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EX-31.1 - EXHIBIT 31.1 - TELESTONE TECHNOLOGIES CORPv232505_ex31-1.htm
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EX-31.2 - EXHIBIT 31.2 - TELESTONE TECHNOLOGIES CORPv232505_ex31-2.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q/A
(Amendment No. 1)

(Mark One)

 
x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarterly period ended June 30, 2011
 
¨
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2011

Commission File Number: 001-32503
 
TELESTONE TECHNOLOGIES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
 
Delaware
 
84-1111224
(State or Other Jurisdiction of
 
(I.R.S. Employer Identification No.)
Incorporation or Organization)
   

Floor 10, China Ruida Plaza
No. 74 Lugu Road
Shi Jingshan District
Beijing, People’s Republic of China 100040
(Address of Principal Executive Offices)

(86 10) 6860-8335
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. Yes x    No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨  No x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer ¨
 
Accelerated filer ¨
 
Non-accelerated filer ¨
 
Smaller reporting company x
       
(Do not check if a smaller reporting
company)
   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
 
As of August 15, 2011, 12,333,264 shares of the Issuer’s $.001 par value common stock were outstanding.

 
 

 

Telestone Technologies Corporation

EXPLANATORY NOTE

The purpose of this Amendment No. 1 to Telestone Technology Corporation’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2011, filed with the Securities and Exchange Commission on August 15, 2011, (“Form 10-Q”), is to furnish Exhibit 101 to the Form 10-Q in accordance with Rule 405 of Regulation S-T and to amend certain information on the cover page of the Form 10-Q.

Exhibit 101 to this report provides the consolidated financial statements and relates notes from the Form 10-Q formatted in XBRL (eXtensible Business Reporting Language). Pursuant to Rule 406T of Regulation S-T, the interactive data files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

The Company is also filing this Amendment No. 1 for the purpose of revising the cover page to indicate (i) that the Company has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and has been subject to the filing requirements for at least the past 90 days, and (ii) that the Company has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Finally the Company is also filing this Amendment No.1 for the purpose of correcting certain typographical errors and omissions, namely inaccuracies in the table of contents, the omission of the footnote stating that the “notes are an integral part of the condensed consolidated financial statements,” and inaccuracies in the titles of the financial statements and accompanying notes.

Pursuant to Rule 12b-15 under the Securities Exchange Act of 1934, as amended, new certifications of our principal executive officer and principal financial officer are being filed as Exhibits 31.1 and 31.2, respectively, to this Amendment No. 1 on Form 10-Q/A, such certifications allowed to be abbreviated in accordance with published interpretations of the SEC.

No other changes have been made to the Form 10-Q. This Amendment No. 1 to the Form 10-Q speaks as of the original filing date of the Form 10-Q, does not reflect events that may have occurred subsequent to the original filing date, and does not beyond the amendments discussed above modify or update in any way disclosures made in the original Form 10-Q.

 
2

 

TELESTONE TECHNOLOGIES CORPORATION

INDEX
 
 
Page
   
PART I. FINANCIAL INFORMATION
 
   
Item 1. Condensed Financial Statements.
4
   
Condensed Consolidated Statements of Operations and Other Comprehensive Income, for the three and six months ended June 30, 2011 and 2010 (unaudited)
4
   
Condensed Consolidated Balance Sheets, as of June 30, 2011 (unaudited) and December 31, 2010
5
   
Condensed Consolidated Statements of Cash Flows, for the six months ended June 30, 2011 and 2010 (unaudited)
6
   
Notes to Condensed Consolidated Financial Statements (unaudited)
7
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
24
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
43
   
Item 4. Controls and Procedures.
43
   
PART II. OTHER INFORMATION
 
   
Item 1. Legal Proceedings.
44
Item 1A. Risk Factors.
44
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
44
Item 3. Defaults Upon Senior Securities.
44
Item 4. (Removed and Reserved).
44
Item 5. Other Information.
44
Item 6. Exhibits.
44

Except as otherwise indicated by the context, references in this Form 10-Q to:

“TSTC,” the “Company,” “we,” “our,” or “us” are references to Telestone Technologies Corporation
“U.S. Dollar,” “$” and “US$” mean the legal currency of the United States of America.
“RMB” means Renminbi, the legal currency of China.
“China” or the “PRC” are references to the People’s Republic of China.
“U.S.” is a reference to the United States of America.
“SEC” is a reference to the Securities & Exchange Commission of the United States of America.

 
3

 

ITEM 1. FINANCIAL STATEMENTS
Telestone Technologies Corporation

Condensed Consolidated Statements of Operations and Other Comprehensive Income
Three months and six months ended June 30, 2011 and 2010

         
Three months ended June 30,
   
Six months ended June 30,
 
         
2011
   
2010
   
2011
   
2010
 
   
Note
   
US$’000
   
US$’000
   
US$’000
   
US$’000
 
         
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
Operating revenues:
                             
Net sales of equipment
          8,834       7,060       15,826       12,160  
Service income
          15,503       9,559       22,983       15,591  
                                       
Total operating revenues
          24,337       16,619       38,809       27,751  
                                       
Cost of operating revenues:
                                     
Cost of net sales
          5,305       3,998       9,136       6,868  
Cost of service
          8,398       5,123       12,441       8,446  
                                       
Total cost of operating revenues
          13,703       9,121       21,577       15,314  
                                       
Gross income
          10,634       7,498       17,232       12,437  
                                       
Operating expenses:
                                     
Sales and marketing
          3,026       4,176       5,157       6,904  
General and administrative
          1,360       882       3,365       3,816  
Research and development
          620       191       868       415  
Depreciation and amortization
          120       81       222       152  
                                       
Total operating expenses
          5,126       5,330       9,612       11,287  
                                       
Operating income
          5,508       2,168       7,620       1,150  
Interest expense
          (187 )     (134 )     (336 )     (260 )
Other income, net
          121       194       324       529  
                                       
Income before income taxes
          5,442       2,228       7,608       1,419  
Income taxes
          (918 )     (508 )     (1,465 )     (829 )
                                       
Net income
          4,524       1,720       6,143       590  
                                       
Other comprehensive income
                                     
Foreign currency translation adjustment
          1,911       -       1,911       -  
                                       
Total comprehensive income
          6,435       1,720       8,054       590  
                                       
Earnings per share:
    3                                  
                                         
Weighted average number of common stock outstanding
                                       
Basic
            12,333,264       10,549,143       12,333,264       10,531,304  
Effect of dilutive warrants and stock options
            8,571       -       12,690       21,647  
                                         
Diluted
            12,341,835       10,549,143       12,345,954       10,552,951  
                                         
           
US$
   
US$
   
US$
   
US$
 
Net income per share of common stock
                                       
Basic
            0.37       0.16       0.50       0.06  
Diluted
            0.37       0.16       0.50       0.06  

The accompanying notes are an integral part of the condensed consolidated financial statements.

 
4

 

Telestone Technologies Corporation

Condensed Consolidated Balance Sheets
As of June 30, 2011 and December 31, 2010

         
As of
June 30,
   
As of December
31,
 
         
2011
   
2010
 
   
Note
   
US$’000
   
US$’000
 
         
(Unaudited)
       
ASSETS
                 
                   
Current assets:
                 
Cash and cash equivalents
          19,905       31,020  
Accounts receivable, net of allowance
    5       206,318       192,487  
Due from related parties
    14       1,509       2,018  
Inventories, net of allowance
    10       7,222       3,123  
Prepayments
            1,661       1,748  
Other current assets
            4,240       1,630  
                         
Total current assets
            240,855       232,026  
                         
Goodwill
    6       3,119       3,119  
Property, plant and equipment, net
    7       1,906       1,565  
Lease prepayment
    8       2,555       2,528  
                         
              7,580       7,212  
                         
Total assets
            248,435       239,238  
                         
LIABILITIES AND STOCKHOLDERS’ EQUITY
                       
                         
Current liabilities:
                       
Short-term bank loans
 
9 & 14
      10,368       9,846  
Accounts payable – Trade
            43,266       40,685  
Customer deposits for sales of equipment
            2,482       2,089  
Due to related parties
    14       1,801       3,977  
Income tax payable
            15,336       13,760  
Accrued expenses and other accrued liabilities
            49,374       52,031  
                         
Total current liabilities
            122,627       122,388  
                         
Commitments and contingencies
    15                  
                         
Stockholders’ equity:
                       
Preferred stock, US$0.001 par value, 10,000,000 shares authorized, no shares issued
            -       -  
Common stock and paid-in-capital, US$0.001 par value:
                       
Authorized – 100,000,000 shares as of June 30, 2011  and December 31, 2010
                       
Issued and outstanding – 12,233,264 shares as of June 30, 2011 and December 31, 2010
    13       12       12  
Additional paid-in capital
            43,954       43,050  
Dedicated reserves
            5,115       5,115  
Other comprehensive income
            10,348       8,437  
Retained earnings
            66,379       60,236  
                         
Total stockholders’ equity
            125,808       116,850  
                         
Total liabilities and stockholders’ equity
            248,435       239,238  

The accompanying notes are an integral part of the condensed consolidated financial statements.

 
5

 

Telestone Technologies Corporation

Condensed Consolidated Statements of Cash Flows
Six months ended June 30, 2011 and 2010

   
Six months ended June 30,
 
   
2011
   
2010
 
   
US$’000
   
US$’000
 
   
(Unaudited)
   
(Unaudited)
 
Cash flows from operating activities
           
Net income
    6,143       590  
Adjustments to reconcile net income to net cash used in operating activities:
               
Depreciation and amortization
    222       152  
Loss on disposal of property, plant and equipment
    3       -  
Stock-based compensation
    904       2,701  
Changes in assets and liabilities:
               
Accounts receivable
    (9,694 )     (11,972 )
Inventories
    (4,032 )     (1,933 )
Prepayments
    124       465  
Other current assets
    (2,411 )     370  
Accounts payable
    1,713       2,854  
Customer deposits for sales of equipment
    348       7  
Due to related parties
    (1,829 )     1,379  
Income tax payable
    1,283       963  
Accrued expenses and other accrued liabilities
    (3,898 )     1,102  
                 
Net cash used in operating activities
    (11,124 )     (3,322 )
                 
Cash flows from investing activities
               
Purchase of property, plant and equipment
    (505 )     (173 )
                 
Net cash used in investing activities
    (505 )     (173 )
                 
Cash flows from financing activities
               
Repayment of short-term bank loans
    (3,868 )     (3,656 )
Short-term bank loans raised
    4,180       3,656  
                 
Net cash from financing activities
    312       -  
                 
Net decrease in cash and cash equivalents
    (11,317 )     (3,495 )
                 
Cash and cash equivalents, beginning of the period
    31,020       11,233  
                 
Effect on exchange rate changes
    202       -  
                 
Cash and cash equivalents, end of the period
    19,905       7,738  
                 
Supplemental disclosure of cash flow information
               
Interest received
    24       29  
Interest paid
    (314 )     (195 )
Tax paid
    (120 )     (221 )

The accompanying notes are an integral part of the condensed consolidated financial statements.

