20-F 1 d20f.htm FORM 20-F Form 20-F
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 20-F

 


 

¨ REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR 12(g) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

OR

 

¨ SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 000-50631

 


TOM Online Inc.

(Exact Name of Registrant as Specified in Its Charter)

 


N/A

(Translation of Registrant’s Name Into English)

 

Cayman Islands
(Jurisdiction of Incorporation or Organization)

8th Floor, Tower W3, Oriental Plaza

No. 1 Dong Chang An Avenue

Beijing, China 100738

(Address of Principal Executive Offices)

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

       

Name of Each Exchange On Which Registered

Ordinary shares, par value HK0.01 per share*

American depositary shares, each representing 80 ordinary shares

    

The NASDAQ Stock Market LLC

(The NASDAQ Global Market)

Securities registered or to be registered pursuant to Section 12(g) of the Act:

None

(Title of class)

 

* Not for trading, but only in connection with the listing on The Nasdaq Stock Market, Inc. of American depositary shares, or ADSs, each representing 80 ordinary shares.

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:

None

(Title of Class)

 


Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

As of December 31, 2006, 4,259,654,528 ordinary shares, par value HK$0.01 per share, were issued and outstanding. Ordinary shares of the Company are listed on the Growth Enterprise Market of the Stock Exchange of Hong Kong Limited.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.    Yes  ¨    No  x

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer   ¨    Accelerated Filer   x    Non-Accelerated Filer  ¨

Indicate by check mark which financial statement item the registrant has elected to follow. Item 17  ¨    Item 18  x

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 



Table of Contents

TABLE OF CONTENTS

 

FORWARD-LOOKING STATEMENTS    ii

PART I

   1

Item 1. Identity of Directors, Senior Management and Advisers

   1

Item 2. Offer Statistics and Expected Timetable

   1

Item 3. Key Information

   1

Item 4. Information on the Company

   26

Item 4A. Unresolved Staff Comments

   26

Item 5. Operating and Financial Review and Prospects

   60

Item 6. Directors, Senior Management and Employees

   83

Item 7. Major Shareholders and Related Party Transactions

   90

Item 8. Financial Information

   102

Item 9. The Offer and Listing

   102

Item 10. Additional Information

   103

Item 11. Quantitative and Qualitative Disclosures About Market Risks

   109

Item 12. Description of Securities Other than Equity Securities

   109

PART II

   109

Item 13. Defaults, Dividend Arrearages and Delinquencies

   109

Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds

   109

Item 15. Controls and Procedures

   110

Item 16.

   111

Item 16A. Audit Committee Financial Expert

   111

Item 16B. Code of Ethics

   111

Item 16C. Principal Accountant Fees and Services

   111

Item 16D. Exemptions from the Listing Standards for Audit Committees

   112

Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers

   112

PART III

   112

Item 17. Financial Statements

   112

Item 18. Financial Statements

   112

Item 19. Exhibits

   112

 

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FORWARD-LOOKING STATEMENTS

This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements include, without limitation, statements that are not historical facts relating to:

 

   

our financial performance and business operations;

 

   

our ability to successfully execute our business strategies and plans;

 

   

our network expansion and capital expenditure plans;

 

   

the expected benefit and future prospects of our strategic alliances, joint ventures and acquisitions, and our ability to cooperate with our alliance and joint venture partners or integrate acquired businesses;

 

   

management estimations with respect to the growth rate of our total revenues, wireless Internet revenues and online advertising revenues;

 

   

the development of our latest product offerings;

 

   

the development of the regulatory environment; and

 

   

future growth in the telecommunications, Internet and wireless value-added industries in China and other places where we conduct business.

The words “forecast,” “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “seek,” “will,” “would” and similar expressions, as they relate to us, are intended to identify a number of these forward-looking statements.

These forward-looking statements are subject to risks, uncertainties and assumptions, some of which are beyond our control. In addition, these forward-looking statements reflect our current views with respect to future events and are not a guarantee of future performance. Actual results may differ materially from the information contained in the forward-looking statements as a result of a number of factors, including, without limitation, the risk factors set forth in “Item 3 — Key Information — Risk Factors” and the following:

 

   

any changes in our relationship with telecommunications operators in China;

 

   

the effect of competition on the demand for and the price of our services;

 

   

any changes in customer demand and usage preference for our products and services;

 

   

any changes in our contemplated privatization;

 

   

any changes in the regulatory policies of the Ministry of Information Industry, or MII, and other relevant government authorities relating to, among other matters, the granting and approval of licenses and the restrictions on Internet and wireless Internet content;

 

   

any changes in wireless value-added technology, telecommunications and related technology and applications based on such technology;

 

   

any changes in political, economic, legal and social conditions in China, India and other places where we conduct business operations, including the PRC government’s specific policies with respect to foreign investment and entry by foreign companies into the telecommunications market, economic growth, inflation, foreign exchange and the availability of credit; and

 

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changes in population growth and GDP growth and the impact of those changes on the demand for our services.

We do not intend to update or otherwise revise the forward-looking statements in this annual report, whether as a result of new information, future events or otherwise. Because of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this annual report might not occur in the way we expect, or at all. Accordingly, you should not place undue reliance on any forward-looking information.

 

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PART I

 

Item 1. Identity of Directors, Senior Management and Advisers

Not Applicable.

 

Item 2. Offer Statistics and Expected Timetable

Not Applicable.

 

Item 3. Key Information

Selected Financial Data

The following selected historical consolidated financial data should be read in conjunction with our audited historical consolidated financial statements, the notes thereto and “Item 5 — Operating and Financial Review and Prospects.” The selected historical consolidated statements of operations data for the years ended December 31, 2004, 2005 and 2006, and the selected historical consolidated balance sheet data as of December 31, 2005 and 2006 set forth below are derived from our audited historical consolidated financial statements included elsewhere in this annual report. The selected historical consolidated statement of operations data for the years ended December 31, 2002 and 2003 and the selected historical consolidated balance sheet data as of December 31, 2002, 2003 and 2004 set forth below are derived from our audited historical consolidated financial statements that are not included in this annual report.

Our historical consolidated financial data reflects the effects of our reorganization from September 26, 2003 and of our acquisitions of Puccini International Limited, or Puccini, Treasure Base Investments Limited, or Treasure Base, Whole Win Investments Limited, or Whole Win, Indiagames Limited, or Indiagames, Beijing Huan Jian Shu Meng Network Technology Limited, or Huan Jian Shu Meng, and Gainfirst Asia Limited, or Gainfirst, from November 19, 2003, August 11, 2004, November 19, 2004, February 24, 2005, January 4, 2006 and June 1, 2006, respectively. Our board of directors decided on December 29, 2006 to sell substantially all our equity interest in Indiagames and initiated actions to locate a buyer. Accordingly, results of Indiagames were separately presented as “Discontinued Operations” in the consolidated statements of operations for the years ended December 31, 2005 and 2006 and the assets and liabilities of Indiagames were classified as “held for sale” of the consolidated balance sheet as of December 31, 2006. The consolidated statements of operations for the year ended December 31, 2005 have been restated accordingly. Our audited historical consolidated financial statements have been prepared and presented in accordance with U.S. GAAP. For a description of our reorganization, see “Item 4 — Information on the Company.”

 

     For the year ended December 31,  
     2002     2003     2004     2005
(restated(1))
    2006  
     (in thousands of U.S. dollars)  

Historical Consolidated Statements of Operations Data

  

Revenues:

          

Wireless Internet services(2)

   9,958     55,843     112,880     157,833     152,637  

Advertising(3)

   4,228     5,845     7,583     9,210     13,279  

Others(4)

   15,789     15,385     2,257     1,025     2,449  
                              

Total revenues

   29,975     77,073     122,720     168,068     168,365  
                              

Cost of revenues:

          

Cost of services

   (16,731 )   (32,794 )   (63,966 )   (96,900 )   (105,919 )

Cost of goods sold

   (8,143 )   (11,291 )   (791 )   —       —    
                              

Total cost of revenues

   (24,874 )   (44,085 )   (64,757 )   (96,900 )   (105,919 )
                              

Gross profit

   5,101     32,988     57,963     71,168     62,446  

 

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Operating expenses:

          

Selling and marketing expenses

   (3,069 )   (2,772 )   (7,695 )   (7,176 )   (6,974 )

General and administrative expenses

   (7,356 )   (9,133 )   (12,385 )   (21,144 )   (23,087 )

Product development expenses

   (692 )   (689 )   (886 )   (1,528 )   (1,617 )

Amortization of intangibles

   (88 )   (629 )   (5,614 )   (535 )   (1,045 )

Provision for impairment of goodwill and intangibles

   (2,215 )   —       (307 )   —       —    
                              

Total operating expenses

   (13,420 )   (13,223 )   (26,887 )   (30,383 )   (32,723 )
                              

Operating (loss)/profit

   (8,319 )   19,765     31,076     40,785     29,723  
                              

Other (expenses)/income:

          

Net interest (expenses)/income

   (408 )   (320 )   3,095     2,543     1,424  

Exchange gain

   —       —       —       1,132     2,382  

Gain on disposal of available-for-sale securities

   —       —       —       450     —    
                              

(Loss)/income from continuing operations before tax

   (8,727 )   19,445     34,171     44,910     33,529  

Income tax (expense)/credit

   (16 )   254     41     63     140  
                              

(Loss)/income from continuing operations after tax

   (8,743 )   19,699     34,212     44,973     33,669  

Minority interests

   389     (127 )   (304 )   34     35  
                              

(Loss)/income from continuing operations

   (8,354 )   19,572     33,908     45,007     33,704  

Loss from discontinued operations, net of income tax

   —       —       —       (1 )   (5,049 )
                              

Net (loss)/income attributable to shareholders

   (8,354 )   19,572     33,908     45,006     28,655  
                              

(Losses)/Earnings per ordinary share – basic (cents):

          

Continuing operations

   (0.30 )   0.70     0.94     1.10     0.79  

Discontinued operations

   —       —       —       —       (0.12 )
                              

Total (losses)/earnings per ordinary shares – basic

   (0.30 )   0.70     0.94     1.10     0.67  
                              

Earnings/(Losses) per ordinary share – diluted (cents):

          

Continuing operations

   N/A     N/A     0.85     1.07     0.79  

Discontinued operations

   N/A     N/A     —       —       (0.12 )
                              

Total earnings per ordinary shares – diluted

   N/A     N/A     0.85     1.07     0.67  
                              

(Losses)/Earnings per ADS – basic (cents):

          

Continuing operations

   (23.8 )   55.9     75.2     87.7     63.4  

Discontinued operations

   —       —       —       —       (9.5 )
                              

Total (losses)/earnings per ADS—basic

   (23.8 )   55.9     75.2     87.7     53.9  
                              

Earnings/(Losses) per ADS – diluted (cents)

          

Continuing operations

   N/A     N/A     68.4     85.4     63.0  

Discontinued operations

   N/A     N/A     —       —       (9.4 )
                              

Total earnings per ADS—diluted

   N/A     N/A     68.4     85.4     53.6  
                              

Weighted average number of ordinary shares (in thousands) – basic

   2,800,000     2,800,000     3,608,743     4,107,486     4,254,457  

Weighted average number of ordinary shares (in thousands) – diluted

   2,800,000     2,800,000     3,967,559     4,217,527     4,282,032  

Weighted average number of ADSs (in thousands) – basic

   35,000     35,000     45,109     51,344     53,181  

Weighted average number of ADSs (in thousands) – diluted

   35,000     35,000     49,594     52,719     53,525  

(1) Financial data for 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”
(2)

Includes revenue from our download products, information products and community-oriented products that we provide through the wireless Internet services platforms of China Mobile Communications Corporation, or China Mobile, and China United Telecommunications Corporation, or China Unicom. Revenues from the wireless Internet services of Beijing Lei Ting Wu Ji

 

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Network Technology Company Limited, or Wu Ji Network, Beijing LingXun Interactive Science Technology and Development Company Limited, or LingXun, Startone (Beijing) Information Technology Company Limited, or Startone, and Beijing Bo Xun Rong Tong Information Technology, or Beijing Infomax, are included beginning as of November 19, 2003, August 11, 2004, November 19, 2004 and June 1, 2006 respectively.

(3) In 2002 and 2003 only, includes offline advertising revenue that is bundled with online advertising revenue. Beginning in 2004, is comprised of online advertising only.
(4) For the years ended December 31, 2005 and 2006, primarily includes revenue from online games, e-commerce and fee-based e-mail services. For the years ended December 31, 2002, 2003 and 2004, primarily includes revenue from our commercial enterprise solutions business, including the computer hardware sales. For the years ended December 31, 2002 and 2003, also includes revenue from sales of internet access cards. We gradually phased out our commercial enterprise solutions business from 2003 to 2005.

 

     As of or for the year ended December 31,  
     2002     2003     2004     2005     2006  
     (in thousands of U.S. dollars, except percentages and operating data)  

Historical Consolidated Statements of Operations Data

  

Cash and cash equivalents

   6,752     22,636     79,320     99,869     110,993  

Short-term bank deposits

   —       —       —       1,863     25,613  

Other current assets

   12,310     32,182     33,100     42,748     43,270  

Restricted cash

   —       —       —       300     300  

Property and equipment, net

   5,518     7,094     11,927     15,346     15,360  

Available-for-sale securities

   —       —       116,471     38,519     —    

Restricted securities

   —       —       —       59,122     97,729  

Goodwill, net

   —       214     158,494     184,678     214,791  

Other assets

   994     5,250     3,789     3,562     5,543  
                              

Total assets

   25,574     67,376     403,101     446,007     513,599  
                              

Consideration payables

   —       6,580     133,613     16,615     12,037  

Other current liabilities

   8,498     26,251     34,608     41,101     61,479  

Long-term liabilities

   26,316     19,983     —       56,281     55,423  
                              

Total liabilities

   34,814     52,814     168,221     113,997     128,939  
                              

Minority interests

   224     152     456     2,900     3,202  

Total shareholders’ (deficit)/equity

   (9,464 )   14,410     234,424     329,110     381,458  
                              

Total liabilities, minority interests and shareholders’ (deficit)/equity

   25,574     67,376     403,101     446,007     513,599  
                              

Other Historical Consolidated Financial Data(1)

          

Continuing operations:

          

Gross profit margin

   17 %   43 %   47 %   42 %   37 %

Operating (loss)/profit margin

   (28 %)   26 %   25 %   24 %   18 %

Net (loss)/profit margin

   (28 %)   25 %   28 %   27 %   20 %

Depreciation

   1,865     3,016     4,544     6,909     8,436  

Amortization

   88     629     5,614     535     1,045  

Capital expenditure

   4,451     4,790     9,175     9,618     6,263  

Unaudited Operating Data

          

Registered users (millions)(2)

   10.1     27.4     137     173     298  

(1) Financial data for 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”

 

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(2) Approximate cumulative number of users of our wireless Internet data services that have registered with us since our launch of these services in July 2001, irrespective of activity level.

Exchange Rate Information

We present our historical consolidated financial statements in U.S. dollars. In addition, solely for the convenience of the reader, certain pricing information is presented in U.S. dollars and certain contractual amounts that are in Renminbi and Hong Kong dollars include a U.S. dollar equivalent. Except as otherwise specified, this pricing information and these contractual amounts are translated at RMB7.8041 = US$1.00 and HK$7.7771 = US$1.00, which were the noon buying rates in New York City for cable transfers as certified for customs purposes by the Federal Reserve Bank of New York on December 29, 2006. The translations are not a representation that the Renminbi amounts could actually be converted to U.S. dollars at this rate. For a discussion of the exchange rates used for the presentation of our financial statements, see note 5(t) to our financial statements.

The People’s Bank of China sets and publishes a base exchange rate each day. Up until July 21, 2005, the People’s Bank of China set this rate with reference primarily to the supply and demand of Renminbi against the U.S. dollar in the market during the prior day. Beginning on July 21, 2005, the People’s Bank of China has set this rate with reference primarily to the supply and demand of Renminbi against a basket of currencies in the market during the prior day. The People’s Bank of China also takes into account other factors such as the general conditions existing in the international foreign exchange markets. Although Chinese governmental policies were introduced in 1996 to reduce restrictions on the convertibility of Renminbi into foreign currency for current account items, conversion of Renminbi into foreign exchange for capital items, such as foreign direct investment, loans or security, requires the approval of the State Administration for Foreign Exchange, or SAFE, and other relevant authorities.

The following table sets forth for the periods indicated the noon buying rate for cable transfers in Renminbi or Hong Kong dollars, respectively, as certified for customs purposes by the Federal Reserve Bank of New York. On July 3, 2007, the noon buying rates in New York City for cable transfers as certified for customs purposes by the Federal Reserve Bank of New York were RMB7.5948 = US$1.00 and HK$7.8129 = US$1.00.

 

     Noon Buying Rate
     RMB per US$1.00    HK per US$1.00

Period

   High    Low    High    Low

January 2007

   7.8127    7.7705    7.8112    7.7797

February 2007

   7.7632    7.7410    7.8141    7.8041

March 2007

   7.7454    7.7232    7.8177    7.8093

April 2007

   7.7345    7.7090    7.8212    7.8095

May 2007

   7.7065    7.6463    7.8236    7.8044

June 2007

   7.6680    7.6120    7.8188    7.8062

July 2007 (through July 3, 2007)

   7.6055    7.5948    7.8165    7.8129

The following table sets forth the average noon buying rates between Renminbi and U.S. dollars and between Hong Kong dollars and U.S. dollars for each of 2002, 2003, 2004, 2005, 2006 and 2007 calculated by averaging the noon buying rates on the last day of each month during the relevant year.

 

     Average Noon Buying Rate

Period

   RMB per US$1.00    HK per US$1.00

2002

   8.2772    7.7996

2003

   8.2771    7.7864

2004

   8.2768    7.7899

2005

   8.1826    7.7755

2006

   7.9579    7.7685

2007 (through July 3, 2007)

   7.6861    7.8135

Capitalization and Indebtedness

Not applicable.

 

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Reasons for the Offer and Use of Proceeds

Not applicable.

Risk Factors

You should consider carefully all of the information in this annual report, including the risks and uncertainties described below. Our business, financial condition or results of operations could be materially adversely affected by any of these risks and the trading price of our ADSs or ordinary shares could decline due to any of these risks.

Risks Relating to Our Business

A substantial portion of our business depends on mobile telecommunications operators in China, and any loss or deterioration of our relationships may result in severe disruptions to our business operations and the loss of a significant portion of our revenues.

We derive a significant portion of our revenues from the provision of wireless Internet services. For the years ended December 31, 2004, 2005 and 2006 wireless Internet services revenue represented approximately 92.0%, 93.9% and 90.7%, respectively, of our total revenues. Because our current business plan is to further expand our wireless Internet services and our subscriber base, we expect to continue to rely on wireless Internet services to generate a significant portion of our revenues. We rely primarily on the networks and gateways of China Mobile and China Unicom to provide our wireless Internet services. Thus, we face certain risks in conducting our wireless Internet services business, such as the following:

 

   

China Mobile and China Unicom currently are the main mobile telecommunications operators in China that have platforms for wireless Internet services. Our agreements with them are generally for terms of twelve months or less and generally do not have automatic renewal provisions. If neither of them is willing to continue to cooperate with us, we will not be able to conduct our existing wireless Internet services business.

 

   

Our agreements with mobile telecommunications operators are subject to negotiation upon renewal. Some mobile telecommunications operators increased their share of revenues in the past. We cannot assure you that mobile telecommunications operators will not demand more changes to our revenue-sharing arrangements in the future. If any of the mobile telecommunications operators decides to change its content or transmission fees or its share of revenue, or does not comply with the terms of the agreements, our revenue and profitability could be materially adversely affected.

 

   

The mobile telecommunications operators have launched competing services, some of which are being provided on a complimentary basis, and they may launch additional competing services in the future. In addition, mobile telecommunications operators may discontinue entirely the use of external content aggregators such as ourselves at any time.

Due to our reliance on the mobile telecommunications operators for our wireless Internet services, any loss or deterioration of our relationship or any dispute or proceeding with any of the mobile telecommunications operators may result in severe disruptions to our business operations, the loss of a significant portion of our revenue and a material adverse effect on our financial condition and results of operations.

Our financial condition or results of operations may be materially affected by the changes in policies or guidelines of the mobile telecommunications operators.

The mobile telecommunications operators in China may, from time to time, issue operating policies or guidelines that request or state their preferences for specified actions to be taken by all wireless Internet service providers using their platforms. Because of our reliance on the mobile telecommunications operators, a significant change in their policies or guidelines may have a material effect on us. For example, in recent years some mobile telecommunications operators have:

 

   

extended the payment cycle to service providers from two months to three months;

 

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imposed stricter regulations over wireless Internet content and the quality of wireless Internet products and services; and

 

   

imposed various penalties on service providers in connection with their wireless Internet content and business practices.

For example, effective January 1, 2005, China Mobile changed its billing policy so that we can no longer collect revenue with respect to undeliverable multimedia messaging services, or MMS messages. Previously, MMS messages that were undeliverable because the recipient’s handset was turned off, out of the network service area or not equipped to handle MMS messages were forwarded to an Internet mailbox, and we were entitled to collect revenue in connection with the message. Following the adoption of this new policy, our MMS revenues decreased significantly, although they subsequently rebounded. In 2005, China Mobile also began canceling subscriptions of users who have not accessed their wireless Internet service subscriptions for a certain period of time or who fail to pay China Mobile or its provincial subsidiaries.

In July 2006, China Mobile began implementing new policies applicable to all wireless Internet service providers including:

 

   

a one-month free-trial period for all new short messaging service, or SMS, MMS and wireless application protocol, or WAP subscriptions;

 

   

a requirement that new subscribers to wireless Internet services shall confirm twice, in response to reminders from China Mobile, that they wish to start subscriptions;

 

   

sending a reminder to existing subscribers about their subscriptions and the fees they are being charged. Certain provincial subsidiaries of China Mobile including Guangdong Mobile, one of China Mobile’s largest subsidiaries, will not continue to charge existing subscribers unless they respond to such reminder notices by confirming their intent to subscribe; and

 

   

canceling WAP subscriptions that have been inactive for more than four months.

China Unicom also began requiring subscribers to wireless Internet services to double confirm their subscriptions during the quarter ended September 30, 2006. As a result of the 2006 policies, our SMS and WAP revenues decreased significantly during the second half of 2006 and first quarter of 2007. As of January 2007, China Mobile increased its share of the fees we generate by providing IVR services over its networks from 15% to 30%. In addition, in May 2007, China Mobile introduced a new practice of sending fee reminders to its WAP service users when they request downloads of WAP pages onto their mobile handsets and seeking their confirmations before such download requests are processed. We expect this new practice to have a significant adverse effect on our WAP business in particular and our wireless value-added service business as a whole.

These and other changes in policies or guidelines have resulted and may further result in lower revenues or additional operating costs for us. We cannot assure you that our financial condition and results of operations will not be materially adversely affected by any policy or guideline change by the mobile telecommunications operators in the future.

We may be subject to adverse actions for any breach or perceived breach by us of the policies or guidelines imposed by the mobile telecommunications operators with respect to content provided on or linked through our websites.

The mobile telecommunications operators in China may impose policies or guidelines to govern or restrict the content provided by all wireless Internet services providers, including content developed by us or content supplied by others to us. The mobile telecommunications operators from time to time have requested wireless Internet services providers, including us, to remove content deemed objectionable or links to or from websites with certain categories of content, including content they may deem to be sexually

 

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explicit. We aggregate and develop content that we consider attractive to our targeted user base, and we cannot assure you that the mobile telecommunications operators will not from time to time find portions of our content to be objectionable. In addition, the mobile telecommunications operators have in recent years enforced their policies with respect to content control, customer service and promotion activities more rigorously than in the past. In the third quarter of 2004, the relative contribution of our interactive voice response, or IVR services to our total revenue decreased from prior quarters because sanctions were imposed on the IVR businesses of certain wireless Internet services providers, and prudent operating practice required a reduction in the overall activity in IVR services with mobile telecommunications operators.

In the case of a breach or perceived breach of such policies or guidelines, the mobile telecommunications operators may require us to reduce or curtail the content on our Internet portal, which may reduce our portal traffic, and the mobile telecommunications operators may have the right to impose monetary fines upon us, or terminate our agreements with them. In addition, we would be liable to the mobile telecommunications operators for their economic losses pursuant to our agreements with these operators if we were found to be in breach of the policies or guidelines promulgated by them. For example, in late July 2005, China Unicom notified several major service providers, including our operating company, Beijing Lei Ting Wan Jun Network Technology Limited, or Beijing Lei Ting, that China Unicom was temporarily suspending the settlement of service fees because of complaints it received from mobile phone users relating to services rendered during the period from January 2005 to June 2005. According to the notice, China Unicom received complaints from users regarding Beijing Lei Ting’s provision of SMS services in possible breach of certain conditions of the agreement with the mobile operator with respect to service failure and inaccurate billing. In September 2005, as a result of China Unicom’s investigation, Beijing Lei Ting received two sanction notices from China Unicom together with a fine of US$209,000. We cannot assure you that we will not be subject to operator-imposed sanctions again in future, as a result of which our reputation, financial condition and results of operations may be materially adversely affected and, as a consequence, the market prices for our ordinary shares and ADSs may decline. See “— Risks Relating to Our Industry — Regulation and censorship of information distribution over the Internet in China may adversely affect our business, and we may be liable for information displayed on, retrieved from, or linked to our Internet portal.”

Our dependence on the substance and timing of the billing systems of the mobile telecommunications operators may require us to estimate portions of our reported revenue for wireless Internet services from time to time. As a result, subsequent adjustments may have to be made to our wireless Internet services revenue in our financial statements.

Because we do not bill our wireless Internet services users directly, we depend on the billing systems and records of the mobile telecommunications operators to record the volume of our wireless Internet services provided, charge our users through mobile telephone bills and collect payments from our users and pay us. In addition, we do not generally have the ability to independently verify or challenge the accuracy of the billing systems of the mobile telecommunications operators.

When we report our financial results from time to time, we typically have not received statements of account from all of the mobile telecommunications operators in respect of the period covered by our reports. In the event that a monthly statement for any operator has not been received at the time such financial results are reported, we will report wireless Internet services revenue based on our estimate of the collectible wireless Internet services relating to such operator. As a result, we may overstate or understate our wireless Internet services revenue for that reporting period. Any difference between the amount that is eventually received and our estimate of the collectible wireless Internet services for such operator may result in subsequent adjustments to our wireless Internet services revenue reported in our financial statements.

We have a limited operating history, which may make it difficult for you to evaluate our business.

Our operating history is limited and the revenue and income potential of our business and markets are unproven. We launched our Internet portal in China in July 2000 and began providing wireless Internet data services in the second half of 2001. Wu Ji Network, one of our PRC operating companies, was incorporated in July 2002 and entered into an agreement with China Mobile to provide wireless IVR services in October 2002. Gainfirst Asia Limited, which we acquired in 2006, is a relatively new company with limited operating track records. From time to time we may expand our business into new geographical regions or new lines of service

 

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in which we have no prior operating experience. For example, although we had no prior experience operating outside China, in February 2005, we acquired a majority of the issued share capital of Indiagames, a wireless game developer and publisher of mobile entertainment content based in India. Our board of directors decided in December 2006 to refocus on our core business in China and sell our equity interest in Indiagames. In September 2005, we established a joint venture with Skype Communications, S.A., or Skype, a company that provides voice over Internet protocol, or VoIP, services. The joint venture company will develop and distribute a simplified Chinese version of Skype’s peer-to-peer software in China. On February 1, 2007, we established a joint venture online and wireless Internet auction and marketplace company, TOM Eachnet PRC Holdings (BVI) Inc., in which we hold a 51% stake and eBay International AG, or eBay, holds a 49% stake. EBay has injected into the joint venture its subsidiary, eBay Eachnet Network Information Services (Shanghai) Co. Ltd., which operates an online auction and marketplace business in China. Prior to the establishment of such joint ventures, we had no operating experience in the business of distributing VoIP software or online auction and marketplace business. There can be no assurance that these joint ventures will generate significant revenue or be profitable at all.

In addition, prior to September 26, 2003, we did not operate as a separate, stand-alone entity, and we relied on our parent company for support in certain aspects of our operations. We face numerous risks, uncertainties, expenses and difficulties frequently encountered by companies at an early stage of development. Some of these risks and uncertainties relate to our ability to:

 

   

maintain our current, and develop new contractual arrangements upon which our business depends;

 

   

increase the number of our website page views of our target Internet user base by expanding the type, scope and technical sophistication of the content and services we offer and successfully convert these Internet users to fee-paying wireless Internet services users;

 

   

respond effectively to competitive pressures;

 

   

increase awareness of our brand and continue to build user loyalty;

 

   

attract and retain qualified management and employees;

 

   

successfully integrate our new acquisitions into our business operations and realize synergies from the resulting business combinations;

 

   

successfully address the business challenges and risks posed by the new geographical regions or new lines of business we enter into;

 

   

raise additional funds to meet the needs of our business growth; and

 

   

accurately assess the political, economic and social conditions in our markets.

We cannot predict whether we will meet internal or external expectations of our future performance. If we are not successful in addressing these risks and uncertainties, our business, financial condition and results of operations may be materially adversely affected.

Our historical financial information may not be representative of our future results of operations.

Our historical financial information for periods prior to September 26, 2003 may not reflect what our results of operations, financial condition and cash flow would have been if we had been a separate, stand-alone entity during those periods. In addition, our historical financial information may not be representative of what our results of operations, financial condition or cash flow will be in the future. This is because:

 

   

we have made certain adjustments, such as allocations of head office expenses and imputed interest, in preparing our historical financial information for periods prior to September 26, 2003 since we were not operated as a single, stand-alone entity for those periods; and

 

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we historically experienced rapid growth in our business in part due to the growth in China’s wireless Internet services industry, and such industry growth may not be indicative of future growth.

We first attained profitability in 2003, and our operating results may fluctuate significantly and may differ from market expectations.

We have attained profitability only since 2003. We recorded a net loss in each year prior to 2003, and we cannot assure you that our profitability will be sustained.

Our operating results have varied significantly in the past, and may vary significantly in the future, due to a number of factors, many of which are beyond our control. Our revenues are generally subject to consumer demand. For example, our revenue may increase when there is a surge in usage of wireless Internet services due to major promotional events sponsored by us or the mobile telecommunications operators. In addition, our revenue may also fluctuate due to our acquisition of additional businesses as well as changes in policies or guidelines implemented by the mobile telecommunications operators. See “— Our financial condition or results of operations may be materially affected by the changes in policies or guidelines of the mobile telecommunications operators.” As a result, we believe that year-to-year comparisons of our past operating results are not indicative of our future performance. In addition, our future operating results may not meet the expectations of financial analysts, investors and other market participants, and, as a consequence, the trading price of our ADSs or ordinary shares may decline.

We may be subject to, and may expend significant resources in defending against, claims based on the content and services we provide through our Internet portal.

Because of the manner in which we obtain, collect, produce and aggregate content for our Internet portal and wireless Internet services, and because our services and platforms may be used for the distribution of information and third-party content, claims may be filed against us for defamation, negligence, copyright or trademark infringement or other violations due to the nature and content of such information. In addition, we may be subject to claims relating to the online activities of our users. Furthermore, we offer web- based e-mail services, which may expose us to liability relating to unsolicited e-mail messages, lost or misdirected e-mail messages, illegal or fraudulent use of e-mail services or interruptions or delays in e-mail services. We may incur significant costs, and may be required to divert management and other resources from our business and operations, investigating and defending these types of claims even if they do not result in liability. We have not, however, purchased liability insurance for these types of claims.

PRC laws and regulations restrict foreign investment in China’s telecommunications services industry, and substantial uncertainties exist with respect to our contractual arrangements with our PRC operating companies due to uncertainties regarding the interpretation and application of current or future PRC laws and regulations.

In December 2001, in order to comply with China’s commitments with respect to its entry into the World Trade Organization, or WTO, the State Council promulgated the Administrative Rules for Foreign Investments in Telecommunications Enterprises, or the Telecom FIE Rules. The Telecom FIE Rules set forth detailed requirements with respect to capitalization, investor qualifications and application procedures in connection with the establishment of a foreign invested telecommunications enterprise. Pursuant to the Telecom FIE Rules, the ultimate ownership interest of a foreign investor in a foreign-funded telecommunications enterprise that provides Internet telecommunications services may not exceed 50%.

We and our subsidiaries are considered as foreign persons or foreign funded enterprises under PRC laws. PRC laws and regulations restrict foreign ownership of companies that provide Internet telecommunications services and Internet content services in China. As a result, we operate our wireless Internet services and online advertising businesses in China through Beijing Lei Ting, Shenzhen Freenet Information Technology Company Limited, or Shenzhen Freenet, Wu Ji Network, LingXun, Startone and Beijing

 

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Infomax, which are owned by certain PRC citizens. We do not have any equity interest in these PRC operating companies and instead enjoy the economic benefit in such companies through contractual arrangements. Our PRC operating companies conduct substantially all of our operations and generate substantially all of our revenue and hold the licenses and approvals that are essential to our business. For a description of our contractual arrangements with our PRC operating companies, see “Item 4 — Information on the Company” and “Item 7 — Major Shareholders and Related Party Transactions.”

In the opinion of our PRC legal counsel, Jun He Law Offices, the ownership structures of our PRC operating companies and our subsidiaries incorporated in China, and contractual agreements among, certain of our wholly owned subsidiaries and our PRC operating companies and their shareholders as described herein are in compliance with all existing PRC laws, rules and regulations and are enforceable in accordance with their terms and conditions, and subject to the applicable laws at the time of the enforcement, including, without limitation, that the enforcement of pledge of shares or assets will be subject to the relevant registration of such pledge, and that the enforcement of loan agreements will be subject to the foreign debt registration requirement. However, there are substantial uncertainties regarding the interpretation and implementation of current PRC laws and regulations, including without limitation, the Interim Provisions on the Takeover of Domestic Enterprises by Foreign Investors issued in August 2006 and the Circular on Strengthening the Administration of Foreign Investment in the Operation of Value-added Telecommunications Business issued by the Ministry of Information Industry, or MII, in July 2006. Accordingly, we cannot assure you that PRC regulatory authorities will not determine that our contractual arrangements among our wholly owned subsidiaries, our PRC operating companies and their shareholders, and the business operations of our PRC operating companies as described herein violate PRC laws or regulations.

If we or any of our PRC operating companies were found to be in violation of any existing or future PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such violation, including, without limitation, the following:

 

   

levying fines;

 

   

confiscating our income of that of our PRC operating companies;

 

   

revoking our business license or those of our PRC operating companies;

 

   

shutting down our servers or those of our PRC operating companies, or blocking our websites or those of our PRC operating companies;

 

   

requiring us or our PRC operating companies to restructure our ownership structure or operations; and/or

 

   

requiring us or our PRC operating companies to discontinue our wireless Internet services and online advertising businesses.

Any of these or similar actions could cause significant disruption to our business operations or render us unable to conduct a substantial portion of our business operations and may materially adversely affect our business, financial condition and results of operations.

Our contractual arrangements with our PRC operating companies may not be as effective in providing operational control as direct ownership of these businesses.

PRC laws and regulations currently restrict foreign ownership of companies that provide Internet telecommunications services, which includes wireless Internet services and Internet content services. As a result, we conduct substantially all of our operations and generate substantially all of our revenue through our PRC operating companies, Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone and Beijing Infomax, each of which is wholly owned by certain PRC citizens, pursuant to a series of contractual arrangements with these entities and their respective shareholders. These arrangements, however, may not be as effective in providing control over our Internet content operations as direct ownership of these businesses as these arrangements will not preserve our

 

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control in the occurrence of certain events which may be outside the control of the shareholders and us, including the imposition of statutory liens, judgments, court orders, death or incapacity. In particular, our PRC operating companies could fail to perform or make payments as required under those contractual agreements, and we will have to rely on the PRC legal system to enforce those agreements.

The PRC legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have little precedential value. Although legislation in China over the past 20 years has significantly improved the protection afforded to various forms of foreign investment and contractual arrangements in China, these laws, regulations and legal requirements are relatively new and their interpretation and enforcement involve uncertainties, which could limit the legal protection available to us. In addition, the PRC government may propose new laws or amend current laws that may be detrimental to our current contractual arrangements with our PRC operating companies, which may in turn have a material adverse effect on our business operations. Furthermore, because these entities, their shareholders and the assets of these entities and their shareholders are located in China, it may not be possible to effect services of processes within the United States or elsewhere outside of China upon these entities or assets or enforce judgments of courts in jurisdictions outside of China against these entities or assets. See also “— Risks Relating to the People’s Republic of China — You may experience difficulties in effecting service of legal process and enforcing judgments against us and our management.”

We face intense competition, which could reduce our market share, and materially adversely affect our financial condition and results of operations.

The markets for wireless Internet and Internet services and products, particularly Internet content services, Internet search and retrieval services and online advertising, are intensely competitive due to low barriers of entry and as a result, there are an increasing number of entrants to the PRC wireless Internet services.

We face intense competition from a number of companies that provide wireless Internet services and online advertising in China. Our primary competitors in wireless Internet services (including data and voice services) and online advertising services include, but are not limited to, Sina Corporation, Sohu.com Inc., Netease.com Inc., Linktone Ltd., Kongzhong Corporation, Tencent Technology Limited, Rock Mobile, Baidu, Beijing Longtech Company Limited, Beijing QTT Information Services Company Limited, and Hurray Solutions. In addition, we may face competition from new entrants in the wireless Internet services and Internet industries. Some of our major competitors have certain advantages over us, including better brand recognition among users, wider user base, a longer operating track record, access to more capital resources and strategic alliances with foreign partners that have extensive resources. With these advantages, our competitors may be better able to develop, market and sell their products and services, attract a larger number of new users as well as online advertisers and cooperation arrangements, and attract potential merger and acquisition targets. We cannot assure you that we will be able to compete successfully against our current or future competitors.

In addition to competition from other wireless Internet services providers, mobile telecommunications operators have begun offering services that compete with ours, some of which are being provided on a complimentary basis. We cannot assure you that mobile telecommunications operators will not offer additional competing services in the future. Increased competition from mobile communications operators could have an adverse effect on our results of operations and financial condition.

There are risks associated with our acquisitions, each of which may result in a material adverse effect on our operating or financial performance.

We have historically made and continue to pursue strategic acquisitions as part of our growth strategy. We regularly assess the opportunity to expand our business through mergers and acquisitions, joint ventures and strategic alliances and we intend to make further acquisitions in the future to enhance our product portfolio, proprietary content, distribution channels and technology. Our acquisitions may not contribute to our profitability, and we may be required to incur or assume debt or contingent liabilities as part of any acquisition. Our acquisitions could also result in potentially dilutive issuances of equity securities. We may have difficulty assimilating the personnel, technology and operations of the acquired companies, and these difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses. Moreover, the acquired businesses may not perform as

 

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well as we expect, and we may not capitalize on the synergies we expected from our acquisitions. If any of these happens, our revenue and profitability may not grow as we expect and this could also result in impairment related to goodwill or other intangible assets associated with the business acquired.

We are controlled by TOM Group Limited, who may not always act in your best interest and whose business may be in competition with ours.

TOM Group Limited (formerly TOM.COM LIMITED), or TOM Group, our parent company, owns an aggregate of approximately 65.7% equity interest in us as of March 31, 2007. Accordingly, TOM Group is able to:

 

   

indirectly influence the selection of our senior management;

 

   

determine the timing and amount of our dividend payments; and

 

   

otherwise control or influence actions that require the approval of our shareholders.

The interests of TOM Group as our controlling shareholder could conflict with our interests or with the interests of our minority shareholders. As a result, TOM Group may take actions that may not be in the best interests of us or our other shareholders.

In addition, TOM Group’s business may be in competition with ours. We have entered into a deed of non-competition with TOM Group. The terms of the deed of non-competition, however, do not prohibit TOM Group from engaging in limited online activities that may compete with our business. The deed of non-competition will also not preclude TOM Group from engaging in limited online services or activities that are ancillary to its outdoor media, publishing, sports as well as television and entertainment business, subject to certain revenue limits, or prevent TOM Group from undertaking any ISP business, television or broadcasting business, audio-visual business or investments in listed companies that engage in online activities (provided its interest does not exceed 5%) or any investment funds (provided that any such investment fund does not take a majority interest in any online business and that such online business shall not be operated by TOM Group). In addition, the deed of non-competition will terminate on the later of (i) when TOM Group ceases to hold 30% or more of our issued capital (ii) when our ordinary shares or ADSs are no longer listed on either Nasdaq or the Growth Exchange Market, or GEM, of the Stock Exchange of Hong Kong Limited, or the Hong Kong Stock Exchange, or (iii) February 27, 2006. We cannot assure you that such conflict of interests and any overlap of business activities and operations between TOM Group and us will not have a material adverse effect on our business operations, financial condition or results of operations.

Our directors and those of our parent, TOM Group, jointly announced on March 9, 2007 that TOM Group requested our board of directors to put forward a proposal for our privatization by way of a scheme of arrangement. See “— Related Party Transactions — Ongoing Related Party Transactions between Us or Our Subsidiaries and Our Parent Company or its Subsidiaries — Privatization.” If the privatization is consummated, we will be approximately 90.002% owned by TOM Group. We expect that such privatization, if consummated, would result in the withdrawal of listing of our ADSs from Nasdaq and that we would no longer be a reporting company under the U.S. Securities Exchange Act of 1934, as amended, or the Exchange Act.

We would face severe disruptions to our business operations, and our results of operations and financial condition would be materially adversely affected, if we lose the right to use or fail to reach a trademark license agreement with respect to the use of the tom.com trademarks on acceptable terms in the event that such trademarks are assigned back to Tom.com Enterprises Limited.

In order to comply with a recent MII notice regarding trademark ownership by Internet content provider license holders, the rights, titles and interests in and to the tom.com trademark have been assigned from Tom.com Enterprises Limited, a wholly owned subsidiary of our parent company, TOM Group, to Beijing Lei Ting, our wholly-owned subsidiary and one of our operating companies, by signing a deed of trademark and domain name assignment dated September 26, 2006. Under this deed, in the event that Beijing Lei Ting ceases to be a wholly owned subsidiary, directly or indirectly, of us or if we cease to be a subsidiary, directly or indirectly, of TOM Group, Tom.com

 

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Enterprises Limited shall have the right to require, by notice in writing to Beijing Lei Ting, the assignment back to Tom.com Enterprises Limited of all of Beijing Lei Ting’s rights, titles and interests in and to the tom.com trademark. Beijing Lei Ting undertakes that it will not sell, transfer, assign or otherwise dispose of all or any of its rights, titles and interests in and to all or any of the tom.com trademarks to any third party without the prior written consent of Tom.com Enterprises Limited. In the event that Beijing Lei Ting ceases to be a wholly owned subsidiary, directly or indirectly, of us or we cease to be a subsidiary of TOM Group, we will have to renegotiate with TOM Group or any such trademark holder on the license fee and terms of use for the tom.com trademark. We cannot assure you that the license fee and terms of use, if revised, will be commercially advantageous to us. In the event that we and TOM Group cannot agree on the trademark license fee or the terms of use, we will lose the benefit of the brand recognition of the tom.com trademarks we have developed and there can be no assurance that we will succeed in developing a new brand . As a result, we may face severe disruptions to our business operations, and our results of operations and financial condition may be materially adversely affected.

