Wednesday, August 01, 2007
China Expert Technologies (CXTI) 2006 10-K
I bought into CXTI starting July 20 and continuing into July 26. They've been doing extremely well at landing new contracts and when the CFO resigned, I believe the market way overreacted.
I'm leaving out a lot of stuff that I've covered in previous 10-K reports.
Year ending Dec 31, 2006.
31 million shares on March 15, 2007.
Jan 8, 2007: CXTI amended SEC share registration for 11.6 million shares (amendment number 3) from the various financiers. There was another amendment for 16 million shares in June 2006, an SB-2 amendment around the same time for the same shares (SEC form description). S-1 is the form for the initial registration of shares while SB-2 is for subsequent shares, although it's the small business version? covered by the prior S-1?
I've covered the history previously, including the toxic convertibles (now gone).
Jan 8, 2007, CXTI filed an amendment to their S-1 securities registration to sell up to 11.6 million shares related to the convertibles and warrants.
57 full-time employees on Dec 31, 2006. 24 permanent, 33 contractors.
Various types of bidding on e-government contracts
open bidding on a website
invited bidding (Jinjiang project was invited) seems to involve more close up-front work between CXTI and the government
CXTI will sometimes prepare a feasibility report covering whether the city is suitable to construct an e-government system. CXTI does a site visit, gathers info, and advises the city.
CXTI has issued a lot of shares to consultants for a variety of areas of work. There's a continuing relationship with Macro Business Limited ("Consultant") started in Feb 2004. CXTI agreed to issue 1.1 million shares for sourcing contracts. When the Consultant gets a successful contract, CXTI pays out 15% of the gross contract amount. in cash or stock (CXTI's option).
In June 2005, CXTI made an agreement with Zhao Wei of China e-internet Technologies Ltd: 1.1 million shares for sourcing the Huian County contracts. Other contracts pay 10% of gross amount.
In Jan 2006, CXTI made an agreement with e-Internet Technologies Ltd: 1.2 million shares for sourcing the Licheng District contract and related preliminary work.
In March 2006, CXTI made an agreement with FuJian Internet Consultants Ltd: 15%, payable in stock.
Nov 2006, agreement with Cangshan Science Park Huada Electronic etc. etc. Company. This pays only 4% of the contract total, much better terms for CXTI. Paid in cash, $600K.
Nov 2006, agreement with Minqing Jin Nua Information Technology Co Ltd. Sourcing in Minqing County of Fuzhou City in Fujian. Pays 5%. $1.3 million cash paid.
Dec 2006, agreement with Quanzhou Guo Guang Scientific etc. etc. Company Ltd. Sourcing in Quangang District of Quanzhou City in Fujian. Pays 6%. $1.9 million cash paid.
Dec 2006, agreement with Pingtan County Shun Wei Information Technology Company Ltd. Sourcing in Pingtan County of Fuzhou City in Fujian. Pays 5%. $1.2 million cash paid.
Dec 2006, agreement with Fuzhou C.H. Network Science & Technology Ltd. Sourcing in Mawei District of Fuzhou City in Fujian. Pays 4%. $900K paid.
Dec 2006, agreement with Yongtai Jia Zheng Consultants. Sourcing in Yongtai County of Fuzhou City in Fujian. Pays 5%. $1.5 million paid.
CXTI prefers to pay these consultants in cash whenever possible. Consultants, you ask?
The Company would use independent consultants who are not employees of the Chinese Government but have tides and knowledge of the local cities where they have citizenship to explore opportunities in new cities. The costs of using these independent would be the amount of commission, usually payable in shares of the Company’s common stock or cash, paid to these consultants.There's a lot of gray area where you need to get the ear of the right people who have connections with people with influence etc. I have a tangible fear that there are kickbacks involved.
Now let's see if any of the risk factors are unexpected. They're still saying they only have 12 cities out of the total 82 in Fujian, which is good since it leaves room for more business. I thought they had one contract outside of Fujian, perhaps that was after Dec 31. [down on page 23 they mention that Yinzhou District, Ningbo City is outside of Fujian].
