ZW Data Action Technologies Inc.: Form 10-Q for the period ended Mar 31, 2015

Forward-Looking Statements

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this interim report. Our consolidated financial statements have been prepared in accordance with U.S. GAAP. The following discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words “expect,” “anticipate,” “intend,” “believe,” or similar language. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our business and financial performance are subject to substantial risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information set forth under the heading “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014. Readers are cautioned not to place undue reliance on these forward-looking statements.

Overview

We were incorporated in the State of Texas in April 2006 and re-domiciled to become a Nevada corporation in October 2006. On June 26, 2009, we consummated a share exchange transaction with China Net Online Media Group Limited (the “Share Exchange”), a company organized under the laws of British Virgin Islands (“China Net BVI”). As a result of the Share Exchange, China Net BVI became a wholly owned subsidiary of us and we are now a holding company, which, through certain contractual arrangements with operating entities in the PRC, is engaged in providing advertising, marketing, brand management and online-to-offline (O2O) sales channel building services for SMEs and entrepreneurial management and networking services for entrepreneurs in the PRC.

Through our PRC operating subsidiary and VIEs, we primarily operate a one-stop services for our clients through our integrated service platforms, including multi-channel advertising and promotion platform, brand management and sales channel building platform and management tools platform. Our multi-channel advertising and promotion platform primarily consists of internet advertising and marketing portals, including www.28.com (http://www.28.com) (“28.com”), www.liansuo.com (http://www.liansuo.com) (“liansuo.com”) and www.sooe.cn (http://www.sooe.cn) (“sooe.cn”), ChinaNet TV as our TV production and advertising unit and the bank kiosk advertising unit. We provide varieties of marketing campaigns through this platform by the combination of the Internet, mobile, television, bank kiosks and printed-medias to maximize market exposure and effectiveness for our clients. Our band management and sales channel building platform consists of our brand consulting and management service and offline sales channel expansion service, which is to physically help small businesses to recruit dealers, wholesalers, partners or franchisees based on their business needs. Management tools platform consists of a mobile-based sales and administrative management tools specifically designed for small business in China to match their simplicity.

Basis of presentation, management estimates and critical accounting policies

Our unaudited condensed consolidated interim financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, as promulgated by the SEC, and include the accounts of our Company, and all of our subsidiaries and VIEs. We prepare financial statements in conformity with U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities on the date of the financial statements and the reported amounts of revenues and expenses during the financial reporting period. We continually evaluate these estimates and assumptions based on the most recently available information, our own historical experience and various other assumptions that we believe to be reasonable under the circumstances. Since the use of estimates is an integral component of the financial reporting process, actual results could differ from those estimates. Some of our accounting policies require higher degrees of judgment than others in their application. In order to understand the significant accounting policies that we adopted for the preparation of our condensed consolidated interim financial statements, you should refer to the information set forth in Note 3 “Summary of significant accounting policies” to our audited financial statements in our 2014 Form 10-K.

A. RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2015 AND 2014

The following table sets forth a summary, for the periods indicated, of our consolidated results of operations. Our historical results presented below are not necessarily indicative of the results that may be expected for any future period. All amounts, except number of shares and per share data, are presented in thousands of U.S. dollars.

(Unaudited)

(Unaudited)

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Revenue

The following tables set forth a breakdown of our total revenue, divided into six segments for the periods indicated, with inter-segment transactions eliminated:

(Amounts expressed in thousands of US dollars, except percentages)

Total Revenues: Our total revenues increased to US$5.85 million for the three months ended March 31, 2015 from US$5.18 million for the three months ended March 31, 2014, which represents a 13% increase. This increase was primarily due to the increase in revenues from search engine marketing service, which increase was partially offset by the decrease in revenues from internet adverting and TV adverting services during the period.

We derive the majority of our advertising service revenues from the sale of advertising space on our internet portals and from providing the related value-added technical support and services, internet marketing service and content management services to unrelated third parties and to certain related parties. Beginning in the second fiscal quarter of 2014, we elaborated an existing stream of internet marketing service by providing enhanced third-party search engine marketing (“SEM”) services to the SMEs as a strategic supplement to the internet advertising services provided to our clients. We also derive revenue from the sale of advertising time purchased from different provincial satellite TV stations. Our advertising and marketing services to related parties were provided in the ordinary course of business on the same terms as those provided to our unrelated clients. For the three months ended March 31, 2015 and 2014, our service revenue from related parties in the aggregate was less than 1.1% of the total revenue for each respective reporting period.

