UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

x

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2012.

 

or

 

o

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from                   to                   .

 

Commission File Number

 

QKL STORES INC.

(Exact name of registrant as specified in its charter)

 

Delaware		75-2180652
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

 

4 Nanreyuan Street

Dongfeng Road

Sartu District

Daqing, P.R. China 163311

 (Address of Principal Executive Offices including zip code)

 

011-86-459-4607987

(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 Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x No o

 

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  x No o

 

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company

 

Large Accelerated Filer   o

Accelerated Filer   o

Non-Accelerated Filer o (Do not check if a smaller reporting company)

Smaller reporting company   x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act).

Yes  o No x

 

The Registrant had 10,527,637 shares of common stock outstanding on November 14, 2012.

 

  

QKL STORES, INC.

TABLE OF CONTENTS

 

PART I:  FINANCIAL INFORMATION			2
Item 1 – Interim Financial Statements			2
Condensed Consolidated Balance Sheets			3
Condensed Consolidated Statements of Income			3
Condensed Consolidated Statements of Cash Flows			4
Notes to Unaudited Condensed Consolidated Financial Statements			5
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
Item 3 – Quantitative and Qualitative Disclosures about Market Risk			24
Item 4 – Controls and Procedures			24
PART II:  OTHER INFORMATION			25
Item 1 – Legal Proceedings			25
Item 1A – Risk Factors			25
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3 – Defaults Upon Senior Securities			25
Item 4 –Mine Safety Disclosures			25
Item 5 – Other Information			25
Item 6 – Exhibits			25
Signatures			26

 

 

PART 1. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

 

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

 

		September 30, 2012				December 31, 2011
		(Unaudited)
ASSETS
Cash		$	27,387,082			$	9,037,550
Restricted cash			253				253
Accounts receivable			117,230				115,163
Inventories			45,567,703				54,336,501
Other receivables			8,990,737				11,991,134
Prepaid expenses			5,945,518				6,085,379
Advances to suppliers			8,124,527				10,160,552
Deferred income tax assets			2,979,111				2,972,570
Total current assets			99,112,161				94,699,102
Property, plant and equipment, net			41,973,123				43,042,136
Land use rights, net			725,192				748,410
Goodwill			26,567,797				26,346,942
Other assets			468,894				520,559
Total assets		$	168,847,167			$	165,357,149
LIABILITIES AND SHAREHOLDERS’ EQUITY
Short-term loans		$	15,787,812			$	10,998,162
Accounts payable			26,508,022				28,417,894
Cash card and coupon liabilities			16,273,617				16,024,437
Customer deposits received			791,673				931,604
Accrued expenses and other payables			14,005,318				14,328,656
Income taxes payable			176,242				227,016
Total current liabilities			73,542,684				70,927,769
Total liabilities			73,542,684				70,927,769
Shareholders’ equity
Common stock, $0.001 par value per share, authorized 100,000,000 shares, issued and outstanding 10,527,637 and 10,448,197 shares at September 30, 2012 and December 31, 2011, respectively*			10,527				10,448
Series A convertible preferred stock, par value $0.01, authorized 10,000,000 shares, issued and outstanding 5,457,960 and 5,694,549 at September 30, 2012 and December 31, 2011, respectively			54,580				56,945
Additional paid-in capital			91,828,974				91,610,531
Retained earnings – appropriated			7,282,560				7,282,560
Retained earnings			(16,025,611	)			(15,758,416	)
Accumulated other comprehensive income			12,153,453				11,227,312
Total shareholders’ equity			95,304,483				94,429,380
Total liabilities and shareholders’ equity		$	168,847,167			$	165,357,149

 

*The number of shares of common stock has been retroactively restated to reflect the Reverse Stock Split effected on June 11, 2012.

 

See notes to unaudited condensed consolidated financial statements.

 

 

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Income

 

		(Unaudited)								(Unaudited)
		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Net sales		$	84,343,510			$	82,068,788			$	279,603,670			$	266,833,256
Cost of sales			70,189,152				67,874,242				231,825,748				219,918,263
Gross profit			14,154,358				14,194,546				47,777,922				46,914,993
Operating expenses:
Selling expenses			13,330,045				13,040,763				40,878,831				38,327,459
General and administrative expenses			2,074,153				2,333,267				6,539,428				6,483,350
Total operating expenses			15,404,198				15,374,030				47,418,259				44,810,809
(Loss) income from operations			(1,249,840	)			(1,179,484	)			359,663				2,104,184
Non-operating income (expense):
Interest income			111,903				175,745				216,674				629,130
Interest expense			(295,564	)			(10,593	)			(691,212	)			(41,693	)
Total non-operating income (expense)			(183,661	)			165,152				(474,538	)			587,437
(Loss) income before income taxes			(1,433,501	)			(1,014,332	)			(114,875	)			2,691,621
Income taxes			(326,094	)			(164,822	)			152,320				986,869
Net (loss) income		$	(1,107,407	)		$	(849,510	)		$	(267,195	)		$	1,704,752
Comprehensive income statement:
Net (loss) income		$	(1,107,407	)		$	(849,510	)		$	(267,195	)		$	1,704,752
Foreign currency translation adjustment			(25,012	)			1,023,116				926,141				3,385,552
Comprehensive income		$	(1,132,419	)		$	173,606			$	658,946			$	5,090,304
Weighted average number of shares outstanding:
Basic*			10,527,637				10,362,508				10,514,746				10,071,728
Diluted*			10,527,637				10,362,508				10,514,746				12,346,380
(Losses) earnings per share:
Basic*		$	(0.105	)		$	(0.082	)		$	(0.025	)		$	0.138
Diluted*		$	(0.105	)		$	(0.082	)		$	(0.025	)		$	0.138

 

* The earnings (losses) per share data and the weighted average shares outstanding for all periods have been retroactively restated to reflect the 1-for-3 Reverse Stock Split effected on June 11, 2012.

 

See notes to unaudited condensed consolidated financial statements.

 

 

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

 

		(Unaudited)
		Nine Months Ended September 30,
		2012				2011
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income		$	(267,195	)		$	1,704,752
Depreciation – property, plant and equipment			4,926,896				5,815,703
Amortization			21,672				22,519
Share-based compensation			637,786				648,474
Deferred income tax			7,866				(225,151	)
Loss on disposal of fixed assets			6,128				153,494
Adjustments to reconcile net income to net cash provided by operating activities:
Accounts receivable			(1,510	)			(562,574	)
Inventories			9,041,509				3,086,917
Other receivables			3,319,138				18,037,812
Prepaid expenses			223,775				604,642
Advances to suppliers			2,087,430				(2,500,125	)
Accounts payable			(2,049,728	)			(3,476,958	)
Cash card and coupon liabilities			171,689				2,975,779
Customer deposits received			(144,596	)			(13,012	)
Accrued expenses and other payables			(490,608	)			2,996,074
Income taxes payable			(51,928	)			(1,904,396	)
Net cash provided by operating activities			17,438,324				27,363,950
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment			(3,648,874	)			(20,686,955	)
Decrease of restricted cash			-				69,952
Net cash used in investing activities			(3,648,874	)			(20,617,003	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Bank loan borrowing			7,902,077				3,074,081
Bank loan repayment			(3,157,562	)			-
Net cash provided by financing activities			4,744,515				3,074,081
Effect of foreign currency translation			(184,433	)			701,027
Net increase in cash			18,349,532				10,522,055
Cash – beginning of period			9,037,550				17,460,034
Cash – end of period		$	27,387,082			$	27,982,089
Supplemental disclosures of cash flow information:
Interest paid		$	691,212			$	41,693
Income taxes paid		$	548,175			$	3,024,287

 

See notes to unaudited condensed consolidated financial statements.

