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SKY DIGITAL STORES CORP. - 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 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. This section should be read together with the consolidated financial statements and related notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, which was filed on March 30, 2012. Overview We are a mobile internet product and application service provider. We have retail stores targeting the Chinese consumers. We design, manufacture and sell mobile communication products and accessories under the Donxon/EMI brand, and operate retail business through our website and retail store chains. We are developing licensed digital retail stores under our Sky Digital Stores brand, retailing various smartphones and accessories to end-users. Business growth for traditional mobile phone sales has been flat for the past two years. Customer demand for name brand smartphones has increased significantly. In the second quarter of 2011, we signed up as a reseller for a top global smartphone supplier. We opened our first concept store under our Sky Digital Stores brand on July 10, 2011. As of September 30, 2012, we have three such stores in Guangdong Province and two more in Henan Province. We intend to seek business opportunities with more global brands in the future and expect these stores to provide increased revenue sources for our company. Corporate History We were incorporated in the state of Nevada on March 23, 2006 under the name Hoopsoft Development Corp ("Hoopsoft").On January 9, 2007, we entered into an agreement and plan of merger ("Agreement and Plan of Merger") with Yellowcake Mining Inc. ("Yellowcake"), a Nevada corporation and wholly-owned subsidiary of Hoopsoft Development Corp., incorporated for the sole purpose of effecting the merger. Pursuant to the terms of the Agreement and Plan of Merger, Yellowcake merged with and into Hoopsoft, with Hoopsoft carrying on as the surviving corporation under the name "Yellowcake Mining Inc." On May 5, 2011, SKY Digital Stores, Corp. (the "Company", "we" or "SKYC"), Hong Kong First Digital Holding Ltd. ("First Digital"), and the shareholders of First Digital (the "FDH Shareholders") entered into a Share Exchange Agreement ("Exchange Agreement"). The closing of the transaction (the "Closing") took place on May 5, 2011 (the "Closing Date"). On the Closing Date, pursuant to the terms of the Exchange Agreement, we acquired all of the outstanding shares (the "Shares") of First Digital from the FDH Shareholders; and FDH Shareholders transferred and contributed all of their Shares to us. In exchange, we issued to the FDH Shareholders, their designees or assigns, an aggregate of 23,716,035 shares (the "Shares Component") or 97.56% of the shares of common stock of the Company issued and outstanding after the Closing (the "Share Exchange"), at $0.20 per share. This exchange was based on an acquisition value of First Digital of $4,743,207. The acquisition of First Digital was treated as a reverse acquisition, and the business of First Digital became the business of the Company. After the Closing of the Share Exchange, the Company controlled all the subsidiaries of First Digital in mainland China through First Digital and the administration, organization, management teams and operation models of all the subsidiaries in mainland China remained unchanged from before the Share Exchange. First Digital owns (i) 100% of the issued and outstanding capital stock of Shenzhen Dong Sen Mobile Communication Technology Co., Ltd (also known as Shenzhen Donxon Mobile Communication Technology Co., Ltd, "Donxon"), a company organized under the laws of the People's Republic of China ("China" or the "PRC"); and (ii) 100% of the issued and outstanding capital stock of Shenzhen Xing Tian Kong Digital Company Limited ("Xingtiankong"), a PRC company. Xingtiankong is the holder of 100% of the issued and outstanding capital stock of Shenzhen Da Sheng Communication Technology Company Limited (also known and doing business as Shenzhen Dasen Communication Technology Company Limited, "Shenzhen Dasen"), a PRC company. Shenzhen Dasen is the holder of 70% of the issued and outstanding capital stock of Foshan Da Sheng Communication Chain Service Company Limited (also known as Foshan Dasen Communication Chain Service Co. Ltd, "Foshan Dasen"), a company incorporated in PRC on January 19, 2007. Two PRC individuals own the remaining 30% ownership interest in Foshan Dasen. Pursuant to the Exchange Agreement, First Digital became a wholly-owned subsidiary of the Company, and the Company directly owned 100% of Donxon, 100% of Xingtiankong, 100% of Dasen and indirectly owned 70% of Foshan Dasen through First Digital. First Digital was established on September 30, 2010 in Hong Kong. First Digital