In addition, we believe that maintaining and further developing the quality associated with and awareness of the tom.com trademarks is critical to our ability to expand our user base and increase our revenue. Our success in promoting and enhancing the brand recognition of the tom.com trademarks, as well as our ability to remain competitive, will depend on our success in offering high quality content, features and functionality. If we fail to promote our brand successfully, or if users, advertisers or potential partners do not perceive our content and services to be of a high quality, we may not be able to continue to attract users, advertisers and business partners, which may have a material adverse effect on our business operations.

We may need additional capital and may not be able to obtain additional capital on acceptable terms.

Capital requirements are difficult to plan in our rapidly changing industry. We currently expect that we will need capital to fund the expansion of our Internet portal and computer infrastructure, including acquisitions of complementary assets, technologies or businesses, the expansion into new geographical markets, the expansion of our content and products as well as the expansion of our sales and marketing activities.

Our ability to obtain additional capital on acceptable terms is subject to a variety of uncertainties, including:

 

   

investors’ perceptions of, and demand for, securities of Internet companies;

 

   

conditions of the U.S., Hong Kong and other capital markets in which we may seek to raise funds;

 

   

our future results of operations, financial condition and cash flows;

 

   

PRC governmental regulation of foreign investment in Internet companies;

 

   

the regulatory and political environment in the United States that affects investment by U.S. investors in Chinese Internet companies;

 

   

economic, political and other conditions in China; and

 

   

PRC governmental policies relating to foreign currency borrowings.

Any failure by us to raise additional funds on terms favorable to us, or at all, may have a material adverse effect on our business, financial condition and results of operations. For example, we may not be able to carry out parts of our growth strategy to acquire assets, technologies and businesses that are complementary to our existing business or necessary to maintain our growth and competitiveness.

 

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As a stand-alone entity, we no longer receive from our parent company the same kind or degree of financial support as we did prior to becoming a stand-alone entity, and as of December 31, 2006, the amount due from us to our parent company was nil.

Prior to our initial public equity offering, we primarily financed our operations through capital contributions and advances from our parent company. Amount due from us to our parent company was approximately US$19,456,000, US$19,281,000 and nil as of December 31, 2004, 2005 and 2006, respectively. After the completion of our initial public equity offering, our parent company has not provided us with any additional capital contributions or advances, and it has advised us that it does not intend to do so in the future. Accordingly, we may need to seek other sources of financing to meet our funding needs.

We were not subject to any financial covenants under the terms of the borrowings from our parent company, but they were payable on demand. Our parent company had, however, agreed not to demand any repayment of these loans prior to December 31, 2006 unless (i) our ordinary shares had been listed on GEM for one year, (ii) in the most recent fiscal year we had positive cash flow from operations and net profit and (iii) each of our independent non-executive directors agreed that such repayment would not adversely affect our operations or the implementation of our business objectives. These loan arrangements were generally more favorable to us than what we believed that we could have received in the market as a stand-alone entity. We repaid all outstanding loan balances to our parent company in 2006. Our future financing terms may not be as favorable as the financial support we received from our parent company prior to our becoming a stand-alone entity.

The proposal by our parent, TOM Group, to privatize us has distracted our management and other resources from developing our business and may disrupt our relationships with our customers, suppliers, other strategic partners or employees, which could have a material adverse effect on our business and operations.

Our directors and those of our parent, TOM Group, jointly announced on March 9, 2007 that TOM Group requested our board of directors to put forward a proposal for our privatization by way of a scheme of arrangement, or Scheme, under Section 86 of the Companies Law of the Cayman Islands. If the Scheme is approved by our shareholders other than TOM Group, Cranwood Company Limited, Handel International Limited, Schumann International Limited and Devine Gem Management Limited, who are deemed related parties under the rules of the Hong Kong Stock Exchange, and becomes effective, we understand that TOM Group will cause us to apply to the Hong Kong Stock Exchange to withdraw the listing of our ordinary shares on GEM, and to Nasdaq to withdraw the listing of our ADSs, and will also cause us to file a Form 15F with the SEC to request that our reporting obligations under the Exchange Act be terminated or suspended because the effectiveness of the Scheme will cause the number of holders of our ordinary shares in the United States to fall below 300 or otherwise cause us to become eligible for de-registration.

The on-going privatization process has caused us to incur significant expenses and distracted our management and other resources from developing our business, as a result of which it may have an adverse effect on our business and results of operations, especially if further delays are encountered. In addition, in response to this announcement, our customers, suppliers or other strategic partners may terminate or cancel their existing relationships with us, or delay or defer decisions to enter into or to renew those arrangements, which could have a material adverse effect on our business and operations. In addition, our current and prospective employees may experience uncertainty about their future roles with us, which may adversely affect our ability to attract and retain key management, sales, marketing and technical personnel. Furthermore, on June 8, 2007, our shareholders voted to adjourn to a later date the meetings originally scheduled to be held on June 8, 2007 to vote on the Scheme so that the shareholders and ADS holders would have additional time to consider the Scheme. There is no assurance that the Scheme will not encounter further delays or that it will eventually be approved by our shareholders. See “Item 7 Major Shareholders and Related Party Transactions — Related Party Transactions — Ongoing Related Party Transactions between Us or Our Subsidiaries and Our Parent Company or its Subsidiaries — Privatization.”

 

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Litigation may arise in connection with the proposed privatization, which could negatively impact our business and our results of operations.

Litigation may be brought against, among others, us and our directors and officers alleging, among other claims, breaches of fiduciary duties relating to the proposed privatization. There can be no assurance as to the outcome of any such litigation (if it arises) or the impact on our business and results of operations. Any such litigation, with or without merit, could substantially divert the attention of management and resources in general. In addition, the cost of defending any such litigation, even if resolved favorably, could be substantial.

We depend on certain key executives and employees and our business may be disrupted if we lose the services of our key executives and employees.

Our future success is dependent upon the continued service of our key executives and employees. We rely on their expertise in our business operations and on their personal relationships with the regulatory authorities, our partners and our PRC operating companies. In particular, we rely heavily on Mr. Wang Lei Lei, our chief executive officer and executive director, for his management skills, technological expertise, experience in the Internet industry and working relationship with the relevant PRC regulatory authorities, our clients, suppliers and mobile telecommunications operators in China. If one or more of our key executives, in particular, Mr. Wang Lei Lei, becomes unable or unwilling to continue in their present positions, or if they join a competitor or form a competing company in contravention of their employment agreements, we may not be able to replace them easily, our business may be significantly disrupted and our financial condition and results of operations may be materially adversely affected.

The dividends and other distributions on equity we may receive from our subsidiaries or other payments we may receive from our PRC operating companies are subject to restrictions under PRC law or agreements that these entities may enter into with third parties.

We are a holding company. We own a number of subsidiaries that have entered into contractual arrangements with our PRC operating companies, Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone and Beijing Infomax, through which we conduct our wireless Internet and other business activities and receive substantially all of our revenues in the form of service fees. We rely on dividends and other distributions on equity paid by our subsidiaries and service fees from our PRC operating companies for our cash requirements in excess of any cash raised from investors and retained by us. If any of our subsidiaries incurs debt in the future, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us. In addition, PRC law requires that payment of dividends by our subsidiaries that are incorporated in China can only be made out of their net income, if any, determined in accordance with PRC accounting standards and regulations. Under PRC law, those subsidiaries are also required to set aside a portion of up to 10% of their after-tax net income each year to fund certain reserve funds until the aggregate balance of the common reserve has accounted for over 50% of such company’s registered capital, and these reserves are not distributable as dividends. Any limitation on the payment of dividends by our subsidiaries could materially adversely affect our ability to grow, make investments, make acquisitions, pay dividends, and otherwise fund and conduct our business.

In certain instances we have contracted with third parties to provide content for our wireless Internet services or our portal or have entered into exclusive relationships with third parties for distribution of our wireless Internet services, and our business may be adversely affected if these relationships are not renewed.

From time to time we make arrangements with third parties to provide content for our wireless Internet services or our portal or have exclusive relationships for the distribution of certain of our wireless Internet services. For instance, many of the SMS, MMS, WAP, IVR and color ring back tone, or CRBT, products that we offer through our wireless Internet service and certain of the content we exhibit on our portal are provided to us by third parties. Additionally, through LingXun, Treasure Base provides wireless services, including sports content, in exclusive cooperation with CCTV 5. We are also an exclusive partner of CCTV 2 in wireless Internet services through Beijing Infomax. Our content licensing arrangements with third parties generally have terms ranging from one to two years, and our distribution agreements with third parties generally have terms from one to three years. Any deterioration of our relationship with these third parties or failure to renew these arrangements or agreements may reduce the attractiveness of our wireless Internet services or our portal. As a result, our business, financial condition and results of operations may be adversely affected.

 

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Intellectual property is important to our business, and any unauthorized use of our intellectual property by third parties may adversely affect our business.

We regard the copyrights, service marks, trademarks, trade secrets and other intellectual property we use as important to our business, and any unauthorized use of such intellectual property by third parties may adversely affect our business and reputation. We rely on the protection of the intellectual property laws and contractual arrangements with our employees, clients, business partners and others to protect such intellectual property rights. Despite precautions taken by us, our parent company and its subsidiaries, third parties may still be able to obtain and use such intellectual property without authorization. Furthermore, the validity, enforceability and scope of protection of intellectual property in Internet-related industries in China is uncertain and still evolving, and these laws may not protect intellectual property rights to the same extent as the laws of some other jurisdictions, such as the United States and Hong Kong. Moreover, litigation may be necessary in the future to enforce our intellectual property rights, 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.

The discontinuation of any of the preferential tax treatments or the financial incentives currently available to us in the PRC could adversely affect our business, operating results and financial condition.

The PRC government has provided various incentives to our subsidiaries and variable interest entities that are incorporated in the PRC, such as Shenzhen Freenet, Beijing Lei Ting, Wu Ji Network, Beijing GreaTom United Technology Company Limited, or GreaTom, Beijing Super Channel Network Limited, or Beijing Super Channel, LingXun, Startone and Beijing Infomax due to the location of their registered offices inside special economic zones or special development zones, or due to their status as high technology enterprises. These subsidiaries and variable interest entities must continue to meet a number of criteria in order to continue to qualify for the preferential tax treatments or the financial incentives currently available to them. Moreover, the government could determine at any time to eliminate or reduce the scale of such preferential tax policies. For example, a newly enacted PRC tax law that will take effect on January 1, 2008, could increase the enterprise income tax rate applicable to these subsidiaries and variable interest entities. See “Item 5 — Operating and Financial Review and Prospects — Income Taxation — China.” Any increase in the enterprise income tax rate of these subsidiaries and variable interest entities or discontinuation or reduction of any of the preferential tax treatments or financial incentives currently enjoyed by these subsidiaries and variable interest entities could adversely affect our business, operating results and financial condition.

We may be subject to intellectual property infringement claims, which may force us to incur substantial legal expenses and, if determined adversely against us, materially disrupt our business.

We source some of our content from the public domain, including from third party websites for which copyrights may not be clearly identified, and we cannot be certain that our products and services do not or will not infringe upon valid patents, copyrights or other intellectual property rights held by third parties. We have, in the past, been subject to legal proceedings and claims relating to intellectual property, and we may in the future be subject to similar or other legal proceedings and claims relating to intellectual property in our ordinary course of business. We do not believe that our business operations have been materially adversely affected by the legal proceedings or claims in which we were previously involved. However, if we are found to have infringed the intellectual property rights of others in the future, we may be enjoined from using such intellectual property, and we may incur licensing fees or be forced to develop alternative intellectual property. We may also incur substantial expenses, or may be required to divert management or other resources from our business operations, in defending against third party infringement claims, regardless of their merit. Successful infringement claims against us may result in substantial monetary liability or severe disruptions to our business operations.

 

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Any future outbreak of SARS or any other epidemic in China may have a material adverse effect on our business operations, financial condition and results of operations.

From December 2002 to June 2003, China and certain other countries experienced an outbreak of a new and highly contagious form of atypical pneumonia now known as SARS. On July 5, 2003, the World Health Organization declared that SARS had been contained. However, following this declaration, a few new cases of SARS were reported in Asia. In addition, during 2005 and 2006 China reported cases of humans becoming infected with a strain of avian influenza or bird flu known as H5N1, which is often fatal to humans. While the outbreak of SARS may have increased the usage of the Internet, as well as the usage of our products and services, an outbreak of SARS or other contagious diseases such as meningitis, avian influenza or nipah virus in the future may disrupt our business operations and have a material adverse effect on our financial condition and results of operations. For instance, a new outbreak of SARS or any other contagious diseases may reduce the level of economic activity in affected areas, which may lead to a reduction in our advertising revenue if our clients cancel existing contracts or defer future advertising expenditures. In addition, health or other government regulations may require temporary closure of our offices, or the offices of our advertisers, content providers or partners, which will severely disrupt our business operations and have a material adverse effect on our financial condition and results of operations. We have not adopted any written preventative measures or contingency plans to deal with the consequences of any future outbreak of SARS, avian influenza or other disease.

We have limited operating experience outside China, and our results of operations could be adversely affected if our investments outside the PRC are not successful.

We have made investments outside the PRC although we have limited experience operating outside the PRC. We have limited knowledge of the local cultures, customs and habits in markets outside the PRC, and we will rely heavily on our foreign business partners to market and operate successfully. We may face intense competition in non-PRC markets and our operating costs could be higher than those of locally-owned companies. We may face other risks in connection with any non-PRC operations, including:

 

   

currency exchange fluctuations;

 

   

political and economic instability or social unrest;

 

   

trade, legal and other restrictions;

 

   

difficulties in profit repatriation;

 

   

longer payment cycles by clients;

 

   

a shortage of expertise and talent;

 

   

long-distance management difficulties; and

 

   

cultural difference and language barriers.

In February 2005, we acquired 76.29% of the issued share capital of Indiagames, a wireless game developer and publisher of mobile entertainment content based in India, an investment that was subsequently diluted to 62.42%. Following a management review of Indiagames and a desire to focus more exclusively on our core business activities in the PRC, our board of directors decided on December 29, 2006 to sell substantially all our equity interest in Indiagames and initiated actions to locate a buyer. Although a binding term sheet was signed with a potential buyer of Indiagames, a definitive agreement is still under negotiation and there is no assurance that we will be able to successfully sell such equity interest at a price that will enable us to make a profit on our investment, or at any price. Furthermore, we may make additional investments outside the PRC in the future, and our results of operations could be adversely affected if such investments are not successful.

 

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Our efforts to develop new lines of business that are untested in the PRC or to broaden our business into new media segments may not succeed or generate enough revenues to offset the costs that we incur in development or become profitable.

We have recently entered into a number of new lines of business. Since we have no prior operating experience in these businesses, we may lack the resources and expertise to address the challenges posed by these new businesses. In addition, these businesses are untested in the PRC and involve risks and uncertainties that are unfamiliar to us. For example, in late 2004, we entered into contractual arrangements with Skype to jointly provide instant messaging services in the PRC with the ability to conduct voice conversations over the Internet, or VoIP. In September 2005, we established a joint venture with Skype to develop and distribute a Chinese version of Skype’s peer-to-peer communication software, which includes VoIP functionality. The use of personal computers to conduct voice conversations over the Internet is new to the PRC market, and may not be widely accepted by consumers. In addition, it may not generate enough revenues to offset the costs we will incur as we develop the business or experience continued growth. The delivery of high-quality VoIP also depends upon users subscribing to broadband Internet access. If broadband Internet usage fails to become widespread in the PRC, our VoIP business is unlikely to generate significant revenues or be profitable. Furthermore, industry analysts have reported that subsidiaries of China Telecommunications Corporation, or China Telecom, a PRC provider of fixed-line telephone services, from time to time have blocked their subscribers from using Skype to make voice calls from one computer to another computer or to ordinary telephones. While our joint venture with Skype does not offer the capability of making voice calls from computers to ordinary telephones, it does offer computer-to-computer telephony. We cannot assure you that China Telecom or MII will not decide in the future to bar computer-to-computer telephony, which might prevent us from continuing to operate our Skype joint venture.

In September 2005 we entered into an agreement with Union Mobile Pay Ltd., or UMPay, the sole authorized mobile payment gateway on China Mobile’s platform, to jointly develop and market bank card, debit card and credit card-based mobile payment products and services in China. The use of such payment methods is relatively new to the PRC and there can be no assurance that our products and services will be accepted by Chinese consumers or generate enough revenues to offset the costs we incur as we develop the business.

In addition, since 2006, our management has adopted the strategy to broaden our business beyond our wireless Internet services into other new media segments. For example, on February 1, 2007, we established a joint venture online and wireless Internet auction and marketplace company, TOM Eachnet PRC Holdings (BVI) Inc., in which we hold a 51% stake and eBay holds a 49% stake. EBay has injected into the joint venture its subsidiary, eBay Eachnet Network Information Services (Shanghai) Co. Ltd., which operates an online auction and marketplace business in China. We expect to undertake significant business restructuring and additional capital investments to continue to broaden our business, which may not succeed or generate enough revenue to offset the costs that we have incurred and will incur in developing and implementing such strategies to broaden our business.

Failure to achieve and maintain effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business, our results of operations and the market price of our ADSs.

We are subject to reporting obligations under the U.S. securities laws. We are required by the U.S. Securities and Exchange Commission, or SEC, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act, to include a report by our management on our internal control over financial reporting in our Annual Reports on Form 20-F that contains an assessment by management of the effectiveness of our internal control over financial reporting. In addition, beginning with our Annual Report on Form 20-F for the fiscal year ending December 31, 2007, our independent auditor must attest to and report on management’s assessment of the effectiveness of our internal control over financial reporting.

Although our management has concluded that our internal control over our financial reporting was effective as of December 31, 2006, the end of the period covered by this annual report, we cannot assure you that our management will reach a similar conclusion at the end of future reporting periods. In addition, even if our management concludes at the end of future reporting periods that our internal control is effective, our independent auditor may disagree. If our independent auditor is not satisfied with our internal control over financial reporting or the level at which our internal control over financial reporting is documented, designed, operated or reviewed, or if the independent auditor interprets the requirements, rules or regulations differently from us, then it may issue an

 

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adverse opinion. Any of these possible outcomes could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our consolidated financial statements, which ultimately could have a material adverse effect on the market price of our ADSs. We also may need to incur significant costs and use significant management and other resources in an effort to comply with Section 404 of the Sarbanes-Oxley Act and other requirements.

Moreover, internal control over financial reporting may not prevent or detect misstatements because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud. Therefore, even effective internal control over financial reporting can provide only reasonable assurance with respect to the preparation and fair presentation of financial statements. If we fail to maintain the adequacy of our internal control over financial reporting, including any failure to implement required new or improved controls, or if we experience difficulties in their implementation, our business and operating results could be harmed, we could fail to meet our reporting obligations, and there could be a material adverse effect on the market price of our common shares.

Risks Relating to Our Industry

The Internet industry is highly regulated by the PRC government. If we fail to obtain or maintain all pertinent permits and approvals or if the government changes existing regulations or imposes new ones, our business operations may be materially adversely affected.

The Internet industry is highly regulated by the PRC government. Regulations issued or implemented by the State Council, the MII, and other relevant regulatory authorities regulate many aspects of the Internet industry, including the provision of value-added telecommunications services, foreign investment in the telecommunications industry, and the scope of permissible online business activities. In September 2000, the PRC’s State Council promulgated the Telecommunications Regulations, which categorized all telecommunications businesses as either infrastructure telecommunications businesses or value- added telecommunications businesses, with various Internet-related services and activities classified as value-added telecommunications businesses. According to the Telecommunications Regulations, a commercial operator of any of the telecommunications services must obtain the requisite operating licenses.

Since the publication of the Telecommunications Regulations, various administrative measures have been introduced or amended to govern various aspects of the Internet services, such as Internet information services, online news services, Internet publishing, Internet medical, health and drug information services, online advertising services, Internet access services and international connections for computer information networks. We are required to obtain applicable permits or approvals from different PRC regulatory authorities in order to provide those services. For example, an Internet content provider, or ICP, must obtain a Value-Added Telecommunications Business Operations Permit, or ICP license, in order to engage in any commercial ICP operations within China. In addition, an ICP that provides content involving news, publishing, education, health care, medicine and medical devices is required to obtain additional approvals for each area from the relevant authorities.

The PRC’s telecommunications laws currently do not specifically regulate personal computer-based VoIP services, and as a result there are significant uncertainties regarding licensing and approval requirements for our VoIP joint venture with Skype.

If we fail to obtain or maintain any of the above-mentioned required permits or approvals or comply with MII’s operating guideline for wireless value-added service providers, we may be subject to various penalties, such as fines, suspension or a shutdown of operations, which could severely disrupt our business operations. For example, on June 5, 2007, MII notified 265 service providers, including Beijing Lei Ting and Wu Ji Network, that certain of their business practice had failed MII’s annual performance review. Our operating companies and the other service providers were required to rectify the problems before June 24, 2007 and submit a report to MII detailing the measures they have taken to correct those problems. Beijing Lei Ting and Wu Ji Network were included in such notice because a small number of services they provided to mobile phone users did not match the service codes they were required to use. The problem arose because both companies had reshuffled certain product offerings after they submitted their annual business reports to MII in December 2006. After receiving the MII notice, both companies rectified the problem and submitted reports to MII prior to June 24, 2007. However, we cannot assure you that we will not fail in future to comply with MII guidelines or that the resultant penalties will not be severe.

 

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In July 2006, the MII issued the Circular on Strengthening the Administration of Foreign Investment in the Operation of Value-added Telecommunications Business. In the circular, the MII reiterated the existing regulations regarding foreign investment in telecommunications business, which require foreign investors to set up foreign-invested enterprises and obtain a business operating license for Internet content provision, or ICP license, in order to conduct any value-added telecommunications business in China. Under this circular, a domestic company that holds an ICP license is prohibited from leasing, transferring or selling the license to foreign investors in any form, and from providing resources, sites or facilities to foreign investors that conduct value-added telecommunications business illegally in China. Furthermore, the relevant trademarks and domain names that are used in the value-added telecommunications business shall be owned by the local ICP license holder or its shareholders. This circular further requires each ICP license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to the lack of further interpretation from the regulator, it remains unclear what impact the above circular will have on us or the other Chinese Internet companies that have adopted the same or similar corporate and contractual structures as ours.

In addition, MII and other regulatory agencies may change the existing regulations, announce new applications or interpretations of the existing regulations or issue new regulations. Such changed, re-interpreted or new regulations may impose additional costs on our business or force us to change the way in which we conduct our business. In addition, we cannot assure you that we will be able to comply with all such changed, re-interpreted or new regulations, which may result in us being subject to penalties. As a result, our financial condition and results of operations may be materially adversely affected.

For example, industry analysts have reported in recent years that MII had plans to implement a policy of requiring the users of mobile phone prepaid service cards, who do not have billing accounts with the mobile telecommunications operators, to register their names with such operators or face possible termination of service. The reported purpose of such policy would be to reduce the sending of unwanted or “spam” wireless Internet service messages. We have not been notified by MII of any such policy or seen any official announcement of such policy, but we cannot assure you that such policy will not be implemented in the future and, if implemented, will not adversely affect our customer base and revenues.

In addition, MII has recently imposed restrictions on our cooperation arrangements with mobile phone producers, and we cannot guarantee that MII, China Mobile or the other telecommunications operators will not impose further restrictions or completely halt our cooperation with the mobile phone producers. On April 11, 2007, MII issued a notice barring the production of mobile handsets with wireless Internet services icons embedded in the handset menus in such a way that the icons and codes cannot be changed or deleted by consumers. Such notice took effect on June 1, 2007. Although mobile phone producers are still permitted to pre-load our icons into the handset menus as long as consumers are able to delete the icons if they wish, we cannot assure you that MII will not expand its regulation to bar pre-loading icons in the future.

Furthermore, in the past, China Mobile entered into its own strategic alliances with selected mobile phone producers pursuant to which it embedded menus in their handsets for all the best-selling products on China Mobile’s MonternetTM wireless portal, including certain of our products. However, beginning in May 2007, China Mobile has started to promote only its own wireless value-added service products in such menus and not those of us or other third-party value-added service providers. We cannot assure you that China Mobile or other telecommunications operators will not take other steps, such as imposing penalties on us, to limit or halt our cooperative arrangements with the mobile phone producers.

 

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Regulation and censorship of information distribution over the Internet in China may adversely affect our business, and we may be liable for information displayed on, retrieved from, or linked to our Internet portal.

In recent years, the PRC government has adopted certain regulations governing Internet access and the distribution of news and other information over the Internet. Under those regulations, ICPs and Internet publishers are prohibited from posting or displaying over the Internet content that opposes the fundamental principles in PRC’s Constitution; compromises state security, divulges state secrets, subverts state power or damages national unity; harms the dignity or interests of the state; incites ethnic hatred or racial discrimination or damages inter-ethnic unity; sabotages PRC’s religious policy or propagates heretical teachings or feudal superstitions; disseminates rumors, disturbs social order or disrupts social stability; propagates obscenity, pornography, gambling, violence, murder or fear or incites the commission of crimes; insults or slanders a third party or infringes upon the lawful rights and interests of a third party; or includes other content prohibited by laws or administrative regulations. Failure to comply with those requirements may result in the revocation of ICP licenses and the closing down of the concerned websites. In the past, failure to comply with those requirements has resulted in the closing down of certain concerned websites. The website operator may also be held liable for such censored information displayed on, retrieved from or linked to such website.

In addition, the MII has published regulations that subject website operators to potential liability for content included on their websites and the actions of users and others using their systems, including liability for violations of PRC laws prohibiting the distribution of content deemed to be socially destabilizing. The PRC’s Ministry of Public Security has the authority to order any local Internet service provider, or ISP, to block any Internet website maintained outside China at its sole discretion. Periodically, the Ministry of Public Security has stopped the distribution over the Internet of information which it believes to be socially destabilizing. The PRC’s State Secrecy Bureau, which is directly responsible for the protection of State secrets of the PRC government, is authorized to block any website it deems to be leaking State secrets or failing to meet the relevant regulations relating to the protection of State secrets in the distribution of online information.

Because these regulations are relatively new and subject to interpretation by the relevant authorities, it may not be possible for us to determine in all cases the type of content that could result in liability for us as a website operator. In addition, we may not be able to control or restrict the content of other ICPs that are linked to or accessible through our websites, or content generated or placed on our websites by our users, despite our attempt to monitor such content. To the extent that regulatory authorities find any portion of our content to be objectionable, they may require us to limit or eliminate the distribution of such information or otherwise curtail the nature of such content on our websites, which may reduce our user traffic and have a material adverse effect on our financial condition and results of operations. In addition, we may be subject to significant penalties for violations of those regulations arising from information displayed on, retrieved from or linked to, our websites, including a suspension or shutdown of our operations.

The laws and regulations governing the Internet industry in China are developing and subject to future changes, and substantial uncertainties exist as to the interpretation and implementation of those laws and regulations.

In recent years, the PRC government has begun to enact laws and regulations applicable to Internet-related services and activities, including wireless value-added services, many of which are relatively new and untested and subject to future changes. In addition, various regulatory authorities of the central PRC government, such as the State Council, the MII, the State Administration of Industry and Commerce, or SAIC, the State News and Publication Administration, or SNPA, the Ministry of Public Security, and the State Administration of Radio, Film and Television, are empowered to issue and implement regulations to regulate certain aspects of Internet-related services and activities. Furthermore, some local governments have also promulgated local rules applicable to Internet companies operating within their respective jurisdictions. Because the Internet industry itself is at an early stage of development in China, there will likely be new laws and regulations adopted in the future to address issues that arise from time to time. As a result of the foregoing, substantial uncertainties exist regarding the interpretation and implementation of current and future PRC Internet laws and regulations. We cannot assure you that we will not be found in violation of any current or future PRC laws and regulations due to these substantial uncertainties.

 

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The Internet infrastructure in China, which is not as well developed as in the United States, Hong Kong or certain other countries, may limit our growth.

The Internet infrastructure in China is not as well developed as in the United States, Hong Kong or certain other countries. We depend significantly on the PRC government and fixed line telecommunications operators in China to establish and maintain a reliable Internet infrastructure to reach a growing base of Internet users in China. We cannot assure you that the Internet infrastructure in China will support the demands associated with the continued growth of the Internet industry, and in particular the development and growth of services that may require higher bandwidth, such as MMS, WAP, Java™ and VoIP. If the necessary infrastructure standards or protocols, or complementary products, services or facilities are not developed in China on a timely basis or at all by these enterprises, our business, financial condition and results of operations could be materially adversely affected.

The relatively high cost of Internet access in China may limit the growth of the Internet industry in China and impede our growth.

While the cost of Internet access in China has decreased dramatically in recent years due to the decrease in the cost of personal computers and laptops and the introduction and expansion of broadband access in China, it remains relatively high in comparison to the average income in China, which may make it less attractive for users to access, and transact business, over the Internet. Any fee or tariff increase could further decrease our user traffic and our ability to derive revenues from transactions over the Internet, which could have a material adverse effect on our business, financial condition and results of operations.

We depend largely on the infrastructure of the telecommunications operators in China, and any interruption of their network infrastructure may result in severe disruptions to our business.

Although private Internet service providers exist in China, substantially all access to the Internet in China is maintained through the telecommunications operators, under the administrative control and regulatory supervision of the MII. In addition, local networks connect to the Internet through a government-owned international gateway. This international gateway is the only channel through which a domestic Chinese user can connect to the international Internet network. We rely on this infrastructure and, to a lesser extent, certain other Internet data centers in China to provide data communications capacity primarily through local telecommunications lines. In the event of a large-scale infrastructure disruption or failure, we may not have access to alternative networks and services, on a timely basis or at all. We may not be able to lease additional bandwidth from the telecommunications operators in China on acceptable terms, on a timely basis or at all. In addition, we may not have means of getting access to alternative networks and services on a timely basis or at all in the event of any disruption or failure of the network.

Our operations could be disrupted by unexpected network interruptions caused by system failures, natural disasters and unauthorized tampering with our system.

The uninterrupted availability of our websites and the performance and reliability of our network infrastructure are important to our reputation and our ability to attract and retain users, advertisers and merchants. Any system failure or performance inadequacy that causes an interruption in the availability of our websites or increases the response time of our services could reduce our attractiveness to users, advertisers and merchants. Factors that could disrupt our operations include:

 

   

failure of our system;

 

   

failure of the systems of our Internet data center backbone;

 

   

system failures and outages caused by power shortages, substandard equipment or natural disasters such as fire, flood, typhoon or earthquakes; and

 

   

computer viruses, Internet and e-mail worms and other malicious programs or unauthorized tampering with our system.

 

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We have limited backup systems and have previously experienced system failures, which have disrupted our operations. Moreover, we have not purchased business interruption insurance. Interruptions of our services may adversely affect our business, financial condition and results of operations.

Concerns about the security and confidentiality of information on the Internet may increase our costs, reduce the use of our websites and impede our growth.

A significant barrier to confidential communications over the Internet has been the need for security. There have been several well-publicized compromises of Internet security as a result of global virus outbreaks. We may incur significant costs to protect against the threat of security breaches or to alleviate problems caused by these breaches. If unauthorized persons are able to penetrate our network security, they could misappropriate proprietary information or cause interruptions in our services. As a result, we may be required to expend substantial costs and divert our other resources to protect against or to alleviate these problems. Security breaches could have a material adverse effect on our business, financial condition and results of operations.

If we are unable to respond successfully to technological or industry developments, our business may be materially adversely affected.

The telecommunications market is characterized by rapid advancements in technology, evolving industry standards and changes in customer needs. New standards, services or technologies may render our existing services or technologies less competitive or obsolete. Mobile operators in China are currently upgrading their telecommunications networks in preparation for the introduction of the third generation standard of wireless telecommunications transmission, or 3G. Responding and adapting to 3G and other technological developments and standard changes in our industry, integrating new technologies or industry standards or upgrading our networks may require substantial time, effort and capital investment. In the event that we are unable to respond successfully to technological industry developments, this may materially adversely affect our business, results of operations and competitiveness.

Risks Relating to the People’s Republic of China

Substantially all of our assets are located in China and substantially all of our revenue is derived from our operations in China. Accordingly, our results of operations and prospects are subject, to a significant extent, to the economic, political and legal developments in China.

The PRC’s economic, political and social conditions, as well as government policies, could affect our business.

The PRC economy differs from the economies of most developed countries in many respects, including:

 

   

amount of government involvement;

 

   

level of development;

 

   

growth rate;

 

   

control of foreign exchange; and

 

   

allocation of resources.

While the PRC economy has experienced significant growth in the past 20 years, growth has been uneven, both geographically and among various sectors of the economy. The PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us.

 

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The PRC economy has been transitioning from a planned economy to a more market-oriented economy. Although in recent years, the PRC government has implemented measures emphasizing the utilization of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of productive assets in China is still owned by the PRC government. In addition, the PRC government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over PRC economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies.

An economic slowdown in China may adversely affect our financial condition and results of operations, as well as our future prospects.

We conduct most of our business and generate most of our revenues in China. As a result, economic conditions in China have a significant effect on our business operations, financial condition and results of operations, as well as our future prospects. Since 1978, China has been one of the world’s fastest growing economies in terms of gross domestic product, or GDP, growth. We cannot assure you, however, that such growth will be sustained in the future. Moreover, the performance of the economies of the United States, the European Union and certain Asian countries may adversely affect economic growth in China. In addition, if an outbreak of SARS recurs, it may cause a decrease in the level of economic activity and may adversely affect economic growth in China, Asia and elsewhere in the world. We cannot assure you that our financial condition and results of operations, as well as our future prospects, will not be adversely affected by an economic downturn in China.

Government control of currency conversion may adversely affect our financial condition and results of operations.

We receive substantially all of our revenues in Renminbi, which currently is not a freely convertible currency. A portion of these revenues must be converted into other currencies to meet our foreign currency obligations. These foreign currency-denominated obligations include:

 

   

payment of interest and principal on foreign currency-denominated debt;

 

   

payment for equipment and materials purchased offshore; and

 

   

payment of dividends declared, if any, in respect of our ordinary shares.

Under China’s existing foreign exchange regulations, we are able to pay dividends in foreign currencies, without prior approval from the State Administration of Foreign Exchange, by complying with certain procedural requirements. However, we cannot assure you that the PRC government will not take measures in the future to restrict access to foreign currencies for current account transactions.

Certain foreign exchange transactions under the capital accounts of certain of our subsidiaries and our PRC operating companies, including foreign currency-denominated borrowings from PRC or foreign banks and principal payments in respect of foreign currency-denominated obligations, continue to be subject to significant foreign exchange controls and require the approval of the State Administration of Foreign Exchange. These limitations could affect our ability to obtain foreign exchange through debt or equity financing, or to obtain foreign exchange for capital expenditures.

Recent PRC regulations relating to offshore investment activities by PRC residents may increase our administrative burden and restrict our overseas and cross-border investment activity. If our shareholders who are PRC residents fail to make any required applications and filings under such regulations, we may be unable to distribute profits and may become subject to liability under PRC law.

In October 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Return Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 75, which took

 

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effect on November 1, 2005. Notice 75 supersedes prior SAFE regulations promulgated in January and April of 2005. On May 29, 2007, SAFE further issued practice guidance for Notice 75. Notice 75 requires PRC residents to register with the relevant local SAFE branch in connection with their establishment or control of an offshore entity established for the purpose of overseas equity financing involving onshore assets or equity interests held by them. The term PRC residents as used in Notice 75 includes PRC citizens as well as other persons who habitually reside in the PRC for economic benefit. Such PRC residents are required to complete amended registrations with the relevant SAFE branch upon (i) injection of equity interests or assets of an onshore enterprise into the offshore entity, (ii) subsequent overseas equity financing by such offshore entity, or (iii) any material change in the shareholding or capital of the offshore entity, such as changes in share capital, share transfers and long-term equity or debt investments, and providing security. PRC residents who have already incorporated or gained control of offshore entities that made onshore investments in the PRC before Notice 75 was promulgated must register with the relevant local SAFE branch on or before March 31, 2006. In addition, such PRC residents are required to repatriate into China all of their dividend profits or capital gains from their shareholdings in the offshore entity within 180 days of their receipt of such profits or gains.

The registration and amendment procedures set forth by Notice 75 are prerequisites for other approval and registration procedures necessary for capital inflow from the offshore entity, such as inbound investment or shareholders loans, or capital outflow to the offshore entity, such as the payment of profits or dividends, liquidating distributions, equity sale proceeds or the return of funds upon a capital reduction.

A number of terms and provision in Notice 75 remain unclear. Because of uncertainty over how Notice 75 will be interpreted and implemented, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as remitting dividends and foreign-currency denominated borrowings, may be subject to compliance with Notice 75 requirements by our PRC resident shareholders. Despite our efforts to fully comply with the SAFE regulations, we cannot assure you that we will obtain, or receive waivers from, any necessary approvals or not be found in violation of the SAFE regulations or any other related foreign exchange regulations. In particular, we cannot assure you that we will be able to cause all our present or prospective PRC resident shareholders to comply with all SAFE regulations. A failure by our PRC resident shareholders to comply with Notice 75 or our inability to secure required approvals or registrations may subject us to fines or legal sanctions, limit our subsidiaries’ ability to make distributions or pay dividends, restrict our overseas or cross-border investment activities or affect our ownership structure, any of which could affect our business and prospects.

SAFE issued Measures for the Administration of Individual Foreign Exchange and its implementation rules effective on February 1, 2007. In March 2007, SAFE further promulgated the Work Guidance Concerning Foreign Exchange Management of Domestic Individual’s Participation in Employee Stock Ownership Plans and Stock Option Plans of Overseas Listed Companies, or Notice 78. Notice 78 requires any domestic agency, which may be the onshore subsidiary of the overseas listed company, to report its individual stock plans with SAFE on a regular basis and comply with the relevant approval or registration procedures for the exercises under such individual stock plans. Since this requirement is relatively new and also due to the uncertainty relating to the practice adopted or to be adopted by SAFE or its various local branches in connection with this notice, there is no assurance that our current or future individual stock plans could be implemented without any challenge from the government.

Fluctuation of the Renminbi could adversely affect the value of and dividends payable on our ADSs.

The value of the Renminbi fluctuates and is subject to changes in PRC political and economic conditions. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi to the U.S. dollar. Under the PRC government’s new policy, the Renminbi is permitted to fluctuate within a managed band against a basket of certain foreign currencies. Although daily fluctuations of the Renminbi against the basket of currencies are currently limited to 0.5% per day, the Renminbi may appreciate or depreciate significantly in value against the U.S. dollar in the long term. We cannot guarantee that the Renminbi will not be permitted to enter into a full float, which also may result in a significant appreciation or depreciation of the Renminbi against the U.S. dollar. Because we receive substantially all of our revenues in Renminbi, any fluctuation in the exchange rate against the U.S. dollar will affect our balance sheet and earnings per share in U.S. dollar terms as well as the value of, and dividends, if any, payable on, our ordinary shares in U.S. dollar terms and the value of any U.S. dollar-denominated investments we may make in the future. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk.

 

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You may experience difficulties in effecting service of legal process and enforcing judgments against us and our management.

We are a company incorporated under the laws of the Cayman Islands, and substantially all of our assets and the assets of all our subsidiaries are located outside the United States. In addition, some of our directors and substantially all of our officers and their assets are located outside the United States. As a result, it may not be possible to effect service of process within the United States upon our directors or officers, including with respect to matters arising under U.S. federal securities laws or applicable state securities laws.

Our PRC legal counsel has advised us that the PRC does not have treaties providing for the reciprocal recognition and enforcement of judgments of courts with the United States, the United Kingdom or most other western countries. As a result, recognition and enforcement in China of judgments of a court obtained in those jurisdictions in relation to any matter not subject to a binding arbitration provision may be difficult or impossible.

We have been advised by Maples and Calder, our Cayman Islands legal advisers, that the courts of the Cayman Islands are unlikely (i) to recognize or enforce against us judgments of courts of the United States predicated upon certain of the civil liability provisions of the securities laws of the United States or any State thereof and (ii) in original actions brought in the Cayman Islands, to impose liabilities against us predicated upon certain of the civil liability provisions of the securities laws of the United States or any State thereof, if and to the extent that such provisions are penal in nature. However, in the case of laws that are not penal in nature, although there is no statutory enforcement in the Cayman Islands of judgments obtained in the United States, the courts of the Cayman Islands will generally recognize and enforce a judgment of a foreign court of competent jurisdiction without retrial on the merits. A Cayman Islands court may stay proceedings if concurrent proceedings are being brought elsewhere.

 

Item 4. Information on the Company

We were incorporated in 2001 under the laws of the Cayman Islands and became a wholly owned subsidiary of our parent company, TOM Group. TOM Group, a Cayman Islands company, is listed on the main board of the Hong Kong Stock Exchange and is principally engaged in four business segments: Internet, publishing, outdoor media, television and entertainment. Our business operations comprise a significant part of the online media segment of our parent company, TOM Group.

Our Reorganization and Our Initial Public Offering

We did not have any material assets or business operations until shortly before our reorganization in 2003. Prior to our reorganization, TOM Group’s online media segment consisted of 25 entities as follows:

 

  (i) Core Internet business entities: nine entities providing a wide range of Internet services, wireless Internet services, online advertising and commercial enterprises solutions in the PRC.

 

  (ii) Non-core Internet business entities: six entities that conducted certain portal and advertising businesses in the PRC. Most of their operations have been integrated with or moved to our core Internet business entities.

 

  (iii) Excluded business entities: ten entities engaging in either non-portal businesses within the PRC, online businesses outside the PRC or passive investments of TOM Group.

Both the core Internet business entities and non-core Internet business entities discussed above have been operating under the same management team led by Wang Lei Lei since their inception or acquisition, as the case may be.

In connection with our initial public offering, we completed a reorganization pursuant to which TOM Group transferred to us nine core Internet business entities. The six non-core Internet business entities were not transferred to us primarily due to the fact that

 

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most of their operations had been moved to the nine core Internet business entities, and they were expected to be wound down or used by our parent company for other purposes. However, as these six entities were managed by the management group of the nine core Internet business entities prior to our reorganization, they are included in our historical consolidated financial statements up until September 26, 2003.

Our reorganization was consummated pursuant to a series of agreements, all of which were duly executed on or by September 26, 2003. All other entities of TOM Group that were not transferred to us remained with our parent company, including the ten excluded business entities within the Internet, publishing, outdoor media, television and entertainment segments.

In connection with our reorganization, we also entered into various agreements with our parent company and a number of its subsidiaries, including a deed of non-competition. For a detailed discussion of those agreements, see “Item 7 — Major Shareholders and Related Party Transactions.”