Our advertising service revenues are recorded net of any sales discounts. Sales discounts include volume discounts and other customary incentives offered to our small and medium-sized franchise and merchant clients, including providing them with additional advertising time for their advertisements if we have unused space available on our websites and represent the difference between our official list price and the amount we actually charge our clients. For advertising services, we typically sign service contracts with our small and medium-sized franchisor and other clients that require us to place the advertisements on our portal websites in specified locations on the sites and for agreed periods; and/or place the advertisements onto our purchased advertisement time during specific TV programs for agreed periods. We recognize revenues as the advertisement airs over the contractual term based on the schedule agreed upon with our clients. Revenue from SEM services is recognized on a monthly basis based on the direct cost consumed through search engines for providing such services with a premium. We recognize this revenue on a gross basic, as we believe that we act as the primary obligor of this transaction, which is considered the most important factor for a gross revenue recognition in accordance with ASC Topic 605, subtopic 45. We also sell effective sales lead information to our clients, which is recognized based on fixed price per sales lead when information is delivered and accepted by clients.

The tables below summarize the revenues, cost of sales, gross margin and net loss generated from each of our VIEs and subsidiaries for the three months ended March 31, 2015 and 2014, respectively, with inter-company transactions eliminated:

For the three months ended March 31, 2015:

For the three months ended March 31, 2015:

For the three months ended March 31, 2015:

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For the three months ended March 31, 2014:

For the three months ended March 31, 2014:

For the three months ended March 31, 2014:

Management considers revenues generated from internet advertising, SEM services and other related technical services as one aggregate business operation and relies upon the consolidated results of all the operations in this business unit to make decisions about allocating resources and evaluating performance.

• Internet advertising revenues for the three months ended March 31, 2015 decreased to approximately US$2.45 million compared to US$3.50 million for the same period in 2014, which was primarily due to a decrease in number of clients during the period compared to the same period of last year. The decrease in number of clients for the three months ended March 31, 2015 was primarily due to the fact that (1) we have placed persistent effort in integrating and upgrading our internet advertising and marketing services to our SME clients, and during the process, we have gradually eliminated some smaller clients with insufficient spending on our services and concentrated our resources on increasing our cooperation with larger SME clients who have better brand awareness. As a result, we successfully singed approximately 75 new clients during the period, and the number of larger customers served by liansuo.com, our premium advertising and marketing web portal continued to increase since it was established; and (2) we experienced intensified competition in the industry and clients’ hesitation on investing in advertising and marketing expenses due to the overall economic decline in China. In response to this situation, we increased our investment in brand building and new marketing service activities, and expanded our existing stream of internet marketing services by providing enhanced search engine marketing services to our clients, which as an important strategic supplement, will direct our clients to use our internet advertising and marketing services through various platforms, thereby increasing our recurring revenues and number of clients in the future. We have also launched Business Direct 3.0 service in cooperation with Baidu Direct Reach. Business Direct 3.0 is a technically marked-up service based on the Baidu Direct Reach mobile platform for traditional service enterprises, which is centered on mobile search, accounts, maps, personalized recommendations and other ways for customers to direct the online attentions to offline stores and create revenue for customers. We believe the launching of this service will help to increase our market penetration in the SME segment, and thereby increasing our recurring revenues in the future.
• Revenues generated from technical services offered by Rise King WFOE were US$0.10 million for the three months ended March 31, 2015 compared to US$0.08 million for the same period in 2014.
• Search engine marketing services was introduced to our clients from the second fiscal quarter of 2014. Revenue generated from search engine marketing services for the three months ended March 31, 2015 was approximately US$3.05 million. This enhanced third-party search engine marketing service is designed to help our clients select the most effective key words and to prioritize the ranking of the anticipated search engine results on selected key words in order to increase the sales lead conversion rate for our clients’ business promotion on both mobile and PC searches. Management believes this service will be an effective supplement to the internet advertising services provided to our clients, and will help increase the overall satisfaction on our services, thereby increasing recurring revenues and number of clients from online advertising and marketing in the future.
• Our TV advertising revenue decreased to US$0.06 million for the three months ended March 31, 2015 from US$1.18 million for the same period in 2014. The decrease in our TV advertising revenue for the three months ended March 31, 2015 compared to the same period of last year was primarily due to the adoption of a restriction notice to TV shopping infomercials broadcasted in provincial satellite television station, issued by the SARFT in October 2013, which further restricts the content, air time and duration of these infomercials, as a result, the demand of TV advertising service from our clients decreased accordingly. We will continue to monitor our clients’ needs of the TV advertising services, work with our clients to develop non-TV shopping infomercials programs and improve the profitability of this business segment in future periods.
• For the three months ended March 31, 2015 and 2014, we earned both approximately US$0.07 million of revenue from the bank kiosk business segment. The bank kiosk advertising business is not intended to expand at the moment as management’s primary focus is expanding our internet business. It was not a significant contributor to revenue for both the three months ended March 31, 2015 or 2014. Management currently maintains this business without any expansion plans and some of the technology used in this business unit will need to be fully integrated into the overall advertising and marketing platform.
• For the three months ended March 31, 2015, we generated approximately US$0.12 million service revenue from our brand management and sales channel building segment compared to US$0.35 million service revenue generated in the same period of 2014. The decrease in the revenue from this business segment was primarily due to the hesitation of our client’s investment in offline marketing expending due to the overall economic decline and uncertainty in China. Due to the slow recovery of economy and tightening of our clients advertising budget, we do not expect prompt recovery in this business segment in 2015. In order to improve the business performance in future periods, our brand management and sales channel building operating entity, Quanzhou Zhilang has launched a pilot project by cooperating with a real estate developer to initiate an O2O business zone near Huaqiao University in Quanzhou, Fujian Province, China, to help establish and grow new commercial occupants by using "Business Direct 3.0" solutions in connection with brand management and developing solution. Management anticipants the pilot project will demonstrate the power of a combining big date, mobile marketing with location based service and management services to efficiently create a healthy and sustainable business ecosystem for both business and consumers.