 

 

QKL STORES INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION AND BUSINESS OPERATIONS

 

QKL Stores Inc. (“Store”) was incorporated under the laws of the State of Delaware on December 2, 1986. The Store currently operates through a wholly owned subsidiary in the British Virgin Islands: Speedy Brilliant Group Ltd. (“Speedy Brilliant (BVI)”), wholly owned subsidiary of Speedy Brilliant (BVI) located in Mainland China: Speedy Brilliant (Daqing) Ltd. (“Speedy Brilliant (Daqing)” or “WFOE”), operating company located in Mainland China: Daqing Qingkelong Chain Commerce & Trade Co., Ltd. (“Qingkelong Chain”), which the Store controls, through contractual arrangements between WFOE and Qingkelong Chain, as if Qingkelong Chain were a wholly owned subsidiary of Store, and wholly owned operating subsidiary of Qingkelong Chain located in Mainland China:  Daqing Qinglongxin Commerce & Trade Co., Ltd (“Qinglongxin Commerce”).

 

The Store and its subsidiaries (hereinafter, collectively referred to as the “Company”) are engaged in the operation of retail chain stores in the PRC.

 

The Company is a regional supermarket chain that currently operates 31 supermarkets, 16 hypermarkets and 4 department stores in northeastern China and Inner Mongolia. The Company’s supermarkets and hypermarkets sell a broad selection of merchandise including groceries, fresh food and non-food items. A supermarket offers various daily necessities on a self-service basis and averages 2,500 square meters in sales area. A hypermarket is similar to a supermarket but has a larger operating scale, and is typically over 4,500 square meters in sales area. The Company currently has two distribution centers servicing its supermarkets.

 

 The Company is the first supermarket chain in northeastern China and Inner Mongolia that is a licensee of the Independent Grocers Alliance, or IGA, a United States-based global grocery network. As a licensee of IGA, the Company is able to engage in group bargaining with suppliers and have access to more than 2,000 private IGA brands, including many that are exclusive IGA brands.

 

Principles of Consolidation and Presentation

 

The condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).  The condensed consolidated financial statements include the financial statements of QKL Stores Inc., and its wholly owned subsidiaries.  All intercompany accounts, transactions, and profits have been eliminated upon consolidation.

 

The accompanying interim unaudited condensed consolidated financial statements (“Interim Financial Statements”) of the Company and its wholly owned subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and are presented in accordance with the requirements of Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these Interim Financial Statements do not include all of the information and notes required by GAAP for complete financial statements. These Interim Financial Statements should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2011 included in the Company’s Form 10-K. In the opinion of management, the Interim Financial Statements included herein contain all adjustments, including normal recurring adjustments, considered necessary to present fairly the Company’s financial position, the results of operations and cash flows for the periods presented.  The operating results and cash flows of the interim periods presented herein are not necessarily indicative of the results to be expected for any other interim period or the full year.

 

 

QKL STORES INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

 

Segment Reporting

 

The Company operates in one industry segment, operating retail chain stores.  ASC 280, Segment Reporting, establishes standards for reporting information about operating segments. Given the economic characteristics of the similar nature of the products sold, the type of customer and the method of distribution, the Company operates as one reportable segment as defined by ASC 280, Segment Reporting.

 

Revenue Recognition

 

The Company earns revenue by selling merchandise primarily through its retail stores. Revenue is recognized when merchandise is purchased by and delivered to the customer and is shown net of estimated returns during the relevant period. The allowance for sales returns is estimated based upon historical experience.

 

Cash received from the sale of cash cards (aka “gift cards”) is recorded as a liability, and revenue is recognized upon the redemption of the cash card or when it is determined that the likelihood of redemption is remote (“cash card breakage”) and no liability to relevant jurisdictions exists. The Company determines the cash card breakage rate based upon historical redemption patterns and recognizes cash card breakage on a straight-line basis over the estimated cash card redemption period.  The Company recognized approximately nil in cash card breakage revenue for the nine months ended September 30, 2012 and 2011.

 

 

The Company records sales tax collected from its customers on a net basis, and therefore excludes it from revenue as defined in ASC 605, Revenue Recognition.

 

Included in revenue are sales of returned merchandise to vendors specializing in the resale of defective or used products, which accounted for less than 0.5% of net sales in each of the periods reported.

 

Cost of Sales

 

Cost of sales includes the cost of merchandise, related cost of packaging and shipping cost, and the distribution center costs.

 

Selling Expenses

 

Selling expenses include store-related expense, other than store occupancy costs, as well as advertising, depreciation and amortization, utilities, labour costs, preliminary expenses and certain expenses associated with operating the Company’s corporate headquarters.

 

Advertising Costs

 

Advertising costs are expensed as incurred. Advertising expense, net of reimbursement from suppliers, amounted to $102,801 and $160,627 for the nine months ended September 30, 2012 and 2011, and amounted to $49,293 and $57,650 for the three months ended September 30, 2012 and 2011, respectively. Advertising expense is included in selling expenses in the accompanying condensed consolidated statements of income. The Company receives co-operative advertising allowances from vendors in order to subsidize qualifying advertising and similar promotional expenditures made relating to vendors’ products. These advertising allowances are recognized as a reduction to selling expenses when the Company incurs the advertising cost eligible for the credit. Co-operative advertising allowances recognized as a reduction to selling expenses amounted to nil for the nine months and three months ended September 30, 2012 and 2011.

 

Vendor Allowances

 

The Company receives allowances for co-operative advertising and volume purchase rebates earned through programs with certain vendors. The Company records a receivable for these allowances which are earned but not yet received when it is determined the amounts are probable and reasonably estimable, in accordance with ASC 605. Amounts relating to the purchase of merchandise are treated as a reduction of inventory cost and reduce cost of goods sold as the merchandise is sold. Amounts that represent a reimbursement of costs incurred, such as advertising, are recorded as a reduction in selling and administrative expense. The Company performs detailed analyses to determine the appropriate amount of vendor allowances to be applied as a reduction of merchandise cost and selling expenses.

 

Inventories

 

Inventories primarily consist of merchandise inventories and are stated at lower of cost or market and net realizable value. Cost of inventories is calculated on the weighted average basis which approximates cost.

 

Management regularly reviews inventories and records valuation reserves for damaged and defective returns, inventories with slow-moving or obsolescence exposure and inventories with carrying value that exceeds market value. Because of its product mix, the Company has not historically experienced significant occurrences of obsolescence.

 

 

Inventory shrinkage is accrued as a percentage of revenues based on historical inventory shrinkage trends. The Company performs physical inventory count of its stores once per quarter and cycle counts inventories at its distribution centers once per quarter throughout the year. The reserve for inventory shrinkage represents an estimate for inventory shrinkage for each store since the last physical inventory date through the reporting date.

 

These reserves are estimates, which could vary significantly, either favorably or unfavorably, from actual results if future economic conditions, consumer demand and competitive environments differ from expectations.

 

Income Taxes

 

The Company follows ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

 

The Company adopted ASC 740-10-25 on January 1, 2007, which provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position.  The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize any additional liabilities for uncertain tax positions as a result of the implementation of ASC 740-10-25.

 

Fair Value Measurements

 

ASC 820 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.