entered into a share exchange agreement with the shareholders of Donxon on November 3, 2010, and as a result of the transaction, Donxon became a wholly-owned subsidiary of First Digital. Xingtiankong was established by First Digital on February 28, 2011 in Shenzhen, PRC. Xingtiankong completed a 100% ownership acquisition transaction with Shenzhen Dasen on April 7, 2011 and has an indirect interest ownership of 70% of Foshan Dasen through Shenzhen Dasen. Shenzhen Dasen was established on November 26, 2007 in Shenzhen, PRC. Foshan Dasen was established on January 19, 2007 in Foshan, PRC. Shenzhen Dasen acquired a 70% interest ownership of FDSC on January 7, 2008. On August 1, 2011, Donxon, a wholly owned subsidiary of the Company incorporated a subsidiary, Xinyang City Donxon Mobile Communication Technology Company Limited, in Henan Province ("Xinyang Donxon"). Xinyang Donxon is a logistics center, manufacturing facility, customer service and training center for the Company. 1-------------------------------------------------------------------------------- Table of Contents On October12, 2011, Donxon entered into an acquisition agreement with Vaslink Technology Ltd. ("Vaslink") and the sole shareholder of Vaslink to acquire Vaslink for RMB 7,500,000 (approximately $1,180,675), paid in the Company's common stock, valued at $1.21 per share. Vaslink is a company incorporated in China and engaged in the research, development, wholesale and retail of computer information technology, communications product, hardware and software in Guangzhou, China. On March 12, 2012, Xingtiankong established Shenzhen Sky Digital Technology Company Ltd. ("Xingtiankong Digital") with two unrelated parties. Xingtiankong Digital was established to expand our authorized reseller network under Sky Digital Stores brand throughout China. Xingtiankong owns 60% of Xingtiankong Digital. Economic and Political Risks Our operations are conducted primarily in the PRC. Accordingly, our 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. Our 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. Our 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, among other things. Critical Accounting Policies and Estimates In preparing our consolidated financial statements in accordance with US GAAP, we are required to make judgments, estimates and assumptions that affect: (i) the reported amounts of our assets and liabilities; (ii) the disclosure of our contingent assets and liabilities at the end of each reporting period; and (iii) the reported amounts of revenue and expenses during each reporting period. We continually evaluate these estimates based on our own historical experience, knowledge and assessment of current business and other conditions, our expectations regarding the future based on available information and reasonable assumptions, which together form our basis for making judgments about matters that are not readily apparent from other sources. Since the use of estimates is an integral component of the financial reporting process, our actual results could differ materially from those estimates. We believe that any reasonable deviation from those judgments and estimates would not have a material impact on our financial condition or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of operations and corresponding balance sheet accounts would be necessary. These adjustments would be made in future financial statements. When reading our financial statements, you should consider: (i) our critical accounting policies; (ii) the judgment and other uncertainties affecting the application of such policies; and (iii) the sensitivity of reported results to changes in conditions and assumptions. We have not made any material changes in the methodology used in our accounting policies which are consistent with those discussed in our annual report on Form 10-K for the year ended December 31, 2011. We believe the critical accounting policies and related judgments and estimates are identified in Note 2 to our unaudited consolidated financial statements accompanying in this report involve the most significant judgment and estimates used in the preparation of our financial statements. 