Cost of revenues

Our cost of revenue consisted of costs directly related to the offering of our advertising services, technical services, marketing services and brand management and sales channel building services. The following table sets forth our cost of revenues, divided into six segments, by amount and gross profit ratio for the periods indicated, with inter-segment transactions eliminated:

(Amounts expressed in thousands of US dollars, except percentages)

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Cost of revenues: Our total cost of revenues increased to US$4.95 million for the three months ended March 31, 2015 from US$3.82 million for the same period in 2014. This was primarily due to the increase in costs associated with our search engine marketing service, which was in line with the increase in the related revenues as discussed above. Our cost of revenues related to our advertising and marketing services primarily consists of internet resources purchased from key search engines and technical services providers related to lead generation, sponsored search, TV advertisement time costs purchased from TV stations and direct labor cost associated with providing services.

• For internet advertisement, cost associated with obtaining internet resources was the largest component of our cost of revenue, accounting for over 80% of our total internet advertisement cost of sales. We purchased these internet resources from other well-known search engines and portal websites in China, such as: Baidu, Qihu 360 and Sohu (Sogou). The purchase of these internet resources in large volumes allowed us to negotiate discounts with our suppliers. For the three months ended March 31, 2015 and 2014, our total cost of sales for internet advertising was US$1.80 million and US$2.54 million, respectively. The decrease in our internet advertising cost was in line with the decrease in our internet advertising revenue as discussed above. The gross margin for our internet advertising revenue was both 27% for the three months ended March 31, 2015 and 2014.
• Costs for search engine marketing services were direct internet resource costs consumed for search engine marketing services provided to clients as described above. We normally charge our clients service fees for this service as a certain percentage of the related direct cost consumed. Gross margin of this service for the three months ended March 31, 2015 was approximately 3%.
• TV advertisement time cost is the largest component of cost of revenue for TV advertisement revenue. We purchase TV advertisement time from TV stations in China and resell it to our TV advertisement clients. Our TV advertisement time cost was approximately US$0.11 million and US$1.1 million for the three months ended March 31, 2015 and 2014, respectively. The decrease in our total TV advertisement time cost was in line with the decrease in TV advertising revenue as discussed above. In response to the overall decrease in the demands of our TV advertising services, we strategically decreased our unit selling price to encourage our clients to continue use our TV advertising service. As a result, we incurred a gross loss in this business segment for the three months ended March 31, 2015. We will continue to monitor our clients’ needs of the TV advertising services and improve the profitability of this business segment in future periods.
• Cost recognized for brand management and sales channel building business segment primarily consisted of director labor cost for providing these services to our clients and other related direct cost.

