and monitoring and development
of automation products could help us grow rapidly and develop to be a leader in
this segment of the oilfield service industry.
Factors Affecting Our Results of Operations - Generally
Our operating results in any period are subject to general conditions typically
affecting the Chinese oilfield service industry including:
• the amount of spending by our customers, primarily those in the oil and gas
industry;
• growing demand from large corporations for improved management and software
designed to achieve such corporate performance;
• the procurement processes of our customers, especially those in the oil and gas
industry;
• competition and related pricing pressure from other oilfield service solution
providers, especially those targeting the Chinese oil and gas industry;
• the ongoing development of the oilfield service market in China; and
• inflation and other macroeconomic factors.
Unfavorable changes in any of these general conditions could negatively affect
the number and size of the projects we undertake, the number of products we
sell, the amount of services we provide, the price of our products and services,
and otherwise affect our results of operations.
Our operating results in any period are more directly affected by
company-specific factors including:
• our revenue growth, in terms of the proportion of our business dedicated to
large companies and our ability to successfully develop, introduce and market
new solutions and services;
• our ability to increase our revenues from both old and new customers in the oil
and gas industry in China;
• our ability to effectively manage our operating costs and expenses; and
• our ability to effectively implement any targeted acquisitions and/or strategic
alliances so as to provide efficient access to markets and industries in the
oil and gas industry in China.
Critical Accounting Policies and Estimates
Estimates and Assumptions
We prepare our unaudited condensed consolidated financial statements in
conformity with accounting principles generally accepted in the United States of
America (U.S. GAAP), which require us to make judgments, estimates and
assumptions. We continually evaluate these estimates and assumptions based on
the most recently available information, our own historical experience and
various other assumptions that we believe to be reasonable under the
circumstances. Since the use of estimates is an integral component of the
financial reporting process, actual results could differ from those estimates.
An accounting policy is considered critical if it requires an accounting
estimate to be made based on assumptions about matters that are highly uncertain
at the time such estimate is made, and if different accounting estimates that
reasonably could have been used, or changes in the accounting estimates that are
reasonably likely to occur periodically, could materially impact the unaudited
condensed consolidated financial statements. We believe that the following
policies involve a higher degree of judgment and complexity in their application
and require us to make significant accounting estimates. The following
descriptions of critical accounting policies, judgments and estimates should be
read in conjunction with our unaudited condensed consolidated financial
statements and other disclosures included in this quarterly report. Significant
accounting estimates reflected in our Company's unaudited condensed consolidated
financial statements include revenue recognition, allowance for doubtful
accounts, and useful lives of property and equipment.
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Consolidation of VIEs
We recognize an entity as a VIE if it either (i) has insufficient equity to
permit the entity to finance its activities without additional subordinated
financial support or (ii) has equity investors who lack the characteristics of a
controlling financial interest. We consolidate a VIE as its primary beneficiary
when we have both the power to direct the activities that most significantly
impact the entity's economic performance and the obligation to absorb losses or
the right to receive benefits from the entity that could potentially be
significant to the VIE.
Assets recognized as a result of consolidating VIEs do not represent additional
assets that could be used to satisfy claims against our general assets.
Conversely, liabilities recognized as a result of consolidating these VIEs do
not represent additional claims on our general assets; rather, they represent
claims against the specific assets of the consolidated VIEs.
Revenue Recognition
We recognize revenue when the following four criteria are met: (1) persuasive
evidence of an arrangement exists, (2) delivery has occurred or services have
been provided, (3) the sales price is fixed or determinable, and
(4) collectability is reasonably assured. Delivery does not occur until products
have been shipped or services have been provided to the client and the client
has signed a completion and acceptance report, risk of loss has transferred to
the client, client acceptance provisions have lapsed, or we have objective
evidence that the criteria specified in client acceptance provisions have been
satisfied. The sales price is not considered to be fixed or determinable until
all contingencies related to the sale have been resolved.
Hardware
Revenue from hardware sales is generally recognized when the product is shipped
to the customer and when there are no unfulfilled company obligations that
affect the customer's final acceptance of the arrangement.
Software
We sell self-developed software. For software sales, we recognize revenues in
accordance with the provisions of ASC 985-605, "Software Revenue Recognition,"
and related interpretations. Revenue from software is recognized according to
project contracts. Contract costs are accumulated during the periods of
installation and testing or commissioning. Usually this is short term. Revenue
is not recognized until completion of the contracts and receipt of acceptance
statements.