In March 2004, we successfully completed our initial public offering of ordinary shares, raising approximately US$168,221,000, net of issuing expenses. Following our initial public offering, our ordinary shares became listed on GEM and ADSs representing our ordinary shares became listed on The Nasdaq Global Market, or Nasdaq.

Our Acquisitions

Puccini

On November 19, 2003, we acquired from Cranwood, a 24.5% shareholder of our parent company at the date of the acquisition, its 100% interest in Puccini, which provides wireless IVR services through Wu Ji Network. PRC regulations currently restrict foreign ownership of companies that provide Internet telecommunications services, which include wireless IVR services. As a result, Puccini conducts its operations through Wu Ji Network, which is owned by PRC citizens. In connection with our acquisition, Puccini has entered into a series of contractual arrangements with Wu Ji Network and its owners. For a discussion of the contractual relationships with Wu Ji Network, see “Item 7 — Major Shareholders and Related Party Transactions.”

Treasure Base

On August 11, 2004, we and our wholly owned subsidiary, TOM Online Media Group Limited, or TOM Online Media, entered into a sale and purchase agreement with the shareholders of Treasure Base, a company established under the laws of the British Virgin Islands, and their respective owners to acquire the entire issued share capital of Treasure Base. Pursuant to the sale and purchase agreement, the aggregate purchase price payable, which is subject to various adjustments based on the combined after-tax profit of Treasure Base, will not exceed US$66,420,000. As at December 31, 2005, we had paid out US$33,034,000, equal to 4.5 times Treasure Base’s 2004 audited combined after-tax profit, as settlement of the initial consideration. In March 2006, we paid the earn-out consideration, which was equal to 1.75 times Treasure Base’s 2005 audited combined after-tax profit which amounted to US$16,615,000. The consideration payable and additional goodwill of Treasure Base have been reflected in the consolidated financial statements for the year 2005.

Because PRC regulations currently restrict foreign ownership of companies that provide Internet telecommunications services, Treasure Base conducts its operations through LingXun, which is owned by PRC citizens. Ling Xun provides entertainment, sports and lifestyle content via SMS in cooperation with major television broadcasters in China. In connection with our acquisition, Treasure Base has entered into a series of contractual arrangements with LingXun and its owners. For a discussion of the contractual relationships with LingXun, see “Item 7 — Major Shareholders and Related Party Transactions.”

Whole Win

On November 19, 2004, our wholly owned subsidiary, TOM Online Media, entered into a sale and purchase agreement with Key Result Holdings Limited, or Key Result, and the owners of Startone to acquire the entire issued share capital of Whole Win, a

 

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company established under the laws of the British Virgin Islands, which provides WAP services through Startone. Pursuant to the sale and purchase agreement, the aggregate purchase price payable, which is subject to various adjustments based on the 2004 net profit of Whole Win, was determined to be US$7,231,000. We made a cash payment of US$2,169,000 in December 2004, and the remaining balance of US$5,062,000 was paid in cash in 2005.

Because PRC regulations currently restrict foreign ownership of companies that provide Internet telecommunications services, Whole Win conducts its operations through Startone, which is owned by PRC citizens. Startone provides WAP services to PRC mobile phone users. In connection with our acquisition, Whole Win has entered into a series of contractual arrangements with Startone and its owners. For a discussion of the contractual relationships with Startone, see “Item 7 — Major Shareholders and Related Party Transactions.”

Indiagames

On February 24, 2005, our wholly owned subsidiary, TOM Online Games Limited, or TOM Online Games, acquired 76.29% of the outstanding shares of Indiagames, a wireless game developer and publisher of mobile entertainment content based in India, for a total consideration of US$13,732,000. This investment was subsequently diluted to 62.42% when Cisco Systems Inc. and Macromedia Inc. acquired share interests in Indiagames. Following a management review of Indiagames and a desire to focus more exclusively on our core business activities in the PRC, our board of directors decided on December 29, 2006 to sell substantially all our equity interest in Indiagames and initiated actions to locate a buyer. Accordingly, results of Indiagames were separately presented as “Discontinued Operations” in the consolidated statements of operations for the years ended December 31, 2005 and 2006 and the assets and liabilities of Indiagames were classified as “held for sale” of the consolidated balance sheet as of December 31, 2006. The consolidated statements of operations for the year ended December 31, 2005 have been restated accordingly. On March 5, 2007, a binding term sheet was signed with a potential buyer of Indiagames, and a definitive agreement is still under negotiation.

Huan Jian Shu Meng Network Technology Limited

On January 4, 2006, through our variable interest entity, Beijing Lei Ting, we entered into a sale and purchase agreement with the shareholders of Huan Jian Shu Meng to acquire 75% of the entire issued share capital of Huan Jian Shu Meng for an aggregate consideration of RMB22,000,000 (equivalent to US$2,728,000 at the then-prevailing exchange rate) of which approximately RMB10,000,000 (equivalent to US$1,240,000 at the then-prevailing exchange rate) was injected as additional paid-in-capital. On August 23, 2006, through Beijing Lei Ting, we obtained an exclusive call option to purchase the remaining 25% of Huan Jian Shu Meng for US$2,400,000, exercisable at any time after two years from February 8, 2006. As of March 31, 2007, we had not exercised this option. Huan Jian Shu Meng operates the Internet website www.hjsm.net, which provides original Chinese novels to online readers. The investment in Huan Jian Shu Meng helped to increase traffic to our Internet portal, increase online advertising opportunities and generate synergies with our wireless Internet business through the provision of literature content. In March 2006 and in August 2006, we made payments of RMB21,000,000 (approximately US$2,612,000 at the then-prevailing exchange rate) and RMB1,000,000 (approximately US$116,000 at the then-prevailing exchange rate) respectively as the total consideration for the acquisition. We have determined that Huan Jian Shu Meng, a subsidiary of Beijing Lei Ting, is a variable interest entity as we are the primary beneficiary of this entity.

Gainfirst Asia Limited

On June 1, 2006, we acquired 100% of the equity interest in Gainfirst for a maximum consideration of RMB600,000,000 (approximately US$75,000,000 at the then-prevailing exchange rate). Through a series of contractual arrangements, Gainfirst is the primary beneficiary of Beijing Infomax, a wireless Internet services company with an extensive TV distribution network. Beijing Infomax holds an exclusive 5-year license with CCTV2, a national economic news and lifestyle TV channel, to provide wireless interactive services for programs shown on the channel. CCTV2’s programs include the popular programs “Dream China” and “6+1.” The acquisition helped us to strengthen our market position in the wireless Internet value-added services business in China.

 

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In August 2006, we paid an initial consideration of RMB150,000,000 (approximately US$18,750,000 at the then-prevailing exchange rate). During 2007, we expect to make a cash payment of RMB93,991,000 (approximately US$12,037,000), which is equal to 3.5 times Gainfirst’s 2006 estimated adjusted combined after-tax profit minus initial consideration, as payment of the 2006 earn-out consideration. A final earn-out consideration is payable in 2008, and will be equal to either three times (if the 2007 adjusted audited combined after-tax profit is less than RMB65,000,000) or four times (if the 2007 adjusted audited combined after-tax profit is equal to or more than RMB65,000,000) Gainfirst’s 2007 adjusted audited combined after-tax profit plus adjusted 2006 earn-out consideration, minus consideration previously paid up to the final payment.

Because PRC regulations currently restrict foreign ownership of companies that provide Internet telecommunications services, Gainfirst conducts its operations through Beijing Infomax, which is owned by PRC citizens. In connection with our acquisition, Gainfirst has entered into a series of contractual arrangements with Beijing Infomax and its owners. For a discussion of the contractual relationships with Beijing Infomax, see “Item 7 — Major Shareholders and Related Party Transactions.”

Recent Developments

Our directors and those of our parent, TOM Group, jointly announced on March 9, 2007 that TOM Group requested our board of directors to put forward a proposal for our privatization by way of the Scheme, under Section 86 of the Companies Law of the Cayman Islands. Details of the Scheme were set forth in a Scheme Document that was dispatched on or about April 30, 2007 to holders of our ordinary shares, our ADSs and options in our ordinary shares. This transaction constitutes a “going private” transaction for purposes of Section 13e-3 of the Exchange Act.

An Independent Board Committee, comprising Mr. Kwong Che Keung, Gordon, Mr. Ma Wei Hua and Dr. Lo Ka Shui, was appointed to make recommendations to the shareholders, ADS holders and option holders in respect of TOM Group’s proposals. An independent financial adviser, ING Bank N.V., was engaged to advise the Independent Board Committee. The recommendations to our security holders by our Independent Board Committee and the reasons for those recommendations are set forth in the Scheme Document, which also contains a letter from the independent financial adviser setting forth its view and recommendations in respect of the proposals. The Scheme Document was filed under cover of a Schedule 13E-3, which can be obtained without charge at www.sec.gov. Our security holders should read the Schedule 13E-3, as amended, as they contain important information about the Scheme, the Independent Board Committee’s recommendations, the advice of the independent financial adviser and other related matters.

Under the Scheme, in exchange for HK$1.52 in cash for each share, all of our ordinary shares, including those underlying our ADSs, other than those held by TOM Group, Cranwood Company Limited, Handel International Limited, Schumann International Limited and Devine Gem Management Limited will be cancelled, resulting in a reduction of our issued share capital. We will issue new shares in the same number as that of the cancelled shares to TOM Group or a subsidiary of TOM Group as TOM Group may direct. TOM Group has also proposed to acquire for cancellation all of the outstanding share options granted under our pre-initial public offering share option plan and our share option scheme, both adopted on February 12, 2004. If approved, upon completion of the Scheme, we will be approximately 90.002% owned by TOM Group, approximately 4.999% owned by Cranwood Company Limited and its subsidiaries, Handel International Limited and Schumann International Limited, and approximately 4.999% held by Devine Gem Management Limited, assuming no outstanding share options are exercised. Each of Cranwood, Handel, Schumann and Devine Gem is controlled by Ms. Chau Hoi Shuen.

The meetings to vote on the Scheme and TOM Group’s proposals in connection with the Scheme originally were scheduled for June 8, 2007. However, TOM Group and we proposed that such meetings be adjourned to a later date so that our shareholders and holders of our ADSs would have additional time to consider the Scheme. The meetings have been adjourned to August 10, 2007. TOM Group and we propose to issue in early to mid-July a supplement to the Scheme Document, which will include, among other things, a revised expected timetable and notices for the meetings to approve the Scheme.

If the Scheme is approved by our shareholders other than TOM Group, Cranwood Company Limited, Handel International Limited, Schumann International Limited and Devine Gem Management Limited, who are deemed related parties under the rules of

 

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the Hong Kong Stock Exchange, and becomes effective, we understand that TOM Group will cause us to apply to the Hong Kong Stock Exchange to withdraw the listing of our ordinary shares on GEM, and to Nasdaq to withdraw the listing of our ADSs, and will also cause us to file a Form 15F with the SEC to request that our reporting obligations under the Exchange Act be terminated or suspended because the effectiveness of the Scheme will cause the number of holders of our ordinary shares in the United States to fall below 300 or otherwise cause us to become eligible for de-registration.

Our Corporate Structure

Our corporate structure consists of 45 entities. The chart below sets forth our corporate and share ownership structure as of March 31, 2007.

 

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(1) We do not have any ownership interest in Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Beijing Infomax or Beijing Yi Lian Tong He. Through certain of our subsidiaries and a jointly controlled entity, we have entered into a series of contractual arrangements with these entities and their respective shareholders.
(2) We or our intermediary holding companies registered outside of PRC have equity ownership in Beijing Super Channel, Beijing Lahiji Technology Development Limited, or Lahiji, Puccini, Ceng Dong Yi (Beijing) Technology Company Limited, or Ceng Dong Yi, Heng Dong Wei Xin (Beijing) Technology Company Limited, or Heng Dong Wei Xin, Beijing Dong Kui Lin Information Technology Limited, or Dong Kui Lin and eBay Eachnet Network Information Services (Shanghai) Co., Ltd.
(3) Mr. Wang Lei Lei, our chief executive officer and an executive director of our company, owns 20% of the equity interest in Beijing Lei Ting. He is also the chairman of the board of directors and president of Beijing Lei Ting.
(4) Mr. Fan Tai, an executive director of our company, owns 20% of the equity interest in Wu Ji Network.
(5) The remaining 10% equity interest in GreaTom is held by Great Wall Technology Company Ltd., a PRC company whose shares are listed on the main board of the Hong Kong Stock Exchange.
(6) We do not have unilateral control over these entities and account for their results using equity method of accounting.

PRC regulations currently restrict foreign ownership of companies that provide Internet telecommunications services, which include wireless Internet services and Internet content services. See also “Regulation.” To comply with PRC regulations, we conduct substantially all of our operations through our PRC operating companies, Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Beijing Infomax and Beijing Yi Lian Tong He, each of which is wholly owned by PRC citizens and incorporated in the PRC. In addition, we do not have any equity interest in these seven operating companies but instead enjoy the economic benefits of these companies through a series of contractual arrangements, which certain of our wholly owned subsidiaries and a jointly controlled entity have entered into with these companies and their respective shareholders as described below. For a description of each of those agreements, see “Item 7 — Major Shareholders and Related Party Transactions.”

As part of these contractual arrangements, our intermediary holding companies entered into loan agreements with certain shareholders of our PRC operating companies pursuant to which long-term loans were provided to those shareholders to be invested exclusively in the working capital of those companies. The shareholders have also agreed to repay those loans only in the form of the transfer of all of their interest in those companies to either our intermediary holding companies or their designees, including in the circumstances when (i) current restrictions on foreign ownership in those entities are lifted under PRC law, (ii) those shareholders commit a criminal offense, (iii) any third party raises against those shareholders a claim over RMB500,000, or (iv) the shareholders die or become incapacitated.

Our PRC operating companies and their shareholders have also entered into exclusive share option agreements with the intermediary holding companies. Pursuant to these agreements, each shareholder of our PRC operating companies granted an exclusive option to the relevant intermediary holding company to purchase all or part of such shareholder’s equity interest in the relevant PRC operating company in accordance with PRC laws, and covenanted not to encumber those equity interests in any way other than as permitted by our intermediary holding companies.

In addition, our wholly owned subsidiaries and a jointly controlled entity entered into certain business operation agreements with our PRC operating companies and their respective shareholders. Pursuant to these agreements, our wholly owned subsidiaries agreed to guarantee the performance of our PRC operating companies under their operations-related contractual arrangements with third parties. In return, each of our PRC operating companies pledged to our wholly owned subsidiaries its accounts receivables and assets. In addition, each of our PRC operating companies and their respective shareholders agreed to appoint individuals designated by our wholly owned subsidiaries to the management team of the PRC operating companies, and to refrain from taking certain actions that may materially affect those companies’ operations, including lending or assuming any obligation of any third parties or selling or transferring any assets to any third parties, without the prior written consent of our wholly- owned subsidiaries or their designees. Each of the

 

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shareholders of our PRC operating companies also executed an irrevocable power of attorney in favor of individuals designated by our wholly owned subsidiaries, some of whom also hold senior management positions at those companies as appointed by our wholly owned subsidiaries under the business operations agreements. Pursuant to those powers of attorney, those individuals have full power and authority to exercise all of each shareholder’s rights with respect to such shareholder’s interests in the relevant PRC operating company.

Our wholly owned subsidiaries entered into exclusive technical and consulting services agreements with each of our PRC operating companies. Pursuant to these exclusive technical and consulting services agreements, our wholly owned subsidiaries provide technical and consulting services to our PRC operating companies in exchange for services fees, which amount to substantially all of the net income of those companies. Each of the shareholders of our PRC operating companies also entered into equity pledge agreements with our wholly owned subsidiaries. Pursuant to these equity pledge agreements, each shareholder pledged such shareholder’s interest in the relevant PRC operating company for the performance of such company’s payment obligations under its respective exclusive technical and consulting services agreement.

As a result of these contractual arrangements, we bear the risks of, and enjoy the rewards associated with, and therefore are the primary beneficiary of our investments in, our seven PRC operating companies, and we consolidate their results of operations in our historical consolidated financial statements. See also “Item 5 — Operating and Financial Review and Prospects — Overview.”

Set forth below is a chart illustrating the flow of benefits and obligations among our intermediary holding companies, our wholly owned subsidiaries, our PRC operating companies, and their shareholders under those agreements.

 

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(1) In addition to Beijing Superchannel, Lahiji also provides technical and consulting services to Beijing Lei Ting in exchange for service fees.

 

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(2) In addition to Beijing Superchannel, GreaTom also provides technical and consulting services to Shenzhen Freenet in exchange for service fees.

In the opinion of our PRC legal counsel, Jun He Law Offices, the ownership structures of our PRC operating companies and our subsidiaries incorporated in China, and contractual agreements among, certain of our wholly owned subsidiaries and our PRC operating companies and their shareholders as described in the chart above are in compliance with all existing PRC laws, rules and regulations and are enforceable in accordance with their terms and conditions, and subject to the applicable laws at the time of the enforcement, including, without limitation, that the enforcement of pledge of shares or assets will be subject to the relevant registration of such pledge, and that the enforcement of loan agreements will be subject to the foreign debt registration requirement. However, there are substantial uncertainties regarding the interpretation and implementation of current PRC laws and regulations, including without limitation, the Interim Provisions on the Takeover of Domestic Enterprises by Foreign Investors issued on August 8, 2006 and the MII regulations of July 13, 2006. See “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — PRC laws and regulations restrict foreign investment in China’s telecommunications services industry, and substantial uncertainties exist with respect to our contractual arrangements with our PRC operating companies due to uncertainties regarding the interpretation and application of current or future PRC laws and regulations,” “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — Our contractual arrangements with our PRC operating companies may not be as effective in providing operational control as direct ownership of these businesses” and “— Regulation — General.” As discussed in those risk factors, there may be certain circumstances that will cause us to lose the benefit and control intended to be created by these arrangements.

Capital Expenditures and Divestitures

See “Item 5 — Operating and Financial Review and Prospects — Liquidity and Capital Resources — Capital Expenditures” for information concerning our principal capital expenditures for the previous three years and those currently in progress. We have not undertaken any significant divestitures.

General Information

Our principal executive office is located at 8th Floor, Tower W3, Oriental Plaza, No. 1 Dong Chang An Avenue, Dong Cheng District, Beijing, China 100738. Our telephone number at this location is (8610) 6528-3399. In addition, we also have substantial offices located at Beijing Economic Technology Development Zone, Room 610, Tower C, No. 18 Xihuan Nan Lu, Beijing, China 100176 and Tower C, Webok Times Center, 17 South Zhongguancun Street, Haidian District, Beijing China. Our registered office in the Cayman Islands is located at M&C Corporate Services Limited, P.O. Box 309, Ugland House, South Church Street, George Town, Grand Cayman, Cayman Islands, British West Indies. Our primary website address is www.tom.com. Information contained on our website does not constitute a part of this annual report. Our agent for service of process is CT Corporation System, located at 111 Eighth Avenue, New York, New York 10011.

Business Overview

We are one of the leading wireless Internet companies in China by revenues, based on our comparison of our revenues with the publicly disclosed revenues of our competitors. We operate one of China’s most trafficked online properties, as measured by average daily page views, according to iResearch, a market research firm. We seek to provide wireless Internet services that are relevant and essential to young consumers, with a focus on entertainment, lifestyle and sports products and services. We deliver our services to our users through mobile telecommunication operators’ channels, portal and web alliances, alliances with mobile phone manufacturers, users’ mobile phones and traditional media, including television, radio and print.

We distinguish and differentiate ourselves through (1) our broad and diverse distribution channels, which allow us to reach a large portion of the overall Chinese population that has mobile phones but not necessarily Internet access, (2) our operational excellence, which allows us to provide high quality products and services to both our mobile operator partners and end users, (3) our acquisition and development of quality content and services tailored for the mobile phone, and (4) our integration of our online platforms (primarily www.tom.com) and online communities with our mobile services. In addition, we have enhanced our online features by establishing the TOM-Skype joint venture, which provides next-generation communication services to mainland Chinese Internet users.

 

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In July 2000, we launched our Internet portal, www.tom.com, and focused on providing Internet-based content and services to users through our websites. We began providing wireless Internet data services to mobile phone users through the networks of China Mobile and China Unicom in the second half of 2001. Wireless Internet services accounted for approximately 90.7% of our total revenues in 2006, down from 93.9% of our total revenues in 2005.

Prior to 2003, our offline advertising revenue accounted for the majority of our advertising revenue. From 2004 to 2006, our online advertising revenue accounted for all our advertising revenue. Our Internet portal is one of the leading Internet portals in China, and to monetize this position, we focused on developing our online advertising business by increasing the number of quality and branded companies advertising on our websites. We continue to attract leading advertisers from such industries as online auctions, consumer electronics, high-tech products, consumables and fashion who wish to target our young audience. Our advertising revenues accounted for approximately 7.9% of our total revenues in 2006, up from 5.5% of our total revenues in 2005.

Our other business mainly includes online games, e-commerce and fee-based e-mail services. Prior to 2005, our others business consisted mainly of providing technical and consulting services, including purchasing and installing computer hardware for customers. In 2006, our others revenue accounted for approximately 1.4% of our total revenues, up from 0.6% of our total revenues from 2005.

In 2004, we invested approximately US$1,494,000 in Sichuan Great Wall Software Group, or Sichuan Great Wall, a leading software developer and application provider for mobile telephones, in order to facilitate our transition from 2.5G products and services, consisting of WAP and location-based services, to 3G products and services. Sichuan Great Wall focuses on developing wireless applications based on JavaTM and BREW technologies. QUALCOMM Incorporated and IDG Technology Venture Investment also participated in this round of investment in Sichuan Great Wall. As of December 31, 2006, we owned approximately 13.95% of the equity interest in Sichuan Great Wall.

In August 2005, jointly with Skype Technologies, S.A., or Skype, we established Tel-Online Limited, or Tel-Online, a Cayman Islands incorporated company, to develop next-generation communication services in the mainland China market. Tel-Online offers instant messaging and chat functions to registered users in the PRC. We conducted sustained marketing activities relating to the TOM-Skype service during 2006. As of March 31, 2007, there were more than 35.5 million registered TOM-Skype users, up from the 7.43 million registered users at the end of December 31, 2005. We plan in 2007 to focus on attracting more registered users and continue promoting paid services over the TOM-Skype platform. As of December 31, 2006, we owned 51% of Tel-Online. We have determined that under US GAAP, Tel-Online is a variable interest entity and we are the primary beneficiary of the investments in the joint-venture. We consolidate its results of operations under “other business” in our consolidated financial statements.

On September 13, 2005, we entered into an alliance with UMPay (whose shareholders include China Mobile and China UnionPay) to become its wireless and online payment portal partner and to work with UMPay to offer mobile payment products to Chinese consumers and merchants. Under the terms of our alliance with UMPay, we will receive a percentage of the fees that merchants will pay to UMPay for mobile payment services, such percentage to be specified in a supplemental agreement into which the parties will enter. For the year ended December 31, 2006, our alliance with UMPay generated revenues of US$32,000. We do not expect material revenues from this alliance in the near term. We reflect the results of our alliance with UMpay under “other business” in our consolidated financial statements.

On February 1, 2007, we established a joint venture online and wireless Internet auction and marketplace company, TOM Eachnet PRC Holdings (BVI) Inc., in which we hold a 51% stake and eBay holds a 49% stake. eBay provided initial funding of US$40,000,000 in February 2007, and we have agreed to provide an initial shareholder’s loan in the amount of US$20,000,000 when such loan is needed. If this initial funding and initial shareholder’s loan have been fully utilized and we and eBay agree that additional funding is needed, we and eBay will each provide shareholder’s loans, in equal proportions, not to exceed US$10,000,000 in the aggregate. EBay has injected into the joint venture its subsidiary, eBay Eachnet Network Information Services (Shanghai) Co. Ltd.,

 

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which operates an online auction and marketplace business in China, and we will contribute our local industry expertise, management services, technology and brand. We will account for this joint venture using the equity method of accounting starting from February 1, 2007.

Our Business

Our primary business activities are wireless Internet services and online advertising. Our Internet portal that contains our content is the foundation and gateway for our primary business activities. Users can access our content through their mobile phones using various services, such as SMS, MMS, WAP, IVR and CRBT services, as well as through our websites using their personal computers. In addition, users were able to access our wireless services through over 400 television channels as of December 31, 2006.

We aggregate content from other providers as well as produce our own content. Our content is edited, redesigned and repackaged through our content management system for our different products and services. Our experienced team of editors and producers focuses on selecting information from our content sources that will attract the younger generation of consumers. We obtain content for our various channels from third-party suppliers, the public domain, freelance writers and in-house writers, which enables us to provide a wide range of content offerings that target young and trendy users. Moreover, we have exclusive rights over the content produced by our freelance and in-house writers, as well as some of the content produced by third parties through our licensing agreements. In 2006, we increased our proprietary content production by increasing the number of our freelance and in-house writers and by acquiring content providers and/or other content aggregators. As of December 31, 2006, we had more than 210 freelance writers and approximately 270 external content suppliers. We contract with our content providers to use their content for a fixed licensing fee, for a share of revenue or in exchange for access to our content. These arrangements are usually short-term and not exclusive, except for the content specifically produced for us by our freelance writers and our in-house writers as well as certain third parties.

The following table sets forth the revenues attributable to our various business activities for the periods indicated:

 

     For the year ended December 31,
     2004    2005 (restated(1))    2006
     (in thousands of U.S. dollars, except percentages)

Wireless Internet services(2)

   112,880    157,833    152,637

Online advertising

   7,583    9,210    13,279

Others(3)

   2,257    1,025    2,449
              

Total revenues

   122,720    168,068    168,365
              

(1) Financial data in 2005 have been restated as revenue from mobile games products of Indiagames has been separately presented under “Discontinued Operations.”
(2) Includes revenue from our download products, information products and community-oriented products that we provide through the wireless Internet services platforms of China Mobile and China Unicom. Revenues from the services of LingXun, Startone and Beijing Infomax are included beginning as of August 11, 2004, November 19, 2004 and June 1, 2006, respectively.
(3) During the years ended December 31, 2005 and 2006, consists primarily revenue from online games, e-commerce and fee-based email services; during the year ended December 31, 2004, consists primarily of revenue from technical and consulting services, including purchasing and installing computer hardware for customers. We gradually phased out our commercial enterprise solutions business from 2003 to 2005.

Wireless Internet Services

Our wireless Internet services include wireless Internet data services and wireless Internet voice services. We launched our wireless Internet data services business in the second half of 2001, and on November 19, 2003, we acquired Puccini, which provides wireless Internet voice services through Wu Ji Network. We also provide wireless Internet services through Treasure Base, Whole Win, Indiagames and Gainfirst and their respective PRC operating companies.

 

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Wireless Internet Data Services

Our wireless Internet data services include SMS, MMS, WAP and mobile games. In 2006, the majority of our wireless Internet data services revenue was derived from our music and entertainment services. Our entertainment, music, information and community-oriented products include news headlines, sports news, games, chatrooms and wallpaper. We deliver these products to customers’ mobile phones from our Internet portal and through other distribution channels such as mobile handsets, television and radio. Our users can order our products on a per download basis or subscribe to our products on a monthly basis.

Products and Services. Our wireless Internet data products include download, information and community-oriented products.

 

   

Download products. User can download ring tones, ring-back tones, wallpaper to serve as background for their mobile phone display, pictures, logos, games and screen savers from our Internet portal onto their mobile phones or to send to other mobile phone users. Users may choose to download such products on a per message basis or subscribe to receive new downloads on a regular basis.

 

   

Information products. Users can download our information content, including news headlines and articles, sports updates, entertainment information, jokes and horoscopes, from our Internet portal onto their mobile phones. Users may access such content on a per message basis or subscribe to receive new information content on a regular basis.

 

   

Community-oriented products. Users can engage in community-oriented activities such as chatting, dating and friends networking. Users may also download games to play on their mobile phones. Users may access our wireless community-oriented products only on a monthly subscription basis.

We provide our wireless Internet data products through our SMS, MMS and WAP technology platforms.

 

   

Short Messaging Services (SMS). SMS allows users to access our download and information products, such as news headlines, sports news, games, ring tones, and wallpaper, through their mobile phones. Users are also able to interact with other users by subscribing to our community-oriented products. In 2006, our SMS revenue accounted for approximately 39.4% of our total wireless Internet services revenue.

 

   

Multimedia Messaging Services (MMS). MMS is a technology which is an extension of SMS technology, but instead of being able to send just text, MMS allows for sound, images and other multimedia content to be sent as well. As a result, MMS enables users to download colorful pictures and advanced ring tones as well as transmit more data in a single message. In 2006, our MMS revenue accounted for approximately 8.2% of our total wireless Internet services revenue.

 

   

Wireless Application Protocol (WAP). WAP allows users to browse content in a more user-friendly format on their mobile phones so that users can request and receive information in a manner similar to accessing information on Internet websites. WAP uses General Packet Radio Service or GPRS technology and allows users to download pictures, logos, wallpaper, interactive games, ring tones and other Internet content. We launched our WAP services in May 2002. In 2006, our WAP revenue accounted for approximately 19.1% of our total wireless Internet services revenue.

The following table sets forth the number of subscribers for our wireless Internet data services business as of the dates indicated:

 

     December 31, 2005    December 31, 2006
     (in millions)

SMS subscribers

   92.3    55.9

MMS subscribers

   2.3    2.0

WAP subscribers

   18.6    27.3

 

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Despite the decline in the numbers of SMS and MMS subscribers in 2006 as a result of changes in China Mobile and China Unicom subscription policies as described herein, we believe that China’s wireless Internet data services market will grow over the long term as its mobile telecommunications market expands, mobile telecommunications operators continue to promote wireless Internet data services and users become more receptive to such services. We also believe some of the policies introduced by the Chinese government and mobile operators in 2006 will help create a more regulated environment for the healthy development of the industry, although they may have a temporary negative impact on certain portions of our business.

Wireless Internet Data Services Cooperation Arrangements. We have established cooperation arrangements with mobile telecommunications operators, mobile phone producers, other distribution partners and third-party content providers in connection with our wireless Internet data services business. In 2006, we continued to establish new promotion arrangements with other distribution partners pursuant to which they promote our products through their channels.

We provide our wireless Internet data services through China Mobile’s MonternetTM and China Unicom’s UNI-InfoTM platforms pursuant to revenue-sharing agreements that we have entered into with these mobile telecommunications operators. China Mobile and China Unicom control the mobile telecommunications networks through which most wireless Internet data services are currently provided to mobile phone users in China. Our close working relationships with China Mobile and China Unicom are critical to the operation and continued development of our wireless Internet data services business. See “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — A substantial portion of our business depends on mobile telecommunications operators in China, and any loss or deterioration of such relationship may result in severe disruptions to our business operations and the loss of a significant portion of our revenues.” As of December 31, 2006, we had entered into approximately 130 cooperation and revenue sharing agreements with various provincial subsidiaries of mobile telecommunications operators to provide wireless Internet data services to mobile phone users, to research and develop new wireless data technologies and to promote the use of wireless Internet data services in China. In particular, we were the first wireless Internet data services provider to jointly develop and launch MMS services, and one of the first to offer WAP services with China Mobile. In addition, we have jointly promoted wireless Internet data services with China Mobile, which is generally more cost effective than promoting these services through traditional advertising. We have held a number of joint promotional events with China Mobile every year since 2002.

We have also established cooperation arrangements with mobile phone producers, such as Nokia, Samsung, Motorola and SonyEricsson, which manufacture select handset models with a wireless Internet services icon pre-loaded into the handset’s menu that enables users to access our wireless Internet services directly from their mobile phones. Pursuant to an MII notice that was issued on April 11, 2007 and took effect June 1, 2007, mobile phone producers can no longer embed our wireless Internet services icon into the handset menu in such a way that the icon cannot be deleted by consumers. Mobile phone producers are still permitted to pre-load our icons into the handset menus as long as consumers are able to delete the icons if they wish, and we are altering our arrangements with the mobile phone producers to comply with the MII notice. Furthermore, in the past, China Mobile entered into its own strategic alliances with selected mobile phone producers pursuant to which it embedded menus in their handsets for all the best-selling products on China Mobile’s MonternetTM wireless portal, including certain of our products. However, beginning in May 2007, China Mobile has started to promote only its own wireless value-added service products in such menus and not those of us or other third-party value-added service providers. See “Item 3 — Key Information — Risk Factors — Risks Relating to Our Industry — The Internet industry is highly regulated by the PRC government. If we fail to obtain or maintain all pertinent permits and approvals or if the government changes existing regulations or imposes new ones, our business operations may be materially adversely affected.”

We also have entered into joint marketing programs with mobile phone producers to target young users, such as campus roadshows. Such partnerships have led to cooperation relationships in which the mobile phone producers become our online advertising clients.

 

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Fees and Revenue Sharing. We establish the fees for our wireless Internet data services in consultation with mobile telecommunications operators in China. We share the revenue from these fees with the mobile telecommunications operators, content providers, mobile phone producers and other distribution partners. We also pay a transmission fee to the appropriate mobile telecommunications operator with respect to messages that we send through its wireless Internet services platform.

The mobile telecommunications operators establish standards within which wireless Internet data services providers are able to set the fees for their services. These standards are filed with the MII by the mobile telecommunications operators. In accordance with these standards, we charge our users content fees on either a per-message or a monthly subscription basis. Both our per-message and our monthly subscription content fees vary for our different wireless data products and services.

Pursuant to our revenue-sharing agreements with the subsidiaries of China Mobile, generally we receive 85% of the content fees for wireless Internet data services that we provide to users through China Mobile’s MonternetTM platform. In addition, for services other than WAP services, China Mobile deducts a transmission fee from our portion of the content fees. Such transmission fee is charged on a per message basis as set forth in the table below. The amount of such transmission fee is different for SMS and MMS services and varies depending on the volume of wireless data messages sent. Generally, the term of these revenue-sharing agreements is twelve months.

Pursuant to our revenue-sharing agreements with China Unicom, China Unicom deducts from the monthly revenue due to us a fee for bad debts, and in the case of SMS services, China Unicom also deducts transmission fees on a per-message basis. Pursuant to the new revenue-sharing arrangement announced by China Unicom in 2007, starting from April 1, 2007, we receive 80% of the monthly revenue China Unicom actually received instead of 80% of the monthly revenue receivable after deducting a fee of up to 8% for bad debts. As a result, the amount of monthly revenue we collect from China Unicom after April 1, 2007, could be greater or smaller than the amount we received prior to April 1, 2007, depending on the actual level of bad debts experienced by China Unicom. In 2006, we generally received, after the deduction of fees, about 75% and 55%, respectively, of the receivable content fees for WAP and SMS services that we provided to users through China Unicom’s platform, compared to 75% and 60% in 2005. Generally the term of our revenue-sharing agreements with China Unicom is twelve months.

The following table sets forth our principal fees and revenue-sharing arrangements with China Mobile’s subsidiaries and China Unicom as of December 31, 2006. The percentage of revenue we share with the mobile telecommunications operators may be increased or decreased, based on negotiations between the mobile telecommunications operator and us on the terms, including whether we agree to bear the credit risk of end users.

 

     Content fee     Transmission Fee
     Fee per message    Fee per monthly
subscription
   Our share before
transmission fees,
bad debts and
other fees
    Fee per message
     (in RMB(1), except percentage)      

SMS (China Mobile)

   0.10–2.00    3.00–30.00    85 %   0.05–0.08

SMS (China Unicom)

   0.05–2.00    4.50–30.00    80 %   0.05

MMS (China Mobile)

   0.50–4.00    5.00–30.00    85 %   0.15–0.20

WAP (China Mobile)

   1.00–2.00    3.00–8.00    85 %   0

WAP (China Unicom)

   1.00–2.00    5.00–8.00    80 %   0

(1) Our per message and subscription-based content fees are charged in Renminbi. The noon buying rate certified by the Federal Reserve Bank of New York was RMB7.8041=US$1.00 on December 29, 2006.

China Mobile and China Unicom provide us with billing and collection services for our wireless Internet data services business. The fees for our services are incorporated into the mobile telecommunications operators’ invoices, which are sent to users on a

 

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monthly basis. We receive monthly statements from each of the mobile telecommunications operators, which indicate the amount of fees that were charged to users for wireless Internet data services that we provided. The migration of our wireless Internet data services onto China Mobile’s MISC platform was completed in 2006. MISC is a mobile data management platform that records, processes and analyzes information relating to the provision of wireless Internet data services, including usage, transmission and billing information. Following the introduction of MISC, the discrepancy between our revenue estimates and the revenue calculated by China Mobile decreased slightly in 2006. For a description of our wireless Internet services revenue recognition policy, see “Item 5 — Operating and Financial Review and Prospects — Critical Accounting Policies — Wireless Internet Services Revenue Recognition.” Also see “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — A substantial portion of our business depends on telecommunications operators in China, and any loss or deterioration of such relationship may result in severe disruptions to our business operations and the loss of a significant portion of our revenues.”

From time to time, China Mobile, China Unicom or their provincial subsidiaries or MII may change their policies or guidelines toward Internet service providers, including us. For example, in 2004, some mobile telecommunications operators extended to three months the time it took them to pay us for services provided to consumers, up from the previous two months. Beginning in 2004, operators also have:

 

   

imposed stricter regulations over wireless Internet content and the quality of wireless Internet products and services, and

 

   

imposed various penalties on service providers in connection with their wireless Internet content and business practices.

For example, effective January 1, 2005, China Mobile changed its billing policy so that we can no longer collect revenue with respect to undeliverable MMS messages. Previously, MMS messages that were undeliverable because the recipient’s handset was turned off, out of the network service area or not equipped to handle MMS messages were forwarded to an Internet mailbox, and we were entitled to collect revenue in connection with the message. Following the adoption of this new policy, our MMS revenues decreased significantly, although they subsequently rebounded. In 2005, China Mobile also began canceling subscriptions of users who have not accessed their wireless Internet service subscriptions for a certain period of time or who fail to pay China Mobile or its provincial subsidiaries.

In July 2006, in accordance with a policy directive from MII, China Mobile began implementing new measures with respect to wireless Internet service subscriptions, including:

 

   

a one-month free-trial period for all new SMS, MMS and WAP subscriptions;

 

   

a requirement that new subscribers to wireless Internet services shall confirm twice, in response to reminders from China Mobile, that they wish to start subscriptions;

 

   

sending a reminder to existing subscribers about their subscriptions and fees they are being charged. Certain provincial subsidiaries of China Mobile including Guangdong Mobile, one of China Mobile’s largest subsidiaries, will not continue to charge existing subscribers unless they respond to such reminder notices by confirming their intent to subscribe; and

 

   

canceling WAP subscriptions that have been inactive for more than four months.

China Unicom also began requiring subscribers to wireless Internet services to double confirm their subscriptions during the quarter ended September 30, 2006. As a result of the 2006 policies, our SMS revenues decreased 25.1% during the third quarter of 2006 as compared to the second quarter and 33.6% during the fourth quarter of 2006 as compared to the third quarter. In addition, in May 2007, China Mobile introduced a new practice of sending fee reminders to its WAP service users when they request downloads of WAP pages onto their mobile handsets and seeking their confirmation before such download requests are processed. We expect this new practice to have a significant adverse effect on our WAP business in particular and our wireless value-added service business as a whole.

 

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In late July 2005, China Unicom notified several major service providers, including Beijing Lei Ting, of a temporary suspension of the settlement of service fees, because of complaints it received from mobile phone users pertaining to services rendered during the period from January 2005 to June 2005. According to the notice, China Unicom received complaints from users regarding Beijing Lei Ting’s provision of short messaging services, or SMS, in possible breach of certain conditions of the agreement with the mobile operator with respect to service failure and inaccurate billing. In September 2005, as a result of China Unicom’s investigation, Beijing Lei Ting received two sanction notices from China Unicom together with a fine of US$209,000. In addition, on June 5, 2007, the MII notified 265 service providers, including Beijing Lei Ting and Wu Ji Network, that certain of their business practice had failed MII’s annual performance review. Such service providers were required to rectify the problems before June 24, 2007 and submit a report to the MII detailing the measures they have taken to correct those problems. Beijing Lei Ting and Wu Ji Network were included in such notice because a small number of services they provided to mobile phone users did not match the service codes they were required to use. The problem arose because both companies had reshuffled certain product offerings after they submitted their annual business reports to the MII in December 2006. Since receiving the MII notice, both companies have rectified the problem and submitted reports to the MII prior to June 24, 2007.

We also share revenue from our wireless Internet data services with the mobile phone producers with whom we have cooperation arrangements. Pursuant to our revenue-sharing arrangements, mobile phone producers receive 50% to 70% of the revenue, net of transmission fees and payment commissions, that we receive from mobile telecommunications operators, with respect to wireless Internet data services that are accessed through the link to our Internet portal in the user’s handset. The terms of these agreements are generally for three years and relate to specific mobile phone models.

In addition, we entered into mutual promotion arrangements with other distribution partners such as television stations and radio broadcasters in 2006 for the placing of our products on their programs. Pursuant to these arrangements, we generally pay 40% to 60% of the revenue, net of transmission fees and payment commissions we receive from the mobile telecommunications operators in connection with the services delivered to users that utilize products on their programs. Such agreements are generally for terms of one to three years.

We have also entered into content licensing agreements with content providers. Pursuant to these agreements, we either pay a fixed fee for the content that we license or we remit a percentage of the revenue that we receive from mobile telecommunications operators with respect to messages that contain the licensed content. Such agreements are generally for terms of one to two years.

Wireless Internet Voice Services

Our wireless Internet voice services consist of wireless IVR services and CRBT services.

Wireless IVR Products and Services. Wireless IVR services allow users to access voice content from their mobile phones. We provide entertainment and other products through our wireless IVR services.

 

   

Entertainment products. Our wireless IVR entertainment products include music and celebrity voice greetings. In 2006, the majority of our wireless IVR services revenue was derived from our music and entertainment channels. During 2006, we continued to promote our “Wanleba” Internet music brand through music roadshows to different cities and university campuses. Wanleba is a music community that leverages the www.tom.com portal to allow singers and songwriters to take advantage of our mobile distribution channels.

 

   

Other products. Other products include sports-related products such as score updates for sports matches, community-oriented products such as chat and friend-finding services, and information products such as weather information.

 

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We operate a recording studio in which we create all of our wireless IVR services content. We develop our own content for certain channels by utilizing content in the public domain and content developed in-house, and obtain content for other channels from third-party content providers on a revenue-sharing basis or by paying a fixed fee. We operated 27 channels as of December 31, 2006. The content we provide is subject to regulation by the PRC government. For a description of the regulations associated with our wireless IVR services business, see “— Regulation.” Also see “Item 3 — Key Information — Risk Factors — Risks Relating to Our Industry — Regulation and censorship of information distribution over the Internet in China may adversely affect our business, and we may be liable for information displayed on, retrieved from, or linked to our Internet portal.”

