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CHINANET ONLINE HOLDINGS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this interim report. Our consolidated financial statements have been prepared in accordance with U.S. GAAP. The following discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words "expect," "anticipate," "intend," "believe," or similar language. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our business and financial performance are subject to substantial risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information set forth under the heading "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Readers are cautioned not to place undue reliance on these forward-looking statements. Overview We were incorporated in the State of Texas in April 2006 and re-domiciled to become a Nevada corporation in October 2006. On June 26, 2009, we consummated a share exchange transaction with China Net Online Media Group Limited (the "Share Exchange"), a company organized under the laws of British Virgin Islands ("China Net BVI"). As a result of the Share Exchange, China Net BVI became a wholly owned subsidiary of us and we are now a holding company, which, through certain contractual arrangements with operating entities in the PRC, is engaged in providing advertising, marketing, communication and brand management and sales channel building services to SMEs in China. Through our PRC operating subsidiary and VIEs, we primarily operate an one-stop services for our clients on four major service platforms, including social networking service information platform, multi-channel advertising and promotion platform, brand management and sales channel building platform and management tools platform. Our social networking service information platform primarily consists of www. chuangye.com, an information and service portal for entrepreneurs or any individual who plans to start their own business. Our multi-channel advertising and promotion platform primarily consists of internet advertising and marketing portals, including www.28.com ("28.com"), www.liansuo.com ("liansuo.com") and www.sooe.cn ("sooe.cn"), ChinaNet TV as our TV production and advertising unit and the bank kiosk advertising unit. We provide varieties of marketing campaigns through this platform by the combination of the Internet, mobile, television, bank kiosks and printed-medias to maximize market exposure and effectiveness for our clients. Our band management and sales channel expansion platform consists of our brand consulting and management service and offline sales channel expansion service, which is to physically help small businesses to recruit dealers, wholesalers, partners or franchisees based on their business needs. Management tools platform consists of a mobile-based sales and administrative management tools specifically designed for small business in China to match their simplicity. Basis of presentation, management estimates and critical accounting policies Our unaudited interim consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, as promulgated by the SEC, and include the accounts of our Company, and all of our subsidiaries and VIEs. We prepare financial statements in conformity with U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities on the date of the financial statements and the reported amounts of revenues and expenses during the financial reporting period. We continually evaluate these estimates and assumptions based on the most recently available information, our own historical experience and various other assumptions that we believe to be reasonable under the circumstances. Since the use of estimates is an integral component of the financial reporting process, actual results could differ from those estimates. Some of our accounting policies require higher degrees of judgment than others in their application. In order to understand the significant accounting policies that we adopted for the preparation of our interim consolidated financial statements, you should refer to the information set forth in Note 3 "Summary of significant accounting policies" to our audited financial statements in our 2013 Form 10-K. 28 --------------------------------------------------------------------------------Recent Accounting Standards In April 2014, the Financial Accounting Standard Board ("FASB") issued Accounting Standards Update ("ASU") 2014-08, "Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity." This ASU changes the threshold for reporting discontinued operations and adds new disclosures. The new guidance defines a discontinued operation as a disposal that "represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results." The standard is required to be adopted by public business entities in annual periods beginning on or after December 15, 2014, and interim periods within those annual periods. Early adoption is permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. The adoption of this standard is not expected to have a material impact on our consolidated financial position or results of operations. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)". This ASU supercedes the revenue recognition requirements in Accounting Standards Codification ("ASC") 605-Revenue Recognition and most industry-specific guidance throughout the Codification. The standard requires that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. This ASU should be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the ASU recognized at the date of initial application. For a public entity, the amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. For all other entities (nonpublic entities), the amendments in this ASU are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. A nonpublic entity may elect to apply this guidance earlier, however, only as prescribed in this ASU. The adoption of this standard is not expected to have a material impact on our consolidated financial position and results of operations. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on our consolidated financial statements upon adoption. A. RESULTS OF OPERATIONS FOR THE SIX AND THREE MONTHS ENDED JUNE 30, 2014 AND 2013 The following table sets forth a summary, for the periods indicated, of our consolidated results of operations. Our historical results presented below are not necessarily indicative of the results that may be expected for any future period. All amounts, except number of shares and per share data, are presented in thousands of US dollars. Six Months Ended June 30, Three Months Ended June 30, 2014 2013 2014 2013 US$ US$ US$ US$ (Unaudited) (Unaudited) (Unaudited) (Unaudited) Sales From unrelated parties $ 15,361 $ 15,767 $ 10,179 $ 8,777 From related parties 183 174 182 115 15,544 15,941 10,361 8,892 Cost of sales 12,487 9,757 8,665 5,290 Gross margin 3,057 6,184 1,696 3,602 Operating expenses Selling expenses 2,095 1,390 1,506 602 General and administrative expenses 2,009 3,146 1,022 1,744 Research and development expenses 892 912 442 463 4,996 5,448 2,970 2,809 (Loss)/income from operations (1,939 ) 736 (1,274 ) 793 Other income (expenses) Interest income 60 64 29 32 Interest expense (32 ) - (16 ) - Other expenses (3 ) (2 ) (2 ) (1 ) 25 62 11 31 (Loss)/income before income tax expense, equity method investments and noncontrolling interests (1,914 ) 798 (1,263 ) 824 Income tax expense (120 ) (268 ) (72 ) (354 ) (Loss)/income before equity method investments and noncontrolling interests (2,034 ) 530 (1,335 ) 470 Share of losses in equity investment affiliates (58 ) (125 ) (43 ) (54 ) Net (loss)/income (2,092 ) 405 (1,378 ) 416 Net loss attributable to noncontrolling interests 93 59 47 18 Net (loss)/income attributable to ChinaNet Online Holdings, Inc. (1,999 ) 464 (1,331 ) 434 (Loss)/earnings per share (Loss)/earnings per common share Basic $ (0.09 ) $ 0.02 $ (0.06 ) $ 0.02 Diluted $ (0.09 ) $ 0.02 $ (0.06 ) $ 0.02 Weighted average number of common shares outstanding: Basic 22,376,540 22,193,391 22,376,540 22,200,166 Diluted 22,376,540 22,193,391 22,376,540 22,200,166 29--------------------------------------------------------------------------------Revenue The following tables set forth a breakdown of our total revenue, divided into six categories for the periods indicated, with inter-segment transactions eliminated: Six Months Ended June 30, 2014 2013 Revenue type (Amounts expressed in thousands of US dollars, except percentages) Internet advertisement and related services $ 11,808 75.9 % $ 9,247 57.9 % -Internet advertisement 8,454 54.4 % 9,046 56.7 % -Technical services 237 1.5 % 201 1.2 % -Search engine marketing service 3,117 20 % - - TV advertisement 2,994 19.3 % 5,127 32.2 % Bank kiosks 138 0.9 % 140 0.9 % Brand management and sales channel building 604 3.9 % 1,427 9.0 % Total $ 15,544 100 % $ 15,941 100 % Three Months Ended June 30, 2014 2013 Revenue type (Amountsexpressed in thousands of US dollars, except percentages) Internet advertisement and related services $ 8,228 79.4 % $ 5,436 61.1 % -Internet advertisement 4,958 47.9 % 5,335 60.0 % -Technical services 153 1.5 % 101 1.1 % -Search engine marketing service 3,117 30.0 % - - TV advertisement 1,812 17.5 % 2,489 28.0 % Bank kiosks 67 0.6 % 71 0.8 % Brand management and sales channel building 254 2.5 % 896 10.1 % Total $ 10,361 100 % $ 8,892 100 % 30-------------------------------------------------------------------------------- Total Revenues: Our total revenues were US$15.54 million and US$15.94 million for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014, our total revenues increased to US$10.36 million from US$8.89 million for the three months ended June 30, 2013. The increase in our total revenues for the three months ended June 30, 2014 was primarily due to the increase in our search engine marketing service revenue during the period, which is discussed in detail in our revenue analysis section below. We derive the majority of our advertising service revenues from the sale of advertising space on our internet portals and from providing the related value-added technical support and services, internet marketing service and content management services to unrelated third parties and to certain related parties. Beginning in the second fiscal quarter of 2014, we elaborated an existing stream of internet marketing service by providing enhanced third-party search engine marketing ("SEM") services to the SMEs as an effective supplement to the internet advertising services we provide to our customers. We also derive revenue from the sale of advertising time purchased from different TV programs. Our advertising services to related parties were provided in the ordinary course of business on the same terms as those provided to our unrelated advertising clients. For the six and three months ended June 30, 2014 and 2013, our service revenue from related parties in the aggregate was less than 1.5% of the total revenue we achieved for each respective reporting period. Our advertising service revenues are recorded net of any sales discounts. Sales discounts include volume discounts and other customary incentives offered to our small and medium-sized franchise and merchant clients, including providing them with additional advertising time for their advertisements if we have unused space available on our websites and represent the difference between our official list price and the amount we actually charge our clients. For advertising services, we typically sign service contracts with our small and medium-sized franchisor and other clients that require us to place the advertisements on our portal websites in specified locations on the sites and for agreed periods; and/or place the advertisements onto our purchased advertisement time during specific TV programs for agreed periods. We recognize revenues as the advertisement airs over the contractual term based on the schedule agreed upon with our clients. For SEM services, we charge certain percentage of service fees to our customers based on the internet resources cost consumed for their SEM services. The tables below summarize the revenues, cost of sales, gross margin and net (loss)/income generated from each of our VIEs and subsidiaries for the six and three months ended June 30, 2014 and 2013, respectively. For the six months ended June 30, 2014: Revenue from Revenue Revenue unrelated from related from inter- Name of subsidiary or VIE parties parties company Total ($'000) ($'000) ($'000) ($'000) Rise King WFOE 237 - - 237 Business Opportunity Online and subsidiaries 14,986 183 - 15,169 Beijing CNET Online and subsidiaries 138 - - 138 Total revenue 15,361 183 - 15,544 For the three months ended June 30, 2014: Revenue from Revenue Revenue unrelated from related from inter- Name of subsidiary or VIE parties parties company Total ($'000) ($'000) ($'000) ($'000) Rise King WFOE 153 - - 153 Business Opportunity Online and subsidiaries 9,959 182 - 10,141 Beijing CNET Online and subsidiaries 67 - - 67 Total revenue 10,179 182 - 10,361 31--------------------------------------------------------------------------------For the six months ended June 30, 2014: Name of subsidiary or VIE Cost of Sales Gross Margin ($'000) ($'000) Rise King WFOE 1 236 Business Opportunity Online and subsidiaries 12,481 2,688 Beijing CNET Online and subsidiaries 5 133 Total 12,487 3,057 For the three months ended June 30, 2014: Name of subsidiary or VIE Cost of Sales Gross Margin ($'000) ($'000) Rise King WFOE 1 152 Business Opportunity Online and subsidiaries 8,659 1,482 Beijing CNET Online and subsidiaries 5 62 Total 8,665 1,696 For the six months ended June 30, 2014: Name of subsidiary or VIE Net Loss ($'000) Rise King WFOE (291 ) Business Opportunity Online and subsidiaries (1,599 ) Beijing CNET Online and subsidiaries (50 ) Shanghai Jing Yang (19 ) ChinaNet Online Holdings, Inc. (133 ) Total net loss before allocation to the noncontrolling