 
6

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

1.
ORGANIZATION AND PRINCIPAL ACTIVITIES

Telestone Technologies Corporation (“TSTC”), formerly known as Milestone Capital, Inc., was organized under the laws of the State of Colorado in February 1987 under the name Shield Enterprises, Inc.  In August 2004, TSTC reincorporated in the State of Delaware under the name Telestone Technologies Corporation.

Success Million International Limited (“SMI”), a company established in the Hong Kong Special Administrative Region of the People’s Republic of China (the “PRC”) on August 23, 2004, is a wholly owned subsidiary of TSTC and had no business operations since incorporation. Beijing Telestone Technology Company Limited (“Beijing Telestone”), a wholly-owned subsidiary of SMI established in Beijing, the PRC with an operating period until April 12, 2024, is engaged in the business of design, development, installation and trading of wireless telecommunication coverage system equipment.

Beijing Telestone Wireless Telecommunication Company Limited (“BTWTC”)(note), a company established in Beijing, the PRC with tenure of 20 years from June 17, 2005 to June 16, 2025 for provision of wireless telecommunication networking and system integration services, is owned by certain key management personnel of the Company (the “Owners”).  Contractual agreements have been entered into between the Owners and Beijing Telestone so as to give effect that Beijing Telestone is the beneficial owner of BTWTC. Beijing Telestone does not hold the ownership interests in BTWTC directly because Beijing Telestone is considered as a foreign entity under the PRC laws. Due to the restrictions on foreign ownership to provide and engage in certain wireless telecommunication networking services in the PRC, Beijing Telestone, through loans to the Owners, established BTWTC with a view to conduct such operations without violating the relevant PRC rules and regulations.  As a result of the above contractual arrangement, Beijing Telestone has obtained control and interest over BTWTC.  Beijing Telestone is considered as the primary beneficiary of BTWTC and therefore BTWTC is considered as a variable interest entity (“VIE”) of Beijing Telestone so that the financial statements of BTWTC are consolidated into the financial statements of Beijing Telestone for all periods presented in accordance with ASC Topic 810 – Consolidation (ASC 810).

On July 5, 2007, BTWTC, Shandong Guolian Telecommunication Technology Limited (“Guolian”)(note) and owners of Guolian entered into a Share Transfer Agreement (the “Agreement”). Under the Agreement, 100% equity ownership interests in Guolian and its wholly owned subsidiary, Pan-pacific Telecommunication Company Limited (“Pan-pacific”)(note), had been transferred by the owners of Guolian to BTWTC. Guolian and Pan-pacific were established in Jinan, Shandong Province, the PRC on February 9, 1999 and October 22, 1999 respectively. The principal business activities of Guolian and Pan-pacific are design, development, production and installation and trading of wireless telecommunication coverage system equipment.

On October 8, 2007, BTWTC established a wholly-owned subsidiary company, Beijing Telestone Communication Technology Company Limited (“BTCTC”)(note), with operating period of 20 years until October 7, 2027. The principal activity of BTCTC is developing and managing the business operations of the Company outside the PRC.

 
7

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

1.
ORGANIZATION AND PRINCIPAL ACTIVITIES (CONTINUED)

On December 14, 2009, Beijing Telestone established a wholly-owned subsidiary, Guan Telestone Telecommunication Technologies Company Limited (“Guan Telestone”)(note) in Guan, Hebei Province, the PRC with operating period of 20 years until December 13, 2029. Guan Telestone has been inactive since its incorporation and management plans to develop a research and development center and a manufacturing plant of telecommunication equipment in Guan County through Guan Telestone. Currently, Guan Telestone holds a land use right in Guan County for future development.

In this report, TSTC, SMI, Beijing Telestone, BTWTC, Guolian, Pan-pacific, BTCTC and Guan Telestone are collectively referred to as the “Company”.

 
Note:
These are direct translations of names in Chinese for identification purposes only and are not the official names in English.

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation
These unaudited condensed consolidated financial statements have been prepared based upon Securities and Exchange Commission ("SEC") rules that permit reduced disclosure for interim periods and include, in the opinion of management, all adjustments (consisting of normal recurring adjustments and reclassifications) necessary to present fairly the financial position, results of operations and cash flows as of  June 30, 2011 and for all periods presented.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("USA") have been condensed or omitted. The balance sheet as of December 31, 2010 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's Form-10K for the year ended December 31, 2010 filed on March 31, 2011. The results of operations for the three-month and six-month periods ended June 30, 2011 are not necessarily indicative of the operating results to be expected for the year ending December 31, 2011.

The unaudited condensed consolidated financial statements and accompanying notes are presented in United States dollars and prepared in accordance with generally accepted accounting principles in the USA ("USGAAP") which requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Basis of consolidation
The unaudited condensed consolidated financial statements include the accounts of TSTC, its subsidiaries and a VIE.  All significant intercompany accounts and transactions have been eliminated upon consolidation.

 
8

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

3.
EARNINGS PER SHARE

The Company reports earnings per share in accordance with ASC Topic 260 – Earnings Per Share (ASC 260). ASC 260 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share.

Basic earnings per share is computed based upon the weighted average number of shares of common stock outstanding during each period presented and included the 100,000 shares of restricted common stock not yet issued as of June 30, 2011 (see note 13).

Diluted earnings per share is computed based on net income attributable to stockholders and the weighted average number of shares of common stock outstanding during each period presented, adjusted for the effect of the dilutive common stock equivalents outstanding during the periods presented.

The dilutive effect of warrants and stock options to purchase common stock outstanding during the six-month periods ended June 30, 2011 and 2010 is reflected in the calculation of diluted earnings per share by applying the treasury stock method. Any anti-dilutive effect of the warrants and stock options is excluded from calculation of the earnings per share.

For the three-month and six-month periods ended June 30, 2011, 40,000 shares of warrants are dilutive and included in the weighted-average number of common stock outstanding for calculation of diluted earnings per share. Another 40,000 shares of warrants and 601,663 shares of stock options are anti-dilutive.

For the three-month period ended June 30, 2010, all warrants outstanding are anti-dilutive, so there is no dilutive effect of warrants in the calculation of diluted earnings per share. For the six-month period ended June 30, 2010, 85,666 shares of warrants are dilutive and included in the weighted-average number of common stock outstanding for calculation of diluted earnings per share. Another 40,000 shares of warrants are anti-dilutive.

4.
OPERATING RISK

 
(a)
Concentration of major customers and suppliers
   
Six months ended June 30,
 
   
2011
   
2010
 
   
US$’000
   
US$’000
 
   
(Unaudited)
   
(Unaudited)
 
Major customers with revenues of more than 10% of the Company’s total operating revenues
           
Revenues from major customers
    33,277       27,132  
Percentage of operating revenues
    86 %     98 %
Number
    2       3  
                 
Major suppliers with purchases of more than 10% of the Company’s purchases
               
Purchases from major suppliers
    6,940       913  
Percentage of purchases
    52 %     10 %
Number
    2       1  

 
9

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

4.
OPERATING RISK (CONTINUED)

 
(a)
Concentration of major customers and suppliers (continued)

Accounts receivable related to the Company’s major customers comprised 88% and 98% of the total accounts receivables as of June 30, 2011 and December 31, 2010 respectively.

 
Credit risk represents the accounting loss that would be recognized at the reporting date if counter parties failed to perform as contracted. Concentrations of credit risk (whether on or off balance sheet) arise from financial economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The major concentrations of credit risk arise from the Company’s accounts receivable. Even though the Company has major concentrations, it does not consider itself exposed to significant risk with regards to the related receivables.

 
(b)
Country risks

 
The Company may also be exposed to the risks as a result of its principal operation being primarily in the PRC. These include risks associated with, among others, the political, economic and legal environmental and foreign currency exchange. The Company’s results may be adversely affected by change in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things. The Company’s management does not believe these risks to be significant. There can be no assurance, however, those changes in political and other conditions will not result in any adverse impact.

 
(c)
Cash and time deposits

 
The Company mainly maintains its cash balances with various banks located in the PRC. In common with local practice, such amounts are not insured or otherwise protected should the financial institutions be unable to meet their liabilities. There has been no history of credit losses. There are neither material commitment fees nor compensating balance requirements for any outstanding loans of the Company.

 
10

 
 
Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

5.
ACCOUNTS RECEIVABLE
   
As of
June 30,
2011
   
As of
December 31,
2010
 
   
US$’000
   
US$’000
 
   
(Unaudited)
       
             
Completed contracts
    200,761       181,649  
Retentions
    13,555       18,701  
                 
      214,316       200,350  
Allowance for doubtful accounts
    (7,998 )     (7,863 )
                 
      206,318       192,487  

Of the retentions balance as of June 30, 2011 and December 31, 2010, approximately US$537,000 and US$888,000 respectively are due to be paid by the debtors after one year.

The movement in the allowance for doubtful accounts represents exchange rate re-alignment.

6.
GOODWILL

Goodwill acquired in connection with the acquisition of Guolian and Pan-pacific by BTWTC on July 5, 2008 represented the excess of the purchase cost over the fair value of identifiable net assets acquired at acquisition date. Goodwill is tested at least annually for impairment in accordance with ASC Topic 350 – IntangiblesGoodwill and other.

7.
PROPERTY, PLANT AND EQUIPMENT, NET

Property, plant and equipment are summarized as follows:
   
Estimated useful life
   
As of
June 30,
2011
   
As of
December 31,
2010
 
   
(in years)
   
US$’000
   
US$’000
 
         
(Unaudited)
       
                   
Buildings
  30       330       323  
Leasehold improvement
  5       171       168  
Plant and machinery
  5       924       797  
Office equipment
  5       1,616       1,395  
Motor vehicles
  5       1,015       948  
Construction in progress
  N/A       154       -  
                       
            4,210       3,631  
Accumulated depreciation
          (2,304 )     (2,066 )
                       
            1,906       1,565  

 
11

 
 
Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

7.
PROPERTY, PLANT AND EQUIPMENT, NET (CONTINUED)

 
Construction-in-progress consists of factories and office buildings under construction and includes the costs of construction incurred during the period of construction or installation. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use.
 
