Business context and reporting period
Datasea Inc. filed this unaudited Form 10-Q for the quarter and six months ended December 31, 2016, its fiscal second quarter. Through subsidiaries and a variable interest entity in China, the company provides internet security products, new-media advertising, micro-marketing and data-analysis services. The company began selling products in 2016.
Its first reported revenue came from a Daqing City public-security procurement contract. The project was accepted in the quarter ended December 31, 2016; reported revenue excludes approximately $22,604 of value-added tax.
Financial results and liquidity
| Metric | Three months ended Dec. 31, 2016 | Six months ended Dec. 31, 2016 |
|---|---|---|
| Revenue | $132,964 | $132,964 |
| Cost of goods | $139,018 | $139,018 |
| Gross loss | $6,054 | $6,054 |
| Operating expenses | $217,916 | $487,810 |
| Operating loss | $223,970 | $493,864 |
| Net loss | $212,573 | $479,408 |
| Total comprehensive loss | $260,656 | $488,559 |
Gross margin was approximately negative 4.6%. The company reported no revenue in the comparable 2015 periods. Six-month basic and diluted loss per share was $0.01, versus $0.02 in 2015.
At December 31, 2016, cash was $325,144 and current assets were $419,128, against current liabilities of $211,708, for working capital of $207,420. Current liabilities included $104,288 due to the president under an interest-free, unsecured, payable-on-demand shareholder loan. Total assets were $503,408 and stockholders’ equity was $291,700.
Six-month operating cash use was $381,611; investing cash use was $8,540; and financing provided $713,028, primarily from common-stock sales, partly offset by payments to a related party. Cash increased by $313,342 to $325,144. The filing reports no cash paid for interest or income taxes. No material off-balance-sheet arrangements were reported.
Changes versus comparable periods
For the six months, net loss narrowed to $479,408 from $559,886, while operating expenses fell to $487,810 from $559,924. Management attributed lower general and administrative expense to reduced professional fees related to the 2015 reverse merger. Selling expense increased to $55,092 from zero, primarily because the company hired employees for the government contract. The new contract produced $132,964 of revenue but a $6,054 gross loss; management cited high raw-material costs on this first completed project.
Cash rose from $11,802 at June 30, 2016 to $325,144 at December 31, 2016, mainly reflecting equity financing. Accounts payable fell to $44,533 from $197,970, and the shareholder loan fell to $104,288 from $176,621.
Outlook, risks and unusual items
Management expects revenue during the fiscal year ending June 30, 2017 and believes demand for internet services in China offers growth opportunities. It was developing its “Safe Campus” program and expected to pursue sales contracts with schools in Anhui Province during fiscal Q4 2017. These are expectations, not reported orders or guaranteed results.
The filing states that the company needs additional funds for planned operations over the next 12 months and that substantial doubt exists about its ability to continue as a going concern. Management intends to seek debt or equity financing, but gives no assurance that funding will be available on acceptable terms. The company had an accumulated deficit of $1,806,998 and losses since inception.
For the completed government contract, the company estimated warranty costs of RMB 393,000 (approximately $58,227); coverage includes a five-year warranty on equipment and a lifetime warranty for software updates. The company also reported that its disclosure controls were ineffective, citing inadequate segregation of duties and risk assessment, insufficient U.S. GAAP expertise, and insufficient written accounting and reporting procedures. Planned remediation depends in part on obtaining additional financing.
On January 20, 2017, the company sold 205,500 shares for $279,450. It also reported a total of 462,500 shares sold in November 2016 and January 2017 private placements for proceeds of $638,250. The filing reports no pending legal proceedings. Risks identified include customer demand and order timing, product acceptance or installation delays, Chinese regulation, financing availability, suppliers, and China’s economic and political conditions.
Important facts for investors to verify
- Whether the company can obtain sufficient financing to address the stated going-concern uncertainty and fund operations.
- Whether the Daqing contract’s gross loss and estimated warranty costs are representative of future project economics.
- Whether the expected Safe Campus school contracts were secured and generated revenue.
- The share counts, proceeds and potential dilution from the private placements, including the January 2017 issuance.
- A cash-flow discussion inconsistency: MD&A refers to a six-month net loss of $497,408, while the financial statements report $479,408.
- Progress in remediating the disclosed material weaknesses in financial reporting controls.