Deferred income represents unearned amounts billed to customers related to sales
contracts.
Cost of Revenues
When the criteria for revenue recognition have been met, costs incurred are
recognized as cost of revenues. Cost of revenues includes wages, materials,
handling charges, the cost of purchased equipment and pipes, and other expenses
associated with manufactured products and services provided to customers. We
expect cost of revenues to grow as our revenues grow. It is possible that we
could incur development costs with little revenue recognition, but based upon
our past history, we expect our revenues to grow.
Fair Values of Financial Instruments
The carrying amounts reported in the consolidated balance sheets for trade
accounts receivable, other receivables, advances to suppliers, trade accounts
payable, accrued liabilities, advances from customers and notes payable
approximate fair value because of the immediate or short-term maturity of these
financial instruments.
Allowance for Doubtful Accounts
Trade receivables are carried at original invoiced amount less a provision for
any potential uncollectible amounts. Provisions are applied to trade receivables
where events or changes in circumstances indicate that the balance may not be
collectible. The identification of doubtful accounts requires the use of
judgment and estimates of management. Our management must make estimates of the
collectability of our accounts receivable. Management specifically analyzes
trade accounts receivable, historical bad debts, customer creditworthiness,
current economic trends and changes in our customer payment terms when
evaluating the adequacy of the allowance for doubtful accounts.
Property and Equipment
We record property and equipment at cost. We depreciate property and equipment
on a straight-line basis over their estimated useful lives using the following
annual rates:
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Items Useful life
Motor vehicles 5-10 years
Office equipment 2-5 years
Leasehold improvements 5 years
We expense maintenance and repair expenditures as they do not improve or extend
an asset's productive life. These estimates are reasonably likely to change in
the future since they are based upon matters that are highly uncertain such as
general economic conditions, potential changes in technology and estimated cash
flows from the use of these assets.
Valuation of Long-Lived Assets
We review the carrying values of our long-lived assets for impairment whenever
events or changes in circumstances indicate that they may not be recoverable.
When such an event occurs, we project undiscounted cash flows to be generated
from the use of the asset and its eventual disposition over the remaining life
of the asset. If projections indicate that the carrying value of the long-lived
asset will not be recovered, we reduce the carrying value of the long-lived
asset by the estimated excess of the carrying value over the projected
discounted cash flows. In the past, we have not had to make significant
adjustments to the carrying values of our long-lived assets, and we do not
anticipate a need to do so in the future. However, circumstances could cause us
to have to reduce the value of our capitalized software more rapidly than we
have in the past if our revenues were to significantly decline. Estimated cash
flows from the use of the long-lived assets are highly uncertain and therefore
the estimation of the need to impair these assets is reasonably likely to change
in the future. Should the economy or acceptance of our software change in the
future, it is likely that our estimate of the future cash flows from the use of
these assets will change by a material amount.
Results of Operations
Three Months Ended December 31, 2011 Compared to Three Months Ended December 31,
2010
Our historical reporting results are not necessarily indicative of the results
to be expected for any future period.
Revenues
For the Three Months Ended December 31,
2011 2010 Increase Percentage Change attributable to:
(Decrease) Change Deconsolidation of ENI Operations
Hardware ¥ 23,127,757 ¥ 20,533,998 ¥ 2,593,759 12.63 % ¥ (5,719,858 ) ¥ 8,313,617
Software 3,952,991 2,111,111 1,841,880 87.25 % - 1,841,880
Hardware-related
parties 3,763,481 9,538,637 (5,775,156 ) (60.54 )% - (5,775,156 )
Total revenue ¥ 30,844,229 ¥ 32,183,746 ¥ (1,339,517 ) (4.16 )% ¥ (5,719,858 ) ¥ 4,380,341
Revenues. Our total revenues decreased by 4.16%, or ¥1,339,517 ($210,460), from
¥32,183,746for the three months ended December 31, 2010 to ¥30,844,229
($4,846,140) for the same period of 2011. Of the revenues from sales of
hardware, sales of transportation equipment and oil-water separator equipment
increased by 33.20%, sales of automation decreased by 9.02%, and sales of
accessories decreased to zero, respectively. The decrease of our revenues for
the three-month period was due to the following factors:
(1) The overall increase of hardware sales was mainly attributable to improved
operations, despite the deconsolidation of ENI which caused a decrease of
¥5,719,858 ($898,685). In light of the ownership change of ENI on December
16, 2010, our Audit Committee concluded that ENI is no longer a VIE and we
should not include ENI's operations in our operating results starting
December 16, 2010. Our management believes that even though ENI's not being a
VIE caused short-term loss for us, it will not have a significant impact on
our long-term business development.