We provide wireless IVR services on the China Mobile and China Unicom platforms. Pursuant to our revenue-sharing arrangements with China Mobile and China Unicom, we generally received 85% and 60%, respectively, of the fees we generated by providing IVR services over their platforms in 2006. Effective January 2007, China Mobile increased to 30%, from 15%, its share of such fees. This change in China Mobile’s share of our IVR fees resulted from China Mobile having centralized all IVR operations from different platforms such as our own platforms to its single nationwide platform.

During 2006, based on our internal records, approximately 28.3 million unique users accessed our wireless IVR services, compared with approximately 29.9 million unique users in 2005.

CRBT Services. We launched our CRBT tone services on the China Mobile and China Unicom platforms in January 2004 and April 2004, respectively. CRBT services allow mobile phone users to play music, sound or phrases to incoming callers. Users can download the services through the mobile telecommunications operators’ platforms.

We provide CRBT services pursuant to cooperation agreements with China Mobile and China Unicom. These agreements have one-year terms and do not provide for automatic renewal. We are generally entitled to 85% of the CRBT content revenues pursuant to our agreements with China Mobile. With China Unicom, our share of CRBT revenues ranges between 50% and 70%. We have also established cooperation arrangements with third-party content providers to provide products and services to the users. We usually pay third-party content providers 10% to 50% of the revenue we receive from the mobile telecommunications operators.

Online Advertising

Our online advertising services, which we have been offering since 2001, consist of placing advertisements on our websites in various forms, such as banners, links logos and pop-up boxes. As we provide various free online services on our websites and because users access our wireless Internet data services through our websites, our user traffic on our websites has increased, which makes our online advertising services more attractive to advertising clients. Prior to our 2003 reorganization, our offline advertising business accounted for the majority of our advertising revenue, but following our reorganization, the offline advertising business is no longer part of our company.

In 2006, our online advertising business grew as both the number of our advertising clients and the average size of contracts continued to expand. Some of our major advertisers during 2006 included General Motors Corp., eBay Inc., Lenovo Group, SonyEricsson Mobile Communications AB and Nokia Corporation. We expect our online advertising business to further expand as we attract more user traffic to our websites by offering products and services that appeal to young and trendy users, seek cross-selling opportunities and focus our sales and marketing efforts to develop our online advertising and directory listings businesses. Users who use our wireless Internet data services also increase our website traffic, thereby making our websites more attractive to online advertisers.

To develop our online advertising business, we use our strengths and partnerships in our other business activities to build relationships with advertisers that target young and trendy users. For example, we utilized our strengths in wireless Internet data services to sell online advertising services to mobile phone producers and mobile and fixed line telecommunications operators. We have also developed online advertising relationships with Internet companies to market their websites by sending advertising e-mails to our e-mail subscribers and by placing advertisements on our websites. Furthermore, we target key industries that we believe would benefit from online advertising, such as the automobile, telecommunications, education and consumer goods industries, and cater to the younger and more affluent market. The terms of our online advertising contracts range from one day to one year, with varying contractual amounts.

 

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We track the performance of online advertisements placed on our websites with the Allyes software system. This system records the number of clicks, impressions and click rates for advertisements on our websites, thus providing our online advertising clients with a measure of the effectiveness of their advertisements.

Others

Our other business mainly includes online games, e-commerce and fee-based e-mail services. From 2001 through 2004, our other business included our commercial enterprise solutions business, which provided technical and consulting services for the Internet-related needs of our clients such as purchasing and installing computer hardware and software. We began to phase out our commercial enterprise solutions business in the second half of 2003. In 2006, revenues from paid e-mail services, online games and other business, accounted for approximately 1.4% of our total revenues.

Internet Access Cards

Due to increased competition and low profit margins, we stopped selling Internet access cards in the fourth quarter of 2002. The last Internet access card that we sold expired at the end of the first quarter of 2004, and we have not recognized any revenue with respect to this business in subsequent periods. We did not recognize any costs with respect to this business in 2004 because such costs were accrued in 2003.

Our Content

To support our primary business activities, we provide various content and services through our websites, which include about 56 content channels, instant messaging software, various chat rooms, Internet navigational and search capabilities and both basic free e-mail and advanced fee-based e-mail. As of December 31, 2006, we had approximately 33.5 million registered users of our free e-mail services. Our primary website address is www.tom.com. In addition, we began in January 2006 to provide an online literature service through our acquisition of a 75% stake in Huan Jian Shu Meng, which provides original Chinese novels to readers at its website www.hjsm.net.

Although we provide a comprehensive range of content channels on our websites, we focus on channels that are targeted at young and trendy users, such as our sports, entertainment, automobile, music and women channels. Our entertainment channel appeals to young users interested in information about celebrities, music news, album reviews, artist biographies, movie news and special features. Our sports channel attracts users with an interest in up-to-the-minute news, real-time statistics and scoring, localized and global coverage of sporting events and an online sports community. On March 29, 2006, we announced an exclusive strategic partnership agreement with Titan Sports, one of China’s largest sports newspapers, to launch a new sports channel titan.tom.com and cooperate on a number of long-term initiatives. The strategic cooperation allows us to use such newspaper’s content in our online and wireless services. From time to time we also carry out joint promotions. In 2007, the paper’s editorial staff has started writing news blogs on our website.

Our primary content channels include:

 

News    Provides comprehensive, up-to-the-minute information on national and international news from newspapers, magazines, television stations and other information providers throughout China, as well as a chat room discussion of news events and issues. Our news content sources include traditional news sources, such as People’s Daily, Xinhua News Agency, China Daily, Reuters, individual freelancers with whom we have contracted and our internal staff writers.
Sports    Covers the latest in national and international sports headlines and statistics, including events such as the FIFA World Cup 2006, Asian Games, China Open tennis tournament, table tennis world cup and selected National Basketball Association games.

 

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Entertainment    Provides a mix of exclusive content, movie news and special features, including celebrity interviews, music reviews and photo galleries, as well as links to movie-related content in our portal.
Automobile    Offers information about buying and owning automobiles, such as pricing information, specification information and other research information.
Women    Covers a broad range of lifestyle-related topics that are of particular interest to Chinese women, including beauty tips, fashion advice and health information.
Community    Offers a variety of communication and community tools, including chat rooms, dating services, electronic greetings, bulletin boards, free and fee-based e-mail and photo album channels, to enable members to easily communicate with other individuals with similar interests.

The table below sets forth the average daily website page views for our primary content channels for the periods indicated, as calculated by our internally developed software program.

 

     For the year ended
     2004    2005    2006
     (in millions)

News

   15.2    35.0    28.6

Sports

   13.1    21.4    37.3

Entertainment

   12.7    15.5    17.7

Homepage

   14.6    31.0    21.9

Automobile

   8.5    17.2    10.7

Music

   4.3    3.2    8.6

Women

   8.4    7.2    9.8

Games information

   9.8    8.6    4.0

Total

   86.6    139.1    138.6

Our e-mail, chat and bulletin board services also generate significant daily page views for our website.

In addition to the content channels described above, we also provide our users with content channels that focus on technology, games, military affairs, horoscopes, art, culture, humor, finance, fashion, careers, real estate, health, flash downloads, pictures, education, greetings and shopping. Furthermore, each of our primary content channels contains various subcategories that cover a range of related topics. In 2006, we streamlined the number of content channels to 56 from 60 in 2005. The four channels now defunct or absorbed into other channels are childcare, school alumni networks, life and car quotes. We expect to continue to provide content that is more appealing to our audience through increased in-house development as well as through the acquisition of, and cooperation with, external content providers, and will continue to engage in discussions with external content providers that we believe may provide opportunities to increase and improve our content. We currently have about 273 external content providers.

Sales, Marketing and Customer Service

Sales

Our sales efforts focus primarily on our wireless Internet services and online advertising services. Our internal sales teams are responsible for the majority of our wireless Internet services and online advertising sales.

Our wireless Internet sales team is represented in all provinces and in major municipalities such as Shanghai. The sales team works closely with the provincial and municipal branches of mobile telecommunications operators to promote our wireless Internet services and to tailor such services to the local markets.

 

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Our online advertising sales team provides business consultation and post-sale customer services, promotes pre-sale activities and furnishes performance tracking reports. Our online advertising sales team also manages our relationships with key clients and periodically reviews the performance of certain online advertisements on our portal in order to enhance the results of our online advertisements for our clients. The compensation package for our sales staff typically consists of a base salary plus sales commissions. Sales quotas are assigned to all sales personnel according to quarterly sales plans. Through our sales offices in Beijing, Shanghai and Guangzhou, we work directly with key clients that have significant advertising budgets and we organize specific sales teams to target certain industries in the northern, eastern and southern regions of China.

In 2006, we built new relationships with more advertising agencies to recommend our online marketing to their clients by offering rebate incentives to advertising agencies for bulk purchases. As some clients require all advertising business to be conducted through their advertising agencies, we target leading advertising agencies that service large corporations with substantial advertising budgets in key industries that we believe would benefit from online advertising.

Marketing

The focus of our marketing strategy is to generate and enhance awareness of our tom.com brand name and promote our products and services. In 2006, we spent about 44% of our marketing budget on promoting our brand and services. Those marketing activities included advertising on outdoor billboards, buses, in elevator ad panels and on television. We also held marketing events such as our annual Internet Entertainment Award Gala and FIFA World Cup promotion, advertised at trade events such as automobile shows and participated in conferences to increase awareness for our tom.com brand name.

We conduct frequent public relations events, such as product launching events, campus promotions, and product promotional events at which we offer awards to select participants to market our brand name and our products. Since our major target market is young and trendy users, we promote our products and services on college campuses throughout China. We also conduct market research in order to determine the interests of the young and trend-setting consumer in order to target the younger generation market. In addition, we utilize our online media platform to exchange our free online advertising services for traditional media coverage, such as newspapers, magazines and television, to promote our brand, products and services.

As of December 31, 2006, our sales and marketing department consisted of 83 full-time employees based in ten cities, including Beijing, Shanghai and Guangzhou.

Customer Service

Our customer service center handles calls, faxes and e-mails from our paid online services clients and wireless Internet data and voice services users, as well as inquiries forwarded from mobile telecommunications operators. Our customer service representatives also interact on a regular basis with, and provide training materials to, customer service representatives of mobile telecommunications operators to enhance our wireless Internet data and voice services. We have three regional call centers, which are located in Beijing, Shanghai and Guangzhou, and employed 38 full-time customer service representatives as of December 31, 2006. Our call centers operate 24 hours a day, seven days a week, and currently handle an average of more than 3,200 inquiries from our clients and users per day.

Customers and Suppliers

We collect our wireless Internet services revenue through China Mobile and China Unicom, who act as our billing and collection agents. Our revenue collected through them was approximately US$111,900,000, US$157,719,000 and US$152,165,000 in the years ended December 31, 2004, 2005 and 2006, respectively.

Our aggregate payments to China Mobile and China Unicom in the form of transmission fees incurred for SMS and MMS messages that we sent on through their wireless Internet platforms were approximately US$25,951,000, US$42,735,000 and US$40,234,000 in the years ended December 31, 2004, 2005 and 2006, respectively.

 

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Product Development

Our product development team refines and upgrades our current products and creates new and innovative products that utilize the latest technology. In addition, our product development team works closely with China Mobile’s research and development department to offer new products and services that meet China Mobile’s product specifications and timing criteria. As of December 31, 2006, our product development team consisted of 94 full-time employees, down from 147 in 2005, as a result of our cost control program in response to the negative impact of the new China Mobile and China Unicom policies with respect to wireless Internet subscription.

Our product development team includes engineers with a wide range of technical experience across platforms in the wireless telecommunications sector. It also creates innovative products that utilize new technologies, including 2.5G and 3G. In the second quarter of 2002, 2.5G services were officially launched in China. This technology enables wireless Internet service providers to send more data in a shorter period of time, thereby facilitating the transmission of more advanced data products. We have been engaged by mobile telecommunications operators to develop products and services that are compatible with more advanced technologies such as 3G.

In 2006, our product development team continued to work closely with the mobile telecommunications operators’ research and development departments to offer new products. We were the first wireless Internet service provider to develop and offer MMS and one of the first to offer WAP services. We believe that our timely delivery of new products and services that meet mobile telecommunications operators’ specifications has demonstrated our technical capabilities and strengthened our cooperative relationship with mobile telecommunications operators.

For our wireless Internet services, we plan to devote our product development team to enhance our 2.5G products and services, develop new services and applications for 3G and create more attractive and complex wireless applications, including mobile games and video downloads. In addition, we will continue to develop cooperative arrangements to improve our Internet portal technologies and service offerings.

Information Technology Systems and Infrastructure

We utilize our information technology system to collect and analyze marketing and online advertising data, as well as to process and manage our content. Our information technology system produces marketing and demographic reports based on a daily analysis of our number of website page views, registered users, message volume, Internet protocols and bandwidth. In addition, we use software from Allyes to automatically process and manage our online advertisements and to measure the number of page views, impressions and click-throughs that advertisements on our websites receive, in order to evaluate the effectiveness of our online advertising service. We also intend to work with other third party service providers to enhance our online advertising management and analysis.

Our content management system facilitates the accurate and timely posting of news and information on our websites and through our wireless Internet services. We enter information into our content management system formatted to match certain standard templates and we classify our content by channel. Once entered into our content management system, data can be delivered to users through our websites or our various wireless Internet data services.

We maintain most of our servers at the premises of Beijing Communication Corporation, which is the administrator of the central hub of the ChinaNet backbone. We also maintain servers at other Internet data centers including Beijing Mobile Communication Company Limited, or Beijing Mobile, and Chongqing Mobile Communication Company Limited. We added servers in 2006 at approximately 10 China Telecom subsidiaries including in Beijing, Chengdu and Changsha. We believe that these hosting partners provide significant operating advantages, including an enhanced ability to protect our systems from power loss, break-ins and other potential external causes of service interruption. We believe we will be able to increase our server capacity as needed to accommodate our growth in the future.

 

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Competition

We face competition from other companies in each of our primary business activities. In particular, these companies compete with us for wireless Internet data services users, website traffic and online advertising clients. We also compete for experienced and talented employees. While we are one of the leading Internet companies in China, some of our competitors may have greater access to capital, human and financial resources than we do, and may have a longer operating history than us. Furthermore, our competitors may be able to offer a broader range of products and services than we are presently able to offer.

In addition to competition from other wireless Internet service providers, mobile telecommunications operators have begun offering services that compete with ours, some of which are being provided on a complimentary basis. While the competing services offered by mobile telecommunications operators are currently limited and therefore do not pose significant competition to us, we cannot assure you that mobile telecommunications operators will not offer additional competing services in the future. See “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — We face intense competition, which could reduce our market share, and materially adversely affect our financial condition and results of operations.”

Wireless Internet Data Services

Competition is intense in China’s wireless Internet data services market as the barriers to entry are relatively low and the number of wireless data service providers is high. We are one of the leading wireless Internet data service providers in China by revenue and the only provider with top-three market share by revenue in each of MMS, WAP, SMS, IVR and CBRT services, according to Analysys International. Our primary competitors in the wireless Internet data services market include Sina.com, Sohu.com, Netease.com, Linktone.com, Kongzhong.com, Tencent.com, Rock Mobile, Beijing Longtech Company Limited, Beijing QTT Information Services Company Limited and Hurray.com. We may face increasing competition from these and other wireless Internet data services providers in China as they strive to improve their wireless Internet data services products and develop cooperation relationships with mobile phone producers. We compete with other wireless data service providers primarily on the basis of brand name, product and service offerings and content. We believe we have advantages over our competitors because of the close cooperation arrangements we have with leading mobile phone producers in China, our focus on the high-margin wireless Internet data services, our targeting of the young and trendy user base, our innovative product development team and our promotion and marketing programs.

Wireless Internet Voice Services

We are the leading provider of wireless IVR services in China in terms of revenue in 2006, according to Analysys International. Our competitors in the wireless IVR services sector include most of our competitors in wireless Internet data services. We believe that we have advantages over these competitors because we offer a range of products through more diversified distribution channels and are one of a few wireless IVR service providers that are also a leading Internet portal in China. We also indirectly compete with providers of fixed-line IVR services. Because of the localized nature of fixed-line telecommunications networks, however, a nationwide coverage of fixed-line IVR services would require a long distance telephone charge, which would be substantially higher than wireless IVR air-time charges. As a result, the fixed-line IVR services market is segmented along regional lines, while a single nationwide market exists for wireless IVR services.

The major competitors of our CRBT services include 5130.cn, qtt.cn, Sina.com, Tencent.com and A8.com. We believe we have advantages over our competitors because of our content development strategy, creative marketing programs and the large existing user base of our wireless Internet services.

Online Advertising

The online advertising industry is highly competitive. Since the beginning of 2003, we have focused on developing our online advertising services by leveraging our growing user base to compete with the leading Internet portals in China. Our primary competitors in the online advertising market include Sina.com, Sohu.com, Netease.com, Tencent, and Baidu. Some of our major competitors have a longer operating history and a more established track record in the online advertising business than we do. In

 

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addition, we believe the rapid increase in the number of Internet users in China has drawn and will continue to draw the attentions of large media companies to the Chinese online advertising market. For example, WPP Group PLC. has purchased Beijing Hua Yang Lian Zhong Advertising Co. and Focus Media has acquired Allyes Information Technology Company Limited in order to enter the Chinese online advertising market. As larger media companies tend to have greater bargaining power than smaller advertising agencies in the market, they may have the ability to drive online advertising margins lower in the future.

User traffic is one of the primary bases of competition among online advertising service providers, and we compete for user traffic on the basis of the quality of our content, breadth of our online services and our brand recognition. In addition, we compete with other major online advertising service providers on the basis of advertising agency relationships, strength of our internal sales team and price. Furthermore, our online advertising business competes with traditional forms of advertising, such as television, radio, newspapers and magazines, for the limited advertising budgets of companies in China. Moreover, we compete for users against major Chinese search engines including Baidu, Sohu, Sina and Yahoo! China.

Employees

General

We have implemented a number of initiatives in recent years to enhance the qualifications and fulfillment of our employees. We have refined our recruiting strategy to attract and retain quality employees by hiring experienced or creative personnel who are compatible with our company culture and understand the lifestyle trends of the younger generation. We conduct periodic reviews of our employees’ job performance, and we determine salaries and discretionary bonuses based upon those reviews. In addition, we offer internal training programs tailored to different job requirements to help enhance our employees’ talents and skills. We believe that these initiatives have contributed to the growth of our business.

As of December 31, 2006, we had 1,208 full-time employees in China, compared to 1,037 and 828 as of December 31, 2005 and 2004, respectively. The table below sets forth the number of our China-based employees by function as of December 31, 2006:

 

     Our Employees
     Number    % of Total

Management

   15    1.24

Sales and marketing

   83    6.87

Technology and engineering

   90    7.45

Research and development

   94    7.78

Production

   814    67.39

General and administrative

   112    9.27
         

Total

   1,208    100.00

As of December 31, 2006, we also had retained approximately 95 temporary employees as part-time employees, working mainly in Beijing.

We believe that we maintain a good working relationship with our employees and we have not experienced any significant labor disputes or any difficulty in recruiting staff for our operations. Our employees are not represented by any collective bargaining agreements or labor unions.

Employee Benefits Plan

As stipulated by PRC regulations, we participate in various housing programs, medical care, welfare subsidies, unemployment insurance and pension benefits through defined contribution plans that are organized by municipal and provincial governments for our employees. We are required under PRC law to accrue for these benefits based on percentages ranging from 8.0% to 22.5% of the salaries, bonuses and certain allowances of our employees. A member of the retirement plan is entitled to a pension equal to a fixed proportion of the salary prevailing at the member’s retirement date. The total amount we accrued under our employee benefits plan

 

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was approximately US$1,121,000, US$2,086,000 and US$1,989,000 for the years ended December 31, 2004, 2005 and 2006, respectively. We are required to make contributions to the plans out of the amounts accrued for medical and pension benefits. The total amount of contributions we made for such employee benefit plans was approximately US$1,045,000, US$1,881,000 and US$1,908,000 for the years ended December 31, 2004, 2005 and 2006, respectively.

Pursuant to our pre-initial public offering option plan, we granted certain of our employees options to acquire our ordinary shares at the initial public offering price. In addition, we have adopted a broad-based share option scheme. For a description of our pre-initial public offering share option plan and broad-based share option scheme, see “Item 6 — Directors, Senior Management and Employees — Compensation of Directors and Executive Officers.”

Intellectual Property and Proprietary Rights

We regard our copyrights, trademarks, trade secrets and other intellectual property rights as critical to our business. We rely on trademark and copyright law, trade secret protection, non-competition and confidentiality and/or licensing agreements with our executive officers, clients, partners and others to protect our intellectual property rights. Despite our efforts to protect our proprietary rights, we cannot be certain that the steps we have taken will prevent misappropriation of our content or technology, particularly in foreign countries where the relevant laws may not protect our proprietary rights as fully as in the United States or Hong Kong. For a description of the regulations of the Internet industry in China, see “Item 4 — Information on the Company — Business Overview — Regulation.” See also “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — Intellectual property is important to our business, and any unauthorized use of our intellectual property by third parties may adversely affect our business.”

We own certain domain names in association with the services provided by Shenzhen Freenet. In order to comply with a recent MII notice regarding trademark and domain name ownership by ICP license holders, the tom.com trademark and tom.com domain name have been assigned from Tom.com Enterprises Limited, a wholly owned subsidiary of our parent company, to Beijing Lei Ting, our wholly-owned subsidiary and one of our operating companies, by signing a deed of trademark and domain name assignment dated September 26, 2006. Under this deed, Tom.com Enterprises Limited assigns to Beijing Lei Ting, and Beijing Lei Ting accepts the assignment of, all of Tom.com Enterprises Limited’s rights, titles and interests in and to the tom.com trademark and tom.com domain name in consideration of the sum of US$1. In the event that Beijing Lei Ting ceases to be a wholly owned subsidiary, directly or indirectly, of us or if we cease to be a subsidiary, directly or indirectly, of TOM Group, Tom.com Enterprises Limited shall have the right to require, by notice in writing to Beijing Lei Ting, the assignment back to Tom.com Enterprises Limited of all of Beijing Lei Ting’s rights, titles and interests in and to the tom.com trademark and tom.com domain name at a consideration of US$1. Beijing Lei Ting undertakes that it will not sell, transfer, assign or otherwise dispose of all or any of its rights, titles and interests in and to all or any of the tom.com trademark and tom.com domain name to any third party without the prior written consent of Tom.com Enterprises Limited.

In the event that Beijing Lei Ting ceases to be a wholly owned subsidiary, directly or indirectly, of Tom Online Inc. or we cease to be a subsidiary of TOM Group, we may lose the right to use or have to renegotiate with our parent company or other trademark or domain name holder with respect to the license fee and terms of use of the trademark and domain name. See “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — We would face severe disruptions to our business operations, and our results of operations and financial condition would be materially adversely affected if we lose the right to use or fail to reach a trademark license agreement with respect to the use of the tom.com trademarks on acceptable terms in the event that such trademarks are assigned back to Tom.com Enterprises Limited.” Beijing Super Channel has granted each of Beijing Lei Ting, Shenzhen Freenet and Wu Ji Network a non-exclusive right to use the domain names and other intellectual property for a license fee. See “— Our Corporate Structure” and “Item 7 — Major Shareholders and Related Party Transactions.” In addition, from time to time, we may need to license additional technologies in order to remain competitive in the dynamic Internet market.

 

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Properties

Our principal executive office is located in approximately 4,742 square meters of office space at the 5th, 8th and 9th Floors, Tower W3, Oriental Plaza, No. 1 Dong Chang An Avenue, Beijing, China. The leases will expire on December 14, 2009. We also lease substantial office space at Beijing Economic Technology Development Zone, Room 610, Tower C, No. 18 Xihuan Nan Lu, Beijing, China 100176 and Tower C, Webok Times Center, 17 South Zhongguancun Street, Haidian District, Beijing China. We also lease sales and marketing office space in Shanghai, Guangzhou and most provinces where our sales representatives are based, such as Liaoning, Zhejiang, Jiangsu and Anhui.

Legal Proceedings

There are no material legal proceedings pending or, to our knowledge, threatened against us. Despite our efforts to comply with the intellectual property rights of third parties, we cannot be certain that we have not, and will not, infringe on the intellectual property rights of others, which may subject us to legal proceedings and claims in the ordinary course of our business from time to time. Such legal proceedings or claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources. For example, in February 2007, we settled a claim by Beijing News that we infringed on its copyright by paying Beijing News RMB1,949,932 in total. We made a provision of RMB 1,900,000 for such dispute in 2006. In addition, we may also initiate litigation to protect our intellectual property rights. See “Item 3 — Key Information — Risk Factors — Risks Relating to Our Business — We may be subject to intellectual property infringement claims, which may force us to incur substantial legal expenses and, if determined adversely against us, materially disrupt our business.”

Regulation

Overview of Our Operational Licenses

Under the existing PRC laws, rules and regulations, we are required, and have obtained, the licenses, permits, approvals or other consents for our operations. The following are the principal licenses, permits, approvals and other consents that are required and have been obtained for our operations:

Wireless Internet Services. This business requires:

 

   

a permit to be issued by the local Telecommunications Administration Bureau to operate an Internet information service business, which has been obtained by each of Beijing Lei Ting, Wu Ji Network, LingXun, Startone, Beijing Infomax and Beijing Yi Lian Tong He;

 

   

a permit to be issued by the MII to operate a nationwide value-added telecommunications business, which has been obtained by each of Beijing Lei Ting, Wu Ji Network, LingXun, Startone and Beijing Infomax; such nationwide permit is further required to be filed with the local telecommunications bureaus of relevant provinces and cities of connection as indicated on the permit;

 

   

a permit to be issued by the local Telecommunications Administration Bureau to operate a value-added telecommunications and information service business, which has been obtained by each of Beijing Lei Ting, Wu Ji Network, LingXun, Startone, Shenzhen Freenet and Beijing Infomax.

Online advertising. This business requires an advertising operating registration with the Beijing AIC, which has been registered by Beijing Lei Ting as it is our only entity that conducts an online advertising business.

General

The telecommunications industry, including computer information and Internet access services, is highly regulated by the PRC government. Regulations issued or implemented by the State Council, the MII, and other relevant government authorities cover

 

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virtually every aspect of telecommunications network operations, including entry into the telecommunications industry, the scope of permissible business activities, interconnection and transmission line arrangements, tariff policy and foreign investment.

In March 1998, the National People’s Congress of the PRC approved a government restructuring plan that directed the MII to assume, among other things, the regulatory, administrative and other responsibilities of, and rights previously exercised by, the former Ministry of Post and Telecommunications.

The MII, under the leadership of the State Council, is responsible for, among other things:

 

   

formulating and enforcing telecommunications industry policy, standards and regulations;

 

   

granting licenses to provide telecommunications and Internet access services;

 

   

formulating tariff and service charge policies for telecommunications and Internet access services;

 

   

supervising the operations of telecommunications and Internet access service providers; and

 

   

maintaining fair and orderly market competition among operators.

In September 2000, the PRC State Council promulgated the Telecommunications Regulations, or the Telecom Regulations. The Telecom Regulations categorize all telecommunications businesses in China as either infrastructure telecommunications businesses or value-added telecommunications businesses, with ICP services and e-mail services classified as value-added telecommunications businesses. According to the Telecom Regulations, the commercial operator of such services must obtain an operating license. The Telecom Regulations also set forth extensive guidelines with respect to different aspects of telecommunications operations in China.

In December 2001, in order to comply with China’s commitments with respect to its entry into the WTO, the State Council promulgated the Telecom FIE Rules. The Telecom FIE Rules set forth detailed requirements with respect to capitalization, investor qualifications and application procedures in connection with the establishment of a foreign invested telecommunications enterprise. Pursuant to the Telecom FIE Rules, the ultimate capital contribution ratio of the foreign investor(s) in a foreign-funded telecommunications enterprise that provides value- added telecommunications services (including the radio paging services included in infrastructure telecommunications services) shall not exceed 50%. To comply with PRC regulations, we conduct substantially all of our operations through Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, Lingxun, Startone and Beijing Infomax, each of which is wholly owned by PRC citizens and incorporated in the PRC. We do not have any equity interests in these operating companies and instead enjoy the economic benefit of such operating companies through a series of contractual arrangements, which certain of our wholly owned subsidiaries have entered into with such companies and their respective shareholders as described in “Item 7 — Major Shareholders and Related Party Transactions.”

The Administrative Measures for Telecommunications Business Operating Licenses, or Telecom License Measures, were promulgated by the MII on December 26, 2001. The Telecom License Measures confirm that there are two types of telecommunications operating licenses for operators in China (including foreign-invested telecommunications enterprises), namely, licenses for infrastructure services and licenses for value-added services. With respect to the latter, a distinction is made as to whether a license is granted for intra-provincial or “trans-regional” (inter-provincial) activities. An appendix to the license will detail the permitted activities of the enterprise to which it was granted. An approved telecommunications service operator must conduct its business (whether infrastructure or value-added) in accordance with the specifications recorded on its Telecom Business Operating License. The Telecom License Measures also confirm that the MII is the competent approval authority for foreign-invested telecommunications enterprises.

In addition to the regulations promulgated by the central PRC government, some local governments have also promulgated local rules applicable to Internet companies operating within their respective jurisdictions. In Beijing, the Beijing Municipal Administrative

 

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Bureau of Industry and Commerce, or the Beijing AIC, has promulgated a number of Internet-related rules. On October 1, 2004, the Beijing AIC invalidated a previously issued circular and adopted a new set of rules requiring owners of the domain names of commercial websites located within Beijing to register their website names and commercial websites with the Beijing AIC. In April 2001, the Beijing AIC also promulgated the Online Advertising Tentative Administrative Measures requiring all ICPs within Beijing which provide online advertising services to obtain an advertising operating license. In addition, the Beijing Telecommunications Administration Bureau issued a circular requiring bulletin board services, or BBS, providers to obtain approval from the Beijing Telecommunications Administration Bureau.

In July 2006, the MII issued the Circular on Strengthening the Administration of Foreign Investment in the Operation of Value-added Telecommunications Business. In the circular, the MII reiterated the existing regulations regarding foreign investment in telecommunications business, which require foreign investors to set up foreign-invested enterprises and obtain a business operating license for Internet content provision, or ICP license, in order to conduct any value-added telecommunications business in China. Under this circular, a domestic company that holds an ICP license is prohibited from leasing, transferring or selling the license to foreign investors in any form, and from providing resources, sites or facilities to foreign investors that conduct value-added telecommunications business illegally in China. Furthermore, the relevant trademarks and domain names that are used in the value-added telecommunications business shall be owned by the local ICP license holder or its shareholders. This circular further requires each ICP license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to the lack of further interpretation from the regulator, it remains unclear what impact the above circular will have on us or the other Chinese Internet companies that have adopted the same or similar corporate and contractual structures as ours. In light of this circular, a deed of trademark and domain name assignment has been entered into by Tom.com Enterprise Limited and Beijing Lei Ting. See “— Intellectual Property and Proprietary Rights.”

Beijing Lei Ting has obtained or filed (1) a License of Internet Information Service, or the ICP License, issued by Beijing Telecommunications Bureau; (2) a nationwide License for Value-added Telecommunication Services, or the SP License, issued by MII, with filings with relevant telecommunications bureaus of relevant provinces and cities of connection; (3) a commercial website registration with Beijing AIC; (4) website name registrations with China Internet Network Information Center; (5) an approval for providing BBS from Beijing Telecommunications Administration Bureau; (6) an approval from the Beijing Telecommunications Administration Bureau to operate an Internet connection services business; (7) a license of Internet News Information Services issued by State Council News Offices; (8) an Internet Culture Business Operation License issued by the Ministry of Culture and (9) a License of Transmission of Audio-visual Programs issued by State Administration of Radio, Film and Television, or SARFT.

Shenzhen Freenet has obtained (1) a SP License issued by Guangdong Province Telecommunications Administration Bureau to provide both Internet information and wireless information service and (2) an Internet Culture Business Operation License issued by the Ministry of Culture.

Wu Ji Network has obtained (1) an ICP License issued by Beijing Telecommunications Administration Bureau; (2) a nationwide SP License issued by MII, with filings with relevant telecommunications bureaus of relevant provinces and cities of connection and (3) a SP License issued by Beijing Telecommunications Administration Bureau.

LingXun has obtained (1) an ICP license issued by Beijing Telecommunications Administration Bureau; (2) a nationwide SP License issued by MII, with filings with relevant telecommunications bureaus of relevant provinces and cities of connection and (3) a SP License issued by Beijing Telecommunications Administration Bureau.

Startone has obtained (1) an ICP License issued by Beijing Telecommunications Administration Bureau; (2) a nationwide SP License issued by MII, with filings with relevant telecommunications bureaus of relevant provinces and cities of connection and (3) a SP License issued by Beijing Telecommunications Administration Bureau.

 

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Beijing Informax has obtained (1) an ICP License issued by Beijing Telecommunications Administration Bureau; (2) a nationwide SP License issued by MII, with filings with relevant telecommunications bureaus of relevant provinces and cities of connection and (3) a SP License issued by Beijing Telecommunications Administration Bureau.

Beijing Yi Lian Tong He has obtained (1) an ICP License issued by Beijing Telecommunications Administration Bureau and (2) an approval for providing BBS from Beijing Telecommunications Administration Bureau.

Regulation of Internet Content Services, Publications

Subsequent to the State Council’s promulgation of the Telecom Regulations and the Internet Information Services Administrative Measures, or the ICP Measures, in September 2000, the MII and other regulatory authorities formulated and implemented a number of Internet-related regulations, including but not limited to the Internet Electronic Bulletin Board Service Administrative Measures, or the BBS Measures, and the Tentative Administrative Measures Concerning Internet Portals Carrying on the News Displaying Business, or the Internet News Measures. On September 25, 2005, State Council News Office and the MII jointly promulgated the Internet News Information Service Administrative Measures which states that a news information service provider must obtain approval for those services from the appropriate governmental authorities.

The ICP Measures require that commercial ICP operators must obtain an ICP license from the appropriate telecommunications authorities in order to carry on any commercial ICP operations within China. ICP operators must display their operating license numbers in a conspicuous location on their home page. ICP operators are obliged to police their websites in order to remove categories of harmful content that are broadly defined. This obligation reiterates Internet content restrictions that have been promulgated by other ministries over the past few years. In addition, the ICP Measures also provide that ICP operators which operate in sensitive and strategic sectors, including news, publishing, education, health care, medicine and medical devices, must obtain additional approvals from the relevant authorities in charge of those sectors as well. Of particular note to foreign investors, the ICP Measures provide that ICP operators must obtain the consent of the MII prior to establishing an equity or cooperative joint venture with a foreign partner.

The BBS Measures provide that any ICP operator engaged in providing online BBS is subject to a special approval and filing process with the relevant governmental telecommunications authorities.

The Internet News Measures require that any ICP operator engaging in any news displaying services must obtain approval for those services from the appropriate governmental authorities on news.

On February 20, 2006, MII promulgated the Internet Electronic Mail Service Administrative Measures, which state that an e- mail service provider must obtain a permit to operate a value-added telecommunications business or a non-commercial website registration certificate and register the IP address of the e-mail severs. In practice, however, such registration requirement of the IP address of the e-mail servers has not been implemented strictly by local telecommunication bureaus.

Certain local governments have promulgated local rules applicable to Internet companies operating within their respective jurisdictions. In Beijing, the Beijing AIC has promulgated a number of Internet-related rules. On October 1, 2004, the Beijing AIC invalidated a previously issued circular and adopted a new set of rules requiring owners of the domain names of commercial websites located within Beijing to register their website names and commercial websites with the Beijing AIC.

The State Food and Drug Administration and Ministry of Hygiene of the PRC have also, respectively, adopted regulations regarding the online dissemination of online medical or drug-related information. These regulations require that, among other things, medical, health, medical device and drug information must be scientific and accurate and the sources of the information must be

 

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identified. The regulations require that the commercial website operator must obtain approval from the State Food and Drug Administration for drug related information or with hygiene department for medical-related information (including that of medical devices).

On November 17, 2000, the Internet News Measures were promulgated by the State Council News Office and the MII. These rules stipulate that general websites established by non-news organizations, such as Beijing Lei Ting, may publish news released by domestic official news agencies if such websites satisfy the requirements set forth in Article 9 of the rules and have acquired the requisite approval, but may not publish news items produced by themselves or news sources from elsewhere or link to overseas new organizations, unless specifically approved by the State Council News Office. The aforementioned requirements include the following:

 

   

they must have a purpose and guidelines with respect to online news services that comply with laws and regulations;

 

   

they must have the necessary news editorial departments, funds, equipment and premises;

 

   

they must have professional staff in charge of editing who are experienced in journalism and are qualified at a medium or higher level to hold technical positions in journalism, and an appropriate number of editorial staff who are qualified at a medium or higher level to hold technical positions in journalism; and

 

   

they must use news sources such as State news agencies, news bureaus of departments under the State Council or news agencies directly under the provinces, autonomous regions or directly administered municipalities.

The aforementioned rules also require the general websites of non-news organizations to apply to the State Council News Office at the national level for approval after securing the consent of the local government news office before they commence operating news dissemination services. Also, general websites intending to publish news released by the aforementioned news agencies or bureaus must enter into agreements with them and submit copies of those agreements to the relevant administration department.

Under the Internet News Information Service Administrative Measures dated September 25, 2005, ICP operators that re-publish news information on Internet websites or provide BBS services on current and political affairs must obtain an Internet news information service license from appropriate government authorities. Such ICP operators must have sound and comprehensive internal regulations with respect to the management of Internet news information services, and must have at least 10 staff members designated for news editorial work, of whom at least five must have no less than three years’ experience in professional journalism. Such ICP operators also must have been in operation for at least two years without violating any laws, regulations or rules concerning Internet information services.

The SNPA is the government agency responsible for regulating publishing activities in China. On June 27, 2002, MII and the SNPA jointly promulgated the Internet Publishing Tentative Administrative Measures, or the Internet Publishing Measures, which took effect on August 1, 2002. The Internet Publishing Measures require Internet publishers to secure approval from SNPA. The term “Internet publishing” is defined as an act of online dissemination whereby Internet information service providers select, edit and process works created by themselves or others (including content from books, newspapers, periodicals, audio and video products, electronic publications, etc. that have already been formally published or works that have been made public in other media) and subsequently post the same on the Internet or transmit the same to users via the Internet for browsing, use or downloading by the public.

Under the relevant regulations, ICP operators and Internet publishers must obtain an approval for publishing business from SNPA.

 

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On July 6, 2004, the SARFT promulgated Administrative Measures for Transmission of Audio-Visual Programs through Internet, which requires that any entity conducting business of disseminating video-audio programs through information networks obtain a License for Dissemination of Audio-Visual Programs.

The Regulations on the Protection of the Rights to Networks Dissemination of Information was promulgated by the State Council on May 18, 2006 and effective on July 1, 2006. The regulations state that an entity providing any other person’s works, performance or audio-visual products to the general public through information networks shall obtain the owner’s permission and pay relevant remunerations unless otherwise prescribed by any law or administrative regulations.

Regulation of Web Logs or Blogs

Users of our portal, www.tom.com, are able to post blogs on the website. At present, there are no specific PRC laws at the national level governing web logs, or blogs, or defining blog activities and no PRC government authority has been designated to regulate blog activities. There are existing regulations governing Internet publication. However, it is unclear whether these existing regulations will be applied to blogs. There is no assurance that the PRC government will not, in the future, promulgate specific regulations governing blogs, designate a government agency to regulate blog activities or apply existing Internet publication regulations to blog activities, any of which events could restrict our business activities.

Regulation of Advertisements

The SAIC is the government agency responsible for regulating advertising activities in China, which issued relevant regulations regulating the general advertising activities, including online advertising. While there are no nationwide uniform laws or regulations in China specifically governing online advertising businesses, certain local government authorities, such as the Beijing AIC, have issued regulations governing online advertising businesses. In April 2001, the Beijing AIC promulgated the Online Advertising Tentative Administrative Measures, which require all ICPs providing online advertising services within Beijing to obtain an advertising operations license and such ICPs’ business scopes stated on their business licenses must contain advertising business. According to the Online Advertising Tentative Administrative Measures, those companies that have already obtained an advertising operating license may undertake design and production and agency work in relation to online advertising and may carry out advertising publication business via their own websites. According to Beijing AIC, Beijing AIC has actually not required companies to obtain a separate license for online advertising in practice. When approving a company to conduct online advertising, Beijing AIC will allow such company’ business scope as indicated in their business license to contain such business. Beijing Lei Ting’s approved business scope as shown on its business license contains “design and production of online advertisements and publication of online advertisements through tom.com website.”

Regulation of E-Commerce

At present, except for certain rules or directives issued by certain governmental authorities, there are no specific PRC laws at the national level governing e-commerce or defining e-commerce activities, and no PRC government authority has been designated to regulate e-commerce. There are existing regulations governing retail and auction businesses which require companies to obtain licenses in order to engage in these businesses. However, it is unclear whether these existing regulations will be applied to e- commerce. There is no assurance that the PRC government will not, in the future, promulgate specific regulations governing e-commerce, designate a government agency to regulate e-commerce activities or apply existing retail and auction regulations to e- commerce activities, any of which events could restrict our business activities.

Regulation of Wireless Internet Services

Our business activities include the provision of online services related to SMS, MMS, WAP, IVR and Color Ring-back Tones. PRC legislation on wireless telecommunications is generally aimed at regulating equipment and infrastructure rather than applications and Internet service providers. In September 2000, the State Council promulgated the Telecommunications Regulations, or Telecom Regulations. The Telecom Regulations categorize all telecommunications businesses in China as either an infrastructure telecommunications business or a value-added telecommunications business, with ICP services and e-mail services classified as a value-added telecommunications business. According to the Telecom Regulations, the commercial operator of such services must obtain an operating license. The Telecom Regulations also set forth extensive guidelines with respect to different aspects of telecommunications operations in China.

 

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The Administrative Measures for Telecommunications Business Operating Licenses, or Telecom License Measures, were promulgated by the MII on December 26, 2001. The Telecom License Measures confirm that there are two types of telecommunications operations licenses for operators in China (including foreign-invested telecommunications enterprises), namely, licenses for infrastructure services and licenses for value-added services, for which a distinction is made as to whether a license is granted for intra-provincial or “trans-regional” (inter-provincial) activities. An appendix to the license details the permitted activities of the enterprise to which it was granted. An approved telecommunications service operator must conduct its business, for both infrastructure and value-added services types of businesses, according to the specifications recorded on its Telecom Business Operating License. The Telecom License Measures also confirm that the MII is the competent approval authority for foreign-invested telecommunications enterprises. On April 15, 2004, the MII promulgated the Notice on Relevant Issues Concerning Regulating Short Messaging Services, which confirmed the need for SMS operators to obtain value-added telecommunications business licenses.