interest (2,092 ) For the three months ended June 30, 2014: Name of subsidiary or VIE Net Income/(loss) ($'000) Rise King WFOE 7 Business Opportunity Online and subsidiaries (1,226 ) Beijing CNET Online and subsidiaries (40 ) Shanghai Jing Yang (17 ) ChinaNet Online Holdings, Inc. (102 ) Total net loss before allocation to the noncontrolling interest (1,378 ) For the six months ended June 30, 2013: Revenue from Revenue Revenue unrelated from related from inter- Name of subsidiary or VIE parties parties company Total ($'000) ($'000) ($'000) ($'000) Rise King WFOE 106 95 - 201 Business Opportunity Online and subsidiaries 10,540 79 - 10,619 Beijing CNET Online and subsidiaries 5,121 - - 5,121 Total revenue 15,767 174 - 15,941 32--------------------------------------------------------------------------------For the three months ended June 30, 2013: Revenue from Revenue Revenue unrelated from related from inter- Name of subsidiary or VIE parties parties company Total ($'000) ($'000) ($'000) ($'000) Rise King WFOE 53 48 - 101 Business Opportunity Online and subsidiaries 6,413 67 6,480 Beijing CNET Online and subsidiaries 2,311 - - 2,311 Total revenue 8,777 115 - 8,892 For the six months ended June 30, 2013: Name of subsidiary or VIE Cost of Sales Gross Margin ($'000) ($'000) Rise King WFOE - 201 Business Opportunity Online and subsidiaries 5,642 4,977 Beijing CNET Online and subsidiaries 4,115 1,006 Total 9,757 6,184 For the three months ended June 30, 2013: Name of subsidiary or VIE Cost of Sales Gross Margin ($'000) ($'000) Rise King WFOE - 101 Business Opportunity Online and subsidiaries 3,616 2,864 Beijing CNET Online and subsidiaries 1,674 637 Total 5,290 3,602 For the six months ended June 30, 2013: Name of subsidiary or VIE Net (Loss)/Income ($'000) Rise King WFOE (593 ) Business Opportunity Online and subsidiaries 1,341 Beijing CNET Online and subsidiaries (93 ) Shanghai Jing Yang (2 ) ChinaNet Online Holdings, Inc. (248 ) Total net income before allocation to the noncontrolling interest 405 For the three months ended June 30, 2013: Name of subsidiary or VIE Net (Loss)/Income ($'000) Rise King WFOE (318 ) Business Opportunity Online and subsidiaries 678 Beijing CNET Online and subsidiaries 169 Shanghai Jing Yang (1 ) ChinaNet Online Holdings, Inc. (112 ) Total net income before allocation to the noncontrolling interest 416 33-------------------------------------------------------------------------------- Management considers revenues generated from internet advertising, SEM services and other related technical services as one aggregate business operation and relies upon the consolidated results of all the operations in this business unit to make decisions about allocating resources and evaluating performance. ? Internet advertising revenues for the six months ended June 30, 2014 were approximately US$8.45 million as compared to approximately US$9.05 million for the same period in 2013, representing a 7% decrease. For the three months ended June 30, 2014 and 2013, internet advertising revenue was approximately US$4.96 million and US$5.34 million, respectively, representing a 7% decrease. The decrease in internet advertising revenue for the six and three months ended June 30, 2014 was primarily due to a decrease in number of customers during the periods as compared to the same periods last year. The decrease in number of customers for the six and three months ended June 30, 2014 was primarily due to the fact that (1) we are still in the recovery phase from the internal technical management deficiency detected in the fourth fiscal quarter of 2013- one of the technical staff stole and intercepted our websites visitors' message and information from our database for his own benefit- which damaged the effectiveness of our online advertising platform and its ability to satisfy the overall advertising effects expected by our clients for a certain time of period. As a result, the confidence of our customers relating to the effectiveness of our online advertising portals was also harmed; and (2) experienced intensified competition in the industry and customers' hesitation on investing in advertising and marketing expenses. In response to this situation, we increased our investment in brand building and new marketing service activities, and expanded our existing stream of internet marketing services by providing enhanced search engine marketing services to our customers, which as an effective supplement, will direct our customers to use our internet advertising and marketing services through various platforms, thereby increasing our recurring revenues in the future. ? Revenues generated from technical services provided by Rise King WFOE were US$0.24 million for the six months ended June 30, 2014 as compared to US$0.20 million for the same period in 2013. For the three months ended June 30, 2014 and 2013, revenues generated from technical services were approximately US$0.15 million and US$0.10 million, respectively. Due to unexpectedly economic difficulties and the overall economic downturn in China from the second half of 2011, with no significant improvement afterwards, many of our clients, including our branded clients, who are mostly SMEs, reduced their advertising spending significantly. A majority of our clients cancelled the subscription of these services and only continued their basic internet advertising service, which was recorded as internet advertising revenue discussed above. As there was no significant improvement in the overall economic in China for the past two years, our technical services revenue generated by Rise King WFOE was insignificant for the six and three months ended June 30, 2014 and 2013. ? Revenue generated from search engine marketing services for the six months and three months ended June 30, 2014 was approximately US$3.12 million. This enhanced third-party search engine marketing service is designed to help our customers select the most effective key words and to prioritize the ranking of the anticipated search engine results on selected key words in order to increase the click rate for our customers' business promotion on both mobile and computer searches. Management believes this service will be an effective supplement to the internet advertising services provided to our customers, and will help raise overall customer satisfaction, thereby increasing recurring revenues from online advertising and marketing in the future. ? Our TV advertising revenue decreased to US$2.99 million for the six months ended June 30, 2014 from US$5.13 million for the same period in 2013. For the three months ended June 30, 2014, our TV advertising revenue decreased to US$1.81 million from US$2.49 million for the same period in 2013. The decrease in TV advertising revenue for the six and three months ended June 30, 2014 was primarily due to the adoption of a restriction notice to TV shopping infomercials broadcasted in provincial satellite television station, issued