Recon Technology, Ltd. — Form 10-Q Summary
Reporting period: Quarter ended March 31, 2014, the company’s fiscal third quarter, with year-to-date results for the nine months ended March 31, 2014. The filing is unaudited and reports primarily in RMB; U.S. dollar figures are approximate translations. Recon supplies equipment, automation systems, software, and services to China’s oil and gas industry through consolidated variable interest entities (VIEs).
Key financial results
| Metric | Three months ended March 31, 2014 | Nine months ended March 31, 2014 |
|---|---|---|
| Revenue | RMB 18.23 million (about $3.0 million), up 143.0% year over year | RMB 76.01 million (about $12.34 million), up 21.5% |
| Gross profit / margin | RMB 5.24 million; 28.8%, versus 55.4% | RMB 27.06 million; 35.6%, versus 33.0% |
| Operating income (loss) | Loss of RMB 0.57 million, versus loss of RMB 2.15 million | Income of RMB 7.83 million, versus RMB 1.19 million |
| Net income (loss) | Loss of RMB 1.81 million; loss attributable to ordinary shareholders was RMB 1.93 million | Income of RMB 4.98 million; income attributable to ordinary shareholders was RMB 3.93 million |
| Operating cash flow | Used RMB 15.28 million for the nine-month period, versus RMB 17.27 million provided in the prior-year period | |
| Cash and working capital | At March 31, cash was RMB 8.86 million (about $1.44 million); working capital was about RMB 94.9 million | |
| Debt | RMB 15.63 million in short-term bank loans and RMB 0.20 million in related-party short-term borrowings at March 31 |
Material changes versus comparable periods
- Quarterly revenue growth came mainly from non-related-party hardware sales, particularly automation products and furnaces. Hardware and software revenue from related parties fell sharply as Recon increasingly contracted directly with oilfield customers.
- Quarterly gross margin contracted materially because hardware made up more of sales and carried lower margins; the prior-year quarter included higher-margin software revenue. Despite higher quarterly revenue and improved operating results, the company’s net loss widened, principally reflecting a warrant-liability fair-value charge, lower subsidy income, and investment loss.
- For the nine-month period, revenue and gross profit rose, with hardware growth more than offsetting a steep decline in service revenue. The prior-year period included RMB 20.57 million of fracturing-service revenue; current-period service revenue was RMB 0.48 million. Gross margin improved as lower-margin fracturing services were a smaller share of sales.
- Receivables, inventories, and supplier advances increased. The company attributed negative operating cash flow mainly to working-capital investment, including higher receivables and inventory for projects in upcoming quarters.
Liquidity, financing, and other notable items
- Nine-month financing cash inflow was RMB 11.89 million, including RMB 12.13 million net proceeds from a November 2013 share offering and RMB 18.5 million of bank-loan proceeds, partly offset by repayments of bank and related-party borrowings.
- Current assets were RMB 148.59 million and current liabilities RMB 53.72 million at March 31, 2014. Net third-party and related-party receivables totaled about RMB 72.60 million; the related-party portion was RMB 16.79 million.
- The November 2013 offering issued 546,500 ordinary shares and warrants to purchase 218,600 shares. Warrants are recorded as a liability because their exercise price is denominated in U.S. dollars while the company’s functional currency is RMB. The quarter included a RMB 0.90 million fair-value charge; the warrant liability was RMB 5.99 million at March 31.
- Recon held a 24.4% interest in Avalon Oil and Gas and recorded an equity-method investment loss of RMB 0.87 million for the nine months. Avalon’s latest available results were used as an estimate for the reporting period.
Outlook, risks, and contingencies
- Management described plans to grow automation/SCADA, furnace and burner sales, fracturing services, and down-hole tools. It expected revenue from the new down-hole product line and anticipated continued fiscal 2014 fracturing growth, but provided no quantified revenue or earnings guidance.
- Management pursued potential overseas SCADA work connected with a second phase of construction in Turkmenistan expected in 2014; bidding had not yet commenced.
- Key exposures include oilfield customer spending and procurement timing, competitive pricing, macroeconomic and input-cost changes, project acceptance and collection timing, and customer and supplier concentration. CNPC and Sinopec together represented 44.32% of nine-month revenue in 2014; three suppliers accounted for 66.4% of purchases in the quarter.
- The company is a holding company dependent on distributions from PRC operating entities. Its VIE structure carries structural and legal risks; VIE assets are not available to satisfy claims against the parent’s general assets. Most PRC bank balances were uninsured.
- Management concluded disclosure controls and procedures were ineffective at timely alerting it to information required in SEC filings. It reported remedial documentation, review, testing, and training initiatives; the filing does not state that the controls had become effective.
- An estimated RMB 1.3 million of potential employee severance payments was not accrued because management considered payment remote. No legal proceedings were reported. Subsequent events included a proposed BHD registered-capital increase, option exercises, and an approved restricted-share issuance for advisory/finder services.
Important facts for investors to verify
- Whether the quarter’s lower gross margin and the nine-month operating cash outflow reverse as projects are delivered and receivables collected.
- Receivable aging, actual collections, and recoverability of related-party balances, loans to third parties, and supplier advances.
- Near-term loan maturities, refinancing needs, and the terms or guarantees supporting bank borrowings.
- Warrant valuation assumptions and potential dilution from outstanding warrants, options, restricted shares, and subsequent share issuances; the cover-page and balance-sheet share counts are not the same reporting date.
- Progress in correcting ineffective disclosure controls and the legal and operational implications of the VIE arrangements.
- Customer and supplier concentration, and whether management’s stated fiscal 2014 product and project expectations convert into accepted, collectible sales.