8.
LEASE PREPAYMENTS, NET
   
As of
June 31,
   
As of
December 31,
 
   
2011
   
2010
 
   
US$’000
   
US$’000
 
   
(Unaudited)
       
             
Prepaid land use rights
    2,635       2,580  
Accumulated amortization
    (80 )     (52 )
                 
      2,555       2,528  
 
Lease prepayment as of June 30, 2011 and December 31, 2010 represented the land use rights for a piece of land located in Guan County, Hebei Province, the PRC. The land use rights will expire in 2059.
 
The prepaid land use rights have been pledged to a bank in the PRC as collateral for short-term bank loans (Note 9).
 
The movement in the cost of prepaid land use rights represents exchange rate re-alignment.

 
12

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

9.
SHORT-TERM BANK LOANS

As of June 30, 2011 and December 31, 2010, the balance included bank loans of RMB67 million and RMB 65 million respectively, equivalent to approximately US$10.37 million and US$9.85 million respectively, which bear interest to be charged quarterly at the standard short-term borrowing rate as stipulated by the People’s Bank of China on the date of the first withdrawal. The loans are wholly repayable within one year and secured by guarantees provided by a third party guaranty company.

The guarantee provided by the independent guaranty company is secured by the following:

 
(a)
Accounts receivable of the Company with an aggregate carrying value as of June 30, 2011 and December 31, 2010 amounting to RMB177.18 million and RMB95.43 million, equivalent to approximately US$27.41 million and US$14.45 million, respectively;

 
(b)
Motor vehicles of the Company with an aggregate carrying value as of December 31, 2010 amounting to RMB0.97 million, equivalent to approximately US$0.15 million;

 
(c)
Land use rights of the Company with a carrying value as of June 30, 2011 and December 31, 2010 amounting to RMB16.52 million and RMB16.68 million, equivalent to approximately US$2.56 million and US$2.53 million, respectively;

 
(d)
Personal guarantee provided by Mr. Daqing Han, Telestone’s Chairman and Chief Executive Officer (“Mr. Han”); and

 
(e)
Personal real estate property and securities of the Company held by Mr. Han.

10.
INVENTORIES

Inventories consisted of the following:
   
As of
June 30,
2011
   
As of
December 31,
2010
 
   
US$’000
   
US$’000
 
   
(Unaudited)
       
             
Raw materials
    1       1  
Finished goods and parts
    7,683       3,574  
                 
      7,684       3,575  
Provision for slow-moving and obsolete items
    (462 )     (452 )
                 
      7,222       3,123  

 
13

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

11.
INCOME TAXES

TSTC and its subsidiaries are subject to income taxes on an entity basis on income arising in or derived from the tax jurisdictions in which each entity is domiciled.

TSTC had net operating losses carried forward for income tax reporting purposes that might be offset against future taxable income. The use of these net operating losses carried forward is severely limited when TSTC experiences a change in control.  Therefore, following the re-capitalization in August 2005, the amount available to offset future taxable income is limited. No tax benefit has been reported in the financial statements, because TSTC believes that it is more likely than not that the tax loss carry-forward will finally expire and therefore cannot be used.  Accordingly, the potential tax benefits of the loss carry-forward are offset by a valuation allowance of the same amount.

No provision for withholding or United States federal or state income taxes or tax benefits on the undistributed earnings and/or losses of the Company's subsidiaries has been made as the earnings of these subsidiaries, in the opinion of the management, will be reinvested indefinitely.

The Company’s income is principally generated in the PRC by Beijing Telestone, BTWTC, BTCTC, Guan Telestone, Guolian and Pan-pacific. All these entities are subject to enterprise income tax (“EIT”) in the PRC at the following applicable rates:

Unified EIT rate
    25 %
Small scale / low profit enterprises
    20 %
High / new technology enterprises (“Hi-tech enterprises”)
    15 %

Beijing Telestone and BTWTC are qualified as Hi-tech enterprises under the current Enterprise Income Tax Law in the PRC, so they enjoy the preferential tax rate of 15% in the PRC for a three-year period commencing from the year 2009. All other entities including BTCTC, Guolian and Pan-pacific are subject to the unified tax rate of 25% for the six-month periods ended June 30, 2011 and 2010.

Income tax expenses, comprising EIT, have been provided at the applicable rates on the respective subsidiaries’ / VIE’s estimated assessable income arising in the PRC during the periods.

12.
SEGMENT INFORMATION

During the periods ended June 30, 2011 and 2010, all revenues of the Company are from its network installation and optimization services and trading of wireless telecommunication equipment. No financial information by business segment is presented.

As the Company operates mainly in the PRC and over  99% of its revenue during the periods ended June 30, 2011 and 2010 are from the PRC and almost all of the Company’s assets are located in the PRC, no geographical segment analysis is presented.

 
14

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

13.
COMMON STOCK

TSTC had 12,233,264 shares of outstanding common stock as of June 30, 2011 and December 31, 2010.

On December 31, 2010, the Board of Directors of TSTC approved a grant of 100,000 shares of restricted common stock with two years restriction for sale to certain senior officers of the Company as incentive compensation for their services rendered in previous years in improving the business result of the Company and their contribution to the success of the Company. As of June 30, 2011 and December 31, 2010, the 100,000 shares of restricted common stock have not yet been issued.

14.
RELATED PARTY TRANSACTIONS

Summary of related party transactions
   
Note
   
As of
June 30,
2011
   
As of
December 31,
2010
 
         
US$’000
   
US$’000
 
         
(Unaudited)
       
Due from related parties
                 
Employees
  a       -       540  
Ex-stockholders of SMI/Guolian
  b       1,509       1,478  
                       
            1,509       2,018  
                       
Due to related parties
                     
Directors
  a       245       2,454  
Ex-stockholders of Beijing Telestone/Guolian
  b       1,556       1,523  
                       
            1,801       3,977  
                       
Guarantor of short term loan
                     
A director
  9       10,368       9,846  

Note:

 
(a)
The amounts due from employees and due to directors represent unsecured advances made to / from those parties from time to time. These amounts are interest free and repayable on demand.

 
15

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

14.
RELATED PARTY TRANSACTIONS (CONTINUED)

 
Note: (continued)

 
(b)
The amounts due to ex-stockholders of Beijing Telestone represented the consideration arising from the consummation of the business combination. The ex-stockholders of SMI had represented that they had fully settled the amount with the ex-stockholders of Beijing Telestone and also undertaken to fully indemnify SMI against any claims from the ex-stockholders of Beijing Telestone (the “Undertaking”). However, an ex-stockholder of Beijing Telestone has initiated a lawsuit against SMI alleging that the consideration amount has not been settled. The court hearing commenced on May 10, 2006 and finalized on December 19, 2006. A verdict has been issued by the Second Intermediate People’s Court of Beijing (“北京市第二中級人民法院”) and announced that SMI and Beijing Telestone are not required to compensate the ex-stockholder of SMI.  On October 23, 2007, another verdict was issued by the High People’s Court of Beijing (“北京市高級人民法院”) to announcing that the verdict from the Second Intermediate People’s Court of Beijing was upheld and SMI was not required to compensate the ex-shareholder. The movement of the balances represented exchange rate re-alignment.

15.
COMMITMENTS AND CONTINGENCIES

The Company recognizes its revenue upon the completion of contracts and has made full tax provision in accordance with relevant national and local laws and regulations of the PRC.  A contract is considered as completed upon completion of all essential contract work and the installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. The Company follows the practice of reporting its revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. For PRC tax reporting purpose, the PRC subsidiaries of the Company recognize revenue on an “invoice basis” instead of when goods are delivered and services are rendered. This is not in strict compliance with the relevant laws and regulations.  Accordingly, despite the fact that the PRC subsidiaries of the Company had made full tax provision in the financial statements, these PRC subsidiaries may be subject to penalties for the deferred reporting of tax obligations. The exact amount of penalties cannot be estimated with any reasonable degree of certainty.  The board of directors considers it is more-likely-than-not that tax penalties will not be imposed.

 
16

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

16.
STOCK OPTION PLAN

On June 27, 2005, a Stock Option Plan (the “Plan”) was approved at the 2005 annual meeting of stockholders. The purpose of the Plan is to promote the growth and general prosperity of the Company by permitting the Company to grant incentive and nonqualified stock options to purchase common stock and restricted stock of the Company to key employees, non-employee directors, and advisors.  The Plan is designed to help the Company and its subsidiaries and affiliates attract and retain superior personnel for positions of substantial responsibility and to provide key employees, non-employee directors, and advisors with an additional incentive to contribute to the success of the Company.

On November 30, 2010, stock options to subscribe for a total of 601,663 shares were granted to certain eligible employees of the Company (Note 17(iii)).

17.
STOCK-BASED COMPENSATION

The following table sets forth a summary of the nature of stock-based compensation recognized for the three-month and six-month periods ended June 30, 2011 and 2010.

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
US$’000
   
US$’000
   
US$’000
   
US$’000
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
Warrants (i)
    -       -       -       492  
Restricted stock (ii)
    -       100       -       2,209  
Stock options (iii)
    452       -       904       -  
                                 
      452       100       904       2,701  

The table below sets forth the functional classification of stock-based compensation recognized for the three-month and six-month periods ended June 30, 2011 and 2010.

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
US$’000
   
US$’000
   
US$’000
   
US$’000
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
Sales and marketing
    -       -       -       492  
General and administrative
    452       100       904       2,209  
                                 
      452       100       904       2,701  

No tax benefit was recognized for the stock-based compensation recorded for the three-month and six-month periods ended June 30, 2011 and 2010.

 
17

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

17.
STOCK-BASED COMPENSATION (CONTINUED)

Stock-based compensation to non-employees (Continued)

 
(i)
During the period ended June 30, 2011, no warrants were granted by the Company.

During the period ended June 30, 2010, 40,000 shares of warrants were granted to a service provider as part of the cost of services.

For the six-month periods ended June 30, 2011 and 2010, the Company recognized stock-based compensation in relation to warrants granted to non-employees of US$Nil and US$492,000 respectively.

The following table summarizes activities of the warrants:
   
Number of
shares
 
       
Warrants outstanding and exercisable as of January 1, 2011
    165,666  
         
Expired on February 19, 2011
    (85,666 )
         
Warrants outstanding and exercisable as of June 30, 2011
    80,000  

The following table sets forth the details of warrants outstanding, vested and exercisable as of June 30, 2011 and December 31, 2010.