In July 2006, the MII issued the Circular on Strengthening the Administration of Foreign Investment in the Operation of Value-added Telecommunications Business. In the circular, the MII reiterated the existing regulations regarding foreign investment in telecommunications business, which require foreign investors to set up foreign-invested enterprises and obtain a business operating license for Internet content provision, or ICP license, in order to conduct any value-added telecommunications business in China. Under this circular, a domestic company that holds an ICP license is prohibited from leasing, transferring or selling the license to foreign investors in any form, and from providing resources, sites or facilities to foreign investors that conduct value-added telecommunications business illegally in China. Furthermore, the relevant trademarks and domain names that are used in the value-added telecommunications business shall be owned by the local ICP license holder or its shareholders. This circular further requires each ICP license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to the lack of further interpretation from the regulator, it remains unclear what impact the above circular will have on us or the other Chinese Internet companies that have adopted the same or similar corporate and contractual structures as ours.

Online Education

Pursuant to the Measures for the Administration of Education Websites and Online Education School released on July 5, 2000, educational websites and online education schools shall not be operated without the approval of the Administration Departments of Education.

Regulation of Online Games and Internet Culture Activities

On May 10, 2003, the Ministry of Culture of the PRC promulgated the Internet Culture Administration Tentative Measures, or the Internet Culture Measures, which became effective as of July 1, 2003. The Internet Culture Measures require ICPs that engage in “Internet Culture Activities” to obtain a license for Internet Culture Business Operations from the Ministry of Culture in accordance with the Internet Culture Measures. The term “Internet Culture Activities” includes, among other things, acts of online dissemination of “Internet Cultural Products,” such as audio-visual products, gaming products, performances of plays or programs, works of art and cartoons, and the production, reproduction, importation, sale (wholesale or retail), leasing and broadcasting of Internet Cultural Products. In addition, these regulations require a separate review of the content of any online games which are imported into China.

Regulation of International Connections for Computer Information Networks

The State Council and the MII have promulgated certain regulations governing international connections for computer networks in China. Under these regulations, any entity wishing to access international connections for their computer information networks in China, such as Beijing Lei Ting and Shenzhen Freenet, must comply with the following requirements:

 

   

be a PRC legal person;

 

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have the appropriate equipment, facilities and technical and administrative personnel;

 

   

have implemented and registered a system of information security and censorship; and

 

   

effect international connections through an international communications gateway established with the approval of the MII.

Regulation of Information Security and Censorship

Under the PRC law, ICP operators are prohibited from posting or displaying any content that:

 

   

opposes the fundamental principles determined in the PRC’s Constitution;

 

   

compromises State security, divulges State secrets, subverts State power or damages national unity;

 

   

harms the dignity or interests of the State;

 

   

incites ethnic hatred or racial discrimination or damages inter-ethnic unity;

 

   

sabotages the PRC’s religious policy or propagates heretical teachings or feudal superstitions;

 

   

disseminates rumors, disturbs social order or disrupts social stability;

 

   

propagates obscenity, pornography, gambling, violence, murder or fear or incites the commission of crimes;

 

   

insults or slanders a third party or infringes upon the lawful rights and interests of a third party; or

 

   

includes other content prohibited by laws or administrative regulations.

Failure to comply with this content censorship requirement may result in the confiscation of illegal income, imposition of penalty, until the revocation of the approval for publication.

PRC legislation concerning information security and censorship specifically prohibits the use of Internet infrastructure where it results in a breach of public security, the provision of socially destabilizing content or the divulgence of State secrets.

 

   

“A breach of public security” includes breach of national security or disclosure of state secrets; infringement on state, social or collective interests or the legal rights and interests of citizens; or illegal or criminal activities.

 

   

“Socially destabilizing content” includes any action that: incites defiance or violation of PRC laws; incites subversion of state power and the overturning of the socialist system; fabricates or distorts the truth, spreads rumors or disrupts social order; advocates cult activities or; spreads feudal superstition, involves obscenities, pornography, gambling, violence, murder, or horrific acts or instigates criminal acts.

 

   

“State secrets” are defined as “matters that affect the security and interest of the State.” The term covers such broad areas as national defense, diplomatic affairs, policy decisions on State affairs, national economic and social development, political parties and “other State secrets that the State Secrecy Bureau has determined should be safeguarded.”

 

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According to the aforementioned legislation, it is mandatory for Internet companies in China to complete security filing procedures with the local public security bureau and for them to update regularly with the local public security bureau regarding information security and censorship systems for their websites.

The Detailed Implementing Rules for the Measures for the Administration of Commercial Website Filings for the Record, promulgated in October 2004 by the Beijing AIC, state that websites must comply with the following requirements:

 

   

they must file with the Beijing AIC and obtain electronic registration marks;

 

   

they must place the registration marks on their websites’ homepages; and

 

   

they must register their website names with the Beijing AIC.

Regulation of Foreign Exchange Control

The principal regulations governing foreign exchange in China are the Foreign Exchange Control Regulations (1996) and the Administration of Settlement, Sale and Payment of Foreign Exchange Regulations, or the Exchange Regulations (1996). Under the Exchange Regulations, the Renminbi is freely convertible into foreign exchange for current account items, including the distribution of dividends. Conversion of Renminbi for capital account items, such as direct investment, loans, security investment and repatriation of investment, however, is still subject to the registration or approval of SAFE.

Under the Exchange Regulations, foreign-invested enterprises are required to open and maintain separate foreign exchange accounts for capital account items. In addition, foreign-invested enterprises may buy, sell or remit foreign currencies only at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from SAFE.

Capital investments by foreign-invested enterprises outside of China (excluding Hong Kong, Macau and Taiwan) also are subject to limitations, which include approvals by the Ministry of Commerce, SAFE and the State Reform and Development Commission.

In October 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Return Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 75, which took effect on November 1, 2005. Notice 75 supersedes prior SAFE regulations promulgated in January and April of 2005. On May 29, 2007, SAFE further issued the practice guidance for registration under Notice 75. Notice 75 requires PRC residents to register with the relevant local SAFE branch in connection with their establishment or control of an offshore entity established for the purpose of overseas equity financing involving onshore assets or equity interests held by them and direct investment through such an offshore entity in China. The term “PRC residents,” as used in Notice 75, includes not only PRC citizens but also other persons who habitually reside in the PRC for economic benefit. Such PRC residents are required to register with the relevant SAFE branch before establishing or taking control of such an offshore entity and complete amended registrations with the relevant SAFE branch upon (i) injection of equity interests or assets of an onshore enterprise into the offshore entity, (ii) subsequent overseas equity financing by such offshore entity, or (iii) any material change in the shareholding or capital of the offshore entity, such as changes in share capital, share transfers and long-term equity or debt investments, and providing security. PRC residents who have already incorporated or gained control of offshore entities that had completed onshore investments in the PRC before Notice 75 took effect must, on a retroactive basis, register with the relevant local SAFE branch. In addition, such PRC residents are required to repatriate into China all of their dividend profits or capital gains from their shareholdings in the offshore entity within 180 days of their receipt of such profits or gains.

The registration and amendment procedures set forth by Notice 75 are prerequisites for other approval and registration procedures necessary for capital inflow from the offshore entity, such as inbound investment or shareholders loans, or capital outflow to the offshore entity, such as the payment of profits or dividends, liquidating distributions, equity sale proceeds or the return of funds upon a capital reduction.

 

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A number of terms and provisions in Notice 75 remain unclear. Because of uncertainty over how Notice 75 will be interpreted and implemented, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as remitting dividends and foreign currency-denominated borrowings, may be subject to compliance with Notice 75 requirements by our PRC resident shareholders. Despite our efforts to fully comply with the SAFE regulations, we cannot assure you that we will obtain, or receive waivers from, any necessary approvals or not be found in violation of the SAFE regulations or any other related foreign exchange regulations. In particular, we cannot assure you that we will be able to cause all our present or prospective PRC resident shareholders to comply with all SAFE regulations. A failure by our PRC resident shareholders to comply with Notice 75 or our inability to secure required approvals or registrations may subject us to fines or legal sanctions, limit our subsidiaries’ ability to make distributions or pay dividends, restrict our overseas or cross-border investment activities or affect our ownership structure, any of which could affect our business and prospects.

SAFE issued Measures for the Administration of Individual Foreign Exchange and its implementation rules effective on February 1, 2007. In March 2007, SAFE further promulgated the Work Guidance Concerning Foreign Exchange Management of Domestic Individual’s Participation in Employee Stock Ownership Plans and Stock Option Plans of Overseas Listed Companies, or Notice 78. Notice 78 requires any domestic agency, which may be the onshore subsidiary of the overseas listed company, to report its individual stock plans with SAFE on a regular basis and comply with the relevant approval or registration procedures for the exercises under such individual stock plans. Since this requirement is relatively new and also due to the uncertainty relating to the practice adopted or to be adopted by SAFE or its various local branches in connection with this notice, there is no assurance that our current or future individual stock plans could be implemented without any challenge from the government.

Operational Licenses

Each of Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Beijing Infomax and Beijing Yi Lian Tong He has a business license issued by the local office of SAIC in their respective place of registration.

In the opinion of our PRC legal counsel, Jun He Law Offices, each of Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Beijing Infomax and Beijing Yi Lian Tong He is, respectively, authorized to undertake their business operations within the business scope as stated in their business license, respectively, and subject to the relevant licenses, permits, or registration as required by law.

In the opinion of our PRC legal counsel, Jun He Law Offices, the ownership structures of all of our subsidiaries and operating companies, comply with all existing PRC laws, rules and regulations. In addition, the subsidiaries and operating companies have obtained the relevant consent, approval or license as required under existing PRC laws, rules and regulations for such ownership structures, failure of which will materially and adversely impact our business and operations in China.

 

Item 4A. Unresolved Staff Comments

None.

 

Item 5. Operating and Financial Review and Prospects

The following discussion and analysis should be read in conjunction with our audited historical consolidated financial statements together with the respective notes thereto, included elsewhere in this document. Our audited historical consolidated financial statements have been prepared in accordance with US GAAP.

Our audited historical consolidated financial statements and the discussion and analysis herein include the financial position and results of operations of (i) Treasure Base, Whole Win, Huan Jian Shu Meng and Beijing Infomax beginning as of August 11, 2004, November 19, 2004, January 4, 2006 and June 1, 2006 respectively, the dates of their respective acquisitions by us, and (ii) the TOM-Skype joint-venture, Tel-Online, as of August 22, 2005, the date the joint venture was incorporated.

In December 2006, we decided to sell substantially all of our equity interests in Indiagames to focus on the China market. Accordingly, the results of Indiagames have been separately presented on the face of consolidated statements of operations under “Discontinued Operations” for the years ended December 31, 2005 and 2006. Our consolidated statements of operations for the year ended December 31, 2005 have been restated accordingly.

 

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Overview

We are one of the leading wireless Internet companies in China by revenues, based on our comparison of our revenues with the publicly disclosed revenues of our competitors. We operate one of China’s most trafficked online properties, as measured by average daily page views, according to iResearch. We seek to provide wireless Internet services that are relevant and essential to our users with a bias towards entertainment, lifestyle and sports products and services. We deliver our services to our users through their mobile phones as well as mobile telecommunication operators’ channels, portal and web alliances, alliances with handset manufacturers and traditional media, including television, radio and print.

We distinguish and differentiate ourselves through (1) our broad and diverse distribution channels, which allow us to reach a large portion of the overall Chinese population that has mobile phones but not necessarily Internet access; (2) our operational excellence, which allows us to provide high quality products and services to both our mobile operator partners and end users; (3) our acquisition and development of quality content and services tailored for the mobile phone and (4) our integration of our online platforms (primarily www.tom.com) and online communities with our mobile services. In addition, we have enhanced our online features by establishing the TOM-Skype joint venture, which provides next-generation communication services to mainland Chinese Internet users.

We launched our Internet portal, www.tom.com, in July 2000 and began providing wireless Internet services in the second half of 2001. Our total revenues were US$168,365,000 and US$168,068,000 for the years ended December 31, 2006 and 2005, respectively. Our net income attributable to shareholders was US$28,655,000 and US$45,006,000 for the years ended December 31, 2006 and 2005, respectively.

The major factors affecting our results of operations and financial condition include:

 

   

the growth of the wireless Internet services and online advertising markets in China;

 

   

the technological advancement of the wireless Internet services market, including advances in the technological standards of mobile handsets and networks, in China;

 

   

the attractiveness and variety of our services;

 

   

our product development efforts to capitalize on market opportunities;

 

   

our marketing and promotion activities;

 

   

change in the number, scope and terms of our cooperation arrangements with the mobile telecommunications operators, content providers, mobile phone producers and other distribution partners, and other key players in China’s mobile telecommunications industry; and

 

   

changes in government or mobile telecommunications operator regulatory policies.

As a result of our on-going privatization, we expect to continue to incur significant expenses in investment banking, legal and other fees and use significant amounts of internal resources. It is not possible to accurately predict the amount of money or internal resources that will be required in connection with these matters. The additional costs expected to be incurred in connection with these matters may have an adverse effect on our results of operations. While we are dealing with these matters, we may not be able to provide any guidance on our future quarterly results of operations. See “Item 7 — Major Shareholders and Related Party Transactions — Related Party Transactions — Ongoing Related Party Transactions between Us or Our Subsidiaries and Our Parent Company or its Subsidiaries — Privatization.”

 

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Revenues

Our revenues in 2006 are derived from our two primary operating segments, wireless Internet services and online advertising. We derive a minor portion of our revenues from others, a category comprised of online games, e-commerce and fee-based e-mail revenue.

Our revenues are primarily derived from our wireless Internet services, which include SMS, MMS, WAP, IVR and CRBT services. Through these services we provide music and entertainment downloads, information and community-oriented products, as well as news headlines, sports information, games, wallpaper and dating services.

Our revenues represent our total revenues from operations net of certain business and value-added taxes. Our revenues are primarily derived from our PRC operating companies, Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Huan Jian Shu Meng and Beijing Infomax, and from our subsidiaries that are incorporated in the PRC. Our wireless Internet services revenue in China is subject to a 3.3% business tax and our online advertising revenue is subject to a business tax of up to 8.5%. Any service fees that our subsidiaries charge and subsequently collect pursuant to exclusive technical and consulting service agreements with our variable interest entities are subject to a 5.0% business tax. Before we phased out our other commercial enterprises solutions business in 2005, revenue from this business was subject to a 5.5% business tax and our computer hardware sales revenue related to this business was subject to a 17.0% value-added tax, which was partially offset by value-added taxes paid on purchases.

The following table sets forth certain historical consolidated revenue data in terms of amount and as a percentage of our total revenues for the periods indicated:

 

     For the year ended December 31,  
     2004     2005 (restated(1))    2006  
     Amount    Percentage of
revenues
    Amount    Percentage of
revenues
   Amount    Percentage of
revenues
 
     (in thousands of U.S. dollars, except percentages)  

Wireless Internet services(2)

   112,880    92.0 %   157,833    93.9%    152,637    90.7 %

Online advertising

   7,583    6.2 %   9,210    5.5%    13,279    7.9 %

Others(3)

   2,257    1.8 %   1,025    0.6%    2,449    1.4 %
                                     

Total revenues

   122,720    100.0 %   168,068    100.0%    168,365    100.0 %
                                     

(1) Financial data in 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”
(2) Includes revenue from our download products, information products and community-oriented products that we provide through the wireless Internet services platforms of China Mobile and China Unicom. Revenues from the services of LingXun, Startone and Beijing Infomax are included beginning as of August 11, 2004, November 19, 2004 and June 1, 2006, respectively.
(3) Primarily includes revenue from online games, e-commerce and fee-based e-mail services for the years ended December 31, 2005 and 2006 and primarily includes revenue from our commercial enterprise solutions business, including the computer hardware sales, for the year ended December 31, 2004.

Wireless Internet services

The majority of our wireless Internet services revenue is derived from products and services that we provide through China Mobile’s MonternetTM platform and China Unicom’s UNI-InfoTM platform. We recognize revenue derived from our wireless Internet services in China on a gross basis, that is, before deducting the share of revenue due to, and the transmission fees paid to, the mobile telecommunications operators.

 

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Our wireless Internet services include SMS, MMS, WAP, IVR, CRBT and other wireless Internet services, which consists largely of Java-based mobile games. In 2006, our SMS, MMS, WAP, IVR, CRBT and other wireless Internet services accounted for approximately 39.4%, 8.2%, 19.1%, 26.3%, 6.3% and 0.7%, respectively, of our wireless Internet services revenue. The primary factors affecting our wireless Internet services revenue include, but are not limited to, the number of subscriptions, the number of downloads, pricing of our subscriptions and downloads, mobile telecommunication operators’ policies, changing consumers tastes, competition and the availability of distribution channels.

Revenue from our wireless Internet services decreased by 3.3% to US$152,637,000 in 2006 from US$157,833,000 in 2005, primarily due to the negative impact of the new subscription-related policies introduced by China Mobile and China Unicom during 2006, which was partially offset by the acquisition of Beijing Infomax. We expect our revenues generated by our wireless Internet services and our WAP business in particular to be materially and adversely affected by the new practice China Mobile introduced in May 2007 of sending fee reminders to and seeking confirmations from users before processing their WAP page download requests.

The following table sets forth certain historical consolidated revenue data in terms of amount and as a percentage of our total revenues for the periods indicated:

 

     For the year ended December 31,  
     2004     2005 (restated(1))     2006  
     Amount    Percentage
of revenues
    Amount    Percentage
of revenues
    Amount    Percentage
of revenues
 
     (in thousands of U.S. dollars, except percentages)  

SMS

   54,956    48.7 %   63,428    40.2 %   60,057    39.4 %

MMS

   11,784    10.4 %   12,012    7.6 %   12,526    8.2 %

WAP

   17,114    15.2 %   31,686    20.1 %   29,226    19.1 %

IVR

   26,152    23.2 %   40,059    25.4 %   40,166    26.3 %

CRBT

   2,874    2.5 %   10,557    6.7 %   9,597    6.3 %

Others(2)

   —      —       91    —       1,065    0.7 %
                                 

Wireless Internet services revenues

   112,880    100.0 %   157,833    100.0 %   152,637    100.0 %
                                 

(1) Financial data in 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”
(2) Comprised largely of Java-based mobile games.

Our wireless Internet services operating data is generated by an internal operating system that tracks the delivery confirmations provided to us by the mobile telecommunications operators. Due to the nature of our billing arrangements, however, the revenue that we recognize is based upon the monthly revenue statements provided to us that the mobile telecommunications operators generate from their own internal operating data, which we do not independently verify. Generally, differences exist between the value of our revenue calculated from our own internal operating data and the monthly revenue statements provided to us by the mobile telecommunications operators. In 2006, the average difference between our estimates and our actual revenue, calculated on a quarterly basis, was approximately 3%, compared to approximately 5% in 2005. In 2006, China Mobile and China Unicom contributed 82% and 17%, respectively, to our wireless Internet services revenues.

Online Advertising

We sell online advertisements through our direct sales force and through advertising agencies. The primary factors affecting our online advertising revenues are the number of our advertising clients that contribute revenue during the relevant period, the average

 

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revenue per client, consumer preferences for the products and brands advertised, user traffic to our portal and websites and seasonality of popular sporting, entertainment and national events. Revenue from online advertising increased by 44.2% to US$13,279,000 in 2006, from US$9,210,000 in 2005, primarily due to increased user traffic on our portal, higher average spending per client and our initiatives starting from the second half of 2005 to focus our sales efforts on a few more strategically important channels.

Others

Our other business mainly includes online games, e-commerce and fee-based e-mail services. Prior to 2005, our other business included our commercial enterprise solutions business, which provided technical and consulting services for the Internet-related needs of our clients such as purchasing and installing computer hardware and software. We began to phase out our commercial enterprise solutions business in the second half of 2003. Revenue from others increased by 138.9% to US$2,449,000 in 2006 from US$1,025,000 in 2005, primarily due to a higher contribution from online games which had an increase of US$1,146,000 in revenue in 2006 as compared to 2005.

Cost of Revenues

The following table sets forth certain historical consolidated cost of revenues data in terms of amount and as a percentage of our total revenues for the periods indicated:

 

     For the year ended December 31,  
     2004     2005 (restated(1))     2006  
     Amount    Percentage
of revenues
    Amount    Percentage
of revenues
    Amount    Percentage
of revenues
 
     (in thousands of U.S. dollars, except percentages)  

Cost of services

   63,966    52.1 %   96,900    57.7 %   105,919    62.9 %

Cost of goods sold

   791    0.7 %   —      —       —      —    
                                 

Total cost of revenues

   64,757    52.8 %   96,900    57.7 %   105,919    62.9 %
                                 

(1) Financial data in 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”

Cost of Services

Cost of services includes direct cost of services and common cost of services.

Our wireless Internet services direct costs consist primarily of the share of revenue due to, and the transmission fees paid to, the Chinese mobile telecommunications operators, the share of revenue due to our industry cooperation partners, royalties, handset alliances costs, certain content costs and product promotion and marketing expenses.

Our online advertising direct costs include the cost of sales commissions and staff bonuses that are based on revenues.

Our common costs include bandwidth leasing charges, portal content acquisition costs, costs for our portal content production staff, wireless Internet services staff and depreciation and maintenance costs relating to equipment used to provide services. For the purpose of calculating our gross profits, common costs are allocated to our wireless Internet services business and our online advertising business in proportion to the gross profits from these businesses prior to the allocation of these common costs.

 

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Our cost of services increased 9.3% to US$105,919,000 in 2006 from US$96,900,000 in 2005, primarily due to higher content acquisition costs to produce a more variety of products or services to attract customers and higher distribution channel fees, resulting from higher fees charged by television channels and higher revenue sharing ratio of certain distribution partners. Our cost of services, as a percentage of revenues, increased to 62.9% in 2006 from 57.7% in 2005. We expect our cost of services to continue to increase as a percentage of revenues compared to 2006 due to the potential increases in the share of revenues by mobile telecommunications operators and increases in costs related to distribution channels and content acquisition as the industry continues to adjust to ongoing negative policy changes as well as competitive pressures. Our direct cost of services and our common cost of services accounted for 76.8% and 23.2%, respectively, of our cost of services in 2006, as compared to 79.3% and 20.7% in 2005, respectively. The increase in the percentage of cost of services accounted for by common costs was primarily due to higher cost for content acquisitions.

Cost of Goods Sold

We did not record costs in this category in 2006. Historically, cost of goods sold consisted primarily of the cost of computer hardware and software that we purchased and installed on behalf of our commercial enterprise solutions clients. We gradually phased out this business from 2003 to 2005, and as a result, we do not expect to incur significant cost of goods sold going forward.

Gross Profit Margin

The following table sets forth the historical consolidated gross profits and gross profit margin of our business activities for the periods indicated:

 

     For the year ended December 31,  
     2004     2005 (restated(1))     2006  
     (in thousands of U.S. dollars, except percentages)  

Gross Profits: (2)

      

Wireless Internet services

   51,901     64,027     52,425  

Online advertising

   4,847     6,333     8,354  

Others

   1,215     808     1,667  
                  

Total gross profits

   57,963     71,168     62,446  
                  

Gross Profit Margin:

      

Wireless Internet services

   46.0 %   40.6 %   34.3 %

Online advertising

   63.9 %   68.8 %   62.9 %

Others

   53.8 %   78.8 %   68.1 %
                  

Total gross profit margin

   47.2 %   42.3 %   37.1 %
                  

(1) Financial data in 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”
(2) For the purpose of calculating our gross profits, certain costs that are common to our wireless Internet services business and our online advertising business are allocated to these businesses in proportion to gross profits from these businesses prior to the allocation of these common costs.

Operating Expenses

The following table sets forth certain historical consolidated operating expenses data in terms of amount and as a percentage of our total revenues for the periods indicated:

 

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      For the year ended December 31,  
      2004     2005 (restated(1))     2006  
      Amount    Percentage
of revenues
    Amount    Percentage
of revenues
    Amount    Percentage
of revenues
 
     (in thousands of U.S. dollars, except percentages)  

Selling and marketing expenses

   7,695    6.3 %   7,176    4.3 %   6,974    4.1 %

General and administrative expenses

   12,385    10.1 %   21,144    12.6 %   23,087    13.7 %

Product development expenses

   886    0.7 %   1,528    0.9 %   1,617    1.0 %

Amortization of intangibles

   5,614    4.6 %   535    0.3 %   1,045    0.6 %

Provision for impairment of intangibles

   307    0.3 %   —      —       —      —    
                                 

Total operating expenses

   26,887    22.0 %   30,383    18.1 %   32,723    19.4 %
                                 

(1) Financial data in 2005 have been restated as the results of Indiagames are separately presented under “Discontinued Operations.”

Selling and Marketing Expenses

Selling and marketing expenses primarily consist of advertising, sales and marketing expenses, including expenses associated with sponsoring promotional events, and salaries and benefits for our direct sales force, which are not related to sales target. Our selling and marketing expenses have declined both in real terms and as a percentage of our revenues during each of 2005 and 2006 primarily due to the cost control programs that we implemented in response to the negative impact of the new China Mobile and China Unicom policies with respect to wireless Internet subscriptions. We expect our selling and marketing expenses to increase as a percentage of total revenues over time as we continue to invest in our brand and marketing activities in order to maintain and increase our market share.

General and Administrative Expenses

General and administrative expenses primarily consist of compensation and benefits for general management, finance and administrative personnel costs, professional fees, lease expenses, other office expenses, provisions for bad debts and depreciation with respect to equipment used for general corporate purposes. Our general and administrative expenses have increased both in real terms and as a percentage of our revenues during each of 2005 and 2006. In 2005, the increase was primarily due to payment of 2004 management performance bonus, accrual of 2005 management bonus and increases in professional fees and staff compensation. In 2006, the increase was primarily due to the recognition of the share-based compensation, or SBC, expenses upon the adoption of SFAS 123R in 2006. We expect our general and administrative expenses to comprise roughly the same percentage of total revenues in 2007 as in 2006 as we maintain our cost control program.

Product Development Expenses

Product development expenses primarily consist of research and development staff costs. Our product development expenses have increased both in real terms and as a percentage of our revenues during each of 2005 and 2006 primarily due to continued investment in new products and services. We expect our product development expenses to increase at a similar pace as we continue to invest in new products and services.

Amortization of Intangibles

Amortization of intangibles primarily relates to the amortization of intangible assets acquired in connection with our purchase of Puccini in 2003, Treasure Base and Whole Win in 2004 and Huan Jian Shu Meng and Beijing Infomax in 2006.

 

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Provision for Impairment of Intangibles

Provision for impairment of intangible assets consists of impairment charges relating to intangible assets that have suffered a decline in value.

Discontinued Operations

On December 29, 2006, our board of directors approved a plan to sell substantially all of our equity interests in Indiagames, which we had acquired on February 24, 2005, in order to focus on the China market. Accordingly, the results of Indiagames were separately presented on the face of our consolidated statements of operations under “Discontinued Operations” for the years ended December 31, 2006 and 2005. Consolidated statements of operations for the year ended December 31, 2005 have been restated accordingly. Loss from discontinued operations was US$5,049,000 (including an impairment of goodwill of US$4,628,000) and US$1,000 (including a loss of US$69,000 resulting from the dilutive effect of our interest upon the issuance of shares to new shareholders) for the years ended December 31, 2006 and 2005, respectively.

Critical Accounting Policies

The preparation of financial statements often requires the selection of specific accounting methods and policies from several acceptable alternatives. Further, significant estimates and judgments may be required in selecting and applying those methods and policies in the recognition of the assets and liabilities in our consolidated balance sheet, the revenues and expenses in our consolidated statements of operations, the information that is contained in the significant accounting policies and notes to our consolidated financial statements. Management bases its estimates and judgments on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates and judgments under different assumptions or conditions. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that affect our financial condition and results of operations.

Wireless Internet Services Revenue Recognition

Wireless Internet services revenues are derived principally from providing mobile phone users in China with SMS, MMS, WAP, IVR, CRBT and other wireless internet services. These include news subscriptions, music, entertainment, sports information, mobile e-mail, friend-making services, picture downloads, wallpaper, mobile games, ring tones, logo downloads, chat rooms and access to music files. Wireless Internet services are billed on monthly subscription basis or on usage basis.

Our services are delivered to users through the wireless data platforms of the mobile telecommunications operators, mainly China Mobile, China Unicom and their provincial subsidiaries, and we rely upon these operators to provide us with billing and collection services. In addition, we have a proprietary internal system that records the number of messages that we send, the related fees and the delivery confirmations that the mobile telecommunications operators provide us with respect to messages we send once the messages are received by the users. Generally within 20 to 60 days after the end of each month, we receive a statement from each of the mobile telecommunications operators confirming the value of our wireless Internet services that they billed to users in that month. Generally within 60 days after delivery of such statement, we are paid by the mobile telecommunications operators for the wireless Internet services recorded in such statement, net of the relevant mobile telecommunications operator’s revenue share, transmission fees and applicable business taxes.

We initially ascertain the value of the wireless Internet services provided based on delivery confirmations sent to us by the networks of the mobile telecommunications operators with respect to the amount of services we deliver to the users. Because there has historically been a discrepancy between this value and the value of the services based on the monthly statements provided by the mobile telecommunications operators as a result of technical issues with the transmission and billing systems, at the end of each month, we will, based on the historical data regarding such discrepancies, our observation of the stability of the various network systems during the month in question and other factors, make an estimate of the collectible wireless Internet services fees for such month. This estimate may be higher or lower than the actual revenue we have a right to receive based on the monthly statements from the mobile telecommunications operators.

 

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By the time we report our financial results, we generally have received well over a majority of the monthly statements from the mobile telecommunications operators and would have recognized our revenue for the wireless Internet services based on those monthly statements. In the event that a monthly statement for any mobile telecommunication operator has not been received at the time such financial results are reported, we report wireless Internet services revenue based on our estimate of the collectible wireless Internet services relating to such mobile telecommunication operator. As a result, we may overstate or understate our wireless Internet services revenue for that reporting period. Any difference between the operator’s monthly statement that is eventually received and our estimate of the collectible wireless Internet services for such operator may result in subsequent adjustments to our wireless Internet services revenue reported in our financial statements. In 2006 and 2005, the average differences between our estimates and our actual revenue, calculated on a quarterly basis, were approximately 3% and 5%, respectively. The decline in the average differences between our internal estimates and our actual revenue was due primarily to our accumulated experience.

Revenues from wireless Internet services in China are recognized as the services are rendered and are recorded based on the gross amounts billed to the mobile phone users as we market, support and contract for our services directly with the mobile phone users. Revenues retained by China Mobile and China Unicom are calculated based on agreed percentages of revenues generated from our wireless Internet services. We evaluated our revenue sharing arrangements with the mobile telecommunications operators and content providers to determine whether to recognize our wireless Internet services revenue gross or net of the shared revenues. Our determination was based upon an assessment of whether we act as principal or agent when providing wireless Internet services. We believe that the primary factor with respect to this assessment is that we are the primary obligor to the user with respect to the provision of the wireless Internet services.

Online Advertising Revenue Recognition

Revenues from online advertisements are derived from written contracts with customers that include the related fee, payment terms and provide persuasive evidence of the arrangement. The majority of the online advertising contracts are for the provision of online advertisement for a fixed period of time with no guaranteed minimum impression level. Revenues from these contracts are recognized based on the time period the advertisement is displayed. Certain of our online advertising contracts do not include a fixed delivery pattern for the online advertising. In these situations, revenues are deferred until completion of the contract. In all contracts, there are no future obligations after the completion of the contract and no rights of refund related to the impression levels.

Impairment of Intangibles and Goodwill

We assess the carrying value of our goodwill and intangibles with indefinite life on an annual basis and when factors are present that indicate impairment may have occurred. We amortize our intangibles with definite life and assess their carrying values when factors are present that indicate impairment may have occurred. We determine the amount of any impairment charge by using a future discounted cash flow methodology, or an approach based on appraisals performed by independent professional appraisal firms.

During the year ended December 31, 2004, due to the continued weak performance of our first online game, Karma Online, we recorded impairment charges of US$307,000 to write off the remaining book value of the license rights for Karma Online. In 2004, goodwill impairment tests were carried out at the reporting unit level. The major reporting units identified were our wireless Internet services businesses, Puccini, acquired in 2003 and Treasure Base and Whole Win, acquired in 2004, which had not been fully integrated in our main China operations.

For the year ended December 31, 2005, we determined that there was no impairment of goodwill based on valuations performed by an independent professional appraisal firm on our wireless Internet business in China and Indiagames. The valuations were arrived at after using a combination of a market value approach (with comparisons to selected publicly traded companies operating in same industry) and an income approach (Discounted Cash Flows). For our 2005 impairment tests, the whole of our wireless Internet services business in China was taken as one reporting unit, because of the successful completion of operational and managerial integration and because our chief executive officer, when making strategic business decisions, focuses on the wireless Internet services business as a whole rather than by entity. Goodwill relating to Indiagames was tested separately for impairment.

 

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For the year ended December 31, 2006, goodwill was tested for impairment at the reporting unit level with the assistance of an independent valuer. During the year, the Company acquired Huan Jian Shu Meng and Beijing Infomax. Goodwill associated with Huan Jian Shu Meng and Beijing Infomax was tested for impairment separately since they had not been fully integrated into our existing China wireless Internet business. Consistent with 2005, the valuations were arrived at after using a combination of a market value approach (with comparisons to selected public traded companies operating in the same industry) and an income approach (discounted cash flows). We determined that there was no impairment of goodwill of Huan Jian Shu Meng, Beijing Infomax or existing China wireless Internet business based on the valuation. Goodwill relating to Indiagames was tested separately for impairment and we recorded an impairment of US$4,628,000 under “Discontinued Operations” based on the sale price of a legally binding term sheet with a potential buyer.

The impairments recorded in 2004 and 2006 were triggered by events or changes in circumstances which had occurred in 2004 and 2006 and resulted in changes in management’s estimates with respect to assumptions, including future revenues, cost of revenues and operating expenses in the discounted cash flow. If different judgments or estimates had been utilized, material differences could have resulted in the amount and timing of the impairment charges.

Impairment of Property and Equipment

We assess the carrying value of our property and equipment on a regular basis and/or when factors are present that indicate impairment may have occurred. If the total of the expected future undiscounted cash flow is less than the carrying value, impairment is present and a loss is recognized in the statements of operations for the difference between the fair value and the carrying value of the assets. The future undiscounted cash flow is based on management’s estimates and assumptions with respect to future revenues, cost of revenues and operating expenses. We cannot provide you with any assurances that actual results will be equal to our estimates. If management makes different judgments or adopts different assumptions, material differences could result in the amount and timing of any impairment charge that is recorded.

Deferred Tax Valuation Allowance

We record a valuation allowance to reduce our deferred tax assets if, based on an estimate of our future taxable income, it is more likely than not that some portion of, or all of our deferred tax assets will not be realized. If unanticipated future events allow us to realize more of our deferred tax assets than the previously recorded net amount, an adjustment to the deferred tax asset would increase our net income when those events occur. Our largest deferred tax asset item relates to our loss carry forwards. For details regarding our tax loss carry forwards, see “— Income Taxation.”

Allowances for Doubtful Accounts

We establish provisions for bad debts on a quarterly basis. We maintain allowances for doubtful accounts receivable based on various information, including aging analysis of accounts receivable balances, historical bad debt rates, repayment patterns, client credit worthiness and industry trend analysis. Generally, when an account receivable is 180, 270 or 360 days overdue, we establish a provision for bad debts equal to 25%, 50% or 100% of the amount of the account receivable, respectively. We also make specific provisions for bad debts if there is strong evidence showing that the receivable is likely to be irrecoverable. If the financial conditions of our clients were to deteriorate, resulting in their potential inability to make payments, we might require additional allowance for doubtful accounts. Provision for bad debts as of December 31, 2006 amounted to US$4,352,000, up from US$3,933,000 in 2005. The primary reason for this increase was due to a higher balance of aging receivables.

Available-for-sale Securities and Restricted Securities

Investments in available-for-sale securities are stated at fair value with unrealized gains or losses, net of tax, recorded in other comprehensive income/(loss). Realized gains and losses and decline in value judged to be other than temporary, if any, on available-for-sale securities are reported in gain/(loss) on disposal of available-for-sale securities and impairment of available-for-sale securities of other income/(expense), respectively. Interest on available-for-sale securities is reported in interest income.

 

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When determining whether a decline in value of an available-for-sale security is other than temporary, we evaluate current factors including the economic environment, market conditions, operational performance, near term prospects and other specific factors relating to the business underlying the securities.

Restricted securities are those securities distinguished from available-for-sale securities as being pledged and set aside as collateral for securing other sources of finance, such as a bank loan facility. Restricted securities are accounted for the same as available-for-sale securities.

We did not realize any gain or loss from our investments in available-for-sale securities and restricted securities for the year ended December 31, 2006.

Share-based Compensation Expenses

Prior to 2006, we accounted for share option grants under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, or APB 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, the amount of compensation expense was determined based on the intrinsic value (which is the excess, if any, of the quoted market price of the shares over the exercise price of the options at the date of the grant), and was amortized over the vesting period of the option concerned. Statement of Financial Accounting Standards No. 148, or SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” allowed entities to continue applying the provisions of APB 25 and provide pro forma net income or loss and pro forma earnings or loss per share disclosures in the notes to financial statements for employee share options using fair-value based methods of accounting as prescribed in SFAS No. 123, or SFAS 123, “Accounting for Stock-Based Compensation,” and SFAS 148.

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123R, or SFAS 123R, “Share-Based Payment.” This statement replaces SFAS 123 and requires that the costs resulting from all share-based compensation transactions be recognized in the financial statements. SFAS 123R applies to all share-based compensation transactions in which an entity acquires goods and services by issuing or offering to issue its shares, share options or other equity instruments or by incurring liabilities to an employee or other supplier (a) in amounts based, at least in part, on the price of the entity’s shares or other equity instruments or (b) that require or may require settlement by issuing the entity’s equity shares or other equity instruments. SFAS 123R is effective as of the beginning of the first interim or annual reporting period beginning after June 15, 2005 for public entities that do not file as small business issuers.

Effective from January 1, 2006, we have adopted the modified prospective method under SFAS 123R and recognize share-based compensation costs based on the fair values of the awards in the consolidated financial statements on a prospective basis. We use the Black-Scholes option pricing model to determine the fair value of share options. The determination of the fair value of share-based compensation awards on the date of grant using an option-pricing model is affected by our share price as well as assumptions regarding a number of complex and subjective variables, including our expected share price volatility over the term of the awards, actual and projected employee share option exercise behavior, risk-free interest rates and expected dividends. When estimating the fair value of our ordinary shares, both internal and external sources of information are reviewed. Furthermore, we are required to estimate forfeitures at the time of grant and record share-based compensation expenses only for those awards that are expected to vest. If actual forfeitures differ from these estimates, we may need to revise those estimates used in subsequent periods.

If factors change and we employ different assumptions for estimating share-based compensation expense in future periods or if we decide to use a different valuation model, our share-based compensation in future periods may differ significantly from what we have recorded in prior periods and could materially affect our operating income, net income and net income per share.

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, which are characteristics not present in our option grants. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair value of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may be significantly different from the actual values realized upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based compensation awards, such as employee share options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair value originally estimated on the grant date and reported in our financial statements. Alternatively, values that are significantly higher than fair values originally estimated on the grant date and reported in our financial statements may be realized from these instruments. There is currently no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.

The guidance provided in SFAS 123R and Staff Accounting Bulletin No. 107 is relatively new. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimates of share-based compensation awards. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.

Consolidation of Variable Interest Entities

PRC laws and regulations restrict foreign ownership of companies that provide value-added telecommunications services, including wireless Internet services and Internet content services in China. As a result, we conduct substantially all of our operations through Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone and Beijing Infomax, each of which is wholly owned by PRC citizens. In addition, we have entered into a series of contractual arrangements with each of these companies and their respective shareholders, pursuant to which we guarantee any obligations undertaken by these companies under their contractual arrangements with third parties and are entitled to receive service fees in an amount equal to substantially all of the net income of these companies. Accordingly, we bear the risks of, and enjoy the rewards associated with, the investments in these companies.

In December 2003, FASB issued FASB Interpretation No. 46, revised in December 2003, or FIN 46R, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.” FIN 46R is intended to achieve a more consistent application of consolidation policies to variable interest entities to improve comparability among enterprises engaged in similar activities even if some of those activities are conducted through variable interest entities. We have evaluated our relationship with Beijing Lei Ting,

 

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Shenzhen Freenet, Wu Ji Network, LingXun, Startone and Beijing Infomax and have concluded that these entities are our variable interest entities as we are the primary beneficiary of these entities. Consequently, we have included the results of operations of these variable interest entities in our consolidated financial statements. In addition, we have also determined that Tel-Online and Huan Jian Shu Meng, a subsidiary of Beijing Lei Ting, are our variable interest entities as we are the primary beneficiary of these entities.

The results of operations of these variable interest entities have been included in our consolidated financial statements.

Purchase Price Allocations

We account for our acquisitions using the purchase method. This method requires not only ascertaining the total cost of the acquisition but also allocating that cost to the individual assets and liabilities that we acquired based upon their fair values. We make judgments and estimates in determining the fair value of the acquired assets and liabilities. We base our determination upon independent appraiser valuation reports, our experience with similar assets and liabilities based upon our industry expertise and forecasted future cash flows. The excess of the cost of the acquisition over the sum of the amounts allocated to identifiable assets and liabilities is recorded as goodwill. If we were to use different assumptions in determining fair value, the amounts assigned to the individual acquired assets and liabilities could be materially different and could result in a material difference in the amount of goodwill recorded.

Our Acquisitions and Investments

On November 19, 2003, we acquired from Cranwood, a 24.5% shareholder of our parent company at the date of the acquisition, 100% equity interest in Puccini, which provides wireless IVR services through Wu Ji Network. On December 31, 2004, we allotted 96,200,000 ordinary shares with a total value of US$18,500,000 to Cranwood. In April 2005, we paid an earn-out consideration totaling US$113,594,000, consisting of US$66,047,000 in cash and 304,155,503 newly issued ordinary shares with a total value of US$47,547,000.

On August 11, 2004, we acquired 100% of the equity interest in Treasure Base. Treasure Base provides SMS, MMS and WAP services in cooperation with major television broadcasters in China through LingXun. As of December 31, 2005, we had paid out US$33,034,000, equal to 4.5 times Treasure Base’s 2004 audited combined after-tax profit, as settlement of the initial consideration. We paid an earn-out consideration of US$16,615,000, which was equal to 1.75 times Treasure Base’s 2005 audited combined after-tax profits, in cash in March 2006.

In August 2004, we invested US$1,494,000 in Sichuan Great Wall for a 13.95% equity interest. This investment is accounted for using the cost method. We received no dividends from Sichuan Great Wall in any of the years ended December 31, 2006, 2005 or 2004, and we concluded that no impairment occurred in the book value of this investment. We did not take up an option to increase our stake to 20.55% as of December 31, 2006.

On November 19, 2004, we acquired 100% of the equity interest in Whole Win, which provides WAP services through Startone. We paid the initial consideration of US$2,169,000 in cash in 2004 and paid an earn-out consideration of US$5,062,000 in 2005.