 

ASC 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.  ASC 820 establishes three levels of inputs that may be used to measure fair value:

 

·

Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company holds. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

 

·

Level 2 – Valuation based on quoted prices in markets that are not active for which all significant inputs are observable, either directly or indirectly.

 

·

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

The Company adopted ASC 820, Fair Value Measurements and Disclosures, on January 1, 2008 for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis (at least annually). ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The Company has also adopted ASC 820, on January 1, 2009 for non financial assets and non financial liabilities, as these items are not recognized at fair value on a recurring basis. The adoption of ASC 820 for all financial assets and liabilities and non-financial assets and non-financial liabilities did not have any impact on the Company’s consolidated financial statements.

 

 

Financial instruments include cash, accounts receivable, prepayments and other receivables, short-term borrowings from banks, accounts payable and accrued expenses and other payables. The carrying amounts of cash, accounts receivable, prepayments and other receivables, short-term loans, accounts payable and accrued expenses approximate their fair value due to the short-term maturities of these instruments. See footnote 7 regarding the fair value of the Company’s warrants, which are classified as Level 3 liabilities in the fair value hierarchy.

 

Recently Issued Accounting Guidance

 

In January 2011, the FASB issued ASU 2011-01, “Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20”, which temporarily delay the effective date of the disclosures about troubled debt restructurings in ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, for public entities. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings for public entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011. The deferral in ASU 2011-01 is effective January 19, 2011 (date of issuance).

 

In April 2011, the FASB issued ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”, which clarifies when creditors should classify loan modifications as troubled debt restructurings. The guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the year. The guidance on measuring the impairment of a receivable restructured in a troubled debt restructuring is effective on a prospective basis. A provision in ASU 2011-02 also ends the FASB’s deferral of the additional disclosures about troubled debt restructurings as required by ASU 2010-20. The adoption of ASU 2011-02 is not expected to have a material impact on the Company’s financial condition or results of operations.

 

In April 2011, the FASB issued ASU 2011-03, Consideration of Effective Control on Repurchase Agreements, which deals with the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. ASU 2011-03 changes the rules for determining when these transactions should be accounted for as financings, as opposed to sales. The guidance in ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of ASU 2011-03 is not expected to have a material impact on the Company’s financial condition or results of operation.

 

In May 2011, the FASB issued ASU 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 (“IFRS”). ASU 2011-04 clarifies some existing concepts, eliminates wording differences between U.S. GAAP and IFRS, and in some limited cases, changes some principles to achieve convergence between U.S. GAAP and IFRS. ASU 2011-04 results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and IFRS. ASU 2011-04 also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. ASU 2011-04 will be effective for the Company beginning after December 15, 2011. The Company does not expect the adoption of ASU 2011-04 to have a material effect on its operating results or financial position.

 

In June 2011, the Financial Accounting Standard Board (“FASB”) issued Accounting Standard Update (“ASU”) 2011-05, Presentation of Comprehensive Income, which 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. ASU 2011-05 eliminates the option to present components of other comprehensive income as part of the statement of equity. ASU 2011-05 will be effective for the Company beginning after December 15, 2011. The Company does not expect the adoption of ASU 2011-05 to have a material effect on its operating results or financial position. However, it will impact the presentation of comprehensive income.

 

In September 2011, the FASB has issued Accounting Standards Update (ASU) No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 is intended to simplify how entities, both public and nonpublic, test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles-Goodwill and Other. The more-likely-than-not threshold is defined as having a likelihood of more than 50%. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance.

 

In September 2011, the FASB has issued Accounting Standards Update (ASU) No. 2011-09, Compensation-Retirement Benefits-Multiemployer Plans (Subtopic 715-80): Disclosures about an Employer’s Participation in a Multiemployer Plan. ASU 2011-09 is intended to address concerns from various users of financial statements on the lack of transparency about an employer’s participation in a multiemployer pension plan. Users of financial statements have requested additional disclosure to increase awareness of the commitments and risks involved with participating in multiemployer pension plans. The amendments in this ASU will require additional disclosures about an employer’s participation in a multiemployer pension plan. Previously, disclosures were limited primarily to the historical contributions made to the plans. ASU 2011-09 applies to nongovernmental entities that participate in multiemployer plans. For public entities, ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2011. For nonpublic entities, ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2012. Early adoption is permissible for both public and nonpublic entities. ASU 2011-09 should be applied retrospectively for all prior periods presented.

 

 

In December 2011, the FASB has issued Accounting Standards Update (ASU) No. 2011-10, Property, Plant, and Equipment (Topic 360): Derecognition of in Substance Real Estate-a Scope Clarification. ASU No. 2011-10 is intended to resolve the diversity in practice about whether the guidance in Subtopic 360-20, Property, Plant, and Equipment—Real Estate Sales, applies to a parent that ceases to have a controlling financial interest (as described in Subtopic 810-10, Consolidation—Overall) in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt. This Update does not address whether the guidance in Subtopic 360-20 would apply to other circumstances when a parent ceases to have a controlling financial interest in a subsidiary that is in substance real estate. ASU 2011-10 should be applied on a prospective basis to deconsolidation events occurring after the effective date; with prior periods not adjusted even if the reporting entity has continuing involvement with previously derecognized in substance real estate entities. For public entities, ASU 2011-10 is effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2012. For nonpublic entities, ASU 2011-10 is effective for fiscal years ending after December 15, 2013, and interim and annual periods thereafter. Early adoption is permitted.

 

In December 2011, the FASB has issued Accounting Standards Update (ASU) No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. ASU No. 2011-11 is intended to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this Update. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented.

 

In December 2011, the FASB has issued Accounting Standards Update (ASU) No. 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. ASU No. 2011-11 is intended to supersede certain pending paragraphs in Accounting Standards Update No. 2011-05,Comprehensive Income (Topic 220): Presentation of Comprehensive Income, to effectively defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. All other requirements in ASU No. 2011-05 are not affected by ASU No. 2011-12, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities should begin applying these requirements for fiscal years ending after December 15, 2012, and interim and annual periods thereafter.

 

In July 2012, the FASB has issued Accounting Standards Update (ASU) No. 2012-02, Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU states that an entity has the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, then it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with Codification Subtopic 350-30, Intangibles—Goodwill and Other, General Intangibles Other than Goodwill.

 

Under the guidance in this ASU, an entity also has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period.

 

The amendments in this ASU are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance.

 

In August 2012, the FASB has released Accounting Standards Update (ASU) No. 2012-03, Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB Accounting Standards Update 2010-22. This ASU amends various SEC paragraphs: (a) pursuant to the issuance of Staff Accounting Bulletin No. 114; (b) pursuant to the issuance of the SEC’s Final Rule, Technical Amendments to Commission Rules and Forms Related to the FASB’s Accounting Standards Codification, Release Nos. 33-9250, 34-65052, and IC-29748 August 8, 2011; and (c) related to ASU No. 2010-22, Accounting for Various Topics.

 

The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on results of operations, financial condition, or cash flows, based on current information.