Gross Profit

As a result of the foregoing, our gross profit was US$0.90 million for the three months ended March 31, 2015 compared to US$1.36 million for the same period in 2014. Our overall gross margin decreased to 15% for the three months ended March 31, 2015 compared with 26% for the same period in 2014. The decrease in gross profit and gross margin for the three months ended March 31, 2015 was primarily due to the increase in lower margin revenue from search engine marketing service, which accounted for approximately 52% of our total revenue for the three months ended March 31, 2015.

Operating Expenses and Net Loss

Our operating expenses consist of sales and marketing expenses, general and administrative expenses and research and development expenses. The following tables set forth our operating expenses, divided into their major categories by amount and as a percentage of our total revenues for the periods indicated.

(Amounts expressed in thousands of US dollars, except percentages)

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Operating Expenses: Our operating expenses increased to US$3.0 million for the three months ended March 31, 2015 from US$2.03 million for the same period of 2014.

• Sales and marketing expenses: Sales and marketing expenses increased to US$1.20 million for the three months ended March 31, 2015 from US$0.59 million for the same period of 2014. Our sales and marketing expenses primarily consist of advertising expenses for brand development that we pay to different media outlets for the promotion and marketing of our advertising web portals, other advertising and promotional expenses, website server hosting and broadband leasing expenses, staff salaries, staff benefits, performance bonuses, travelling expenses, communication expenses and other general office expenses of our sales department. For the three months ended March 31, 2015, the increase in our sales and marketing expenses was primarily due to the increase in our brand marketing expenses of approximately US$0.62 million, which we spent through key search engines to promote our brand, websites and services.
• General and administrative expenses: General and administrative expenses increased to US$1.30 million for the three months ended March 31, 2015 from US$0.99 million for the same period in 2014. Our general and administrative expenses primarily consist of salaries and benefits for management, accounting and administrative personnel, office rentals, depreciation of office equipment, professional service fees, maintenance, utilities and other office expenses. For the three months ended March 31, 2015, the change in our general and administrative expenses was primarily due to the following reasons: (1) the increase in general administrative expenses, such as: professional service expenses, travelling expenses and entertainment expenses of approximately US$0.14 million; (2) the decrease in allowances for doubtful accounts of approximately US$0.22 million; and (3) the increase in share-based compensation expense of approximately US$0.40 million, which was related to the restricted common stock awarded to the executive officers.
• Research and development expenses: Research and development expenses were US$0.49 million and US$0.45 million for the three months ended March 31, 2015 and 2014, respectively. Our research and development expenses primarily consist of salaries and benefits for the research and development staff, equipment depreciation expenses, and office utilities and supplies allocated to our research and development department.

Loss from operations: As a result of the foregoing, we incurred a loss from operations of approximately US$2.09 million and US$0.67 million for the three months ended March 31, 2015 and 2014, respectively.

Interest income: For the three months ended March 31, 2015 and 2014, interests income we earned was primarily contributed from the approximately US$3.5 million of term deposit we placed in one of the major financial institutions in the PRC.

Interest expense: For the three months ended March 31, 2015 and 2014, interests expenses we paid were primarily related to the approximately US$0.8 million of short-term bank loan we borrowed from a major financial institution in the PRC to supplement our short-term working capital needs.

Loss before income tax expense, equity method investments and noncontrolling interests: As a result of the foregoing, we incurred a loss before income tax expense, equity method investment and noncontrolling interest of approximately US$2.05 million and US$0.65 million for the three months ended March 31, 2015 and 2014, respectively.

