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WPCS INTERNATIONAL INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS(Edgar Glimpses Via Acquire Media NewsEdge) OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements that reflect Management's current views with respect to future events and financial performance. You can identify these statements by forward-looking words such as "may," "will," "expect," "anticipate," "believe," "estimate" and "continue," or similar words. Those statements include statements regarding the intent, belief or current expectations of us and members of our management team as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risk and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission. Important factors currently known to Management could cause actual results to differ materially from those in forward-looking statements. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results over time. We believe that management's assumptions are based upon reasonable data derived from and known about our business and operations and the business and operations of the Company. No assurances are made that actual results of operations or the results of our future activities will not differ materially from management's assumptions. Factors that could cause differences include, but are not limited to, expected market demand for the Company's services, fluctuations in pricing for materials, and competition. Overview We are a global provider of design-build engineering services for communications infrastructure, with over 375 employees in five (5) operations centers on three continents, following the asset sales of our Hartford and Lakewood Operations described below. We provide our engineering capabilities including wireless communication, specialty construction and electrical power to a diversified customer base in the public services, healthcare, energy and corporate enterprise markets worldwide. Recent Developments On December 4, 2012, we entered into the Purchase Agreement with the Buyers pursuant to which, we sold an aggregate of (i) $4,000,000 principal amount of Notes and (ii) Warrants to purchase 15,923,567 shares of our Common Stock to the Buyers for aggregate gross Financing proceeds of $4,000,000. Pursuant to the terms of the Notes, we agreed to deposit the initial funds received from the Financing, minus the Initial Lending Amount of $2,178,516 into the Lockbox Account controlled by the Collateral Agent, as collateral agent on behalf of the Buyers. In addition, all payments of our accounts receivable (and our domestic subsidiaries) shall be deposited into the Lockbox Account. We are permitted to receive from the Lockbox Account, on a daily basis, such amount of cash equal to: (A) (i) cash balance in the Lockbox Account plus (ii) 95% of available qualified accounts receivable minus (iii) $250,000 minus (B) amount of principal, accrued interest, fees, costs and expenses owed pursuant to the Notes. The Notes contain certain customary representations and warranties, affirmative and negative covenants and events of default. The principal covenant is that we shall maintain a current ratio of not less than 0.6 to 1.0 as of the last calendar day of each month. We used the Initial Lending Amount to repay the existing loan of $2,000,000, plus $78,516 of interest accrued and fees and expenses to Sovereign, which Credit Agreement was terminated in connection with the Financing, and $100,000 for Buyer legal fees in connection with the Notes. On July 25, 2012, we and the Hartford and Lakewood Operations entered into the Asset Purchase Agreement, pursuant to which the Hartford and Lakewood Operations sold substantially all of their assets and liabilities to two newly-created subsidiaries of Kavveri for a purchase price of $5.5 million in cash, subject to adjustment and assumption of their various liabilities. At closing, we received $4.9 million in cash, and the remaining $600,000 of the purchase price is to be placed into escrow pursuant to the Asset Purchase Agreement. We used the proceeds from this sale to repay the full amount outstanding under the Credit Agreement of $4,022,320 as of July 25, 2012. The difference of $877,680 was deposited in our operating cash account. 28 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The parties agreed to place $350,000 of the purchase price into escrow pending assignment of certain contracts post-closing, with us receiving those funds upon successful assignment of the contracts. The remaining $250,000 is to be escrowed for purposes of satisfying certain adjustments to the purchase price based on a final net asset valuation to be completed after closing as well as repurchase obligations of certain delinquent accounts receivable. No later than three days after the final determination of the net asset valuation, the purchasers are required to deposit the $600,000 into escrow. On September 4, 2012, Kavveri provided us with its calculation of the net asset valuation, and claimed that we owed them $251,868. On October 2, 2012, we provided Kavveri our calculation of the net asset valuation, and claimed Kavveri owes us $94,493. We are currently working with Kavveri to resolve the net asset valuation dispute. If the parties disagree, and if they are unable to come to an agreement, the matter will then be submitted to one or more independent, nationally-recognized accounting firms for final determination. On November 7, 2012, Kavveri submitted to us an aggregate claim for indemnification of $1,938,288 with regard to (a) delinquent receivables to be repurchased of $546,077; (b) $916,500 for accounts receivable Kavveri deems are not collectible in the ordinary course of business, and (c) $475,000 for the replacement, programming an installation of replacement radios on a project that was completed by our Hartford Operations and accepted by the customer on or prior to July 25, 2012. With regard to the delinquent receivables claimed, we are disputing the amount of the delinquent receivables, and we believe that after consideration of reserves for uncollectible accounts and other offsets previously considered in our calculation of the net asset valuation described above, the total amount of delinquent receivables to be repurchased is less, and is subject to further reduction based on additional collection of receivables by Kavveri. Furthermore, with regard to the timing in the Asset Purchase Agreement for notification to us, we believe that Kavveri missed the deadline to notify us regarding the repurchase of delinquent receivables, which would eliminate any repurchase payment owed by us to Kavveri. We believe the remaining two claims are without merit, and we are currently preparing a response to Kavveri, to dispute each of these indemnification claims. All operating results disclosed in this quarterly report only include the results from continuing operations, and exclude the results for the St. Louis and Sarasota Operations divested in September 2011, and the Hartford and Lakewood Operations asset sales, each of which are presented as discontinued operations. The Sarasota, Lakewood and Hartford Operations were previously reported in the wireless communications segment and the St. Louis Operation was reported in the specialty construction segment. We have also combined the management and operations of the Seattle and Portland Operations for efficiency. Wireless Communication Throughout the community or around the world, in remote and urban locations, wireless networks provide the connections that keep information flowing. The design and deployment of a wireless network solution requires an in-depth knowledge of radio frequency engineering so that wireless networks are free from interference with other signals and amplified sufficiently to carry data, voice or video with speed and accuracy. We have extensive experience and methodologies that are well suited to address these challenges for our customers. We are capable of designing wireless networks and providing the technology integration necessary to meet goals for enhanced communication, increased productivity and reduced costs. We have the engineering expertise to utilize all facets of wireless technology or combination of various technologies to develop a cost effective network for a customer's wireless communication requirements. This includes Wi-Fi networks, point-to-point systems, mesh networks, microwave systems, cellular networks, in-building systems and two-way communication systems. With the divestiture of the Hartford and Lakewood Operations, we expect to perform less project work in the police, fire, and emergency dispatch markets. However, we will continue to provide wireless communications services through our remaining operations in markets such as utilities, education, military and transportation infrastructure, as part of the services we provide in our other operations. Specialty Construction With the development of communities and industry, pipeline services are an integral part of the infrastructure process. We have expertise in the construction and maintenance of pipelines in our China Operations for natural gas and petroleum transmission. This includes experience in transmission infrastructure, horizontal directional drilling and rock trenching. In addition, we offer trenching services for power lines, telecommunications and water lines. Our services are performed with minimal ground disruption and environmentalimpact. 