by SARFT in October 2013, which further restricts the content, air time and duration of these infomercials. This restriction notice has had and may continue to have adverse impacts on the demands of our TV advertising service. In response to these restrictions, management plans to cooperate with the television stations to develop and produce new form of TV program which will replace TV shopping infomercials to help our clients raise their brand and product awareness, and to develop non-TV shopping advertising customers. We will continue to monitor our customers' needs for TV advertising services in order to improve the profitability of this business segment in future periods. ? For the six months ended June 30, 2014 and 2013, we earned both US$0.14 million of revenue from our bank kiosk business segment. For the three months ended June 30, 2014 and 2013, we earned approximately US$0.07 million of revenue from our bank kiosk business segment. The bank kiosk advertising business is not intended to expand at the moment as management's primary focus is expanding our internet business. It was not a significant contributor to revenue for the six and three months ended June 30, 2014 or 2013. Management currently maintains this business without any expansion plans and some of the technology used in this business unit will need to be fully integrated into the overall advertising and marketing platform. 34--------------------------------------------------------------------------------? For the six months ended June 30, 2014, we achieved approximately US$0.60 million service revenue from our brand management and sales channel building segment as compared to US$1.43 million service revenue generated in the same period of 2013. For the three months ended June 30, 2014, we achieved approximately US$0.25 million service revenue from this segment as compared to US$0.90 million service revenue generated in the same period of 2013. Due to the slow recovery of economy in 2014 and tightening of our customers' advertising budget, we do not expect growth in this business segment in 2014. Cost of revenues Our cost of revenue consisted of costs directly related to the offering of our advertising services, technical services, marketing services and brand management and sales channel building services. The following table sets forth our cost of revenues, divided into six segments, by amount and gross profit ratio for the periods indicated, with inter-segment transactions eliminated: Six Months Ended June 30, 2014 2013 (Amounts expressed inthousands of US dollars, except percentages) Revenue Cost GP ratio Revenue Cost GP ratio Internet advertisement and related services $ 11,808 $ 9,395 20 % $ 9,247 $ 4,264 54 % -Internet advertisement 8,454 6,368 25 % 9,046 4,264 53 % -Technical services 237 1 100 % 201 - 100 % -Search engine marketing service 3,117 3,026 3 % - - - TV advertisement 2,994 2,772 7 % 5,127 4,743 7 % Bank kiosk 138 5 96 % 140 - 100 % Brand management and sales channel building 604 315 48 % 1,427 750 47 % Total $ 15,544 $ 12,487 20 % $ 15,941 $ 9,757 39 % Three Months Ended June 30, 2014 2013 (Amounts expressed inthousands of US dollars, except percentages) Revenue Cost GP ratio Revenue Cost GP ratio Internet advertisement and related services $ 8,228 $ 6,853 17 % $ 5,436 $ 2,620 52 % -Internet advertisement 4,958 3,826 23 % 5,335 2,620 51 % -Technical services 153 1 99 % 101 - 100 % -Search engine marketing service 3,117 3,026 3 % - - - TV advertisement 1,812 1,677 7 % 2,489 2,243 10 % Bank kiosk 67 5 93 % 71 - 100 % Brand management and sales channel building 254 130 49 % 896 427 52 % Total $ 10,361 $ 8,665 16 % $ 8,892 $ 5,290 41 % Cost of revenues: Our total cost of revenues increased to US$12.49 million for the six months ended June 30, 2014 from US$9.76 million for the same period in 2013. For the three months ended June 30, 2014, our total cost of revenues increased to US$8.67 million from US$5.29 million for the same period in 2013. Our cost of revenues related to our advertising and marketing services primarily consists of internet resources purchased from key search engines and technical services providers related to lead generation, sponsored search, TV advertisement time costs purchased from TV stations, direct labor cost associated with providing services. ? Cost associated with obtaining internet resources was the largest component of our cost of revenue for internet advertisement, accounting for over 80% of our total internet advertisement cost of sales. We purchased these internet resources from other well-known search engines and portal websites in China, such as: Baidu, Qihu 360 and Sohu (Sogou). The purchase of these internet resources in large volumes allowed us to negotiate discounts with our suppliers. For the six months ended June 30, 2014 and 2013, our total cost of sales for internet advertising was US$6.37 million and US$4.26 million, respectively. For the three months ended June 30, 2014 and 2013, our total cost of sales for internet advertising was US$3.83 million and US$2.62 million, respectively. The increase in our internet advertising cost for the six and three months ended June 30, 2014 was primarily due to (1) continuously increasing internet advertising resources costs at a rate of 5%-15% per annum due to the overall decrease in demand of TV advertising and other traditional advertising media and stronger bargaining power of key search engines in China; and (2) intensified competition in the industry, which resulted in the increased costs. As a result, our gross profit ratio for internet advertising revenue decreased to 25% and 23% for the six and three months ended June 30, 2014, respectively, compared to 53% and 51% for the same periods last year, respectively. 35--------------------------------------------------------------------------------? Costs for search engine marketing services were direct internet resource costs consumed for search engine marketing services provided to customers as described above. We normally charge our customers service fees for this service as a certain percentage of the related direct cost consumed. Gross margin of this service for the six and three months ended June 30, 2014 was approximately 3%. ? TV advertisement time cost is the largest component of cost of revenue for TV advertisement revenue. We purchase TV advertisement time from provincial satellite TV stations in China and resell it to our TV advertisement clients. Our TV advertisement time cost was approximately US$2.77 million and US$4.74 million for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014 and 2013, our TV advertisement time cost was approximately US$1.68 million and US$2.24 million, respectively. The decrease in our total TV advertisement time cost was in line with the decrease in TV advertising revenue for the six and three months ended June 30, 2014, compared to that in the same periods of 2013, as discussed above. Gross