   
Outstanding, Vested and Exercisable
 
Exercise price
 
Number of
shares
   
Weighted
average
remaining
contractual
life
   
Weighted
average
exercise
price
 
US$
       
Years
   
US$
 
                   
As of June 30, 2011
                 
4.95
    40,000       2.20          
9.55
    10,000       2.44          
18.47
    30,000       2.20          
                         
      80,000       2.23       10.60  

 
18

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

17.
STOCK-BASED COMPENSATION (CONTINUED)

Stock-based compensation to non-employees (Continued)

   
Outstanding, Vested and Exercisable
 
Exercise price
 
Number of
shares
   
Weighted
average
remaining
contractual
life
   
Weighted
average
 exercise
 price
 
US$
       
Years
   
US$
 
                   
As of December 31, 2010
                 
4.95
    40,000       2.69          
9.55
    10,000       2.94          
11.60
    85,666       0.14          
18.47
    30,000       2.69          
                         
      165,666       1.39       11.11  

Stock-based compensation to employees

 
(ii)
On January 20, 2010, the Board of Directors of TSTC approved to grant 100,000 shares of restricted common stock with three years restriction for sale to certain senior officers of the Company as an incentive compensation for their services rendered in previous years in improving the business result of the Company and their contribution to the success of the Company.

The issuance of 100,000 shares of restricted common stock is accounted for as equity instruments issued in exchange for receipt of services. The stock-based compensation costs are recognized and measured at the quoted price on the date of grant.

For the six-month periods ended June 30, 2011 and 2010, the Company recognized stock-based compensation in relation to restricted common stock granted to employees of US$Nil and US$2,209,000 respectively.

 
(iii)
On November 30, 2010, 601,663 shares of stock options were granted to certain eligible employees of the Company as incentive compensation to attract and retain superior personnel for positions of substantial responsibility and to provide them with an additional incentive to contribute to the success of the Company.

The 601,663 shares of stock options are accounted for as equity instruments issued in exchange for receipt of services. Costs are measured at the estimated fair value of the equity instruments issued and recognized as an expense over the employee’s requisite service period.

 
19

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

17.
STOCK-BASED COMPENSATION (CONTINUED)

Stock-based compensation to employees (Continued)

 
(iii)
(continued)

During the six-month periods ended June 30, 2011 and 2010, no stock option was granted by the Company.

For the six-month periods ended June 30, 2011 and 2010, the Company recognized stock-based compensation in relation to stock options granted to employees of US$904,000 and US$Nil respectively.

A summary of stock option activity as of June 30, 2011 and changes during the six-month periods ended June 30, 2011 is presented below:

   
Number
of shares
   
Weighted
average
exercise
price
 
         
US$
 
             
Outstanding as of June 30, 2011 and December 31, 2010
    601,663       11.04  
                 
Vested and exercisable as of June 30, 2011 and December 31, 2010
    179,501       11.06  

The following table sets forth the details of stock options outstanding, vested and exercisable as of June 30, 2011 and December 31, 2010.

   
Outstanding
   
Vested and exercisable
 
Exercise price
 
Number
of shares
   
Weighted
average
exercise
price
   
Weighted
average
remaining
contractual
life
   
Number
of shares
   
Weighted
average
exercise
price
 
         
US$
   
Years
         
US$
 
As of June 30, 2011
                             
                               
10.91
    529,663       10.91       9.41       155,501       10.91  
12.00
    72,000       12.00       9.41       24,000       12.00  
                                         
      601,663       11.04       9.41       179,501       11.06  

 
20

 
Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

17. 
STOCK-BASED COMPENSATION (CONTINUED)

Stock-based compensation to employees (Continued)

(iii)         (continued)

   
Outstanding
   
Vested and exercisable
 
Exercise price
 
Number
of shares
   
Weighted
average
exercise
price
   
Weighted
average
remaining
contractual
life
   
Number
of shares
   
Weighted
average
exercise
price
 
         
US$
   
Years
         
US$
 
                               
As of December 31, 2010
                             
10.91
    529,663       10.91       9.91       155,501       10.91  
12.00
    72,000       12.00       9.91       24,000       12.00  
                                         
      601,663       11.04       9.91       179,501       11.06  

The aggregate intrinsic value of all outstanding stock options and exercisable stock options at June 30, 2011 and December 31, 2010 amounted to US$Nil. There were no options exercised during the six-month periods ended June 30, 2011 and 2010. As of June 30, 2011 and December 31, 2010, the Company had total unrecognized compensation amounting to US$1,596,000 and US$2,560,000 respectively under ASC 718. The unrecognized compensation will be recognized over a weighted average period of approximately 2.5 years.

18.
RECENT ACCOUNTING PRONOUNCEMENTS

In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”).  ASU 2009-13 addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services separately rather than as a combined unit and modifies the manner in which the transaction consideration is allocated across the separately identified deliverables.  ASU 2009-13 significantly expands the disclosures requirements for multiple-deliverable revenue arrangements.  ASU 2009-13 will be effective for the first annual reporting period beginning on or after September 15, 2010, and may be applied retrospectively for all periods presented or prospectively to arrangements entered into or materially modified after the adoption date.  Early adoption is permitted, provided that the guidance is retroactively applied to the beginning of the year of adoption. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

 
21

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

18.
RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED)

In April 2010, the FASB issued ASU 2011-13, Compensation – Stock Compensation. This ASC provides amendments to FASB ASC 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trade should not be considered to contain a condition that is not a market, performance, or service condition. As a result, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In July, 2010, the FASB issued ASU 2010-20, Receivables (Topic 310). The ASC provides updates to FASC ASC 310 to enhance disclosures about the credit quality of financing receivables and the allowance for credit losses. Existing disclosure guidance is amended to require an entity to provide a greater level of disaggregated information about the credit quality of its financing receivables and its allowance for credit losses. In addition, the amendments in this Update require an entity to disclose credit quality indicators, past due information, and modifications of its financing receivables. For public entities, the disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In January 2011, the FASB issued ASU 2011-01, Receivables (Topic 310), Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in ASU No. 2010-20 (see above). The ASU delays the effective date of the disclosures about troubled debt restructuring the ASU 2010-20. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring and to issue its guidance on the topic currently anticipated for interim and annual periods after June 15, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310), A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The ASU provide additional guidance or clarification to help the creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purpose of determining whether a restructuring constitutes a troubled debt restricting. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards.” ASU No. 2011-04 provides a consistent definition of fair value to ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. ASU No. 2011-04 is effective for interim and annual periods beginning after December 15, 2011. The Company is currently evaluating the impact that this update will have on its consolidated financial statements.

 
22

 

Telestone Technologies Corporation
 
Notes to Condensed Consolidated Financial Statements
Six months ended June 30, 2011 and 2010

18.
RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED)

In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” ASU No. 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of stockholders’ equity. It requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Regardless of whether one or two statements are presented, an entity is required to show reclassification adjustments on the face of the financial statements for items that are reclassified from other comprehensive income to net income. ASU No. 2011-05 is to be applied retrospectively and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently evaluating the impact this update will have on its consolidated financial statements.

19. 
SUBSEQUENT EVENT REVIEW

In July, 2011, the Company entered into an agreement with a contractor for construction of a research and development center and a manufacturing plant of approximately RMB56.9 million, equivalent to US$8.8 million.

 
23

 

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following is management's discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. This report includes forward-looking statements. Generally, the words “believe,” “anticipate,” “may,” “will,” “should,” “expect,” “intend,” “estimate,” “continue,” and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents we file with the SEC from time to time, which could cause actual results or outcomes to differ materially from those projected. Undue reliance should not be place on these forward-looking statements which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements, except to the extent required by law.

The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Quarterly Report on Form 10-Q.

Overview

We are a leading access-network solution provider serving the Chinese market. We have operated in the Chinese market since 1997, and in 2006, we expanded our marketing efforts to include Vietnam, Indonesia, Malaysia, Thailand and India. In 2007, Beijing Telestone Communication Technology Corp. Ltd. was established as one of our subsidiaries focusing on developing and managing our overseas businesses. Currently, our marketing efforts have expanded to 29 countries around the world, including the U.S., Vietnam, Mexico, Brazil, Russia, India, the Philippines, Thailand, Ireland, Ecuador, Mongolia, South Africa, Turkey, Indonesia, Colombia, Costa Rica, Argentina, the Ukraine, Kazakhstan, Singapore, South Korea, Hong Kong (SAR), Saudi Arabia, New Zealand, Bangladesh, the UAE, Canada and Iceland. Continuous expansion outside of China is one of our core strategies. We believe that the quality of our products and services will allow Telestone to be increasingly competitive internationally.

Our access-network solutions include the research and development (“R&D”) and application of access-network technology. In addition to our homegrown access-network equipment, which includes repeaters, antennas and radio-frequency peripherals, we also offer project design, project management, installation, maintenance and other after-sales services required by our customers. Our access-network solutions were created to further enhance the coverage of mobile telecommunications networks; with the goal of improving the quality of reception for mobile phone users. The solutions we provide to the telecommunications industry cover indoor and outdoor environments, including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels.

In 2008, we launched WFDS™ (as defined below), a new generation of wireless distribution system. WFDS™ is an all-optical network that combines the technologies of both wireless and optical telecommunications. This system supports all mobile telecom networks and various other networks, including WLAN, FTTH, traditional telephone, and video surveillance systems. In 2010, we began generating revenues from WFDS™ installations, and, as of December 31, 2010, we had completed 316 WFDS™ installations. In addition, our WFDS™ technology provides several important benefits for Telestone and its investors: (i) revenue from WFDS™ has raised our revenue growth rate above that of the past three years; (ii) WFDS™ offers an opportunity for us to diversify our customer base; and (iii) WFDS™ generates gross margins above our corporate average, in the range of 45% to 50%. WFDS™ also targets a different customer base — property developers and managers — rather than large telecom carriers, and these customers tend to make payments more quickly, which should, over time, as WFDS™ grows as a percentage of our revenues, reduce our accounts-receivable days’ sales outstanding (“DSOs”). Finally, WFDS™ is a technology platform, and we have a pipeline of WFDS™ technologies slated for launch over the next several years.

 
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While we expanded our product portfolio from one purely consisting of RF-based wireless products to one including our Unified Local-Access Solution (“ULAN”) products, our traditional RF-based products still remain a strong growth driver for Telestone, and we received more than 70% of our revenues from RF-based products in 2010. In order to provide a speedy response and a high level of service to our customers, we have established more than 30 locations throughout China.