29 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Electrical Power Electrical power transmission and distribution networks built years ago often cannot fulfill the growing technological needs of today's end users. We provide complete electrical contracting services to help commercial and industrial facilities of all types and sizes to upgrade their power systems. Our capabilities include power transmission, switchgear, underground utilities, outside plant, instrumentation and controls. We provide an integrated approach to project coordination that creates cost-effective solutions. In addition, corporations, government entities, healthcare organizations and educational institutions depend on the reliability and accuracy of voice, data and video communications. However, the potential for this new technology cannot be realized without the right electrical infrastructure to support the convergence of technology. In this regard, we create integrated building systems, including the installation of advanced structured cabling systems and electrical networks. We support the integration of renewable energy, telecommunications, life safety, security and HVAC in an environmentally safe manner and design for future growth by building in additional capacity for expansion as new capabilities are added. As part of the divestiture transactions described above, we reclassified the reporting units within our reportable segments. As a result, wireless communications includes the Suisun City and Australia Operations, specialty construction includes the China Operations, and electrical power includes the Trenton, Seattle and Portland Operations, for each of the periods presented. For the six months ended October 31, 2012, wireless communication, specialty construction and electrical power represented approximately 39.6%, 7.9% and 52.5%, respectively, of our total revenue. For the six months ended October 31, 2011, wireless communication, specialty construction and electrical power represented approximately 33.8%, 9.3% and 56.9%, respectively, of our totalrevenue. Industry Trends We focus on markets such as public services, healthcare, energy and international which continue to show growth potential. · Public services. We provide communications infrastructure for public services which include utilities, education, military and transportation infrastructure. We believe there is an active market for communications infrastructure in the public service sector due to the need to create cost efficiencies through the implementation of new communications technology. · Healthcare. We provide communications infrastructure for hospitals and medical centers. In the healthcare market, the aging population is resulting in demands for upgraded and additional hospital infrastructure. New construction and renovations are occurring for hospitals domestically and internationally. In addition, there is a need to reduce the cost of delivering healthcare by implementing new communications technology. Our services include electrical power, structured cabling, security systems, life safety systems, environmental controls and communication systems. · Energy. We provide communications infrastructure for petrochemical, natural gas and electric utility companies as well as renewable energy systems for various entities. The need to deliver basic energy more efficiently and to create new energy sources is driving the growth in energy construction. This creates opportunities to upgrade and deploy new communications technology and design and build renewable energy solutions. · International. We provide communications infrastructure internationally for a variety of companies and government entities. China is spending on building its internal infrastructure and Australia is upgrading their infrastructure. Both China and Australia have experienced positive GDP growth rates. Current Operating Trends and Financial Highlights Management currently considers the following events, trends and uncertainties to be important in understanding our results of operations and financial condition during the current fiscal year: In regards to our financial results in the second quarter and year-to-date for fiscal 2013, we continue to make significant progress in turning around our financial performance in our five operations centers for the three and six months ended October 31, 2012, as compared to the year ended April 30, 2012. During fiscal 2012, we employed cost reduction strategies, and made management changes by hiring experienced leadership in Suisun City, especially in the project management and estimating roles, which we believe has significantly helped this operation return to EBITDA profitability. In our Trenton Operations, we have essentially completed the Cooper Project, which was a project we incurred a loss of approximately $6 million in fiscal 2012, and we are re-focusing this operation to concentrate on pursuing smaller revenue projects that can be performed profitably, and cost reduction strategies in order to return this operation to profitability in fiscal 2013. 30 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Excluding our corporate operating expenses, for the three months ended October 31, 2012, the five operation centers generated EBITDA as adjusted of approximately $1,429,000, compared to an EBITDA as adjusted of $894,000 for the three months ended October 31, 2011. The second quarter results ended October 31, 2012 includes approximately $ 750,000 of change orders received by the Trenton Operations related to the Cooper Project. For the six months ended October 31, 2012, we generated EBITDA as adjusted of approximately $2,124,000, as compared to EBITDA as adjusted of $2,915,000 for the six months ended October 31, 2011. The six month results ended October 31, 2012 include approximately $1,486,000 of change orders received by the Trenton Operations related to the Cooper Project. We expect to receive additional change orders in the third fiscal quarter from the Cooper Project for costs incurred and recognized in prior periods, and we have also submitted a claim for approximately $3.0 million to the Owner for significant cost overruns as a result of significant delays, disruptions and construction changes which were beyond our control and required us to perform additional work. If approved, the additional change orders and claim for the Cooper Project are expected to generate future operating income for us, as the costs related to these pending change orders and claim have already been incurred. All current and future amounts to be paid on the Cooper Project are assigned and will be paid to Zurich directly. EBITDA as adjusted is defined as earnings before interest, income taxes including noncash charges for deferred tax asset valuation allowances, gain or loss from discontinued operations, acquisition-related contingent earn-out costs, goodwill impairment, one-time charges related to exploring strategic alternatives and depreciation and amortization. Management uses EBITDA to assess the ongoing operating and financial performance of our company. This financial measure is not in accordance with GAAP and may differ from non-GAAP measures used by other companies. A reconciliation of EBITDA is as follows. Three Months Ended Six Months Ended October 31, October 31, October 31, 2012 2011 2012 2011 NET (LOSS) INCOME ATTRIBUTABLE TO WPCS, GAAP $ (493,386 ) $ (1,665,328 ) $ 500,315 $ (1,700,005 ) Plus: Net income attributable to noncontrolling interest 29,152 44,604 28,605 60,060 Loss from discontinued operations, net of tax 88,267 285,330 727,559 474,015 Loss (gain) from disposal of discontinued operations 485,212 1,027,637 (1,839,419 ) 1,027,637Income tax (benefit) provision (72,272 ) (354,384 ) 62,257 57,504 Interest expense 330,135 230,136 455,250 325,929 Interest income (6,161 ) (23,493 ) (15,959 ) (31,969 ) Change in fair value of acquisition-related contingent consideration - 40,560 - 83,628 One-time strategic costs - 76,842 - 140,512 Depreciation and amortization 320,066 441,870 681,780 881,043 Consolidated EBITDA as adjusted, Non-GAAP 681,013 103,774 600,388 1,318,354 Plus: Corporate operating expenses 747,673 790,574 1,523,416 1,596,638 EBITDA as adjusted of Continuing Operation Centers, Non-GAAP $ 1,428,686 $ 894,348 $ 2,123,804 $ 2,914,992 31 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In regards to our financial results for the three months ended October 31, 2012, we generated net income from our continuing operations attributable to WPCS of approximately $80,000, or $0.01 per diluted common share, compared to a net loss from continuing operations attributable to WPCS of $352,000 or $0.05 per diluted common share for the same period in the prior year. For the three months ended October 31, 2012, we generated a net loss of approximately $493,000, or $0.07 per diluted common share, which includes a loss from discontinued operations for the Hartford and Lakewood Operations of approximately $573,000, or $0.08 per diluted common share. This compares to a net loss of $1,665,000, or $0.24 per diluted common share for the same period in the prior year, which includes a loss from discontinued operations of approximately $1,313,000, or $0.19 per diluted common share. For the six months ended October 31, 2012, we generated net income of approximately $500,000, or $0.07 per diluted common share, which includes income from discontinued operations for the Hartford and Lakewood Operations of approximately $1.1 million or $0.16 per diluted common share. This compares to a net loss of approximately $1.7 million, or $0.24 per diluted common share, which includes a loss from discontinued operations of approximately $1.5 million, or $0.22 per diluted common share for the six months ended October 31, 2011. Although the economy has not yet fully recovered and will continue to present challenges for our business, we expect to generate EBITDA as adjusted in the fiscal year ending April 30, 2013. The markets we serve in public services, healthcare, and energy continue to afford opportunities to grow our business. Two of our most important economic indicators for measuring our future revenue producing capability and demand for our services continue to be our backlog and bid list. For comparative purposes our backlog and bid list for prior periods only includes our continuing operations. Our backlog of unfilled orders was approximately $28.9 million at October 31, 2012, compared to backlog of $30.8 million at July 31, 2012, and $25.1 million at October 31, 2011. Our bid list, which represents project bids under proposal for new and existing customers, was approximately $56.3 million at October 31, 2012, compared to approximately $61.1 million at July 31, 2012. Our goal is to continue converting more of these bids into contract awards and to increase our backlog in the quarters ahead. We believe our design-build engineering focus for public services, healthcare, energy and corporate enterprise infrastructure will create additional opportunities both domestically and internationally. We believe that the ability to provide comprehensive communications infrastructure services including wireless communication, specialty construction and electrical power gives us a competitive advantage. In regards to strategic development, our focus is on