margin of this business segment was both 7% for the six and three months ended June 30, 2014, compared to 7% and 10% for the six and three months ended June 30, 2013, respectively. ? Cost recognized for our brand management and sales channel building business segment mainly consisted of director labor cost for providing these services to our customers. Gross Profit As a result of the foregoing, our gross profit was US$3.06 million and US$6.18 million for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014 and 2013, our gross profit was US$1.70 million and US$3.60 million, respectively. Our overall gross margin decreased to 20% and 16% for the six and three months ended June 30, 2014, respectively, compared to 39% and 41% for the same periods in 2013, respectively. The decrease was a direct result of the decrease in the gross margin of our internet advertising segment to 25% and 23% for the six and three months ended June 30, 2014, compared to 53% and 51% for the same periods of last year, respectively, which was primarily due to the decrease in sales and increase in the related cost of sales of this business during the periods, as discussed above. Operating Expenses and Net (Loss)/Income Our operating expenses consist of selling expenses, general and administrative expenses and research and development expenses. The following tables set forth our operating expenses, divided into their major categories by amount and as a percentage of our total revenues for the periods indicated. Six Months Ended June 30, 2014 2013 (Amountsexpressed in thousands of US dollars, except percentages) % of total % of total Amount revenue Amount revenue Total Revenue $ 15,544 100 % $ 15,941 100 % Gross Profit 3,057 20 % 6,184 39 % Selling expenses 2,095 13 % 1,390 9 % General and administrative expenses 2,009 13 % 3,146 20 % Research and development expenses 892 6 % 912 6 % Total operating expenses $ 4,996 32 % $ 5,448 34 % 36-------------------------------------------------------------------------------- Three Months Ended June 30, 2014 2013 (Amountsexpressed in thousands of US dollars, except percentages) % of total % of total Amount revenue Amount revenue Total Revenue $ 10,361 100 % $ 8,892 100 % Gross Profit 1,696 16 % 3,602 41 % Selling expenses 1,506 15 % 602 7 % General and administrative expenses 1,022 10 % 1,744 20 % Research and development expenses 442 4 % 463 5 % Total operating expenses $ 2,970 29 % $ 2,809 32 % Operating Expenses: Our operating expenses decreased to US$5.0 million for the six months ended June 30, 2014 from US$5.45 million for the same period of 2013. For the three months ended June 30, 2014, our operating expenses increased to US$2.97 million from US$2.81 million for the same period of 2013. ? Selling expenses: Selling expenses increased to US$2.10 million for the six months ended June 30, 2014 from US$1.39 million for the same period of 2013. For the three months ended June 30, 2014, selling expense increased to US$1.51 million, compared to US$0.60 million for the same period last year. Our selling expenses primarily consist of advertising expenses for brand development that we pay to different media outlets for the promotion and marketing of our advertising web portals, other advertising and promotional expenses, website server hosting and broadband leasing expenses, staff salaries, staff benefits, performance bonuses, travelling expenses, communication expenses and other general office expenses of our sales department. For the six months ended June 30, 2014, the change in our selling expenses was primarily due to the following reasons: (1) the decrease in staff salary, bonus, employee related benefit expenses and other general selling expenses, such as travelling expenses, business and entertainment expenses and communication expenses of approximately US$0.03 million; (2) the decrease in website server hosting and broadband leasing expense of approximately US$0.10 million due to more favorable contract terms negotiated with the service provider; and (3) the increase in our marketing advertising expenses of approximately US$0.83 million. During the six and three months ended June 30, 2014, the increase in the marketing expense was paid to search engines for the promotion of our websites and new services. Due to increasing competition in the industry, management considered it to be necessary to increase brand building expenses for our operating websites, as well as new services introduced to our customers. Through the SEM technology, we bid on various key words to direct more internet traffic to our main business portals such as 28.com and Liansuo.com. We will also continue to actively participate in both domestic and international franchise exhibitions and in government supported employment promotion programs, which are considered cost-effective ways to build our brand. For the three months ended June 30, 2014, the reason for the increase in our selling expenses was due to the increase in brand marketing expense as discussed above. ? General and administrative expenses: General and administrative expenses decreased to US$2.01 million for the six months ended June 30, 2014 from US$3.15 million for the same period in 2013. For the three months ended June 30, 2014, our general and administrative expenses decreased to US$1.02 million from US$1.74 million for the same period last year. Our general and administrative expenses primarily consist of salaries and benefits for management, accounting and administrative personnel, office rentals, depreciation of office equipment, professional service fees, maintenance, utilities and other office expenses. For the six months ended June 30, 2014, the change in our general and administrative expenses was primarily due to the following reasons: (1) the decrease in general administrative expenses, such as: salary and staff benefits, office supplies, travelling expenses and entertainment expenses of approximately US$0.25 million, due to the cost reduction plan executed by management; and (2) the decrease in allowance for doubtful accounts of approximately US$0.82 million; and (3) the decrease in professional service (such as: investor relations, legal, etc.) charges of approximately US$0.07 million, primarily due to decrease in the related services required from these parties as compared to the same period last year. For the three months ended June 30, 2014, the reasons for the decrease in our general and administrative expenses were similar to those discussed for the six months ended June 30, 2014. ? Research and development expenses: Research and development expenses were US$0.89 million and US$0.91 million for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014 and 2013, research and development expenses were US$0.44 million and US$0.46 million, respectively. Our research and development expenses primarily consist of salaries and benefits for the research and development staff, equipment depreciation expenses, and office utilities and supplies allocated to our research and development department. 