On February 24, 2005, through our wholly-owned subsidiary TOM Online Games Limited, we completed the acquisition of 76.29% of the issued and paid-up share capital of Indiagames by paying US$13,732,000 cash as consideration. On April 29, 2005, Cisco and Macromedia invested US$4,000,000 for a combined stake of 18.18% in Indiagames by subscribing to newly issued shares of Indiagames. As a result, our ownership interest in Indiagames was diluted to 62.42%. Our board of directors decided on December 29, 2006 to sell substantially all our equity interest in Indiagames and initiated actions to locate a buyer. On March 5, 2007, a binding term sheet was signed with a potential buyer of Indiagames and a definitive agreement is still under negotiation.

 

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In August 2005, jointly with Skype, we established Tel-Online to develop next-generation communication services in the mainland China market. Tel-Online offers instant messaging and chat functions to registered users in the PRC. As of December 31, 2006, we owned 51% of Tel-Online. We have determined that under US GAAP we are the primary beneficiary of the investments in Tel-Online and we have consolidated its results of operations in our historical consolidated financial statements beginning August 22, 2005.

On January 4, 2006, through our variable interest entity, Beijing Lei Ting, we acquired 75% equity interest of Huan Jian Shu Meng for an aggregate amount of RMB22,000,000 (equivalent to US$2,728,000 at the then-prevailing exchange rate), of which approximately RMB10,000,000 (equivalent to US$1,240,000) was injected as additional paid-in-capital. Huan Jian Shu Meng operates an Internet website that provides original Chinese novels to online readers. In March 2006 and in August 2006, we made payments of RMB21,000,000 (approximately US$2,612,000 at the then-prevailing exchange rate) and RMB1,000,000 (approximately US$116,000 at the then-prevailing exchange rate) respectively as the total consideration for the acquisition. We account for Huan Jian Shu Meng as a variable interest entity because it is a subsidiary of Beijing Lei Ting.

On June 1, 2006, through our wholly owned subsidiary TOM Online Media Group Limited, we acquired 100% of the equity interest in Gainfirst for a maximum consideration of RMB600,000,000 (equivalent to US$75,000,000 at the then-prevailing exchange rate). Gainfirst provides wireless Internet services in China through Beijing Infomax. In August 2006, we paid an initial consideration of RMB150,000,000 (approximately US$18,750,000 at the then-prevailing exchange rate). During 2007, we expect to make a cash payment of RMB93,991,000 (approximately US$12,037,000), which is equal to 3.5 times of Gainfirst’s 2006 estimated adjusted combined after-tax profit minus initial consideration, as payment of the 2006 earn-out consideration. A final earn-out consideration is payable in 2008, and will be equal to either three or four times of Gainfirst’s 2007 adjusted audited combined after-tax profit plus adjusted 2006 earn-out consideration, minus consideration previously paid up to the final payment. The consideration payable relating to the 2006 earn-out and additional goodwill of Gainfirst have been reflected in the consolidated financial statements for the year ended December 31, 2006.

Our audited historical consolidated financial statements include the financial results of Wu Ji Network, LingXun, Startone, Indiagames, Tel-Online, Huan Jian Shu Meng and Beijing Infomax beginning as of November 19, 2003, August 11, 2004, November 19, 2004, February 24, 2005, August 22, 2005, January 4, 2006 and June 1, 2006, respectively.

On February 1, 2007, pursuant to our joint venture deed with eBay, we established TOM Eachnet PRC Holdings (BVI) Inc., in which we hold a 51% stake and eBay holds a 49% stake. eBay provided initial funding of US$40,000,000 in February 2007, and we have agreed to provide an initial shareholder’s loan in the amount of US$20,000,000 when such loan is needed. If this initial funding and initial shareholder’s loan is fully utilized and we and eBay agree that additional funding is needed, we and eBay will each provide shareholder’s loans, in equal proportions, not to exceed US$10,000,000 in the aggregate. eBay has injected into the joint venture its subsidiary eBay Eachnet Network Information Services (Shanghai) Co. Ltd., which operates an online auction and marketplace business in China, and we will contribute our local industry expertise, management services, technology and brand. We will account for this joint venture using the equity method of accounting starting from February 1, 2007. TOM Eachnet PRC Holdings (BVI) Inc. recorded a loss in the first quarter of 2007 and is expected to record a loss in the second quarter of 2007 as well. TOM Eachnet PRC Holdings (BVI) Inc. conducts substantially all its operations through Beijing Yi Lian Tong He, which is wholly owned by PRC citizens and will be accounted for as the variable interest entity of TOM Eachnet PRC Holdings (BVI) Inc.

Results of Operations

The following discussion of our results of operations for the years ended December 31, 2006, 2005 and 2004 is based upon our audited historical consolidated financial statements included elsewhere in this document, with 2005 financial data restated to conform to current year presentation.

Year Ended December 31, 2006 compared to Year Ended December 31, 2005

Our total revenues were US$168,365,000 in 2006, representing an increase of 0.2% from US$168,068,000 in 2005. The flat performance in total revenues was mainly due to the negative impact of new government and mobile telecommunications operator

 

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policies introduced in July 2006 with respect to wireless Internet subscriptions, which was partially offset by growth in our online advertising business and the acquisition of Beijing Infomax. We expect the impact of policy changes will be on-going and our revenues will continue to be negatively affected by these government and mobile telecommunications operator policies in 2007.

Wireless Internet Services. The majority of our revenues in 2006 continue to be derived from our wireless Internet business. In 2006, our wireless Internet business achieved revenues of US$152,637,000, representing a decrease of 3.3% from US$157,833,000 in 2005. This decrease was mainly due to the policy changes described below, which were partially offset by the contribution from our acquisition of Beijing Infomax. In 2006, our wireless Internet revenues accounted for 90.7% of our total revenues, compared to 93.9% in 2005, as we continued to emphasize our wireless Internet business as our core strategic focus area.

In July 2006, China Mobile adopted policy changes with respect to wireless Internet services offered through China Mobile’s MonternetTM platform. The changes were implemented under the policy directives of MII and aimed to address a number of issues, including reducing customer complaints, increasing customer satisfaction and promoting the healthy development of the MonternetTM. The changes included requiring us and other wireless Internet service providers to offer a one-month free-trial period for all new SMS, MMS and WAP subscriptions, requiring users to confirm twice, in response to reminders from China Mobile, that they wish to start subscriptions, and canceling WAP subscriptions that have been inactive for more than four months. China Unicom implemented similar policies during the quarter ended September 30, 2006. See “Item 4 — Information on the Company — Our Business — Wireless Internet Services — Wireless Internet Data Services — Fees and Revenue Sharing.” These policies had a significant negative impact on our wireless Internet business in the second half of 2006. Excluding the contribution from our acquisition of Beijing Infomax in the middle of 2006, our like-for-like wireless Internet business revenues declined 10.9% from 2005.

In 2006, our wireless Internet business comprised four key categories: 2G services (SMS), 2.5G services (WAP and MMS), voice services (IVR and CRBT) and other wireless Internet revenues. Unlike our historically presented financials, wireless Internet revenues do not include results from our Indiagames subsidiary because this business has been separately presented under “Discontinued Operations.”

2G Services – SMS. In 2006, our SMS services generated US$60,057,000 in revenues, representing a decrease of 5.3% from US$63,428,000 in 2005. In 2006, SMS services accounted for 39.4% of our total wireless Internet revenues, down from 40.2% in 2005. The primary reason for the decline in SMS service revenues was the new China Mobile and China Unicom policies implemented in 2006 and described above. The impact on our SMS service revenues from these new policies was partially offset by the acquisition of Beijing Infomax, which derives the majority of its revenues from SMS and the results of which we began consolidating as of June 1, 2006.

2.5G Services – MMS and WAP. In 2006, our MMS services generated US$12,526,000 in revenues, representing an increase of 4.3% from US$12,012,000 in 2005. In 2006, MMS services accounted for 8.2% of our total wireless Internet revenues, up from 7.6% in 2005. Although our MMS service revenues slightly increased in 2006, we continue to believe that MMS over the medium-term is a transitory product category because our mobile operator partners have indicated to us that they intend to prioritize the development of other wireless services.

In 2006, our WAP services generated US$29,226,000 in revenues, representing a decrease of 7.8% from US$31,686,000 in 2005. In 2006, WAP services accounted for 19.1% of our total wireless Internet revenues, down from 20.1% in 2005. The decline in WAP service revenues was primarily due to the new China Mobile and China Unicom policies implemented in 2006 and described above. In particular, in 2006 the mobile telecommunications operators began canceling WAP subscriptions after four months of inactivity, rather than after six months of inactivity as previously. Other factors included a more stringent operating environment limiting the scope of our marketing and other cross-selling activities as a result of the new policies implemented by China Mobile and China Unicom in 2006 in response to directives from the MII. The impact on WAP service revenues from these new policies was partially offset by the acquisition of Beijing Infomax, whose results we began consolidating as of June 1, 2006.

 

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Voice Services – IVR and CRBT. In 2006, our IVR services generated US$40,166,000 in revenues, representing a small increase of 0.3% from US$40,059,000 in 2005. In 2006, our IVR business accounted for 26.3% of our total wireless Internet business, up from 25.4% in 2005, largely because of the decline in revenues from our SMS and WAP services. Our IVR business showed stable performance in 2006 compared to 2005 as we broadened our distribution channels for our IVR services primarily through TV, radio and print channel partners and other means, but whose benefits were offset by suspension of cross-selling activities by the mobile operators in the second half of 2006 due to changes in the regulatory environment.

In 2006, our CRBT services generated US$9,597,000 in revenues, representing a decline of 9.1% from US$10,557,000 in 2005. In 2006, our CRBT business accounted for 6.3% of our total wireless Internet revenues, down from 6.7% in 2005. Continued strong price competition and a more stringent operating environment due to the new policies implemented by China Mobile and China Unicom in 2006 contributed to the decline in revenues and in its share in our total wireless Internet revenues in our CRBT business.

Other Wireless Internet Services. In 2006, revenues from our other wireless Internet services were US$1,065,000, representing an increase of 1070% compared to US$91,000 in 2005. The increase in revenues from our other wireless Internet services is mainly due to higher revenues from our Java-based mobile game services. Other wireless Internet services consist primarily of Java-based mobile games and made up 0.7% of our total wireless Internet revenues in 2006.

Online Advertising. Our online advertising generated US$13,279,000 in revenues in 2006, up 44.2% from US$9,210,000 in 2005. In 2006, online advertising revenues accounted for 7.9% of our total revenues, up from 5.5% in 2005. The growth in online advertising revenues was driven by a number of factors including increased traffic on our portal, higher average spending per advertiser on our portal and our initiatives in the second half of 2005 to focus our sales efforts on fewer but more strategic portal channels such as our music, entertainment, auto and sports channels.

Others. Others revenue increased 138.9% to US$2,449,000 in 2006 from US$1,025,000 in 2005. In 2006, others revenues accounted for 1.4% of our total revenues, up from 0.6% in 2005. Revenue from online games, which increased by US$1,146,000 as more games were launched in 2006, was the largest contributor to this revenue line and accounted for the year-on-year increase.

Cost of Services. Our cost of services was US$105,919,000, representing an increase of 9.3%from US$96,900,000 in 2005. The increase was primarily due to increased fees charged by third-party content providers and higher costs to promote our wireless Internet products and services. The increase was partially offset by a decrease in transmission fees paid to the mobile telecommunications operators as a result of reduced subscriptions for our wireless Internet services in the second half of 2006.

Gross Profit. As a result of the foregoing, our gross profit was US$62,446,000, representing a decrease of 12.3% from US$71,168,000 in 2005. Our gross profit as a percentage of total revenues, or gross profit margin, decreased to 37.1% in 2006 from 42.3% in 2005 due to an increase in our cost of services.

Selling and Marketing Expenses. Our selling and marketing expenses were US$6,974,000 in 2006, representing a decrease of 2.8% from US$7,176,000 in 2005. Sales and marketing expenses as a percentage of total sales remained relatively flat at 4.1% of 2006 total revenues compared to 4.3% of 2005 total revenues. Our selling and marketing expenses decreased in 2006 because we implemented cost control programs in response to the negative impact that the new China Mobile and China Unicom policies described above were having on our revenues.

General and Administrative Expenses. Our general and administrative expenses were US$23,087,000 in 2006, representing an increase of 9.2% from US$21,144,000 in 2005. Beginning in 2006, with the adoption of SFAS 123R, we recognized US$2,973,000, or 95.7% of the total share-based compensation expenses for 2006, in general and administrative expenses. Excluding these share-based compensation expenses, total general and administrative expenses in 2006 would have declined from 2005 levels because we implemented cost control programs in response to the negative impact that the new China Mobile and China Unicom policies described above were having on our revenues.

 

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Product Development. Our product and development expenses were US$1,617,000 in 2006, representing an increase of 5.8% from US$1,528,000 in 2005, as we continued to invest in new products and services for our online advertising, TOM-Skype and wireless Internet businesses.

Amortization of Intangibles. Our amortization of intangibles were US$1,045,000 in 2006, representing an increase of 95.3% from US$535,000 in 2005. The increase in amortization of intangibles was related primarily from the acquisition of Beijing Infomax in 2006.

Total Operating Expenses. As a result of the foregoing, our total operating expenses increased 7.7% to US$32,723,000 from US$30,383,000 in 2005.

Operating Profit. As a result of the foregoing, our operating profit was US$29,723,000 in 2006, representing a decrease of 27.1% from US$40,785,000 in 2005.

Net Interest Income. We recorded a net interest income of US$1,424,000 in 2006, representing a decrease of 44.0% from US$2,543,000 in 2005. The decline in net interest income was driven by higher total borrowing costs associated with an increase in short-term loans for financing purposes.

Exchange Gain. In 2006, we recognized an exchange gain of US$2,382,000, representing an increase of 110.4% from US$1,132,000 in 2005, due to the appreciation of the Renminbi upon translation of our net non-RMB liabilities at the period end, as our functional currency is the Renminbi.

Income from Continuing Operations. As a result of the forgoing, our income from continuing operations was US$33,704,000 in 2006, representing a decrease of 25.1% from US$45,007,000 in 2005.

Loss from Discontinued Operations. In 2006, we recognized US$5,049,000 in losses associated with our stake in Indiagames, which was classified as “held for sale” at the end of 2006. This was an increase from our 2005 loss from discontinued operations of US$1,000 and was primarily due to a US$4,628,000 goodwill impairment charge made in 2006.

Minority Interest. The portion of income attributable from minority interests was US$35,000 in 2006, compared with US$34,000 in 2005.

Net Income. As a result of the foregoing, our net income attributable to shareholders was US$28,655,000 in 2006, representing a 36.3% decrease from US$45,006,000 in 2005.

Year Ended December 31, 2005 (restated) compared to Year Ended December 31, 2004

Our total revenues were US$168,068,000 in 2005, representing an increase of 37.0% from US$122,720,000 in 2004. This increase was primarily due to increases in our wireless Internet services revenues.

Wireless Internet Services. The majority of our revenues were derived from our wireless Internet business. In 2005, our wireless Internet business achieved revenues of US$157,833,000, representing an increase of 39.8% from US$112,880,000 in 2004. In 2005, our wireless Internet revenues accounted for 93.9% of our total revenues as compared to 92.0% in 2004 as we continued to emphasize our wireless Internet business as our core strategic focus area.

In 2005, our wireless Internet business comprised 4 key categories: 2G services (SMS), 2.5G services (WAP and MMS), voice services (IVR and CRBT) and other wireless Internet revenues.

 

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2G Services – SMS. In 2005, our SMS services generated US$63,428,000 in revenues, compared to US$54,956,000 in 2004, representing an increase of 15.4%. In 2005, SMS services accounted for 40.2% of our total wireless Internet revenues, down from 48.7% in 2004 as our other wireless Internet businesses grew faster. Our SMS business experienced more stable growth as mobile operator billing platforms were upgraded, resulting in more consistent carrier billing statements.

2.5G Services – MMS and WAP. In 2005, our MMS services generated US$12,012,000 in revenues, compared to US$11,784,000 in 2004, representing an increase of only 1.9%. In 2005, MMS services accounted for 7.6% of our total wireless Internet revenues, down from 10.4% in 2004. The flat performance of MMS in 2005 was due to a migration in our mobile operator partner’s MMS billing platform to an upgraded system, as well as to the impact of a change in China Mobile’s billing policy in the first quarter of 2005, which caused a decline in revenues in the early part of 2005. In the second half of 2005, MMS revenues had begun to recover as the MMS billing platform stabilized and some provincial operators actively promoted MMS services. We continue to believe that MMS over the medium-term is a transitory product category.

In 2005, our WAP services generated US$31,686,000 in revenues, compared to US$17,114,000 in 2004, representing an increase of 85.1%. In 2005, WAP services accounted for 20.1% of our total wireless Internet revenues, up from 15.2% in 2004. This strong growth in WAP services was due to a number of factors including mobile operator initiatives to encourage higher usage of WAP, increased penetration of mobile handsets which support WAP and GPRS services, broader distribution of our content and services through channel partners and continued focus on quality content. However, due to mobile operator “silent user clean-up” policies, WAP growth slowed down in the second half of 2005.

Voice Services – IVR and CRBT. In 2005, our IVR services generated US$40,059,000 in revenues, compared to US$26,152,000 in 2004, representing an increase of 53.2%. In 2005, our IVR business accounted for 25.4% of our total wireless Internet business, up from 23.2% in 2004. Our IVR business experienced strong growth in 2005 as we broadened our distribution channels for our IVR services through various means, but primarily TV, radio and print channel partners.

In 2005, our CRBT services generated US$10,557,000 in revenues, compared to US$2,874,000 in 2004, representing an increase of 267.3%. In 2005, our CRBT business accounted for 6.7% of our total wireless Internet revenues, up from 2.5% in 2004. CRBT was a new business, introduced to the mainland China market in the second half of 2004 with growth driven by low penetration rates. We earn revenue on a per song basis which is periodically purchased by users whilst the mobile operators receive all CRBT service subscription fees. Our CRBT revenues declined in the second half of 2005 from the first half of 2005 as we partnered more closely with mobile operators to offer free CRBT songs to mobile phone users in an effort to promote and increase the popularity of CRBT services.

Other Wireless Internet Services. In 2005, revenues from our other wireless Internet businesses were US$91,000, which mainly represented revenue from contents provision and we did not report other wireless Internet revenues in 2004.

Online Advertising. Our online advertising revenues increased 21.5% to US$9,210,000 in 2005 from US$7,583,000 in 2004. In 2005, online advertising revenues accounted for 5.5% of our total revenues, down from 6.2% in 2004. This growth was driven by a number of factors including increased traffic on our portal, higher average spending per advertiser on our portal and our initiatives in the second half of 2005 to focus our sales efforts on fewer but more strategic portal channels such as our music, entertainment, auto and sports channels, amongst others.

Others. Others revenue decreased 54.6% to US$1,025,000 in 2005 from US$2,257,000 in 2004. In 2005, others revenues accounted for just 0.6% of our total revenues, down from 1.8% in 2004. We continued to de-emphasize and phase out our commercial enterprise solutions business and focus on our wireless Internet and online advertising businesses.

Cost of Services. Our cost of services increased 51.5% to US$96,900,000 in 2005 from US$63,966,000 in 2004. Cost of services increased as a percentage of total revenues as we increased payments to mobile operators, third party distribution and content partners to differentiate and effectively market our services to end consumers.

 

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Cost of Goods Sold. Our cost of goods sold was nil in 2005 from US$791,000 in 2004, as we continued to de-emphasize and phase out the commercial enterprise solution business and focus on our wireless Internet and online advertising businesses.

Total Cost of Revenues. As a result of the increase in our costs of services, our total cost of revenues increased 49.6% to US$96,900,000 in 2005 from US$64,757,000 in 2004.

Gross Profit. As a result of the foregoing, our gross profit increased 22.8% to US$71,168,000 in 2005 from US$57,963,000 in 2004. Our gross profit as a percentage of revenues, or gross profit margin, decreased to 42.3% in 2005 from 47.2% in 2004 due to an increase in our cost of services.

Selling and Marketing Expenses. Our selling and marketing expenses were US$7,176,000 in 2005, down by 6.7% from 2004 levels or US$7,695,000. A substantial portion of our promotional expenses was incurred directly in relation to our wireless Internet revenues and thus had been reported as cost of services, while the remaining general sales and marketing expenses were kept under tight control in 2005 compared to 2004 levels.

General and Administrative Expenses. Our general and administrative expenses increased 70.7% to US$21,144,000 in 2005 from US$12,385,000 in 2004. This increase of approximately US$ 8,759,000 in general and administration expenses was due to the following primary factors (a) payment of 2004 management performance bonus of approximately US$1,282,000 in the third quarter of 2005 (b) accrual of 2005 management bonus in the second half of 2005 of approximately US$1,697,000 (c) increased professional fees to prepare for Sarbanes-Oxley compliance and (d) a general increase in staff headcount and salary.

Product Development. Our product and development expenses increased 72.5% to US$1,528,000 in 2005 from US$886,000 in 2004 as we increased headcount of our product development teams.

Amortization of Intangibles. Our amortization of intangibles decreased to US$535,000 in 2005 from US$5,614,000 in 2004. This decrease was primarily due to the fact that a substantial portion of intangible assets acquired in connection with the acquisition of Wu Ji Network, LingXun and Startone, were already all amortized in 2004, in the amounts of US$4,411,000, US$710,000 and US$103,000, respectively.

Total Operating Expenses. As a result of the foregoing, our total operating expenses increased 13.0% to US$30,383,000 from US$26,887,000 in 2004.

Operating Profit. As a result of the foregoing, our income from operations was US$40,785,000 in 2005 compared to income of US$31,076,000 in 2004 representing an increase of 31.2% from 2004.

Net Interest Income. We recorded a net interest income of US$2,543,000 in 2005 compared to US$3,095,000 in 2004. This was derived primarily from our investment in marketable securities and from short-term fixed bank deposits, after deducting interest expenses to loans from bank and from our parent company. We sold part of our portfolio of marketable securities in the year 2005, primarily in order to finance cash obligations associated with the completion of our acquisition of Puccini.

Exchange Gain. In 2005, we recognized an exchange gain of US$1,132,000 compared to nil in 2004, due to the appreciation of RMB upon translation of our net non-RMB liabilities at the period end as our functional currency is RMB.

Income from Continuing Operations. As a result of the foregoing, our income from continuing operations was US$45,007,000 in 2005, representing an increase of 32.7% from US$33,908,000 in 2004.

Loss from Discontinued Operations. In 2005, we recognized US$1,000 in losses (including a loss of US$69,000 resulting from the dilutive effect of our interest upon the issuance of shares to new shareholders) associated with our stake in Indiagames since our acquisition of Indiagames in February 2005.

Minority Interest. The portion of income attributable from minority interests was US$34,000 in 2005, compared with a portion of income attributable to minority interests of US$304,000 in 2004 as we de-emphasized commercial enterprise solutions.

 

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Net Income. As a result of the foregoing, our net income attributable to shareholders was US$45,006,000 in 2005 compared to net income of US$33,908,000 in 2004 representing an increase of 32.7% from 2004.

Liquidity and Capital Resources

Cash Flows and Working Capital

The following table sets forth our cash flows with respect to operating activities, investing activities and financing activities for the periods indicated:

 

      For the year ended December 31,  
     2004     2005     2006  
     (in thousands of U.S. dollars)  

Net cash provided by operating activities

   33,759     51,008     53,878  

Net cash used in investing activities

   (146,099 )   (95,266 )   (66,566 )

Net cash provided by financing activities

   169,024     63,817     21,228  
                  

Net increase in cash and cash equivalents

   56,684     19,559     8,540  
                  

Prior to our initial public offering in March 2004, we primarily financed our operations through capital contributions and advances from our parent company. After the completion of our initial public offering, our parent company did not provide us with any additional capital contributions or advances. After our initial public offering, we have primarily financed our operations from the net proceeds of our initial public offering as well as net cash provided by operating activities. As of December 31, 2006, we had cash and cash equivalents of US$110,993,000, as compared to US$99,869,000 as of December 31, 2005.

Net cash provided by operating activities was US$53,878,000 in 2006, representing an increase of 5.6% from US$51,008,000 in 2005. This increase was primarily due to the improvement of our working capital management in 2006.

Our net accounts receivable were US$23,473,000 as of December 31, 2006, compared with US$33,950,000 as of December 31, 2005. The average collection time for our accounts receivable was 62 days in 2006, a decrease from 64 days in 2005. However, we expect the collection time for accounts receivable to increase in 2007 due to the new China Unicom policy of determining actual bad debts before sending us monthly statements rather than directly deducting a fee of up to 8% for bad debts. The majority of our net accounts receivable consists of fees due to us from mobile telecommunications operators pursuant to our revenue-sharing arrangements for the wireless Internet services that we offer over their networks. We have entered into separate revenue-sharing arrangements with the various subsidiaries of the mobile telecommunications operators in China. In 2005 and 2006, the majority of our wireless Internet services revenue was contributed by two major mobile telecommunications operators, China Mobile and China Unicom, upon whom we rely for billing and collection services in China. China Mobile and China Unicom contributed 82% and 17%, respectively, to our wireless Internet services revenues in 2006, as compared to 83% and 15%, respectively, in 2005. In the event that any of the subsidiaries of the mobile telecommunications operators should withhold, suspend or delay the payment of such fees to us, we may experience cash flow difficulties, such that our net cash from operating activities may not be sufficient to meet our cash needs.

Net cash used in investing activities was US$66,566,000 in 2006, representing a decrease of 30.1% from US$95,266,000 in 2005. This decrease was mainly due to the decrease in our net cash paid for acquisitions to US$34,519,000 in 2006, from US$99,937,000 in 2005, and the increase in our net cash invested in bank deposits amounting to US$25,693,000 in 2006. In addition, we had receipts of US$16,392,000 from disposal of available-for-sale securities in 2005 but made no such disposal in 2006. Our

 

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primary use of cash for investing activities in 2006 was the payment of gross cash as consideration or earn-out consideration in connection with the acquisitions of Treasure Base, Huan Jian Shu Meng and Beijing Infomax amounting to US$16,615,000, US$2,728,000 and US$18,750,000, respectively. We financed our acquisitions primarily by borrowing from banks.

We currently have US$7,000 worth of capital expenditures in progress, consisting primarily of computer equipment, most of which will be located in Beijing. We do not have any material capital divestitures in progress.

The following table sets forth our capital expenditures and divestitures for the periods indicated:

 

      For the year ended December 31,
     2004    2005    2006
     (in thousands of U.S. dollars)

Capital expenditures

   9,175    9,843    6,354

Capital divestitures (cost)

   538    2,510    446

Capital divestitures (book value)

   9    94    23

In addition, as of December 31, 2006, we were committed to finance the new joint venture with eBay by providing a shareholder’s loan of US$20,000,000. The joint venture was subsequently established on February 1, 2007 and the shareholder’s loan will be provided when it is needed. As of March 31, 2007, we did not have any material commitments for other capital expenditures.

Net cash provided by financing activities was US$21,228,000 in 2006, mainly from cash received, net of facility charges, from a one-year bank loan in the amount of US$35,340,000. The loan was effectively pledged with certain debt securities, bearing interest at 0.3% over 3-month London Inter-Bank Offered Rate, and was originally scheduled to be repaid in June 2007. In May 2007, this bank loan was extended to be repaid in August 2009. The purpose of the loan was mainly for potential acquisitions.

As of December 31, 2006, our balance of current assets and restricted securities totaled US$277,905,000 while the balance of our total liabilities amounted to US$128,939,000.

As of December 31, 2006, our balance of long-term liabilities totaled US$55,423,000, comprising a bank loan, amounting to US$55,271,000 and deferred tax liabilities of US$152,000.

We believe that our current cash and cash equivalents and cash flows from operations will be sufficient to meet our anticipated cash needs, including for working capital, capital expenditures and various contractual obligations, for at least the next 12 months. We may, however, require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If these sources are insufficient to satisfy our cash requirements, we may seek to sell debt securities or additional equity or to obtain additional credit facilities. Should we require additional financing, the sale of convertible debt securities or additional equity securities could result in additional dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financial covenants that would restrict our operations. We cannot assure you that financing will be available in amounts or on terms acceptable to us, if at all.

Indebtedness

As of December 31, 2006, our amount due to related parties was US$204,000, which was unsecured, non-interest bearing and had no fixed repayment terms. In 2006, we repaid all outstanding loan balances to our parent company, totaling US$20,038,000. This amount represented the aggregate of several interest-bearing loans from our parent company that did not have fixed repayment terms but that had been repayable upon demand since January 1, 2005. We repaid the loans and imputed interest in full in September 2006.

In addition, as of December 31, 2006, we had bank loans amounting to US$90,611,000. We did not have any material debt securities or material mortgages or liens except that our marketable securities were pledged for the bank loans. Other than our

 

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obligations to pay 2006 earn-out consideration of US$12,037,000 and 2007 earn-out consideration of unknown amount in connection with our acquisition of Beijing Infomax as of December 31, 2006, we did not have any material contingent liabilities.

The following table sets forth our indebtedness as of the dates indicated:

 

      December 31,
     2004    2005    2006
     (in thousands of U.S. dollars)

Bank loan – short term

   —      —      35,340

Bank loan – long term

   —      56,099    55,271

Due to related parties – short term

   20,331    19,430    204
              

Total

   20,331    75,529    90,815
              

Contractual Obligations and Commitments

The following table sets forth our contractual obligations as of December 31, 2006:

 

      Payments due by period within
      Total    1 year    1-3 years    3-5 years    Thereafter
     (in thousands of U.S. dollars)

Bank loans

   90,611    35,340    55,271    —      —  

Due to related parties – short term

   204    204    —      —      —  

Acquisition obligation(1)

   12,037    12,037    —      —      —  

Operating lease commitments

   2,910    1,233    1,677    —      —  

Other contractual commitments(2)

   20,000    20,000    —      —      —  
                      

Total contractual obligations

   125,762    68,814    56,948    —      —  
                        

(1) This is the 2006 earn-out consideration payable in connection with the acquisition of Beijing Infomax. In addition, according to the sale and purchase agreement for the acquisition of Beijing Infomax, we will further pay the 2007 earn-out consideration in connection with the acquisition of which the amount will be determined based on 2007 audited combined after-tax profit of Gainfirst, Dong Kui Lin and Beijing Infomax.
(2) This is the commitment to financing the new joint venture with eBay which was established on February 1, 2007.

Except as otherwise disclosed herein and apart from intra-group liabilities, as of December 31, 2006, we did not have any outstanding loan capital issued or agreed to be issued, bank overdrafts, loans, debt securities or other similar indebtedness, liabilities under acceptance (other than normal trade bills) or acceptance credits, debentures, mortgages, charges, finance leases or hire purchase commitments, guarantees or other material contingent liabilities.

Recently Issued Accounting Pronouncements

In February, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115,” or SFAS 159. This statement permits all entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. SFAS 159 will be effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. We are currently evaluating the effect that the adoption of this statement will have on our consolidated results of operations and financial condition but do not expect it to have a material impact.

 

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In September 2006, FASB issued SFAS No. 157, “Fair Value Measurement,” or SFAS 157. This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures requirement regarding fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and shall be applied prospectively except for several types of financial instruments. We will be required to adopt the statement in the first quarter of fiscal year 2008. We consider that the adoption of SFAS 157 will not have a material impact on our consolidated results of operations and financial condition because the fair value measurement we currently use to measure our assets or liabilities is in accordance with the requirement of this new statement.

In July 2006, the FASB issued the final FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109,” or FIN 48, which clarifies the accounting for uncertainty in tax positions recognized in an enterprise’s financial statements. FIN 48 creates a single model to address uncertainty in income tax positions and clarifies the accounting for income taxes by prescribing a more-likely-than-not recognition threshold that a tax position is required to meet before being recognized in the financial statements. We have adopted FIN 48 on January 1, 2007 resulting in a transition adjustment which reduced retained earnings and increased liabilities for unrecognized tax benefits (including interest and penalties) by the same amount of US$1,373,000 as of January 1, 2007. The FIN 48 provision of US$1,373,000 was provided for in respect of uncertain tax benefits associated with the technical and consulting services fees charged from our wholly owned subsidiaries to our domestic variable interest entities.

Holding Company Structure

We are a holding company with no operations of our own. Our operations are conducted through our PRC operating companies, Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Huan Jian Shu Meng, Beijing Infomax, Beijing Yi Lian Tong He and our subsidiaries in China. As a result, our ability to pay dividends and finance any debt that we may incur is dependent upon license and service fees paid by Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone, Huan Jian Shu Meng, Beijing Infomax and Beijing Yi Lian Tong He and dividends and other distributions paid by our subsidiaries. If our subsidiaries incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends to us. In addition, PRC legal restrictions permit payment of dividends to us by our subsidiaries only out of the net income from our subsidiaries, if any, determined in accordance with PRC accounting standards and regulations. Under PRC law, our subsidiaries are also required to set aside up to 10% of their after tax net income, if any, each year to fund certain reserve funds. These reserve funds are not distributable as cash dividends.

Research and Development

Research and development costs represented 1.0% of our total revenues in 2006, compared to 0.9% of our total revenues in 2005. We anticipate that research and development costs will increase in 2007 to expand our wireless products and services offering and recruit software engineers.

Off-balance Sheet Arrangements

We have not entered into any financial guarantees or other commitments to guarantee the payment obligations of any third parties. In addition, we have not entered into any derivative contract that is indexed to our own shares and classified as shareholder’s equity, or that is not reflected in our financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. Moreover, we do not have any variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

Income Taxation

Cayman Islands. The Cayman Islands currently do not levy any taxes on individuals or corporations based upon profits, income, gains or appreciations and there is no taxation in the nature of inheritance tax or estate duty. In addition, pursuant to Section 6 of the Tax Concessions Law (1999 Revision) of the Cayman Islands, we have obtained an undertaking from the Governor-in-Council that (i) no law which is enacted in the Cayman Islands imposing any tax to be levied on profits or income or gains or appreciation

 

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shall apply to us or our operations and (ii) no tax to be levied on profits, income gains or appreciations or which is in the nature of estate duty or inheritance tax shall be payable by us on or in respect of our shares, debentures or other obligations or by way of withholding in whole or in part of any relevant payment as defined in Section 6(3) of the Tax Concessions Law (1999 Revision). This undertaking is for a period of 20 years from September 25, 2001.

Hong Kong. Advanced Internet Services, our 100% owned subsidiary, is subject to income tax in Hong Kong. Hong Kong companies are generally subject to a 17.5% corporate income tax. Advanced Internet Services has not, however, paid any income taxes in Hong Kong because it is a holding company and does not receive any revenue.

China. In future periods, we expect that substantially all of our revenues will continue to be attributable to our subsidiaries and variable interest entities that are incorporated in the PRC, including GreaTom, Beijing Super Channel, Beijing Lei Ting, Shenzhen Freenet, Wu Ji Network, LingXun, Startone and Beijing Infomax. Generally, PRC companies are subject to an enterprise income tax of 33%. However, certain of our subsidiaries and variable interest entities benefit from preferential tax treatment pursuant to PRC law due to the location of their registered offices inside special economic zones or special development zones, or due to their status as high technology enterprises. On March 16, 2007, the PRC Enterprise Income Tax Law was approved by the National People’s Congress, and it will become effective on January 1, 2008. The PRC Enterprise Income Tax Law adopts a uniform tax rate of 25% for all enterprises, including foreign-invested enterprises. The exact impact of this new law on our financial condition and results of operations will depend on detailed pronouncements that we expect to be subsequently issued, including implementation rules and transitional policy relating to preferential tax treatments granted under the current tax law and administrative regulations. Under this new law and its implementation rules, certain preferential tax treatments may continue to be available, and consequently we cannot reasonably estimate the financial impact of the new law on us at this stage. The following table sets forth the tax rates applicable to certain of our subsidiaries and variable interest entities, according to the current preferential tax rates:

 

      For the year ended/ending December 31,  
     2006     2007     2008     2009     2010     2011  

Shenzhen Freenet (Shenzhen)

   15 %   15 %   15 %   15 %   15 %   15 %

Shenzhen Freenet (Guangzhou)

   33 %   33 %   33 %   33 %   33 %   33 %

Beijing Lei Ting

   7.5 %   15 %   15 %   15 %   15 %   15 %

Beijing Lei Ting (Chengdu)

   33 %   33 %   33 %   33 %   33 %   33 %

Wu Ji Network

   7.5 %   7.5 %   7.5 %   15 %   15 %   15 %

GreaTom

   7.5 %   15 %   15 %   15 %   15 %   15 %

Beijing Super Channel

   15 %   15 %   15 %   15 %   15 %   15 %

Shanghai Super Channel

   33 %   33 %   33 %   33 %   33 %   33 %

Puccini Network

   0 %   7.5 %   7.5 %   7.5 %   15 %   15 %

LingXun

   7.5 %   7.5 %   7.5 %   15 %   15 %   15 %

Ceng Dong Yi

   0 %   7.5 %   7.5 %   7.5 %   15 %   15 %

Beijing Lahiji

   0 %   7.5 %   7.5 %   7.5 %   15 %   15 %

Startone

   7.5 %   7.5 %   7.5 %   15 %   15 %   15 %

Heng Dong Wei Xin

   33 %   33 %   33 %   33 %   33 %   33 %

Huan Jian Shu Meng

   33 %   33 %   33 %   33 %   33 %   33 %

Beijing Infomax

   7.5 %   7.5 %   7.5 %   15 %   15 %   15 %

Dong Kui Lin

   0 %   0 %   0 %   7.5 %   7.5 %   7.5 %

Certain of our subsidiaries and variable interest entities have recorded net losses in the past, which they may carry forward for five years from the end of the period in which the loss was recorded to offset future net income for tax purposes. We cannot, however, give any assurances that these subsidiaries and variable interest entities will record sufficient net income for tax purposes within the carry forward periods to realize the full tax benefit of these past net losses.

 

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The table below sets forth the tax losses carry forward and related expiring periods with respect to certain of our subsidiaries and variable interest entities as of December 31, 2006:

 

      For the year ended/ending December 31,
         2006            2007            2008            2009            2010            2011    
     (in thousands of U.S. dollars)

Shenzhen Freenet (Guangzhou)

   3,829    877    910    965    477    600

Beijing Lei Ting (Chengdu)

   1,789    —      —      538    646    605

Beijing Super Channel

   13,520    —      1,256    —      6,086    6,178

Shanghai Super Channel

   2,772    459    400    560    621    732

In addition, our PRC revenues are subject to business taxes and value-added tax. For a summary of these taxes, see “Revenues.”

 

Item 6. Directors, Senior Management and Employees

General

Our directors are required to retire their position as a director of our company at each annual general meeting. However, they will be eligible for re-election.

The functions and powers of our board of directors include, among others:

 

   

convening shareholders’ meetings and reporting its work to shareholders at such meetings;

 

   

implementing shareholders’ resolutions;

 

   

determining our business plans and investment proposals;

 

   

formulating our profit distribution plans and loss recovery plans;

 

   

formulating our debt and finance policies and proposals for the increase or decrease in our issued share capital and the issuance of debentures;

 

   

formulating our major acquisition and disposal plans, and plans for merger, division or dissolution;

 

   

formulating proposals for any amendments to our memorandum and articles of association; and

 

   

exercising any other powers conferred by the shareholders’ meetings or under our memorandum and articles of association.

Directors and Executive Officers

The following table sets forth certain information concerning our directors and executive officers. The business address of each of our directors and executive officers is 8th Floor, Tower W3, Oriental Plaza, No. 1 Dong Chang An Avenue, Dong Cheng District, Beijing, PRC 100738.

 

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Name

   Age   

Director or

Officer since

  

Position

Frank John SIXT    55    September 2003    Chairman of the Board of Directors
CHOW WOO Mo Fong, Susan    53    October 2003    Alternate Director to the Chairman of the Board of Directors
TONG Mei Kuen, Tommei    42    April 2003    Vice Chairman of the Board of Directors
WANG Lei Lei    33    September 2003    Executive Director and Chief Executive Officer
Jay Kenneth CHANG    35    September 2005    Executive Director and Chief Financial Officer
Peter Andrew SCHLOSS    46    December 2003    Executive Director and Chief Legal Officer
FENG Jue, Elaine    34    September 2003    Executive Director and Executive Vice President of Department of Sales and Marketing
FAN Tai    35    October 2003    Executive Director and Vice President of Finance
KWONG Che Keung, Gordon    57    October 2003    Independent Non-Executive Director
MA Wei Hua    58    October 2003    Independent Non-Executive Director
LO Ka Shui    60    September 2004    Independent Non-Executive Director
MAK Soek Fun, Angela    42    April 2006    Non-Executive Director
LIU Bing Hai    37    December 2003    Vice President of Wireless Operations
YU Pessy Patricia Dawn    34    March 2006    Company Secretary
HE Jing, Sarah    39    August 2004    Director of Sales Department

Executive Directors

WANG Lei Lei, aged 33, has been an executive director and the chief executive officer of our company in charge of the overall management of our company since September 15, 2003. Mr. Wang was appointed as a non-executive director of TOM Group in December 2002, a director of Beijing Super Channel Network Limited in December 2002, a general manager of Beijing Super Channel Network Limited in November 2000, a director of Shanghai Super Channel Network Limited in March 2003, a director of Shenzhen Freenet Information Technology Company Limited in April 2001, an executive director of Beijing Lei Ting Wan Jun Network Technology Limited in November 2000, and the chairman of the board of directors and president of Beijing Lei Ting Wan Jun Network Technology Limited in August 2002. Mr. Wang joined TOM Group in August 1999 and was made head of TOM Group’s online operations in October 2001. Mr. Wang graduated in 1996 from the Electronic Engineering Department of Tsinghua University with a B.S. in electronic technology and information.

Jay Kenneth CHANG, aged 35, has been an executive director of our company since September 28, 2005 and chief financial officer of our company since September 1, 2005. Mr. Chang was previously the deputy chief financial officer of our company since April 13, 2005. Mr. Chang worked in CSFB’s research department in Hong Kong for more than five years. While at CSFB, Mr. Chang was a director of the firm’s Asian equity research department covering the China Internet, telecommunications and technology sectors. Prior to joining CSFB, Mr. Chang was with AIG Direct Investments (Asia), an Asian focused private equity firm based in Hong Kong, between 1997 and 1999. From 1995 to 1997, he was a consultant at Accenture responsible for technology and strategy implementation. From 1994 to 1995 he was an avionics engineer with Boeing’s Defense and Space Group. Mr. Chang holds a degree in electrical engineering from the University of Washington – Seattle, Washington.

Peter Andrew SCHLOSS, aged 46, has been an executive director of our company since December 17, 2003 and the chief legal officer of our company since September 1, 2005. He was previously chief financial officer of our company since December 17, 2003. Mr. Schloss was general counsel at IBM China/Hong Kong Corporation from 1989 to 1991. From 1991 to 1996, he was general counsel of Satellite Television Asian Region Limited, or STAR TV, and was a director of that company from 1993 to 1996 as well as director of Asia Satellite Telecommunications Company Limited from November 1991 to June 1993. He was also managing director of ING Barings and head of its Asia Media, Internet and Technology Group from 1999 to 2001 and managing director of Mediavest Limited before joining our company in December 2003. Mr. Schloss holds a B.A. in political science and a J.D. from Tulane University.