organic growth opportunities and we feel optimistic about the markets we serve as evidenced by our new contract awards and customers continuing to seek bids from us, due to our experience in these markets. Results of Operations for the Three Months Ended October 31, 2012 Compared to the Three Months Ended October 31, 2011 Consolidated results for the three months ended October 31, 2012 and 2011 were as follows: Three Months Ended October 31, 2012 2011 REVENUE $ 9,942,161 100.0 % $ 21,754,833 100.0 % COSTS AND EXPENSES: Cost of revenue 6,324,209 63.7 % 18,379,347 84.5 % Selling, general and administrative expenses 2,936,939 29.5 % 3,348,554 15.4 % Depreciation and amortization 320,066 3.2 % 441,870 2.0 % Change in fair value of acquisition-related contingent consideration - - 40,560 0.2 % Total costs and expenses 9,581,214 96.4 % 22,210,331 102.1 % OPERATING INCOME (LOSS) 360,947 3.6 % (455,498 ) (2.1 )% OTHER EXPENSE (INCOME): Interest expense 330,135 3.2 % 230,136 1.1 % Interest income (6,161 ) - (23,493 ) (0.1 )% Income (loss) from continuing operations before income tax benefit 36,973 0.4 % (662,141 ) (3.1 )% Income tax benefit (72,272 ) (0.7 )% (354,384 ) (1.6 )% INCOME (LOSS) FROM CONTINUING OPERATIONS 109,245 1.1 % (307,757 ) (1.5 )% Discontinued operations Loss from operations of discontinued operations, net of tax (88,267 ) (0.9 )% (285,330 ) (1.3 )% Loss from disposal (485,212 ) (4.9 )% (1,027,637 ) (4.7 )% Loss from discontinued operations, net of tax (573,479 ) (5.8 )% (1,312,967 ) (6.0 )% CONSOLIDATED NET LOSS (464,234 ) (4.7 )% (1,620,724 ) (7.5 )% Net income attributable to noncontrolling interest 29,152 0.3 % 44,604 0.2 % NET LOSS ATTRIBUTABLE TO WPCS $ (493,386 ) (5.0 )% $ (1,665,328 ) (7.7 )% 32 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Revenue Revenue for the three months ended October 31, 2012 was approximately $9,942,000, as compared to approximately $21,755,000 for the three months ended October 31, 2011. The decrease in revenue was due to a number of factors: (1) the planned strategic change to re-focus the Trenton Operation as a smaller revenue producing operation that returns to profitability, while the Cooper Project is completed; and (2) project delays or postponement of new project bid awards at the state and local government level due to political and economic climate. For the three months ended October 31, 2012 and 2011, we had one customer, the Cooper Project, which comprised 12.4% and 16.1% of total revenue, respectively. Wireless communication segment revenue for the three months ended October 31, 2012 and 2011 was approximately $4,649,000 or 46.8% and $6,540,000 or 30.1% of total revenue, respectively. The decrease in revenue was due primarily to project delays on existing contracts and delays or postponements of new project bid awards from prior quarters at the state and local government level for public services projects, the revenue of which is expected to be recognized in future periods. The increase as a percentage of revenue was due to a change in segment revenue mix as a result of a reduction of operations in the electrical power segment. Specialty construction segment revenue for the three months ended October 31, 2012 and 2011 was approximately $823,000 or 8.3% and $2,443,000 or 11.2% of total revenue, respectively. The decrease in revenue was primarily attributable to fewer projects completed in the three months ended October 31, 2012 as compared to the same period in the prior year for the China Operations. Revenue in the China Operations is recognized on a completed contract basis. Electrical power segment revenue for the three months ended October 31, 2012 and 2011 was approximately $4,471,000 or 45.0% and $12,771,000 or 58.7% of total revenue, respectively. The decrease in revenue was due primarily to the planned strategic change to re-focus the Trenton Operation as a smaller revenue producing operation that returns to profitability, while completing the Cooper Project. The Cooper Project accounted for 27.3% of the total revenue in the electrical power segment this quarter compared to 27.5% in the same period in the prior year. The Cooper Project was essentially completed in the second fiscal quarter. It is not expected that similar future projects will replace the Cooper Project or other larger electrical projects that were completed in the prior period, therefore, it is expected that our revenue in the electrical power segment will not substantially increase in the near future. Cost of Revenue Cost of revenue consists of direct costs on contracts, materials, direct labor, third party subcontractor services, union benefits and other overhead costs. Our cost of revenue was approximately $6,324,000, or 63.7% of revenue, for the three months ended October 31, 2012, compared to $18,379,000 or 84.5% for the same period of the prior year. The dollar decrease in our total cost of revenue is primarily due to the corresponding decrease in revenue during the three months ended October 31, 2012. The decrease as a percentage of revenue is due to: (1) the revenue blend of project work completed during the quarter; (2) the current period contained a smaller percentage of lower margin work performed by the Trenton Operations, including the Cooper Project, as compared to the same period in the prior period; and (3) the current quarter included approximately $750,000 of change order revenue related to the Cooper Project, the costs of which were incurred or accrued in fiscal 2012. 33 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Wireless communication segment cost of revenue and cost of revenue as a percentage of revenue for the three months ended October 31, 2012 and 2011 was approximately $3,186,000 and 68.5% and $4,758,000 or 72.7%, respectively. The dollar decrease in cost of revenue is due to the corresponding decrease in revenue during the three months ended October 31, 2012. The decrease as a percentage of revenue is due to the revenue blend of project work performed during the three months ended October 31, 2012. Specialty construction segment cost of revenue and cost of revenue as a percentage of revenue for the three months ended October 31, 2012 and 2011 was approximately $415,000 and 50.4% and $1,867,000 and 76.4%, respectively. The dollar decrease in cost of revenue is due to the corresponding decrease in revenue during the three months ended October 31, 2012 in our China Operations. The decrease as a percentage of revenue is due to the revenue blend of project work performed, and less subcontractor cost as compared to the same periodin the prior year. Electrical power segment cost of revenue and cost of revenue as a percentage of revenue for the three months ended October 31, 2012 and 2011 was approximately $2,724,000 and 60.9% and $11,755,000 and 92.0%, respectively. The dollar decrease in cost of revenue is due to the corresponding decrease in revenue during the three months ended October 31, 2012. The decrease as a percentage of revenue is primarily due to revenue blend of project work performed during the quarter, as the current quarter included approximately $750,000 of change order revenue related to the Cooper Project, the costs of which were incurred or accrued in fiscal 2012. In total, the current period contained a smaller percentage of lower margin work performed by the Trenton Operations, as compared to the same period in the prior year. Selling, General and Administrative Expenses For the three months ended October 31, 2012, total selling, general and administrative expenses were approximately $2,937,000, or 29.5% of total revenue compared to $3,349,000, or 15.4% of revenue, for the prior year. Included in selling, general and administrative expenses for the three months ended October 31, 2012 are $1,754,000 for salaries, commissions, payroll taxes and other employee benefits. The $188,000 decrease in salaries and payroll taxes compared to the prior year is due primarily to the lower salaries from cost reduction strategies. Professional fees were $279,000, which include on-going accounting, legal and investor relations fees. The $63,000 decrease in professional fees compared to the prior year is due primarily to no strategic alternatives costs due to the conclusion of this effort, and reduced on-going professional service fees for other services compared to the same period in the prior year. Insurance costs were $141,000 and rent for office facilities was $119,000. Automobile and other travel expenses were $283,000 and telecommunication expenses were $57,000. Other selling, general and administrative expenses totaled $304,000. For the three months ended October 31, 2012, total selling, general and administrative expenses for the wireless communication, specialty construction and electrical power segments were approximately $1,316,000, $98,000 and $775,000, respectively, with the balance of approximately $748,000 pertaining to corporate expenses. For the three months ended October 31, 2011, total selling, general and administrative expenses were approximately $3,349,000 or 15.4% of total revenue. Included in selling, general and administrative expenses for the three months ended October 31, 2011 was $1,942,000 for salaries, commissions, payroll taxes and other employee benefits. Professional fees were $342,000, which include accounting, legal and investor relation fees. Insurance costs were $270,000 and rent for office facilities was $143,000. Automobile and other travel expenses were $341,000 and telecommunication expenses were $63,000. Other selling, general and administrative expenses totaled $248,000. For the three months ended October 31, 2011, total selling, general and administrative expenses for the wireless communication, specialty construction and electrical power segments were approximately $1,376,000, $94,000 and $1,088,000, respectively, with the balance of approximately $791,000 pertaining to corporate expenses. Depreciation and Amortization For the three months ended October 31, 2012 and 2011, depreciation was approximately $289,000 and $402,000, respectively. The decrease in depreciation is due to the retirement of certain assets. The amortization of customer lists and backlog for the three months ended October 31, 2012 was $31,000 as compared to $40,000 for the same period of the prior year. The net decrease in amortization was due primarily to certain customer lists and backlog being fully amortized in the prior year compared to the current year. All customer lists are amortized over a period of three to nine years from the date of their acquisitions. Backlog is amortized over a period of one to three years from the date of acquisition based on the expected completion period of the relatedcontracts. 