37-------------------------------------------------------------------------------- (Loss)/income from operations: As a result of the foregoing, for the six and three months ended June 30, 2014, our net loss from operations was approximately US$1.94 million and US$1.27 million, respectively. Our income from operations was approximately US$0.74 million and US$0.79 million for the six and three months ended June 30, 2013, respectively. Interest income: For the six and three months ended June 30, 2014 and 2013, interests income earned was primarily contributed from approximately US$3.4 million of term deposit we placed in a major financial institution in the PRC. Interest expense: For the six and three months ended June 30, 2014, interests expense we paid was primarily related to the approximately US$0.8 million of short-term bank loan we borrowed from a major financial institution in the PRC to supplement our short-term working capital needs. (Loss)/income before income tax expense, equity method investments and noncontrolling interests: As a result of the foregoing, for the six and three months ended June 30, 2014, our loss before income tax expense, equity method investments and noncontrolling interests was approximately US$1.91 million and US$1.26 million respectively. our income before income tax expense, equity method investments and noncontrolling interests was approximately US$0.80 million and US$0.82 million for the six and three months ended June 30, 2013, respectively. Income Tax (expenses)/benefit: We recognized a net income tax expense of approximately US$0.12 million and US$0.07 million for the six and three months ended June 30, 2014, respectively. For the six and three months ended June 30, 2014, current income tax expense was approximately US$0.38 million and US$0.20 million, respectively. For the six months ended June 30, 2014, our net income tax expense also included an approximately US$0.26 million deferred income tax benefit, of which approximately US$0.11 million was in relation to the amortization expenses of the intangible assets identified in the acquisition transactions consummated in 2011 and approximately US$0.15 million was in relation to the net operating loss incurred by our PRC operating VIEs for the period, which we consider likely to be able to be utilized with respect to future earnings of the entities to which the operating losses relate. For the three months ended June 30, 2014, our net income tax benefit also included an approximately US$0.13 million deferred income tax benefit, of which approximately US$0.06 million was in relation to the amortization expenses of the intangible assets identified in the acquisition transactions consummated in 2011 and approximately US$0.07 million was in relation to the net operating loss incurred by our PRC operating VIEs, which we consider likely to be able to be utilized with respect to future earnings of the entities to which the operating losses relate. For the six and three months ended June 30, 2013, we recognized a net income tax expense of approximately US$0.27 million and US$0.35 million, respectively. For the six and three months ended June 30, 2013, current income tax expense was approximately US$0.71 million and US$0.48 million, respectively. The current income tax expense for the three months ended June 30, 2013 also include an adjustment of approximately US$0.13 million of income tax expense accrued for Business Opportunity Online Hubei for the three months ended March 31, 2013, due to a new exacted income tax rate for its fiscal year 2013 in relation to the determination of its first profitable year as year 2011 instead of year 2012 by the local tax authorities in early August 2013, which increased the applicable income tax rate of this entity from nil% to 12.5% for its fiscal 2013. For the six months ended June 30, 2013, our net income tax expense also included an approximately US$0.44 million deferred income tax benefit, of which approximately US$0.11 million was in relation to the amortization expenses of the intangible assets identified in the acquisition transactions consummated in 2011 and approximately US$0.33 million was in relation to the net operating loss incurred by our PRC operating VIEs, which we consider likely to be able to be utilized with respect to future earnings of the entities to which the operating losses relate, after net of reversals resulted from net income generated during the period. For the three months ended June 30, 2013, our net income tax benefit also included an approximately US$0.25 million deferred income tax benefit, of which approximately US$0.06 million was in relation to the amortization expenses of the intangible assets identified in the acquisition transactions consummated in 2011 and approximately US$0.19 million was in relation to the net operating loss incurred by our PRC operating VIEs, which we consider likely to be able to be utilized with respect to future earnings of the entities to which the operating losses relate, after net of reversals resulted from net income generated during the period. (Loss)/income before equity method investments and noncontrolling interests: As a result of the foregoing, our loss before equity method investments and noncontrolling interests was approximately US$2.03 million and US$1.34 million for the six and three months ended June 30, 2014, respectively, respectively. Our income before equity method investments and noncontrolling interests was approximately US$0.53 million US$0.47 million for the six and three months ended June 30, 2013, respectively. Share of losses in equity investment affiliates: For the six and three months ended June 30, 2014 and 2013, we beneficially own 23.18% and 25.5% equity interest in Shenzhen Mingshan and Zhao Shang Ke Hubei, respectively. Accordingly, for the six months ended June 30, 2014 and 2013, we recognized our pro-rata share of losses in these two affiliates of approximately US$0.06 million and US$0.13 million, respectively. For the three months ended June 30, 2014 and 2013, we recognized our pro-rata share of losses in these two affiliates of approximately US$0.04 million and US$0.05 million, respectively. 