Income Tax benefit/(expense): We recognized a net income tax benefit of approximately US$0.23 million and a net income tax expense of approximately US$0.05 million and for the three months ended March 31, 2015 and 2014, respectively. For the three months ended March 31, 2015 and 2014, current income tax expense was approximately US$nil and US$0.18 million, respectively. For the three months ended March 31, 2015, our income tax benefit was approximately US$0.23 million, of which approximately US$0.04 million was in relation to the amortization of the intangible assets identified in the acquisition transactions consummated in previous years and approximately US$0.19 million was in relation to the net operating loss incurred by our PRC operating VIEs for the period, which we consider likely to be able to utilized with respect to future earnings of the entities to which the operating losses relate. For the three months ended March 31, 2014, our income tax benefit was approximately US$0.13 million, of which approximately US$0.06 million was in relation to the amortization of the intangible assets identified in the acquisition transactions consummated in previous years and approximately US$0.07 million was in relation to the net operating loss incurred by our PRC operating VIEs for the period, which we consider likely to be able to utilized with respect to future earnings of the entities to which the operating losses relate.

Loss before equity method investments and noncontrolling interests: As a result of the foregoing, for the three months ended March 31, 2015 and 2014, our loss before equity method investments and noncontrolling interests was approximately US$1.82 million and US$0.70 million, respectively.

Share of income/(losses) in equity investment affiliates: For the three months ended March 31, 2015 and 2014, we beneficially own 23.18% and 25.5% equity interest in Shenzhen Mingshan and Zhao Shang Ke Hubei, respectively. Accordingly, for the three months ended March 31, 2015, we recognized our pro-rata share of income in Shenzhen Mingshan and Zhao Shang Ke Hubei of approximately US$0.001 million and US$nil, respectively. For the three months ended March 31, 2014, we recognized our pro-rata share of losses in Shenzhen Mingshan and Zhao Shang Ke Hubei of approximately US$0.002 million and US$0.013 million, respectively.

Net loss: As a result of the foregoing, our net loss incurred for the three months ended March 31, 2015 and 2014 was approximately US$1.82 million and US$0.71 million, respectively.

Loss attributable to noncontrolling interest: Beijing Chuang Fu Tian Xia was 51% owned by Business Opportunity Online upon incorporation. For the three months ended March 31, 2015 and 2014, the net loss allocated to the noncontrolling interests of Beijing Chuang Fu Tian Xia was approximately US$0.03 million and US$0.05 million, respectively.

Net loss attributable to ChinaNet Online Holdings, Inc.: Total net loss as adjusted by the net loss attributable to the noncontrolling interest shareholders as discussed above yields the net loss attributable to ChinaNet Online Holdings, Inc. Our net loss attributable to ChinaNet Online Holdigs, Inc. was approximately US$1.79 million and US$0.67 million for the three months ended March 31, 2015 and 2014, respectively.

B. LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents represent cash on hand and deposits held at call with banks. We consider all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents. As of March 31, 2015, we had cash and cash equivalents of approximately US$2.2 million. We also had approximately US$3.5 million of term deposit placed in one of the major financial institutions in China which will expire in September 2015.

Our liquidity needs include (i) net cash used in operating activities that consists of (a) cash required to fund the initial build-out and continued expansion of our network and (b) our working capital needs, which include deposits and advance payments to TV advertising slots and internet resource providers, payment of our operating expenses and financing of our accounts receivable; and (ii) net cash used in investing activities that consist of the payment for acquisitions to further expand our business and client base, investment in software technologies to enhance the functionality of the management tools provided by our advertising portals and our general network securities, and investment in other general office equipment. To date, we have financed our liquidity need primarily through proceeds from operating activities we generated in prior years. Our existing cash is adequate to fund operations for the next 12 months.

The following table provides detailed information about our net cash flow for the periods indicated:

Amounts in thousands of US dollars

Net cash used in operating activities

For the three months ended March 31, 2015, our net cash used in operating activities of approximately US$2.33 million were primarily attributable to:

(1) net loss of US$1.82 million, adjusted by excluding an approximately US$0.23 million net deferred income tax benefit, an US$0.90 million non-cash expenses of depreciation, amortization, and share-based compensation and an US$0.22 million of reversal of bad debts provisions, yielded the non-cash items excluded net loss of approximately US$1.37 million;

(2) the receipt of cash from operations from changes in operating assets and liabilities such as:

• other receivable decreased by approximately US$0.20 million, primarily due to the partial collection of the TV advertisement deposit and prepayment receivable related to a contract expired on December 31, 2014;
• advances from customers increased by approximately US$1.3 million; and
• other payable increased by approximately US$0.04 million.