 

 

NOTE 3 – OTHER RECEIVABLES

 

Other receivables consisted of the following:

 

		September 30, 2012 (Unaudited)				December 31, 2011
Deposits		$	1,471,540			$	666,207
Purchase deposits			2,053,560				1,324,056
Input value added tax receivables			2,878,906				7,331,965
Rebates receivables			2,395,821				2,363,854
Rent deposits			174,249				277,841
Others			16,661				27,211
Total		$	8,990,737			$	11,991,134

 

NOTE 4 – PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment consisted of the following:

 

		September 30,  2012				December 31,
		(Unaudited)				2011
Buildings		$	6,861,043			$	6,861,043
Shop equipment			20,958,991				19,815,360
Office equipment			4,122,940				4,028,789
Motor vehicles			1,642,125				1,642,125
Car park			20,237				20,237
Leasehold improvements			28,066,316				27,515,996
Construction in progress			3,156,642				2,087,368
Total property, plant and equipment			64,828,294				61,970,918
Less:  accumulated depreciation and amortization			(22,855,171	)			(18,928,782	)
Total property, plant and equipment, net		$	41,973,123			$	43,042,136

 

The depreciation expenses for the nine months period ended September 30, 2012 and September 30, 2011 were $4,926,896 and $ 5,815,703 respectively.

 

 

 NOTE 5 – ACCRUED EXPENSES AND OTHER PAYABLES

 

Accrued expenses and other payables consisted of the following:

 

		September 30, 2012 (Unaudited)				December 31, 2011
Accrued expenses		$	7,285,139			$	8,184,785
VAT and other PRC tax payable			865,151				1,695,669
Shop equipment and leasehold improvements payables			3,004,433				2,535,486
Deposit from vendors and employees			2,850,595				1,912,716
Total accrued expenses and other payables		$	14,005,318			$	14,328,656

 

NOTE 6 – EARNINGS PER SHARE

 

The Company calculates earnings per share in accordance with ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of convertible preferred stock (using the if-converted method) and exercisable warrants and stock options outstanding (using the treasury method). Holder of Class A convertible preferred stock participate in dividends of the Company on the same basis as holders of the Company’s common stock and is therefore included in the calculation of basic earnings per share using the two class method.

 

The following table sets forth the computation of basic and diluted net (loss) income per common share:

 

		(Unaudited)								(Unaudited)
		Three Months Ended September 30,								Nine Months Ended September 30,
		2012				2011				2012				2011
Net (loss) income to QKL Stores, Inc. for computing basic net income per share		$	(1,107,407	)		$	(849,510	)		$	(267,195	)		$	1,704,752
Undistributed earnings allocated to Series A Convertible Preferred Stock			-				-				-				312,914
Net (loss) income attributable to ordinary shareholders for computing basic net (loss) income per ordinary share		$	(1,107,407	)		$	(849,510	)		$	(267,195	)		$	1,391,838
Weighted-average shares of common stock outstanding
Basic			10,527,637				10,362,508				10,514,746				10,071,728
Dilutive shares:
Conversion of series A convertible preferred stock			1,819,320				1,983,871				1,819,320				2,274,652
Dilutive effect of stock warrants and options			-				-				-				-
Anti-dilutive effect of preferred stock			(1,819,320	)			(1,983,871	)			(1,819,320	)			-
Diluted			10,527,637				10,362,508				10,514,746				12,346,380
Basic earnings per share		$	(0.105	)		$	(0.082	)		$	(0.025	)		$	0.138
Diluted earnings per share		$	(0.105	)		$	(0.082	)		$	(0.025	)		$	0.138

 

The 11,768,860 shares of stock warrants and 2,033,000 options were not included in the computation of diluted net earnings per share as their effects would have been anti-dilutive since the average share price for the three and nine months ended September 30, 2012 were lower than the options and warrants exercise price.

 

 

NOTE 7 – STOCK WARRANTS

 

Series A and Series B Stock Warrants

 

As a result of a completed sale of 9,117,647 units for cash proceeds of $15,500,000 on March 28, 2008, the Company issued Series A stock warrants to purchase 1,940,885 shares of the Company’s common stock and Series B stock warrants to purchase 1,933,637 shares of the Company’s common stock which can be converted on a one-for-one basis into shares of the Company’s common stock. The stock warrants have a five year life and the Series A warrants are exercisable at an equivalent price of $10.20 per share and the Series B are exercisable at an equivalent price of $12.75 per share. These stock warrants will expire on March 28, 2013 pursuant to the warrant agreements.

 

The Company used the Black-Scholes option pricing model to determine the fair value of the Series A and B stock warrants on March 28, 2008 (assumptions used – expected life of 5 years, volatility of 89%, risk free interest rate of 2.51%, and expected dividend yield of 0%).

 

Effective January 1, 2009, the Company adopted the provisions of FASB ASC Topic 815, “Derivatives and Hedging” (“ASC 815”) (previously EITF 07-5, “Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity’s Own Stock”). As a result of adopting ASC 815, warrants to purchase 3,874,522 of the Company’s common stock previously treated as equity pursuant to the derivative treatment exemption were no longer afforded equity treatment as there was a down-round protection (full-ratchet down round protection).   As a result, the warrants were not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of these warrants were recognized in earnings until such time as the warrants are exercised or expire.  The Company reclassified the fair value of these warrants from equity to liability, as if these warrants were treated as a derivative liability. On January 1, 2009, the Company recorded as a cumulative effect adjustment of decreasing additional paid-in capital of $6,020,000 and beginning retained earnings of $2,792,017 and $8,812,017 to warrant liabilities to recognize the fair value of such warrants. The fair value of the warrants was $44,304,034 on December 31, 2009. The Company recognized $35,492,017 loss from the change in fair value of warrants for the year ended December 31, 2009.

 

The Company amended Series A and Series B stock warrant agreements deleting the down-round protection (full-ratchet down round protection) provision on March 24, 2010. As a result of this amendment, the Company is no longer required to treat Series A and Series B warrants as a liability and was reclassified to equity as of March 24, 2010 (assumption used – expected life of 3 years, volatility of 57%, and risk free interest rate of 1.67%, and expected dividend yield of 0%). Based on the revaluation, the Company recognized $7,801,649 of income related to this transaction and reclassified $36,502,385 to equity for the year ended December 31, 2010.

 

Warrant C

 

On January 22, 2010, the Company issued a warrant (“Warrant C”) to a non-related individual in exchange for consulting services relating to operational and managerial experience. Warrant C can be converted into 66,666 shares of the Company’s common stock at an exercise price of $15.00 per share. Warrants C has a five year term and became exercisable 180 days from the date of issuance of Warrant C.

 

The Company recognized share-based compensation cost based on the grant-date fair value estimated in accordance with ASC 505-50 “equity based payments to non-employees”.  The fair value of these stock warrants on the date of grant was estimated using the Black-Scholes method (assumption used – expected life of 2.75 years, volatility of 54%, and risk free interest rate of 1.25%, and expected dividend yield of 0%).  The Company recognized $558,180 of compensation expense related to this transaction in the first quarter of 2010.

 

 

A summary of the Company’s stock warrant activities are as follows:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term
Balance – December 31, 2011			3,922,953			$	11.52				1.27
Exercised			-				-				-
Cancelled			-				-				-
Balance – September 30, 2012			3,922,953			$	11.52				0.52

 

NOTE 8 – SHARED BASED COMPENSATION

 

Under the 2009 Omnibus Securities and Incentive Plan, on September 14, 2009, the Company entered into stock option agreements with its three independent directors, granting each director options to purchase 6,666 shares of the Company’s common stock at an exercise price of $24.00 per share.  The options vest in approximately equal amounts on the three subsequent anniversary dates of the grant and expire on the fifth anniversary of the date of agreement of or the date the option is fully exercised. On January 30, 2010, the Company entered into amendment agreements with its three directors to correct the exercise price to $22.50, which was the fair market value on the date of the grant. The correction of this error was considered immaterial.

