| Comtech Group Inc ITEM 1A RISK FACTORS In addition to the other information in this Form 10-K, readers should carefully consider the following important factors |
| These factors, among others, in some cases have affected, and in the future could affect, our financial condition and results of operations and could cause our future results to differ materially from those expressed or implied in any forward-looking statements that appear in this on Form 10-K or that we have made or will make elsewhere |
| Risks Related to Our Business Our operating results fluctuate from quarter to quarter |
| Our quarterly revenue, income and other operating results have fluctuated in the past and may fluctuate significantly in the future due to a number of factors, including the following: • the ability of our suppliers to meet our supply requirements; • the cancellation of large orders; • competitive pressures; • the time required for research and development; • changing design requirements resulting from rapid technology shifts; and • industry trends impacting the overall market for our customers’ end-products |
| As a result of these and other factors, our results of operations may vary on a quarterly basis and net revenue may be adversely affected from period to period |
| Our results of operations for a particular quarter may not be indicative of our future performance |
| If our operating results in a quarter fall below our expectations or the expectations of market analysts or investors, the price of our common stock is likely to decrease |
| 8 ______________________________________________________________________ [37]Table of Contents Our operating results are substantially dependent on development of new customized module design solutions |
| We may be unable to develop new customized module design solutions in a timely or cost-efficient manner, and these new solutions may fail to meet the requirements of our customers’ end-markets |
| If we fail to develop new solutions that help our customers respond to competitive pressures, achieve shorter time-to-market or broaden and improve their product offerings, we will lose business and our results of operations will be materially and adversely affected |
| If our customers do not accept our proposed customized module design solutions or do not purchase from us the specified components contained in the proposed module reference design, our net revenue will be adversely affected |
| While approximately 50prca of our proposed customized module design solutions are accepted by our customers, there is no obligation for customers to accept our proposed solutions |
| We dedicate personnel, management and financial resources to research and development and technical support in developing new customized module design solutions for our customers |
| The time frames for most research and development projects typically range from two to 18 months |
| Because we do not charge a design fee for our services, but rather generate revenue through the resale of specified components contained in our proposed reference designs, if our customers do not accept our proposed designs, we will fail to capitalize on the invested resources, time and effort that we expended on a project |
| Furthermore, our customers typically make purchases on a purchase order basis |
| Prior to submission of a purchase order, our customers are not obligated to purchase from us any quantity of specific components that we propose to sell in our proposed module reference design |
| Our customers may cancel or defer their purchase orders on short notice without significant penalty |
| Even if a customer accepts our proposed module reference design, the customer could bypass us and contract with our competitors or possibly our suppliers directly for the purchase of the specific components we otherwise had proposed to sell |
| The failure to accept our proposed module reference design, the loss of ongoing business from our customers or the transition away from us in favor of direct purchases from our competitors or suppliers could each result in our failure to realize potentially significant net revenue |
| Reliance on our suppliers, with whom we often do not have long-term supply agreements, makes us vulnerable to the loss of one or more key suppliers or the delivery capabilities of our suppliers |
| We typically rely on a limited number of key suppliers, and many customized module design solutions that we develop are designed around technology components provided by our suppliers |
| We typically do not have long-term supply agreements or other forms of exclusive arrangements with our suppliers |
| In 2005, for example, Matsushita Electric Works, Ltd |
| and its affiliated entities, or Matsushita, and Broadcom Corp |
| accounted for approximately 36dtta8prca and 31dtta4prca, respectively, of our cost of revenue |
| Furthermore, although we deal with approximately ten different divisions within Matsushita, purchases of relays and connectors from Matsushita accounted for a substantial portion of our cost of revenue attributable to Matsushita |
| If we lose a key supplier or a supplier reduces the quantity of products it sells to us, does not maintain a sufficient inventory level of products required by us or is otherwise unable to meet our demand for its components, we may have to expend significant time, effort and other resources to locate a suitable alternative supplier and secure replacement components |