34 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Change in Fair Value of Acquisition-Related Contingent Consideration For the three months ended October 31, 2012 and 2011, the change in fair value of acquisition-related contingent consideration was $0 and $41,000, respectively. The change in fair value of acquisition-related contingent consideration is due to the non-cash expense recorded in the fiscal 2012 statement of operations for the change in present value of future payments of acquisition-related contingent consideration related to the Pride acquisition. In connection with the acquisition of Pride on November 1, 2009, during fiscal 2012 we paid additional purchase price of $1,047,732 to the former Pride shareholders upon the achievement of the earnings before interest and taxes (EBIT). As a result, the settlement acquisition-related contingent consideration was completed, and no further expense was recorded. Interest Expense and Interest Income For the three months ended October 31, 2012 and 2011, interest expense was approximately $330,000 and $230,000, respectively. The increase in interest expense is due principally to an increase in the amortization of debt issuance costs for Sovereign compared to the same period in the prior year, offset by a decrease in the total borrowings outstanding under the line of credit with Sovereign over the course of the three months ended October 31, 2012 compared to the line of credit with Bank of America N.A. in the same period in the prior year. As of October 31, 2012, there was approximately $1,034,000 of borrowings outstanding under the line of credit. For the three months ended October 31, 2012 and 2011, interest income was approximately $6,200 and $23,500, respectively. The decrease in interest earned is due principally to a decrease in interest income in our Australia Operations compared to the same period in the prior year. Income Taxes The actual income tax rate from continuing operations for the three months ended October 31, 2012 was -195.0% compared to 53.5% for same period in the prior year. The difference was primarily due to no tax benefit being claimed for Federal and state losses during the three months ended October 31, 2012. Loss from Discontinued Operations As a result of the sale of the assets of the Hartford and Lakewood Operations on July 25, 2012, we recorded the financial results of these operations as discontinued operations. For the three months ended October 31, 2012, we recorded a loss from discontinued operations of approximately $573,000. Included in the loss from discontinued operations are $485,000 associated with the sale of the assets of the Hartford and Lakewood Operations. As a result of the sale of the assets of the Hartford and Lakewood Operations as described above, and the common stock of the St. Louis and Sarasota Operations to Multiband on September 1, 2011, we recorded the financial results of these operations as discontinued operations. For the three months ended October 31, 2011, we recorded a loss from discontinued operations of approximately $1,313,000, net of tax. Included in the loss from discontinued operations was an approximate $1,028,000 loss on disposal of the St. Louis and Sarasota Operations. Net Loss Attributable to WPCS The net loss attributable to WPCS was approximately $493,000 for the three months ended October 31, 2012. The net loss was net of Federal and state income tax benefits of approximately $72,000. The net loss attributable to WPCS was approximately $1,665,000 for the three months ended October 31, 2011. The net loss was net of Federal and state income tax benefits of approximately $354,000. 35 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations for the Six Months Ended October 31, 2012 Compared to the Six Months Ended October 31, 2011 Consolidated results for the six months ended October 31, 2012 and 2011 were as follows: Six Months Ended October 31, 2012 2011 REVENUE $ 23,386,578 100.0 % $ 40,370,924 100.0 % COSTS AND EXPENSES: Cost of revenue 16,838,285 72.0 % 32,586,590 80.7 % Selling, general and administrative expenses 5,947,905 25.4 % 6,606,492 16.4 % Depreciation and amortization 681,780 2.9 % 881,043 2.2 % Change in fair value of acquisition-related contingent consideration - - 83,628 0.2 % Total costs and expenses 23,467,970 100.3 % 40,157,753 99.5 % OPERATING (LOSS) INCOME (81,392 ) (0.3 )% 213,171 0.5 % OTHER EXPENSE (INCOME): Interest expense 455,250 2.0 % 325,929 0.8 % Interest income (15,959 ) (0.1 )% (31,969 ) (0.1 )% Loss from continuing operations before income tax provision (520,683 ) (2.2 )% (80,789 ) (0.2 )% Income tax provision 62,257 0.3 % 57,504 0.1 % LOSS FROM CONTINUING OPERATIONS (582,940 ) (2.5 )% (138,293 ) (0.3 )% Discontinued operations Loss from operations of discontinued operations, net of tax (727,559 ) (3.1 )% (474,015 ) (1.2 )% Gain (loss) from disposal 1,839,419 7.9 % (1,027,637 ) (2.5 )% Income (loss) from discontinued operations, net of tax 1,111,860 4.8 % (1,501,652 ) (3.7 )% CONSOLIDATED NET INCOME (LOSS) 528,920 2.3 % (1,639,945 ) (4.0 )% Net income attributable to noncontrolling interest 28,605 0.1 % 60,060 0.2 % NET INCOME (LOSS) ATTRIBUTABLE TO WPCS $ 500,315 2.2 % $ (1,700,005 ) (4.2 )% Revenue Revenue for the six months ended October 31, 2012 was approximately $23,387,000, as compared to approximately $40,371,000 for the six months ended October 31, 2011. The decrease in revenue was due to : (1) the planned strategic change to re-focus the Trenton Operation as a smaller revenue producing operation that returns to profitability, while the Cooper Project is completed; and (2) project delays or postponement of new project bid awards at the state and local government level due to political and economic climate. For the six months ended October 31, 2012, we had one customer, the Cooper Project, which comprised 22.9% of total revenue. For the six months ended October 31, 2011, we had two customers, the Cooper Project and Irwin & Leighton, Inc. (I&L), which comprised 13.3% and 12.7% of total revenue, respectively. 36 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Wireless communication segment revenue for the six months ended October 31, 2012 and 2011 was approximately $9,265,000 or 39.6% and $13,639,000 or 33.8% of total revenue, respectively. The decrease in revenue was due primarily to project delays on existing contracts and delays or postponements of new project bid awards from prior quarters at the state and local government level for public services projects, the revenue of which is expected to be recognized in future periods. Specialty construction segment revenue for the six months ended October 31, 2012 and 2011 was approximately $1,854,000 or 7.9% and $3,744,000 or 9.3% of total revenue, respectively. The decrease in revenue was attributable to fewer projects completed in the six months ended October 31, 2012 as compared to the same period in the prior year for the China Operations. Electrical power segment revenue for the six months ended October 31, 2012 and 2011 was approximately $12,269,000 or 52.5% and $22,989,000 or 56.9% of total revenue, respectively. The decrease in revenue was due primarily to the planned strategic change to re-focus the Trenton Operation as a smaller revenue producing operation that returns to profitability, while completing the Cooper Project. The Cooper Project accounted for 43.6% of total revenue in the electrical power segment for the six months ended October 31, 2012, compared to 23.3% in the same period in the prior period. It is not expected that similar future projects will replace the Cooper Project or other larger projects such as I&L that were completed in the prior period, therefore, it is expected that our revenue in the electrical power segment will not substantially increase inthe near future. Cost of Revenue Cost of revenue consists of direct costs on contracts, materials, direct labor, third party subcontractor services, union benefits and other overhead costs. Our cost of revenue was approximately $16,838,000 or 72.0% of revenue for the six months ended October 31, 2012, compared to $32,587,000 or 80.7% for the same period of the prior year. The dollar decrease in our total cost of revenue is primarily due to the corresponding decrease in revenue for the six months ended October 31, 2012. The decrease as a percentage of revenue is due to: (1) the revenue blend of project work completed during the period; (2) the current period contained a smaller percentage of lower margin work performed by the Trenton Operations, including the Cooper Project, as compared to the same period in the prior period; (3) the current period included approximately $1,486,000 of change order revenue related to the Cooper Project, the costs of which were incurred or accrued in fiscal 2012. Wireless communication segment cost of revenue and cost of revenue as a percentage of revenue for the six months ended October 31, 2012 and 2011 was approximately $6,406,000 and 69.1% and $9,382,000 and 68.8%, respectively. The dollar decrease in our cost of revenue is due primarily to the corresponding decrease in revenue for the six months ended October 31, 2012. Specialty construction segment cost of revenue and cost of revenue as a percentage of revenue for the six months ended October 31, 2012 and 2011 was approximately $1,147,000 and 61.9% and $2,854,000 and 76.2%, respectively. The dollar decrease in our cost of revenue is due to the corresponding decrease in revenue for the six months ended October 31, 2012 in our China Operations. The decrease as a percentage of revenue is due to the revenue blend of project work performed, and less subcontractor costs as compared to the same period in the prior year. Electrical power segment cost of revenue and cost of revenue as a percentage of revenue for the six months ended October 31, 2012 and 2011 was approximately $9,285,000 and 75.7% and $20,351,000 and 88.5%, respectively. The dollar decrease in our cost of revenue is due to the corresponding decrease in revenue for the six months ended October 31, 2012. The