FENG Jue, Elaine, aged 34, has been an executive director and executive vice president of the department of sales and marketing of our company since September 15, 2003. Since December 2002, Ms. Feng has served as vice president of the department

 

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of sales and marketing at Beijing Super Channel Network Limited. Ms. Feng was appointed as a director of Beijing GreaTom United Technology Company Limited in October 2003 and deputy general manager of Shanghai Super Channel Network Limited and Shenzhen Freenet Information Technology Company Limited in November 2003. Prior to joining our company, Ms. Feng served as vice president of the department of corporate business development at Sohu.com and as project manager at Richina Media Group Limited.

FAN Tai, aged 35, has been an executive director and vice president of finance of our company since October 14, 2003. Since August 2002, Mr. Fan has served as vice president of the department of finance at Beijing Super Channel Network Limited. Prior to joining our company, Mr. Fan served as financial controller at Xin De Telecom and as an auditor at KPMG. Mr. Fan graduated in 2003 from the State University of New Jersey, Rutgers with an MBA and in 1994 from Beijing College of Economics with a B.A. in accounting.

Non-Executive Directors

Frank John SIXT, aged 55, has been a non-executive director and the chairman of our company since September 15, 2003. He is the group finance director of Hutchison Whampoa Limited. He is also an executive director of Cheung Kong Infrastructure Holdings Limited and Hongkong Electric Holdings Limited, a non-executive director of Hutchison Telecommunications International Limited, and a director of Hutchison Telecommunications (Australia) Limited, Husky Energy Inc. and Partner Communications Company Ltd. He is also the chairman of TOM Group, a non-executive director of Cheung Kong (Holdings) Limited and a director of Li Ka-Shing Unity Trustcorp Limited, Li Ka-Shing Unity Trustee Company Limited and Li Ka-Shing Unity Trustee Corporation Limited. Mr. Sixt holds a master’s degree in arts and a bachelor’s degree in civil law, and is a member of the bar and of the Law Society of the Provinces of Quebec and Ontario, Canada.

CHOW WOO Mo Fong, Susan, aged 53, has been an alternate director to the chairman of our company since October 14, 2003. She is the deputy group managing director of Hutchison Whampoa Limited and a non-executive director of TOM Group. She is also an executive director of Cheung Kong Infrastructure Holdings Limited, Hutchison Harbour Ring Limited and Hongkong Electric Holdings Limited, and a director of Hutchison Telecommunications (Australia) Limited and Partner Communications Company Ltd. Mrs. Chow is a solicitor and holds a bachelor’s degree in business administration.

TONG Mei Kuen, Tommei, aged 42, has been a non-executive director of our company since April 1, 2003 and the vice chairman of our company since January 27, 2006, and is an executive director and the chief executive officer of TOM Group. Previously, she was the chief financial officer of TOM Group. She served as the chief financial officer and chief operating officer of Ping An Insurance (Group) of China, Ltd. and prior to that, she was a partner of Arthur Andersen & Co. Ms. Tong graduated from the University of Hong Kong in 1986 with a bachelor of social sciences degree. She is also a Fellow of the Association of Chartered Certified Accountants and the Hong Kong Institute of Certified Public Accountants.

MAK Soek Fun, Angela, aged 42, has been a non-executive director of our company since April 3, 2006. She is also the head corporate general counsel and an executive director of TOM Group. She was the company secretary of our company until March 15, 2006. Ms. Mak holds a bachelor of commerce degree and a bachelor of laws degree from the University of New South Wales in Australia and has been admitted as a solicitor in New South Wales (Australia), England and Wales and Hong Kong. Prior to joining TOM Group, she was a senior group legal counsel of Hutchison Whampoa Limited.

Independent Non-Executive Directors

KWONG Che Keung, Gordon, aged 57, has been an independent non-executive director of our company since October 14, 2003. Mr. Kwong has also been serving as a member of the remunerations committee and the nominations committee of our company and as the chairman of the audit committee of our company since February 12, 2004. He is also an independent non-executive director of a number of companies listed on the Hong Kong Stock Exchange, namely COSCO International Holdings Limited, Tianjin Development Holdings Limited, Beijing Capital International Airport Company Limited, Frasers Property (China) Limited, NWS Holdings Limited, China Oilfield Services Limited, Concepta Investments Limited, China Chengtong Development Group Limited, Global Digital Creations Holdings Limited, Ping An Insurance (Group) Company of China, Limited, Quam Limited, China Power

 

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International Development Limited, Henderson Land Development Company Limited, Henderson Investment Limited and Agile Property Holdings Limited. From 1984 to 1998, Mr. Kwong was a partner of Pricewaterhouse, and he was a council member of the Hong Kong Stock Exchange from 1992-1997. He has a bachelor of social science degree from the University of Hong Kong and is a fellow of the Institute of Chartered Accountants in England and Wales. Mr. Kwong previously served as a non-executive director of COSCO Pacific Limited until his resignation in January 2006 and as an independent non-executive director of New World Mobile Holdings Limited until January 2007, and was an independent non-executive director of Henderson China Holdings Limited until it was privatized in July 2005.

MA Wei Hua, aged 58, has been an independent non-executive director of our company since October 14, 2003 and a member of the audit committee, remunerations committee and nominations committee of our company since February 12, 2004. He is also the president and chief executive officer of China Merchants Bank. Mr. Ma obtained a Ph.D. in economics from Southwestern Finance and Economics University in 1998.

LO Ka Shui, aged 60, has been an independent non-executive director and a member of the audit committee, the remunerations committee and the nominations committee of our company since September 30, 2004. He is chairman and managing director of Great Eagle Holdings Limited and the non-executive chairman of Eagle Asset Management (CP) Limited (manager of the publicly listed Champion Real Estate Investment Trust). He is also a non-executive director of The Hongkong and Shanghai Banking Corporation Limited, Shanghai Industrial Holdings Limited, Phoenix Satellite Television Holdings Limited, China Mobile (Hong Kong) Limited and some other listed public companies in Hong Kong. He formerly was a director of Hong Kong Exchanges and Clearing Limited. He is a vice president of the Real Estate Developers Association of Hong Kong, a trustee of the Hong Kong Centre for Economic Research and a board member of the Airport Authority. He graduated with bachelor of science degree from McGill University and a M.D. from Cornell University. He was certified in cardiology from University of Michigan Hospital. He has more than 26 years’ experience in property and hotel development and investment both in Hong Kong and overseas.

Executive Officers

LIU Bing Hai, aged 37, has been a vice president of wireless operations of our company since December 2003. Mr. Liu was appointed as a director of Beijing GreaTom United Technology Company Limited in October 2003. Mr. Liu joined TOM Group in September 1999 as project manager. Since November 2002, Mr. Liu has served as assistant general manager at Beijing Super Channel Network Limited. Prior to joining our company, Mr. Liu served as departmental manager of the Electronic Data Interchange Computer Center of Beijing Foreign Economic and Trade Commission. Mr. Liu graduated in 1996 from Beijing University of Technology with an M.S. in computer aided design and in 1993 from North China University with a B.S. in transmission controls.

YU Pessy Patricia Dawn, aged 34, has been the company secretary of our company since March 2006. Ms. Yu joined TOM Group in April 2001 and was appointed as senior legal counsel in 2003. She holds a master of arts degree in jurisprudence from Oxford University and has been admitted as a solicitor in Hong Kong, and England and Wales.

HE Jing, Sarah, aged 39, has been director of the Sales Department of our company since August 2004. Prior to joining our company, Ms. He served as customer service director at DangDang Online Bookstore. From July 1998 to September 2003, Ms. He served as programmer at Star Fire Inc. in Canada. From March 1993 to March 1998, Ms. He served as general manager assistant and marketing/communication specialist at Group Schneider (China). Ms. He graduated in 1990 from the Beijing College of Economics with a B.S. in MIS.

There is no family relationship among any of our directors or executive officers.

In January 2006, Sing Wang resigned from his position as non-executive director and Tong Mei Kuen, Tommei was appointed director and vice chairman of the board of directors. In March 2006, Mak Soek Fun, Angela, was appointed a non-executive director. In August 2006, Wu Yun resigned from our board of directors.

 

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As we are 65.7% owned by TOM Group as of May 31, 2007, we are a “controlled company” within the meaning of Rule 4350(c)(5) of the Nasdaq Listing Rules and therefore are exempt from certain requirements of Nasdaq Marketplace Rule 4350 (c), including the requirements that:

 

   

a majority of our board of directors must be independent directors;

 

   

the compensation of our chief executive officer must be determined or recommended by a majority of the independent directors or a compensation committee comprised solely of independent directors; and

 

   

director nominees must be selected or recommended by a majority of the independent directors or a nomination committee comprised solely of independent directors.

Board Practices

Our board held five regular meetings during 2006. In addition, a meeting between the chairman and non-executive directors and independent non-executive directors without the presence of the executive directors was held in the second quarter of 2006.

To enhance our corporate governance, we have established three board committees: an audit committee, a nominations committee and a remunerations committee, all of which are comprised mainly of independent non-executive directors.

Audit Committee

We have established an audit committee, in accordance with the Nasdaq Listing Rules and Chapter 5 of the GEM Listing Rules, which reviews our internal accounting procedures and considers and reports to our board of directors with respect to other auditing and accounting matters, including the selection of our independent auditors, the scope of annual audits, fees to be paid to our independent auditors and the performance of our independent auditors. The committee has a formal written charter that sets forth its duties and powers. All audit committee members are independent non-executive directors. The audit committee is chaired by Kwong Che Keung, Gordon, and the other members are Ma Wei Hua and Lo Ka Shui. The board of directors has determined that Mr. Kwong is an audit committee financial expert. The audit committee held six meetings during 2006.

Nominations Committee

We have established a nominations committee, which identifies individuals qualified to become members of our board of directors and recommends that the board select our director nominees. The committee has a formal written charter that sets forth its duties and powers. The nominations committee is chaired by Frank John Sixt and the other members are Kwong Che Keung, Gordon, Ma Wei Hua and Lo Ka Shui.

Remunerations Committee

We have established a remunerations committee, which reviews and recommends to our board of directors the salaries, benefits and stock option grants of our directors and executive employees. The committee has a formal written charter that sets forth its duties and powers. The remunerations committee is chaired by Frank John Sixt and the other members are Kwong Che Keung, Gordon, Ma Wei Hua and Lo Ka Shui.

Compensation of Directors and Executive Officers

Our directors and executive officers receive compensation in the form of salaries, annual bonuses and share options. Each of our executive directors, Wang Lei Lei, Jay Kenneth Chang, Peter Andrew Schloss, Feng Jue, Elaine and Fan Tai, has entered into a service agreement with us. The service agreements are continuous in term unless terminated upon three months’ written notice by either party. Each executive director is entitled to an annual bonus payable for each twelve-month period completed by such executive director commencing on January 1 of the calendar year immediately following the date of the service agreement. No bonus was paid to the executive directors for the year ended December 31, 2006. In addition, each of Wang Lei Lei, Peter Andrew Schloss and Jay Kenneth Chang received a monthly housing allowance of US$3,271, US$10,263 and US$5,324, respectively, for the year ended December 31, 2006. Our executive directors are also entitled to reimbursement of all reasonable out-of-pocket expenses and medical benefits.

 

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Each of our non-executive directors, including our independent non-executive directors, has entered into a letter of service with us for a 12-month period, which letter of service is automatically renewed for successive 12-month periods unless terminated by either party in writing prior to the end of its term. Each of the non-executive directors is subject to re-election at each annual general meeting of the shareholders.

None of our service agreements or letters of service with our executive or non-executive directors provides benefits to our executive or non-executive directors upon termination. Each of our executive directors is bound by confidentiality and non-competition provisions in his or her employment agreement with us.

The aggregate remuneration paid and benefits in kind granted to our directors for the years ended December 31, 2004, 2005 and 2006 was approximately US$1,195,000, US$4,175,000 and US$4,199,000, respectively. The amounts paid to our non-executive directors in 2006 were as follows:

 

Frank John SIXT

   US$ 6,000

CHOW Woo Mo Fong, Susan

     —  

TONG Mei Kuen, Tommei

   US$ 6,000

MAK Soek Fun, Angela

   US$ 5,000

MA Wei Hua

   US$ 26,000

KWONG Che Keung, Gordon

   US$ 26,000

LO Ka Shui

   US$ 26,000

The basic annual salaries of our executive directors in 2006 were as follows:

 

WANG Lei Lei

   US$ 142,000

Jay Kenneth CHANG

   US$ 193,000

Peter Andrew SCHLOSS

   US$ 185,000

FENG Jue, Elaine

   US$ 68,000

FAN Tai

   US$ 81,000

The total amount set aside or accrued by the company or its subsidiaries for pension, retirement or similar benefits for directors is US$52,000.

Share Ownership

We adopted the TOM Online Inc. Pre-IPO Share Option Plan, pursuant to which we have granted 280,000,000 options to certain of our employees and directors to acquire our ordinary shares at the initial public offering price under the Hong Kong public offering, excluding brokerage and trading fees, and transaction and investor compensation levies. We may not grant any additional options pursuant to this plan. The options granted under this plan will expire ten years from the date of grant. In 2006, options covering 4,087,527 ordinary shares lapsed and options covering 35,122,423 ordinary shares were exercised. Options covering 181,247,231 ordinary shares remained outstanding as of December 31, 2006.

In addition, we adopted the TOM Online Inc. Share Option Scheme, pursuant to which we may grant our officers, directors, employees and business associates options to purchase our ordinary shares. The purchase price for ordinary shares issued upon exercise of an option may not be less than the higher of the closing price of our ordinary shares on GEM on the grant date, the average closing price of our ordinary shares for the five business days immediately preceding the grant date and the nominal value of our ordinary shares. The total number of ordinary shares that are available for issuance upon the exercise of options granted pursuant to this scheme may not exceed 10% of the total number of our issued ordinary shares. We may, however, seek separate approvals from our shareholders and our parent company’s shareholders for refreshing the 10% limit. In addition, under GEM Listing Rules, the aggregate number of our ordinary shares which may be issued upon exercise of all outstanding options granted and yet to be exercised under the TOM Online Inc. Pre- IPO Share Option Plan and the Share Option Scheme must not exceed 30% of our total ordinary

 

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shares in issue from time to time. This scheme will be valid and effective for a period of ten years and no options may be granted pursuant to this scheme following the expiration of the scheme. In 2006, we did not make any option grants under this scheme. In 2006, no options issued under this scheme lapsed or were exercised.

The following table sets forth information on outstanding options that have been granted and are outstanding pursuant to our TOM Online Inc. Pre-IPO Share Option Plan and our TOM Online Inc. Share Option Scheme as of March 31, 2007.

 

      Ordinary Shares Issuable Under(1)    

Exercise Price

Per Share

(HK dollars)(2)

Name of grantee

  

2007 Option

Grants

   Pre-2007 Grants    
       
       

Executive Directors(3)

       

WANG Lei Lei

   —      139,264,000 (4)   1.50  

Jay Kenneth CHANG

   —      18,000,000 (7)   1.204

Peter Andrew SCHLOSS

   —      10,000,000 (5)   1.50  

FENG Jue, Elaine

   —      3,972,000 (6)   1.50  

FAN Tai

   —      7,346,000 (6)   1.50  

Senior Management

       

LIU Bing Hai

   —      2,668,000 (6)   1.50  

Others

       

Other staff (comprising 258 individuals)

   —      17,798,929 (6)   1.50  
             

Total

   —      199,048,929    
             

(1) The expiration dates for the options granted pursuant to the TOM Online Inc. Pre-IPO Share Option Plan and the TOM Online Inc. Share Option Scheme are February 15, 2014, and May 10, 2015, respectively.
(2) The exercise price of options granted pursuant to our TOM Online Inc. Pre-IPO Share Option Plan is HK$1.50. The exercise price of options granted pursuant to our TOM Online Inc. Share Option Scheme may not be less than the higher of the closing price of our ordinary shares on GEM on the grant date, the average closing price of our ordinary shares for the five business days immediately preceding the grant date and the nominal value of our ordinary shares.
(3) Each of our directors has undertaken to the Hong Kong Stock Exchange not to exercise his or her options to the extent that such exercise would result in the public float being reduced below the minimum percentage prescribed by the GEM Listing Rules. Any of our shares which are held by our directors are not considered to be in public hands under the GEM Listing Rules.
(4) Of the options granted, 10% vest one month after our shares are listed on GEM, or the listing date, but are not exercisable until six months after the listing date, and 15%, 20%, 25% and 30%, respectively, vest one, two, three and four years after February 16, 2004.
(5) Of the options granted, 15%, 25%, 30% and 30%, respectively, vest one, two, three and four years after February 16, 2004.
(6) Of the options granted, 10% vest one month after the listing date, but are not exercisable until six months after February 16, 2004, and the remaining options vest ratably over three years on an annual basis commencing on the first anniversary of February 16, 2004.
(7) Of the options granted, 15%, 25%, 30% and 30%, respectively, vest one, two, three and four years after May 11, 2005.

 

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The following table sets forth the number of ordinary shares beneficially held by our directors and executive officers as of March 31, 2007:

 

Name of grantee

   Number of
Shares/Options
Beneficially Owned
   Of which, Shares
Underlying Options
Exercisable Within
60 Days
   Approximate %
Of Our Issued
Share Capital(1)
 

Executive Directors

        

WANG Lei Lei

   89,764,000    89,764,000    2.01 %

Jay CHANG

   2,700,000    7,200,000    *  

Peter Andrew SCHLOSS

   7,000,000    7,000,000    *  

FENG Jue, Elaine

   4,758,000    3,972,000    *  

FAN Tai

   7,346,000    7,346,000    *  

Non-Executive Directors

        

MAK Soek Fun, Angela

   2,508    0    *  

LO Ka Shui

   4,700,000    0    *  

Senior Management

        

LIU Bing Hai

   2,668,000    2,668,000    *  
                

Total

   118,938,508    117,950,000    2.67 %

* Less than one percent.
(1) Adjusted to reflect the issuance of ordinary shares upon full exercise of all outstanding options granted under our pre-initial public offering share option plan and our post-IPO share option scheme.

Employees

See “Item 4 — Information on the Company — Business Overview — Employees.”

 

Item 7. Major Shareholders and Related Party Transactions

Major Shareholders

The table below sets forth certain information with respect to the beneficial owners of 5% or more of our ordinary shares as of the dates indicated:

 

      Ordinary Shares Beneficially
Owned as of March 5, 2004
(immediately prior to our
initial public offering)
    Ordinary Shares Beneficial
Owned as of May 31, 2007
 
      Number    Percent     Number    Percent  

Name of Beneficial Owner of more than 5%

          

TOM Group Limited

   2,800,000,000    96.7 %   2,800,000,000    65.7 %

Cheung Kong (Holdings) Limited(1)

   1,031,717,020    35.6 %   1,037,263,669    24.4 %

Hutchison Whampoa Limited(1)

   687,811,587    23.7 %   694,686,872    16.4 %

Chau Hoi Shuen(2)

   784,011,587    27.1 %   1,093,301,050    25.7 %

(1) Cheung Kong (Holdings) Limited beneficially owns 36.7% of TOM Group through a series of controlled companies, including Hutchison Whampoa Limited, which beneficially owns 24.5% of TOM Group through a series of controlled companies. Li Ka-Shing Unity Holdings Limited, of which each of Mr. Li Ka-shing, Mr. Li Tzar Kuoi, Victor and Mr. Li Tzar Kai, Richard is interested in one-third of the entire issued share capital, owns the entire issued share capital of Li Ka-Shing Unity Trustee Company Limited. Li Ka-Shing Unity Trustee Company Limited as trustee of The Li Ka-Shing Unity Trust, together with certain companies which Li Ka-Shing Unity Trustee Company Limited as trustee of The Li Ka-Shing Unity Trust is entitled to exercise or control the exercise of more than one-third of the voting power at their general meetings, hold more than one-third of the issued share capital of Cheung Kong (Holdings) Limited. In addition, Li Ka-Shing Unity Holdings Limited also owns the entire issued share capital of Li Ka-Shing Unity Trustee Corporation Limited, or TDT1, as trustee of The Li Ka- Shing Unity Discretionary Trust and Li Ka-Shing Unity Trustcorp Limited, or TDT2, as trustee of another discretionary trust. Each of TDT1 and TDT2 hold units in The Li Ka-Shing Unity Trust.
(2) Ms. Chau Hoi Shuen beneficially holds approximately 9.998% of our outstanding ordinary shares through several controlled companies including Cranwood Company Limited and Devine Gem Management Limited. In addition, she beneficially holds approximately 23.8% of TOM Group through several controlled companies.

 

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TOM Group, our controlling shareholder, has its principal place of business at 48/F, The Center, 99 Queen’s Road Central, Central, Hong Kong. TOM Group was incorporated in the Cayman Islands under the Companies Law of the Cayman Islands as an exempted company with limited liability in October 1999, and was listed on GEM under the stock code “8001.” On August 4, 2004, shares of TOM Group were withdrawn from GEM and became listed on the main board of the Hong Kong Stock Exchange under the code “2383.” The three largest shareholders of our parent company are Hutchison Whampoa Limited, Schumann International Limited and Cheung Kong (Holdings) Limited, which indirectly hold approximately 24.5%, 14.9% and12.2%, ownership interest in our parent company, respectively, as of May 31, 2007.

None of our major shareholders has voting rights that differ from the voting rights of other shareholders.

As of December 31, 2006, there were 4,259,654,528 ordinary shares issued and outstanding. Citibank N.A., the depositary under our ADS deposit agreement, has advised us that as of December 31, 2006, there were 6 registered holders of American depositary receipts evidencing 9,242,598 ADSs, representing 739,407,840 ordinary shares. We have no further information as to ordinary shares held or beneficially owned by U.S. persons.

Our directors and those of our parent, TOM Group, jointly announced on March 9, 2007 that TOM Group requested our board of directors to put forward a proposal for our privatization by way of a Scheme. See “— Related Party Transactions — Ongoing Related Party Transactions between Us or Our Subsidiaries and Our Parent Company or its Subsidiaries — Privatization.”

Related Party Transactions

Non-Competition Undertaking

In connection with our initial public offering, we entered into a deed of non-competition with our parent company. Under this deed, among other things and subject to certain conditions:

 

   

our parent company undertakes to us that, without our prior written consent, it will not, and shall ensure that its subsidiaries will not, directly or indirectly, within the PRC engage in, invest in, carry on, participate in or have any interest in, any online activities that compete with our online businesses in the PRC (including wireless Internet services, online advertising and commercial enterprises solutions);

 

   

if our parent company or any of its subsidiaries identifies or is offered by a third party any online business opportunity (i) within the PRC, then our parent company or its subsidiary will give us a right of first refusal to such online business opportunity, and should we decline and our parent company or one of its subsidiaries chooses to engage in such business and subsequently dispose of its interest in the business created from such business opportunity, it shall give us a right of first refusal to acquire its interest, which will expire on the fifth anniversary date of the deed of non-competition or (ii) outside the PRC, then our parent company or its subsidiary will give us a right of first refusal to such online business opportunity; and

 

   

as part of its principal businesses, which comprise outdoor media, print media, sports and entertainment, and any other new business that our parent company may have from time to time, our parent company and its subsidiaries may continue to engage in certain online services ancillary to their businesses so long as:

 

   

the revenue earned for such ancillary online services of any of our parent company’s business divisions (excluding the online services provided through its Hong Kong portal) will not exceed 10% of the total revenue earned from that division in the same financial year;

 

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the revenue earned for such ancillary online services of all of our parent company’s businesses (including online services provided through its Hong Kong portal) will not exceed 5% of the total revenue of our parent company (but excluding the revenue attributed to us which is consolidated into the total revenue of our parent company) in the same financial year; and

 

   

the revenue earned for such ancillary online services of all of our parent company’s businesses (including online services provided through its Hong Kong portal) will not exceed 15% of our total revenue in the same financial year.

In addition, our parent company granted us a call option exercisable within 3 years from the date of listing our ordinary shares on GEM, which allows us to acquire our parent company’s Hong Kong portal at a market price that will be determined by an independent valuer.

The deed of non-competition does not place any restriction on the ten excluded business entities of our parent company in either non-portal businesses within the PRC, online businesses outside the PRC or passive investments of our parent company (other than our parent company’s Hong Kong portal), nor does it restrict our parent company from undertaking any television or broadcasting business, any ISP business, audio-visual business or any investments in either listed companies which engage in online activities (provided our parent company’s interest does not exceed 5%) or any investment funds (provided that any such investment fund does not take a majority interest in any online business and that such online business shall not be operated by our parent company).

The deed of non-competition took effect on the date of listing of our ordinary shares on GEM and our ADSs on Nasdaq and will terminate on the later of (i) when our parent company ceases to hold, directly or indirectly, 30% or more of our issued share capital, (ii) when our ordinary shares or ADSs are no longer listed on either GEM or Nasdaq, or (iii) the second anniversary date of the deed of non-competition, which has already passed.

Agreements Relating to Our Reorganization and Our Initial Public Offering

Restructuring Agreement. We, our parent company and Rich Wealth Holdings Limited, a wholly owned subsidiary of our parent company, entered into a restructuring agreement on September 20, 2003, pursuant to which our parent company and Rich Wealth Holdings Limited transferred to us their 100% interest in the issued share capital of Lahiji, Laurstinus and Advanced Internet Services, respectively.

Ongoing Related Party Transactions Between Us or Our Subsidiaries and Our Parent Company or Its Subsidiaries

In connection with our reorganization, we have entered into various agreements in respect of ongoing provision of media and other services with our parent company or its subsidiaries as described below.

Administrative Services Agreement. TOM Group International Limited, a wholly owned subsidiary of our parent company, entered into an administrative services agreement with us on September 26, 2006. Pursuant to this administrative services agreement, TOM Group International Limited will provide us with certain administrative services, including company secretarial services, legal services and supporting services. The term of the agreement is for two years. We expect that the fees payable annually by us under this agreement will not exceed HK$3 million (US$0.4 million). The fees incurred by us under this agreement will be calculated on a cost reimbursement basis by reference to the actual cost incurred in providing such services.

Lease Agreements. Several of our subsidiaries and PRC operating companies have entered into lease agreements with Beijing Oriental Plaza Company Limited, or Beijing Oriental, an associate of Cheung Kong (Holdings) Limited, pursuant to which our subsidiaries or PRC operating companies lease a total of approximately 4,742 square meters office space in Tower W3, Oriental

 

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Plaza, No. 1 East Chang An Avenue, Dongcheng District, Beijing. Beijing Super Channel entered into a lease agreement with Beijing Oriental on November 20, 2006 to lease Room 1-12 on the 8th Floor. TOM.COM (China) entered into a lease agreement with Beijing Oriental on November 20, 2006 to lease Room 3, 4, 5, 6B and 7B on the 9th Floor. Wu Ji Network entered into a lease agreement with Beijing Oriental on November 20, 2006 to lease Rooms 7-8 on the 5th Floor. These agreements expire on December 14, 2009.

Privatization. Our directors and those of our parent, TOM Group, jointly announced on March 9, 2007 that TOM Group requested our board of directors to put forward a proposal for our privatization by way of a Scheme, under Section 86 of the Companies Law of the Cayman Islands. Details of the Scheme were set forth in a Scheme Document that was dispatched on or about April 30, 2007 to holders of our ordinary shares, our ADSs and options in our ordinary shares. This transaction constitutes a “going private” transaction for purposes of Section 13e-3 of the Exchange Act.

An Independent Board Committee, comprising Mr. Kwong Che Keung, Gordon, Mr. Ma Wei Hua and Dr. Lo Ka Shui, was appointed to make recommendations to the shareholders, ADS holders and option holders in respect of TOM Group’s proposals. An independent financial adviser, ING Bank N.V., was engaged to advise the Independent Board Committee. The recommendations to our security holders by our Independent Board Committee and the reasons for those recommendations are set forth in the Scheme Document, which also contains a letter from the independent financial adviser setting forth its view and recommendations in respect of the proposals. The Scheme Document was filed under cover of a Schedule 13E-3, which can be obtained without charge at www.sec.gov. Our security holders should read the Schedule 13E-3, as amended, as they contain important information about the Scheme, the Independent Board Committee’s recommendations, the advice of the independent financial adviser and other related matters.

Under the Scheme, in exchange for HK$1.52 in cash for each share, all of our ordinary shares, including those underlying our ADSs, other than those held by TOM Group, Cranwood Company Limited, Handel International Limited, Schumann International Limited and Devine Gem Management Limited will be cancelled, resulting in a reduction of our issued share capital. We will issue new shares in the same number as that of the cancelled shares to TOM Group or a subsidiary of TOM Group as TOM Group may direct. TOM Group has also proposed to acquire for cancellation, all of the outstanding share options granted under our pre-initial public offering share option plan and our share option scheme, both adopted on February 12, 2004. If approved, upon completion of the Scheme, we will be approximately 90.002% owned by TOM Group, approximately 4.999% owned by Cranwood Company Limited and its subsidiaries, Handel International Limited and Schumann International Limited, and approximately 4.999% held by Devine Gem Management Limited, assuming no outstanding share options are exercised. Cranwood, Handel, Schumann and Devine Gem are controlled by Ms. Chau Hoi Shuen.

The meetings to vote on the Scheme and TOM Group’s proposals in connection with the Scheme were scheduled for June 8, 2007. However, TOM Group and our Company proposed that such meetings be adjourned to a later date so that our shareholders, including holders of ADSs, have additional time to consider the Scheme. The meetings have been adjourned to August 10, 2007. TOM Group and we propose to issue a supplement in early to mid-July to the Scheme Document, which will include, among other things, a revised expected timetable and notices for the meetings to approve the Scheme.

If the Scheme is approved by our shareholders other than TOM Group, Cranwood Company Limited, Handel International Limited, Schumann International Limited and Devine Gem Management Limited, who are deemed related parties under the rules of the Hong Kong Stock Exchange, and becomes effective, we understand that TOM Group will cause us to apply to the Hong Kong Stock Exchange to withdraw the listing of our ordinary shares on GEM, and to Nasdaq to withdraw the listing of our ADSs, and will also cause us to file a Form 15F with the SEC to request that our reporting obligations under the Exchange Act be terminated or suspended because the effectiveness of the Scheme will cause the number of holders of our ordinary shares in the United States to fall below 300 or otherwise cause us to become eligible for de-registration.

 

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Other Related Party Agreements

Loan Agreements. Our subsidiaries have extended loans totaling US$7,968,000 and US$19,093,000 and US$19,867,000 as of December 31, 2004, 2005 and 2006, respectively, to the registered shareholders of our variable interest entities for the purpose of financing such shareholders’ investments in the respective entities.

Gainfirst has outstanding loans of RMB5,000,000 to each of Chang Chen, who is a 50% shareholder of Beijing Infomax, and Zhang Ying Nan, who is a 50% shareholder of Beijing Infomax. These loans are to be used exclusively toward the working capital of Beijing Infomax. Each of Chang Chen and Zhang Ying Nan entered into his loan agreement with Gainfirst on July 24, 2006; the term of the loan is ten years. Under their respective loan agreements, Chang Chen and Zhang Ying Nan as loan recipients have each agreed that (a) the loan will become due and payable if, inter alia, (i) the loan recipient resigns from or is removed from office by Beijing Infomax or its affiliated entities, (ii) the loan recipient commits a criminal offense, (iii) any third party raises against the loan recipient a claim of over RMB500,000 (US$0.06 million), (iv) foreign investment is permitted in the telecommunications value-added services and the relevant government authorities start approving such foreign investment or (v) the borrower dies or becomes incapacitated; (b) the loan shall be repaid only in the form of a transfer of all of the loan recipient’s equity interest in Beijing Infomax to Gainfirst or its designees; and (c) upon the transfer of the loan recipient’s equity interest in Beijing Infomax, any proceeds from the transfer shall be used to set off such loan recipient’s loan repayment obligation to Gainfirst or its designees.

Tom Eachnet Holdings (BVI) Inc. has outstanding loans of RMB500,000 to Wei Hong Jun, who is a 50% shareholder of Beijing Yi Lian Tong He. Wei Hong Jun entered into loan agreements with Tom Eachnet Holdings (BVI) Inc. on February 1, 2007 and May 14, 2007, pursuant to which Tom Eachnet Holdings (BVI) Inc. provided long-term loans to Wei Hong Jun in the amount of RMB50,000 (US$6,406) and RMB450,000 (US$57,692), respectively, to be invested exclusively in Beijing Yi Lian Tong He. Wei Hong Jun agreed that (a) the loans will become due and payable if, inter alia, (i) Wei Hong Jun resigns from or is removed from office by Tom Eachnet Holdings (BVI) Inc. or its affiliated entities, (ii) Wei Hong Jun commits a criminal offense, (iii) any third party raises against Wei Hong Jun a claim of over RMB500,000 (US$0.06 million), (iv) foreign investment is permitted in the telecommunications value-added services and the relevant government authorities start approving such foreign investment or (v) Wei Hong Jun dies or becomes incapacitated; (b) the loans shall be repaid only in the form of a transfer of all of Wei Hong Jun’s equity interest in Beijing Yi Lian Tong He to Tom Eachnet Holdings (BVI) Inc. or its designees; and (c) upon the transfer of Wei Hong Jun’s equity interest in Beijing Yi Lian Tong He, any proceeds from the transfer shall be used to set off his loan repayment obligation to Tom Eachnet Holdings (BVI) Inc. or its designees. The term of the loan is ten years.

Tom Eachnet Holdings (BVI) Inc. has outstanding loans of RMB500,000 to Ou Yang Zheng Yu, who is a 50% shareholder of Beijing Yi Lian Tong He. Ou Yang Zheng Yu entered into loan agreements with Tom Eachnet Holdings (BVI) Inc. on April 12, 2007 and May 14, 2007, pursuant to which Tom Eachnet Holdings (BVI) Inc. provided long-term loans to Ou Yang Zheng Yu in the amount of RMB50,000 (US$6,406) and RMB450,000 (US$57,692), respectively, to be invested exclusively in Beijing Yi Lian Tong He. Ou Yang Zheng Yu agreed that (a) the loans will become due and payable if, inter alia, (i) Ou Yang Zheng Yu resigns from or is removed from office by Tom Eachnet Holdings (BVI) Inc. or its affiliated entities, (ii) Ou Yang Zheng Yu commits a criminal offense, (iii) any third party raises against Ou Yang Zheng Yu a claim of over RMB500,000 (US$0.06 million), (iv) foreign investment is permitted in the telecommunications value-added services and the relevant government authorities start approving such foreign investment or (v) Ou Yang Zheng Yu dies or becomes incapacitated, (b) the loan shall be repaid only in the form of a transfer of all of Ou Yang Zheng Yu’s equity interest in Beijing Yi Lian Tong He to Tom Eachnet Holdings (BVI) Inc. or its designees; and (c) upon the transfer of Ou Yang Zheng Yu’s equity interest in Beijing Yi Lian Tong He, any proceeds from the transfer shall be used to set off his loan repayment obligation to Tom Eachnet Holdings (BVI) Inc. or its designees. The term of the loan is ten years.

Puccini has outstanding loans of RMB2,000,000 and RMB8,000,000, respectively, to Fan Tai, who is a 20% shareholder of Wu Ji Network, and Ou Yang Zheng Yu, who is an 80% shareholder of Wu Ji Network. These loans are to be used exclusively toward the working capital of Wu Ji Network. Fan Tai assumed his loan on December 13, 2004, from a prior Wu Ji Network shareholder, Wang Xiu Ling; the loan expires in 2014. Ou Yang Zheng Yu entered into his loan agreement with Puccini on September 28, 2005; the term of the loan is ten years. Under their respective loan agreements, Fan Tai and Ou Yang Zheng Yu as loan recipients have each agreed that: (a) the loan will become due and payable if, inter alia, (i) the loan recipient resigns from or is removed from office by Puccini

 

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or its affiliated entities, (ii) the loan recipient commits a criminal offense, (iii) any third party raises against the loan recipient a claim of over RMB500,000 (US$0.06 million), (iv) foreign investment is permitted in the telecommunications value-added services and the relevant government authorities start approving such foreign investment or (v) the borrower dies or becomes incapacitated; (b) the loan shall be repaid only in the form of a transfer of all of the loan recipient’s equity interest in Wu Ji Network to Puccini or its designees; and (c) upon the transfer of the loan recipient’s equity interest in Wu Ji Network, any proceeds from the transfer shall be used to set off such loan recipient’s loan repayment obligation to Puccini or its designees.

Lahiji has an outstanding loan of RMB100,000,000 to Wang Xiu Ling, who is an 80% shareholder of Beijing Lei Ting. Wang Xiu Ling entered into a loan agreement with Lahiji on January 16, 2006, pursuant to which Lahiji provided Wang Xiu Ling with a loan of RMB100,000,000 to be used to develop the business of Beijing Lei Ting. Also on January 16, 2006, Wang Xiu Ling entered into a loan agreement with Wang Lei Lei, who is a 20% shareholder of Beijing Lei Ting, pursuant to which Wang Xiu Ling granted Wang Lei Lei a loan in the amount of RMB20,000,000 to be used for the business development of Beijing Lei Ting.

Wang Xiu Ling entered into a termination agreement with Lahiji on January 16, 2006 with respect to a previous loan agreement dated August 8, 2002 and supplemental loan agreements dated September 26, 2003 and January 19, 2005, pursuant to which Lahiji provided loans to Wang Xiu Ling to be used for general working capital of Beijing Lei Ting. Wang Lei Lei entered into a termination agreement with Lahiji on January 16, 2006 with respect to a previous loan agreement dated August 8, 2002 and supplemental loan agreements dated September 26, 2003 and January 19, 2005, pursuant to which Lahiji provided loans to Wang Lei Lei to be used for general working capital of Beijing Lei Ting. Wang Xiu Ling entered into a termination agreement with Wang Lei Lei on January 16, 2006 with respect to a loan agreement dated January 19, 2005 pursuant to which Wang Xiu Ling provided a loan to Wang Lei Lei.

Advanced Internet Services has outstanding loans of RMB6,900,000 (US$884,151) and RMB16,100,000 (US$2,063,018), respectively, to Sheng Yong, who is a 30% shareholder of Shenzhen Freenet, and Du Ying Shuang, who is a 70% shareholder of Shenzhen Freenet. These loans are to be invested exclusively in Shenzhen Freenet. Sheng Yong entered into his loan agreement with Advanced Internet Services on September 26, 2003 and Du Ying Shuang entered into her loan agreement on September 23, 2004. The terms of the loans are ten years. Under their respective loan agreements, Sheng Yong and Du Ying Shuang have each agreed that: (a) the loan will become due and payable if, inter alia, (i) the loan recipient resigns from or is removed from office by Advanced Internet Services or its affiliated entities, (ii) the loan recipient commits a criminal offense, (iii) any third party raises against the loan recipient a claim of over RMB500,000 (US$0.06 million), (iv) foreign investment is permitted in the telecommunications value-added services and the relevant government authorities start approving such foreign investment or (v) the loan recipient dies or becomes incapacitated; (b) the loan shall be repaid only in the form of a transfer of all of his or her equity interest in Shenzhen Freenet to Advanced Internet Services or its designees; and (c) upon the transfer of the loan recipient’s equity interest in Shenzhen Freenet, any proceeds from the transfer shall be used to set off such loan recipient’s loan repayment obligation to Advanced Internet Services or its designees.

Treasure Base has outstanding loans totaling RMB10,000,000 (US$1,281,378) to Sheng Yong, who is a 49% shareholder in LingXun, and Du Ying Shuang, who is a 51% shareholder in LingXun. These loans are to be used exclusively toward the working capital of LingXun. Each of Sheng Yong and Du Ying Shuang entered into his or her loan agreement on August 11, 2004 and the terms of the loans are ten years. Under the respective loan agreements, Sheng Yong and Du Ying Shuang have each agreed that: (a) the loan will become due and payable if (i) the loan recipient dies or becomes a person with no or limited capacity of civil conduct, (ii) the loan recipient commits a crime or is involved in a crime, (iii) any third party raises a claim against the loan recipient in an amount exceeding RMB500,000 or (iv) foreign investment is permitted in telecommunications value-added services and the relevant government authorities start approving such foreign investment; (b) the loans shall be repaid only in the form of a transfer of all of the loan recipient’s equity interest in LingXun to Treasure Base or its designees; and (c) upon the transfer of the loan recipient’s equity interest in LingXun, any proceeds from the transfer shall be used to set off such loan recipient’s loan repayment obligation to Treasure Base or its designees.

Whole Win has outstanding loans totaling RMB10,000,000 (US$1,281,378) to Zhang Ming Jin, who is a 49% shareholder in Startone, and Liu Bing Hai, who is a 51% shareholder in Startone. These loans are to be used exclusively toward the working capital

 

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of Startone. Zhang Min Jin entered into her loan agreement with Whole Win on October 25, 2005, and Liu Bing Hai entered into his loan agreement on November 19, 2004. The terms of the loans are ten years. Under his loan agreement, Liu Bing Hai agreed that: (a) the loan will become due and payable if (i) the loan recipient dies or becomes a person with no or limited capacity of civil conduct, (ii) the loan recipient commits a crime or is involved in a crime, (iii) any third party raises a claim against the loan recipient in an amount exceeding RMB500,000 or (iv) foreign investment is permitted in telecommunications value-added services and the relevant government authorities start approving such foreign investment; (b) the loans shall be repaid only in the form of a transfer of all of the loan recipient’s equity interest in Startone to Whole Win or its designees; and (c) upon the transfer of the loan recipient’s equity interest in Startone, any proceeds from the transfer shall be used to set off the loan recipient’s loan repayment obligation to Whole Win or its designees. Under her loan agreement, Zhang Ming Jin agreed that: (a) the loan will become due and payable if, inter alia, (i) the loan recipient resigns from or is removed from office by Whole Win or its affiliated entities, (ii) the loan recipient commits a criminal offense, (iii) any third party raises against the loan recipient a claim of over RMB500,000 (US$0.06 million), (iv) foreign investment is permitted in the telecommunications value-added services and the relevant government authorities start approving such foreign investment or (v) the loan recipient dies or becomes incapacitated; (b) the loan shall be repaid only in the form of a transfer of all of the loan recipient’s equity interest in Startone to Whole Win or its designees; and (c) upon the transfer of the loan recipient’s equity interest in Startone, any proceeds from the transfer shall be used to set off the loan recipient’s loan repayment obligation to Whole Win or its designees.

Share Option Agreements. Each of the shareholders of Beijing Lei Ting has entered into an exclusive share option agreement with Beijing Lei Ting and Lahiji, pursuant to which each shareholder grants Lahiji an exclusive option to acquire all of his or her interest in the registered capital of Beijing Lei Ting when permitted under PRC law. The term of each of these agreements is 10 years from the date of execution. Wang Xiu Ling, an 80% shareholder, and Wang Lei Lei, a 20% shareholder, entered into their respective exclusive share option agreements on January 16, 2006.