We are committed to the research and development of wireless communication-related technology. Over 90% of our technology is developed in-house at our research and development center. We employ an experienced and highly trained professional staff of scientists and engineers that concentrate on the invention and further advancement of wireless communication technology. We have over 100 R&D specialists, many of whom are industry experts in telecommunications — all have at least a bachelor’s degree, and 40% have a master’s degree or above. Since its introduction, our innovative WFDS™ technology has received recognition in the telecommunications industry and has won awards and praise from several telecommunications carriers.

We have offices in 30 locations across the PRC, offering sales, project survey, design, project management and installation and maintenance services. We believe that this sales and service strategy enriches our capability to increase our existing customer base in the PRC and enables us to provide timely responses to customers’ inquiries as well as technical and maintenance service upon our customers’ requests. Our sales efforts are neither focused in nor dependent upon any particular region or province of the PRC.

Industry Background

As the mobile market in China continues to mature, mobile operators have begun to invest in the future. In particular, the Chinese telecommunications industry has witnessed accelerated development in recent years with a rapid rollout of 3G network investments as well as commitments to introduce 4G technology by 2011. Such is also evidenced by China Mobile, China Telecom, and China Unicom’s €1.178 billion EUR ($1.625 billion USD) purchase of network and application solutions, and integration and maintenance services from Alcatel-Lucent on November 5, 2010 during the visit of Chinese President Hu Jintao to France.

We also believe that disparate technologies used by mobile carriers in the United States, the continued roll-out of 3G, and the future roll-out of 4G also provide a conducive environment for creating potential demand for our WFDS™ enabled equipment and solutions in the United States.

The Rapid Growth of Wireless Subscribers in China

China has repeatedly expressed a commitment to continuing economic growth, aimed at improving the living standards of its population and at expanding its middle class. This growth has led to increasing urbanization among the Chinese population with migrant workers moving to cities. There is now a growing demand among both enterprises and households in China for improved wireless bandwidth and network performance. China is the largest wireless market in the world with approximately 747 million mobile subscribers. While this number is large, there is still opportunity to expand as the mobile user penetration rate in China is currently relatively low.

 
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The number of wireless subscribers in China across both 2G and 3G platforms is projected to grow from 747 million at the end of 2009 to 925 million by the end of 2011, a compound annual growth rate (CAGR) of 11%. According to the Ministry of Industry and Information Technology, or MIIT, the number of 3G wireless subscribers is expected to grow at a 216% CAGR, increasing from 15 million to 150 million during the same period.

Wireless Infrastructure Growth Drivers in China

During the 2G era, the majority of mobile traffic was comprised of voice, and hence network coverage mainly focused on breadth rather than on depth. However, as we enter into the 3G era in China, approximately 70% of the 3G traffic is comprised of data. As a result, in-depth network coverage has become 3G operators’ first priority and we believe that the demand for wireless enhancement equipment has become much more important than in the past. We believe that the room for growth in such demand is evident as the population coverage levels of existing 3G networks are still below 70% in most cities currently covered, and less than half of China’s 650 major cities support 3G.

Chinese Government Sponsored 3G Build-Out

Telecommunication capital expenditure is expected to continue to grow in the coming years as the Big-3 (China Unicom, China Mobile, and China Telecom) plan to build out their 3G coverage networks through Chinese government support and incentives. According to MIIT, the Chinese government announced plans to contribute $58.6 billion in 3G upgrades from 2009 to 2011, with $23.6 billion already contributed in 2009, in an effort to extend 3G wireless coverage across nearly all of China. With the Chinese government’s assistance, the Big- 3 have budgeted $70 billion of spending from 2009 to 2011 to deploy 3G networks.

Significant Construction of New Residential and Commercial Properties
 
In recent years, the real estate market in China has grown at a fast rate and the demand for new real estate construction is expected to remain healthy going forward in 2011. According to China’s National Bureau of Statistics, in 2009, 702 million square meters of commercial and residential properties were constructed, while 937 million square meters of new property rights were sold. The Chinese government encourages fair competition among the Big-3 and cable service providers to give consumers viable choices. As a result, property owners install hardware platforms for the Big-3’s 2G and 3G technologies, cable and Internet networks. This often results in numerous devices being deployed on-site, which is inefficient and costly for property owners. As a result, it is expected that there will be increasing demand by properties owners for equipment that can integrate coverage from the Big-3 and also provide integrated services in a single platform.

Growth in Mobile Subscribers

Growth in the wireless infrastructure market is also driven by the significant increase in the number of mobile subscribers and in the amount of data transmitted over wireless networks through smart phones in China. This growth results in increasing burdens being placed on the carriers’ wireless infrastructure that can overload the network. Overworked wireless networks result in poor wireless service, slow data transfer rates and dropped calls. In order to alleviate the burdens being put on the wireless infrastructure and to increase wireless network capacity, the Big-3 continue to deploy and upgrade wireless infrastructure equipment.

 
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Integration of the Three Networks

There is continued growth in the number of users of the Internet, mobile phones and cable/digital TV in China. This trend is causing legacy telecom, Internet, TV/radio networks to become more dependent on each other to provide services to their respective customers. For example, TV networks are integrating with Internet networks to offer IPTV, cable networks are integrating with Internet networks to offer cable Internet, and TV networks are integrating with wireless networks to deliver mobile TV. According to the IChina Research Center, $15.2 billion is expected to be spent on telecommunication upgrades to support the integration. 

“The Internet of Things”

In China, a budding phenomenon has developed, referred to as “The Internet of Things” in organizations and businesses. The Internet of Things literally translates into “the connection of things”, whether they are products, components or systems, so that individuals can communicate intelligently with one another and can communicate remotely with their home and office computers and home appliances. Everything from home appliances, public infrastructure and facilities, to logistic processes will be assigned an IP address and connected to the Internet of Things through a wireline or wireless connection. This demand is expected to increase the need for wireless infrastructure.

Digital Cable Network Construction

Last year marked the seventh year in the digitization of cable television in China. At the end of 2009, cable subscribers numbered more than 174 million, and digital cable subscribers accounted for about 36% of the total, reaching 62 million. Concurrent with the technology spending required to deliver extras such as HDTV and programming on demand, an emphasis has been placed on innovating cost-effective cables.

Increasing and Evolving Need for Indoor Wireless Coverage

Historically, “indoor wireless” meant only Wi-Fi enabled laptops, but currently, mobile users in China also rely on mobile and smart phones, BlackBerry devices, PDAs, and two-way radios to communicate. All of these devices require indoor wireless coverage to operate effectively. However, while many residential and commercial properties in China may have wireless local-area networks (LAN networks), the vast majority do not have indoor wireless cellular coverage for mobile or smart phones. In order to better serve the needs of their tenants, we expect that property owners will increasingly look to deploy indoor wireless coverage solutions.

Our Solution

We design, engineer and sell RF-based local-access network solutions for indoor and outdoor wireless coverage and WFDS™ solutions for unified local access network coverage. In the past, our focus has been on RF-based local access network solutions, but in the future we expect to leverage our WFDS™ technology to transition our customers to a unified local access network solution. Our WFDS™ solutions are designed for use by property owners of all types of buildings including enterprises, municipalities, small businesses and homes. Our unified local access network WFDS™ solutions integrate multiple access services, have a lower total cost of ownership and provide better wireless coverage.

 
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Unified Local Access Network WFDS™ Solution

We plan to leverage our first-mover advantage with our WFDS™ technology in order to increase our penetration in China and to strengthen our relationships with the Big-3 for whom we believe our WFDS™ solution is a critical component to remain aligned with industry trends and government-sponsored initiatives.

Key benefits of our unified local access network WFDS™ solution include:

 
·
Compatibility with the Big-3’s technologies and integrated services. Our WFDS™ solution is the industry’s first solution capable of providing integrated services on a single integrated platform. Our unified solution approach as well as our commitment to research and development, have strategically positioned us to be a benefactor of the Chinese government’s directive for network convergence.

 
·
Reduction in capital expenditures. The combination of integrating services along with the use of our patented fiber-optic technology should enable the Big-3 to significantly reduce their wireless infrastructure capital expenditures.

 
·
Reduction in space required. Utilizing our WFDS™ technology, property owners can reduce the installation space required for mobile wireless cable and Internet service by consolidating eleven devices into one. In a single compact, all-optical platform, we offer customers integrated solutions streamlined to meet our customer’s requirements.

 
·
Easy to install, use and maintain. Our WFDS™ solution enables a property owner to deploy a single multi-functional platform in a simple and consolidated form factor. WFDS™ is easy to install and is centrally managed, is compatible with 2G and 3G services, and is forward compatible with 4G services.

RF-based Local Access Network Solutions

We provide RF-based local access network solutions to the telecommunications industry for environments including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels. Our suite of products that we deploy as part of these solutions includes base station and tower mounted amplifiers, antennas, couplers and splitters. Our RF-based products support various 2G and 3G transmission standards, including CDMA, W-CDMA, GSM and TD-SCDMA.

Our Competitive Strengths

We believe that the following competitive strengths enable us to compete effectively and to capitalize on the growth opportunities in our markets:

Strong Research and Development Capabilities

Our R&D capabilities rank among the best in the PRC’s telecommunications industry. We have a robust engineering project- management system and an experienced engineering team. Our research and development center is equipped with the latest equipment and testing facilities, which give our research and development personnel the tools they require to make significant advances in access-network technologies. In addition, we provide our employees with continuing education administered through internal programs. Our R&D team developed our proprietary WFDS™ product, which is one of the leading indoor access-network products in China.

 
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Compared with other traditional wireless distribution systems, our WFDS™ system has many advantages. Firstly, WFDS™ uses optical fiber to transport signals. Based on the low signal-loss characteristic of fiber, through which signals can be transmitted over long distances, the main unit (“MU”) can be placed closer to the signal source, and the remote unit (“RU”) can be placed closer to the subscribers. Therefore, a micro-power signal source can be used, which reduces interference and noise, generates low electromagnetic interference, and expands the coverage area. Secondly, due to the input port of the MU connecting to the signal combiner, WFDS™ systems can support multiple signals’ access and network integration. WFDS™ can provide all broadband communication services access in the 500kHz to 3GHz band for subscribers. Thirdly, due to the fact that each node of the system has the same bandwidth and flow characteristics, WFDS™ can provide the same communication services for every subscriber. WFDS™ systems are also easy to manage and flexible for implementing expansion and upgrades of systems with minimum cost. Our R&D capabilities are recognized and approved by the PRC government and have won accolades such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. We are focused on increasing our research and development efforts to develop superior and proprietary technologies.