| For example, when a key supplier recently relocated its production facilities, interruption in its production capacity resulted in its inability to meet our quarterly supply requirements |
| If suitable replacement components are unavailable, we may be forced to redevelop certain of our solutions, which ultimately may not be accepted by our customers |
| Also, if our suppliers fail to introduce new products that keep up with new technologies, they may be surpassed by other suppliers entering the market with whom we may not have existing relationships |
| The costs and delays related to finding new suppliers or redeveloping solutions could significantly harm our business |
| 9 ______________________________________________________________________ [38]Table of Contents If we fail to attract and retain key personnel, particularly our chief executive officer, our business will be materially impaired and our financial condition and results of operations will suffer |
| Our business greatly relies on the continued services of Jeffrey Kang, our principal shareholder and chief executive officer |
| Many relationships with our key suppliers and key customers have been developed by and continue to be maintained by Mr |
| Our future success will depend to a significant degree upon the performance and contribution of Mr |
| Kang and other members of our senior management team in areas including sales, research and development, information technology and finance |
| Therefore, our business and results of operations may be materially and adversely affected if Mr |
| Kang or another member of our senior management team leaves us, which they may do at any time since, as with the exception of our chief financial officer, they do not have an employment or non-compete agreement with us |
| In addition, we will incur additional expenses to recruit and develop senior management members if one or more of our key employees is unwilling or unable to continue his or her employment with us |
| We do not maintain key man life insurance covering our senior management or any of our key employees |
| Our future success also depends on our ability to identify, attract, hire, train, retain and motivate highly-skilled personnel |
| If we cannot attract and retain the personnel we require at a reasonable cost, our cost of revenue will increase and the profitability of our business could be negatively affected |
| Our business is especially dependent on sales, marketing and research and development personnel |
| Competition in China for executive-level and skilled technical and sales and marketing personnel is strong, and recruiting, training, and retaining qualified key personnel are important factors affecting our ability to meet our growth objectives |
| Should key employees leave our company, we may lose both an important internal asset and net revenue from customer projects in which those employees were involved |
| Loss of key customers may adversely impact our net revenue |
| We generate the majority of our net revenue from a small number of key customers, and we anticipate that a small number of key customers will continue to account for a significant portion of our net revenue in the foreseeable future, particularly in the telecom equipment market |
| In 2005, our sales to Huawei, T&W and ZTE accounted for approximately 8dtta7prca, 8dtta3prca and 7dtta1prca, respectively, of our net revenue |
| Sales to our top 10 customers represented approximately 50dtta6prca of our net revenue in 2005 |
| Should we lose, receive reduced orders from, or experience any adverse change in our relationship with any of our key customers, we will suffer a substantial loss in net revenue |
| The end-markets in which we operate are highly competitive and fragmented |
| We expect competition to intensify in the future, and if we fail to compete effectively, our business will be harmed |
| Pressures from current or future competitors could cause our solutions to lose market acceptance or require us to significantly reduce our sales prices to keep and attract customers |
| Our competitors often have longer operating histories, stronger customer and supplier relationships, larger technical staffs and sales forces, and/or greater financial, technical and marketing resources than we do |
| Although we believe that there are no direct competitors of any meaningful size who operate using the same business model as ours, we face indirect competition from: • Other technology component suppliers |
| For each project, we work with one enabling technology component supplier to compete against other enabling technology component suppliers |
| Consequently, we indirectly compete against our suppliers’ competitors |
| For example, by working with JDS Uniphase, we compete against companies such as Avanex Corp |
| and Bookham Inc |
| in supplying optical transmission module design solutions |
| • Component manufacturers and distributors |
| We compete indirectly with component manufacturers such as Epcos AG, and component distributors such as Arrow Electronics, Inc, Avnet Inc |
| and Memec Inc, which may seek to expand their product/service offerings to include customized module design solutions |
| We may also face indirect competition from customers and suppliers |
| Currently many of our customers and suppliers do not focus on customized module design |
| If our customers or suppliers decide to devote more time and resources to in-house module design, the demand for our solutions may decline |
| In addition, our customers may change their procurement strategy or decide to rely on us primarily for component delivery and not for integration or design work |