(3) offset by the use from operations from changes in operating assets and liabilities such as:

• accounts receivable and due from related parties for the advertising services provided increased by approximately US$0.05 million;
• deposit and prepayment to suppliers increased by approximately US$2.2 million for the purchasing of internet resources and TV advertising slots; and
• aggregate of increase in other current assets and decrease in accounts payable and other current liabilities of approximately US$0.25 million.

For the three months ended March 31, 2014, our net cash used in operating activities of approximately US$1.35 million were primarily attributable to:

(1) net loss excluding an approximately US$0.13 million net deferred income tax benefit, a US$0.38 million and non-cash expenses of depreciation, amortizations, share-based compensation and our share of losses in equity investment affiliates of approximately US$0.46 million;

(2) the receipt of cash from operations from changes in operating assets and liabilities such as:

• accounts receivable and due from related parties for the advertising services provided decreased by approximately US$0.64 million;
• other receivable decreased by approximately US$0.15 million, primarily due to the partial collection of the marketing-related loan made for the production of the TV series “Xiao Zhan Feng Yun”;
• accounts payable increased by approximately US$0.17 million;
• advances from customers increased by approximately US$0.13 million;

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• other payable increased by approximately US$0.07 million; and
• taxes payable increased by approximately US$0.15 million.

(3) offset by the use from operations from changes in operating assets and liabilities such as:

• prepayment to suppliers increased by approximately US$2.09 million for the purchasing of internet resources and TV advertising slots; and
• aggregate of increase in other current assets and decease in other current liabilities of approximately US$0.11 million.

Net cash used in investing activities

For the three months ended March 31, 2015, our cash used in investing activities included the following transactions: (1) we paid approximately US$0.33 million to settle the remaining balance related to the purchasing of software technology, which transaction consummated in December 2014; and (2) we made investments of approximately US$0.18 million in the aggregate to our cost/equity method investees during the period. In the aggregate, these transactions resulted in a net cash outflow from investing activities of approximately US$0.51 million for the three months ended March 31, 2015.

For the three months ended March 31, 2014, our cash used in investing activities included the following transactions: (1) we spent approximately US$0.01 million for the purchasing of general office equipments; (2) we prepaid approximately US$0.85 million for the develop of software systems related to internet environment monitoring, network security and system optimization to enhance the overall safety and efficiency of our network system; and (3) we collected approximately US$0.25 million of short-term loan that we lent to an unrelated entity in fiscal 2013. In the aggregate, these transactions resulted in a net cash outflow from investing activities of approximately US$0.61 million for the three months ended March 31, 2014.

Net cash provided by financing activities

For the three months ended March 31, 2015, there was no cash generated from or spent for financing activities.

For the three months ended March 31, 2014, we borrowed approximately US$0.20 million from the noncontrolling interest of one of our VIEs to supplement the short-term working capital needs of this VIE.

Restricted Net Assets

As most of our operations are conducted through our PRC subsidiary and VIEs, our ability to pay dividends is primarily dependent on receiving distributions of funds from our PRC subsidiary and VIEs. Relevant PRC statutory laws and regulations permit payments of dividends by our PRC subsidiary and VIEs only out of their retained earnings, if any, as determined in accordance with PRC accounting standards and regulations and after it has met the PRC requirements for appropriation to statutory reserves. Paid in capital of the PRC subsidiary and VIEs included in our consolidated net assets are also not distributable for dividend purposes.