Broad and diverse market base

Our business covers a wide region. We have 30 branches throughout China and our business covers approximately 29 countries worldwide.

Experienced marketing staff

We employ a group of experienced telecommunications experts and an experienced and technologically savvy marketing staff in China.

Strong customer relations

We have maintained long-term relationships with China Unicom, China Mobile, China Telecom and China Netcom (which merged with China Unicom in 2008) as customers for approximately 13 years.

Governmental support

As a high-tech enterprise with an established track record, our company enjoys the stimulus plans offered by both China’s industry governmental authorities and by local authorities, including the Ministry of Science and Technology, the Ministry of Industry and Information Technology, the Beijing municipal government and the Administrative Committee of Z-Park.

Our Growth Strategy

In order to maintain our position as one of the leading companies in the PRC’s access-network solutions sector, and expand and diversify our revenue streams, we have adopted the following strategies:

Continue to focus on research and development

We plan to continue to invest in research and development for our key technologies and our products to enhance our leading position in the access-network technology market and take full advantage of the PRC’s investment in 3G networks. We have dedicated research and development programs to advance access-network solutions for the continued development of our business.

 
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Seek selective acquisitions and strategic investments

In the domestic market, we intend to maintain strong relationships with Chinese mobile telecommunications carriers and potentially make selective acquisitions in major provincial markets where we do not have a leading market share. Our potential targets are companies that enjoy a leading market position and have strong business networks in their provincial markets, that have strong production capabilities and companies that own applicable value-added products whose customer network platforms adapt to WFDS™. We believe that we will further our penetration into provincial markets and raise our overall market share through selective acquisitions and the promotion of new solutions.

Strengthen international market presence
  
We plan to focus on increasing our presence in markets outside of the PRC. We will continue to strengthen our presence overseas by leveraging our expertise and leading access-network products and solutions. In the United States, we plan to seek cooperation with peers that have strong research and development abilities, and develop technology and products that are suitable for PRC market. However, we also find partners within the integration business to sell our products, as our products are cost-effective. In developing countries, we only seek cooperation with local integration partners to deliver our access-network solution technologies, whom we utilize as our local product distribution channels.
   
Description of Products and Engineering Services
   
We design and sell electronic equipment used to provide access-network solutions to our customers. Many of these types of equipment, including WFDS™ products, RFPA products, passive components and base station antenna for 2G, 3G, Broadband access and CATV networks, are highly specialized active microwave components designed to meet the needs of our customers.

In addition to designing and selling our products, we also provide systems integration services for our customers. The primary systems integration services provided to our customers are project design and engineering, specifically, the development and design of indoor (living quarters, hospital systems, and hotels) and outdoor (expressways, railways and no coverage zones) wireless signal complementary coverage solutions and their applied products. This includes the design of the required equipment, implementation, project quality evaluation as well as after-sale maintenance and optimization for system integration products, constructive products for engineering design projects and wireless network optimization products.

Research & Development

We maintain a research and development center where the majority of our products are designed by our staff of engineers and scientists. Our research and development center is equipped with the latest equipment and testing facilities which give our research and development personnel the tools they require to make significant advances in access-network technologies. The center comprises several professional research departments including: our Wireless Device Department, Active Parts Department, Antenna and Passive Products Department, Computer Application Department and Mechanical Structure Department. We seek to remain at the forefront of current and future technologies, paying close attention on a consistent basis to evolving development trends in domestic and international technologies. Our R&D capabilities are recognized and affirmed by the PRC government and have won awards such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. Currently the research center has one department that is focusing on technology standards and system solutions and another department that is focusing on the research and development of fiber and RF equipment. These two departments work on designing new products to meet the expected increased demand for 3G wireless products in the PRC.

 
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Competition

Our main domestic competitors are Guangdong Comba, Wuhan Hongxin and China GrenTech.
 
 
·
Guangdong Comba is one of the first Chinese domestic telecom manufacturers. The company is listed on the Hong Kong Stock Exchange under the stock symbol 2342.HK.

 
·
Wuhan Hongxin, originally a state-owned enterprise under the management of Wuhan Post & Telecom Academy, has a strong technical background and sales network. Wuhan Hongxin is a large company with a diverse group of products that extend beyond the wireless coverage sector.

 
·
China GrenTech, formerly Powercom Holdings Limited, was founded in 1999 and is based in Shenzhen. China GrenTech is listed on the NASDAQ Global Select Market under the symbol GRRF.

Our potential international competitors include Powerwave Technologies and Andrew Corporation. We believe that our overseas competitors are not key threats to Telestone because they have no competitive advantage with respect to product costs and are not accustomed to the marketplace of the PRC.

 
·
Powerwave Technologies, Inc. is a global provider of end-to-end wireless infrastructure solutions for use in wireless communications networks. They offer OEMs (Original Equipment Manufacture), operators and network providers in the wireless communications industry a portfolio of antenna systems, base station systems and coverage systems.

 
·
Andrew Corporation (“Andrew”) is a global designer, manufacturer, and supplier of communications equipment, services and systems. Andrew’s products and expertise are found in communications systems throughout the world, including wireless and distributed communications, land mobile radio, cellular and personal communications, broadcast, radar and navigation.

Government Regulation

The following is a summary of the principal governmental laws and regulations that are or may be applicable to our operations in the PRC. The scope and enforcement of many of the laws and regulations described below are uncertain. We cannot predict the effect of further developments in the Chinese legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement of laws.

 
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The telecommunications industry, including certain access-network solution provider services, is highly regulated in the PRC. Regulations issued or implemented by the State-owned Assets Supervision and Administration Commission of the State Council, Ministry of Information Industry of PRC and other relevant government authorities cover many aspects of telecommunications network operations, including entry into the telecommunications industry, the scope of permissible business activities, interconnection and transmission line arrangements, tariff policies and foreign investment.

The principal regulations governing the telecommunications services business in the PRC include:
 
 
·
Telecommunications Regulations (2000), (the “Telecom Regulations”). The Telecom Regulations categorize all telecommunications businesses in the PRC as either infrastructure telecommunications businesses or value-added telecommunications businesses. Under the Telecom Regulations, certain services are classified as being of a value-added nature, including telecommunication information services, online data processing and translation processing, call centers and internet access providers, and require the commercial operator of such services to obtain an operating license. The Telecom Regulations also set forth extensive guidelines with respect to different aspects of telecommunications operations in the PRC.

 
·
Regulations for the Administration of Foreign-Invested Telecommunications Enterprises (2002), (the “FI Telecom Regulations”). The FI Telecom Regulations set forth detailed requirements with respect to capitalization, investor qualifications and application procedures in connection with the establishment of a foreign-invested telecom enterprise.

 
·
Foreign Exchange Controls. The principal regulations governing foreign exchange in the PRC are the Foreign Exchange Control Regulations (1996) and the Administration of Settlement, Sale and Payment of Foreign Exchange Regulations (1996), (“the Foreign Exchange Regulations”). Under the Foreign Exchange Regulations, Renminbi (“RMB”) is freely convertible into foreign currency for current account items, including the distribution of dividends. Conversion of RMB for capital account items, such as direct investment, loans and security investment, however, is still subject to the approval of the State Administration of Foreign Exchange (“SAFE”). Under the Foreign Exchange Regulations, foreign-invested enterprises are required to open and maintain separate foreign exchange accounts for capital account items. In addition, foreign-invested enterprises may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from SAFE.

Gross Margin

Our gross margin has been, and will continue to be, affected by a variety of factors, including:

 
·
product mix and average selling prices;
 
·
new product introductions and enhancements both by us and by our competitors;
 
·
demand for our products and services;
 
·
our ability to attain volume manufacturing pricing from Shijiazhuang Spectrum and our other component suppliers;

 
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·
losses associated with excess and obsolete inventory; and
 
·
growth in our headcount and other related costs incurred in our professional services organization.

Operating Expenses

Operating expenses consist of sales and marketing expenses, general and administrative expenses, and research and development expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, benefits and other compensation for our employees. We had approximately 1300 full-time employees as of June 30, 2011.

Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of sales and marketing expenses, including all related expenses and compensation for sales personnel and travel expenses related to sales of products and market development. We expense sales and marketing expenses as incurred.

We plan to continue to invest strategically in sales and marketing with the intent of adding new customers and increasing penetration within our existing customer base, expanding our domestic and international sales and marketing activities, build brand awareness and sponsor additional marketing events. We expect future sales and marketing expenses to continue to be our most significant operating expenses.

General and administrative expenses primarily consist of compensation for personnel, travel expenses, materials expenses related to ordinary administration, fees for professional services, and provisions for doubtful accounts.

Research and development expenses primarily consist of compensation for research and development staff, material expenses, travel expenses and facility expenses. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest in our research and development efforts because we believe they are essential to maintaining our competitive position. The dollar amount invested in our research and development activities will increase as we continue to increase our revenue. However, as a percentage of revenue, research and development costs are expected to remain relatively low.

Interest Expense

Interest expense includes interest we pay on our short-term bank loans.

Other Income (Expense), net
 
Other income (expense), net includes interest income on cash balances, gain or loss from disposal of assets, gains or losses on conversion of non-Renminbi transactions into Renminbi, and gains from governmental subsidy. Cash has historically been invested in highly liquid investments with original maturities of three months or less.

Income Tax Expense

Income tax expense is computed based on pre-tax income included in the condensed consolidated statement of operations. Income taxes have been provided, using the liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities and their reported amounts. The tax consequences of those differences are classified as current or non-current based upon the classification of the related assets or liabilities in the condensed consolidated financial statements.

 
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Critical Accounting Policies

Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). These accounting principles require us to make estimates and judgments that affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, foreign currency translation, inventory valuation, allowances for doubtful accounts, and goodwill.

Revenue Recognition

Our revenue is derived primarily from two sources: (1) product revenue and  (2)  professional services revenue.

Product revenue represents the contracted value of goods, net of value-added tax (“VAT”) and returns. The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery occurs, the fee is fixed or determinable, and collectability is probable. Professional service revenue is recognized when the service is performed and accepted by the customer.

As part of professional services, the Company provides installation services for certain sales of equipment under fixed-price contracts. Revenues from these fixed-price service contracts are recognized on the completed-contract method. Under the completed-contract method, revenue and costs of individual contracts are included in operations in the year during which they are completed. Losses expected to be incurred on contracts in progress are recognized in the period such losses are determined. This method is used because the contract is completed within a short period of time, and the financial position and results of operations do not vary significantly from those that would result from using the percentage-of-completion method. A contract is considered completed upon completion of all essential contract work and once the installation has been accepted by the customer.