2-------------------------------------------------------------------------------- Table of Contents Results of operations Recent Developments In the third quarter of 2012, we entered into licensing agreements with nine additional retail stores nationwide and granted these retail stores non-exclusive licenses to use our "Sky Digital Stores" brand name and store images and sell our digital products, including our Donxon brand products and other digital products, including Apple products. As of September 30, 2012, we have total 57 licensed stores. We supply the products to be sold in these stores. In the meantime, we opened two Company stores under the "Sky Digital Stores" brand; one is operating in Shenzhen city, Guangdong province, and the other one is in Xinyang city, Henan province. We believe that these newly licensed and company stores will help to expand our market coverage and generate more sales revenue in the near future. Results of operation for the three months ended September 30, 2012 compared with the three months ended September 30, 2011 (Unaudited) The following tables set forth key components of our results of operations and key components of our revenue for the period indicated. For three months ended September 30, 2012 % of Revenue 2011 % of Revenue Change ($) Change (%) Sales $ 23,704,674 100.00 % $ 15,844,644 100.00 % $ 7,860,030 49.61 % Cost of goods sold (23,119,444 ) -97.53 % (14,823,183 ) -93.55 % (8,296,261 ) 55.97 % Gross profit 585,230 2.47 % 1,021,461 6.45 % (436,231 ) -42.71 % Income from commission and licensing stores 117,940 0.50 % 55,084 0.35 % 62,856 114.11 % Operating expenses Selling expenses (159,680 ) -0.67 % (935,676 ) -5.91 % 775,996 -82.93 % General and administrative expenses (1,079,894 ) -4.56 % (68,575 ) -0.43 % (1,011,319 ) 1,474.76 % Total operating expenses (1,239,574 ) -5.23 % (1,004,251 ) -6.34 % (235,323 ) 23.43 % Income (loss) from operations (536,404 ) -2.26 % 72,294 0.46 % (608,698 ) -841.98 % Total other expenses (169,752 ) -0.72 % (45,114 ) -0.28 % (124,638 ) 276.27 % Income (loss) before provision for income taxes (706,156 ) -2.98 % 27,180 0.17 % (733,336 ) -2,698.07 % Provision for income taxes (9,056 ) -0.04 % (69,213 ) -0.44 % 60,157 -86.92 % Net loss $ (715,212 ) -3.02 % $ (42,033 ) -0.27 % $ (673,179 ) 1,601.55 % 3-------------------------------------------------------------------------------- Table of Contents Net Sales / Revenue: We have two types of revenue streams from our two lines of businesses, namely (i) design, manufacturing and sale of mobile phones and digital products (Donxon) and (ii) retail stores (Shenzhen Dasen). For the three months ended September 30, 2012, net sales increased by 49.61% to $23.70 million from $15.84 million as compared to the three months ended September 30, 2011. The increase in our sales was primarily due to the following factors: (1) The addition of the retail store business line opened a new window for us to sell mobile communication products to customers. As an authorized Apple product retailer, we rapidly expanded our sales and market coverage by retailing Apple products and other top smartphone brands in our retail stores and in our licensed stores in Guangdong Province and nearby areas, which in turn led to increased sales of our own Donxon brand products as customers were exposed to our products while shopping for Apple products. (2) The increase in sales was also affected by higher product selling prices for the period indicated. For the three months ended September 30, 2012, a significant portion of our sales were related to Apple iPhone, iPad, other high-end branded smartphones and digital communication accessories in our retail stores. The selling prices of such products are much higher than our own Donxon brand products. As a result of the increased quantity sold and higher selling price, our sales revenue increased accordingly. (3) The rebranding and sale of third-party products under our Donxon brand also increased for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, primarily due to increased product variety and increased quantity sold to target a broader range of customers. (4) Sales of our Donxon brand products decreased for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, because our factory moved from Shenzhen to Henan Xinyang. During the factory shift process, we reduced the manufacturing our own Donxon brand mobile and digital products. The overall increase in our sales revenue for the three months ended September 30, 2012 reflected the above combined factors. The following table sets forth the breakdown of our sales and gross profit for our two business lines for the three months ended September 30, 2012 and 2011: Three Months Ended September 30, 2012 Three Months Ended September 30, 2011 Mobile phone Mobile phone manufacturing Retail store Total manufacturing Retail store Total Sales $ 12,074,060 $ 11,630,614 $ 23,704,674 $ 11,938,568 $ 3,906,076 $ 15,844,644 Cost of goods (11,438,485 ) (11,680,959 ) (23,119,444 ) (11,263,824 ) (3,559,359 ) (14,823,183 ) Gross profit 635,575 (50,345 ) 585,230 674,744 346,717 1,021,461 Gross profit margin 5.26 % -0.43 % 2.47 % 5.65 % 8.88 % 6.45 % Cost of goods sold: Cost of goods sold increased $8.30 million or 55.97% when comparing the three months ended September 30, 2012 to the three months ended September 30, 2011. The increase in our cost of goods sold was in line with our increased sales. The overall increase in our cost of goods sold for the three months ended September 30, 2012 as compared to the prior comparative period were attributable to the following factors. (1) Due to the addition of the retail store business line into our operation, our sales volume increased and we incurred more cost to sell top brand products in our retail stores, such as iPhones, other smartphones and digital products which were purchased from other manufacturers and put into our retail store chain for resale. 