(2) The increase of hardware sales to unrelated parties attributable to
operations amounted to ¥8,313,617($1,306,207). This was mainly attributable
to (i) our subsidiaries' recently acquired qualifications making them
eligible to take on projects with big state-owned enterprises, and (ii)
development of our proprietary oil/water separator and horizontal well
fracturing technology, which contributed about ¥9 million revenue during this
period.
(3) The increase of software sales was ¥1,841,880 ($289,390). For accounting
purposes, sales of software may be counted towards hardware sales under the
category of automation systems from time to time. We record revenue as
software sales if (1) the client signs a separate contract of software with
us, or (2) the client accepts VAT invoices for software. Due to this
accounting treatment, the amount of our revenues categorized as software
sales may fluctuate, but such fluctuation does not necessarily mean
significant changes in our sales of software.
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(4) The decrease of hardware from related parties was mainly caused by (i) delay
of certain key projects and (ii) normal fluctuation due to changing
requirements by oilfield companies.
The Chinese government has attached great importance to the safety problems that
exist in the Chinese energy industry by implementing numerous new projects and
initiatives designed to increase safety and security in the Chinese energy
industry, such as implementing digital oilfield construction to improve safety,
production efficiency and oil recovery ratios in oilfields. This government-led
modernization project is designed to eliminate hidden security dangers, develop
key projects for saving energy and materials, and improve utilization of energy.
Our management has considered these factors carefully and will focus on related
automation and service businesses with an emphasis on safety and energy
efficiency.
Additionally, as we have provided services to CNPC and Sinopec, they have chosen
to continue to use our solutions. During the three months ended December 31,
2011, 70.45% of our revenues were generated through our business engagements
with these companies' operating subsidiaries. This long-term cooperation made it
possible for us to improve our service quality, products' popularity and
adaptability for a very limited number of customers. Further, this long-term
cooperation improves our ability to collect receivables on time.
Cost and Margin
For the Three Months Ended December 31,
2011 2010 Increase Percentage Change attributable to:
(Decrease) Change Deconsolidation of ENI Operations
Total revenues ¥ 30,844,229 ¥ 32,183,746 ¥ (1,339,517 )
(4.16 )% ¥ (5,719,858 ) ¥ 4,380,341
Cost of revenues 21,728,373 20,492,176 1,236,197 6.03 % (4,239,500 ) 5,475,697
Gross profit ¥ 9,115,856 ¥ 11,691,570 ¥ (2,575,714 ) (22.03 )% ¥ (1,480,358 ) ¥ (1,095,356 )
Margin % 29.55 % 36.33 % (6.77 )%
Cost of Revenues. Our cost of revenues includes costs related to the design,
implementation, delivery and maintenance of our software solutions and raw
materials. All materials and components we need can be purchased or manufactured
under contract. Usually the prices for electronic components do not fluctuate
substantially due to market competition, and we do not expect them to
significantly affect our cost of revenues. However, specialized equipment and
chemical products may be directly influenced by the price moves of metal and
oil. Additionally, the prices for some imported accessories mandated by our
clients can also impact our cost.
Our cost of revenues increased by ¥1,236,197 ($194,227), or 6.03%, from
¥20,492,176during the three months ended December 31, 2010 to ¥21,728,373
($3,413,888) for the same period of 2011. The increase in cost of revenues was
due mainly to the deconsolidation of ENI, which resulted in a decrease of
¥4,239,500 ($660,096), offset by higher cost of operations, which amountedto
¥5,475,697($860,323).
As a percentage of revenues, our cost of revenues increased from 63.67% during
the three months ended December 31, 2010 to 70.45% for the same period of 2011,
mainly due to (1) delayed projects for which additional costs were incurred and
(2) our new business of proprietary oil/water separator and horizontal well
fracturing technology.