| Similarly, component suppliers may also seek to offer their component products or modules incorporating key components from our solutions directly to our customers |
| The loss of customers for our customized module design solutions as a result of these competitive factors would have a material adverse effect on our business, financial condition and results of operations |
| 10 ______________________________________________________________________ [39]Table of Contents As we expand our business, we intend to develop new customized module design solutions and technological capabilities in end-markets where we do not currently have extensive experience or technological capability |
| Historically we have derived substantially all of our net revenue from our customized module design solutions provided to customers in the mobile handset and telecom equipment end-markets |
| We recently began targeting the digital consumer electronics and storage solution end-markets as well as developing a location based search application and providing technology and engineering services in which we have not had extensive experience or developed significant technological capability to date |
| In particular, we have not had any prior experience or technological capability in the storage solutions end-market |
| We also do not have any operating history for the location based search application nor the provision of technology and engineering services, although we are cooperating with the business strategic partners who have expertise in these businesses |
| Over time, we hope to develop our integrated circuit and application software design capabilities and provide solutions based on our own proprietary technology, primarily for Internet protocol television, or IPTV, set-top boxes and digital televisions, or DTV We also expect to internally establish a strong research and development team in our proposed location based search application and increase the number of employees providing technology and engineering services |
| Our success in the digital consumer electronics end-market will depend, in significant part, on our ability to develop the necessary technological capability and to leverage our existing customer base that has expanded into this end-market |
| We expect to incur significant research and development expenses, through hiring additional engineering personnel to develop new solutions and expanding our intellectual property capabilities |
| If we are unable to quickly develop technological expertise, increase our research and development capabilities and leverage our customer base as anticipated, our return on our investment with respect to these efforts may be lower than anticipated and our operating results may suffer |
| Moreover, market acceptance of our customers’ new digital consumer electronics products, such as IPTV set-top boxes and DTV, is unproven, and our new markets for digital consumer electronics and storage solutions may not develop as anticipated, or at all |
| Finally, our customer base may not respond to our efforts to expand our proprietary capabilities and may be unwilling to utilize these enhanced capabilities |
| We may be unable to manage rapid growth and a changing operating environment, which could adversely affect our ability to serve our customers and harm our business |
| We have experienced rapid growth over the last five years, with our net revenue increasing from RMB171dtta7 million in 2001 to RMB866dtta3 million (dlra107dtta3 million) in 2005 |
| Over the same period, our number of employees has also increased from approximately 30 to 200 |
| We have limited operational, administrative and financial resources, which may be inadequate to sustain our current growth rate |
| If we are unable to manage our growth effectively, the quality of our solutions could deteriorate and our business may suffer |
| As our customer base increases and we enter new end-markets, such as the digital consumer electronics end-market, or as we expand our technological capabilities to include integrated circuit and application software design, we will need to: • increase our investments in personnel, research and development capabilities, facilities and other operational areas; • continue training, motivating and retaining our existing employees, and attract and integrate new qualified employees; • develop and improve our operational, financial, accounting and other internal systems and controls; and • take enhanced measures to protect any proprietary technology or technological capability we develop |
| Any failure to manage our growth successfully could distract management’s attention and result in our failure to serve our customers and harm our business |
| 11 ______________________________________________________________________ [40]Table of Contents We may not have sufficient funds to pay our accounts payable when due, which could adversely affect our operations and net revenue |
| We experience a time lag in our accounts payable and accounts receivable cycles |
| Consequently, we may experience periods during which our cash from operations is insufficient to fund our working capital requirements |
| We have historically funded our working capital requirements through cash on hand, operating cash flows, as well as short-term credit facilities, factoring arrangements and loans from our principal shareholder and chief executive officer, Jeffrey Kang, and his affiliated companies |