Foreign Currency Translation

All major subsidiaries of the Company consider Renminbi as their functional currency as a substantial portion of their business activities is conducted in Renminbi. However, the Company has chosen the United States dollar as its reporting currency.

Transactions in currencies other than the functional currency during the year are translated into the functional currency at the applicable rates of exchange prevailing at the time of the transactions. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at the applicable rates of exchange in effect at the balance sheet date. Exchange gains and losses are recorded in the condensed consolidated statements of operations.

 
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For translation of financial statements into the reporting currency, assets and liabilities are translated at the exchange rate at the balance sheet date, equity accounts are translated at historical exchange rates, and revenue, expenses, gains and losses are translated at the weighted average rates of exchange prevailing during the period. A translation adjustment, when material, resulting from this process is recorded in accumulated other comprehensive income within stockholders’ equity.

Inventory Valuation

Inventory consists of equipment and related component parts and is stated at the lower of weighted average cost or market. We record inventory write-downs for potentially excess  inventory based on forecasted demand, economic trends and technological obsolescence of our products. If future demand or market conditions are less favorable than our projections, additional inventory write-downs could be required and would be reflected in cost of product revenue in the period the revision is made. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

Allowances for Doubtful Accounts

We record a provision for doubtful accounts based on historical experience and a detailed assessment of the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, our management considers, among other factors, (1) the aging of the accounts receivable, including trends within and ratios involving the age of the accounts receivable, (2) our historical write-offs, (3) the credit-worthiness of each customer, (4) the economic conditions of the customer’s industry, and (5) general economic conditions. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected.

Goodwill

We apply ASC Topic 350 – Goodwill and Other Intangibles and perform an annual goodwill impairment test, or test more frequently if events or changes in circumstances indicate that the carrying value may be impaired. Goodwill is allocated to cash-generating units for the purpose of impairment test and determination of gain or loss on disposal.

Goodwill on acquisition of businesses, being the excess of the cost of the acquisition over the Company’s share of the fair value of the identifiable assets, liabilities and contingent liabilities, is recognized as a separate asset. Goodwill is carried at cost less accumulated impairment losses. An impairment loss on goodwill is not reversed. We did not recognize impairment charges in any of the periods presented.

 
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RESULTS OF OPERATIONS

Our operating results are presented for the quarter ended June 30, 2011, as compared to the quarter ended June 30, 2010.

The following is the statement of our operations for the three months ended June 30, 2011 and 2010:

Item
  2011 Q2     2010 Q2    
Comparisons
 
   
$'000
   
% of
revenue
   
$'000
   
% of
revenue
   
$'000
   
%
 
Revenue
    24337               16619             7718       46.4 %
Equipment and services costs
    13703       56.3 %     9121       54.9 %     4582       50.2 %
Gross profit
    10634       43.7 %     7498       45.1 %     3136       41.8 %
Sales and marketing expenses
    3026       12.4 %     4176       25.1 %     -1150       -27.5 %
General and administrative expenses
    1360       5.6 %     882       5.3 %     478       54.2 %
Research and development expenses
    620       2.5 %     191       1.1 %     429       224.6 %
Depreciation and Amortization
    120       0.5 %     81       0.5 %     39       48.1 %
Interest expenses
    187       0.8 %     134       0.8 %     53       39.6 %
Other income
    121       0.5 %     194       1.2 %     -73       -37.6 %
Net Income before income tax
    5442       22.4 %     2228       13.4 %     3214       144.3 %
Income tax
    918       3.8 %     508       3.1 %     410       80.7 %
Net income
    4524       18.6 %     1720       10.3 %     2804       163.0 %

The following is the statement of our operations for the six months ended June 30, 2011 and 2010:

Item
 
2011 Six months
   
2010 Six months
   
Comparisons
 
   
$'000
   
% of
revenue
   
$'000
   
% of
revenue
   
$'000
   
%
 
Revenue
    38809             27751             11058       39.8 %
Equipment and services costs
    21577       55.6 %     15314       55.2 %     6263       40.9 %
Gross profit
    17232       44.4 %     12437       44.8 %     4795       38.6 %
Sales and marketing expenses
    5157       13.3 %     6904       24.9 %     -1747       -25.3 %
General and administrative expenses
    3365       8.7 %     3816       13.8 %     -451       -11.8 %
Research and development expenses
    868       2.2 %     415       1.5 %     453       109.2 %
Depreciation and Amortization
    222       0.6 %     152       0.5 %     70       46.1 %
Interest expenses
    336       0.9 %     260       0.9 %     76       29.2 %
Other income, net
    324       0.8 %     529       1.9 %     -205       -38.8 %
Net Income before income tax
    7608       19.6 %     1419       5.1 %     6189       436.2 %
Income tax
    1465       3.8 %     829       3.0 %     636       76.7 %
Net income
    6143       15.8 %     590       2.1 %     5553       941.2 %
 
 
36

 

For the three months ended June 30, 2011, our revenue represents an increase of 46.4% from the same period in 2010. The increase in net income from the second quarter of 2010 was 163.0%. For the six months ended June 30, 2011, our revenue represents an increase of 39.8% from the same period in 2010, with an increase in net income of 941.2%. The gross profit margin was 43.7% for the three months ended June 30, 2011, as compared to 45.1% in 2010. The gross profit margin was 44.4% for the six months ended June 30, 2011, as compared to 44.8% in 2010. The net profit margin was 18.6% for the three months ended June 30, 2011, as compared to 10.3% in 2010. The net profit margin was 15.8% for the six months ended June 30, 2011, as compared to 2.1% in 2010. The large increase in the net profit ratio with slight increase in gross profit ratio for the six months ended June 30, 2011 was mainly due to the Company did not issue shares and warrants in 2011, as it did in 2010 which led to the significant decrease in 2011 sales and marketing expenses and general and administrative expenses in 2011.

Revenue

Three months ended June 30, 2011 and 2010:
 
   
2011 Q2
   
2010 Q2
   
Growth
 
   
$'000
   
% of revenue
   
$'000
   
% of revenue
   
$'000
   
%
 
Product sales
    8834       36.3 %     7060       42.5 %     1774       25.1 %
Service sales
    15503       63.7 %     9559       57.5 %     5944       62.2 %
Total
    24337               16619               7718       46.4 %

Six months ended June 30, 2011 and 2010

   
2011 Six months
   
2010 Six months
   
Growth
 
   
$'000
   
% of revenue
   
$'000
   
% of
        revenue
   
$'000
   
%
 
Product sales
    15826       40.8 %     12160       43.8 %     3666       30.1 %
Service sales
    22983       59.2 %     15591       56.2 %     7392       47.4 %
Total
    38809               27751               11058       39.8 %

For the three months ended June 30, 2011, revenue generated from product sales was $8,834,000, representing an increase of 25.1% from the same period in 2010. For the six months ended June 30, 2011, revenue generated from product sales was $15,826,000, representing an increase of 30.1% from the same period in 2010.

For the three months ended June 30, 2011, revenue generated from professional services was $15,503,000, representing an increase of 62.2% from the same period in 2010. For the six months ended June 30, 2011, revenue generated from professional services was $22,983,000, representing an increase of 47.4% from the same period in 2010.

Compared with the same period of 2010, there is no significant change in the proportion of the revenue from product sales to professional services.

 
37

 

Breakdown by Customers

Three months ended June 30, 2011 and 2010:

   
2011 Q2
   
2010 Q2
   
Growth
 
   
 $’000
   
% of
revenue
   
 $’000
   
% of
revenue
   
 $’000
   
%
 
China Mobile
    13038       53.6 %     8694       52.3 %     4344       50.0 %
China Unicom
    8570       35.2 %     4748       28.6 %     3822       80.5 %
China Telecom
    1339       5.5 %     2750       16.5 %     -1411       -51.3 %
Others
    1363       5.6 %     356       2.1 %     1007       282.9 %
Overseas
    27       0.1 %     71       0.4 %     -44       -62.0 %
Total
    24337               16619               7718       46.4 %

Six months ended June 30, 2011 and 2010:

   
2011 Six months
   
2010 Six months
   
Growth
 
   
 $’000
   
% of
revenue
   
 $’000
   
% of
revenue
   
 $’000
   
%
 
China Mobile
    19298       49.7 %     17604       63.4 %     1694       9.6 %
China Unicom
    13979       36.0 %     5831       21.0 %     8148       139.7 %
China Telecom
    2234       5.8 %     3697       13.3 %     -1463       -39.6 %
Others
    3239       8.3 %     356       1.3 %     2883       809.8 %
Overseas
    59       0.2 %     263       1.0 %     -204       -77.6 %
Total
    38809               27751               11058       39.8 %

Revenues from the wireless telecom carriers were the Company’s major source of revenue. For the three months ended June 30, 2011, our revenues generated from China Mobile accounted for 53.6% of our total revenue. Our revenue generated from China Unicom accounted for 35.2% of total revenue. For the six months ended June 30, 2011, our revenues generated from China Mobile accounted for 49.7% of our total revenue. Our revenue generated from China Unicom accounted for 36.0% of total revenue. With the increases in revenues from China Unicom and other customers, revenues for both three months and six months ended June 30, 2011, increased relatively rapidly. The increased revenues from China Unicom were mainly attributable to the significant increase in revenue from Beijing Unicom, Hebei Unicom and Shandong Unicom. And the increased revenues from other customers are due to the significant contracts signed with new customers during the six months ended June 30, 2011.

 Breakdown by Type of technology

   
 2011 Q2
   
 2010 Q2
   
Growth
 
   
 $’000
   
% of
revenue
   
 $'000
   
% of
revenue
   
 $'000
   
%
 
WFDSTM
    5683       23.4 %     4367       26.3 %     1316       30.1
Traditional product
    18654       76.6 %     12252       73.7 %     6402       52.3
Total
    24337       100 %     16619       100 %     7718       46.4

Six months ended June 30, 2011 and 2010:

   
2011 Six months
   
2010 Six months
   
Growth
 
   
 $’000
   
% of
revenue
   
 $'000
   
% of
revenue
   
 $'000
   
%
 
WFDSTM
    9013       23.2 %     7297       26.3 %     1715       23.5 %
Traditional product
    29796       77.8 %     20454       73.7 %     9342       45.7 %
Total
    38809       100 %     27751       100 %     11058       39.9 %
 
 
38

 

For the three months ended June 30, 2011, the revenue of our most competitive WFDS™ product was $5,683,000, contributing 23.4% of the total revenues in Q2, representing an increase of 30.1%, compared to the same period of 2010. For the six months ended June 30, 2011, the revenue of our WFDS™ product was $9,013,000, contributing 23.2% of the total revenues and representing an increase in sales of 23.5%, compared to the same period of 2010.