Gross Profit. Our gross profit decreased by ¥2,575,714 ($404,687), or 22.03%,
from ¥11,691,570for the three months ended December 31, 2010 to ¥9,115,856
($1,432,252) for the same period of 2011. Our gross profit as a percentage of
revenue decreased from 36.33% for the three months ended December 31, 2010 to
29.55% for the same period of 2011. This decrease was caused mainly by the lower
margin of our new business of proprietary oil/water separator and horizontal
well fracturing technology. These new product offerings have acquired
certifications and are now qualified to take up projects for large state-owned
enterprise clients. Our management expects to be able to develop such new
business during the following one-year period, at which time our profit margin
as a whole will improve. Our management also plans to adjust our business
structure by focusing more on our automation business and our own branded
products and services, which provide higher margins, while shifting our focus
away from agency sales, which provide lower margins.
Operating Expenses
For the Three Months Ended December 31,
2011 2010 Increase Percentage Change attributable to:
(Decrease) Change Deconsolidation of ENI Operations
Selling and
distribution ¥ 1,431,883 ¥ 3,272,318 ¥ (1,840,435 ) (56.24 )% ¥ (585,023 ) ¥ (1,255,412 )
% of revenues 4.64 % 10.17 % (5.53 )% -
General and
administrative 5,593,869 19,082,366 (13,488,497 ) (70.69 )% (14,298,155 ) 809,658
% of revenues 18.14 % 59.29 % (41.15 )% -
Operating expenses ¥ 7,025,752 ¥ 22,354,684 ¥ (15,328,932 ) (68.57 )% ¥ (14,883,178 ) ¥ (445,754 )
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Selling and Distribution Expenses. Selling and distribution expenses consist
primarily of salaries and related expenditures of our sales and marketing
organization, sales commissions, costs of our marketing programs including
public relations, advertising and trade shows, and an allocation of our
facilities and depreciation expenses. Selling expenses decreased by 56.24%, from
¥3,272,318for three months ended December 31, 2010 to ¥1,431,883 ($224,973) for
the same period of 2011. Selling expenses as a percentage of total revenues also
decreased, from 10.17% in the three months ended December 31, 2010 to 4.64% in
the same period of 2011. This decrease was mainly attributable to our long-term
relationship with CNPC and Sinopec, as a result of the lower expenses associated
with existing business maintenance. However, as we continue to solidify our
business relationships with current clients and develop new customers, we may
make extensive marketing efforts and incur additional costs. At present, we are
expanding our business in Sichuan and Hebei Provinces. In order to successfully
increase the scope of our client base, we will continue to establish new local
offices in different regions across China. We expect that our selling expenses,
as well as its percentage as against total revenues, may increase
correspondingly.
General and Administrative Expenses. General and administrative expenses consist
primarily of costs in human resources, facilities costs, depreciation expenses,
professional advisor fees, audit fees, option expenses and other expenses
incurred in connection with our general operations. General and administrative
expenses decreased by ¥13,488,497 ($2,119,267), or 70.69%, from ¥19,082,366 in
three months ended December 31, 2010 to ¥5,593,869($878,890) in the same period
of 2011. General and administrative expenses as a percentage of total revenues
also decreased substantially, from 59.29% during the three months ended December
31, 2010 to 18.14% during the same period of 2011. Such decrease is mainly
attributable to (1) the deconsolidation of ENI, which accounted for ¥14,298,155
($2,246,477), and (2) increased expenses for research and development activities
and for audit and attorney fees, which accounted for ¥809,658 ($127,211).
Net Income (Loss)
For the Three Months Ended December 31,
Percentage
2011 2010 Change ChangeIncome (loss) from operations ¥ 2,090,104 ¥ (10,663,114 ) ¥ 12,753,218 119.60 %
Subsidy income 14,100 - 14,100 100.00 %
Interest and other expenses, net (418,255 ) (165,552 ) (252,703 ) (152.64 )%
Loss on deconsolidation - (8,989,614 ) 8,989,614 100.00 %
Net income (loss) before income tax 1,685,949 (19,818,280 ) 21,504,229 108.51 %
Provision for income tax (104,566 ) (198,259 ) (93,693 ) (47.26 )%
Net income (loss) 1,581,383 (20,016,539 ) 21,597,922 107.90 %
Net income attributable to
non-controlling interest (185,457 ) (660,913 ) (475,456 ) (71.94 )%
Net income (loss) attributable to
ordinary shareholders ¥ 1,395,926 ¥ (20,677,452 ) ¥ 22,073,378 106.75 %
Income (Loss) from Operations. Income from operations was ¥2,090,104 ($328,389)
for the three months ended December 31, 2011, an increase of ¥12,753,218, or
119.60%, from a loss of ¥10,663,114for the same period of 2010. This increase in
income from operations is attributed primarily to lower operating expenses.