4-------------------------------------------------------------------------------- Table of Contents (2) The purchase prices for these products were higher than our self-produced Donxon brand products. The increase in our cost of goods sold was largely attributable to the increased purchase cost incurred. (3) Due to the general inflation and increase in market price for raw materials and labor costs, the production costs incurred in our Donxon brand products also increased as compared to the comparable period a year ago, which led to the increased costs to be allocated to products sold. Gross profit and Gross margin: Gross profit decreased by 42.71% to $0.59 million for the three months ended September 30, 2012, as compared with the same period in 2011. The decrease in our gross profit was primarily due to decreased gross margin of retail business. Our gross margin for the three months ended September 30, 2012 was 2.47%, decreased from 6.45% for the three months ended September 30, 2011. The decrease in gross margin was due to higher purchase costs and lower gross margin from retail of Apple products and re-branded products during the quarter ended September 30, 2012. Operating Expenses: Total operating expenses increased from $1.00 million for the three months ended September 30, 2011 to $1.24 million for the three months ended September 30, 2012, representing a 23.43% increase. The increase in our total operating expense was primarily due to increased general and administrative expenses as discussed below: (1) For the three months ended September 30, 2012, we incurred increased travel, office, salary and other administration expenses in connection with managing our newly formed Xinyang factory. (2) For the three months ended September 30, 2012, we opened two new Company stores in Henan province. In order to promote sales from these newly opened Company stores, we incurred more advertising and promotion expenses than we did in the same period of 2011. (3) For the three months ended September 30, 2012, we had more subsidiaries and company stores than in the same period of 2011. We also increased employee hiring, leased more office and retail store space, incurred more administrative and office expenses, accrued more stock-based compensation expense, and faced increased audit, legal and consulting fees as a public company. Accordingly, our operating expenses for the three months ended September 30, 2012 were higher than the prior comparative period. We expect that our operating expenses will increase as we expand our business and operations. The Company will need to devote additional resources to increase our corporate governance and internal controls and to develop experience in complying with the laws, rules and regulations applicable to us as a U.S. public company that conducts business in China. We believe that we will need to hire more personnel as our business continues to grow, and we believe that we will need to incur additional general and administrative costs in the near future to support our business. Net Income/Loss: Net loss for the three months ended September 30, 2012 was $0.72 million, compared with net loss of $0.04 million for the three months ended September 30, 2011. The increase in our net loss for the three months ended September 30, 2012 was primarily due to (i) the increase in our cost of goods sold, which reduced our gross margin and (ii) the increase in our operating expenses as discussed above. We expect to see a positive net income trend in the last quarter of 2012 and beyond because we have designed more new products which will be put into production and attract more customers. In addition, we will expand our retail store business line by opening more retail stores and grant licenses to third parties to operate more retail stores in expanded geographic areas. 