Each of the shareholders of Shenzhen Freenet has entered into an exclusive share option agreement with Shenzhen Freenet and Advanced Internet Services, pursuant to which each shareholder grants Advanced Internet Services an exclusive option to acquire all of his or her interest in the registered capital of Shenzhen Freenet when permitted under PRC law. The term of each of these agreements is 10 years from the date of execution. Sheng Yong, a 30% shareholder, entered in an exclusive share option agreement on September 26, 2003, and Du Ying Shuang, a 70% shareholder, entered into an exclusive share option agreement on September 23, 2004.

Each of the shareholders of Wu Ji Network has entered into an exclusive share option agreement with Wu Ji Network and Puccini, pursuant to which each shareholder grants Puccini an exclusive option to acquire all of his interest in the registered capital of Wu Ji Network when permitted under PRC law. Fan Tai, a 20% shareholder, entered into an exclusive share option agreement on December 13, 2004. Ou Yang Zheng Yu, an 80% shareholder, entered into an exclusive share option agreement on September 28, 2005, and Wang Lei Lei, who had transferred his 80% stake to Ou Yang Zheng Yu, terminated his share option agreement.

Each of the shareholders of LingXun has entered into an exclusive share option agreement with Treasure Base, pursuant to which each shareholder grants Treasure Base an exclusive option to acquire all of his or her interest in the registered capital of LingXun when permitted under PRC law. The term of each of these agreements is 10 years from the date of execution. Sheng Yong, a 49% shareholder, and Du Ying Shuang, a 51% shareholder, entered into their respective exclusive share option agreements with LingXun on August 11, 2004.

Each of the shareholders of Startone has entered into an exclusive share option agreement with Whole Win, pursuant to which each shareholder grants Whole Win an exclusive option to acquire all of his or her interest in the registered capital of Startone when permitted under PRC law. The term of each of these agreements is 10 years from the date of execution. Liu Bing Hai, a 51% shareholder, entered into an exclusive share option agreement with Whole Win on November 19, 2004. Zhang Min Jin, a 49% shareholder, entered into an exclusive share option agreement on October 25, 2005, and Pu Dong Wan, who had transferred his 49% stake to Zhang Min Jin, terminated his share option agreement.

Each of the shareholders of Beijing Infomax entered into an exclusive option agreement with Gainfirst Asia, pursuant to which each shareholder grants Gainfirst Asia an exclusive option to acquire all of his or her interest in the registered capital of Beijing

 

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Infomax when permitted under PRC law. The term of each of these agreements is 10 years from the date of execution. Chang Cheng and Zhang Ying Nan, both of whom are 50% shareholders, entered into their respective exclusive share option agreements with Gainfirst Asia on July 24, 2006.

Each of the shareholders of Beijing Yi Lian Tong He entered into an exclusive option agreement with Tom Eachnet Holdings (BVI) Inc., pursuant to which each shareholder grants Tom Eachnet Holdings (BVI) Inc. an exclusive option to acquire all of his interest in the registered capital of Beijing Yi Lian Tong He when permitted under PRC law. The term of the agreement is 10 years from the date of execution. Ou Yang Zheng Yu and Wei Hong Jun, both of whom are 50% shareholders, entered into their respective exclusive share option agreements with Tom Eachnet Holdings (BVI) Inc. on April 12, 2007.

Exclusive Technical and Consulting Services Agreements. Each of Beijing Lei Ting and Shenzhen Freenet entered into an exclusive technical and consulting services agreement with Beijing Super Channel on September 26, 2003, pursuant to which each of Beijing Lei Ting and Shenzhen Freenet agreed to engage Beijing Super Channel to provide certain technical and consulting services to Beijing Lei Ting and Shenzhen Freenet on an exclusive basis. The service fees will be calculated on the basis of actual page views at the rate of RMB20 (US$2.42) per thousand page views. The service fees are collected on a monthly basis. The term of each of these agreements is 10 years from the date of execution.

On November 30, 2004, Beijing Lei Ting entered into an exclusive technical and consulting services agreement with Beijing Lahiji, pursuant to which Beijing Lei Ting agreed to engage Beijing Lahiji (other than Beijing Super Channel) to provide certain technical and consulting services on an exclusive basis. The service fees will be calculated on the basis of actual page views at the rate of RMB20 (US$2.42) per thousand page views. The service fees are collected on a monthly basis. The term of the agreement is ten years from the date of execution.

Shenzhen Freenet also entered into an exclusive technical and consulting services agreement with GreaTom on September 26, 2003, pursuant to which Shenzhen Freenet agreed to engage GreaTom to provide certain technical and consulting services to Shenzhen Freenet on an exclusive basis. The service fees will be calculated on the basis of actual page views at the rate of RMB20 (US$2.42) per thousand page views. The service fees are collected on a monthly basis. The term of this agreement is 10 years from the date of execution.

Wu Ji Network entered into an exclusive technical and consulting services agreement with Puccini Network on November 19, 2003, pursuant to which Wu Ji Network agreed to engage Puccini Network to provide certain technical and consulting services to Wu Ji Network on an exclusive basis. The fees for such services are calculated by multiplying the actual air-time used by customers of Wu Ji Network with a rate equal to 50% of the air-time rate that Wu Ji Network charges its customers. The term of this agreement is 10 years from the date of execution.

Ceng Dong Yi entered into an exclusive technical and consulting services agreement with LingXun on August 11, 2004, pursuant to which Ceng Dong Yi will provide certain technical and consulting services to LingXun on an exclusive basis. The fees for such services will be an amount equal to 65% of the total number of subscribers of the month multiplied by the net average charge per subscriber for that month (after deduction of business tax). The term of this agreement is 10 years from the date of execution.

Hong Dong Wei Xin (Beijing) Technology Company Limited or Hong Dong Wei Xin, entered into an exclusive technical and consulting services agreement with Startone on November 19, 2004, pursuant to which Hong Dong Wei Xin will provide certain technical and consulting services to Startone on an exclusive basis. The fees for such services will be an amount equal to 65% of the total number of subscribers of the month multiplied by the net average charge per subscriber for that month (after deduction of business tax). The term of this agreement is 10 years from the date of execution.

Dong Kui Lin, entered into an exclusive technical and consulting services agreement with Beijing Infomax on July 24, 2006, pursuant to which Beijing Infomax agreed to engage Dong Kui Lin to provide certain technical and consulting services to Beijing Infomax on an exclusive basis. The fees for such services will be an amount equal to 65% of the total number of subscribers of the month multiplied by the net average charge per subscriber for that month (after deduction of business tax). The term of this agreement is 10 years from the date of execution.

 

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Ebay Eachnet entered into an exclusive technical and consulting services agreement with Beijing Yi Lian Tong He on February 1, 2007, pursuant to which Beijing Yi Lian Tong He agreed to engage eBay Eachnet to provide certain technical and consulting services to Beijing Yi Lian Tong He on an exclusive basis. The service fees will be calculated on the basis of actual page views at the rate of RMB20 (US$2.42) per thousand page views. The service fees are collected on a monthly basis. The term of this agreement is 10 years from the date of execution.

Equity Pledge Agreements. Each of the shareholders of Beijing Lei Ting entered into an equity pledge agreement with Beijing Super Channel on September 26, 2003. Pursuant to these agreements, each of the shareholders of Beijing Lei Ting pledged all of his or her interest in Beijing Lei Ting to Beijing Super Channel as security for the performance by Beijing Lei Ting of its obligations under the exclusive technical and consulting services agreement dated September 26, 2003 between Beijing Lei Ting and Beijing Super Channel. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Beijing Super Channel and Beijing Lei Ting.

Each of the shareholders of Beijing Lei Ting entered into an equity pledge agreement with Lahiji on January 16, 2006. Pursuant to these agreements, each of the shareholders of Beijing Lei Ting pledged all of his or her interest in Beijing Lei Ting to Lahiji as security for the performance by Beijing Lei Ting of its obligations under the exclusive technical and consulting services agreement dated November 30, 2004 between Beijing Lei Ting and Lahiji. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Lahiji and Beijing Lei Ting. Each of Wang Lei Lei, a 20% shareholder, and Wang Xiu Ling, an 80% shareholder, entered into an equity pledge agreement on January 16, 2006.

Each of the shareholders of Shenzhen Freenet has entered into an equity pledge agreement with Beijing Super Channel. Pursuant to these agreements, each of the shareholders of Shenzhen Freenet pledged all of his or her interest in Shenzhen Freenet to Beijing Super Channel as security for the performance by Shenzhen Freenet of its obligations under the exclusive technical and consulting services agreement dated September 26, 2003 between Shenzhen Freenet and Beijing Super Channel. The term of these agreements is from the date of the registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Beijing Super Channel and Shenzhen Freenet. Sheng Yong, a 30% shareholder, entered into an equity pledge agreement on September 26, 2003, and Du Ying Shuang, a 70% shareholder, entered into an equity pledge agreement on September 23, 2004.

Each of the shareholders of Wu Ji Network has entered into an equity pledge agreement with Puccini Network on November 19, 2003. Pursuant to these agreements, each of the shareholders of Wu Ji Network pledged all of his or her interest in Wu Ji Network to Puccini Network as security for the performance by Wu Ji Network of its obligations under the exclusive technical and consulting services agreement dated November 19, 2003 between Wu Ji Network and Puccini Network. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Puccini Network and Wu Ji Network. Fan Tai, a 20% shareholder, entered into an equity pledge agreement on December 13, 2004. Ou Yang Zheng Yu, an 80% shareholder, entered into an equity pledge agreement on September 28, 2005, and Wang Lei Lei, who had transferred his 80% stake to Ou Yang Zheng Yu, terminated his equity pledge agreement.

Each of the shareholders of LingXun entered into an equity pledge agreement with Ceng Dong Yi on August 11, 2004. Pursuant to these agreements, each of the shareholders of LingXun pledged all of his or her interest in LingXun to Ceng Dong Yi as security for the performance by LingXun of its obligations under the exclusive technical and consulting services agreement dated August 11, 2004, between LingXun and Ceng Dong Yi. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between LingXun and Ceng Dong Yi.

Each of the shareholders of Startone has entered into an equity pledge agreement with Heng Dong Wei Xin. Pursuant to these agreements, each of the shareholders of Startone pledged all of his interest in Startone to Heng Dong Wei Xin as security for the performance by Startone of its obligations under the exclusive technical and consulting services agreement dated November 19, 2004,

 

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between Startone and Heng Dong Wei Xin. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Startone and Heng Dong Wei Xin. Liu Bing Hai, a 51% shareholder, entered into an equity pledge agreement on November 19, 2004. Zhang Min Jin, a 49% shareholder, entered into an equity pledge agreement on October 25, 2005, and Pu Dong Wan, who had transferred his 49% equity shareholding to Zhang Min Jin, terminated his equity pledge agreement.

Each of the shareholders of Beijing Infomax has entered into an equity pledge agreement with Dong Kui Lin. Pursuant to these agreements, each of the shareholders of Beijing Infomax pledged all of his or her interest in Beijing Infomax to Dong Kui Lin as security for the performance by Beijing Infomax of its obligations under the exclusive technical and consulting services agreement dated July 24, 2006, between Beijing Infomax and Dong Kui Lin. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Beijing Infomax and Dong Kui Lin. Each of Chang Cheng and Zhang Ying Nan, both of whom are50% shareholders, entered into an equity pledge agreement on July 24, 2006.

Each of the shareholders of Beijing Yi Lian Tong He has entered into an equity pledge agreement with eBay Eachnet. Pursuant to these agreements, each of the shareholders of Beijing Yi Lian Tong He pledged all of his interest in Beijing Yi Lian Tong He to eBay Eachnet as security for the performance by Beijing Yi Lian Tong He of its obligations under the exclusive technical and consulting services agreement dated February 1, 2007, between Beijing Yi Lian Tong He and eBay Eachnet. The term of these agreements is from the date of registration of these agreements with the relevant PRC regulatory authority until the termination or expiration of the exclusive technical and consulting services agreement between Beijing Yi Lian Tong He and eBay Eachnet. Ou Yang Zheng Yu, a 50% shareholder, entered into an equity pledge agreement on April 12, 2007, and Wei Hong Jun, a 50% shareholder, entered into an equity pledge agreement on February 1, 2007.

Business Operation Agreements. Beijing Lei Ting, Wang Lei Lei, Wang Xiu Ling and Beijing Super Channel entered into a business operation agreement on September 26, 2003. Pursuant to this agreement, Beijing Super Channel agreed to guarantee performance by Beijing Lei Ting of its obligations under its transactions with third parties. In return, Beijing Lei Ting agreed to create a security interest in favor of Beijing Super Channel by pledging all of its accounts receivable from its business and its assets. In addition, Beijing Lei Ting, Wang Lei Lei and Wang Xiu Ling agreed that, inter alia (i) without the prior written consent of Beijing Super Channel or its affiliates, Beijing Lei Ting will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assign any third party its rights or obligations under this agreement and (ii) will appoint designees of Beijing Super Channel as directors, general manager and other senior officers of Beijing Lei Ting. The term of this agreement is ten years from the date of execution.

Shenzhen Freenet, Wang Xiu Ling, Sheng Yong and Beijing Super Channel entered into a business operation agreement on September 26, 2003. Pursuant to this agreement, Beijing Super Channel agreed to guarantee performance by Shenzhen Freenet of its obligations under its transactions with third parties. In return, Shenzhen Freenet agreed to create a security interest in favor of Beijing Super Channel by pledging all of its accounts receivables from its business and its assets. In addition, Shenzhen Freenet, Wang Xiu Ling and Sheng Yong agreed that, inter alia (i) without the prior written consent of Beijing Super Channel or its affiliates, Beijing Lei Ting will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assign any third party its rights or obligations under this agreement and (ii) will appoint designees of Beijing Super Channel as directors, general manager and other senior officers of Beijing Lei Ting. The term of this agreement is ten years from the date of execution. On September 23, 2004, the parties terminated their 2003 agreement. On September 23, 2004, Du Ying Shuang, Sheng Yong, Shenzhen Freenet and Beijing Super Channel entered into a business operation agreement the material terms of which were the same as those of the 2003 agreement.

 

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Wu Ji Network, Wang Lei Lei, Wang Xiu Ling and Puccini Network entered into a business operation agreement on November 19, 2003. Pursuant to this agreement, Puccini Network agreed to guarantee the performance by Wu Ji Network of its obligations under its transactions with third parties. In return, Wu Ji Network agreed to create a security interest in favor of Puccini Network by pledging all of its accounts receivables from its business and its assets. In addition, Wu Ji Network, Wang Lei Lei and Wang Xiu Ling agreed that, inter alia (i) without the prior written consent of Puccini Network or its affiliates, Wu Ji Network will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assign any third party its rights or obligations under this agreement and (ii) will appoint designees of Puccini Network as directors, general manager and other senior officers of Wu Ji Network. The term of this agreement is ten years from the date of execution. On December 13, 2004, Wu Ji Network, Wang Lei Lei, Fan Tai and Puccini Network entered into a business operation agreement the material terms of which were the same as those of the 2003 agreement. On September 28, 2005, Wu Ji Network, Wang Lei Lei, Fan Tai and Puccini Network entered into a termination agreement with respect to their 2004 business operation agreement. Upon the transfer of Wang Lei Lei’s 80% share interest in Wu Ji Network to Ou Yang Zheng Yu, Ou Yang Zheng Yu, Fan Tai, Wu Ji Network and Puccini Network entered into a business operation agreement on September 28, 2005, the material terms of which were the same as those of the 2003 agreement.

Ceng Dong Yi, LingXun, Du Ying Shuang and Sheng Yong entered into a business operation agreement on August 11, 2004, pursuant to which Ceng Dong Yi agreed to act as a guarantor for any obligations undertaken by LingXun and in return for which, LingXun will pledge to Ceng Dong Yi its accounts receivable and assets. In addition, LingXun, Dun Ying Shuang and Sheng Yong agreed that, inter alia (i) without the prior written consent of Ceng Dong Yi or its affiliates, LingXun will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation to (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assigning any third party its rights or obligations under this agreement and (ii) will appoint designees of Ceng Dong Yi as directors, general managers and other senior officers of LingXun. The term of this agreement is ten years from the date of execution.

Heng Dong Wei Xin, Startone, Liu Bing Hai and Pu Dong Wan entered into a business operation agreement on November 19, 2004, pursuant to which Heng Dong Wei Xin agreed to act as a guarantor for any obligations undertaken by Startone and in return for which, Startone pledged to Heng Dong Wei Xin its accounts receivable and assets. In addition, Startone, Liu Bing Hai and Pu Dong Wan agreed that, inter alia, (i) without the prior written consent of Heng Dong Wei Xin or its affiliates, Startone will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation to (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assigning any third party its rights or obligations under this agreement and (ii) will appoint designees of Heng Dong Wei Xin as directors, general managers and other senior officers of Startone. The term of this agreement is ten years from the date of execution. On October 25, 2005, Heng Dong Wei Xin, Startone, Liu Bing Hai and Pu Dong Wan entered into a termination agreement with respect to their 2004 business operation agreement. Upon the transfer of Pu Dong Wan’s 49% share interest in Startone to Zhang Ming Jin, Zhang Ming Jin, Liu Bing Hai, Startone and Heng Dong Wei Xin entered into a business operation agreement on October 25, 2005, the material terms of which were the same as those of the 2004 agreement.

Dong Kui Lin, Beijing Infomax, Zhang Ying Nan and Chang Cheng entered into a business operation agreement on July 24, 2006, pursuant to which Dong Kui Lin agreed to act as a guarantor for any obligations undertaken by Beijing Infomax and in return for which, Beijing Infomax pledged to Dong Kui Lin its accounts receivable and assets. In addition, Beijing Infomax, Zhang Ying Nan and Chang Cheng agreed that, inter alia, (i) without the prior written consent of Dong Kui Lin or its affiliates, Beijing Infomax will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation to (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assigning any third party its rights or obligations under this agreement and (ii) will appoint designees of Dong Kui Lin as directors, general managers and other senior officers of Beijing Infomax. The term of this agreement is ten years from the date of execution.

 

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EBay Eachnet Information Service (Shanghai ) Co. Ltd., Beijing Yi Lian Tong He, Ou Yang Zhengyu and Wei Hongjun entered into a business operation agreement on April 12, 2007, pursuant to which eBay Eachnet agreed to act as a guarantor for any obligations undertaken by Beijing Yi Lian Tong He and in return for which, Beijing Yi Lian Tong He pledged to eBay Eachnet its accounts receivable and assets. In addition, Beijing Yi Lian Tong He, Ou Yang Zhengyu and Wei Hongjun agreed that, inter alia, (i) without the prior written consent of eBay Eachnet or its affiliates, Beijing Yi Lian Tong He will not engage in any transactions which may have a material adverse effect on its assets, liabilities, equity or operations, including but without limitation to (a) lending or assuming any obligations from any third party, (b) selling or buying any assets or rights, including but without limitation to any intellectual property, and (c) providing any security over its assets and intellectual property to any third party or assigning any third party its rights or obligations under this agreement and (ii) will appoint designees of eBay Eachnet as directors, general managers and other senior officers of Beijing Yi Lian Tong He. The term of this agreement is ten years from the date of execution.

Powers of Attorney. Wang Xiu Ling executed an irrevocable power of attorney on January 16, 2007 granting Su Ying Qi or any other nominated employee of Lahiji, full power and authority to exercise all of her shareholder’s rights with respect to her interest in Beijing Lei Ting. The term of the agreement is ten years from the date of execution.

Wang Lei Lei executed an irrevocable power of attorney on January 16, 2007 granting Su Ying Qi or any other nominated employee of Lahiji, full power and authority to exercise all of his shareholder’s rights with respect to his interest in Beijing Lei Ting. The term of the agreement is ten years from the date of execution.

Sheng Yong executed an irrevocable power of attorney on September 26, 2003 granting Wang Lei Lei, or any other nominated employee of Beijing Super Channel, full power and authority to exercise all of his shareholder’s rights with respect to his interest in Shenzhen Freenet.

Ou Yang Zheng Yu executed an irrevocable power of attorney on September 28, 2005 granting Fan Tai, or any other nominated employee of Puccini Network, full power and authority to exercise all of his shareholder’s rights with respect to his interest in Wu Ji Network.

Sheng Yong and Du Ying Shuang executed an irrevocable power of attorney on August 11, 2004 granting any two individuals designated by Ceng Dong Yi full power and authority to exercise all of his or her shareholder’s rights with respect to his or her interest in LingXun.

Liu Bing Hai executed an irrevocable power of attorney on November 19, 2004 granting any two individuals designated by Heng Dong Wei Xin full power and authority to exercise all of his shareholders’ rights with respect to his interest in Startone.

Zhang Ming Jin executed an irrevocable power of attorney on October 25, 2005 granting Liu Bing Hai, or any other nominated employee of Heng Dong Wei Xin, full power and authority to exercise all of her shareholders’ rights with respect to her interest in Startone.

Zhang Ying Nan executed an irrevocable power of attorney on July 24, 2006 granting Wang Lei Lei, or any other nominated employee of Dong Kui Lin, full power and authority to exercise all of her shareholders’ rights with respect to her interest in Beijing Infomax.

Chang Cheng executed an irrevocable power of attorney on July 24, 2006 granting Wang Lei Lei, or any other nominated employee of Dong Kui Lin, full power and authority to exercise all of his shareholders’ rights with respect to his interest in Beijing Infomax.

 

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Wei Hong Jun executed an irrevocable power of attorney on February 1, 2007 granting Wang Lei Lei, or any other nominated employee of eBay Eachnet, full power and authority to exercise all of his shareholders’ rights with respect to his interest in Beijing Yi Lian Tong He.

Ou Yang Zheng Yu executed an irrevocable power of attorney on April 12, 2007 granting Wang Lei Lei, or any other nominated employee of eBay Eachnet, full power and authority to exercise all of his shareholders’ rights with respect to his interest in Beijing Yi Lian Tong He.

Intellectual Property Agreements. Beijing Super Channel entered into a trademark license agreement with each of Beijing Lei Ting and Shenzhen Freenet and Wu Ji Network on September 26, 2003 and November 19, 2003, respectively, granting a non- exclusive license to each of them to use certain trademarks for an annual fee of RMB1,000 (US$121) each, without the right to sub- license.

Beijing Super Channel entered into a domain name license agreement with each of Beijing Lei Ting and Shenzhen Freenet and Wu Ji Network on September 26, 2003 and November 19, 2003, respectively, granting a non-exclusive license to each of them to use the tom.com, bj.tom.com, cn.tom.com, music 974.com.cn, 974.com.cn, 163.net and ctn.com.cn domain names for an annual fee of RMB1,000 (US$121) each, without the right to sub-license.

Each of Beijing Lei Ting and Shenzhen Freenet entered into a domain name transfer agreement with Beijing Super Channel, pursuant to which each of Beijing Lei Ting and Shenzhen Freenet transfers to Beijing Super Channel certain domain names for a lump sum.

Puccini Network entered into a domain name transfer agreement with Wu Ji Network on November 19, 2003, pursuant to which Wu Ji Network transferred to Puccini Network the tomkid.com.cn and ltwj.com domain names for a lump sum.

Puccini Network entered into a domain name license agreement with Wu Ji Network on November 19, 2003, granting a non- exclusive license to Wu Ji Network to use the tomkid.com.cn and ltwj.com domain names for an annual fee of RMB1,000 (US$121), without the right to sub-license.

The term of each of the above intellectual property agreements is 10 years and will be automatically extended for another year with consent from the respective grantor.

Interests of Experts and Counsel

Not applicable.

 

Item 8. Financial Information

See “Item 18 — Financial Statements.” Other than as disclosed elsewhere in this annual report, no significant change has occurred since the date of the annual financial statements.

 

Item 9. The Offer and Listing

Market and Share Price Information

Our ADSs are listed and traded on Nasdaq under the symbol “TOMO.” Our ordinary shares are listed and traded on GEM under the stock code “8282.” The Nasdaq and GEM are the principal trading markets for our ADSs and ordinary shares, respectively, which are not listed on any other exchanges in or outside the United States. On May 31, 2007, the closing price of our ordinary shares on GEM was HK$1.47 per share, and on May 31, 2007 the closing price of our ADSs on Nasdaq was US$14.77 per ADS.

At our request, trading in our ordinary shares on the Hong Kong Stock Exchange was suspended with effect from 9:30 a.m. on March 5, 2007 until 9:30 a.m. on March 12, 2007, and trading in our ADSs on the Nasdaq was suspended with effect from 9:30 a.m. on March 5, 2007 until 9:30 a.m. on March 12, 2007, due to the release of an announcement about the proposal for our privatization

 

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by way of the Scheme. At our request, trading in our Company’s ordinary shares on the Hong Kong Stock Exchange was suspended with effect from 9:30 a.m. on June 8, 2007 until 9:30 a.m. on June 11, 2007 due to the release of the announcement on the adjournment of the meetings to approve the Scheme and TOM’s proposals in connection with the Scheme.

The high and low closing prices of our ordinary shares on the Hong Kong Stock Exchange and of our ADSs on Nasdaq since listing are as follows:

 

     Price per Ordinary Share (HK$)    Price per ADS (US$)
     High    Low    High    Low

Annual

           

2004(1)

   1.58    0.98    16.18      9.93

2005

   2.15    1.1      22.24    11.06

2006

   2.75    1.02    28.31    10.37

Quarterly

           

First Quarter, 2005

   1.45    1.12    14.87    11.06

Second Quarter, 2005

   1.27    1.1      13.2      11.2  

Third Quarter, 2005

   1.87    1.23    19.7      12.72

Fourth Quarter, 2005

   2.15    1.6      22.24    17     

First Quarter, 2006

   2.45    1.91    25.44    19.61

Second Quarter, 2006

   2.75    1.72    28.31    17.70

Third Quarter, 2006

   1.87    1.02    19.40    10.37

Fourth Quarter, 2006

   1.72    1.14    17.28    11.51

First Quarter, 2007

   1.63    1.14    16.00    11.6  

Monthly

           

January 2007

   1.63    1.34    16.00    13.63

February 2007

   1.52    1.24    15.25    12.07

March 2007

   1.47    1.14    14.73    11.60

April 2007

   1.46    1.38    15.08    14.18

May 2007

   1.49    1.46    15.17    14.77

June 2007

   1.49    1.33    14.66    13.44

(1) Our ordinary shares commenced trading on GEM on March 11, 2004, at the opening price of HK$1.50 per share. Our ADSs commenced trading on Nasdaq on March 10, 2004, at the opening price of US$15.55 per ADS.

 

Item 10. Additional Information

Share Capital

Not applicable.

Memorandum and Articles of Association

The section entitled “Description of Share Capital” contained in our registration statement on Form F-1 (File No. 333-112800) is incorporated herein by reference.

Material Contracts

Other than the contracts described in “Item 4 — Information on the Company — History and Development of the Company — Our Acquisitions” and “Item 7 — Major Shareholders and Related Party Transactions,” we and our subsidiaries have not entered into any material contracts that are not in the ordinary course of business within the two years preceding the date of this annual report.

 

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Exchange Controls

The Cayman Islands currently have no exchange control restrictions.

Taxation

The following discussion of the material Cayman Islands, Hong Kong and United States federal income tax consequences of an investment in our ordinary shares or ADSs is based upon laws and relevant interpretations thereof in effect as of the date of this annual report, all of which are subject to change. This discussion does not address all possible tax consequences relating to an investment in our ordinary shares or ADSs, such as the tax consequences under United States state and local and other tax laws. The discussion is based upon laws and relevant interpretations in effect as of the date of this annual report, all of which are subject to change.

Cayman Islands Taxation

The following discussion of certain Cayman Islands income tax consequences of an investment in our ordinary shares or ADSs is directly based on the advice of Maples and Calder as to Cayman Islands law. It is not intended as tax advice, does not consider any investor’s particular circumstances, and does not consider tax consequences other than those arising under Cayman Islands law.

The Cayman Islands currently have no exchange control restrictions and no income, corporate or capital gains tax, estate duty, inheritance tax, gift tax or withholding tax applicable to us or to any holder of ADSs or of ordinary shares. Accordingly, any payment of dividends or any other distribution made on the ordinary shares will not be subject to taxation in the Cayman Islands, no Cayman Islands withholding tax will be required on such payments to any shareholder and gains derived from the sale of ordinary shares will not be subject to Cayman Islands capital gains tax. The Cayman Islands are not party to any double taxation treaties.

Our Company has received an undertaking from the Governor-in-Council of the Cayman Islands that, in accordance with section 6 of the Tax Concessions Law (1999 Revision) of the Cayman Islands, for a period of 20 years from the date of such undertaking (which was September 25, 2001), no law which is enacted in the Cayman Islands imposing any tax to be levied on profits, income, gains or appreciations will apply to us or our operations and, in addition, that no tax to be levied on profits, income, gains or appreciations or which is in the nature of estate duty or inheritance tax will be payable (i) on or in respect of our shares, debentures or other obligations or (ii) by way of withholding in whole or in part of a payment of dividend or other distribution of income or capital by us.

Hong Kong Taxation

Tax on Dividends

Under the current practice of the Hong Kong Inland Revenue Department, dividends are generally not subject to profits or withholding tax, unless such dividends are attributable to a trade, profession or business carried on in Hong Kong.

Profits

No tax is imposed in Hong Kong in respect of capital gains from the sale of property such as shares provided the shares are held for long-term investment and not for trading purposes. Trading gains from the sale of property by persons carrying on a trade, profession or business in Hong Kong where such gains are derived from or arise in Hong Kong from such trade, profession or business will be chargeable to Hong Kong profits tax, which is currently imposed at the rate of 17.5% on corporations and at a maximum rate of 16% on individuals. Gains from sales of shares effected on the Hong Kong Stock Exchange will be considered to be derived from or arise in Hong Kong. Liability for Hong Kong profits tax would thus arise in respect of trading gains from sales of shares effected on the Hong Kong Stock Exchange realized by persons carrying on a business of trading or dealing in securities in Hong Kong.

There will be no liability for Hong Kong profits tax in respect of profits from the sale of ADSs, where purchases and sales of ADSs are effected outside Hong Kong, including purchases and sales on Nasdaq.

 

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Stamp Duty

Hong Kong stamp duty will be payable by the purchaser on every purchase and by the seller on every sale of Hong Kong stock. “Hong Kong stock” is stock the transfer of which is required to be registered in Hong Kong. The duty is charged at the rate of 0.2% of the higher of the consideration for or the value of the Hong Kong stock transferred (the buyer and seller each paying half of such stamp duty). In addition, a fixed duty of HK$5 (around US$0.64) is currently payable on any instrument of transfer of Hong Kong stock.

If one of the parties to the sale is a non-resident of Hong Kong and does not pay the required stamp duty, the duty not paid will be assessed on the instrument of transfer (if any), and the transferee will be liable for payment of such duty.

The issuance of ADRs upon the deposit of Hong Kong stock, and the subsequent withdrawal of Hong Kong stock upon the surrender of ADRs, will also attract stamp duty at the rate described above for sale and purchase transactions unless such withdrawal or deposit does not result in a change in the beneficial ownership of Hong Kong stock under Hong Kong law, in which case only a fixed duty of HK$5 (around US$0.64) is payable on the transfer. Where stamp duty has been paid on the deposit of Hong Kong stock for the issuance of ADRs and the register of the ADRs is not kept in Hong Kong, the issuance of the ADRs directly to the depositary bank, as depositary bank of the ADSs, or for the account of the depositary bank should not attract stamp duty. No Hong Kong stamp duty is payable upon the transfer of ADSs if the register of ADSs is maintained outside Hong Kong.

Estate Duty

The shares are Hong Kong property under Hong Kong law, and accordingly these shares may be subject to estate duty on the death of the beneficial owner of these shares, depending on the date of death, regardless of the place of the owner’s residence, citizenship or domicile. The Revenue (Abolition of Estate Duty) Ordinance 2005 abolished estate duty in respect of deaths occurring on or after February 11, 2006 in Hong Kong. In respect of estates of persons who died between July 15, 2005 to February 11, 2006 (the transitional period), a nominal duty of HK$100 (approximately US$13) will be charged on estates with assessed values exceeding HK$7.5 million (around US$1.0 million). In respect of estates of persons who died prior to July 15, 2005 with assessed values exceeding HK$7.5 million, a progressive scale from 5% to 15% applies and the maximum rate of duty of 15% applies to estates with assessed values exceeding HK$10.5 million (around US$1.4 million). Estates with assessed values of HK$7.5 million or less are exempt from estate duty.

United States Taxation

This sub-section describes the material United States federal income tax consequences of the acquisition, ownership and disposition of our ordinary shares or ADSs. It applies to you only if you are a U.S. holder (as defined below) and you hold your ordinary shares or ADSs as capital assets for tax purposes. This section does not apply to you if you are a member of a special class of holders subject to special rules, including:

 

   

a bank;

 

   

a dealer in securities or currencies;

 

   

a trader in securities that elects to use a mark-to-market method of accounting for your securities holdings;

 

   

a tax-exempt organization;

 

   

an insurance company;

 

   

a person liable for alternative minimum tax;

 

   

a person that actually or constructively owns 10% or more of our voting stock;

 

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a person that holds ordinary shares or ADSs that are a hedge or that are hedged against currency risks or as part of a straddle or a conversion transaction; or

 

   

a person whose functional currency is not the U.S. dollar.

This sub-section is based on the Internal Revenue Code of 1986, as amended, its legislative history, existing and proposed regulations, published rulings and court decisions, all as currently in effect. These laws are subject to change, possibly on a retroactive basis. In addition, this section is based in part upon the representations of the Depositary and the assumption that each obligation in the deposit agreement and any related agreement will be performed in accordance with its terms. You are a U.S. holder if you are a beneficial owner of ordinary shares or ADSs and you are:

 

   

a citizen or resident of the United States;

 

   

a domestic corporation;

 

   

an estate whose income is subject to United States federal income tax regardless of its source; or

 

   

a trust if a United States court can exercise primary supervision over the trust’s administration and one or more United States persons are authorized to control all substantial decisions of the trust.

You should consult your own tax advisor regarding the United States federal, state and local tax consequences of owning and disposing of the ordinary shares or ADSs in your particular circumstances.

This discussion addresses only United States federal income taxation.

In general, and taking into account the earlier assumptions, for United States federal income tax purposes, if you hold ADRs evidencing ADSs, you will be treated as the owner of the ordinary shares represented by those ADRs. Exchange of ordinary shares for ADRs, and ADRs for ordinary shares, generally will not be subject to United States federal income tax.

Taxation of Dividends

Under the United States federal income tax laws, and subject to the passive foreign investment company, or PFIC, rules discussed below, if you are a U.S. holder, the gross amount of any dividend we pay out of our current or accumulated earnings and profits (as determined for United States federal income tax purposes) is subject to United States federal income taxation. If you are a noncorporate U.S. holder, dividends paid to you in taxable years beginning before January 1, 2011 that constitute qualified dividend income will be taxable to you at a maximum tax rate of 15% provided that you hold the ordinary shares or ADSs for more than 60 days during the 121 day period beginning 60 days before the ex-dividend date and meet other holding period requirements. Dividends we pay with respect to the ordinary shares or ADSs generally will be qualified dividend income provided that, in the year that you receive the dividend, the ordinary shares or ADSs are readily tradable on an established securities market in the United States.

The dividend is taxable to you when you, in the case of ordinary shares, or the depositary bank, in the case of ADSs, receive the dividend, actually or constructively. The dividend will not be eligible for the dividends-received deduction generally allowed to United States corporations in respect of dividends received from other United States corporations. Distributions in excess of current and accumulated earnings and profits, as determined for United States federal income tax purposes, will be treated as a non-taxable return of capital to the extent of your basis in the ordinary shares or ADSs and thereafter as capital gain. If the dividend is declared and paid in a foreign currency, the amount of the dividend distribution that you must include in your income as a U.S. holder will be the U.S. dollar value of the payments made in the foreign currency, determined at the spot foreign currency/U.S. dollar rate on the date the dividend distribution is includible in your income, regardless of whether the payment is in fact converted into U.S. dollars. Generally, any gain or loss resulting from currency exchange fluctuations during the period from the date you include the dividend payment in income to the date you convert the payment into U.S. dollars will be treated as ordinary income or loss and will not be eligible for the special tax rate applicable to qualified dividend income. The gain or loss generally will be income or loss from sources within the United States for foreign tax credit limitation purposes.

 

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Special rules apply in determining the foreign tax credit limitation with respect to dividends that are subject to the maximum 15% tax rate. Dividends will be income from sources outside the United States, but dividends paid in taxable years beginning before January 1, 2007, generally will be “passive” or “financial services” income, and dividends paid in taxable years beginning after December 31, 2006, will, depending on your circumstances, be “passive” or “general” income which, in either case, is treated separately from other types of income for purposes of computing the foreign tax credit allowable to you.

Taxation of Capital Gains

Subject to the PFIC rules discussed below, if you are a U.S. holder and you sell or otherwise dispose of your ordinary shares or ADSs, you will recognize capital gain or loss for United States federal income tax purposes equal to the difference between the U.S. dollar value of the amount that you realize and your tax basis, determined in U.S. dollars, in your ordinary shares or ADSs. Capital gain of a noncorporate U.S. holder that is recognized in taxable years beginning before January 1, 2011 is generally taxed at a maximum rate of 15% where the holder has a holding period greater than one year. The gain or loss will generally be income or loss from sources within the United States for foreign tax credit limitation purposes. Your ability to deduct capital losses is subject to limitations.

PFIC Rules

We believe that ordinary shares and ADSs should not be treated as stock of a PFIC for United States federal income tax purposes. Whether or not we are a PFIC must be determined on an annual basis and, accordingly, our status is subject to change.

In general, if you are a U.S. holder, we will be a PFIC with respect to you if for any taxable year in which you held your ordinary shares or ADSs:

 

   

at least 75% of our gross income for the taxable year is passive income; or

 

   

at least 50% of the value, determined on the basis of a quarterly average, of our assets is attributable to assets that produce or are held for the production of passive income.

Passive income generally includes dividends, interest, royalties, and rents (not including certain rents and royalties derived in the active conduct of a trade or business), annuities and gains from assets that produce passive income. If a foreign corporation owns directly or indirectly at least 25% by value of the stock of another corporation, the foreign corporation is treated for purposes of the PFIC tests as owning its proportionate share of the assets of the other corporation, and as receiving directly its proportionate share of the other corporation’s income.

If we are treated as a PFIC, and you are a U.S. holder that does not make a mark-to-market election, as described below, you will be subject to special rules with respect to:

 

   

any gain you realize on the sale or other disposition of your ordinary shares or ADSs; and

 

   

any excess distribution that we make to you (generally, any distributions to you during a single taxable year that are greater than 125% of the average annual distributions received by you in respect of the ordinary shares or ADSs during the three preceding taxable years or, if shorter, your holding period for the ordinary shares or ADSs).

 

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Under these rules:

 

   

the gain or excess distribution will be allocated ratably over your holding period for the ordinary shares or ADSs;

 

   

the amount allocated to the taxable year in which you realized the gain or excess distribution will be taxed as ordinary income;

 

   

the amount allocated to each prior year, with certain exceptions, will be taxed at the highest tax rate in effect for that year; and

 

   

the interest charge generally applicable to underpayments of tax will be imposed in respect of the tax attributable to each such year.

Special rules apply for calculating the amount of the foreign tax credit with respect to excess distributions by a PFIC.

If you own ordinary shares or ADSs in a PFIC that are treated as marketable stock, you may make a mark-to-market election. If you make this election, you will not be subject to the PFIC rules described above. Instead, in general, you will include as ordinary income each year the excess, if any, of the fair market value of your ordinary shares or ADSs at the end of the taxable year over your adjusted basis in your ordinary shares or ADSs. These amounts of ordinary income will not be eligible for the favorable tax rates applicable to qualified dividend income or long-term capital gains. You will also be allowed to take an ordinary loss in respect of the excess, if any, of the adjusted basis of your ordinary shares or ADSs over their fair market value at the end of the taxable year (but only to the extent of the net amount of previously included income as a result of the mark-to-market election). Your basis in the ordinary shares or ADSs will be adjusted to reflect any such income or loss amounts. Your gain, if any, recognized upon the sale of your ordinary shares or ADSs will be taxed as ordinary income.

In addition, notwithstanding any election you make with regard to the ordinary shares or ADSs, dividends that you receive from us will not constitute qualified dividend income to you if we are a PFIC either in the taxable year of the distribution or the preceding taxable year. Dividends that you receive that do not constitute qualified dividend income are not eligible for taxation at the 15% maximum rate applicable to qualified dividend income. Instead, you must include the gross amount of any such dividend paid by us out of our accumulated earnings and profits (as determined for United States federal income tax purposes) in your gross income, and it will be subject to tax at rates applicable to ordinary income.

If you own ordinary shares or ADSs during any year that we are a PFIC, you must file Internal Revenue Service Form 8621.

Dividends and Paying Agents

Not applicable.

Statement by Experts

Not applicable.

Documents on Display

You can read and copy documents referred to in this annual report that have been filed with the U.S. Securities and Exchange Commission, or the SEC, at the SEC’s public reference room located at Room 1580, 100 F Street, NE, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference rooms and their copy charges.

Subsidiary Information

Not applicable.

 

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Item 11. Quantitative and Qualitative Disclosures About Market Risks

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to the interest income generated by our cash deposits in banks and our investment in marketable securities, and interest expenses in respect of our bank loans. We have not used derivative financial instruments in our investment portfolio. Interest earning instruments carry a degree of interest rate risk. We have not been exposed, nor do we anticipate being exposed, to material risks due to changes in interest rates. However, our future interest income or expenses may be different from our expectations due to changes in interest rates.

Foreign Currency Risk

While our reporting currency is the U.S. dollar, to date virtually all of our revenues and costs are denominated in Renminbi and substantially all of our assets and liabilities are denominated in Renminbi. We do however have revenues and costs denominated in Indian Rupees, Euros and other currencies. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be impacted by fluctuations in the exchange rate between U.S. dollars, Renminbi, Indian Rupees, Euros and other currencies. If the Renminbi appreciates against the U.S. Dollar, any new Renminbi-denominated investments or expenditures will be more costly to us, to the extent that we need to convert U.S. dollars into Renminbi for such purposes. If the Renminbi depreciates against the U.S. dollar, the value of our Renminbi revenues and assets as expressed in our U.S. dollar financial statements will decline. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. See “Item 3 — Key Information — Risk Factors — Risks Relating to the People’s Republic of China — Fluctuation of the Renminbi could materially affect the value of our ADSs or ordinary shares.”

Inflation

In recent years, China has not experienced significant inflation, and thus inflation has not had a significant effect on our business during the past three years. According to the China Statistical Bureau, China’s overall national inflation rate, as represented by the general consumer price index, was approximately 1.5%, 1.8% and 3.9% in 2006, 2005 and 2004, respectively.

 

Item 12. Description of Securities Other than Equity Securities

Not applicable.

PART II

 

Item 13. Defaults, Dividend Arrearages and Delinquencies

None.

 

Item 14. Material Modifications to the Rights of Security Holders and Use