Subsidy Income. We occasionally receive grants from the local government. For
the three months ended December 31, 2011, we received ¥14,100 ($2,215) subsidy
income. The grant was given by the government in support of local software
companies' operations and research and development in the form of EIT tax return
for high-tech companies. Grants related to research and development projects are
recognized as subsidy income in the combined and consolidated statements of
operations when related expenses are recorded.
Income Tax Expense. Income taxes are provided based upon the liability method of
accounting pursuant to US GAAP. Under this approach, deferred income taxes are
recorded to reflect the tax consequences on future years of differences between
the tax basis of assets and liabilities and their financial reporting amounts. A
valuation allowance is recorded against deferred tax assets if it is not likely
that the asset will be realized. We have not been subject to any income taxes in
the United States or the Cayman Islands. Enterprises doing business in the PRC
are generally subject to federal (state) enterprise income tax at a rate of 25%;
however, Nanjing Recon and BHD were granted the certification of High Technology
Enterprise and are taxed at a rate of 15% for taxable income generated. The
applicable tax rate for each of our subsidiaries changed in the past few years
because of their qualifications and different local policies. For the three
months ended December 31, 2011, Nanjing Recon and BHD were taxed at a rate of
15%. Our effective EIT burden will vary, depending on which of our domestic
companies generate greater revenue.
Income tax expense for the three months ended December 31, 2010 and 2011 was
¥198,259 and ¥104,566 ($16,249), respectively. This decrease was mainly due to a
decrease in taxable operating income.
Net Income (Loss). As a result of the factors described above, net income was
¥1,581,383 ($248,460) for the three months ended December 31, 2011, an increase
of ¥21,597,922 ($3,393,392) from a net loss of ¥20,016,539 for the same period
of 2010.
I-8
Net Income (Loss) Attributable to Ordinary Shareholders. As a result of the
factors described above, net income attributable to ordinary shareholders was
¥1,395,926 ($219,322) for the three months ended December 31, 2011, an increase
of ¥22,073,378($3,648,094), or 106.75%, from a loss of ¥20,677,452 for same
period of 2010.
Adjusted EBITDA
Adjusted EBITDA. We define adjusted EBITDA as net income (loss) adjusted to
income tax expense, interest expense, non-cash stock compensation expense,
depreciation, amortization and accretion expense and loss resulting from the
deconsolidation of a VIE. We think it is useful to an equity investor in
evaluating our operating performance because: (1) it is widely used by investors
in our industry to measure a company's operating performance without regard to
items such as interest expense, depreciation and amortization, which can vary
substantially from company to company depending upon accounting methods and book
value of assets, capital structure and the method by which the assets were
acquired; and (2) it helps investors more meaningfully evaluate and compare the
results of our operations from period to period by removing the impact of our
capital structure and asset base from our operating results.
For the Three Months Ended December 31,
2011 2010 Percentage 2011
RMB RMB Change Change USD
Reconciliation of adjusted EBITDA to net income (loss):
Net income (loss) ¥ 1,581,383 ¥ (20,016,539 ) ¥ 21,597,922 107.90 % $ 248,460
Income tax expense 104,566 198,259 (93,693 ) (47.26 )% 16,429
Interest expense
133,384 213,009 (79,625 ) (37.38 )% 20,957
Stock compensation expense
261,483 431,378 (169,895 ) (39.38 )% 41,083
Depreciation, amortization and accretion
77,434 102,635 (25,201 ) (24.55 )% 12,166
Loss on deconsolidation
- 8,989,614 (8,989,614 ) (100.00 )% -
Adjusted EBITDA ¥ 2,158,250 ¥ (10,081,644 ) ¥ 12,239,894 121.41 % $ 339,095
Adjusted EBITDA increased by ¥12,239,894, or 121.41%, from a loss of ¥10,081,644
for the three months ended December 31, 2010 to an income of ¥2,158,250
($339,095) for the same period of 2011, mainly due to lower operating expenses
and no deconsolidation loss. Compared to net income attributable to ordinary
shareholders, we believe EBITDA more accurately reflects our operations.
Six Months Ended December 31, 2011 Compared to Six Months Ended December 31,
2010
Our historical reporting results are not necessarily indicative of the results
to be expected for any future period.