5-------------------------------------------------------------------------------- Table of Contents Results of operation for the nine months ended September 30, 2012 compared with the nine months ended September 30, 2011 (Unaudited) The following tables set forth key components of our results of operations and key components of our revenue for the period indicated. For nine months ended September 30, 2012 % of Revenue 2011 % of Revenue Change ($) Change (%) Sales $ 72,776,405 100.00% $ 38,066,707 100.00% $ 34,709,698 91.18% Cost of goods sold (70,699,082) -97.15% (35,368,682) -92.91% (35,330,400) 99.89% Gross profit 2,077,323 2.85% 2,698,025 7.09% (620,702) -23.01% Income from commission and licensing stores 406,479 0.56% 90,541 0.24% 315,938 348.94% Operating expenses Selling expenses (371,175) -0.51% (1,900,373) -4.99% 1,529,198 -80.47% General and administrative expenses (3,246,998) -4.46% (307,734) -0.81% (2,939,264) 955.13% Total operating expenses (3,618,173) -4.97% (2,208,107) -5.80% (1,410,066) 63.86% Income (loss) from operations (1,134,371) -1.56% 580,459 1.52% (1,714,830) -295.43% Total other expenses (538,755) -0.74% (42,896) -0.11% (495,859) 1,155.96% Income (loss) before provision for income taxes (1,673,126) -2.30% 537,563 1.41% (2,210,689) -411.24% Provision for income taxes (70,249) -0.10% (270,171) -0.71% 199,922 -74.00% Net income (loss) $ (1,743,375) -2.40% $ 267,392 0.70% $ (2,010,767) -751.99% Net Sales / Revenue: For the nine months ended September 30, 2012, net sales increased by 91.18% to $72.78 million from $38.07 million as compared to the nine months ended September 30, 2011. The increase in our sales was primarily due to the following factors: (1) The addition of the retail store business line opened a new window for us to sell mobile communication products to customers. As an authorized Apple product retailer, we rapidly expanded our sales and market coverage by retailing Apple products and other top smartphone brands in our retail stores and in our licensed stores in Guangdong Province and nearby areas, which in turn led to increased sales of our own Donxon brand products, as customers were exposed to our products while shopping for Apple products. (2) The increase in sales was also affected by higher product selling prices for the period indicated. For the nine months ended September 30, 2012, a significant portion of our sales were related to Apple iPhone, iPad, other high-end branded smartphones and digital communication accessories in our retail stores. The selling prices of such products are much higher than our own Donxon brand products. As a result of the increased quantity sold and higher selling price, our sales revenue increased accordingly. (3) The rebranding and sale of third-party products under our Donxon brand also increased for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011, primarily due to increased product variety and increased quantity sold to target a broader range of customers. 6-------------------------------------------------------------------------------- Table of Contents The following table sets forth the breakdown of our sales and gross profit for our two business lines for nine months ended September 30, 2012 and 2011: Nine months ended September 30, 2012 Nine months ended September 30, 2011 Mobile phone Mobile phone manufacturing Retail stores Total manufacturing Retail stores Total Sales $ 40,225,958 32,550,447 72,776,405 $ 33,037,198 $ 5,029,509 $ 38,066,707 Cost of goods (38,395,198 ) (32,303,884 ) (70,699,082 ) (30,695,597 ) (4,673,085 ) (35,368,682 ) Gross profit 1,830,760 246,563 2,077,323 2,341,601 356,424 2,698,025Gross profit margin 4.55% 0.76% 2.85% 7.09% 7.09% 7.09% Cost of goods sold: Cost of goods sold increased $35.33 million or 99.89% when comparing the nine months ended September 30, 2012 to the nine months ended September 30, 2011. The increase in our cost of goods sold was in line with our increased sales and the overall increase in our cost of goods sold for the nine months ended September 30, 2012 as compared to the prior comparative period were attributable to the following factors. (1) Due to the addition of the retail store business line into our operation, we incurred more cost to sell top brand products in our retail stores, such as iPhones, other smartphones and digital products which we purchased from other manufacturers and put into our retail store chain for resale. (2) The purchase prices on these products were higher than our self-produced Donxon brand products. The increase in our cost of goods sold was largely attributable to the increased purchase cost incurred. (3) Due to the general inflation and increase in market price for raw materials and labor costs, the production costs incurred in our Donxon brand products also increased as compared to the comparable period a year ago, which led to the increased costs to be allocated to products sold. Gross profit and Gross margin: Gross profit decreased by 23.01% to $2.08 million for the nine months ended September 30, 2012, as compared with the same period in 2011. The decrease in our gross profit was primarily due to the significantly decreased gross profit margin in our retail business. Our gross profit margin for the nine months ended September 30, 2012 was 2.85%, decreased from 7.09% for the nine months ended September 30, 2011. The