Gross Profit

For the three months ended June 30, 2010 and 2011, a tabular summary of our gross profit is presented below:

   
 2011 Q2
   
 2010 Q2
   
Growth
 
   
 $’000
 
% of
revenue
   
 $'000
 
% of
revenue
   
 $'000
   
%
 
Revenue
    24337             16619             7718       46.4 %
Equipment and services costs
    13703       56.3 %     9121       54.9 %     4582       50.2 %
Gross profit
    10634       43.7 %     7498       45.1 %     3136       41.8 %

For Six months ended June 30, 2011 and 2010:

   
2011 Six months
   
2010 Six months
   
Growth
 
   
 $’000
 
% of
revenue
   
 $'000
 
% of
revenue
   
 $'000
   
%
 
Revenue
    38809             27751             11058       39.8 %
Equipment and services costs
    21577       55.6 %     15314       55.2 %     6263       40.9 %
Gross profit
    17232       44.4 %     12437       44.8 %     4795       38.6 %

Gross profit ratio

Our gross profit ratio was 43.7% in the second quarter of 2011, as compared to 45.1% in the second quarter of 2010. For the six months ended June 30, 2011, our gross profit ratio was 44.4%, as compared to 44.8% in the same period of time.

Operating Expenses

Three months ended June 30, 2011 and 2010:

    2011 Q2     2010 Q2    
Growth
 
   
 $’000
   
% of
revenue
   
 $'000
   
% of
revenue
   
 $'000
   
%
 
Sales and Marketing expenses
    3026       12.4 %     4176       25.1 %     -1150       -27.5 %
General and Administrative expenses
    1360       5.6 %     882       5.3 %     478       54.2 %
Research and Development expenses
    620       2.5 %     191       1.1 %     429       224.6 %
Depreciation and Amortization
    120       0.5 %     81       0.5 %     39       48.1 %
Total
    5126       21.0 %     5330       32.1 %     -204       -3.8 %
 
 
39

 

Six months ended June 30, 2011 and 2010:

   
2011 Six months
   
2010 Six months
   
Growth
 
      $’000    
% of  revenue
   
$'000
   
% of  revenue
   
$'000
   
%
 
Sales and Marketing expenses
    5157       13.3 %     6904       24.9 %     -1747       -25.3 %
General and Administrative expenses
    3365       8.7 %     3816       13.8 %     -451       -11.8 %
Research and Development expenses
    868       2.2 %     415       1.5 %     453       109.2 %
Depreciation and Amortization
    222       0.6 %     152       0.5 %     70       46.1 %
Total
    9612       24.8 %     11287       40.7 %     -1675       -14.8 %

Sales and Marketing expenses

Sales and marketing expenses were $3,026,000 or 12.4% of our revenue for the three months ended June 30, 2011, as compared to $4,176,000, or 25.1%% of our revenue for the same period in 2010. Sales and marketing expenses were $5,157,000 or 13.3% of our revenue for the six months ended June 30, 2011, as compared to $6,904,000, or 24.9% of our revenue for the same period in 2010.

The decrease of sales and marketing expenses for the six months ended June 30, 2011 were mainly due to the expenses associated with the issuance of warrants in 2010 not recurring in 2011.

General and Administrative expenses.

General and administrative expenses were $1,360,000 or 5.6% of our revenue for the three months ended June 30, 2011, as compared to $882,000 or 5.3% of revenue for the same period in 2010. For the six months ended June 30, 2011, general and administrative expenses were $3,365,000 or 8.7% of our revenue, as compared to $3,816,000 or 13.8% of revenue for the same period in 2010.

Research and Development expenses

Research and development expenses were $620,000 or 2.5% of revenues for the three months ended June 30, 2011, as compared to $191,000, or 1.1% of revenues for the same period in 2010. For the six months ended June 30, 2011, the R&D expenses were $868,000 or 2.2% of revenues, as compared to $415,000 or 1.5% of revenues for the same period in 2010. The rapid increase in R&D expenses is attributable to the expenses of the research exhibition center in Wuxi.  At the same time the ratio of R&D expenses to revenue remains at a relatively low level.

Interest Expense

Three months ended June 30, 2011 and 2010:

   
 2011 Q2
   
 2010 Q2
   
Growth
 
      $’000    
% of
revenue
   
$'000
   
% of 
revenue
   
$'000
   
%
 
Interest expenses
    187       0.77 %     134       0.81 %     53       39.60 %
 
 
40

 

Six months ended June 30, 2011 and 2010:

   
2011 Six months
   
2010 Six months
   
Growth
 
      $’000    
% of  revenue
   
$'000
   
% of revenue
   
$'000
   
%
 
Interest expenses
    336       0.87 %     260       0.94 %     76       29.23 %

Interest Expense

Interest expenses were $187,000 for the three months ended June 30, 2011, an increase of $53,000 or 39.60% as compared to $134,000 for the same period in 2010. For the six months ended June 30, 2011, interest expenses were $336,000, an increase of $76,000 or 29.23% as compared to $260,000 for the same period in 2010. The increase in the interest expense in 2011 was due to more interest paid on short-term loans. The Company’s short-term loans were $10,368,000 and $5,850,000 as of June 30 2011 and 2010 respectively, an increase of 77.23%.

Liquidity and Capital Resources

We generally finance our operations from cash flow generated internally and short-term bank loans. As of June 30, 2011, we had current assets of $240,855,000. Our current assets were mainly comprised of: inventories of $7,222,000, accounts receivable of $206,318,000, prepayments of $1,661,000, other current assets of $4,240,000, amounts due from related parties of $1,509,000, and cash and cash equivalents of $19,905,000. Current liabilities were $122,627,000, mainly comprised of accounts payable of $43,266,000, tax payables of $15,336,000, short-term loans of $10,368,000, customer deposits for sales of equipment of $2,482,000, amounts due to related parties of $1,801,000, and other payables and accruals of $49,374,000.

Our net cash used in operating activities was $11,124,000 for the six months ended June 30, 2011. At June 30, 2011, cash and cash equivalents were $19,905,000. Current assets were $240,855,000 and current liabilities were $122,627,000, reflecting a current ratio (current assets/current liabilities) of 1.96:1.

Our trading terms with our customers are mainly on credit. The accounts receivable turnover period for the three months ended June 30, 2011 was 732 days. The accounts receivable turnover period for the six months ended June 30, 2011 was 882 days. The long accounts receivable turnover period is due to the rapid-growth in revenue in 2010, which resulted in an increase in accounts receivable at the end of 2010 and till June, 2011 and which had a direct impact on our DSO. In 2011 our marketing strategy is to control the growth, enhance the money-return, and open up new markets, which will leads to a steady decrease in  accounts receivable turnover period.

We experienced a long accounts receivable turnover period. This is due to the fact that most of our projects are integrated projects and the accounts receivable turnover period for these kind of sales was relatively longer. Most of our major competitors focus on pure equipment sales, which leads to shorter accounts receivable turnover periods. In addition, most of our customers are the ”Big Three”, which are known as “blue chip” customers and their payment cycles are comparatively long.

That said, our inventory turnover period for the three months ended June 30, 2011 was 102 days, as compared to 129 days in the same period in 2010.

Also, our inventory turnover period decreased for the three months ended June 30, 2011 compared to the same period in 2010, due to internal improvements in our inventory control measures.

 
41

 

Our cash and bank balances are mainly denominated in RMB and U.S. Dollars, while our bank borrowings are mainly denominated in RMB. Our revenue, expenses, assets and liabilities are mainly denominated in RMB and U.S. Dollars. 

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements.

CONTINGENT LIABILITIES

We recognize our revenue upon the completion of contracts and have made full tax provision in accordance with relevant national and local laws and regulations of the PRC. A contract is considered completed upon completion of all essential contract work and when installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. We follow the practice of reporting our revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. Despite the fact that we have made full tax provision in the financial statements, we may be subject to surcharge and penalty for the deferred reporting of tax obligations. The Board of Directors considers it unlikely that the surcharge and tax penalty will be imposed.

 
42

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not required for smaller reporting company.

Item 4. Controls and Procedures
 
(a) Evaluation of disclosure controls and procedures

Under supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”); and whether any change has occurred in the Company’s internal control over financial reporting pursuant to Exchange Act Rules 13a-15(d) and 15d-15(d). Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. This information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were not effective due to the fact that the material weaknesses in the Company’s internal control over financial reporting described in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 have not been remediated as of the Evaluation Date, although steps have been taken toward remediation during the quarter ended June 30, 2011.

It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

(b) Changes in internal control over financial reporting

During the quarter ended June 30, 2011, there were no changes to our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
43

 

PART II

OTHER INFORMATION

Item 1.  Legal Proceedings.

None.

Item 1A.  Risk Factors.

Not required.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3.  Defaults Upon Senior Securities.

None.

Item 4.  (Removed and Reserved).

Item 5.  Other Information.

None.

Item 6.  Exhibits.

31.1+
Chief Executive Officer Certification furnished pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
31.2+
Chief Financial Officer Certification furnished pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
32.1*
Chief Executive Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
32.2*
Chief Financial Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101+
The following materials from Telestone Technologies Corporation’s Quarterly Report on Form 10-Q for the three months ended June 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets (unaudited) as of June 30, 2011 and December 31, 2010; (ii) Statements of Operations (unaudited) for the three and six months ended June 30, 2011 and June 30, 2010; (iii) Consolidated Statements of Changes in Shareholders’ Equity (unaudited); (iv) Consolidated Statements of Cash Flows (unaudited) for the three and six months ended June 30, 2011 and June 30, 2010 and (v) Notes to the Unaudited Consolidated Financial Statements (unaudited).

+ Filed or furnished herewith
* These exhibits were previously included or incorporated by reference in Telestone Technologies Corporation’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2011, filed with the Securities and Exchange Commission on August 15, 2011.

 
44

 

SIGNATURES

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
TELESTONE TECHNOLOGIES CORPORATION
 
       
Date: September 21, 2011
By:  
/s/ Han Daqing
 
   
Han Daqing, Chief Executive Officer
 
   
(Principal Executive Officer)
 
 
Date: September 21, 2011
By: 
/s/ Yu Xiaoli
 
   
Yu Xiaoli, Chief Financial Officer
 
   
(Principal Financial Officer)
 
 
 
45