Revenues
For the Six Months Ended December 31,
Increase Percentage Change attributable to:
2011 2010 (Decrease) Change Deconsolidation of ENI Operations
Hardware ¥ 26,721,529 ¥ 35,856,386 ¥ (9,134,857 ) (25.48 )% ¥ (14,315,657 ) ¥ 5,180,800
Software 3,952,992 2,111,111 1,841,881 87.25 % - 1,841,881
Hardware-related
parties 5,112,297 16,015,560 (10,903,263 ) (68.08 )% (4,365,812 ) (6,537,451 )
Total revenues ¥ 35,786,818 ¥ 53,983,057 ¥ (18,196,239 ) (33.71 )% ¥ (18,681,469 ) ¥ 485,230
Revenues. Our total revenues were ¥35,786,818 ($5,622,703) for the six months
ended December 31, 2011, a decrease of 33.71% from ¥53,983,057 for the same
period of 2010. During the six-month period, our automation business decreased
by 16.07%, sales of transportation equipment increased by 10.19% and our
accessory sales business decreased to zero. This decrease was mainly
attributable to the deconsolidation of ENI's operating results.
I-9
Cost and Margin
For the Six Months Ended December 31,
Increase Percentage Change attributable to:
2011 2010 (Decrease) Change Deconsolidation of ENI Operations
Total revenues ¥ 35,786,818 ¥ 53,983,057 ¥ (18,196,239 ) (33.71 )% ¥ (18,681,469 ) ¥ 485,230
Cost of revenues 24,193,816 34,573,669 (10,379,853 ) (30.02 )% (13,346,098 ) 2,966,245
Gross profit ¥ 11,593,002 ¥ 19,409,388 ¥ (7,816,386 ) (40.27 )% ¥ (5,335,371 ) ¥ (2,481,015 )
Margin % 32.39 % 35.95 % (3.56 )%
Cost of Revenues. Our cost of revenues decreased by ¥10,379,853 ($1,630,847), or
30.02%, from ¥34,573,669 for the six months ended December 31, 2010 to
¥24,193,816($3,801,250) for the same period of 2011. Our cost as a percentage of
revenues increased from 64.05% for the six months ended December 31, 2010 to
67.61% for the same period of 2011. This increase was a result of (1) price
increase for our raw materials, and (2) delays in certain key projects.
Gross Profit. Our gross profit decreased by ¥7,816,386 ($1,228,084), or 40.27%,
from ¥19,409,388 for the six months ended December 31, 2010 to ¥11,593,002
($1,821,453) for the same period in 2011. Our gross profit as a percentage of
revenue decreased from 35.95% for the six months ended December 31, 2010 to
32.39% for the same period of 2011. Our management believes it is necessary to
adjust our business structure to maintain a higher profit margin. We plan to
accomplish this by focusing more on our automation business and our own branded
products and services, while shifting our focus away from agency sales, which
provide a lower margin.
Operating Expenses
For the Six Months Ended December 31,
Increase Percentage Change attributable to:
2011 2010 (Decrease) Change Deconsolidation of ENI Operations
Selling and
distribution ¥ 2,264,680 ¥ 5,075,471 ¥ (2,810,791 ) (55.38 )% ¥ (1,250,756 ) ¥ (1,560,035 )
% of revenues 6.33 % 9.40 % (3.07 )%
General and
administrative ¥ 10,470,052 ¥ 23,304,180 ¥ (12,834,128 ) (55.07 )% ¥ (15,083,473 ) ¥ 2,249,345
% of revenues 29.26 % 43.17 % (13.91 )%
Operating
expenses ¥ 12,734,732 ¥ 28,379,651 ¥ (15,644,919 )
(55.13 )% ¥ (16,334,229 ) ¥ 689,310
Selling and Distribution Expenses. Selling expenses decreased by 55.38%, from
¥5,075,471 for the six months ended December 31, 2010 to ¥2,264,680 ($355,819)
for the same period of 2011. This decrease is mainly attributable to (1) our
stable long-term relationship with CNPC and Sinopec, as a result of the lower
expenses associated with existing business maintenance and (2) the
deconsolidation of ENI.
General and Administrative Expenses. General and administrative expenses
decreased by ¥12,834,128, or 55.07%, from ¥23,304,180 for the six months ended
December 31, 2010 to ¥10,470,052($1,645,019) for the same period of 2011.