 

Under the 2009 Omnibus Securities and Incentive Plan, on June 26, 2010, the Company granted the its Chief Operating Officer, Alan Stewart and 20 employees options to acquire 690,000 shares of the Company's common stock at an exercise price of $13.20 per share.  The options vest in approximately equal amounts on the four subsequent anniversary dates of the grant and expire on the eighth anniversary of the date of agreement of or the date the option is fully exercised. On June 17, 2011, Mr. Alan Stewart resigned from his position as Chief Operating Officer of QKL Stores Inc. On April 20, 2012, Mr. Zhiguo Jin resigned as the board of directors of the Company. These have no material impact on the Company’s consolidated financial statements.

 

Under the 2009 Omnibus Securities and Incentive Plan, on December 2, 2010, the Company granted its Chief Financial Officer, Tsz-Kit Chan options to acquire 33,333 shares of the Company's common stock at an exercise price of $10.26 per share.  The options vest in approximately equal amounts on the four subsequent anniversary dates of the grant and expire on the eighth anniversary of the date of agreement of or the date the option is fully exercised.

 

The Company accounts for its share-based compensation in accordance with ASC 718 and recognizes compensation expense using the fair-value method on a straight-line basis over the requisite service period for share option awards and non-vested share awards granted which vested during the period.  The fair value for these awards was estimated using the Black-Scholes option pricing model on the date of grant with the following assumptions:

 

		September 14, 2009				June 26, 2010				December 2, 2010
Expected life (years)			3.5				3.25				3.25
Expected volatility			41.2	%			53	%			44.9	%
Risk-free interest rate			1.69	%			1.49	%			0.96	%
Dividend yield			-				-				-

 

 

The expected volatilities are based on the historical volatility of the Company’s common stock.  The observation is made on a weekly basis.  The observation period covered is consistent with the expected life of the options.  The expected life of stock options is based on the minimum vesting period required.  The risk-free rate is consistent with the expected terms of the stock options and is based on the United States Treasury yield curve in effect at the time of grant.

 

Stock-based compensation expenses recognized was $212,595 and $637,786 for the three months and the nine months ended September 30, 2012. A summary of the Company’s stock options activities under the 2009 Omnibus Securities and Incentive Plan are as follows:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term(Years)				Intrinsic Value
Outstanding – December 31, 2011			677,666			$	13.32				2.52			$	-
Granted			-				-				-				-
Exercised			-				-				-				-
Forfeited			-				-				-				-
			-				-				-				-
Outstanding– September 30, 2012			677,666			$	13.32				1.77			$	-
Exercisable – September 30, 2012			138,200			$	13.05				1.77			$	-

 

As of September 30, 2012, there was $1,437,020 of total unrecognized compensation cost related to non-vested share option awards granted.  Such cost is expected to be recognized over a weighted-average period of 2-3 years.

 

NOTE 9 - COMMITMENTS AND CONTINGENCIES

 

Operating Leases

 

Certain of our real properties and equipment are operated under lease agreements. Rental expense under operating leases was as follows:

 

		(Unaudited)								(Unaudited)
		Three Months Ended  September 30								Nine Months Ended September 30
		2012				2011				2012				2011
Rent expense		$	2,599,389			$	2,541,478			$	7,988,871			$	6,676,825
Less: Sublease income			(570,921	)			(336,245	)			(1,711,733	)			(1,239,235	)
Total rent expense, net		$	2,028,468			$	2,205,233			$	6,277,138			$	5,437,590

 

Annual minimum payments under operating leases are as follows:

 

As of September 30,		Minimum Lease Payment				Sublease Income				Net Minimum Lease Payment
2013		$	8,082,917			$	542,750			$	7,540,167
2014			8,034,453				23,354				8,011,099
2015			7,988,609				13,244				7,975,365
2016			7,871,981				8,037				7,863,944
2017			7,482,645				1,392				7,481,253
Thereafter			67,931,207				-				67,931,207
Total		$	107,391,812			$	588,777			$	106,803,035

 

NOTE 10 – AMENDMENT TO ARTICLES OF INCORPORATION

 

On June 11, 2012, the Company filed a Certificate of Amendment to the Company’s Certificate of Incorporation, as amended to date, with the Secretary of State of the State of Delaware to effect a one-for-three reverse stock split (the “Reverse Stock Split”) of the issued and outstanding common stock of the Company, so that every three (3) outstanding shares of common stock before the Reverse Stock Split represents one (1) share of common stock after the Reverse Stock Split. The Reverse Stock Split became effective on and as of June 11, 2012. The Reverse Stock Split was duly approved by the Board of Directors of the Company and the Company’s shareholders entitled to vote a majority of the shares of common stock pursuant to Delaware General Corporation Law.

 

As a result of the Reverse Stock Split, the number of outstanding shares of common stock of the Company was reduced to 10,527,637 shares. Fractional stockholdings were rounded up to the nearest whole number. Each shareholder's percentage ownership interest in the Company and proportional voting power remains unchanged after the Reverse Stock Split except for minor changes and adjustments resulting from rounding of fractional interests. The rights and privileges of the holders of common stock are substantially unaffected by the Reverse Stock Split.

 

All common stock based data in our consolidated financial statements and the accompanying notes has been retroactively restated to reflect this Reverse Stock Split.

 

  

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis of the QKL Stores Inc. and subsidiaries (“we”, “our”, “us”) financial condition and results of operations includes information with respect to our plans and strategies for our business and should be read in conjunction with our interim unaudited condensed consolidated financial statements and related notes (“Interim Financial Statements”) included herein and our consolidated financial statements and related notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K for the fiscal year ended December 31, 2011.

 

Overview

 

We are a regional supermarket chain that currently operates 31 supermarkets, 16 hypermarkets and 4 department stores in northeastern China and Inner Mongolia. The Company’s supermarkets and hypermarkets sell a broad selection of merchandise including groceries, fresh food and non-food items. A supermarket offers various daily necessities on a self-service basis and averages 2,500 square meters in sales area. A hypermarket is similar to a supermarket but has a larger operating scale, and is typically over 4,500 square meters in sales area. We currently have two distribution centers servicing our supermarkets.

 

We are the first supermarket chain in northeastern China and Inner Mongolia that is a licensee of the Independent Grocers Alliance, or IGA, a United States-based global grocery network. As a licensee of IGA, the Company is able to engage in group bargaining with suppliers and have access to more than 2,000 private IGA brands, including many that are exclusive IGA brands.

 

Our expansion strategy emphasizes growth through geographic expansion in northeastern China and Inner Mongolia, where we believe local populations can support profitable supermarket operations, and where we believe competition from large foreign and national supermarket chains, which generally have resources far greater than ours, is limited.  Our strategies for profitable operations include buy-side initiatives to reduce supply costs; focusing on merchandise with higher margins, such as foods we prepare ourselves and private label merchandise; and increasing reliance on the benefits of membership in the international trade group IGA.

 

We completed the initial steps in the execution of our expansion plan in March 2008, when we raised financing through the combination of our reverse merger and private placement and also raised additional financing in our public offering in the fourth quarter of 2009. Under our expansion plan, we opened:

 

•

ten new stores in 2008 that have in the aggregate approximately 42,000 square meters of space

                          

•

seven new stores in 2009 that have, in the aggregate, approximately 32,000 square meters of space

 

•

nine new stores in 2010 that have in the aggregate approximately 74,189 square meters of space

                          

•

fourteen new stores in the 2011 that have in the aggregate approximately 101,000 square meters of space

 

•

one new store in the first nine months of 2012 that have in the aggregate approximately 5,700 square meters of space

 

In 2012, we plan to open 2 hypermarkets, supermarkets and department stores having, in the aggregate, approximately 15,000 square meters of space. In the first quarter of 2012, we closed 1 store due to the expiration of the lease contract. In the third quarter of 2012, we closed 1 store due to the expiration of the lease contract and 2 stores due to underperformance. We are making improvements to our logistics and information systems to support our supermarkets. We expect to finance our expansion plan from funds generated from operations and bank loans. 