The tax rate is increasing from 15% to 25%.
800K shares were reserved in the stock compensation program of Jan 2006. Nothing else.
Chart of fianancial results since 2002:
Revenue [net income, per share]:
2002: $1.25 million [loss $950K, 5 cent loss]
2003: $5.67 million [$1.2 million, 6 cents]
2004: $26.8 million [$4.8 million, 20 cents]
2005: $35.6 million [$6.5 million, 26 cents]
2006: $66.1 million [$7.8 million, 22 cents] [we'll see below that I think this is more like 50 cents]
CXTI focuses on second tier cities (Beijing and Shanghai are first tier cities and multinational companies have already been making inroads there). CXTI tailor makes solutions more than multinational competitors (not sure I totally believe that).
There's a problem in expanding outside of Fujian. Here they're saying they have 12 out of 25 cities in Fujian (not 85), but the 25 number are cities that are estimated to be suitable to apply CXTI's e-government systems. Even then, some of the 25 might not end up being suitable.
CXTI needs to expand outside of Fujian. This is a top priority.
14 new e-government contracts were won in 2006 representing $252 million. They started the Jinjiang training and maintenance phase, which was a phase I had worried about being underestimated.
At the end of the year, they had $228 million outstanding in contracts.
Cost of Revenue
Advertising and marketing expenses
General and administrative expenses
Amortization of intangible assets
Interest expenses and finance costs
Loss on extinguishment of debts
Change in fair value of derivatives
Income before income tax
Income tax expenses
Revenue is up due to new projects.
Gross margin is up due to less subcontracted work
Advertising and marketing included all those consultant fees mentioned above. This will continue.
G&A percentage increased due to stock issued to employees, also liquidation damages to pipe investors.
Note that the fair value of the stock issued to consultants is repriced over time, if I understand correctly. This would cause silly fluctuations in costs. This will also tend to cause oscillations in stock price, in my opinion.
Financing costs were pretty high due to the debentures of Oct 2005 that drove the stock down to around 80 cents at that time. Also, when they amended the debenture terms in Oct 2006, they had a $504K loss on extinguishment of debt, which would have been this.
There was a $3.1 million expense from change in fair value of derivatives, which I consider to be a perhaps misleading charge. I'd prefer a realistic estimate of value at the time the derivatives were created and then amortize that charge over the (expected) lifetime of the derivatives.
The overall net margin decrease (to 11.87% from 18.28%) was due to the sourcing fees, employee stock, liquidated damages payment, convertibles financing costs, and other stuff.
Revenue recognition is using the percentage-of-completion method. Losses (when revenue isn't expected to cover costs) are recognized immediately. Lots of judgement needed here, watch for any losses in early projects.
I covered the 1-year warranty period issues long ago.
Zhu Xiao Xin, 41, CEO since 2004, owns 33% of the stock (along with others)
Huang Tao, 44, Chairman since 2005, owns 7.42% of the stock
Fu Wan Chung, Simon, 39, CFO [who just left the company in July 2007] since April 19, 2006, owned no stock.
Song Feng, 43, COO since 2004, owned 285K shares of stock.
Fu Wan Chung, Simon:
Mr. Fu joined the Group in November 2005 and is responsible for the financial control and management of the Group. He was appointed as the Chief Financial Officer on April 19, 2006. Mr. Fu is a fellow member of the Association of Chartered Certified Accountants and holds a Bachelor Degree in Accountancy from the Hong Kong Polytechnic University. Before joining the Group, Mr. Fu worked for Innovative Information Systems Limited, a subsidiary of Itochu Corporation, as the Financial Controller from March 2001 to August 2005. Mr. Fu was appointed as Director of the Company on August 11, 2006.
The salaries are extremely low. The highest total compensation is $42K.
All officers and directors own 41% of the stock.
Audit fees were $187K (vs $115K for 2005). Tax fees were minor.
Auditors were BDO McCabe who I covered here. Unqualified audit opinion.
Cash increased to $10 million from $7.3 million, but I know from the discussion that it's not from operations.