decrease in gross profit margin was due to higher purchase costs and lower gross margin from retail sales of Apple products and re-branding products, and reduced sales of self-produced Donxon brand products during the nine months ended September 30, 2012. Operating Expenses: Total operating expenses increased from $2.21 million for the nine months ended September 30, 2011 to $3.62 million for the nine months ended September 30, 2012, representing a 63.86% increase. The increase in our total operating expense was primarily due to increased general and administrative expenses for the period ended September 30, 2012 as discussed below: (1) For the nine months ended September 30, 2012, we opened a new subsidiary, Shenzhen Xintiankong Technology, and also a new factory in Henan Xinyang and accordingly incurred increased travel, office, salary and other administration expenses in order to manage the Xinyang factory. (2) For the nine months ended September 30, 2012, we had more subsidiaries and company stores than in the same period of 2011. We also increased employee hiring, leased more office space, incurred more administrative and office expenses, accrued more stock-based compensation expense, and faced increased audit, legal and consulting fees as a public company. Accordingly, our operating expenses for the nine months ended September 30, 2012 was higher than the prior comparative period. 7-------------------------------------------------------------------------------- Table of Contents We expect that our operating expenses will increase as we expand our business and operations. The Company will need to enhance our management's skill level to adapt to the complex business environment because we are subject to the rules and regulations of the United States securities laws as well as a certain level of corporate governance and internal controls. We believe that we will need to devote additional resources to increase our corporate governance and internal controls and to develop experience in complying with the laws, rules and regulations applicable to us as a U.S. public company that conducts business in China. Net Income/Loss: Net loss for the nine months ended September 30, 2012 was $1.74 million, compared with net income of $0.27 million for the nine months ended September 30, 2011. The increase in our net loss for the nine months ended September 30, 2012 was primarily due to (i) the increase in our cost of goods sold, which reduced the gross margin, and (ii) the increase in our general and administrative expense, as discussed above. We are designing new products with the goal of attracting more customers to address these challenging trends in our business. In addition, we will expand our retail store business line by opening more retail stores and grant licenses to third parties to operate retail stores in expanded geographic areas. Liquidity Total current assets increased by $3.58 million from $20.73 million as of December 31, 2011 to $24.31 million as of September 30, 2012. The primary changes in our current assets during the nine months ended September 30, 2012 were from changes in cash, accounts receivable, inventory, trade deposit, other receivables and amounts due from related parties. · The increase in our inventories from $3.63 million as of December 31, 2011 to $8.25 million was because we purchased and stock-piled more materials, components to be used in manufacturing our Donxon brand products and digital products from outside manufacturers to be used to expand our retail store business lines. · The increase in trade deposits from $1.04 million as of December 31, 2011 to $3.66 million as of September 30, 2012 was because we made advances to certain vendors for purchase of inventory items, raw materials for our self-produced products and semi-finished third-party products for rebranding and sale under our Donxon brand. · The increase in other receivables from $0.12 million as of December 31, 2011 to $1.82 million as of September 30, 2012 was mainly due the increased temporarily lent funds to third parties, and it will be repaid back to us in the near future. · The increase in due from related parties from $0 as of December 31, 2011 to $2.37 million as of September 30, 2012 was because we temporarily lent funds to these parties to generate interest income, and such amount will be repaid back to us in the near future. · The increase of total current assets was offset in part by a decrease in cash and accounts receivable. · The decrease in cash by $5.7 million was because we repaid $4.30 million (RMB 27.10 million) of bank loans upon maturity, repaid $2.56 million (RMB16.13 million) of stockholder loans, and paid $5.37 million (RMB 33.88 million) to the local government to obtain the land use right in Henan Xinyang. The decrease in accounts receivable by $1.56 