 

 

Our Operations in China

 

Our headquarters and all of our stores are located in the provinces of northeastern China and Inner Mongolia. The economy of this area has grown rapidly over the last four to five years and we believe that the national government is committed to enhancing economic growth in the region. In December 2003, a major economic-development plan for northeastern China, the “Plan for Revitalizing Northeast China,” was announced by an office of the national government’s State Council.

 

Based on our own research, we believe there are approximately 200 to 300 small and medium-sized cities in northeast China without modern supermarket chains. We believe the number of supermarket customers and the demand for supermarkets in these cities are likely to grow significantly over the next several years as the region continues to experience urbanization.

 

Our Strategy for Growth and Profitability

 

Our strategic plan includes the following principal components:  expanding by opening stores in new strategic locations, and improving profitability by decreasing the cost through resource purchase, setting up distribution centers and increasing the percentage of our sales attributable to private label merchandise, membership sales and buying card sales.

 

Expanded Operations

 

As of September 30, 2012, we operated 31 supermarkets, 16 hypermarkets, 4 department stores, and 2 distribution centers in Harbin and Shenyang. In 2012, we plan to open 2 hypermarkets, supermarkets and department stores having, in the aggregate, approximately 15,000 square meters of space. We closed 2 stores due to the expiration of the lease contract and 2 stores due to underperformance. We are also making improvements to our logistics and information systems to support our supermarkets. We expect to finance our expansion plan from funds generated from operations and bank loans. Based on our previous experience, we believe it takes nine to twelve months for a new store to achieve profitability.

 

Private Label Merchandise

 

Some of the merchandise we sell is made to our specifications by manufacturers using the QKL brand name.  We refer to such merchandise as “private label” merchandise.  With private label merchandise, we entrust the manufacturer to make the product and to select the name and design.  Under our agreements with the private label manufacturer, the private label manufacturers cannot sell the product to any other party. Sales of private label merchandise accounted for approximately 6.0% and 5.6% of our total revenues for the nine months ended September 30, 2012 and 2011, respectively. In June 2008, we established a specialized department for designing and purchasing private label merchandise, in which 7 full-time employees currently work. Our goal is to increase private label sales to 20% of our total revenues.

 

Principal Factors Affecting Our Results

 

The following factors have had, and we expect they will continue to have, a significant effect on our business, financial condition and results of operations.

 

Seasonality – Our business is subject to seasonality, with increased sales in the first quarter and fourth quarter, due to increases in shopping and consumer activity as a result of the holidays such as New Year (January 1), Chinese Lunar New Year (January or February), the Dragon Festival (February 2), Women’s Day (March 8), the Back to  School Day (March 1), National Day (October 1), Mid-Autumn Festival (September or October) and Christmas (December 25).

   

 

Timing of New Store Openings – Growth through new store openings is a fundamental part of our strategy. Our new stores typically operate at a loss for approximately three months due to start-up inventory and other costs, promotional discounts and other marketing costs and strategies associated with new store openings, rental expenses and costs related to hiring and training new employees.  Our operating results, and in particular our gross margin, have and will continue to vary based in part on the pace of our new store openings.

 

Locations for New Store – Good commercial space that meets our standards, in locations that meet our needs, may be scarce in some of the cities we wish to enter. One option for entering certain target markets within our intended timeframe may be to begin operations in a location that is not optimal and wait for an opportunity to move to a better location. Alternatively, we may seek to enter into a target market through acquisitions. As such, the timing and costs associated with entry into new markets can be difficult to predict.  Identifying and pursuing opportunities will be a resource-intensive challenge, and if we do not perform or if actual costs of entering new markets exceed our expectations, our total revenues, cash flows, and liquidity could suffer.

 

Logistics of Geographic Expansion –Opening additional stores in cities further from our headquarters in Daqing will mean that the transportation of our supplies and personnel among our stores will become more difficult and subject to disruption. To alleviate this, we have opened a new distribution center in Shenyang in November 2011. We started using our regional purchasing systems in 2008. All fresh food is ordered by individual stores based on their needs from local vendors designated by our headquarters or regional purchasing department and is delivered directly by the local vendors to individual stores. A portion of our non-perishable food and non-food items are distributed from our distribution center to our different stores, and the remaining portion is purchased by our regional purchasing department or headquarters and delivered directly to individual stores. Long-distance transportation for both food and non-food items from our distribution center to our stores can be challenging in the winter as the roads can be covered with snow. As we expand in territories further from our existing or planned distribution facilities, the costs of delivering food and merchandise may become less predictable and more volatile. 

 

Human Resources – In our experience, it takes approximately three months to train new employees to operate a new store. Training and supervision is organized by experienced teachers in our training school. The management team for a new store is hired first and is trained in our training school, where they learn our culture and operations. Employees are hired afterwards, and are trained by both our teachers and the management team. In addition, the management team and the employees are sent to existing stores to get practical training from the employees and management team members in those stores. Eventually, local employees must learn to perform the training and supervisory roles themselves. If we do not perform well in response to these challenges, our operating costs will rise and our margins will fall.

 

Shortages of Trained Staff in Our New Locations – Opening stores in locations with little or no competition from other large supermarkets is a major part of our strategy. However, there are disadvantages to this approach, which relate to human resources. Where competitors operate supermarkets nearby, their trained staff is a potential source for our own human resources needs, especially if we offer a superior compensation package. Cities that have no large supermarkets also have no sources of trained employees. Although we believe we have a good training school, from time to time we have to send experienced management team members from our headquarters or other stores to new stores to provide assistance. This increases our cost of operating and decreases our gross margin. 

  

 

Critical Accounting Estimates

 

As discussed in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, we consider our estimates on revenue recognition, vendor allowances, and inventory valuation to be the most critical in understanding the judgments that are involved in preparing our consolidated financial statements. There have been no significant changes to these estimates in the nine months ended September 30, 2012.

 

Recently Issued Accounting Guidance

 

See Note 2 to condensed consolidated financial statements included in Item 1, Financial Information, of this Quarterly Report on Form 10-Q.

 

Results of Operations

 

Three months ended September 30, 2012 compared with three months ended September 30, 2011.

 

The following table sets forth selected items from our condensed consolidated statements of income by dollar and as a percentage of our net sales for the periods indicated:

 

		(Unaudited) Three Months Ended September 30, 2012								(Unaudited) Three Months Ended September 30, 2011
		Amount				% of Net Sales				Amount				% of Net Sales
Net sales		$	84,343,510				100.0	%		$	82,068,788				100.0	%
Cost of sales			70,189,152				83.2				67,874,242				82.7
Gross profit			14,154,358				16.8				14,194,546				17.3
Selling expenses			13,330,045				15.8				13,040,763				15.9
General and administrative expenses			2,074,153				2.5				2,333,267				2.8
Operating loss			(1,249,840	)			1.5				(1,179,484	)			1.4
Interest income			111,903				0.1				175,745				0.2
Interest expense			(295,564	)			0.4				(10,593	)			0.0
Loss before income taxes			(1,433,501	)			1.7				(1,014,332	)			1.2
Income taxes			(326,094	)			0.4				(164,822	)			0.2
Net loss		$	(1,107,407	)			1.3	%		$	(849,510	)			1.0	%

 

Net Sales – Net sales increased by $2.2 million, or 2.8%, to $84.3 million for the three months ended September 30, 2012 from $82.1 million for the three months ended September 30, 2011. The change in net sales was primarily attributable to the following:

 

•

Same store sales represents sales from stores that were opened for at least one year before the beginning of the comparison period, or by July 1, 2011. Same store (47 stores) sales generated approximately $78.1 million sales in the third quarter of 2012, an increase of $2.7 million, or 3.6% compared with $75.4 million net sales in the third quarter of 2011.