decrease as a percentage of revenue is primarily due to revenue blend of project work performed during the quarter, as the current quarter included approximately $1,486, 000 of change order revenue related to the Cooper Project, the costs of which were incurred or accrued in fiscal 2012. In total, the current period contained a smaller percentage of lower margin work performed by the Trenton Operations, as compared to the same period in the prior year. 37 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Selling, General and Administrative Expenses For the six months ended October 31, 2012, total selling, general and administrative expenses were approximately $5,948,000 or 25.4% of total revenue compared to $6,606,000, or 16.4% of revenue for the same period of the prior year. Included in selling, general and administrative expenses for the six months ended October 31, 2012 is $3,485,000 for salaries, commissions, payroll taxes and other employee benefits. The decrease of $369,000 in salaries and commissions compared to the prior period is due to lower salaries from cost reduction strategies, as well as lower commissions and bonuses. Professional fees were $586,000, which include accounting, legal and investor relation fees. The decrease of $139,000 in professional fees compared to the prior year is due primarily to lower strategic alternative costs and other reduced lower professional service fees for other services compared to the same period in the prior year. Insurance costs were $387,000 and rent for office facilities was $251,000. Automobile and other travel expenses were $617,000 and telecommunication expenses were $106,000. Other selling, general and administrative expenses totaled $515,000. For the six months ended October 31, 2012, total selling, general and administrative expenses for the wireless communication, specialty construction and electrical power segments were approximately $2,661,000, $164,000 and $1,599,000, respectively, with the balance of approximately $1,524,000 pertaining to corporate expenses. For the six months ended October 31, 2011, total selling, general and administrative expenses were approximately $6,606,000, or 16.4% of total revenue. Included in selling, general and administrative expenses for the six months ended October 31, 2011 is $3,854,000 for salaries, commissions, payroll taxes and other employee benefits. Professional fees were $725,000, which include accounting, legal and investor relation fees, and approximately $141,000 of incremental third party investment banking expenses in connection with pursuing strategic alternatives. Insurance costs were $446,000 and rent for office facilities was $298,000. Automobile and other travel expenses were $671,000 and telecommunication expenses were $128,000. Other selling, general and administrative expenses totaled $484,000. For the six months ended October 31, 2011, total selling, general and administrative expenses for the wireless communication, specialty construction and electrical power segments were approximately $2,824,000, $152,000 and $2,039,000, respectively, with the balance of approximately $1,591,000 pertaining to corporate expenses. Depreciation and Amortization For the six months ended October 31, 2012 and 2011, depreciation was approximately $615,000 and $800,000, respectively. The net decrease in depreciation expense is due to new fixed asset additions. The amortization of customer lists and backlog for the six months ended October 31, 2012 was $66,000 as compared to $81,000 for the same period of the prior year. The decrease in amortization expense compared to October 31, 2011, was due primarily to certain customer lists and backlog being fully amortized in the prior year compared to the current year. All customer lists are amortized over a period of three to nine years from the date of their acquisitions. Backlog is amortized over a period of one to three years from the date of acquisition based on the expected completion period of the related contracts. Change in Fair Value of Acquisition-Related Contingent Consideration For the six months ended October 31, 2012 and 2011, the change in fair value of acquisition-related contingent consideration was approximately $0 and $84,000, respectively. The change in fair value of acquisition-related contingent consideration is due to the non-cash expense recorded in the fiscal 2012 statement of operations for the change in present value of future payments of acquisition-related contingent consideration related to the Pride acquisition. In connection with the acquisition of Pride on November 1, 2009, during fiscal 2012 we paid additional purchase price of $1,047,732 to the former Pride shareholders upon the achievement of the earnings before interest and taxes (EBIT). As a result, the settlement acquisition-related contingent consideration was completed, and no further expense was recorded. Interest Expense and Interest Income For the six months ended October 31, 2012 and 2011, interest expense was approximately $455,000 and $326,000, respectively. The increase in interest expense is due principally to an increase in the amortization of debt issuance costs for Sovereign compared to the same period in the prior year, offset by a decrease in the total borrowings outstanding under lines of credit with Bank of America N.A. and Sovereign over the course of the six months ended October 31, 2012 compared to the same period in the prior year. As of October 31, 2012, there was approximately $1,034,000 of borrowings outstanding under the lineof credit. For the six months ended October 31, 2012 and 2011, interest income was approximately $16,000 and $32,000, respectively. The decrease in interest earned is due principally to a decrease in interest income in our Australia Operations compared to the same period in the prior year. 38 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Income Taxes The actual income tax rate from continuing operations for the six months ended October 31, 2012 was -12.0% compared to -71.2% for same period in the prior year. The difference was primarily due to no tax benefit being claimed for federal and state losses during the six months ended October 31, 2012. Income (Loss) From Discontinued Operations As a result of the sale of the assets of the Hartford and Lakewood Operations on July 25, 2012, we recorded the financial results of these operations as discontinued operations. For the six months ended October 31, 2012, we recorded an income from discontinued operations of approximately $1,112,000. Included in the income from discontinued operations are approximately $1,839,000 gain from disposal and $56,000 of expenses directly related with the sale of the assets of the Hartford and Lakewood Operations. As a result of the sale of the assets of the Hartford and Lakewood Operations as described above, and the common stock of the St. Louis and Sarasota Operations to Multiband on September 1, 2011, we recorded the financial results of these operations as discontinued operations. For the six months ended October 31, 2011, we recorded a loss from discontinued operations of approximately $1,502,000, net of tax. Included in the loss from discontinued operations was an approximate $1,028,000 loss on disposal of the St. Louis and Sarasota Operations. Net Income (Loss) Attributable to WPCS The net income attributable to WPCS was approximately $500,000 for the six months ended October 31, 2012. Net income was net of Federal and state income tax provisions of approximately $62,000. The loss attributable to WPCS was approximately $1,700,000 for the six months ended October 31, 2011. Net loss was net of Federal and state income tax provisions of approximately $58,000. Liquidity and Capital Resources At October 31, 2012, we had working capital of approximately $1,266,000, which consisted of current assets of approximately $15,898,000 and current liabilities of $14,632,000. This compares to a working capital deficiency of approximately $1,100,000 at April 30, 2012. The increase in working capital since the fiscal year ended April 30, 2012 is due primarily to the sale of the assets of the Hartford and Lakewood Operations on July 25, 2012. We received approximately $4.9 million in cash from the sale of these assets, and used the proceeds to repay the full amount then outstanding under the Credit Agreement. Our cash and cash equivalents balance at October 31, 2012 of $921,000 included $479,000 of cash in our Australia Operations associated with our permanent reinvestment strategy. Subject to the working capital needs of Australia, there is approximately $837,000 of loans due from Australia that could be repaid to us in the future to help with domestic debt or working capital obligations. Our working capital needs are influenced by our level of operations, and generally increase with higher levels of revenue. Our sources of cash in the last several years have come from operating activities and credit facility borrowings. Our future operating results may be affected by a number of factors including our success in bidding on future contracts and our continued ability to manage our controllable operating costs effectively. To the extent we grow by future acquisitions that involve consideration other than stock, our cash requirements may increase. Our capital requirements depend on numerous factors, including the market for our services, the resources we devote to developing, marketing, selling and supporting our business, and the timing and extent of establishing additional markets and other factors. Operating activities used approximately $986,000 in cash for the six months ended October 31, 2012. The sources of cash from operating activities total approximately $3,318,000, comprised of approximately $529,000 of net income, a $1,894,000 decrease in accounts receivable, a $63,000 decrease in costs and estimated earnings in excess of billings on uncompleted contracts, a $159,000 decrease in income taxes receivable and prepaid taxes, a $15,000 decrease in other assets, and a $658,000 increase in deferred revenue. The uses of cash from operating activities total approximately $4,304,000, comprised of an approximately $801,000 in net noncash charges, an $18,000 increase in inventory, a $156,000 increase in prepaid expenses and other current assets, a $1,753,000 decrease in accounts payable and accrued expenses, and a $1,576,000 decrease in billings in excess of costs and estimated earnings on uncompleted contracts. 