General and administrative expenses as a percentage of total revenues also
decreased, from 43.17% for the six months ended December 31, 2010 to 29.26% for
the same period of 2011. This percentage decrease was primarily attributable to
the deconsolidation of ENI, slightly offset by the increase attributable to
operations. The increase of general and administrative expenses attributable to
operations were mainly due to (1) additional expenses of audit and attorney fees
related to the preparation and filing of quarterly and annual reports, (2)
increased expenses for research and development activities, and (3) expenses for
financial consulting.
Net Loss
For the Six Months Ended December 31,
Percentage
2011 2010 Change Change
Loss from operations ¥ (1,141,730 ) ¥ (8,970,263 ) ¥ (7,828,533 ) (87.27 )%
Subsidy income 14,100 451,520 437,420 96.88 %
Interest and other expenses, net (483,102 ) (320,003 ) 163,099 50.97 %
Loss on deconsolidation - (8,989,614 ) (8,989,614 ) (100.00 )%
Net loss before income tax (1,610,732 ) (17,828,361 ) (16,217,629 ) (90.97 )%
Provision for income tax (213,081 ) (1,004,085 ) (791,004 ) (78.78 )%
Net loss (1,823,813 ) (18,832,446 ) (17,008,633 ) (90.32 )%
Net income attributable to
non-controlling interest (185,457 ) (1,001,243 ) (815,786 ) (81.48 )%
Net loss attributable to ordinary
shareholders ¥ (2,009,270 ) ¥ (19,833,689 ) ¥ (17,824,419 ) (89.87 )%
I-10
Loss from Operations. Loss from operations for the six months ended December 31,
2011 was ¥1,141,730 ($179,385), a decrease of ¥7,828,533 from a loss of
¥8,970,263 for the same period of 2010. The reduction in loss from operations
was mainly due to lower operating expenses.
Subsidy Income. We received grants of ¥451,520 and ¥14,100 ($2,215) from the
local government for the six months ended December 31, 2010 and 2011,
respectively. These grants were given by the government in the form of income
tax return to support local companies to develop advanced technology and improve
their products.
Income Tax Expense. Income tax expense for the six months ended December 31,
2010 and 2011 was ¥1,004,085 and ¥213,081 ($33,480), respectively. The decrease
was mainly due to a decrease in taxable operating income and lower effective tax
rates.
Net Loss Attributable to Ordinary Shareholders. As a result of the factors
described above, there was a net loss attributable to ordinary shareholders in
the amount of ¥2,009,270 ($315,691) for the six months ended December 31, 2011,
a decrease of 89.87% from a net loss of ¥19,833,689 for the same period of2010.
Adjusted EBITDA
For the Six Months Ended December 31,
2011 2010 Percentage 2011
RMB RMB Change Change USD
Reconciliation of adjusted EBITDA to net (loss):
Net (loss) ¥ (1,823,813 ) ¥ (18,832,446 ) ¥ (17,008,633 ) (90.32 )% $ (286,551 )
Income tax expense 213,081 1,004,085 791,004 78.78 % 33,479
Interest expense 276,295 325,469 49,174 15.11 % 43,411
Stock compensation expense 524,847 870,084 345,237 39.68 % 82,462
Depreciation, amortization
and accretion 166,157 201,232 35,075 17.43 % 26,106
Loss on deconsolidation - 8,989,614 8,989,614 100.00 % -
Adjusted EBITDA ¥ (643,432 ) ¥ (7,441,962 ) ¥ (6,798,528 ) (91.35 )% $ (101,094 )
Adjusted EBITDA. Adjusted EBITDA recovered by ¥6,798,528, from a loss of
¥7,441,962 for the six months ended December 31, 2010 to a loss of ¥643,432 for
the same period of 2011. This was due to the lower operating expenses and zero
deconsolidation loss. Compared to the net loss attributable to ordinary
shareholders, we believe adjusted EBITDA more accurately reflects our
operations.
Liquidity and Capital Resources
Cash and Cash Equivalents. Cash and cash equivalents are comprised of cash on
hand, demand deposits and highly liquid short-term debt investments with stated
maturities of no more than six months. As of December 31, 2011, we had cash and
cash equivalents in the amount of ¥1,087,967 ($170,938).
Indebtedness. As of December 31, 2011, except for ¥2,328,633 ($365,867) of
short-term borrowings and ¥4,648,030 ($730,283) of short-term borrowings from
related parties, we did not have any finance leases or hire purchase
commitments, guarantees or other material contingent liabilities.