 

 

•

New store sales increased, reflecting the net opening of 4 new stores since July 1, 2011. The new stores generated approximately $4.1 million sales in the third quarter of 2012.

 

•

The number of stores including supermarkets/hypermarkets and department stores at September 30, 2012 was 51 versus 53 at September 30, 2011.

 

Cost of Sales – Our cost of sales for the three months ended September 30, 2012 was approximately $70.2 million, representing an increase of $2.3 million, or 3.4%, from approximately $67.9 million for the same period in 2011. The increase was due to the increase in volume of sales. Our cost of sales primarily consists of the cost for our merchandise; it also includes costs related to packaging and shipping and the distribution center costs.

 

Gross Profit – Gross profit, or total revenue minus cost of sales, decreased by $0.04 million, or 0.3%, to $14.15 million, or 16.8% of net sales, in the third quarter of 2012 from $14.19 million, or 17.3% of net sales, in the third quarter of 2011. The decrease in gross margin was primarily attributable to the increase in competition in Daqing area.

 

We believe that our gross margin is likely to be between 16.8% and 17.3% over the next few business quarters. New stores tend to be less profitable during their early months of operation. In addition, China’s retail industry in general, and its supermarket industry in particular, are becoming more competitive every year. In this competitive marketplace, it is likely that we will focus on providing our customers with low prices in order to increase our market share and long-term sales volume.

 

Selling Expenses – Selling expenses increased by $0.3 million, or 2.2%, to $13.3 million, or 15.8% of net sales, in the third quarter of 2012 from $13.0 million, or 15.9% of net sales, in the third quarter of 2011. The change in selling expense was mainly due to increase in labor costs resulting from an increase in the number of store employees and pay increases.

 

General and Administrative Expense –General and administrative expenses decreased by $0.2 million, or 11.1%, to $2.1 million, or 2.5% of net sales, in the third quarter of 2012 from $2.3 million, or 2.8% of net sales, in the third quarter of 2011. The decrease was mainly due to our control on our headquarter’s expenses.

 

Income Taxes – The provision for income taxes was $(0.3) million for third quarter of 2012 compared with $(0.2) million for third quarter of 2011.

   

 

Net Income  – For the three months ended September 30, 2012, our net loss was $1.1 million, or $(0.105) per diluted share, compared to $0.8 million, or ($0.082) per diluted share, for the three months ended September 30, 2011. 

  

Nine months ended September 30, 2012 compared with nine months ended September 30, 2011

 

The following table sets forth selected items from our condensed consolidated statements of income by dollar and as a percentage of our net sales for the periods indicated:

 

		(Unaudited) Nine Months Ended September 30, 2012								(Unaudited) Nine Months Ended   September 30, 2011
		Amount				% of Net Sales				Amount				% of Net Sales
Net sales		$	279,603,670				100.0	%		$	266,833,256				100.0	%
Cost of sales			231,825,748				82.9				219,918,263				82.4
Gross profit			47,777,922				17.1				46,914,993				17.6
Selling expenses			40,878,831				14.6				38,327,459				14.4
General and administrative expenses			6,539,428				2.3				6,483,350				2.4
Operating income			359,663				0.1				2,104,184				0.8
Interest income			216,674				0.1				629,131				0.2
Interest expense			(691,212	)			0.2				(41,693	)			0.0
(Loss) income before income taxes			(114,875	)			0.0				2,691,621				1.0
Income taxes			152,320				0.1				986,869				0.4
Net (loss) income		$	(267,195	)			0.1	%		$	1,704,752				0.6	%

 

Net Sales – Net sales increased by $12.8 million, or 4.8%, to $279.6 million for the nine months ended September 30, 2012 from $266.8 million for the nine months ended September 30, 2011. The change in net sales was primarily attributable to the following:

 

•

Same store sales represents sales from stores that were opened for at least one year before the beginning of the comparison period, or by January 1, 2011. Same store (36 stores) sales generated approximately $224.7 million sales in the first nine months of 2012, an increase of $8.7 million, or 4.1% compared with $216.0 million net sales in the first nine months of 2011.

 

•

New store sales increased, reflecting the net opening of 15 new stores since January 1, 2011. The new stores generated approximately $42.4 million sales in the first nine months of 2012.

 

•

The number of stores including supermarket/hypermarket and department stores at September 30, 2012 was 51 versus 53 at September 30, 2011.

 

Cost of Sales – Our cost of sales for the nine months ended September 30, 2012 was approximately $231.8 million, representing an increase of $11.9 million, or 5.4%, from approximately $219.9 million for the same period in 2011. The increase was due to the increase in volume of sales. Our cost of sales primarily consists of the cost for our merchandise; it also includes costs related to packaging and shipping and the distribution center costs.

   

 

Gross Profit – Gross profit, or total revenue minus cost of sales, increased by $0.9 million, or 1.8%, to $47.8 million, or 17.1% of net sales, in the first nine months of 2012 from $46.9 million, or 17.6% of net sales, in the first nine months of 2011. The decrease in gross margin was primarily attributable to the increase in competition in Daqing area.

 

Selling Expenses – Selling expenses increased by $2.6 million, or 6.7%, to $40.9 million, or 14.6% of net sales, in the first nine months of 2012 from $38.3 million or 14.4% of net sales in the first nine months of 2011. The change in selling expense was mainly due to an increase in labor costs resulting from an increase in the number of store employees and pay increases.

 

General and Administrative Expense – General and administrative expenses increased by $0.06 million, or 0.9%, to $6.54 million, or 2.3% of net sales, in the first nine months of 2012 from $6.48 million, or 2.4% of net sales, in the first nine months of 2011. There was no material change in the expenses. .

 

Income Taxes – The provision for income taxes was $0.2 million for first nine months of 2012, compared with $1.0 million for first nine months of 2011. The decrease was primarily due to lower taxable income.

 

Net Income – Net loss for the first nine months of 2012 was $0.3 million, or $(0.025) per diluted share, from net income of $1.7 million, or $0.138 per diluted share, in the prior year period. This decrease was due to lower gross margin, higher selling expenses and higher staff costs in the first nine months of 2012. The number of shares used in the computation of diluted EPS decreased by 14.6% to 10.5 million shares from 12.3 million shares for the same period during 2011 because of the anti-dilutive effect of preferred stock in 2012.

  

Liquidity and Capital Resources

 

Our principal liquidity requirements are for working capital and capital expenditures. We fund our liquidity requirements primarily through cash on hand, cash flow from operations and borrowings from our revolving credit facility. We believe our cash on hand, future funds from operations and borrowings from our revolving credit facility will be sufficient to fund our cash requirements for at least the next twelve months. There is no assurance, however, that we will be able to generate sufficient cash flow or that we will be able to maintain our ability to borrow under our revolving credit facility.