39 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Our investing activities provided cash of approximately $4,324,000 for the six months ended October 31, 2012. Investing activities include total proceeds of $4,554,000 from the asset sales of the Hartford and Lakewood Operations, net of approximately $56,000 of direct transaction costs, and $290,000 of liabilities paid that were not assumed by Kavveri. The net proceeds of the asset sales were used to fully repay amounts outstanding under our line of credit with Sovereign Bank as described under financing activities. These proceeds were offset by the payment of approximately $230,000 used for acquiring property and equipment during the six months ended October 31, 2012. Our financing activities used cash of approximately $3,187,000 for the six months ended October 31, 2012. Financing activities which used cash include repayments under the line of credit with Sovereign Bank of approximately $3,930,000, debt issuance costs paid of $57,000, repayments to joint venture partner of approximately $2,516,000 and repayments of previous loans payable and capital lease obligations of approximately $68,000. These financing uses of cash are offset by additional financing sources including a settlement of $222,000, relating to a Section 16(b) shareholder derivative lawsuit, borrowings of short term bank loan for the joint venture of $2,368,000 and other payable due from Zurich of $794,000. Sovereign Bank Credit Agreement On January 27, 2012, we entered into the Credit Agreement with Sovereign, which was amended May 3, 2012, and again on August 31, 2012. The Credit Agreement, as amended, provides for a revolving line of credit in an amount not to exceed $2,000,000 and letters of credit in an amount not to exceed $200,000. Pursuant to the Credit Agreement, we granted a security interest to Sovereign in all of our assets. In addition, pursuant to a collateral pledge agreement, we pledged 100% of our ownership in our Subsidiaries and 65% of our ownership in WPCS Australia Pty Ltd. Borrowings under the Credit Agreement may be used for general corporate purposes, for permitted acquisitions, for working capital and for related fees and expenses. The interest rate applicable to revolving loans under the Credit Agreement is the Prime Rate (3.25%) plus 2.00%, or 5.25%. On May 3, 2012, we entered into the Amendment to the Credit Agreement with Sovereign. The Amendment reduced the maximum revolving line of credit in amount not to exceed $6,500,000. On August 31, 2012, we entered into the Second Amendment with Sovereign. Pursuant to the terms of the Second Amendment, we are permitted to borrow under the revolving credit line, under a Borrowing Base equal to the lesser of (i) $2,000,000 less the letter of credit amount, or (ii) the sum of (a) 80% of Eligible Accounts Receivable, minus (c) the letter of credit amount minus (d) such reserves, in such amounts and with respect to such matters, as Sovereign may deem reasonably proper and necessary from time to time at its own discretion, which is currently $500,000. As of October 31, 2012, the total amount of borrowings outstanding under the Credit Agreement was $1,034,323. The Credit Agreement contains certain customary representations and warranties, affirmative and negative covenants, and lockbox arrangements. Principal covenants include (a) Fixed Charge Coverage Ratio of not less than 1.2 to 1.0, measured as of April 30, 2012 and as of each fiscal quarter end thereafter, in each case on a trailing two (2) quarter basis; and (b) Leverage Ratio of not more than 1.75 to 1.0, measured as of each fiscal quarter end. Due to the operating losses for the quarters ended April 30, 2012 and July 31, 2012, we did not meet the Fixed Charge Coverage Ratio of 1.2 to 1.0 for the quarters ended April 30, 2012, July 31, 2012, and October 31, 2012, and the Leverage Ratio of 1.75 to 1.0 at April 30, 2012, and we are currently in default under the Credit Agreement. In connection with the Second Amendment, Sovereign reserved all of its available rights and/or remedies as a result of the defaults of the financial covenants, including the right to demand repayment of amounts outstanding or withhold or cease making credit advances under the Credit Agreement. As more fully described below, on December 5, 2012, the outstanding borrowings under the Credit Agreement were repaid in full and the Credit Agreement terminated. Convertible Debenture Offering On December 4, 2012, we entered into the Purchase Agreement with the Buyers pursuant to which, we sold an aggregate of (i) $4,000,000 principal amount of Notes and (ii) the Warrants to purchase 15,923,567 shares of our Common Stock, to the Buyers for aggregate Financing gross proceeds of $4,000,000. In connection with the Financing, (i) we entered into a the Registration Rights Agreement, (ii) we and our subsidiaries entered into the Security Agreement, and (iii) our subsidiaries entered into the Guaranty in favor of the collateral agent for the Buyers. The Closing Date of the Financing was December 5, 2012. 40 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to the terms of the Notes, we agreed to deposit the initial funds received from the Financing, minus the Initial Lending Amount of $2,178,516 into the Lockbox Account controlled by the Collateral Agent, as collateral agent on behalf of the Buyers. In addition, all our accounts receivable (and of our domestic subsidiaries) shall be deposited into the Lockbox Account. We are permitted to receive from the Lockbox Account, on a daily basis, such amount of cash equal to: (A) (i) cash balance in the Lockbox Account plus (ii) 95% of available qualified accounts receivable minus (iii) $250,000 minus (B) amount of principal, accrued interest, fees, costs and expenses owed pursuant to the Notes. The Notes contain certain customary representations and warranties, affirmative and negative covenants, and events of default. The principal covenant is that we shall maintain a current ratio of not less than 0.6 to 1.0 as of the last calendar day of each month. We used the Initial Lending Amount to repay the existing loan described above of $2,000,000, plus $78,516 of interest accrued and fees and expenses to Sovereign, which Credit Agreement was terminated in connection with the Notes, and $100,000 for Buyer legal expenses in connection with the Notes. In addition, we shall pay to the Buyers a consulting fee of not more than $5,000 per month during theterm of the Notes. The Notes will mature on the eighteen month anniversary of the Closing Date and will bear interest at the rate of 4% per annum, which will be payable quarterly in arrears and may be paid, in certain conditions, through the issuance of shares, at the our discretion. Pursuant to the Purchase Agreement, we agreed to use our reasonable best efforts to obtain our Stockholders' Approval at the next annual stockholder meeting of the issuance of all of the securities issuable pursuant to the Purchase Agreement. We agreed to seek to obtain Stockholder Approval by March 4, 2013. If, despite our reasonable best efforts Stockholder Approval is not obtained on or prior to March 4, 2013, we agreed to cause an additional annual stockholder meeting to be held annually at which Stockholder Approval will be sought (or if no Annual Meeting of our stockholders is held in any given year, to seek such approval at a special meeting of our stockholders in such given year) untilthe Stockholder Approval Date. The Notes are initially convertible into shares of Common Stock at a Conversion Price of $0.3768 per share. The Conversion Price will be adjusted to 85% of the average of the closing bid prices for the five consecutive trading dates immediately prior to the following adjustment dates: (1) the earlier of the effective date of a registration statement or six months after closing (the First Adjustment); (2) the later of the date that is three months after the First Adjustment or one year after closing (the Second Adjustment); and (3) the Stockholder Approval Date. The Warrants are exercisable for a period of five years from the Closing Date at an Exercise Price of $0.471 per share. The Exercise Price will be subject to the same adjustments as provided in the Notes as described above. If an event of default under the Notes occurs, upon the request of the holder of the Note, we will be required to redeem all or any portion of the Note (including all accrued and unpaid interest), in cash, at a price equal to the greater of (i) up to 125% of the amount being converted, depending on the nature of the default, and (ii) the product of (a) the number of shares of Common Stock issuable upon conversion of the Note, times (b) 125% of the highest closing sale price of the Common Stock during the period beginning on the date immediately preceding such event of default and ending on the trading day immediately prior to the trading day that the redemption price is paid by us. We have the right, at any time after one year from the Closing Date, to redeem all, but not less than all, of the outstanding Notes, upon not less than 20 trading days nor more than 30 trading days prior written notice. The redemption price shall equal 120% of the amount of principal and interest being redeemed. The Buyers are prohibited from converting the Notes and/or exercising the Warrants and receiving shares of our Common Stock, in the aggregate, such that the number of shares of Common Stock issued upon such conversions and/or exercises exceeds 19.9% of the issued and outstanding shares of our Common Stock as of the Closing Date, unless Stockholder Approval is obtained. The Buyers agree to restrict their ability to convert the Notes and/or exercise the Warrants and receive shares of our Common Stock such that the number of shares of Common Stock held by the Buyer in the aggregate and its affiliates after such conversion or exercise does not exceed 9.99% of the then issued and outstanding shares of our Common Stock. Pursuant to the Registration Rights Agreement, we agreed to file a registration statement with the SEC, within 30 days following receipt of a request from a Buyer (or 45 days with respect to an underwritten offering), covering such shares of common stock issuable upon conversion of the Notes or exercise of the Warrants, as requested by the Buyers, and have such registration statement declared effective by the SEC within 90 days thereafter. We also agreed to notify the Buyers if we at any time propose to register any of our securities under the Securities Act of 1933, as amended, and of such Buyers' right to participate in such registration. 