Holding Company Structure. We are a holding company with no operations of our
own. All of our operations are conducted through our Domestic Companies. As a
result, our ability to pay dividends and to finance any debt that we may incur
is dependent upon the receipt of dividends and other distributions from the
Domestic Companies. In addition, Chinese legal restrictions permit payment of
dividends to us by our Domestic Companies only out of its accumulated net
profit, if any, determined in accordance with Chinese accounting standards and
regulations. Under Chinese law, our Domestic Companies are required to set aside
a portion (at least 10%) of its after-tax net income (after discharging all
cumulated loss), if any, each year for compulsory statutory reserve until the
amount of the reserve reaches 50% of our Domestic Companies' registered capital.
These funds may be distributed to shareholders at the time of its wind up. When
we were incorporated in the Cayman Islands in August 2007, 5,000,000 ordinary
shares were authorized, and 50,000 ordinary shares were issued to Mr. Yin
Shenping, Mr. Chen Guangqiang and Mr. Li Hongqi, at a par value of $0.01 each.
On December 10, 2007, our company sold 2,632 ordinary shares to an investor for
an aggregate consideration of $200,000. On June 8, 2009, in connection with our
initial public offering, the Board of Directors approved a 42.7840667-to-1 split
of ordinary shares and redeemable ordinary shares to shareholders of record as
of such date. After giving effect to the share split of our ordinary shares and
the completion of our initial public offering, we had 3,951,811 ordinary shares
outstanding.
On December 16, 2010, in light of the change of the ownership of ENI, we ceased
to have the power to direct the activities of ENI, which as of that date most
significantly impact its economic performance. As a result, ENI ceased to be our
VIE starting from the same date.
I-11
Off-Balance Sheet Arrangements. We have not entered into any financial
guarantees or other commitments to guarantee the payment obligations of any
third parties. In addition, we have not entered into any derivative contracts
that are indexed to our own shares and classified as shareholders' equity, or
that are not reflected in our financial statements. Furthermore, we do not have
any retained or contingent interest in assets transferred to an unconsolidated
entity that serves as credit, liquidity or market risk support to such entity.
Moreover, we do not have any variable interest in an unconsolidated entity that
provides financing, liquidity, market risk or credit support to us or engages in
leasing, hedging or research and development services with us.
Capital Resources. To date we have financed our operations primarily through
cash flows from operating operations. As of December 31, 2011 we had total
assets of ¥124,861,815 ($19,617,862), which includes cash amounting to
¥1,087,967 ($170,938), and net accounts receivable amounting to ¥65,448,867
($10,283,103). Working capital amounted to ¥73,193,511 ($11,499,914) and
shareholders' equity amounted to ¥87,707,195 ($12,680,439).
Cash from Operating Activities. Net cash used in operating activities was
¥2,023,589 ($317,940) for the six months ended December 31, 2011, a decrease of
¥3,167,736 from ¥5,191,325 for the same period of 2010. The decrease in the use
of cash in the current period was due to an increase in trade accounts
receivable partially offset by an increase in trade accounts payable and
reduction in inventories. During this period, increase in our trade accounts
receivable was mainly caused by increase in revenues attributable to operations.
The majority of inventories used in this period were purchased last year, so we
conducted our business without the need for additional purchases. We also
reserved some equipment for upcoming projects, resulting in increased purchase
advance and trade accounts payable.
Cash from Investing Activities. Net cash used in investing activities was
¥96,231 ($15,119) for the six months ended December 31, 2011, a decrease of
¥2,184,923 from ¥2,281,154 for the same period of 2010. The decrease was mainly
caused by a loss on cash due to the deconsolidation of ENI amounting to
¥2,256,305, while there was no such loss for the same period of 2011.
Cash from Financing Activities. Net cash used in financing activities was
¥178,021 ($27,970) for the six months ended December 31, 2011, compared to net
cash provided by financing activities amounting to ¥3,141,602 for the same
period of 2010. The decrease in net cash provided by financing activities was
mainly due to the payment of bank loans and decrease in short-term borrowings.
Working Capital. As of December 31, 2011, our working capital was ¥73,193,511
($11,499,914). Total current asset as of December 31, 2011 amounted to
¥110,846,721 ($17,415,858), an increase of ¥10,066,282 ($1,581,580) compared to
June 30, 2011. The increase was mainly attributable to an increase in trade
accounts receivable as a result of our business development.
The current ratio decreased from 3.75 at June 30, 2011 to 2.94 at December 31,
2011. This was mainly caused by the increase in trade accounts payable and
short-term borrowings.
Recently Enacted Accounting Standards
None.
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