  

 

At September 30, 2012, we had $27.4 million of cash compared to $28.0 million at September 30, 2011. The following table sets forth a summary of our cash flows for the periods indicated:

 

		(Unaudited) Nine Months Ended September 30,
		2012				2011
Net cash provided by operating activities		$	17,438,324			$	27,363,950
Net cash used in investing activities			(3,648,874	)			(20,617,003	)
Net cash provided by financing activities			4,744,515				3,074,081
Effect of foreign currency translation			(184,433	)			701,027
Net increase in cash		$	18,349,532			$	10,522,055

 

Seasonality

 

The seasonality of our business historically provides greater cash flow from operations during the holiday and winter selling season, with the fourth quarter net sales traditionally generating the strongest profits of each year. Typically, we use operating cash flow and borrowings under our revolving credit facility to fund inventory increases in anticipation of the holidays and our inventory levels are at their highest in the months leading up to Chinese Spring Festival. As holiday sales significantly reduce inventory levels, this reduction, combined with net income, historically provides us with strong cash flow from operations at the end of each year.

 

Operating Activities –Net cash provided by operating activities for the nine month ended September 30, 2012 and 2011 was $17.4 million and $27.4 million, respectively. The decrease in cash provided by operating activities for the nine month ended September 30, 2012 compared to the same period in 2011 primarily reflects net cash inflow caused by a decrease of inventories and other receivables. The decrease of inventories was caused by reducing the inventory after the peak Chinese New Year season. The decrease of other receivables is largely attributable to the recovery of money from vendors.

 

Investing Activities – Net cash used in investing activities for the first nine months of 2012 was $3.6 million and net cash used in investing activities for the first nine months of 2011 was $20.6 million. Capital expenditures represented substantially all of the net cash used in investing activities for each period. Capital expenditures were higher in the first nine months of 2011 due to substantially more new store openings. Our capital spending is primarily for new store openings and store-related remodeling.

 

Financing Activities – Net cash provided by financing activities for the first nine months of 2012 and 2011 were $4.7 million and $3.0 million, respectively which were generated from short-term bank loans.

 

Loan Facility – On July 6, 2011, QKL Chain entered into a working capital agreement with Longjiang Commercial Bank. Under this agreement, QKL Chain has a credit line up to approximately $7.7 million (RMB50.0 million). The term of any loan under the agreement is one year after the date the loan is issued, with the annual interest rate of 6.941%. The loan under this financing agreement is secured by buildings with appraisal value of approximately $11.9 million (RMB 77.0 million).

 

On July 6, 2011, Qinglongxin Commerce also entered into a working capital agreement with Longjiang Commercial Bank. Under this agreement, Qinglongxin Commerce has a credit line up to approximately $7.7 million (RMB50.0 million). The term of any loan under the agreement is one year after the date the loan is issued, with the annual interest rate of 6.941%. The loan under this financing agreement is guaranteed by QKL Chain. 

 

Future Capital Requirements – We had cash on hand of $27.4 million as of September 30, 2012. We expect capital expenditures for the remainder of 2012 primarily to fund the opening of new stores, store-related remodeling and relocation.

 

We believe we will be able to fund our cash requirements, for at least the next 12 months from cash on hand, operating cash flows and borrowings from our revolving credit facility. However, our ability to satisfy our cash requirements depends upon our future performance, which in turn is subject to general economic conditions and regional risks, and to financial, business and other factors affecting our operations, including factors beyond our control. There is no assurance that we will be able to generate sufficient cash flow or that we will be able to maintain our ability to borrow under our credit facility.

 

If we are unable to generate sufficient cash flow from operations to meet our obligations and commitments, we will be required to refinance or restructure our indebtedness or raise additional debt or equity capital. Additionally, we may be required to sell material assets or operations, suspend or further reduce dividend payments or delay or forego expansion opportunities. We might not be able to implement successful alternative strategies on satisfactory terms, if at all.

 

Off-Balance Sheet Arrangements and Contractual Obligations – Our material off-balance sheet arrangements are operating lease obligations. We excluded these items from the balance sheet in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Operating lease commitments consist principally of leases for our retail store facilities and distribution center. These leases frequently include options which permit us to extend the terms beyond the initial fixed lease term. With respect to most of those leases, we intend to renegotiate those leases as they expire.

 

In the ordinary course of business, we enter into arrangements with vendors to purchase merchandise in advance of expected delivery. Because most of these purchase orders do not contain any termination payments or other penalties if cancelled, they are not included as outstanding contractual obligations.

   

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1).

 

Item 4.  Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures –We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules13a15(e) and 15d15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this report. Based on such evaluation, our CEO and CFO have concluded that, as of September 30, 2012, our disclosure controls and procedures are not effective, at a reasonable assurance level, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are not effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

 

In particular, we did not maintain effective controls over the financial reporting process due to an insufficient complement of personnel with a level of accounting knowledge, experience and training in the application of U.S. GAAP commensurate with the Company’s financial requirements. Also, there is an insufficient quantity of dedicated resources and experienced personnel involved in the general controls over information technology on our new ERP system implementation. The lack of sufficient and adequately trained personnel resulted in ineffective top level review, which in turn may affect the timeliness of our periodic financial reporting.

 

The conclusion that our internal control over financial reporting was not effective was based on material weaknesses we identified in relation to our financial closing process.

 

Remediation Measures for Material Weaknesses – We have begun to take steps to remediate the material weaknesses described above in “Evaluation of Disclosure Controls and Procedures” and plan to implement the new measures described below in our ongoing efforts to address the internal control deficiencies described above. We plan to further develop policies and procedures governing the hiring and training of personnel to better ensure sufficient personnel with the requisite knowledge, experience and training in the application of U.S. GAAP commensurate with our financial reporting requirements. We plan to utilize qualified internal control consultants and supervisors to ensure that our staff has adequate professional knowledge and to monitor the need for additional or better qualified staff. In addition, we plan to utilize appropriate training programs on accounting principles and procedures to better ensure the adequacy of our accounting and finance personnel. We plan to continue to develop our corporate culture toward emphasizing the importance of internal controls and to ensure that all personnel involved in maintaining proper internal controls recognize the importance of strictly adhering to U.S. GAAP. We plan to continue to provide additional training to the Company’s internal audit staff on appropriate controls and procedures necessary to document and evaluate our internal control procedures.

 

Changes in Internal Control over Financial Reporting – During the fiscal quarter ended September 30, 2012, no changes occurred with respect to our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, internal controls over financial reporting.

  

 

PART II. OTHER INFORMATION

 

ITEM 1.  LEGAL PROCEEDINGS

 

None.

 

ITEM 1A.  RISK FACTORS

 

As a smaller reporting company, the Company is not required to make disclosures under this Item 1A.

 

ITEM 2:  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4.  MINE SAFETY DISCLOSURES

 

Not applicable.

 

ITEM 5.  OTHER INFORMATION

 

None.

 

ITEM 6:  EXHIBITS

 

(a) Exhibits

 

31.1 - Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

31.2 - Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

32.1 - Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

101 - The following financial statements from QKL Stores Inc.’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2012 formatted in XBRL (eXtensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets; (ii) the Condensed Consolidated Statements of Income; (iii) the Condensed Consolidated Statements of Cash Flows; and (iv) the Notes to Unaudited Condensed Consolidated Financial Statements, tagged in detail.

 

 

   

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) 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.

 

	QKL STORES INC.
Dated: November 14, 2012	By:	/s/ Zhuangyi Wang
		Zhuangyi Wang
		Chief Executive Officer
		(Principal Executive Officer)

 

	By:	/s/ Tsz-Kit Chan
		Tsz-Kit Chan
		Chief Financial Officer
		(Principal Financial and Accounting Officer)