38 -------------------------------------------------------------------------------- Net (loss)/income: As a result of the foregoing, our net loss for the six and three months ended June 30, 2014 was approximately US$2.09 million and US$1.38 million, respectively. Our net income for the six and three months ended June 30, 2013 was approximately US$0.41 million and US$0.42 million, respectively. Net loss attributable to noncontrolling interests: Beijing Chuang Fu Tian Xia and Sheng Tian Hubei were 51% owned by Business Opportunity Online and Business Opportunity Online Hubei, respectively, upon incorporation. In September 2013, we acquired the remaining 49% equity interest in Sheng Tian Hubei and Sheng Tian Hubei became a wholly-owned VIE of ours accordingly. For the six and three months ended June 30, 2014, net loss allocated to the noncontrolling interests of Beijing Chuang Fu Tian Xia was approximately US$0.09 million and US$0.05 million, respectively. For the six and three months ended June 30, 2013, the aggregate net loss allocated to the noncontrolling interests of Beijing Chuang Fu Tian Xia and Sheng Tian Hubei was approximately US$0.06 million and US$0.02 million, respectively. Net (loss)/income attributable to ChinaNet Online Holdings, Inc.: Total net (loss)/income as adjusted by the net loss attributable to the noncontrolling interest as discussed above yields the net (loss)/income attributable to ChinaNet Online Holdings, Inc. Net loss attributable to ChinaNet Online Holdings, Inc. was approximately US$2.0 million and US$1.33 million for the six and three months ended June 30, 2014, respectively. For the six and three months ended June 30, 2013, net income attributable to ChinaNet Online Holdings, Inc. was approximately US$0.46 million and US$0.43 million, respectively. B. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents represent cash on hand and deposits held at call with banks. We consider all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents. As of June 30, 2014, we had cash and cash equivalents of approximately US$2.72 million and we also have approximately US$3.44 million of term deposit placed in one of the major financial institutions in China which will expire in July 2015. Our liquidity needs include (i) net cash used in operating activities that consists of (a) cash required to fund the initial build-out and continued expansion of our network and (b) our working capital needs, which include deposits and advance payments to TV advertising slots and internet resource providers, payment of our operating expenses and financing of our accounts receivable; and (ii) net cash used in investing activities that consist of the payment for acquisitions to further expand our business and client base, investment in software technologies to enhance the functionality of the management tools provided by our advertising portals and our general network securities, and investment in other general office equipment. To date, we have financed our liquidity need primarily through proceeds from operating activities we generated in prior years. Our existing cash is adequate to fund operations for the next 12 months. The following table provides detailed information about our net cash flow for the periods indicated: Six Months Ended June 30, 2014 2013 Amounts in thousands of US dollars Net cash used in operating activities (944 ) (20 ) Net cash used in investing activities (471 ) (2,140 ) Net cash provided by financing activities 717 - Effect of foreign currency exchange rate changes on cash (21 ) 69 Net decrease in cash and cash equivalents (719 ) (2,091 ) 39-------------------------------------------------------------------------------- Net cash used in operating activities: For the six months ended June 30, 2014, our net cash used in operating activities of approximately US$0.94 million were primarily attributable to: (1) net loss excluding an approximately US$0.26 million net deferred income tax benefit, a US$0.79 million non-cash expenses of depreciation, amortizations, share-based compensation and our share of losses in equity investment affiliates and a reversal of approximately US$0.03 million allowance for doubtful accounts, of approximately US$1.59 million; (2) the receipt of cash from operations from changes in operating assets and liabilities such as: - accounts receivable and due from related parties for the advertising services provided decreased by approximately US$2.57 million; - other receivable decreased by approximately US$1.29 million, primarily due to the partial collection of the marketing-related loan made for the production of the TV series "Xiao Zhan Feng Yun" and receivables on disposal of subsidiaries; - other current liabilities increased by approximately US$0.30 million; and - taxes payable increased by approximately US$0.17 million. (3) offset by the use from operations from changes in operating assets and liabilities such as: - deposit and prepayment to suppliers increased by approximately US$3.46 million for the purchasing of internet resources and TV advertising slots; - accruals decreased by approximately US$0.16 million, and - other current assets increased by approximately US$0.07 million. For the six months ended June 30, 2013, our net cash used in operating activities of approximately US$0.02 million were primarily attributable to: (1) net income excluding an approximately US$0.44 million net deferred income tax benefit, a US$0.99 million non-cash expenses of depreciation, amortizations, share-based compensation and our share of losses in equity investment affiliates, and a US$0.79 million of allowances for doubtful debts of approximately US$1.74 million; (2) the receipt of cash from operations from changes in operating assets and liabilities such as: - accounts payable increased by approximately US$0.14 million; - accruals increased by approximately US$0.03 million; - prepayment to suppliers decreased by approximately US$0.26 million; - other assets decreased by approximately US$0.03 million; and - taxes payable increased by approximately US$0.74 million. (3) offset by the use from operations from changes in operating assets and liabilities such as: - accounts receivable and due from related parties for the advertising services provided increased by approximately US$1.94 million; - other receivables increased by approximately US$0.71 million; - advance from customers decreased by US$0.27 million; and - other current liabilities decreased by approximately US$0.04 million. 40-------------------------------------------------------------------------------- Net cash used in investing activities: For the six months ended June 30, 2014, our cash used in investing activities included the following transactions: (1) we spent approximately US$0.02 million for purchase of general office equipment; (2) we prepaid approximately US$0.85 million for the development of software systems related to internet environment monitoring and system optimization to enhance the overall safety and efficiency of our network system; and (3) we collected approximately US$0.39 million of short-term loan that we lent to an unrelated entity in last year. In the aggregate, these transactions resulted in a net cash outflow from investing activities of approximately US$0.47 million for the six months ended June 30, 2014. For the six months ended June 30, 2013, our cash used in investing activities included the following transactions: (1) we spent approximately US$0.06 million for the purchase of general office equipment; (2) we made a deposit to an unrelated technical consulting entity of approximately