Troops, Inc. annual report, Q4 FY2011

Business context and reporting period

This is SGOCO Group, Ltd.’s Form 20-F annual report for the fiscal year ended December 31, 2011—not a filing for Troops, Inc. or a standalone 2011 fourth quarter. The report was filed August 30, 2012 and uses U.S. GAAP. SGOCO designs, brands, markets and distributes LCD/LED monitors, TVs and application-specific displays, primarily in China.

In November 2011, SGOCO agreed to sell Honesty Group, its core manufacturing business, for $76 million and shift to a lighter-asset model. Honesty’s results are included through November 30, 2011; after the sale, it remained a supplier. The reported annual results therefore include a major change in the business perimeter and may not represent the ongoing business on a comparable basis.

Key financial metrics

At December 31, 2011, SGOCO reported $57.5 million of sale consideration receivable. The $76 million consideration was paid in installments and was fully received by May 31, 2012, partly in cash, goods and offsets against amounts owed. Operating cash flow was negative despite reported net income. No separate fourth-quarter revenue, earnings or cash-flow figures are clearly provided in the filing.

Material changes versus the prior comparable period

• Revenue rose 44.1%, but cost of goods sold rose 51.4%, compressing gross margin from 15.0% to 10.8%.
• Net income declined from $19.9 million to $16.6 million, reflecting margin pressure and the sale-related tax provision, despite higher operating income.
• The sale removed manufacturing assets, inventory and substantial debt from SGOCO’s consolidated balance sheet. SGOCO reported $0.2 million of unsecured, non-interest-bearing shareholder loans payable on demand at year-end.
• Cash from operations swung from a $1.5 million inflow to a $58.2 million outflow. Management reported faster receivables and inventory turnover, but the cash-flow statement shows significant working-capital uses, including supplier advances.
• SGOCO’s employee count fell from approximately 630 to 80 as the business shifted toward design, branding, marketing and distribution. Own-brand sales were 61.5% of revenue, down from 75.0% in 2010.

Outlook, risks, contingencies and unusual items

• Management intended to phase out lower-margin OEM sales over one to two years and emphasize its own brands, licensed TCL and Founder brands, and higher-margin application-specific products. The filing provides no quantified company-wide earnings or revenue guidance.
• Management projected the April 2012 exclusive TCL China distribution agreement would generate sales exceeding $80 million; this is a projection, not reported performance, and the agreement had no minimum purchase requirement.
• SGOCO continued to rely substantially on Honesty as a manufacturer after the sale, without long-term supplier contracts. The company identified risks relating to supplier dependence, product quality, customer concentration, price erosion and customer credit.
• The buyer assumed obligations for $8.75 million of remaining registered capital in Guanwei and approximately $14 million of remaining Guanke Technology Park investment commitments. SGOCO cautioned that authorities might still seek payment from it if the buyer failed to perform.
• Management concluded Honesty was not a variable interest entity at the reporting date. If that conclusion were overturned, SGOCO could be required to consolidate Honesty and its liabilities.
• Management reported ineffective internal control over financial reporting at December 31, 2011, citing insufficient qualified accounting personnel and inadequate review capacity. Remediation was underway, but success was not assured.
• Grant Thornton resigned in May 2012, citing concerns about internal-control matters that affected its willingness to be associated with management-prepared financial statements. Crowe Horwath audited the 2011 statements and issued an unqualified opinion; its report did not express an opinion on internal controls.
• NASDAQ halted trading in SGOCO ordinary shares on May 16, 2012; at the report date trading had not resumed, and continued listing was at risk due to late SEC filings. The company’s warrants were delisted from the OTC Bulletin Board and quoted on the Pink Sheets.
• The filing describes no material pending litigation and no outstanding off-balance-sheet guarantees or similar arrangements. The company did not expect to pay dividends in the foreseeable future.

Important facts investors should verify

1. Confirm the issuer and filing scope: this report is for SGOCO Group, Ltd., not Troops, Inc., and covers the full year ended December 31, 2011 rather than Q4 alone.
2. Reconcile the $76 million sale consideration: the year-end receivable, cash receipts, goods delivered and offsets, and full collection reported by May 31, 2012.
3. Assess the sustainability of post-sale revenue and margins, including ongoing reliance on Honesty as a supplier and the planned reduction in OEM sales.
4. Investigate the negative $58.2 million operating cash flow, especially the supplier-advance and other working-capital movements, and distinguish recurring cash generation from disposal-related effects.
5. Track remediation of the disclosed material weakness, the auditor transition and any developments affecting financial statement reliability or SEC/NASDAQ compliance.
6. Evaluate exposure to the buyer’s assumed capital and investment commitments, potential Honesty consolidation, and customer and supplier concentration.