million was because we systematically follow up on collection of outstanding accounts. Total current liabilities as of September 30, 2012 amounted to $25.41 million, compared with $15.54 million as of December 31, 2011. The increase in current liabilities was primarily due to an increase in short-term bank loans, notes payable, accounts payable and advance from customers balance, partially offset by amounts due to related parties and loans from third parties. · The increase in short-term bank loans was because we received bank loans of $9.43 million (RMB 59.50 million) and repaid bank loans of $4.30 million (RMB 27.10 million) upon maturity. · The increase in notes payable was because Shenzhen Donxon issued bank-accepted notes of $2.38 million (RMB 15 million) to vendors for the purpose of inventory purchase. · The increase in our accounts payable was because we purchased more materials, components, and digital products from various suppliers, and such amount had not been paid as of September 30, 2012. · The increase of advance from customers was because we received cash advance from customer sales orders for several of our newly developed smart phone models, which are still under manufacturing as of the balance sheet date. We expect such sales orders will be fulfilled in November 2012 once the production is completed and the products are delivered to these customers. · Amounts due to related parties also decreased by approximately $2.29 million because we made a repayment of $2.29 million to the relevant related parties. · The decrease in loans from third parties from $2.86 million as of December 31, 2011 to $1.73 million as of September 30, 2012 was because we repaid the funds to these parties when cash became available. 8-------------------------------------------------------------------------------- Table of Contents As reflected in the Company's condensed consolidated financial statements as of September 30, 2012, the Company suffered recurring net losses and negative cash flow from operating activities. The Company also has a working capital deficit. The Company relies upon funds from financing activities to support its ongoing operations. The Company plans to improve its liquidity and strengthen working capital source through the following efforts: (1) Utilizing funds from local banks to support daily operation, including ICBC Xinyang branch with an amount of $791,264 (RMB5,000,000), which is expected to be granted by the Bank in December 2012, assuming successful completion of the approval process. We are also negotiating with other financial institutions to obtain further loans to meet our operating demand. (2) With the aid of our newly strengthened R&D team, we plan to launch a series of new products in the next twelve months, including our smart phone Model SK8, Model SK9 and first and second generation of Xinghe smart phones. These new products will increase our product variety and diversify our product offerings to target a broader range of customers. (3) Open more licensed stores and Company stores in broadened geographic areas to expand our market share. (4) Improve the sales and marketing skills of our sales person through training. With the aid of strong marketing personnel, we believe our sales will be increased within our entire retail network. (5) Reducing costs and expenditures through integrating our internal resources, improving facility utilization, maximize our production capacity, improve employee work efficiency. We believe such efforts will cut our costs and improve our profitability in the near future. Based on the above remedial plan, the Company believes that it will generate sufficient capital to meet its ongoing needs for the next 12 months. Capital Resources In summary, our cash flows for the periods indicated are as follows: Nine months ended September 30, 2012 2011Cash flows (used in) provided by operating activities $ (3,222,150 ) $ 1,399,119 Cash flows used in investing activities (6,758,503 ) (1,253,998 ) Cash flows provided by financing activities 4,231,584 8,156,625 Operating Activities Net cash used in operating activities was $3.22 million for the nine months ended September 30, 2012, which consisted of our net loss of $1.74 million and noncash adjustments of $0.61 million which mainly derived from depreciation and amortization of $0.41 million and stock-based compensation of $0.14 million, offset by net changes in operating assets and liabilities due to our expanded operating activities, including an increase of inventory of $4.65 million because we purchased and stock-piled more materials, components to be used in manufacturing our Donxon brand products and digital products to be used in our retail store business lines, and an increase in accounts payable of $3.37 million because we increased our purchases of inventory on credit. 