AR increased to $34 million from $15 million! Later on in Q1, this gets slightly better at $31 million.
Prepayments jumped to $19 million from $10 million!
Amount due to a former officer increased to $1.8 million from $850K.
Tax payable increased to $1.1 million from $642K and deferred tax liabilities increased to $471K from around $100K.
There are big derivatives liabilities in the balance sheet due to the convertible debentures.
Equity jumped to $59 million from $21 million, somewhat due to retained earnings, but mostly due to additional capital associated with the derivatives.
2004: $26.8 million
2005: $35.6 million
2006: $66.1 million
The rest is covered above.
Started the year with 26 million shares and $21 million equity
2.3 million issued for sourcing contract(s)
844K issued for convertible debentures
800K issued for employee compensation
184K issued for debenture interest
614K issued for liquidated damages
Ended the year with 31 million shares.
CASH FLOW STATEMENT
Operations burned $1.7 million in cash despite earnings of $7.8 million.
AR increased $17.7 million
prepayments etc. increased $14.3 million (these are the cash commission payments and prepaid contract costs)
non-cash stock compensation of $8.6 million
non-cash charge fair value of derivatives $5.4 million
non-cash amortized finance costs $4.2 million
non-cash charge for change in fair value of derivatives $3.1 million
$3.7 million increase in cash due to refund of a deposit for acquiring a subcontractor, which can explain the entire increase in cash.
$1.5 million sloshed back and forth with a former director
Furniture/fixtures/office equipment 5 years
Computer equipment and software 3.3 years
Cars 3.3 years
Leasehold improvements 3.3 years (or lease term if shorter)
These seem good for a Chinese company (CEDA in particular)
The P&E is currently fairly evenly split among these groups. It's nearly entirely depreciated.
Cost of revenue is subcontracting costs, labor, and costs by those directly working on the contracts
The related party transactions with a former officer involve cash advances in both directions. Interest free, repayable within one year.
Also, there's a rental agreement with the same guy and he sold a car to the company for $23K, this was all back in 2005 and 2004.
The "toxic" convertible debentures are old news and I'm not going to cover them again.
Taxes are often a good double check against claims of income. These are the current PRC tax expenses for each year.
2004: $1.8 million
2005: $2.4 million
2006: $4.9 million
3.76 million options/warrants/convertibles that are anti-dilutive.
6.6 million outstanding warrants.
31 million shares outstanding
I don't have the information needed to compute fully diluted shares, but I'll make a guess at something like 45 million totally diluted shares.
So net income per share assuming 45 million shares would need to back out the various non-cash charges related to stock, which I figure is around $17 million (look at the related modifications in operating cash flow*). If we add that to the $7.8 million net income, we get $23.7 million. If we divide that by our totally diluted 45 million shares, we get around 55** cents per share. The statement claims 22 cents per diluted share.
** I find this 55 cent number suspicious because it's hard to believe the non-cash expenses would be that much higher than my method of assuming the worst dilution and backing that stuff out. I must have made a mistake somewhere or else didn't count some expense. Then again, the huge increase in the stock price will cause a huge GAAP accounting expense, if I understand correctly.
A good double check is the operating income which increased from $14 million in 2005 to $21 million in 2006, and that's even after the big jump in G&A due to the consultants' sourcing fees (much of which includes stock compensation).
* stock based compensation related modifications to operating cash flow
Change in fair value and amortization of prepaid consultancy fees: $5.4 million (these are the non-cash related ones, cash charges are simply... cash)
Expenses compensated by common stock: $8.6 million
Change in fair value of derivatives: $3.1 million
Looks pretty solid. They really need to expand outside of Fujian very soon. I think a realistic view of earnings are much better than the GAAP number, perhaps more like 55 cents, but I might have made a mistake in overestimating the stock based expenses on the income statement or missing something else.
It's easy to worry that all the e-government work will complete all over China and leave CXTI out in the cold. But does anyone believe that government computer IT work will decrease going forward in time? Especially for a control-freak sort of country? I think not.