In accordance with the PRC regulations on Enterprises with Foreign Investment, a WFOE established in the PRC is required to provide certain statutory reserves, namely general reserve fund, the enterprise expansion fund and staff welfare and bonus fund which are appropriated from net profit as reported in the enterprise’s PRC statutory accounts. A WFOE is required to allocate at least 10% of its annual after-tax profit to the general reserve until such reserve has reached 50% of its registered capital based on the enterprise’s PRC statutory accounts. Appropriations to the enterprise expansion fund and staff welfare and bonus fund are at the discretion of the board of directors. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. Rise King WFOE is subject to the above mandated restrictions on distributable profits. Additionally, in accordance with the Company Law of the PRC, a domestic enterprise is required to provide a statutory common reserve of at least 10% of its annual after-tax profit until such reserve has reached 50% of its registered capital based on the enterprise’s PRC statutory accounts. A domestic enterprise is also required to provide for a discretionary surplus reserve, at the discretion of the board of directors. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends. All of our PRC VIEs are subject to the above mandated restrictions on distributable profits.

As a result of these PRC laws and regulations, our PRC subsidiary and VIEs are restricted in their ability to transfer a portion of their net assets to us. As of March 31, 2015 and December 31, 2014, net assets restricted in the aggregate, which includes paid-in capital and statutory reserve funds of our PRC subsidiary and VIEs that are included in our consolidated net assets, was both approximately US$7.3 million.

The current PRC Enterprise Income Tax (“EIT”) Law also imposed a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Rise King WFOE is invested by its immediate holding company in Hong Kong and will be entitled to the 5% preferential withholding tax rate upon distribution of the dividends to its immediate holding company.

The ability of our PRC subsidiaries to make dividends and other payments to us may also be restricted by changes in applicable foreign exchange and other laws and regulations.

Foreign currency exchange regulation in China is primarily governed by the following rules:

• Foreign Exchange Administration Rules (1996), as amended in August 2008, or the Exchange Rules;
• Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules.

Currently, under the Administration Rules, Renminbi is freely convertible for current account items, including the distribution of dividends, interest payments, trade and service related foreign exchange transactions, but not for capital account items, such as direct investments, loans, repatriation of investments and investments in securities outside of China, unless the prior approval of the State Administration of Foreign Exchange (the “SAFE”) is obtained and prior registration with the SAFE is made. Foreign-invested enterprises like Rise King WFOE that need foreign exchange for the distribution of profits to its shareholders may effect payment from their foreign exchange accounts or purchase and pay foreign exchange rates at the designated foreign exchange banks to their foreign shareholders by producing board resolutions for such profit distribution. Based on their needs, foreign-invested enterprises are permitted to open foreign exchange settlement accounts for current account receipts and payments of foreign exchange along with specialized accounts for capital account receipts and payments of foreign exchange at certain designated foreign exchange banks.

Although the current Exchange Rules allow the convertibility of Chinese Renminbi into foreign currency for current account items, conversion of Chinese Renminbi into foreign exchange for capital items, such as foreign direct investment, loans or securities, requires the approval of SAFE, which is under the authority of the People’s Bank of China. These approvals, however, do not guarantee the availability of foreign currency conversion. We cannot be sure that it will be able to obtain all required conversion approvals for our operations or the Chinese regulatory authorities will not impose greater restrictions on the convertibility of Chinese Renminbi in the future. Currently, most of our retained earnings are generated in Renminbi. Any future restrictions on currency exchanges may limit our ability to use retained earnings generated in Renminbi to make dividends or other payments in U.S. dollars or fund possible business activities outside China.

As of March 31, 2015 and December 31, 2014, there were approximately US$29.4 million and US$30.8 million retained earnings in the aggregate, respectively, which were generated by our PRC subsidiary and VIEs in Renminbi included in our consolidated net assets, aside from US$2.8 million statutory reserve funds as of March 31, 2015 and December 31, 2014, that may be affected by increased restrictions on currency exchanges in the future and accordingly may further limit our PRC subsidiary’s or VIEs’ ability to make dividends or other payments in U.S. dollars to us, in addition to the approximately US$7.3 million restricted net assets as of March 31, 2015 and December 31, 2014, as discussed above.

C. OFF-BALANCE SHEET ARRANGEMENTS

None.

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal accounting and financial officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the fiscal quarter ended March 31, 2015, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our principal executive officer and principal financial officer have concluded that during the period covered by this report, the Company’s disclosure controls and procedures were effective as of such date to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting that occurred during the first fiscal quarter of 2015 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.