9-------------------------------------------------------------------------------- Table of Contents Investing Activities Net cash used in investing activities primarily relates to expenditures associated with the acquisition of property and equipment as well as intangible assets, such as system application software and land use rights. Net cash used in investing activities increased approximately $5.51 million, from approximately $1.25 million for the nine months ended September 30, 2011 to approximately $6.76 million for the nine months ended September 30, 2012. This increase was primarily attributable to an increase of $1.39 million in the purchase of property, plant and equipment, an increase of $5.37 million due to the acquisition of land use rights on which our new factory was opened in April 2012. Financing Activities Net cash used in financing activities mainly consists of proceeds from short-term bank loans and shareholders' loans, repayment of related party loans, third party loans and bank loans. Our net cash provided by financing activities significantly decreased $3.93 million, from $8.16 million for the nine months ended September 30, 2011 to $4.23 million for the nine months ended September 30, 2012. This was because we borrowed a bank loan of $9.43 million and at the same time repaid $4.30 million in bank loans upon maturity, repaid third-party loans of $1.15 million, and borrowed and repaid related party loans of $2.56 million and $2.38 million, respectively. The net change in our cash flows from financing activities reflects the above factors. Off-Balance Sheet Arrangements Guarantee of Third-Party Indebtedness-No Liability Is Recorded As China only began its economic reform and development of a market economy in the 1980s, its credit evaluation system has had only a very short history and is far less sophisticated than that in the developed countries. Therefore, when an enterprise applies for a loan from a commercial bank, it is difficult for the bank to evaluate the credit risk of the applicant. As an alternative tool, it is a common practice in China for commercial banks to require the applicant to find an unrelated third party in its local economy to provide a loan guarantee for the applicant, which serves as a sort of credit check for the bank. In return, and also to avoid the risk of having to make payments under the guarantee, such guarantors often require the counterparty to provide similar guarantees on their own debt. Therefore, this type of guarantee is usually a cross-guarantee. For mutual benefit, the Company reached agreements with three unrelated third parties to provide such a cross-guarantee on bank loans as of September 30, 2012 and December 31, 2011. As of September 30, 2012, the Company, through its subsidiary is contingently liable as guarantor with respect to the maximum exposure of $3,323,311 (RMB21,000,000) to unrelated third parties, AIV Technology, Huafoli and SPA Moment on a cross-guarantee basis. The term of these guarantees are for one year, expiring on October 16, 2012. At any time from the date of guarantees, should AIV Technology, Huafoli and SPA Moment fail to make their due debt payments, the Company will be obligated to perform under the guarantees by primarily making the required payments, including late fees and penalties. Subsequently on October 16, 2012, the four parties did not repay the bank loans upon maturity but entered into amended agreements with the bank to extend the bank loan for additional one year, expiring on October 15, 2013. The related cross-guarantee agreement has also been extended for one year. Guarantee of Subsidiaries' Indebtedness-No Liability Is Recorded As of July 17, 2012, Sky Digital became contingently liable as guarantor with respect to the maximum exposure of $3,956,322 (RMB 25,000,000) to Shenzhen Donxon, which is one of the subsidiaries of the Company. The term of this guarantee is for one year, expiring on July 16, 2013. At any time from the date of guarantees, should Shenzhen Donxon fail to make its due debt payments, Sky Digital will be obligated to perform under the guarantees by primarily making the required payments, including late fees and penalties. As of August 29, 2012, Shenzhen Donxon became contingently liable as pledgor with respect to the maximum exposure of $1,503,402 (RMB 9,500,000) to Shenzhen Dasen, which is one of the subsidiaries of the Company. The term of this pledge is for one year, expiring on August 28, 2013. At any time from the date of guarantees, should Shenzhen Dasen fail to make its due debt payments, Shenzhen Donxon will be obligated to perform under the guarantees by primarily making the required payments, including late fees and penalties. 10-------------------------------------------------------------------------------- Table of Contents |