| As we grow and our working capital requirements increase, these facilities may not be sufficient to meet our needs |
| We may be unable to maintain these liquidity sources or obtain additional liquidity sources on commercially reasonable terms to meet our increased funding requirements |
| For additional details regarding our working capital needs and arrangements, please see “Management’s discussion and analysis of financial condition and results of operations—Liquidity and Capital Resources |
| ” We generally cannot replace a supplier without the need to redevelop the modules that incorporate its components, and in doing so, we would incur significant expenses and consume additional development time |
| If we do not have sufficient working capital to pay our suppliers on a timely basis, we may be unable to grow our business, and our suppliers may reduce the quantity of components they supply or may no longer sell components to us, either of which would have a material adverse effect on our net revenue and results of operations |
| We face risks associated with future investments or acquisitions |
| An important component of our growth strategy is to invest in or acquire companies that possess complementary design capabilities and technologies |
| We may be unable to identify suitable investment or acquisition candidates or to make these investments or acquisitions on a commercially reasonable basis, if at all |
| If we complete an investment or acquisition, we may not realize the anticipated benefits from the transaction |
| Integrating an acquired company or technology is complex, distracting and time consuming, as well as a potentially expensive process |
| The successful integration of an acquisition would require us to: • integrate and retain key management, sales, research and development, and other personnel; • incorporate the acquired products or capabilities into our offerings both from an engineering and sales and marketing perspective; • coordinate research and development efforts; • integrate and support pre-existing supplier, distribution and customer relationships; and • consolidate duplicate facilities and functions and combine back office accounting, order processing and support functions The geographic distance between the companies, the complexity of the technologies and operations being integrated and the disparate corporate cultures being combined may increase the difficulties of combining an acquired company or technology |
| Acquired businesses are likely to have different standards, controls, contracts, procedures and policies, making it more difficult to implement and harmonize company-wide financial, accounting, billing, information and other systems |
| Management’s focus on integrating operations may distract attention from our day-to-day business and may disrupt key research and development, marketing or sales efforts |
| Our acquisition strategy also depends on our ability to obtain necessary government approvals that may be required, as described under “—Risks Related to Doing Business in China—Our acquisition strategy depends on government regulatory approvals in China |
| ” The unauthorized use of our module design solutions could have a material adverse impact on our net revenue |
| Our in-house design engineering teams develop our customized module design solutions |
| We typically do not have patent or other intellectual property protection for our solutions, nor do we typically have non-disclosure or confidentiality agreements with most of our suppliers or customers to keep our design specifications confidential |
| Suppliers or other competitors may attempt to circumvent us by selling products or providing module design solutions directly to our customers |
| 12 ______________________________________________________________________ [41]Table of Contents A component of our growth strategy is to begin to develop proprietary solutions in-house, specifically integrated circuits and application software design, and to make strategic investments in, form strategic alliances with or acquire, companies that possess complementary design capabilities and technology |
| Therefore, we expect that proprietary intellectual property will become increasingly important to our business |
| The unauthorized use by our suppliers or other competitors of our module design solution specifications or other intellectual property in the future would result in a substantial loss of our net revenue |
| The validity, enforceability and scope of protection of intellectual property in China is uncertain and still evolving, and PRC laws may not protect intellectual property rights to the same extent as the laws of some other jurisdictions, such as the United States |
| Moreover, litigation may be necessary in the future to enforce any intellectual property rights we may establish or acquire in the future, which could result in substantial costs and diversion of our resources, and have a material adverse effect on our business, financial condition and results of operations |
| We became a public company through a share exchange with a non-operating public shell company, where we were the accounting acquirer and assumed all known and unknown potential liabilities of our predecessor entity |
| Our July 2004 share exchange with Trident was accounted for as a reverse merger in which Comtech Cayman was deemed the accounting acquirer and Trident, which was originally incorporated in 1917, was the legal acquirer |
| We have retained all the known and unknown liabilities of Trident |