US$0.80 million the purchasing of software technology that related to operation management applications for SMEs; and (3) we paid approximately US$1.28 million to settle the outstanding payment for the acquisition of the 49% equity interest in Sou Yi Lian Mei. In the aggregate, these transactions resulted in a net cash outflow from investing activities of approximately US$2.14 million for the six months ended June 30, 2013. Net cash provided by financing activities: For the six months ended June 30, 2014, we borrowed approximately US$0.72 million from the noncontrolling interest of one of our VIEs to supplement the short-term working capital needs of this VIE. For the six months ended June 30, 2013, no cash was generated from financing activities or spent for financing activities. Restricted Net Assets As most of our operations are conducted through our PRC subsidiary and VIEs, our ability to pay dividends is primarily dependent on receiving distributions of funds from our PRC subsidiary and VIEs. Relevant PRC statutory laws and regulations permit payments of dividends by our PRC subsidiary and VIEs only out of their retained earnings, if any, as determined in accordance with PRC accounting standards and regulations and after it has met the PRC requirements for appropriation to statutory reserves. Paid in capital of the PRC subsidiary and VIEs included in our consolidated net assets are also not distributable for dividend purposes. In accordance with the PRC regulations on Enterprises with Foreign Investment, a WFOE established in the PRC is required to provide certain statutory reserves, namely general reserve fund, the enterprise expansion fund and staff welfare and bonus fund which are appropriated from net profit as reported in the enterprise's PRC statutory accounts. A WFOE is required to allocate at least 10% of its annual after-tax profit to the general reserve until such reserve has reached 50% of its registered capital based on the enterprise's PRC statutory accounts. Appropriations to the enterprise expansion fund and staff welfare and bonus fund are at the discretion of the board of directors. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. Rise King WFOE is subject to the above mandated restrictions on distributable profits. Additionally, in accordance with the Company Law of the PRC, a domestic enterprise is required to provide a statutory common reserve of at least 10% of its annual after-tax profit until such reserve has reached 50% of its registered capital based on the enterprise's PRC statutory accounts. A domestic enterprise is also required to provide for a discretionary surplus reserve, at the discretion of the board of directors. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. All of our PRC VIEs are subject to the above mandated restrictions on distributable profits. As a result of these PRC laws and regulations, our PRC subsidiary and VIEs are restricted in their ability to transfer a portion of their net assets to us. As of June 30, 2014 and December 31, 2013, net assets restricted in the aggregate, which includes paid-in capital and statutory reserve funds of our PRC subsidiary and VIEs that are included in our consolidated net assets, was both approximately US$7.3 million. The current PRC Enterprise Income Tax ("EIT") Law also imposed a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Rise King WFOE is invested by its immediate holding company in Hong Kong and will be entitled to the 5% preferential withholding tax rate upon distribution of the dividends to its immediate holding company. The ability of our PRC subsidiaries to make dividends and other payments to us may also be restricted by changes in applicable foreign exchange and other laws and regulations. 41--------------------------------------------------------------------------------Foreign currency exchange regulation in China is primarily governed by the following rules: ? Foreign Exchange Administration Rules (1996), as amended in August 2008, or the Exchange Rules; ? Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules. Currently, under the Administration Rules, Renminbi is freely convertible for current account items, including the distribution of dividends, interest payments, trade and service related foreign exchange transactions, but not for capital account items, such as direct investments, loans, repatriation of investments and investments in securities outside of China, unless the prior approval of the State Administration of Foreign Exchange (the "SAFE") is obtained and prior registration with the SAFE is made. Foreign-invested enterprises like Rise King WFOE that need foreign exchange for the distribution of profits to its shareholders may effect payment from their foreign exchange accounts or purchase and pay foreign exchange rates at the designated foreign exchange banks to their foreign shareholders by producing board resolutions for such profit distribution. Based on their needs, foreign-invested enterprises are permitted to open foreign exchange settlement accounts for current account receipts and payments of foreign exchange along with specialized accounts for capital account receipts and payments of foreign exchange at certain designated foreign exchange banks. Although the current Exchange Rules allow the convertibility of Chinese Renminbi into foreign currency for current account items, conversion of Chinese Renminbi into foreign exchange for capital items, such as foreign direct investment, loans or securities, requires the approval of SAFE, which is under the authority of the People's Bank of China. These approvals, however, do not guarantee the availability of foreign currency conversion. We cannot be sure that it will be able to obtain all required conversion approvals for our operations or the Chinese regulatory authorities will not impose greater restrictions on the convertibility of Chinese Renminbi in the future. Currently, most of our retained earnings are generated in Renminbi. Any future restrictions on currency exchanges may limit our ability to use retained earnings generated in Renminbi to make dividends or other payments in U.S. dollars or fund possible business activities outside China. As of June 30, 2014 and December 31, 2013, there were approximately US$37.2 million and US$39.3 million retained earnings in the aggregate, respectively, which were generated by our PRC subsidiary and VIEs in Renminbi included in our consolidated net assets, aside from US$2.8 million statutory reserve funds as of June 30, 2014 and December 31, 2013, that may be affected by increased restrictions on currency exchanges in the future and accordingly may further limit our PRC subsidiary's or VIEs' ability to make dividends or other payments in U.S. dollars to us, in addition to the approximately US$7.3 million restricted net assets as of June 30, 2014 and December 31, 2013, as discussed above. C. OFF-BALANCE SHEET ARRANGEMENTS None. |