41 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to the Guaranty, our subsidiaries guaranteed to the collateral agent, for the benefit of the Buyers, the punctual payment, as and when due and payable, of all amounts owed by us in respect of the Purchase Agreement, the Notes and the other transaction documents executed in connection with the Purchase Agreement. Pursuant to the Security Agreement, we and our subsidiaries granted, in favor of the collateral agent for the Buyers, a continuing security interest in all our personal property and assets, as collateral security for our and the subsidiaries under the Purchase Agreement, the Notes, the Guaranty and theother transaction documents. Hartford and Lakewood Operations Asset Sales On July 25, 2012, the Company and the Hartford and Lakewood Operations entered into the Asset Purchase Agreement, pursuant to which the Hartford and Lakewood Operations sold substantially all of their assets to two newly-created subsidiaries of Kavveri for a purchase price of $5.5 million in cash, subject to adjustment, and the assumption of their various liabilities. At closing, we received $4.9 million in cash, and the remaining $600,000 of the purchase price is to be placed in escrow pursuant to the Asset Purchase Agreement. We used the proceeds from this sale to repay the full amount outstanding under the Credit Agreement of $4,022,320 as of July 25, 2012. The difference of $877,680 was deposited in our operating cash account. The parties agreed to place $350,000 of the purchase price into escrow pending assignment of certain contracts post-closing, with our receiving those funds upon successful assignment of the contracts. The remaining $250,000 is to be escrowed for purposes of satisfying certain adjustments to the purchase price based on a final net asset valuation to be completed after closing as well as repurchase obligations of certain delinquent accounts receivable. No later than three days after the final determination of the net asset valuation, the purchasers are required to deposit the $600,000 into escrow. On September 4, 2012, Kavveri provided us with its calculation of the net asset valuation, and claimed that we owed them $251,868. On October 2, 2012, we provided Kavveri our calculation of the net asset valuation, and claimed Kavveri owes us $94,493. We are currently working with Kavveri to resolve the net asset valuation dispute. If the parties disagree, and we are unable to come to an agreement, the matter will then be submitted to one or more independent, nationally-recognized accounting firms for final determination. On November 7, 2012, Kavveri submitted to us an aggregate claim for indemnification of $1,938,288 with regard to (a) delinquent receivables to be repurchased of $546,077; (b) $916,500 for accounts receivable Kavveri deems are not collectible in the ordinary course of business, and (c) $475,000 for the replacement, programming an installation of replacement radios on a project that was completed by our Hartford Operations and accepted by the customer on or prior to July 25, 2012. With regard to the delinquent receivables claimed, we are disputing the amount of the delinquent receivables, and we believe that after consideration of reserves for uncollectible accounts and other offsets previously considered in our calculation of the net asset valuation described above, the total amount of delinquent receivables to be repurchased is less, and is subject to further reduction based on additional collection of receivables by Kavveri. Furthermore, with regard to the timing in the Asset Purchase Agreement for notification to us, we believe that Kavveri missed the deadline to notify us regarding the repurchase of delinquent receivables, which would eliminate any repurchase payment owed by us to Kavveri. We believe the remaining two claims are without merit, and we are currently preparing a response to Kavveri, to dispute each of these indemnification claims. We have reflected the estimated changes in the gain/(loss) from the disposal of these operations in the three and six months ended October 31, 2012. Short-Term Commitments with the China Operations On August 2, 2012, the China Operations entered into a secured loan with the Bank of China (the Short Term Loan). The Short Term Loan provides for a loan in the amount of $2,404,545. The proceeds from the Short Term Loan were used to repay outstanding unsecured loans of $2,404,545 due to its joint venture partner, Taian Gas Group (TGG). The Short Term Loan has an interest rate of 8.24%, and interest is due on a quarterly basis. 42 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS As of October 31, 2012, the China Operations had outstanding unsecured loans due the joint venture partner, TGG, totaling $781,268 and is due on demand and represents interest accrued and working capital loans from TGG to the China Operations in the normal course of business Other Payable with Zurich On July 12, 2012, we executed the Zurich Agreement with Zurich. Under the terms of the Zurich Agreement, as of October 31, 2012, Zurich advanced us $793,927 for the payment of labor and labor-related benefits to assist in completing the Cooper Project. The Cooper Project is a $15.1 million project completed by our Trenton Operations. Zurich and its affiliate F&D, as surety, have issued certain performance and payment bonds on behalf of the Owner in regard to our work on this project. We were required to repay Zurich the financial advances pursuant to the following repayment schedule: (1) $397,000 on or about August 3, 2012; and (2) the balance of $396,927 on or about September 7, 2012. As a condition precedent to the financial advance, we executed two letters held by Zurich: (1) a letter to the Owner voluntarily terminating its contract for reason of our default and assigning the contract to Zurich, and (2) a letter of direction to the Owner. The letters may be forwarded to the Owner in an Event of Default. An Event of Default under the Zurich Agreement includes: (a) our failure to make repayments to Zurich in accordance with the repayment schedule; (b) Zurich, at our request, advances more than $888,000; (c) Zurich pays any of our vendors, subcontractors, suppliers or material men pursuant to Zurich's obligations under its payment bond or any other reason; or (d) we use any of the funds advanced by Zurich for any reason other than the payment of labor and labor benefits incurred in regard to the Cooper Project. We are in default under the Zurich Agreement as we have not repaid Zurich the $793,927. As a result, a letter of direction was sent to the Owner, requesting that all current and future amounts to be paid on the contract be assigned and paid to Zurich directly. We are contingently liable to Zurich and its affiliate F&D under the Indemnity Agreement. Zurich and F&D, as surety, have issued certain performance and payment bonds on behalf of owners or customers regarding our work on various projects under the Indemnity Agreement. We agree to indemnify the surety for any payments made on contracts of suretyship, guaranty or indemnity. As of October 31, 2012, we have approved $4,074,814 of accounts receivable, and $5,672,038 of accounts payable to be assigned to Zurich and F&D under the Indemnity Agreement, and reclassified such amounts from consolidated accounts receivable and accounts payable, respectively, resulting in a net amount owed to Zurich and F&D under the Indemnity Agreement of $1,597,224. Including the $793,927 owed under the Zurich Agreement, the net Other Payable owed to Zurich by us is $2,391,151as of October 31, 2012. On November 12, 2012, we received a demand notice from Zurich for $3,298,751, regarding unpaid amounts due under the Zurich Agreement and in regard to claims asserted against Zurich under the Indemnity Agreement as described above, without consideration of any offsets for assigned accounts receivable paid or to be paid. On November 15, 2012, a payment of $2,758,588 was made by the Owner in partial payment of outstanding assigned accounts receivable amounts due. We are currently working with on a response to the demand notice, with the expected response to include directing Zurich to apply $793,927 of the November 15, 2012 payment by the Owner to repay the amounts due under the Financing Agreement, with the balance applied to partially repay amounts due under the Indemnity Agreement, and requesting forbearance on the balance of the demand notice. To date, a total of $3,128,379 of assigned accounts receivable have been paid by our customers to Zurich, which includes the November 15, 2012 payment of $2,758,588 described above. To date, a total of $5,570,631 of assigned accounts payable has been paid by Zurich to our vendors. The remaining accounts and retention payable properly recorded at October 31, 2012, yet to be approved and to be assigned in the future under the Indemnity Agreement, is approximately $338,000, and future billings of customer accounts to be assigned to Zurich is approximately $836,000, which we expect will reduce the net Other Payable by $498,000, resulting in a final net Other Payable due Zurich of approximately $1,893,000. In addition, we have submitted a claim and request for equitable adjustment to the Owner in the amount of $3,019,813 for significant delays, disruptions and construction changes that were beyond its control and required the Company to perform additional work, and if successful in settlement of this claim, expects to use the proceeds from the claim to repay Zurich the estimated remaining balance due. There can be no assurance that we will be successful in settling with the Owner for all or a portion of the submitted claim, and there can be no assurance that Zurich and the Company will come to any agreement regarding repayment, future forbearance terms, or waiver or modification of terms under the Zurich Agreement and Indemnity Agreement, which would have a serious adverse effect on our business, operations and future prospects. 