Recon Technology, Ltd. — Form 10-Q summary
Business context and reporting period. The filing covers the quarter and six months ended December 31, 2014, the second quarter and first half of the company’s fiscal year ending June 30, 2015. The unaudited consolidated results include its Chinese variable interest entities (VIEs), which conduct its oilfield equipment, automation, software, and service businesses. Amounts below are in RMB unless noted.
Financial results and liquidity
| Metric | Three months ended Dec. 31, 2014 | Six months ended Dec. 31, 2014 |
|---|---|---|
| Revenue | 21.3 million, down 53.9% year over year | 25.6 million, down 55.6% |
| Gross profit / margin | 9.0 million / 42.1%, versus 35.7% | 9.6 million / 37.4%, versus 37.8% |
| Operating income (loss) | 2.4 million, versus 7.9 million income | (2.1) million, versus 8.4 million income |
| Net income | 5.8 million, down 12.5% | 1.6 million, down 76.4% |
| Net income attributable to Recon | 5.3 million, down 8.4% | 1.2 million, down 80.1% |
| Cash from operations | Not separately reported in the supplied filing text | (15.4) million, versus (6.8) million |
Quarterly operating results were supported by 4.1 million of interest and other income, primarily the non-cash gain from a reduction in the fair value of warrant liabilities. For the six months, the corresponding income was 4.3 million. Adjusted EBITDA was 1.2 million for the six months, down from 11.2 million; adjusted net income attributable to Recon was a loss of 0.6 million. These are non-GAAP measures.
At December 31, cash was 4.9 million; current assets were 136.1 million and current liabilities 49.0 million, yielding reported working capital of 87.1 million. Total assets were 156.1 million and shareholders’ equity 98.4 million. Debt included 8.0 million in short-term bank loans and 9.6 million in short-term related-party borrowings. Management said working capital should support routine operations for the next twelve months without extraordinary expansion.
Material changes and management commentary
- Revenue fell substantially as lower oil prices and reduced capital spending by major customers CNPC and SINOPEC slowed or cancelled projects and delayed completion and acceptance. Hardware sales, especially furnaces, and software revenue declined; service revenue remained very small.
- For the six-month period, cost of revenue fell roughly in line with revenue, leaving gross margin slightly lower. Operating expenses declined 13.1%, but general and administrative expense rose 20.7%, including higher consulting, salary, share-based compensation, and travel costs.
- Management expected finished-project volume to recover and revenue to increase during the remainder of fiscal 2015. It highlighted down-hole equipment development and overseas business development, and identified SCADA, gathering and transferring equipment, fracturing services, and down-hole tools as growth areas. This outlook is forward-looking and not quantified.
- Management cited oil prices, customer capital spending and procurement, seasonality, competition, collections, and project acceptance as factors that could affect results. The company noted its second fiscal quarter is generally a high season for customer payments.
Risks, contingencies, and unusual items
- Customer concentration: In the six-month period, CNPC represented 56.79% of revenue and SINOPEC 8.89%. The business is therefore highly exposed to a small number of customers and their spending decisions.
- Cash conversion and receivables: Operating cash use was 15.4 million, primarily reflecting working-capital movements and inventory purchases. Net trade receivables from third parties were 50.4 million, with a further 14.5 million classified as long-term, including a customer balance scheduled for collection over four years beginning in 2016.
- Control weakness: Management concluded disclosure controls and procedures were ineffective at timely alerting it to information required in SEC filings. It described remediation steps; no material control changes during the quarter were reported apart from those initiatives.
- VIE and liquidity structure: The Cayman Islands holding company has no operations of its own and depends on distributions from Chinese operating entities. PRC rules restrict distributions, and VIE assets are not available to satisfy claims against the parent’s general assets. Most PRC bank balances were uninsured.
- Fair-value gain: The six-month results included a 4.1 million non-cash gain from revaluing warrants, contributing materially to reported net income despite an operating loss. The warrant liability was 0.9 million at period-end.
- Other items: The filing reported no legal proceedings. Estimated employee severance of approximately 1.5 million was not accrued because management considered payment remote. Office lease commitments were 1.3 million.
Subsequent developments
After quarter-end, the company borrowed 1.6 million from its COO; engaged Maxim Group in connection with a proposed registered offering of up to $10 million; and shareholders approved increasing authorized ordinary shares from 25 million to 100 million. The company also granted equity awards and, on February 13, 2015, agreed to exchange certain warrants for 204,938 ordinary shares. These developments may affect funding, dilution, and the warrant liability.
Investor facts to verify
- Whether customer project activity and accepted project completions recovered as management expected, and whether that translated into revenue and cash receipts.
- Collection timing and credit quality of the large receivable balances, particularly the long-term customer receivable and other receivables.
- Whether operating cash use and related-party borrowing needs continued after December 31, and the terms and availability of financing.
- The effect of the proposed offering, increased authorized share count, equity awards, and warrant exchange on dilution and capital needs.
- Progress and evidence of effectiveness for the disclosure-control remediation; also assess dependence on CNPC, SINOPEC, and the VIE structure.