43 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Going Concern Our failure to comply with the terms of the Zurich Agreement and Indemnity Agreement, raise substantial doubt about our ability to continue as a going concern. Our continuation as a going concern is ultimately dependent upon our future financial performance and ability to refinance or restructure our credit facilities, which will be affected by general economic, competitive, and other factors, many of which are beyond our control. There can be no assurance that the execution of one or more of the alternatives described above to repay Zurich will be successful to ensure our continuation as a going concern. Backlog As of October 31, 2012, we had a backlog of unfilled orders of approximately $28.9 million compared to approximately $30.8 million at July 31, 2012. We define backlog as the value of work-in-hand to be provided for customers as of a specific date where the following conditions are met (with the exception of engineering change orders): (i) the price of the work to be done is fixed; (ii) the scope of the work to be done is fixed, both in definition and amount; and (iii) there is a written contract, purchase order, agreement or other documentary evidence which represents a firm commitment by the customer to pay us for the work to be performed. These backlog amounts are based on contract values and purchase orders and may not result in actual receipt of revenue in the originally anticipated period or at all. We have experienced variances in the realization of our backlog because of project delays or cancellations resulting from external market factors and economic factors beyond our control and we may experience such delays or cancellations in the future. Backlog does not include new firm commitments that may be awarded to us by our customers from time to time in future periods. These new project awards could be started and completed in this same future period. Accordingly, our backlog does not necessarily represent the total revenue that could be earned by us in future periods. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Critical Accounting Policies Financial Reporting Release No. 60, published by the SEC, recommends that all companies include a discussion of critical accounting policies used in the preparation of their financial statements. While all these significant accounting policies impact our financial condition and results of operations, we view certain of these policies as critical. Policies determined to be critical are those policies that have the most significant impact on our consolidated financial statements and require management to use a greater degree of judgment and estimates. Actual results may differ from those estimates. We believe that given current facts and circumstances, it is unlikely that applying any other reasonable judgments or estimate methodologies would cause a material effect on our condensed consolidated results of operations, financial position or liquidity for the periods presented in this report. The accounting policies identified as critical are as follows: Use of Estimates In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. The most significant estimates relate to the calculation of percentage-of-completion on uncompleted contracts, allowance for doubtful accounts, valuation of inventory, realization of deferred tax assets, amortization method and lives of customer lists, acquisition-related contingency consideration and estimates of the fair value of reporting units and discounted cash flows used in determining whether goodwill has been impaired. Actual results could differ from those estimates. 44 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Accounts Receivable Accounts receivable are due within contractual payment terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Credit is extended based on evaluation of a customer's financial condition. Accounts that are outstanding longer than the contractual payment terms are considered past due. We determine our allowance by considering a number of factors, including the length of time trade accounts receivable are past due, our previous loss history, the customer's current ability to pay its obligation to the us, and the condition of the general economy and the industry as a whole. We write off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. Goodwill and Other Long-lived Assets We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that their carrying value may not be recoverable from the estimated future cash flows expected to result from their use and eventual disposition. Our long-lived assets subject to this evaluation include property and equipment and amortizable intangible assets. We assess the impairment of goodwill annually as of April 30 and whenever events or changes in circumstances indicate that it is more likely than not that an impairment loss has been incurred. Intangible assets other than goodwill are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be fully recoverable. We are required to make judgments and assumptions in identifying those events or changes in circumstances that may trigger impairment. Some of the factors we consider include a significant decrease in the market value of an asset, significant changes in the extent or manner for which the asset is being used or in its physical condition, a significant change, delay or departure in our business strategy related to the asset, significant negative changes in the business climate, industry or economic condition, or current period operating losses, or negative cash flow combined with a history of similar losses or a forecast that indicates continuing losses associated with the use of an asset. Deferred Income Taxes We determine deferred tax liabilities and assets at the end of each period based on the future tax consequences that can be attributed to net operating loss carryovers and differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, using the tax rate expected to be in effect when the taxes are actually paid or recovered. The recognition of deferred tax assets is reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized. The ultimate realization of deferred tax assets depends upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider past performance, expected future taxable income and prudent and feasible tax planning strategies in assessing the amount of the valuation allowance. Our forecast of expected future taxable income is based over such future periods that we believe can be reasonably estimated. Changes in market conditions that differ materially from our current expectations and changes in future tax laws in the U.S. may cause us to change our judgments of future taxable income. These changes, if any, may require us to adjust our existing tax valuation allowance higher or lower than the amount we have recorded. Revenue Recognition We generate our revenue by providing design-build engineering services for communications infrastructure. Our engineering services report revenue pursuant to customer contracts that span varying periods of time. We report revenue from contracts when persuasive evidence of an arrangement exists, fees are fixed or determinable, and collection is reasonably assured. We record revenue and profit from long-term contracts on a percentage-of-completion basis, measured by the percentage of contract costs incurred to date to the estimated total costs for each contract. Contracts in process are valued at cost plus accrued profits less earned revenues and progress payments on uncompleted contracts. Contract costs include direct materials, direct labor, third party subcontractor services and those indirect costs related to contract performance. Contracts are generally considered substantially complete when engineering is completed and/or site construction is completed. We have numerous contracts that are in various stages of completion. Such contracts require estimates to determine the appropriate cost and revenue recognition. Cost estimates are reviewed monthly on a contract-by-contract basis, and are revised periodically throughout the life of the contract such that adjustments to profit resulting from revisions are made cumulative to the date of the revision. Significant management judgments and estimates, including the estimated cost to complete projects, which determines the project's percent complete, must be made and used in connection with the revenue recognized in the accounting period. Current estimates may be revised as additional information becomes available. If estimates of costs to complete long-term contracts indicate a loss, provision is made currently for the total loss anticipated. 45 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The length of our contracts varies. Assets and liabilities related to long-term contracts are included in current assets and current liabilities as they will be liquidated in the normal course of contract completion, although this may require more than one year. We record revenue and profit from short-term contracts for our China Operations under the completed contract method, whereas income is recognized only when a contract is completed or substantially completed. Accordingly, during the period of performance, billings and costs are accumulated on the balance sheet, but no revenue or income is recorded before completion or substantial completion of the work. Our decision is based on the short-term nature of the work performed. We also recognize certain revenue from short-term contracts when equipment is delivered or the services have been provided to the customer. For maintenance contracts, revenue is recognized ratably over the service period. Recently Issued Accounting Pronouncements In December 2011, the FASB issued ASU No. 2011-11 (ASU 2011-11), Disclosures about Offsetting Assets and Liabilities where entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements, and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. These disclosures assist users of financial statements in evaluating the effect or potential effect of netting arrangements on a company's financial position. We are required to apply the amendments for annual reporting periods beginning on or after January 1, 2013 (May 1, 2013 for us). We do not expect the provisions of ASU 2011-11 to have a material impact on our consolidated financial statements. 46 WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES |