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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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

OR

 

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

Commission file number: 000-30134

 


CDC Corporation

(Exact name of Registrant as specified in its charter)

Cayman Islands

(Jurisdiction of incorporation or organization)

c/o CDC Corporation Limited

33/F Citicorp Centre

18 Whitfield Road

Causeway Bay

Hong Kong

852-2893-8200

e-mail: investor_relations@cdccorporation.net

(Address of principal executive offices)

 


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

Class A common shares

Indicate the number of outstanding shares of each of the Issuer’s class of capital or common stock as of the close of the period covered by this Annual Report:

 

Class of shares

 

Number outstanding as of March 31, 2007

Class A common shares   114,944,204

 


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

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

Note – Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.

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

 

     Page

PART I.

      1
  Item 1.    Identity of Directors, Senior Management And Advisors    5
  Item 2.    Offer Statistics and Expected Timetable    5
  Item 3.    Key Information    5
  Item 4.    Information on the Company    63
  Item 4A.    Unresolved Staff Comments    107
  Item 5.    Operating and Financial Review and Prospects    107
  Item 6.    Directors, Senior Management and Employees    140
  Item 7.    Major Shareholders and Related Party Transactions    164
  Item 8.    Financial Information    168
  Item 9.    The Offer and Listing    168
  Item 10.    Additional Information    169
  Item 11.    Quantitative and Qualitative Disclosures About Market Risk    193
  Item 12.    Description of Securities Other Than Equity Securities    197

PART II.

      198
  Item 13.    Defaults, Dividend Arrearages and Delinquencies    198
  Item 14.    Material Modifications To The Rights Of Security Holders And Use Of Proceeds    198
  Item 15.    Controls and Procedures    198
  Item 15T    Controls and Procedures    199
  Item 16.    [Reserved]    201
  Item 16A.    Audit Committee Financial Expert    201
  Item 16B.    Code of Ethics    201
  Item 16C.    Principal Accountant Fees and Services    201
  Item 16D.    Exemptions from the Listing Standards for Audit Committees    202
  Item 16E.    Purchases of Equity Securities by the Issuer and Affiliated Purchasers    203

PART III.

      205
  Item 17.    Financial Statements    205
  Item 18.    Financial Statements    205
  Item 19.    Exhibits    205

SIGNATURES

      208


Table of Contents

PART I.

General Introduction

In April 2005, we changed our name from “chinadotcom corporation” to “CDC Corporation”. Concurrently, in April 2005, our then 81%-owned subsidiary listed on the Growth Enterprise Market of The Stock Exchange of Hong Kong Limited, changed its name from “hongkong.com Corporation” to “China.com Inc.” All references herein to “China.com” refer to China.com Inc. and its subsidiaries, as applicable. Throughout this Annual Report, we use the new names of these companies.

In this Annual Report on Form 20-F, except as otherwise specified, all references to “we,” “us,” “our,” the “Company” or “CDC” refer to CDC Corporation and our consolidated subsidiaries. Unless otherwise specified, all information contained in this Annual Report, including share and per share data, reflects the two-for-one share splits approved by our shareholders as of each of December 6, 1999 and April 28, 2000, respectively, and effective as of the close of trading on the Nasdaq Global Market, or NASDAQ, on December 13, 1999 and May 8, 2000, respectively. In this Annual Report, any reference to “US GAAP” means the United States generally accepted accounting principles. The consolidated financial statements provided herein have been prepared in accordance with US GAAP. Unless indicated otherwise, any reference to “U.S.$”, “US$”, or “$” is to United States dollars.

Several of our affiliated entities and subsidiaries have been organized under the laws of the People’s Republic of China (the “PRC” or “Greater China”) with Chinese names and do not have official English names. Some of these entities which are organized under the laws of the PRC are referred to in this Annual Report with their English names, such as Beijing Newpalm Technology Co., Ltd., Beijing Wisecom Technology Co., Ltd., Beijing China.com Technology Services Co., Ltd., Beijing He He Technology Co., Ltd., and Shenzhen KK Technology Ltd. and Beijing TimeHeart Information Technology Limited for Timeheart. We have occasionally referred to these entities in our contracts, other arrangements and audited financial statements as Beijing Newpalm Information Technology Co., Ltd., or Beijing Newpalm, Beijing Wisecom Information Technology Co., Ltd., or Beijing Wisecom, Beijing China Net Communication Technology Service Ltd,, or Beijing China.com, Beijing He He Technology Co., Ltd., or Beijing He He, Shenzhen KK Technology Ltd. and Beijing TimeHeart Information Technology Limited, or Beijing TimeHeart.

References in this Annual Report to Xinhua are to the Liaison Office of the Central People’s Government of HKSAR (formerly Xinhua News Agency).

Forward-Looking Statements

This Annual Report contains certain “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995, and Section 21E of the Securities Exchange Act of 1934, as amended, about us and our subsidiaries that are subject to risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, are forward looking statements. Forward looking statements may be identified by the use of words such as “may,” “will,” “expect,” “anticipate,” “intend,” “estimate,” “plan,” “continue,” or “believe” or other words of similar meaning or future or conditional verbs such as “should,” “would” and “could.” Forward-looking statements include, among other things, discussions of our expected business outlook, future operations, financial performance, pending acquisitions, financial strategies, future working capital needs and projected industry trends, as well as our strategies for growth, product development, regulatory approvals and compliance, market position and expenditures.

Forward-looking statements are only predictions and are not guarantees of performance. Forward-looking statements are based on current expectations of future events and are based on our current views and assumptions regarding future events and operating performance. These assumptions could prove inaccurate, or unknown risks or uncertainties could materialize, which could cause our actual results to differ materially from our expectations or predictions. Many of these factors are beyond our ability to control or predict.

 

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We have made forward-looking statements concerning the following, among others:

 

   

our goals and strategies in each of our present and target markets, and our plans for expansion;

 

   

our competitive strengths in each of our present and target markets, including our competitive advantages, strengths and opportunities in emerging growth and other geographic markets;

 

   

expectations and targets for our results of operations;

 

   

our business prospects;

 

   

our beliefs regarding our sales and distribution networks, the outcome of litigation matters and our compliance with all applicable regulations and policies;

 

   

our business prospects and the results of our strategic partnerships;

 

   

our internal development capabilities and our ability to build and maintain relationships with licensors;

 

   

the expected growth of the enterprise software, online games, mobile services and applications and internet and media markets, and the expectations of the customers and consumers in these industries;

 

   

the pace of change in the enterprise software, online games, mobile services and applications, internet and media markets, and the need for research and development;

 

   

the demand for, and utility, flexibility and characteristics of, our enterprise software, online games, mobile services and applications, internet and media products and services;

 

   

our relationships with our present and future customers, as well as our cross-selling opportunities; and

 

   

our acquisition and expansion strategy.

These statements are based on management’s current expectations and are subject to risks and uncertainties and changes in circumstances. Factors that could cause actual results to differ materially from those anticipated in the forward looking statements include, but are not limited to, risks associated with the following:

Factors Relating to our Overall Business and International Operations

 

   

our ability to operate in markets in which we lack experience and have a limited operating history;

 

   

our ability to achieve and/or sustain sufficient revenue growth, effectively manage our internal restructuring objectives, continue to expand through acquisitions, integrate the operations of the various businesses we have acquired, and manage our exposure to increased regulatory and other risks in domestic and foreign jurisdictions;

 

   

our ability to grow our businesses organically in the future, manage distinct business segments several of which are quite disparate in, among other things, purpose, scope and location,

 

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manage costs, particularly as a result of our past and present acquisition strategy, adapt to a rapidly changing operating environment, remediate existing, and avoid experiencing future, material weaknesses in our internal controls over financial reporting, access funds and manage revenue and expense fluctuations;

 

   

uncertain economic and political climate in Asia, the U.S. and throughout the rest of the world, and the potential that such climate may deteriorate; and

 

   

increased global competition in all of our business segments.

Factors Relating to our Enterprise Software and Business Services Businesses

 

   

the development and licensing of software in general, including potential delays in software development and technical difficulties that may be encountered in the development or use of our software;

 

   

the development of new software technologies and applications or services affecting our current and future business;

 

   

our ability to efficiently expand or restructure our software sales organization;

 

   

our ability to take advantage of opportunities to market and sell our enterprise software products and services to customers directly and through distribution channels and business partners in emerging markets;

 

   

our ability to maintain and manage our contracts with our business services and other customers, as well as our ability to manage risks efficiently, successfully develop, market and sell enterprise software products for specific targeted vertical industries, offer high quality services and support, and protect intellectual property rights for our software products; and

 

   

our ability to accurately estimate the costs of our business services engagements which are billed on a fixed price basis.

Factors Relating to our Online Games Business

 

   

the distribution, development and licensing of online games generally, including potential delays in software development and technical difficulties that may be encountered in the development of online games we may distribute;

 

   

our dependence on one online game for substantially all of our online games revenue;

 

   

our ability to maintain and build relationships with our current and potential future licensors of online games, correctly identify and implement our growth strategies, license or develop and launch new games, and manage the effects thereof on our existing game or games, detect and avoid programming errors, and adapt to changes in applicable regulations and consumer tastes;

 

   

the development of new networking technologies and online games which affect our current and future business;

 

   

the future growth of the online games market in the PRC;

 

   

our ability to efficiently expand or restructure our distribution network, take advantage of opportunities to market the online games we license and distribute to customers directly and through distribution channels and business partners, and protect intellectual property rights for any of the online games we develop or license; and

 

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our ability to accurately estimate the costs of marketing, distributing and operating any online games we offer.

Factors Relating to our Mobile Applications and Internet and Media Businesses

 

   

the various contractual relationships with China Mobile, China Unicom or any other mobile network operators and their subsidiaries and affiliates, including that such agreements will terminate or be altered in a way that adversely affects our mobile services and applications business;

 

   

changes in the regulatory policies of the Ministry of Information Industry, or MII, in the PRC, and other relevant government authorities or the mobile network operators relating to, among other matters, the grant and approval of mobile services and applications licenses, acceptance of existing ownership structures, and regulating content delivered;

 

   

the future growth of the mobile telecommunications industry in the PRC;

 

   

our ability to obtain accurate and timely information regarding customer usage levels, manage the effects of network transmission failures, satisfy customers and the mobile network operators, avoid sanctions and penalties by regulators and the mobile network operators, effectively compete, and avoid competition with the mobile network operators and obtain content from third parties;

 

   

our ability to maintain up-to-date datasets in our database marketing business; and

 

   

changes in political, economic, legal and social environment in the PRC, including the Chinese government’s specific policies with respect to foreign investment in the telecommunications, internet and online games industries, economic growth, inflation, foreign exchange and the availability of credit.

Factors Relating to our Online Games, Mobile Applications and Internet and Media Segments as a Result of Conducting Operations in the People’s Republic of China

 

   

our ability to manage risks relating to content which we may provide or communicate, or which may be provided, displayed or communicated by third parties;

 

   

the governmental control of currency conversion and exchange rates;

 

   

our contractual arrangements with our PRC-related entities, which may be difficult to enforce or may not be compliant with all applicable laws, rules and regulations; and

 

   

our ability to comply and maintain compliance with all applicable licensing, regulatory and business requirements, including, without limitation, tax and insurance regulations.

Factors Relating to our Intellectual Property, Personnel, Technology and Network

 

   

our ability to adequately protect or enforce our intellectual property rights through litigation or other means, to use our intellectual property free of infringement by third parties, and our ability to avoid infringing others’ intellectual property;

 

   

the ability of our licensors to avoid infringement claims by third parties;

 

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our ability to attract and maintain key and skilled employees, and our ability to provide adequate compensations and incentives for them;

 

   

product liability claims; and

 

   

hacking, viruses, spamming and other disruptions by third parties, as well as the risk of illegal game servers, software and hardware systems failures, service interruptions, and the dependability of the internet and telecommunications infrastructure in the PRC.

Factors Relating to our Class A Common Shares

 

   

major and strategic shareholders, whose interests may differ from those of our other shareholders, substantially changing their holdings of our common shares;

 

   

the continued volatility of the market price for our common shares;

 

   

the potential effect of our outstanding senior exchangeable convertible notes on our business, financial position and the market price of our common shares;

 

   

our status as a foreign private issuer and the regulations applicable to us relating to our foreign private issuer status, as well as our PFIC and investment company status and changes thereto;

 

   

the potential dilutive effect of any potential issuance of a large number of additional shares that we may make; and

 

   

risks relating to a shareholder’s ability to enforce its rights against us and our officers and directors since we are a Cayman Islands company.

All forward looking statements contained in this Annual Report are based upon information available to management as of the date of this Annual Report, and you are cautioned not to place undue reliance on any forward looking statements which speak only as of the date of this Annual Report. We assume no obligation to update or alter the forward-looking statements made herein whether as a result of new information, future events or otherwise. You should read these statements in conjunction with the risk factors disclosed under in Item 3.D., Key Information, Risk Factors in this Annual Report.

 

ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS

Not applicable.

 

ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE

Not applicable.

 

ITEM 3. KEY INFORMATION

 

A. Selected Financial Data

The following selected consolidated financial data of CDC and our subsidiaries should be read in conjunction with the consolidated balance sheets as of December 31, 2004, 2005 and 2006 and the related consolidated statements of operations, cash flows and shareholders’ equity for the years then ended and the notes thereto, together referred to as the Consolidated Financial Statements, included in Item 18, Financial Statements, and the information included in Item 5, Operating and Financial Review and Prospects. The Consolidated Financial Statements have been prepared and presented in accordance with US GAAP.

 

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In June 2007, we amended and restated our Annual Report on Form 20-F for the year ended December 31, 2005, to restate our consolidated financial statements and notes related thereto for the years ended December 31, 2003, 2004 and 2005, and provide separate financial statements and notes related thereto of Equity Pacific Limited, its subsidiaries and its variable interest entity. Please see our recently filed Annual Report on Form 20 – F/A for additional information related to the aforementioned restatements.

All historical amounts relating to our financial information for the years ended December 31, 2003, 2004 and 2005 refer to such amended and restated amounts.

We currently report operating results in five business segments, “Software,” “Business Services,” “CDC Games,” “Mobile Services and Applications” and “Internet and Media”. During 2005 we reorganized our business into two core business units, CDC Software and China.com, and during 2006 we further reorganized our business to add a third core business unit, CDC Games. The operations of Software and Business Services are included in the CDC Software business unit, the operations of CDC Games are included in the CDC Games business unit and the operations of Mobile Services and Applications and Internet and Media are included in the China.com Inc business unit in all years presented. See “Note 28 – Segment Information” in Item 18, Financial Statements for additional disclosure of segment information.

In addition, during 2004 and 2005, we discontinued the operations of certain of our subsidiaries. The operating results of the discontinued operating units were retroactively reclassified as a Loss from operations of discontinued subsidiaries, net of tax, in all periods presented in this Annual Report.

The following selected consolidated financial data of CDC and our subsidiaries is derived from our audited financial data, after adjustment for the reclassification of discontinued operations and segment reporting and the amendment and restatement of our financial statements for the years ended December 31, 2004, 2005 and 2006.

 

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CONSOLIDATED INCOME STATEMENT DATA:    Year ended December 31,  
     (in thousands, except share and per share data)  
     2002     2003     2004     2005     2006  

Revenues:

          

CDC Software

   $ 16,332     $ 53,368     $ 150,575     $ 201,490     $ 240,821  

China.com

     6,468       24,483       31,877       43,384       41,926  

CDC Games

     —         —         —         —         26,780  
                                        
     22,800       77,851       182,452       244,874       309,527  
                                        

Cost of Revenues:

          

CDC Software

     (6,828 )     (32,899 )     (74,801 )     (95,238 )     (119,732 )

China.com

     (4,197 )     (6,209 )     (7,916 )     (18,711 )     (17,099 )

CDC Games

     —         —         —         —         (10,631 )
                                        
     (11,025 )     (39,108 )     (82,717 )     (113,949 )     (147,462 )
                                        

Gross profit

     11,775       38,743       99,735       130,925       162,065  

Selling, general and administrative expenses

     (22,307 )     (31,606 )     (80,326 )     (100,549 )     (125,500 )

Research and development expenses

     —         —         (13,825 )     (22,605 )     (19,981 )

Depreciation and amortization expenses

     (9,015 )     (6,829 )     (8,919 )     (9,937 )     (10,976 )

Restructuring expenses

     —         —         (3,760 )     (1,667 )     (1,974 )
                                        

Total operating expenses

     (31,322 )     (38,435 )     (106,830 )     (134,758 )     (158,431 )
                                        

Operating income (loss)

     (19,547 )     308       (7,095 )     (3,833 )     3,634  
                                        

Interest income

     23,631       13,412       9,654       8,156       10,680  

Interest expense

     (2,461 )     (1,070 )     (1,895 )     (1,257 )     (3,038 )

Gain (loss) on disposal of available-for-sale securities

     (163 )     4,599       167       525       344  

Gain (loss) on disposal of subsidiaries and cost investments

     (66 )     (1,263 )     892       483       3,087  

Other non-operating gains

     508       934       —         —         —    

Other non-operating losses

     (288 )     (143 )     —         —         531  

Impairment of cost investments and available-for-sale securities

     (5,351 )     —         (1,362 )     —         —    

Share of income (losses) in equity investees(1)

     682       (124 )     (468 )     (1,172 )     976  
                                        

Total other income

     16,492       16,345       6,988       6,735       12,580  
                                        

Income (loss) before income taxes

     (3,055 )     16,653       (107 )     2,902       16,214  

Income tax benefit (expenses)

     162       448       (3,375 )     (4,957 )     (3,062 )
                                        

Income (loss) before minority interests

     (2,893 )     17,101       (3,482 )     (2,055 )     13,152  

Minority interests in losses (income) of consolidated subsidiaries

     248       (2,257 )     (925 )     (1,409 )     (2,312 )
                                        

Income (loss) from continuing operations

     (2,645 )     14,844       (4,407 )     (3,464 )     10,840  

Discontinued operations:

          

Loss from operations of discontinued subsidiaries, net of tax

     (16,131 )     (1,203 )     (610 )     (47 )     —    

Gain (loss) on disposal/dissolution of discontinued subsidiaries, net

     545       2,127       (950 )     (3 )     —    
                                        

Net income (loss)

   $ (18,231 )   $ 15,768     $ (5,967 )   $ (3,514 )   $ 10,840  
                                        

Basic and diluted earnings (loss) per share from continuing operations(2)

   $ (0.03 )   $ 0.14     $ (0.04 )   $ (0.03 )   $ 0.10  

Basic and diluted earnings (loss) per share(2)

   $ (0.18 )   $ 0.15     $ (0.06 )   $ (0.03 )   $ 0.10  

Weighted average number of shares:

          

Basic

     102,269,735       100,532,594       105,898,392       111,085,657       107,950,544  

Diluted

     102,269,735       103,199,421       105,898,392       111,085,657       109,079,391  

(1) The term “equity investees” refers to CDC’s investments in which it has the ability to exercise significant influence (generally 20% to 50% owned investments).
(2) The computation of diluted earnings (loss) per share did not assume the conversion of the Company’s warrants for 2002 and 2003 and its stock options for 2002, 2004, and 2005 because their inclusion would have been antidilutive due to the required two class method of fully diluted per share used by the company. 2,263,642 weighted average shares related to the convertible notes were not included in the 2006 diluted earnings per share calculation because to do so would have been antidilutive.

 

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CONSOLIDATED BALANCE SHEET DATA:    As of December 31,
     (in thousands, except share data)
     2002    2003    2004    2005    2006

Cash and cash equivalents

   $ 33,153    $ 55,508    $ 110,206    $ 93,719    $ 223,548

Restricted cash

     109      238      3,886      1,886      1,996

Available-for-sale debt securities(3)

     320,056      282,145      104,159      115,881      126,446

Restricted available-for-sale debt securities(4)

     151,123      19,803      75,780      32,270      —  

Restricted held-to-maturity debt securities(5)

     —        —        —        —        30,504

Available-for-sale equity securities

     2,050      —        527      659      3,532

Bank loans(6)

     127,384      26,826      63,781      26,249      18,991

Working capital(7)

     340,476      270,451      177,602      75,447      240,926

Convertible notes

     —        —        —        —        161,859

Embedded derivatives related to convertible notes

     —        —        —        —        5,786

Total assets

     580,957      553,074      693,871      633,032      857,591

Common stock

     25      25      28      28      28

Total shareholders’ equity

     377,700      395,701      449,976      446,498      454,829

(3) Available-for-sale debt securities includes short and long-term available-for-sale debt securities.
(4) Restricted available-for-sale debt securities include short and long-term restricted debt securities.
(5) Restricted held-to-maturity debt securities include short-term restricted debt securities.
(6) Bank loans include short and long-term bank loans.
(7) Working capital represents current assets less current liabilities.

 

B. Capitalization and Indebtedness

Not applicable.

 

C. Reasons for the Offer and Use of Proceeds

Not applicable.

 

D. Risk Factors

Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below together with other information included or incorporated by reference in this Annual Report in your decision as to whether or not to invest in our common stock. If any of the following risks or uncertainties actually occur, our business, financial condition or results of operations would likely suffer. In that case, the trading price of our common stock could fall, and you may lose all or part of the money you paid to buy our common stock.

Risks Relating to Our Overall Business

Because our business model and strategy have evolved, we lack experience and have a limited operating history in our new markets and we may not be successful in meeting the needs of customers in these markets. Our operating results could fall below expectations, resulting in a decrease in our stock price.

We began in June 1997 as a pan-Asian integrated Internet company. Our business model and strategy has evolved with a new focus and goal to be a global company focused on enterprise software and business services through our CDC Software business unit, on online games through our CDC Games business unit and on mobile applications and internet and media services through our China.com business unit. You will not be able to evaluate our prospects solely by reviewing our past businesses and results, but should consider our prospects in light of the changes in our business focus. Each of our targeted markets is rapidly changing, and

 

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we may not successfully address the challenges in our new lines of business or adapt our business model and strategy to meet the needs of customers in these markets. If we fail to modify our business model or strategy to adapt to these markets, our business could suffer.

We have incurred losses in prior periods, may incur losses in the future and cannot provide any assurance that we can achieve or sustain profitability.

We have incurred operating losses and net losses in each of our last 5 fiscal years (except for fiscal years 2003 and 2006) as follows:

 

     2002     2003    2004     2005     2006
     (in thousands)

Operating loss

   $ (19,547 )   $ 308    $ (7,095 )   $ (3,833 )   $ 3,635

Net income (loss)

   $ (18,231 )   $ 15,768    $ (5,967 )   $ (3,514 )   $ 10,840

Our operating losses and net losses may increase in the future, and we may not sustain operating profitability or net profitability. We may continue to incur operating losses and post net losses in the future due to several factors, including:

 

   

planned acquisition activities related to the growth and development of our three core business units, CDC Software, CDC Games and China.com;

 

   

continuing effects of acquisition-related adjustments including intangible asset amortization, stock compensation and deferred tax expense;

 

   

a high level of planned operating expenditures, including costs we expect to incur as a result of our ongoing efforts to comply with the regulations promulgated under the Sarbanes-Oxley Act of 2002; and

 

   

increased investment activities related to our new businesses as we seek to achieve organic growth, which may include:

 

   

increased sales and marketing costs; and

 

   

greater levels of product development expenses.

In addition, while, from time to time, we experienced sequential quarterly increases in revenues, we cannot be certain that revenue growth will occur or continue in the future. We may see a reversal of any sequential growth in quarterly revenues due to several factors, including:

 

   

any decisions to dispose of business units, subsidiaries, products or services which we no longer believe to be central to our new business model and strategy, which would decrease our revenue base;

 

   

a substantial portion of our software license revenue is recognized in the last month of a quarter, and often in the last weeks or days of a quarter, which may result in increased volatility in quarterly revenues if customers decide to defer or cancel orders or implementations, particularly large orders or implementations, from one quarter to the next;

 

   

the delay of new software product releases which can result in a customer’s decision to delay execution of a contract or, for contracts that include the new software release as an element of the contract, will result in deferral of revenue recognition until such release;

 

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the imposition of penalties, such as a temporary suspension of service, for violation of current or future Chinese laws, rules or regulations regarding Internet related services and telecom related activities, such as that experienced by our Go2joy subsidiary during 2004 and one of our mobile services and applications units, Shenzhen KK Technology Ltd., in 2006;

 

   

the potential or actual loss of key clients and key personnel;

 

   

our failure to increase market awareness of our company, our brands and our products and services; and

 

   

a slowdown in the U.S., European, Asian and/or other economic markets.

These factors could also adversely affect our ability to achieve or sustain profitability. We may not generate sufficient revenue to achieve or sustain profitability, or that we can sustain or increase profitability on a quarterly or annual basis. Even though our revenue is difficult to predict, we base our decisions regarding our operating expenses on anticipated revenue trends. Many of our expenses are relatively fixed, and we cannot quickly reduce spending in response to lower revenue growth than expected. As a result, revenue shortfalls could result in significantly lower income or result in a greater loss than anticipated for any given period, which could result in a decrease in our stock price. If revenue does not meet our expectations, or if operating expenses exceed what we anticipate or cannot be reduced accordingly, our business, results of operations and financial condition will be materially and adversely affected.

As part of our reorganization into three core business units, we may incur future restructuring costs and increase our potential liabilities as we continue to transition the financial and administrative functions of our business units.

During 2005 we reorganized our business into two core business units, CDC Software and China.com, and during 2006 we further reorganized our business to add a third core business unit, CDC Games. As part of these reorganizations we initiated a series of restructurings of our operations involving, among other things, the reduction of overlapping personnel predominately from our Hong Kong office in financial and administrative functions and the transition of those financial and administrative functions to our business units, particularly to our operations in Atlanta, Georgia. As we continue with this transition, we need to ensure that all operational, managerial and financial controls, procedures and policies are fully and completely transitioned. Significant risks relating to this transition could cause us to continue to incur costs and potential liability which may outweigh the benefits of these restructurings. The failure to successfully transition our financial and administrative functions to our business units could materially and adversely affect our business and financial condition.

Further, as a result of this transition, we have ceased to use certain of our leased facilities and, accordingly, we are negotiating certain lease terminations and/or subleases of our facilities. We cannot predict when or if we will be successful in negotiating lease terminations and/or subleases of our facilities on terms acceptable to us. If we are not successful at negotiating terms acceptable to us, or at all, we may be required to increase our restructuring and related expenses in future periods.

Our strategy of expansion through acquisitions or investments has been and will continue to be costly and may not be effective, and we may realize losses on our investments.

As a key component of our business and growth strategy, we have acquired and invested in, and intend to continue to acquire and invest in, companies and assets that we believe will enhance our business model, revenue base, operations and profitability, particularly relating to our strategy in enterprise software, business services, online games and mobile services. Our acquisitions and investments have resulted in, and will continue to result in, the use of significant amounts of cash, the incurrence of debt, dilutive issuances of our common shares and amortization expenses related to certain intangible assets, each of which could materially and adversely affect our business, results of operations and financial condition.

 

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Our continued international acquisitions and investments may expose us to additional regulatory and political risks, and could negatively impact our business prospects.

Our expansion throughout international markets exposes us to the following risks, any of which could negatively impact our business prospects:

 

   

adverse changes in regulatory requirements, including export restrictions or controls;

 

   

potentially adverse tax and regulatory consequences;

 

   

differences in accounting practices and investment requirements;

 

   

different cultures which may be relatively less accepting of our business;

 

   

difficulties in staffing and managing operations;

 

   

differences and inconsistencies in legal interpretations, laws, rules and regulations;

 

   

greater legal uncertainty and difficulty in complying with such laws and regulations;

 

   

tariffs and other trade barriers;

 

   

changes in the general economic and investment climate affecting valuations and perception of our business sectors;

 

   

political instability and fluctuations in currency exchange rates; and

 

   

different seasonal trends in business activities.

During each of 2003, 2004 and 2006, we depended more on acquisitions for our increase in revenues than the organic growth of our businesses. We may not be successful in increasing our revenues through organic growth or through acquisitions and may lose our investment if we do not successfully integrate the businesses we acquire.

 

   

During 2003, our acquisitions included the acquisition of Praxa, an Australian information technology outsourcing and professional services organization; the acquisition of Palmweb Inc. which operates Newpalm, a provider of mobile services and applications in China; and the acquisition of IMI, an international provider of software to the supply chain management sector principally in Europe and the United States.

 

   

During 2004, our acquisitions included the acquisition of Pivotal Corporation, or Pivotal, a customer relationship management (CRM) company focused on mid-sized enterprises; the acquisition of Group Team Investments Limited, which holds Beijing He He Technology Co. Ltd. which operates Go2joy, a mobile services and applications provider based in Beijing, China; and the acquisition of Ross Systems, Inc., or Ross, an ERP company focused on the food and beverage, life sciences, chemicals, metals and natural products industries.

 

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During 2006, our acquisitions included a number of enterprise software and business solutions companies, including: c360 Solutions, Inc., a provider of add-in products and development tools for Microsoft Dynamics CRM platform, MVI Holdings Limited, a real-time performance management solutions provider, DB Professionals, Inc., an outsourced IT support and consulting services provider based in Oregon, Vis.align, Inc., an enterprise solutions and IT services provider based in Pennsylvania and OST International, an outsourced IT support and consulting services provider based in Illinois.

Between 2003 and 2004, our consolidated net revenues increased 134%, or approximately $104.6 million, from $77.9 million in 2003 to $182.5 million in 2004 primarily due to the acquisitions of Ross, Pivotal, and Go2joy, as well as the inclusion of a full year of results from acquisitions made in 2003. Between 2004 and 2005, our consolidated net revenues increased 34%, or approximately $62.4 million, from $182.5 million in 2004 to $244.9 million primarily from the inclusion of Ross, Pivotal and Go2joy for the full year in 2005 and increased sales volumes in certain key products as discussed under the section entitled “Results of Operations” in Item 5 Operating Financial Review and Prospects. Between 2005 and 2006, our consolidated net revenues increased 26.4% or approximately $64.6 million, from $244.9 million in 2005 to $309.5 million in 2006, primarily as a result of acquisition related activities.

Our ability to achieve organic growth in our businesses is subject to a number of risks and uncertainties, including the following:

 

   

our investments in sales and marketing, research and development and personnel training could require significant resources and may not ultimately prove successful in generating organic growth;

 

   

we may not be successful in introducing our products and services into new markets, such as the emerging markets, including China and India, targeted by our Enterprise Software Group; and

 

   

our strategy to sell new products to our existing customer base, which has expanded through acquisitions, may not be successful or as profitable as we expect. Our customers sometimes do not find our other enterprise software applications to be as attractive. In addition, the revenues generated are often less than that of an independent third-party software supplier. The lower revenues are the result of the customer viewing the purchase of the cross-sold software product as only a module to its existing enterprise software solution, rather than a complete stand-alone software product and, therefore, being less willing to pay the full market price for the product than if the sale had been made by an independent third party.

Although we have experienced revenue growth in the past, primarily due to acquisitions, if we are unable to achieve organic growth in our businesses, there will be a material and adverse effect on our business, results of operations and financial condition. We cannot assure you that we will be able to achieve organic growth in our business.

From 2004 to 2006, we expanded our operations rapidly, both in size and scope, through acquisitions, and during 2007 and in the future need to integrate, manage and protect our interests in the businesses we acquire. We may experience difficulties in integrating, assimilating and managing the operations, technologies, intellectual property, products and personnel of our acquired businesses individually and cumulatively, and may need to reorganize or restructure our operations to achieve our operating goals. This may include creating or retaining separate units or entities within each of our operating segments. Our failure to integrate and manage our acquired businesses successfully could delay the contribution to profit that we anticipate from these acquisitions, and could have a material adverse effect on our business, results of operations and financial condition.

 

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We intend to continue to evaluate and pursue strategic acquisitions. We may incur significant costs in our efforts to engage in strategic transactions and these expenditures may not result in successful acquisitions. Furthermore, we may be unable to integrate our past or future acquisitions successfully, which could result in increased costs, divert management’s attention and materially and adversely affect our business, results of operations and financial condition.

We intend to continue to evaluate and pursue strategic acquisitions that can, among other things, broaden our customer base, provide enhanced geographic presence and provide complementary technical and commercial capabilities.

We believe that attractive acquisition candidates currently exist in our target markets for each of our business segments, and we continuously consider a number of transactions, some of which would be material to our operations and financial condition if consummated. Our ability to complete future acquisitions depends upon a number of factors that are not entirely within our control, including our ability to identify suitable acquisition candidates, negotiate acceptable terms, conclude satisfactory agreements and secure financing. We may incur significant costs arising from our efforts to engage in strategic transactions and these expenditures may not result in the successful completion of acquisitions.

We also may be unable to integrate our past or future acquisitions successfully. In order to realize the benefits anticipated from each acquisition, we need to conform the operational, managerial and financial controls, procedures and policies between our corporate headquarters and the businesses we have acquired, which may divert management’s attention, increase transaction costs and reduce employee morale. Our ability to integrate past and future acquisitions is subject to a number of risks, including:

 

   

our inability to retain and integrate key employees and manage employee morale;

 

   

our inability to integrate or combine different corporate cultures;

 

   

our inability to effectively integrate products, research and development, sales, marketing, accounting and finance functions and other support operations;

 

   

our inability to maintain focus on our day-to-day operations;

 

   

the discovery of unanticipated liabilities or other contingencies that we did not identify during the course of our due diligence investigations;

 

   

potential claims filed by terminated employees or contractors; and

 

   

our inability to adapt to local market conditions and business practices.

We could be prevented from, or significantly delayed in, achieving our strategic goals if we are unable to complete strategic transactions or successfully integrate acquired businesses. Our failure to complete strategic transactions or to integrate and manage acquired businesses successfully may materially and adversely affect our business, results of operations and financial condition.

Rapid growth and a rapidly changing operating environment strain our limited resources.

We have limited operational, administrative and financial resources, which may be inadequate to sustain the growth we want to achieve. As the demands of our customers change and if our business continues to expand, we will need to increase our investment in our network infrastructure, facilities and other areas of operations. If we are unable to manage our growth and expansion effectively, the quality of our products and services could deteriorate and our business may suffer. Our future success will depend on, among other things, our ability to:

 

   

adapt our products and services and maintain and improve the quality of our products and services;

 

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continue training, motivating and retaining our existing employees and attract and integrate new employees; and

 

   

develop and improve our operational, financial, accounting and other internal systems and controls.

We have identified material weaknesses in our internal control over financial reporting for the years ended December 31, 2005 and 2006. If we are unable to remediate the material weaknesses in our internal control over financial reporting, our ability to report timely and accurate financial information could be materially and adversely affected.

After we filed our Annual Report on Form 20-F for the year ended December 31, 2005, we identified errors in our previously filed consolidated financial statements and concluded that our financial statements for the years ended December 31, 2005, 2004 and 2003 included in our 20-F should be restated. We filed an amendment to our Form 20-F for the year ended December 31, 2005 with the Securities and Exchange Commission in July 2007.

In connection with our restatement, we also reevaluated our disclosure controls and procedures. This evaluation was performed under the supervision and with the participation of our management, including our CEO and CFO, to assess the effectiveness of the design and operation of our disclosure controls and procedures (as defined under the Exchange Act). Based on that evaluation, our management, including our CEO and CFO, concluded that our internal controls and disclosure controls and procedures were not effective as of December 31, 2005, 2004 and 2003 because of material weaknesses in our internal controls over financial reporting. As of the date hereof, these material weaknesses remain outstanding and management has further concluded that our internal control over financial reporting and our disclosure controls and procedures were not effective as of December 31, 2006.

A material weakness is defined as a significant deficiency or a combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of our annual or interim financial statements would not be prevented or detected by our personnel in the normal course of performing their assigned functions. We have identified material weaknesses relating to insufficient resources with the appropriate level of expertise in the accounting and finance organizations to ensure appropriate application of GAAP, particularly in the areas of accounting for income taxes, foreign currency translation adjustments related to goodwill and intangible assets and the accounting for certain of our non-routine transactions. We believe that these control deficiencies resulted primarily from a lack of senior accounting and finance personnel.

Since 2006, we have implemented, or plan to implement, certain measures to remediate the identified material weaknesses and to enhance our internal control over financial reporting processes.

Although we believe that our remediation actions represent ongoing improvement measures, we cannot assure you that our remediation plans will be effective in correcting our material weaknesses. These material weaknesses were not fully remediated as of December 31, 2006, and we have not yet tested and implemented all of our remedial actions and measures. Furthermore, we cannot assure you if or when we will be able to remedy these control deficiencies, that our independent accounting firm will agree with our assessment that such deficiencies have been fully remediated, or that additional material weaknesses or significant deficiencies in our internal control over financial reporting will not be identified in the future. If the control deficiencies

 

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we have identified recur, or if we identify additional deficiencies or fail to implement new or improved controls successfully in a timely manner, we may be unable to issue timely and accurate financial reports and investors could lose confidence in the reliability of our financial statements, and such conclusion could negatively impact the trading price of our class A common shares.

Several of our products and services are quite disparate and have very different uses and functionalities, and it is difficult to discern significant synergies between and among them, which limits the amount of integration, cost savings and cross-selling we may be able to achieve among our business segments.

We are a global company focused on enterprise software through our CDC Software business unit, on online games through our CDC Games business unit and on mobile applications and internet and media services through our China.com business unit. Several of our products and services are quite disparate and have very different uses and functionalities. As such, it is difficult to discern significant synergies between and among some of our business segments. For example, our Software segment focuses on delivering enterprise software applications and related services around the world for enterprise resource planning, supply chain management, customer relationship management, order management systems, human resource management and business intelligence. Our Online Games segment focuses on operating online games for the China market. Our Mobile Services and Applications segment focuses upon providing popular news and mobile applications services targeting the consumer market in China through wireless services such as short message service, multimedia message service, wireless application protocol and interactive voice response. Because our segments are quite distinct, there may be limits to the amount of integration, cost savings and cross-selling we may be able to achieve among our business segments.

While as of December 31, 2006, we had cash and cash equivalents of $223.5 million and total debt securities of $152.7 million, much of this cash balance is held at our China.com subsidiary, and we have limited ability to use these funds for our benefit or our other subsidiaries outside of the China.com chain of subsidiaries.

As of December 31, 2006, we had cash and cash equivalents of $223.5 million and total debt securities of $152.7 million. Of such amounts, $87.3 million of the cash and cash equivalents and $97 million of the total debt securities are held at China.com. China.com is a 77% owned subsidiary of ours listed on the Growth Enterprise Market of the Hong Kong Stock Exchange. Although we have the ability to appoint a majority of the board of directors of China.com, the board of directors of China.com owes fiduciary duties to all of the shareholders of China.com to act in the best interests of and use the assets of China.com, including the cash and cash equivalents balance and debt securities, for the benefit of such shareholders. As a result, aside from the board of directors of China.com declaring a dividend to its shareholders for which we would receive a pro rata portion as a 77% shareholder of China.com or a related party inter-company loan or similar transaction from China.com which would likely require the approval of the minority shareholders of China.com, we have limited ability to transfer or move the cash, cash equivalents and debt securities balance to us at the parent entity level, or to use the amounts of cash, cash equivalents and securities balance for the benefit of entities other than China.com and its subsidiaries.

We have significant fixed operating expenses, which may be difficult to adjust in response to unanticipated fluctuations in revenues, and therefore could have a material adverse effect on our operations.

A significant part of our operating expenses, particularly personnel, rent, depreciation and amortization, are fixed in advance of any particular quarter. As a result, an unanticipated decrease in the number or average size of, or an unanticipated delay in the scheduling for, our engagements may cause significant variations in operating results in any particular quarter and could have a material adverse effect on operations for that quarter. In the near-term, we believe our costs and operating expenses may increase in certain areas as we fund new initiatives and continue to pay for costs related to compliance with the Sarbanes-Oxley Act of 2002, mergers and acquisitions and other corporate initiatives we may undertake. Although we intend to strive to keep our costs and operating expenses in the near-term to a level that is in line with our expected revenue, we may not be able to increase our revenue sufficiently to keep pace with any growth in expenditures.

 

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Because we rely on local management for many of our localized CDC Software, CDC Games and China.com businesses, our business may be adversely affected if we cannot effectively manage local officers or prevent them from acting in a manner contrary to our interests or failing to act at our direction.

In connection with our strategy to develop our enterprise software products and services through our CDC Software business unit, online games through our CDC Games business unit and mobile applications and internet and media services through our China.com subsidiary, we have interests in companies in local markets where we have limited experience with operating assets and businesses in such jurisdictions, including enterprise software companies in the United States, Canada and Europe, business services companies in Australia, Korea and the U.S. and online games and mobile services and applications companies in the PRC. As a result, we rely on our local management and have limited oversight over these persons. If we cannot effectively manage our local officers and management, or prevent them from acting in a manner contrary to our interests or failing to act at our direction, these problems could have a material adverse effect on our business, financial condition, results of operations and share price.

We are exposed to potential risks of noncompliance with rules and regulations under Section 404 of the Sarbanes-Oxley Act of 2002.

Under Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, management is required to conclude on the effectiveness of internal controls over financial reporting for the fiscal year ending on or after December 31, 2006 as part of our Annual Report on Form 20-F. Our independent registered accounting firm is required to attest to, and report on, management’s assessment of the design and effectiveness of our internal controls as part of our Annual Report beginning with the fiscal year ending on or after December 31, 2007.

Under the supervision of, and with the participation of our management, we are continuing to evaluate and improve our internal controls in order to allow our registered independent public accounting firm to attest to, our internal controls, as required by Section 404. For the year ended December 31, 2006, management performed the system and process evaluation and testing required to complete management’s certification of internal control over financial reporting. We continue this process in 2007 in an effort to comply with the management certification and auditor attestation requirements of Section 404 for the year ended December 31, 2007. As a result, we have incurred, and will continue to incur, additional expenses and a diversion of management’s time. If we are not able to meet the requirements of Section 404, we might be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or NASDAQ. In addition, as a result of the evaluation of our internal controls, we have experienced, and continue to experience, material weaknesses in our internal controls over financial reporting, which are required to be publicly-reported. Either of the foregoing could adversely affect our financial results and the market price of our common shares.

If we need to raise additional capital in the future, it may not be available to us on favorable terms, if at all.

We may require additional capital in the future to pursue potential acquisitions or grow our business organically. We intend to meet our capital requirements through a variety of sources, including accessing the capital markets. If we are unable to obtain capital on favorable terms, or if we are unable to obtain capital at all, it could have a material and adverse effect on our business, results of operations and financial condition.

Risks Relating to Our International Operations

A large part of our business is international and, as a result, there are a number of factors beyond our control associated with international operations that could materially and adversely affect our business, results of operations and financial condition.

 

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Approximately 58% and 57% of our total revenues in 2005 and 2006, respectively, were derived from customers outside of North America. We anticipate that revenues from customers outside the United States will continue to account for a significant portion of our total revenues in the future, particularly as we intend to expand into targeted emerging markets, such as the PRC. Our operations outside the United States are subject to additional risks, including:

 

   

changes in or interpretations of U.S. or foreign law that may materially and adversely affect our ability to sell our products, perform services or repatriate profits to the United States;

 

   

the imposition of tariffs;

 

   

hyperinflation or economic or political instability in foreign countries;

 

   

imposition of limitations on or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries;

 

   

conducting business in places where business practices and customs are unfamiliar and unknown or prohibited by applicable law;

 

   

the imposition of restrictive trade policies, including changes in export restrictions;

 

   

worldwide political conditions;

 

   

the imposition of inconsistent laws or regulations;

 

   

the imposition or increase of investment requirements and other restrictions by foreign governments;

 

   

difficulty in staffing and managing our operations;

 

   

different seasonal and other trends in business activities;

 

   

longer collection cycles for accounts receivable;

 

   

uncertainties relating to foreign laws and legal proceedings;

 

   

having to comply with a variety of U.S. laws, including the Foreign Corrupt Practices Act;

 

   

having to comply with U.S. export control regulations and policies that restrict our ability to communicate with non-U.S. employees and supply foreign affiliates and customers with products and services; and

 

   

adverse determinations or findings by applicable export control authorities restricting our ability to export goods and services.

A change in currency exchange rates could increase our costs relative to our revenues.

Our revenues, expenses and liabilities are denominated in a number of currencies, including Australian dollars, British pounds, Canadian dollars, Euros, Renminbi, South Korean won, Swedish Kronas and U.S. dollars. However, our financial results are reported in U.S. dollars. In the future, we may also conduct business in additional foreign countries and generate revenues, expenses and liabilities in other foreign currencies. As a result, we are subject to the effects of exchange rate fluctuations with respect to any of these currencies and the related interest rate fluctuations. We have not entered into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future.

 

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Global events beyond our control may disrupt our operations and harm our business, results of operations and financial condition.

Our business may be materially and adversely affected by a war, terrorist attack, third-party acts, natural disaster or other catastrophe. Such a catastrophic event could have a direct negative impact on us, our customers, the financial markets or the overall economy. It is impossible to fully anticipate and protect against all potential catastrophes. A security breach, criminal act, military action, power or communication failure, flood, hurricane, severe storm or the like could lead to service interruptions, data losses for customers, disruptions to our operations, or damage to our facilities, and could reduce acceptance and reliance on our products. Any of these could have a material and adverse effect on our business, results of operations and financial condition. In addition, we may incur costs in repairing any damage or other liabilities beyond our applicable insurance coverage.

Risks Relating to Our Enterprise Software Group

Our strategy of developing and acquiring products for specific industry segments, or targeted vertical industries, may not be successful, which could materially and adversely affect our business, results of operations and financial condition.

Our strategy at CDC Software focuses on the development of industry-specific enterprise software applications. This strategy may not be successful due to numerous risks and uncertainties, including the following:

 

   

companies in our targeted vertical industries may not select our products;

 

   

many of our targeted vertical industries are subject to their own economic cycles, regulatory considerations and other factors beyond our control. For example, the homebuilding and real estate vertical industry is sensitive to interest rate movements and the healthcare vertical industry is subject to significant governmental regulations;

 

   

some of our products have only been recently introduced, so they have neither a significant installed base of users nor significant recognition in their targeted vertical industry;

 

   

development of industry-specific products is time-consuming and requires significant expertise;

 

   

we may experience difficulty in recruiting sales, business and technical personnel who have experience in a particular targeted vertical industry;

 

   

due to resource constraints, we have a limited number of developers who can focus on product development for our targeted vertical industries; and

 

   

if we decide to devote our limited resources to a targeted vertical industry, such as by dedicating a sales representative to a particular market, then that resource may not be available to focus on sales to our other targeted vertical industries.

If this strategy of developing products for specific vertical industries is not successful, our business, results of operations and financial condition will be materially and adversely affected.

Our failure to successfully develop, introduce, market or sell new products or adopt new technology platforms could have a material and adverse effect on our business, results of operations and financial condition.

The enterprise software applications market is characterized by rapid technological advances in hardware and software development, evolving standards in computer hardware and software technology and frequent new product introductions and enhancements that may render existing products and services obsolete.

 

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While we continually seek to expand and refresh our product offerings to include newer features, products, technologies and standards, and enter into agreements allowing the integration of third-party technology into our products, we may not be able to compete effectively or respond to rapid technological changes in our industry. In addition, the introduction of new products or updated versions of existing products has inherent risks, including, but not limited to, risks concerning:

 

   

product quality, including the possibility of software defects, which could result in claims against us or the inability to sell our software products;

 

   

the fit of the new products and features with a customer’s needs;

 

   

the need to educate our sales, marketing and consulting personnel to work with the new products and features, which may strain our resources and lengthen sales cycles;

 

   

market acceptance of initial product releases;

 

   

marketing effectiveness; and

 

   

the accuracy of research or assumptions about the nature and extent of customer demand.

In addition, we may need to adopt newer technology platforms for our enterprise software products as older technologies become obsolete. We may not be successful in making the transition to new technology platforms for our products in the future. We may be unable to adapt to the new technology, may encounter errors resulting from a significant rewrite of the software code for our products or may be unable to complete the transition in a timely manner. In addition, as we transition to newer technology platforms for our products, our customers may encounter difficulties in the upgrade process, delay decisions about upgrading our products or review their alternatives with another supplier or competitor. Any of these risks could materially and adversely affect our business, results of operations and financial condition.

Because we commit substantial resources to developing new software products and services, if the markets for these new products or services do not develop as anticipated, or demand for our products and services in these markets does not materialize or materializes later than we expect, we will have expended substantial resources and capital without realizing sufficient offsetting or resulting revenues, and our business and operating results could be materially and adversely affected. In 2006, our research and development expense was $20.0 million, or approximately 6.5% of our total consolidated net revenues. In addition, as we or our competitors introduce new or enhanced products, the demand for our older products and older versions of such products is likely to decline. If we are unable to provide continued improvements in the functionality of our older products or move customers with our older products to our newer products, maintenance and license revenues from older products may decline, which could have a material and adverse effect on our business, results of operations and financial condition.

We may not receive significant revenues from our research and development efforts for several years.

Developing, enhancing and localizing software is expensive, and the investment in product development may involve a long payback cycle. In 2006 our research and development expense was $20.0 million or approximately 6.5% of our total consolidated net revenues. Our future plans include significant additional investments in software research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. However, we do not expect to receive significant revenues from these investments for several years, if at all.

Revenues from our Enterprise Software Group fluctuate significantly from quarter to quarter, which may cause volatility in our business, results of operations and financial condition and the trading price of our Class A common shares.

 

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During 2004, 2005 and 2006, our Enterprise Software Group, accounted for 59%, 65% and 57%, respectively, of our total revenues. Our Enterprise Software Group together with our Business Services Group comprises our CDC Software Business Unit.

In addition, many factors have caused, and may continue to cause, revenues from our Enterprise Software Group to fluctuate significantly, including:

 

   

the practice of recognizing a substantial portion of our software license revenues in the last month of a quarter, and often in the last weeks or days of a quarter, which may result in increased volatility in quarterly revenues if customers decide to defer or cancel orders or implementations, particularly large orders or implementations, from one quarter to the next;

 

   

the gain or loss of any significant customer;

 

   

the number, timing and significance of new product announcements and releases by us or our competitors;

 

   

our ability to acquire or develop products, independently or through strategic relationships with third parties, or introduce and market new and enhanced versions of our products on a timely basis, which may result in a customer delaying the execution of a contract or, for contracts that include a new software release as an element of the contract, the deferral of revenue recognition until such release;

 

   

shipment rescheduling or delays;

 

   

reductions in the historical rate at which opportunities in our pipeline convert into license agreements;

 

   

patterns of capital spending and changes in budgeting cycles by our customers. For example, in 2001 and continuing through most of 2003, capital spending for enterprise software applications was negatively impacted by challenging economic conditions in the United States, Europe and Asia;

 

   

market acceptance of new and enhanced versions of our products;

 

   

changes in the pricing and the mix of our products and services;

 

   

seasonal variations in our sales cycle;

 

   

the level of product and price competition;

 

   

exchange rate fluctuations; and

 

   

changes in personnel and related costs.

In addition, we expect that a substantial portion of our enterprise software application revenues will continue to be derived from renewals of maintenance contracts from customers of our software applications. These maintenance contracts typically expire on an annual basis, and if they are not renewed, the timing of cash collections from related revenues will vary from quarter to quarter, which could materially and adversely affect our business and results of operations.

Some customers are reluctant to make large purchases before they have had the opportunity to evaluate the performance of our software applications in their business and opt to purchase our products in stages or

 

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subject to certain conditions. Additional purchases, if any, may follow only if the software performs as expected. To the extent the number of customers who opt to purchase in stages or subject to conditions remains significant or increases, our revenues could be materially and adversely affected.

We have been increasingly moving software development capabilities for our enterprise software applications to India and China, which subjects us to several risks that may affect our business, results of operations and financial condition.

We have been increasingly moving software development capabilities for our enterprise software applications to India and China. We have established a CRM-focused software development center in Bangalore, India and an ERP and SCM-focused software development center in Shanghai, China. Such off-shoring subjects us to various risks, including the following:

 

   

inability to hire sufficient qualified programmers and developers in these markets;

 

   

risks associated with turnover of programmers and developers, particularly where we have devoted significant time and resources to train such persons to be familiar with our enterprise software applications;

 

   

challenges due to the need to remotely manage developers and programmers in India and China, particularly when the persons most familiar with the needs of the customer and the desired new functionality and features are not located in India and China;

 

   

language and other communications barriers, particularly with software development in China; and

 

   

time zone differences, which make communicating with persons in India and China more difficult.

If we are unable to successfully grow our direct and indirect sales channels, our ability to organically grow our business will be harmed.

To date, we have sold our products primarily through our direct sales force, particularly in North America. Our future revenue growth will depend in large part on recruiting, training and retaining direct sales personnel and expanding our indirect distribution channels. These indirect channels include value-added re-sellers, or VARs, original equipment manufacturers, or OEMs, partners, systems integrators and consulting firms.

We may experience difficulty in recruiting and retaining qualified sales personnel and in establishing third-party relationships with VARs, OEMs, partners, systems integrators and consulting firms, in part because our products are designed for certain targeted vertical industries, which means we seek persons with significant experience and expertise in these markets who may be difficult to locate and retain. If we are unable to successfully grow our direct and indirect sales channels, our ability to organically grow our business will be harmed. In addition, we are exposed to the risk that the third parties through which we indirectly sell our products and services will not devote sufficient time, attention and resources to learning our products, markets and potential customers, which could materially and adversely affect our reputation and the reputation of our products in the market.

The market for enterprise software applications and services is highly competitive, and any failure by us to compete effectively in such market could have a material and adverse effect on our business, results of operations and financial condition.

The business information systems industry in general, and the enterprise software industry in particular, are highly competitive and subject to rapid technological change. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical and marketing resources, greater name

 

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recognition, larger technical staffs and a larger installed customer base than we do. A number of companies offer products that are similar to our products and target the same markets as we do. In addition, many of these competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, and devote greater resources to the development, promotion and sale of their products than we can. Furthermore, because there are relatively low barriers to entry in the software industry, we expect additional competition from other established and emerging companies. Such competitors may develop products and services that compete with our products and services or may acquire companies, businesses and product lines that compete with us. It is also possible that competitors may create alliances and rapidly acquire a significant market share. Accordingly, our current or potential competitors may develop or acquire products or services comparable or superior to those that we develop, combine or merge to form significant even more competitors or adapt more quickly than we can to new technologies, evolving industry trends and changing customer requirements. Competition could result in price reductions, reduced margins or loss of market share, any of which could materially and adversely affect our strategy in this market. If we are unable to compete effectively, our business, results of operations and financial condition could be materially and adversely affected.

 

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Our major competitors include:

 

   

enterprise resource planning, or ERP, providers, including Epicor, Infor Global Solutions, Microsoft Corporation, Oracle/Peoplesoft, QAD, Inc., SAP AG, Sage Group and various local providers in the Greater China market such as FlexSystem Holdings Ltd., Kingdee International Software Group Company Limited and UFIDA Software Co. Ltd.;

 

   

customer relationship management, or CRM, providers, including Chordiant Software, Inc., Infor Global Solutions, Microsoft Corporation, Onyx Software Corporation, Oracle/Peoplesoft, Salesforce.com, SalesLogix (part of Best Software/Sage Group plc), SAP AG and Siebel Systems, Inc.;

 

   

supply chain management, or SCM, providers, including Aspen Technologies, i2 Technologies, Inc., Infor Global Solutions, Logility Inc., Manhattan Associates and Manugistics Group, Inc.;

 

   

human resource management, or HRM, providers, including Oracle/Peoplesoft, SAP AG, and various local providers in the Greater China market, including BenQ Group, Cityray Technology (China) Ltd., Kingdee International Software Group Co., Ltd., Shanghai Kayang Information System Co., Ltd., Strategy Software Systems Co., Ltd, UFIDA Software Co. Ltd. and Vanguard Software Corporation;

 

   

business intelligence, or BI, providers, including Business Objects SA, Cognos, Inc., Hyperion, Inc. and SAS Institute, Inc.; and

 

   

information technology consulting and outsourcing service providers including Accenture Ltd., Cambridge Technology Partners Inc., Cap Gemini, Electronic Data Systems Corporation, IBM Global Services, Infosys Technologies, Wipro Ltd., and various niche local service providers specializing in IT outsourcing services.

Many of these companies are well funded with long operating histories of profitable performance. They possess a number of tangible strengths and advantages, including high quality client lists and high numbers of highly qualified staff, complemented by extensive operating infrastructures. The principal competitive factors in the market for enterprise software application software include product reputation, product functionality, performance, quality of customer support, size of installed base, financial stability, corporate viability, hardware and software platforms support, price, and timeliness of installation.

Our ability to sell our products is highly dependent on the quality of our service and support offerings, and our failure to offer high-quality service could have a material adverse effect on our ability to market and sell our products.

Our customers depend upon our customer service and support staff to resolve issues relating to our products. High-quality support services are critical for the successful marketing and sale of our products. If we fail to provide high-quality support on an ongoing basis, our customers may react negatively and we may be materially and adversely affected in our ability to sell additional products to these customers. This could also damage our reputation and prospects with potential customers. Our failure to maintain high-quality support services could have a material and adverse effect on our business, results of operations and financial condition.

Risks Relating to Our Business Services Group and the Professional Services Provided by Our Enterprise Software Group

Because most of our business services contracts can be cancelled with limited notice and without significant penalty, we could suffer a significant loss of business service revenues if our clients were to unexpectedly terminate their contracts.

 

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The standard terms for many of our business services contracts include an up-front payment of a relatively low percentage of the total fee of the contract with the balance of the payments subject to our achieving specific milestones and deliverables. We generally do not require collateral for accounts receivable, and generally, final payments are not due until completion of successful user acceptance testing. In addition, most of our business services contracts can be cancelled by the client with limited advance notice and without significant penalty. Termination by any client of a contract for our services could result in a loss of expected revenues, additional expenses for redeployment of staff and resources that were allocated to the terminated engagement, and underutilized employees and resources. Any unexpected cancellations or significant reductions in the scope of any of our large business services projects could have a material and adverse effect on the business of our business services companies, particularly those companies that depend upon a relatively small number of key clients for a substantial portion of their revenues. Should any of those key clients unexpectedly terminate their contracts for our services, we may suffer a significant loss of revenues for such companies which, in turn, could have a material and adverse effect on our business, results of operations and financial condition.

If our Business Services Group fails to compete effectively, our business, results of operations and financial condition could be materially and adversely affected.

Our Business Services Group, which consists primarily of many smaller, regionally-focused subsidiaries that operate primarily in Australia and parts of the United States, faces intense competition. Many of our existing competitors, as well as a number of potential new competitors, have longer operating histories, greater name recognition, larger customer bases and greater financial, technical and marketing resources than we do. We also face competition from many of the large Asia/Pacific-based outsourcing firms. Any of our present or future competitors may provide services that provide significant performance, price, creative or other advantages over those offered by our Business Services Group. We may not be able to compete successfully against our current or future competitors, particularly as markets continue to consolidate, change and mature.

If we fail to accurately estimate the resources and time required for any engagements we enter into on a fixed-price basis, we could experience cost overruns and be subjected to penalties.

A significant portion of our Business Services Group’s engagements consist of individual, non-recurring, short-term projects billed on a fixed-price basis, as distinguished from billing on a time and materials basis. In addition, while most of our professional services engagements associated with the sale and implementation of our enterprise software applications are billed on a time and materials basis, some of our engagements are also contracted on a fixed-price basis. These fixed-price engagements require us, at times, to commit unanticipated additional resources to complete these engagements, which may result, and has in the past resulted, in losses on certain engagements. Clients may also change the scope of the projects on which we are engaged. Our failure to accurately estimate the resources and time required for a particular engagement or to effectively manage client expectations and changes regarding the timing and scope of the services to be delivered could expose us to risks associated with cost overruns and penalties, any of which could have a material and adverse effect on our business, results of operations and financial condition.

Because some of our business services contracts do not have disclaimers of, or limitations on, liability for special, consequential and incidental damages, we may be exposed to potential litigation and liabilities.

A large portion of our service agreements with customers of our Business Services Group do not have disclaimers or limitations on liability for special, consequential and incidental damages, and/or do not have caps on liabilities or have relatively high caps on the amounts our customers can recover for damages. In addition, some of our subsidiaries do not carry professional indemnity or other insurance against liability for any claims or breaches under our customer contracts. If a dispute were to arise with respect to one of these agreements, we would likely be held liable for the obligations of these subsidiaries that do not carry insurance.

 

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Claims relating to our business services contracts have arisen and may arise in the future. Any claim under customer contracts could subject us to litigation and give rise to substantial liability for damages, including special, consequential or incidental damages, that could materially and adversely affect our business, results of operations and financial condition.

Each of our business services businesses face intense competition. If we fail to compete effectively, our failure could have a material adverse effect on our business financial condition and results of operation.

Each of our business services businesses, many of which are smaller in size and operate in localized regional markets (such as Australia, Korea, and the northeast United States) face intense competition. A significant portion of the revenues from some of our business services companies is obtained through key software owners who use our businesses as channel partners on a non-exclusive basis. Should any of those key partners decide to sell their software or provide services directly into our market, or use other service providers, this could result in a loss of expected revenues.

In addition, many of our existing competitors, as well as a number of potential new competitors, have longer operating histories in each of our target business services markets, greater name recognition, larger customer bases and greater financial, technical and marketing resources when compared to us. For example, as our business evolves to place greater emphasis on outsourced software development and support services, we will face competition from many of the large Asia Pacific-based outsourcing firms such as Infosys Technologies Ltd and Wipro Ltd. Any of our present or future competitors may provide products and services that provide significant performance, price, creative or other advantages over those offered by us. We can provide no assurance that we will be able to compete successfully against our current or future competitors, particularly as markets continue to consolidate, change or mature.

Risks Relating to Our Online Games Business

Our limited relevant operating history and the unproven long-term potential of our online game business model make evaluating our business and prospects difficult.

We commenced the distribution and operation of our first free to play massive multi-player online role playing game, or MMORPG, Yulgang, in July 2005, and plan to commercially launch additional online games in China in the future. In addition, we have launched an open beta program for Special Force, the first free-to-play, pay-for-merchandise FPS (first person shooter) game in China. We also plan to launch Stone Age 2, The Lord of the Rings Online and several additional games. Many of our online games are in the beta test phase or in earlier stages of development. As a result, we have a limited relevant operating history for you to evaluate our business. It is also difficult to evaluate our prospective business, because we may not have sufficient experience to address the risks frequently encountered by early stage companies using new and unproven business models and entering new and rapidly evolving markets, including the online game market.

These risks may include our potential failure to:

 

   

retain existing customers and attract new customers;

 

   

develop, or acquire additional online games that are appealing to users;

 

   

anticipate and adapt to rapidly changing consumer tastes and preferences;

 

   

adapt to competitive market conditions;

 

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timely respond to technological changes and challenges or resolve unexpected network interruptions;

 

   

properly predict the popularity, price and timing of new online games offered by us and our competitors;

 

   

provide timely upgrades to our games to extend their commercial lifespan;

 

   

successfully expand our operations within and outside of China;

 

   

protect the security of our servers and software against hackers;

 

   

adequately and efficiently operate, upgrade and develop our transaction and service platform;

 

   

maintain adequate control of our expenses;

 

   

attract and retain qualified personnel;

 

   

maintain solid relationships with our developer partners and our distribution customers;

 

   

diversify our revenues into different genres of games;

 

   

diversify our revenues reliance across different countries;

 

   

maintain adequate internal security and controls;

 

   

find cost effective ways to continue to market existing and new online games;

 

   

secure and retain the appropriate government licenses associated with each online game;

 

   

work with our developer partners in continuing to provide content updates to existing games; and

 

   

work with our developer partners to prevent illegal access and hacking activities to the online games.

If we are unsuccessful in addressing any of the risks listed above, our games and our overall business will be materially and adversely affected.

As we currently depend on one game for almost all of our online games revenue and profits, any adverse developments relating to this game may adversely affect our future results of operations.

More than 95% of our online game revenues and profits are currently derived from one game, Yulgang. We intend to acquire or develop new games in the future. The costs associated with commercializing and developing each new online game are substantial, and the substantial majority of these costs are incurred prior to meaningful revenue generation from the online game. The combination of our current reliance on a single online game and the significant costs associated with commercializing each new online game may cause our results of operations to fluctuate significantly, and poor operating results for any one game or a delay in the planned launch of a new game could materially affect us, making the investment risks related to any one online game larger than those associated with competitors that currently have a more broadly established set of online game offerings. Our dependence on a single game for substantially all of our games revenue could materially and adversely affect our future results of operations.

 

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If we are unable to consistently license, acquire or develop additional new online games, our games business will be harmed.

Our long-term growth strategy requires us to continue to consistently license, develop or acquire new online games that are attractive to users. A primary component of our strategy for strengthening ties to online game developers is to make early-stage investments in start-up online game developers in return for distribution and other rights. We have made, and intend to continue to make, these investments in companies with limited or no operating history. These investments may be unsuccessful.

Our ability to successfully license online games that are attractive to users depends in part on the availability of these games at acceptable costs, our ability to compete effectively to attract the licensors of online games, and our ability to identify games and developers that will be commercially successful. At the testing phase, it is difficult to determine whether an online game will appeal to our users. Many games licensed by overseas developers were not designed specifically for China’s online game market, further complicating the task of identifying or implementing games that will appeal to our users. Moreover, due to increased competition among online game operators in China, the terms upon which we may license games are less favorable to us since upfront license fees for licensed games have increased and some licensors are demanding guaranteed minimum royalty payments. We may be unable to fully recover upfront and minimum royalty licensing costs if a licensed game does not gain acceptance with users.

Furthermore, our ability to license games that are developed outside of China and imported into China, on an ongoing basis, may be limited by any laws, rules, regulations limitations or quotas that may be enacted by the PRC government and other governments, or that may be in effect from time to time. Any such limitation on our ability to license such games would have a material adverse effect on our present and future business, financial condition and results of operations.

Our ability to internally develop successful online games depends on our ability to successfully develop this internal capability, anticipate changing consumer tastes and preferences, to adopt new technologies, to attract, retain and motivate talented online game developers and to effectively execute online game development plans. Internal online game development requires substantial investment prior to commercial launch and a significant commitment of future resources. In addition, we have never developed proprietary online games, and may not be successful in developing proprietary online games in the future.

Finally, we believe that the online game market in China is moving toward casual games. Casual games tend to have a shorter commercial lifespan than MMORPGs, further increasing the importance of maintaining a consistent pipeline of new games.

If we are not able to consistently license, acquire or develop additional attractive online games, particularly those with lasting appeal to users, our financial condition and results of operations may be materially and adversely affected.

If we are unable to maintain stable relationships with the licensors of our online games, we may experience difficulties with the continued operation of our existing licensed games, the extension of existing licenses and the granting of licenses for new games.

We must maintain stable working relationships with our licensors to facilitate the continued smooth operation of our licensed online games and our continued access to new online game licenses. We depend on our licensors to provide necessary technical support for the operation of our licensed games as well as expansion packs and upgrades that help to sustain interest in our games among online users. In addition, certain marketing activities often require the consent of our licensors. Moreover, certain of our licenses may

 

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be terminated or fail to be renewed by the licensor. If a licensed game is successful during its initial term of operation, we may be required to negotiate with our licensors to extend that term of operation, which may be unavailable on reasonable terms, or at all. Our ability to maintain stable working relationships with our overseas licensors also affects our ability to license new online games developed by the same or other licensors. If we are unable to maintain stable relationships with our licensors, our financial condition and results of operations may be materially and adversely affected.

 

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We may not be able to successfully implement our growth strategies, which could materially and adversely affect our business, financial condition and results of operations.

We are currently pursuing a number of growth strategies, including offering additional MMORPGs and casual games. Some of these strategies relate to new services and products for which there are no established markets in China or are in areas which we lack experience and expertise. Moreover, the development cycle for online games is long, ranging up to several months or years. Further, the creative process inherent in video game development makes the length of the development cycle difficult to predict, especially in connection with online games involving new technologies. As a result, we may experience delays in online game introductions. If an unanticipated delay affects the release of an online game, we may not achieve anticipated revenues for that game and such delay could require us to spend more to accelerate completion of the game, which would increase our costs and lower our margins, and could affect the development schedule for future online games. We may not be able to deliver new products or services on a commercially viable basis or in a timely manner, or at all. If we are unable to successfully implement our growth strategies, our competitive position may be harmed and our business, financial condition and results of operations may be materially and adversely affected.

If consumer tastes and preferences move away from online games or the games that we offer, particularly MMORPGs, the revenues and profitability derived from our games business will likely decline.

Our ability to successfully plan for product development and distribution and promotional activities depends significantly on our ability to anticipate and adapt to rapid changes in consumer tastes and preferences. Currently, one of the most popular types of online games in China are MMORPGs, and we expect to continue to rely on MMORPGs for a significant percentage of our revenues in the near future. The popularity of MMORPGs in China may decline, and their status as one of the most popular types of online games in the Chinese online game industry may be replaced by new and different types of online or other games, such as casual games. A decline in the popularity of online games in general or the games that we offer, particularly MMORPGs, will likely harm our revenues and profitability.

If we are unable to successfully launch and operate our new online game types, our future results of operations will be adversely affected and we may not generate sufficient revenues to consistently develop new online games.

We plan to commence beta testing and/or launch several online games during 2007 and afterwards, and plan to invest a significant amount of financial and personnel resources in launching and operating these and other new games. These games have limited or no successful operating history in China. If our new online games fail to gain market acceptance, our future results of operations will be adversely affected and we may not generate sufficient revenues to consistently introduce new online games, which is critical to our business.

Our introduction of new online games may negatively impact our existing online games and harm the growth and profitability of our games business.

We expect that as we introduce new games, a portion of our existing customers will reduce their spending on our then-current games or switch to these new games. If this reduction in play or switching of players from our existing games exceeds our expectations, we may have to adjust our marketing, pricing and other business plans. Any revenues generated by new online games may be offset, at least in part, by loss of revenues from our current online games, harming our growth and profitability.

Undetected programming errors or flaws in our online games could harm our reputation or decrease market acceptance of our online games, which would harm our business.

 

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Our online games may contain errors or flaws, particularly as we launch new games or introduce new features to existing games under tight time constraints. We believe that if our online games contain programming errors or other flaws, our users may be less inclined to continue playing or resume playing them or recommend them to other potential users, and they may switch to a competitor's games. Undetected programming errors and game defects can disrupt our operations, adversely affect the game experience of our users, harm our reputation, cause our users to stop playing our current or future online games, divert our resources and delay market acceptance of our online games, any of which would harm our business.

Negative publicity in China regarding online games could lead to additional government regulations that may have a material and adverse impact on our business, financial condition and results of operations.

The media in China has reported incidents of violent crimes allegedly inspired by online games, as well as incidents of theft of online game virtual items among users. In addition, incidents of excessive online game playing and allegations that online games distract students and interfere with their education have also been reported in the media. This negative publicity has contributed to several regulatory initiatives, such as:

 

   

In June 2005, the Ministry of Culture and the Ministry of Information Industry jointly issued an opinion which requires online game operators to develop systems and software for identity certification, to implement anti-addiction modifications to game rules and to restrict players under eighteen years of age from playing certain games.

 

   

In August 2005, the State Administration of Press and Publications, or SAPP, proposed an online game anti-addiction system that would have reduced and eliminated experience points that a user can accumulate after three and five hours of consecutive playing, respectively.

 

   

In March 2006, SAPP amended its proposal to require players to register with their real names and identity card numbers and to apply the anti-addiction system only to players under eighteen years of age.

 

   

In April 2007 we became subject to the Online Game Anti-addiction System Development Standard and are required to comply therewith.

Anti-addiction laws and regulations in China could have a material and adverse impact on our business, financial condition and results of operations.

On April 5, 2007, eight PRC governmental agencies, including the Ministry of Education, Ministry of Information Industry, the General Administration of Press and Publication and the Ministry of Public Security jointly promulgated the Notice on the Implementation of Online Game Anti-Addiction System to Protect the Physical and Psychological Health of Minors. Under this anti-addiction notice, all online game operators, including us, are required to develop a system according to the Online Game Anti-addiction System Development Standard, which was released as an attachment to the notice, and the corresponding Identity Authentication Scheme of the anti-addiction system developed for our online games is aimed to reduce “fatigue time” and “unhealthy time” such that, when a user under the age of 18 has been playing an online game for more than three consecutive hours, he or she will automatically be sent periodic warnings within the game environment prompting him or her to leave the game and rest. Such warnings will become more frequent as the user accumulates more playing time. In addition, this system will cause the rate at which the game user can obtain experience points and other virtual items such as special equipment to decrease to half the normal levels during the “fatigue time” period and to zero during the “unhealthy time” period. According to the anti-addiction notice, the anti-addiction system shall be put into operation in all online games from July 16, 2007. The implementation of this anti-addiction notice in China could have a material and adverse impact on our business, financial condition, and results of operations. In addition, anti-addiction laws and regulations may apply or may develop in certain overseas markets in which we conduct our business and could have a material and adverse impact on our business, financial condition and results of operations in such markets.

 

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Also, in March 2006, the Chinese government announced an authentication system which requires all players to enter their identification card numbers before being allowed to play online games. This authentication system as well as the new anti-addiction regulations could have a material adverse effect on our business, financial conditional and results of operations.

 

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Acquisitions and investments may have an adverse effect on our ability to manage our business.

Our growth strategy involves the acquisition of, and investments in, new technologies, businesses, products and services, or the creation of strategic alliances in areas which we do not currently operate. For example, we have recently made significant investments in video game companies such as Auran, Gorilla Banana and MGame Corporation. We have limited experience in evaluating investments in gaming companies and integrating acquired companies or assets into our business. Accordingly, we believe that investment, acquisition and integration will require significant attention from our management and could require that our management develop expertise in new areas and manage new business relationships. The diversion of our management’s attention and any difficulties encountered in the integration process could have an adverse effect on our ability to manage our business.

Acquisitions and investments will also expose us to potential risks, including risks associated with:

 

   

the assimilation of new operations, technologies and personnel;

 

   

unforeseen or hidden liabilities;

 

   

the financial loss of our investment or the failure to receive any benefit from our investment;

 

   

the diversion of resources from our existing businesses, sites and technologies;

 

   

the inability to generate sufficient revenues to offset the costs and expenses of acquisitions; and

 

   

the potential loss of, or harm to, our relationships with employees, customers, licensors and other suppliers as a result of integration of new businesses.

Our ability to grow through acquisitions or investments will depend on the availability of suitable acquisition and investment candidates at an acceptable cost, our ability to compete effectively to attract these candidates, and the availability of financing to complete larger acquisitions or investments. The benefits of an acquisition or investment may also take considerable time to develop and we cannot assure you that any particular acquisition or investment will produce the intended benefits, if any.

We may be unable to compete successfully against new entrants and established industry competitors.

We face intense competition in the online games market in China. There are numerous online game operators in China. Given the relatively low barriers to entry, we expect more companies to enter the online game industry in China and a wider range of online games to be introduced into the China market. Our competitors vary in size and include large companies such as Shanda Interactive Entertainment Limited, Netease.com, Inc., The9 Limited and Sina Corporation, many of which have significantly greater financial, marketing and game development resources and name recognition than we have. As a result, we may be unable to devote adequate resources to developing, licensing or acquiring new games, undertaking extensive marketing campaigns, adopting aggressive pricing policies, paying high compensation to game developers or compensating independent game developers to the same degree as some of our competitors. Any of our competitors may offer online games with better game performance, more attractive pricing, more developed storylines or other improvements over the games offered or to be offered by us. In addition, the increased competition we anticipate in the online game industry may also reduce the number of our users or growth rate of our user base, reduce the average revenues generated by our users, or cause us to reduce our fees. All of these competitive factors could adversely affect our business and results of operations.

We depend upon third parties for the printing, distribution and delivery of our prepaid point cards to users. If these companies mishandle our cards or the related passcodes or if there are production or delivery defects or delays, our reputation and business would be harmed.

We depend primarily on third parties for the printing, distribution and delivery of our prepaid point cards to more than 200,000 retail points of sale in China. These cards are generally produced in large batches,

 

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with each card having an individual passcode that enables the purchaser to deposit the points on the card into their online user account. Before the cards are purchased by our users, we activate them on our internal systems. If our partners mishandle these cards or the related passcodes, if there are production or distribution defects or delays, or if we encounter difficulty with our internal systems, our reputation, business and results of operations would be materially and adversely affected and harmed.

The limited use of personal computers in China and the relatively high cost of Internet access with respect to per capita income may limit the development of the Internet in China and impede our growth.

Although the use of personal computers in China has increased in recent years, the penetration rate for personal computers in China is much lower than that in the United States. In addition, despite a decrease in the cost of Internet access in China due to a decrease in the cost of personal computers and the introduction and expansion of broadband access, the cost of Internet access remains relatively high in comparison to the average per capita income in China. The limited use of personal computers in China and the relatively high cost of Internet access may limit the potential number of users and therefore the growth of our business. Furthermore, any increase in the cost of Internet access or personal computers or a decline or slowdown of the China economy, which could affect our users or potential users disposable income, could reduce the number of users or potential users that play or may play our online games.

The PRC government has announced its intention, and has begun, to intensify its regulation of Internet cafés, which are currently the primary venue for our users to play online games. Intensified government regulation of Internet cafés could restrict our ability to maintain or increase our revenues and expand our customer base.

In April 2001, the PRC government began tightening its regulation and supervision of Internet cafés. In particular, a large number of unlicensed Internet cafés have been closed. In addition, the PRC government has imposed higher capital and facility requirements for the establishment of Internet cafés. Furthermore, the PRC government’s policy, which encourages the development of a limited number of national and regional Internet café chains and discourages the establishment of independent Internet cafés, may slow down the growth of Internet cafés. Recently, the State Administration of Industry and Commerce, one of the government agencies in charge of Internet café licensing, issued a notice suspending the issuance of new Internet café licenses. It is unclear when this suspension will be lifted, if at all. So long as Internet cafés are the primary venue for our users to play online games, any reduction in the number, or any slowdown in the growth, of Internet cafés in China could limit our ability to maintain or increase our revenues and expand our customer base, thereby reducing our profitability and growth prospects.

Currently there are no laws or regulations in the PRC specifically governing virtual asset property rights and therefore, it is not clear what liabilities, if any, online game operators may have for virtual assets.

In the course of playing online games, some virtual assets, such as special equipment, player experience grades and other features of our users’ game characters, are acquired and accumulated. These virtual assets can be important to online game players and in some cases are exchanged between players for monetary value. In practice, virtual assets can be lost for various reasons, often through unauthorized use of the game account of one user by other users and occasionally through data loss caused by a delay of network service or by a network crash. Currently there are no PRC laws and regulations specifically governing virtual asset property rights. As a result, it is unclear who is the legal owner of virtual assets and whether and how the ownership of virtual assets is protected by law. In case of a loss of virtual assets, we may be sued by online game players and may be held liable for damages, which may negatively affect our business, financial condition and results of operations.

We may be unable to respond to future changes in the revenue model for the online games industry in China and in our overseas markets, which could materially and adversely affect our business, financial condition and results of operations.

 

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We pioneered the free-to-play revenue model for online games in China. Our existing game, Yulgang, and many other future games that we intend to release, operate under this revenue model. Under the free-to-play revenue model, users can play our massively multiplayer online games, or MMOGs, for free but have the option to purchase in-game virtual items and value-added services to enhance their overall game playing experience. If any new revenue models develop in the online games industry in China or in our overseas markets, we may be unable to launch new games utilizing such new models in a timely manner or at all. We may also be required to expend significant resources to launch such games. In addition, we may unable to adapt our current games to such new models. Any of these factors could materially and adversely affect our business, financial condition and results of operations.

Acts of cheating by users of online games could lessen the popularity of our online games, adversely affect our reputation and our results of operations.

Cheating in online games may occur through a variety of methods, by which cheaters may be able to modify the rules of our online games during game play in a manner that allows them to disadvantage our other online game users, which often has the effect of causing players to stop using the game and shortening the game’s lifecycle. Although we have taken a number of steps to deter our users from engaging in cheating when playing our online games, we cannot assure you that we or the third parties from whom we license some of our online games will be successful or timely in taking corrective steps necessary to prevent users from modifying the terms of our online games.

Risks Relating to our Mobile Applications and Internet and Media Segment

The mobile applications and portal markets in China are highly competitive. If we fail to compete effectively, our failure could have a material adverse effect on our business, financial condition and results of operations.

We are not the only company providing mobile services and applications, such as wireless services including Short Message Service, or SMS, Interactive Voice Response, or IVR, Multimedia Message Service, or MMS, and Wireless Application Protocol, or WAP, in China. We face intense and increasing competition for subscribers, mobile services and applications, and content from companies such as: Sina Corporation, Sohu.com Inc., NetEase.com Inc., Tom Online Inc., Tencent.com Technology Limited, Linktone Ltd., Mtone Wireless Corporation and Kongzhong and Hurray! Holding Co. Ltd., as well as a number of smaller companies that serve China’s mobile services and applications market. In addition, in our portal business, our competition for user traffic, ease of use and functionality include Chinese and/or English language based Web search and retrieval companies, including AltaVista Co., Apple Daily, ChinaByte, FindWhat.com, Lycos, Inc., MSN, Netease.com, Inc., Shanghai Online, Sina Corporation, Sohu.com, Inc., Tom Online Inc. and Yahoo!, Inc., Oak Pacific Interactive, 21CN.com and qianlong.com.

Many of our competitors have more experience and longer operating histories in our target markets than us, as well as greater name recognition, larger customer bases and greater financial, technical and marketing resources. We may not be able to compete successfully in these markets. Our failure to remain competitive may cause us to lose our market share in the mobile services and applications and/or portals business, and our business, financial condition and results of operations may suffer.

We depend primarily on China Mobile, China Unicom and other mobile operators in China for delivery of our mobile services and applications, and the termination or alteration of our various contracts with any of them or their provincial or local affiliates could materially and adversely impact our business.

Our MVAS offerings depend mainly on cooperation arrangements we have entered into with China Mobile, China Unicom, China Telecommunications Corporation, or China Telecom, and China Network Communications Group Corporation, or China Netcom and their subsidiaries and national, provincial and local affiliates. The dominant market position of these network operators limits our negotiating leverage with

 

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them. As such, we may be forced to accept terms and conditions that are not commercially favorable to us. If our various contracts with any network operator are terminated or adversely altered, it may be impossible to find appropriate replacement operators with the requisite licenses and permits, infrastructure and customer base to offer our services, and our business would be significantly impaired. A significant portion of the total revenues we receive from our Mobile Services and Applications segments were derived in reliance upon these mobile network operators.

Delivery of our mobile services and applications is also governed by contracts between us and the national, provincial or local affiliates of the mobile network operators. Generally, each of these contracts is nonexclusive and has a limited term (typically one or two years). We typically renew these contracts, or enter into new ones, when the prior contracts expire, but on occasion the renewal or new contract can be delayed by significant periods of time. The terms of these contracts vary from operator to operator, but the mobile network operators are generally entitled to terminate them in advance for a variety of reasons or, in some cases, for no reason, at their discretion. For example, several of our contracts with the mobile network operators can be terminated if:

 

   

we fail to achieve performance standards established by the applicable mobile network operator from time to time;

 

   

we breach our obligations under the contracts, which include, in many cases, the obligation not to deliver content that violates the network operator’s policies and applicable law;

 

   

the mobile network operator receives high levels of customer complaints about our mobile services or applications; or

 

   

the mobile network operator sends us written notice that it wishes to terminate the contract at the end of the applicable notice period.

We may also be compelled to alter our arrangements with these mobile network operators in ways which materially and adversely affect our business. Our agreements with the mobile network operators are subject to negotiation and performance evaluation upon renewal, and we are aware that the mobile network operators have notified other mobile service providers of their intention to either not renew their agreements or to revise their revenue sharing arrangements upon the expiration of the existing cooperation agreements. We cannot assure you that the mobile network operators will either renew our agreements or not demand further changes to our revenue sharing arrangements in the future. If any of the mobile network operators decide to change its content or transmission fees or its share of revenue, does not comply with the terms of our agreements, or terminates our agreements, our business, operating results and revenues could be materially adversely affected.

Regulators and the mobile network operators in China have imposed unilateral changes in their regulations and policies, have enhanced enforcement of their policies and have adopted new billing systems and policies. Depending upon the nature of these regulatory and policy changes, we may not be able to implement and adhere to them, and our business and financial results could be materially adversely affected.

Regulators in China have unilaterally changed their regulations relating to third party service providers in the past, and may do so again in the future. In addition, some of the mobile network operators have unilaterally changed their policies relating to third party service providers in the past, and may do so again in the future.

Examples of these changes in regulatory measures and policies include:

 

   

In July 2003, China Mobile banned all cooperative arrangements known as “SMS Website Unions,” effectively precluding large service providers from aggregating unregistered websites and utilizing China Mobile’s billing platform to gather fees for these services. In August 2003, China Mobile further banned service providers from using its network to charge customers for services which were deemed by it to be not purely wireless services. Although we were not engaged in these activities and, therefore, these particular policy changes did not impact our business, we may not be able to respond adequately to negative developments in our contractual relationships with the relevant mobile network operators in the future because we are not able to predict any unilateral policy changes.

 

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In mid 2004, the Ministry of Information and Industry in China began requiring wireless service providers to apply for a nationwide value-added telecommunications services operating license, or a CP license, in order to provide value-added telecommunication services throughout China. China Mobile then issued a notice requiring all service providers to provide evidence of a CP license by October 31, 2004. After October 31, 2004, China Mobile and its subsidiaries ceased working with most of the service providers without CP licenses. Although our Newpalm and Go2joy businesses were able to acquire the required CP licenses in this particular instance, we may not be able to respond adequately to negative regulatory developments in the future because we are not able to predict any unilateral regulatory changes.

 

   

In January 2005, the Chinese State Administration of Radio, Film and Television, or SARFT, which regulates radio and television stations in China, issued a notice prohibiting commercials for mobile services related to “fortune-telling” from airing on radio and television stations effective in February 2005. We believe this notice could also lead to further actions by other Chinese government authorities which could have a material adverse effect on our financial position, results of operations, or cash flows. SARFT or other Chinese government authorities may prohibit the marketing of other mobile services via a channel we depend upon to generate revenues, which could have a material adverse effect on our financial position, results of operations or cash flows.

 

   

In April 2005, the National Copyright Administration and the Ministry of Information Industry issued the Measures for the Administrative Protection of Internet Copyright, or the Measures, which, amongst other things, allows a copyright owner to issue a notice to an Internet Service Provider, or ISP, informing them that materials are being made available on the internet without authorization from the copyright owner. Under the Measures, upon receipt of such notice, the ISP is obligated to block access to the identified material until an alleged breach is confirmed. We anticipate an increased amount of notices being issued by copyright owners which may result in us being denied access to the identified material until the alleged breach is confirmed which could have a material adverse impact on our business.

 

   

In April 2006, China Unicom issued a new policy that sets price ceilings for usage-based and monthly subscription SMS. Such change may require us to lower our current prices on certain SMS services or discontinue offering these services completely.

 

   

In July 2006, China Mobile made significant changes to its policy on subscription-based MVAS, which included requiring double confirmations on new MVAS subscriptions as well as sending SMS reminders to existing monthly subscribers of SMS, MMS and WAP to inform them of their MVAS subscription and fee information. Certain provincial subsidiaries, such as Guangdong Mobile, one of China Mobile’s largest provincial subsidiaries, have begun to discontinue charging MVAS users monthly subscription fees unless the users reply to the SMS reminders and reconfirm their subscription. In addition, China Mobile’s provincial subsidiaries began canceling existing WAP subscriptions that have been inactive for the prior four months and existing SMS subscriptions of users who have not successfully received more than three SMS messages during the month. These policy changes from China Mobile have reduced our ability to acquire new monthly MVAS subscribers and increased the churn rate of existing monthly MVAS subscribers.

 

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In September 2006, China Unicom began enforcing a policy of double confirmation on new MVAS subscriptions. Such change has significantly reduced our ability to acquire new monthly MVAS subscribers.

Furthermore, in July 2006, MII issued The Circular of the Ministry of Information Industry on Intensifying the Administration of Foreign Investment in Value-added Telecommunication Services (the “MII Circular 2006”). According to the MII Circular 2006, since the FITE Regulation went into effect, some foreign investors have, by means of delegation of domain names and license of trademarks, conspired with domestic value-added telecom enterprises to circumvent the requirements of FITE Regulations and been engaged in value-added telecom services illegally.

In order to further intensify the administration of FITEs, the MII Circular 2006 provides that (i) any domain name used by a value-added telecom carrier shall be legally owned by such carrier or its shareholder(s); (ii) any trademark used by a value-added telecom carrier shall be legally owned by the carrier or its shareholder(s); (iii) the operation site and facilities of a value-added telecom carrier shall be installed within the scope as prescribed by operating licenses obtained by the carrier and shall correspond to the value-added telecom services that the carrier has been approved to provide; and (iv) a value-added telecom carrier shall establish or improve the measures of ensuring safety of network information. As to the companies which have obtained the operating licenses for value-added telecom services, they are required to conduct self-examination and self-correction according to the said requirements and report the result of such self-examination and self-correction to MII.

We are currently evaluating and considering our response to the July 2006 regulations, including the potential transfer of our domain name, china.com, from CDC Corporation to China.com. We cannot assure you that our efforts to comply with this or any other regulation will be successful, and if we are not successful in complying, our related business, financial condition and results of operations may suffer.

The interpretation and application of existing Chinese laws, regulations and policies, the stated positions of MII and possible new laws, regulations or policies have created substantial uncertainties regarding the legality of existing and future foreign investments in, and the businesses and activities of, Internet businesses in China, including our business.

We believe the changes in regulatory measures, policies, procedures and standards have impacted and resulted, and may further impact and result in, lower mobile services and applications, online games and internet 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 new system, policy or guideline imposed by the mobile network operators or any other regulators in the future.

If any of the mobile network operators fail to bill their customers or to provide billing confirmations for our mobile applications, our mobile applications revenues could be significantly reduced.

We depend upon the mobile network operators to maintain accurate records of the fees paid by users and their willingness to remit payment to us. Specifically, the mobile network operators provide us with monthly statements that do not provide itemized information indicating for which mobile services and applications the mobile network operator has collected fees. As a result, monthly statements that we have received from the mobile network operators cannot be reconciled to our internal records on a segmented basis. In addition, access to the mobile network operators’ internal billing and collection records is subject to the discretion of such operators. As such, we have only limited means to independently verify the information provided to us. Our mobile services and applications revenues could be significantly reduced if these mobile network operators miscalculate the revenues generated from our mobile services and applications and our portion of those revenues.

 

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Because the mobile network operators do not provide information showing revenues and transmission information on a service-by-service basis, we can only estimate our actual revenues by service type.

The mobile network operators’ monthly statements to service providers regarding mobile applications delivered through their networks currently do not contain revenues and billing and transmission failure information on a service-by-service basis. Although we maintain our own records reporting the mobile applications provided, we can only estimate our actual revenues by service type because we are unable to confirm which services were transmitted but resulted in billing and transmission failures, from all provincial operators. As a result, we are unable to calculate and monitor service-by-service revenues, margins and other financial information, such as average revenue per user by service and total revenues per user by service, with sufficient precision to allow us to accurately determine which of our mobile applications are or may be profitable.

Our mobile applications revenues are affected by billing and transmission failures which are often beyond our control.

We do not collect fees for delivery of our mobile services and applications from the mobile network operators in a number of instances, including if:

 

   

the delivery of our mobile services and applications to a subscriber is prevented because his or her mobile phone is turned off for an extended period of time, the customer’s prepaid phone card has no value or the subscriber has ceased to be a customer of the applicable mobile network operator;

 

   

the applicable mobile network operator experiences technical problems with its network which prevent the delivery of our mobile services and applications to the subscriber;

 

   

we experience technical problems with our technology platform that prevents delivery of our mobile services and applications; or

 

   

the subscriber refuses to pay for our mobile services and applications due to quality or other problems.

These situations are known in the mobile services and applications industry as billing and transmission failures. We do not expect to recover revenues that are lost due to billing and transmission failures. The failure rate can vary among network operators, and by province, and also have fluctuated significantly in the past. For example, for the year ended December 31, 2006, the average monthly transmission failure rate ranged from 5% to 10%. Under our agreements with the network operators, we do not have the right to adjust lost revenues from excessive network failures. The mobile network operators have absolute discretion in the adjustment of any difference. Any significant billing and transmission failures therefore will significantly lower our recorded revenues.

The mobile network operators may impose higher service or network fees if we are unable to satisfy customer usage and other performance criteria, thereby reducing our mobile applications revenues.

Fees for our mobile services and applications are charged on a monthly subscription or per usage basis. Based on our contractual arrangements, we rely upon the mobile network operators for both billing of, and collection from, subscribers of fees for our mobile applications.

The mobile network operators generally charge us service fees of 15% to 60% of the revenues generated by our mobile applications. To the extent that the number of messages sent by us over the mobile’s network exceeds the number of messages our subscribers send to us, we must pay per message channel fees,

 

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which decrease, in several provinces, as the volume of customer usage of our mobile applications increases. The number of messages sent by us will exceed those sent by our subscribers, for example, if the subscriber sends us a single message to order a game but we must send that subscriber several messages to confirm his or her order and deliver the game itself. Any increase in the mobile network operators’ network fees and service charges could reduce our gross margins.

The mobile network operators may not authorize our mobile applications to be offered on their networks if we fail to achieve minimum customer usage, revenues and other criteria, thereby adversely affecting our mobile services and applications revenues.

Our business could be adversely affected if we fail to achieve minimum customer usage, revenues and other criteria imposed or revised by the mobile network operators at their discretion from time to time. China Mobile and China Unicom, through their provincial and local offices, have historically preferred to work only with a small group of the best-performing mobile application providers, based upon the uniqueness of the service offered by each provider, total number of subscribers, usage and revenues generated in the applicable province or municipality, the rate of customer complaints, and marketing expenditures in the applicable province or municipality.

In the future, we may fail to meet the then-current performance criteria that mobile network operators in these or other provinces or municipalities set from time to time. In any such case, our mobile applications could be excluded from certain services or from their entire networks at a national, provincial or municipal level, or we could be precluded from introducing new services, which would adversely affect our revenues and growth prospects.

China Mobile has imposed penalties on our mobile services and applications businesses for breaches and irregularities in the provision of services to users. If penalties are imposed by the mobile network operators in the future with respect to either our past or future activities, our business and financial results could be materially adversely affected.

In August 2004, Go2joy, one of our mobile services and applications units, received a notice from China Mobile informing us that China Mobile was imposing sanctions and penalties upon Go2joy and 21 other mobile value added service providers in China for various violations of China Mobile’s regulations and requirements. China Mobile indicated that Go2joy had inadvertently charged inactive users in Shanxi province; as a result of an agreement to take on certain services of a content partner, had transferred certain users to its SMS platform without positive confirmation of the users or approval from China Mobile, in Hunan province; had sent inappropriately worded SMS promotional messages to users in Shanxi and Henan provinces; and had inadvertently continued to charge some cancelled accounts for SMS services.

The sanctions resulted in the temporary suspension of Go2joy's existing SMS services from August 2004 until February 2005 when Go2joy was able to resume billing for SMS services over China Mobile’s network. In addition, China Mobile temporarily suspended the approval of Go2joy's application to operate on new platforms until the end of 2004 and suspended the approval of Go2joy's application to offer new products and services on all existing platforms, such as SMS and IVR, until June 30, 2005. China Mobile also imposed fines of approximately RMB1.3 million, or approximately $160,000. The sanctions imposed by China Mobile did not affect Go2joy's existing IVR services. Under the sanctions, Go2joy was required, among other things, to establish a satisfactory connection with the Mobile Information Service Center, or MISC platform, a centralized service provider monitoring system operated by China Mobile.

The mobile network operators have a wide range of policies and procedures regarding customer service, quality control and other aspects of the wireless value-added services industry. As this industry has evolved over the last several years, the mobile network operators have refined these policies to improve overall service quality. In addition, acting under the guidance of China’s Ministry of Information Industry,

 

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the mobile network operators have begun enforcing their customer service policies more rigorously than in the past and have initiated steps to improve customer service. If enforcement of such policies in the future results in additional penalties, such as being precluded from offering certain services over a mobile network operator’s network or from offering new services for a fixed period, our business and financial results could be materially adversely affected.

In addition, we may also be subject to liability and penalties if we deliver inappropriate content through our mobile value added services. For example:

 

   

In July 2004, China Mobile temporarily terminated the IVR service of one of our competitors for violating certain operating procedures. One of the violations cited in the notice for temporary termination was that it had provided inappropriate content to its mobile subscribers through its IVR service.

 

   

In July 2006, Shenzhen KK Technology Ltd., one of our mobile services and applications units, received a notice from China Mobile informing us of violations of China Mobile’s regulations and requirements. China Mobile indicated that Shenzhen KK had sent inappropriately worded SMS messages to users; and had inadvertently charged some users for SMS services without users’ positive confirmation.

The definition and interpretation of inappropriate content in many cases is vague and subjective. We are not sure whether mobile network operators, including China Mobile and China Unicom, or the Chinese government will find our mobile content inappropriate and therefore prevent us from operating the mobile value added services relating to such content in the future. If they prevent us from offering such services, our profit from mobile values added services will suffer.

Further, we may not be able to adequately respond to other developments in mobile network operator policies, or changes in the manner in which such policies are enforced. Furthermore, because the mobile network operators’ policies are in a state of change at this time and they are highly sensitive to customer complaints (even if the complaints may not have a bona fide basis), we cannot be certain that our business activities will always be deemed in compliance with those policies despite our efforts to comply. Accordingly, we may be subject to monetary penalties or service suspensions or both, even for conduct which we believed to be permissible. Any future noncompliance with the mobile network operators’ policies by us, whether inadvertent or not, could result in a material and adverse effect on our revenue and profitability.

Our mobile applications business could be adversely affected if any of the mobile network operators begin providing their own mobile applications.

Our mobile business may be adversely affected if any of the mobile network operators decide to terminate our existing revenue-sharing relationships and begin providing their own mobile services and applications to subscribers. In that case, we would not only face enhanced competition, but could be partially or fully denied access to their networks. As a result, our business, operations and financial condition would likely be materially and adversely affected.

In the event we fail to achieve or maintain a prominent position on the Wireless Application Portals, or WAPs, of the principal mobile network operators in China, we may not be able to capture opportunities presented by the expected high growth in the market for WAP services in China, which could affect our mobile applications business’ financial condition.

 

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The current practice of the mobile network operators is to place the most popular WAP services at the top of the menu on the first page of the list of services available in each service category on their WAP portals. Services at the top of the menu are more accessible to users than other services and, in our experience, are more frequently accessed than those services lower on the menu. This effectively reinforces the position of the most popular services. The placement of services on these menus creates significant competitive advantages for the top-ranked services and significant challenges for newer and less popular services. In the event we fail to achieve or maintain a prominent position on the WAP portals of the four principal mobile network operators in China, we may not be able to capture opportunities presented by the expected high growth in the market for WAP services in China. This could materially and adversely affect the revenue from our services, and thus our overall financial condition.

Our mobile applications and their pricing are subject to approval by the applicable mobile network operator, and if requested approvals are not granted in a timely manner, our mobile services and applications business could be adversely affected.

We must obtain approval from the applicable mobile network operator with respect to each mobile application that we propose to offer or charge to their subscribers and the pricing for such mobile application. No assurance can be given that approvals will be granted in a timely manner or at all. Moreover, under some of our contracts with the mobile network operators, we cannot change prices more than once every six months or charge prices outside a fixed range. Failure to obtain, or a delay in, obtaining such approvals could place us at a competitive disadvantage in the market and adversely affect our mobile applications business.

We rely heavily on certain regions in China for a significant share of our mobile applications revenues. An economic downturn or any loss of our contracts with mobile operators in these provinces could have a material adverse effect on our results of operations.

A significant portion of our revenues from mobile applications are derived from the Shandong, Jiangsu, Sicuan, Shanxi and Henan provinces in China. As such, our results of operations are susceptible to changes in the economies of these regions. An economic downturn in any one of these regions, or our failure to renew our contracts with the applicable mobile network operator in any one of these regions, could reduce our mobile services and applications revenues.

The Chinese government has granted licenses to offer basic wireless telecommunications services in China to third parties with whom we have relatively new relationships, and may grant additional licenses to others in the future. If those parties that receive licenses are successful in the mobile applications market, and we are unable to maintain our existing relationships, establish new arrangements or develop cooperative relationships with them, our mobile applications business, revenue and overall financial condition could be adversely affected.

The success of our mobile applications business depends on our relationship with China’s mobile network operators and their national, local and provincial subsidiaries and affiliates. While China Mobile and China Unicom are the largest and most-established companies permitted to provide mobile services in China, the Chinese government has granted licenses to offer basic wireless telecommunications services in China to China Network Communications Group Corporation, or China Netcom, and China Telecommunications Corporation, or China Telecom. Our business relationships with each of China Netcom and China Telecom and their national, local and provincial subsidiaries and affiliates are less established than those we have with China Mobile and China Unicom. If we are unable to sustain and further develop our relationships with each of China Telecom and China Netcom and their national, local and provincial subsidiaries and affiliates, our revenue and overall financial condition could be adversely affected if they take market share from China Mobile and China Unicom.

 

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Further, China Netcom and China Telecom have recently decided to offer wireless value-added services created by them (or a division of them), rather than by third party service providers such as our company. It is also possible that other parties receiving basic wireless telecommunications licenses may decide to offer wireless value-added services created by them, rather than by a company such as ours. We will be in direct competition with those operators, and our revenue and overall financial condition could be adversely affected if we are not able to compete effectively against them.

Our China.com and other portal businesses depend substantially on third party content providers and may be adversely affected if we are unable to maintain existing arrangements with these content providers.

We rely on third parties to create traffic and provide content for our portal network to make it more attractive to advertisers and consumers. Our content providers include Xinhua, a major shareholder of CDC, as well as commercial content providers and our registered community members. If Xinhua or these third parties fail to provide us with high quality content, our portal network could lose viewers, subscribers and advertisers and our revenue from these sources would decrease. Our existing relationships with Xinhua and other commercial content providers are not exclusive and may not result in sustained business partnerships or successful service offerings or sustained traffic on our portal network or future revenues.

Risk Relating to Our Online Games, Mobile Applications and Internet and Media Segments as a Result of Conducting Operations in the People’s Republic of China

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

While the economy in the PRC has experienced significant growth in the past twenty 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.

The economy in the PRC has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the PRC government has implemented measures that emphasize the utilization of market forces for economic reform, reduce the state ownership of productive assets and help establish sound corporate governance in business enterprises, a substantial portion of productive assets in the PRC is still owned by the 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 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.

Our financial results have been, and are expected to continue to be, affected by the growth of the economy and the Internet industry in China. A slowdown of economic growth in China would reduce the growth of the Internet industry and related products and services, which in turn could adversely affect our business, operating results and financial condition.

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

 

   

higher level of government involvement;

 

   

early stage of development of a market-oriented economy;

 

   

rapid growth rate;

 

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higher level of control on foreign exchange; and

 

   

less efficient allocation of resources.

The PRC government has also implemented certain measures, including a recent interest rate increase, to control the pace of economic growth. These measures may cause decreased economic activity in China, including a slowing or decline in consumer spending, which in turn could adversely affect our financial condition and results of operations.

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 website.

The online game, mobile services and Internet content distribution industries in China are highly regulated by the PRC government. Various regulatory authorities of the central PRC government, such as the State Council, the Ministry of Information Industry, the State Administration of Industry and Commerce, the State Press and Publication Administration, and the Ministry of Public Security, are empowered to issue and implement regulations governing various aspects of each of these industries.

China has enacted laws and regulations governing Internet access and the distribution of news, information or other content, as well as products and services, through the Internet. The PRC government has previously stopped the distribution of information through the Internet that it deems in violation of PRC laws and regulations. Under regulations promulgated by the State Council, the Ministry of Information Industry, the State Press and Publication Administration and the Ministry of Culture, Internet content providers and Internet publishers are prohibited from posting or displaying over the Internet, content that, among other things:

 

   

opposes the fundamental principles in the PRC 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 China’s religious policy or propagates heretical teachings or feudal superstition;

 

   

disseminates rumors, disturbs social order or disrupts social stability;

 

   

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

 

   

undermines public morality or the cultural traditions of the PRC;

 

   

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

 

   

includes other content prohibited by laws or administrative regulations.

The mobile network operators in the PRC also have their own policies regarding the distribution of inappropriate content by wireless value-added service providers and have recently sanctioned certain providers for distributing inappropriate content, including the imposition of fines and service suspensions.

If any Internet content we offer or will offer through our affiliated PRC entities were deemed by the PRC government or the mobile network operators to violate any of such content restrictions, we would not be

 

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able to continue such offerings and could be subject to penalties, including confiscation of income, fines, suspension of business and revocation of required licenses, which could materially and adversely affect our business, financial condition and results of operations. Additionally, we may face liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of information originating from our online games network, portal network or communicated through our mobile services and applications, including our SMS, MMS, WAP and IVR products.

We may also be subject to potential liability for any unlawful actions of our clients or affiliates or for content we distribute that is deemed inappropriate. It may be difficult to determine the type of content that may result in liability for us, and if we were found to be liable, we may be prevented from operating our online game, mobile applications and internet and media services in China. Such content could include material posted by our registered community members on our message boards, online communities, voting systems, e-mail or chat rooms. By providing technology for hypertext links to third-party websites, we may be held liable for copyright or trademark violations by those third-party sites. Third parties could assert claims against us for losses incurred in reliance on erroneous information distributed by us. Users of our web-based e-mail or SMS, MMS, WAP or IVR products could seek damages for:

 

   

unsolicited e-mail or messages;

 

   

lost or misplaced messages;

 

   

illegal or fraudulent use of e-mail or SMS messages; or

 

   

interruptions or delays in service.

We do not carry liability insurance to cover potential claims of these types. In the event such claims are asserted against us, we may incur significant costs in investigating and contesting these claims. Any judgment, fine, damage award or liability imposed on us could significantly increase our costs. Moreover, our reputation may suffer as a result of these claims, which could reduce traffic on our portal network or reduce our revenues.

Because many laws, regulations and legal requirements with regard to the Internet in the PRC are relatively new and untested, their interpretation and enforcement of what is deemed to be socially destabilizing by Chinese authorities may involve significant uncertainty. In addition, the legal system in the PRC 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. As a result, it is difficult to determine the type of content that may result in liability. We cannot predict the effect of further developments in the Chinese legal system, particularly with regard to the Internet and the dissemination of news content, including the creation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the pre-emption of local rules and regulations by national laws.

Violations or perceived violations of laws in China arising from information displayed, retrieved from or linked to our portals could result in significant penalties, including a temporary or permanent cessation of our business in China. The Chinese government agencies have announced restrictions on the transmission of state secrets through the Internet. State secrets have been broadly interpreted by Chinese governmental authorities in the past. We may be liable under these pronouncements for content and materials posted or transmitted by users on our message boards, virtual communities, chat rooms or e-mails. If the Chinese government were to take any action to limit or eliminate the distribution of information through our portal network or to limit or regulate any current or future applications available to users on our portal network, this action could have a material adverse effect on our business, financial condition and results of operations.

Government control of currency conversion may limit our ability to utilize our revenues effectively.

 

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Substantially all of the revenues and operating expenses of our CDC Games and China.com businesses, are denominated in Renminbi. The Renminbi is currently convertible to foreign exchange with respect to “current account” transactions, but not with respect to “capital account” transactions. Current account transactions include ordinary course import/export transactions, payments for services rendered and payments of license fees, royalties, interest on loans and dividends. Capital account transactions include cross-border investments and repayments of principal of loans. Currently, our PRC subsidiaries may purchase foreign exchange for settlement of “current account transactions,” including payment of dividends to us and payment of license fees to content licensors, without the approval of the State Administration for Foreign Exchange, or SAFE. Our PRC subsidiaries may also retain foreign exchange in their current accounts, subject to a ceiling approved by SAFE, to satisfy foreign exchange liabilities or to pay dividends. However, the relevant PRC governmental authorities may limit or eliminate the ability for our PRC subsidiaries to purchase and retain foreign currencies in the future. Foreign exchange transactions under the capital account remain subject to limitations and require approvals from or registration with SAFE. This could affect our PRC subsidiaries’ ability to obtain debt or equity financing from outside the PRC, including by means of loans or capital contributions from us.

Fluctuations in exchange rates could materially and adversely affect the value of our common shares and result in foreign currency exchange losses.

Because our earnings and cash and cash equivalent assets earned or held in the PRC are denominated in Renminbi, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. In July 2005, the PRC government discontinued pegging the Renminbi to the U.S. dollar. However, the Renminbi exchange rate versus the U.S. dollar is restricted to a rise or fall of no more than 0.3% per day and the People’s Bank of China regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate. Nevertheless, the Renminbi may appreciate or depreciate significantly in value against the U.S. dollar in the medium to long term. Moreover, it is possible that in the future, PRC authorities may lift restrictions on fluctuations in the Renminbi exchange rate and lessen intervention in the foreign exchange market. Fluctuations in the exchange rate will also affect the relative value of any dividend we may issue that will be exchanged into U.S. dollars and earnings from and the value of any future U.S. dollar-denominated investments we make.

Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedging transactions may be limited and we may not be able to successfully hedge our exposure at all. In addition, our currency exchange losses may be magnified by Chinese exchange control regulations that restrict our ability to convert Renminbi into foreign currency.

Recent PRC regulations relating to offshore investment activities by PRC residents may increase the administrative burden we face and create regulatory uncertainties that could restrict our overseas and cross-border investment activity, and a failure by our shareholders who are PRC residents to make any required applications and filings pursuant to such regulations may prevent us from being able to distribute profits and could expose us and our PRC resident shareholders to liability under PRC law.

In October 2005, SAFE promulgated regulations that require PRC residents and PRC corporate entities to register with and obtain approvals from relevant PRC government authorities in connection with their direct or indirect offshore investment activities. These regulations apply to our shareholders who are PRC residents in connection with our prior and any future offshore acquisitions.

The SAFE regulation required registration by March 31, 2006 of direct or indirect investments previously made by PRC residents in offshore companies prior to the implementation of the Notice on Issues

 

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Relating to the Administration of Foreign Exchange in Fund-Raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies on November 1, 2005. If a PRC shareholder with a direct or indirect stake in an offshore parent company fails to make the required SAFE registration, the PRC subsidiaries of such offshore parent company may be prohibited from making distributions of profit to the offshore parent and from paying the offshore parent proceeds from any reduction in capital, share transfer or liquidation in respect of the PRC subsidiaries. Furthermore, failure to comply with the various SAFE registration requirements described above could result in liability under PRC law for foreign exchange evasion.

These regulations are still relatively new and there is uncertainty concerning the reconciliation of the new regulation with other approval requirements, it is unclear how the regulation, and any future legislation concerning offshore or cross-border transactions, will be interpreted, amended and implemented by the relevant government authorities. Some of our shareholders may not comply with our request to make or obtain any applicable registrations or approvals required by the regulation or other related legislation. The failure or inability of our PRC resident shareholders to obtain any required approvals or make any required registrations may subject us to fines and legal sanctions, prevent us from being able to make distributions or pay dividends, as a result of which our business operations and our ability to distribute profits to you could be materially and adversely affected.

We rely on contractual arrangements, including a voting proxy, with our affiliated PRC entities for the control and operation of our online games, mobile services and Internet content distribution businesses. These arrangements may be difficult to enforce under the PRC legal system. If any of our affiliated PRC entities fails to perform its obligations under these contractual arrangements, we may have to try to legally enforce such arrangements, and our business, financial condition and results of operations may be materially and adversely affected if these arrangements cannot be enforced.

Foreign ownership in the Internet content distribution and online game businesses is subject to significant restrictions under current PRC laws and regulations. The PRC government regulates Internet access, the distribution of online information, the conduct of online commerce and the provision of online game services through strict business licensing requirements and other government regulations. These laws and regulations also include limitations on foreign ownership in PRC companies that provide Internet content distribution and online game services. Specifically, foreign investors are not allowed to own more than a 50% equity interest in any Internet content provision business.

Because we are a Cayman Islands company, we and our PRC subsidiaries and their branch companies in China are treated as foreign or foreign-invested enterprises under PRC laws and regulations. To comply with PRC laws and regulations, we conduct our operations in China through a series of contractual arrangements entered into among our PRC subsidiaries. These licenses held by our affiliated PRC entities are essential to the operation of our business.

Generally employees of the respective business units who are Chinese nationals own the shares of the respective domestically registered companies in China which hold the relevant required domestic licenses for operation. These Chinese nationals, in turn, have entered into trust deed arrangements with respect to the domestically registered companies in China and affiliates of the respective business units under which the Chinese nationals serve as trustees of the trusts, and the business units have formed offshore holding vehicles to be 100% beneficiaries of the trusts. For a further description of the corporate structure in China, see Item 4.C., “Information on the Company – Organizational Structure – Corporate Structure in China for our CDC Games and China.com Business Units.”

CDC Games and China.com have no ownership interest in our affiliated PRC entities. These contractual arrangements, including the voting proxies granted to us, may not be as effective in providing us with control over these companies as direct ownership. If we were the controlling shareholders of these

 

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companies with direct ownership, we would be able to exercise our rights as shareholders to effect changes in the board of directors, which in turn could effect change, subject to any applicable fiduciary obligations, at the management level. However, under the current contractual arrangements, as a legal matter, if any of our affiliated PRC entities fails to perform its obligations under these contractual arrangements, we may have to (i) incur substantial costs and resources to enforce such arrangements, including the voting proxy, and (ii) rely on legal remedies under PRC law, which we cannot be sure would be effective. In the event that CDC Games and China.com are unable to enforce these contractual arrangements, or if we suffer significant time delays or other obstacles in the process of enforcing these contractual arrangements, our business, financial condition and results of operations could be materially and adversely affected.

If our past or current business operation structure is found not to comply with PRC laws and regulations, we could be subject to severe penalties, including the shutting down of our servers.

The relevant PRC regulatory authorities have broad discretion in determining whether a particular contractual structure is in violation of law. If our past or current ownership structures, contractual arrangements and businesses, or those of our PRC subsidiaries and our affiliated PRC entities are found to be in violation of PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such violations, including:

 

   

revoking the business and operating licenses of our PRC subsidiaries or affiliated PRC entities, which licenses are essential to our business operations;

 

   

levying fines;

 

   

confiscating our income or the income of our PRC subsidiaries or affiliated PRC entities;

 

   

shutting down our servers and/or blocking our website;

 

   

discontinuing or restricting our operations or the operations of our PRC subsidiaries or affiliated PRC entities;

 

   

imposing conditions or requirements with which we, our PRC subsidiaries or our affiliated PRC entities may not be able to comply;

 

   

requiring us, our PRC subsidiaries or our affiliated PRC entities to restructure the relevant ownership structure, operations or contractual arrangements;

 

   

restricting or prohibiting our use of the proceeds from any offering we may make to finance our business and operations in China; and

 

   

taking other regulatory or enforcement actions that could be harmful to our business.

Moreover, we could face material and adverse tax consequences if the PRC tax authorities determine that our undocumented or documented arrangements with our affiliated PRC entities were not priced at arm’s length for purposes of determining tax liability. If the PRC tax authorities determine that these arrangements were not entered into on an arm’s length basis, they may perform a transfer pricing adjustment. A transfer pricing adjustment could result in a reduction, for PRC tax purposes, of deductions recorded by our affiliated PRC entities, which could adversely affect us by increasing the tax liabilities of our affiliated PRC entities without reducing the tax liabilities of our PRC subsidiaries. This increased tax liability could further result in late payment fees and other penalties to our affiliated PRC entities for under-paid taxes. Any payments we make under these arrangements or adjustments in payments under these arrangements that we may decide to make in the future will be subject to the same risk.

 

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Any of these actions could materially and adversely affect our business, financial condition and results of operations.

If the Chinese government considers our existing licenses to be insufficient in meeting compliance requirements with applicable regulations, or if we fail to comply with changes to these requirements or restrictions, our online games, Internet and mobile services and applications businesses could be materially adversely affected.

The Chinese government regulates access to the Internet by imposing strict licensing requirements on Internet service providers, or ISPs. Generally, the provision of different types of infrastructure telecommunication services and value-added telecommunication services is subject to different licensing regimes in China.

While we believe that our current operation complies with all existing laws, rules and regulations in China, there are substantial uncertainties regarding the interpretation of current Internet laws and regulations. It is possible the Chinese government may take a view contrary to ours because there are no well established precedents or clear judicial interpretations to support our interpretations and views of the laws, rules and regulations. Issues, risks and uncertainties relating to government regulation of China’s Internet sector include:

 

   

regulations applying to Internet-related services and telecom-related activities. While many aspects of these regulations remain unclear, they purport to limit and require licensing of various aspects of the provision of Internet information services. If these regulations are interpreted to preclude our current ownership structure or business model, our portal and mobile services and applications businesses could be severely impaired; and

 

   

the activities of ICPs are subject to regulation by various government authorities in China depending on the specific activities conducted by the ICP as stated by the Ministry of Information and Industry. Various government authorities have enacted several laws and regulations that govern these activities. The areas of regulation include:

 

   

online advertising;

 

   

online news reporting;

 

   

online publishing;

 

   

online securities trading;

 

   

online gaming;

 

   

online broadcasting;

 

   

bulletin board service; and

 

   

the provision of industry-specific information (e.g., pharmaceutical products) over the Internet, etc.

Other aspects of our online operations may be subject to regulation in the future.

In addition to the regulations promulgated by the Chinese national government, some local governments, such as the Beijing local government, have also promulgated local rules applicable to Internet companies operating within their respective jurisdictions. These local rules may also create additional barriers in relation to the operation of our business.

 

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Our ability to use and enjoy assets held by our affiliated PRC entities that are important to the operation of our business may be reduced or lost, particularly if any of these entities goes bankrupt or becomes subject to a dissolution or liquidation proceedings.

As part of our contractual arrangements with our affiliated PRC entities, they are required to hold certain of the assets that are important to the operation of our business.

Our PRC subsidiaries and affiliated PRC entities are required under PRC laws and regulations to provide for certain statutory reserves, such as a general reserve, an enterprise expansion fund and a staff welfare and bonus fund. Our PRC subsidiaries and affiliated PRC entities are required to allocate at least 10% of their after tax profits as reported in their PRC statutory financial statements to the general reserve and have the right to discontinue allocations to the general reserve once the reserve balance has reached 50% of their registered capital. These statutory reserves are not available for distribution to the shareholders of these companies, except in a liquidation, and may not be transferred in the form of loans, advances, or cash dividends.

Further, if any of these entities incurs substantial debt, the instruments governing such debt may restrict their ability to pay dividends or make other distributions to us; and if any of these entities goes bankrupt and all or part of its assets become subject to liens or rights of third-party creditors, we may be unable to continue some or all of our business activities, which could materially and adversely affect our business, financial condition and results of operations. If any of our affiliated PRC entities undergoes a voluntary or involuntary liquidation proceeding, the shareholders or unrelated third-party creditors may claim rights to some or all of these assets. Any of the foregoing, thereby hindering our ability to operate our business, which could materially and adversely affect our business, financial condition and results of operations.

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

Our subsidiaries incorporated in China are governed by the PRC Enterprise Income Tax Law Concerning Foreign-Invested Enterprises and Foreign Enterprises.

Our subsidiary, Beijing He He Technology Co., Ltd. has enjoyed preferential tax treatment as a “new technology enterprise” pursuant to which its net income was exempted from enterprise income tax from 2003 to 2005, and will be subject to a 7.5% enterprise income tax rate from 2006 to 2008 and a 15% enterprise income tax rate thereafter so long as it maintains its status as a new technology enterprise. In addition, our subsidiary and our affiliated PRC entity have applied for the same preferential tax treatment as new technology enterprises pursuant to which their net income will be exempt from enterprise income tax from 2006 to 2008, and will be subject to a 7.5% enterprise income tax rate from 2009 to 2011 and a 15% enterprise income tax rate thereafter, if they are approved as new technology enterprises and so long as they maintain their new technology enterprise status.

The financial and non-financial criteria that our subsidiary must meet in order to obtain or maintain preferential tax treatment as new technology enterprises are promulgated by the PRC Ministry of Science and Technology, and are as follows:

 

   

the enterprise must engage in the research, development, production and the provision of technical services for, one or more high technology products. Pure commercial distribution of such technology products is not sufficient;

 

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the enterprise must be a legal entity;

 

   

scientific and technical personnel with college and university education must account for more than 30% of the enterprise’s total employees. Scientific and technical personnel engaged in the research and development of high and new technology products must account for more than 10% of the enterprise’s total employees;

 

   

more than 5% of the gross revenue of the enterprise shall have been allotted as research and development expenses of high and new technology products;

 

   

more than 60% of the enterprise’s gross annual revenues shall have been generated from the provision of technical services for, and sales of, high and new technology products, and the investment of any newly established enterprises in high and new technology-related areas must account for more than 60% of the enterprise’s total investment amount; and

 

   

the persons in charge of the enterprise should be familiar with and focus on the research, development, production and sale of the products in their enterprise.

While we expect our subsidiaries and affiliated PRC entities to be able to enjoy their respective preferential tax rates or tax exemptions, this preferred tax treatment is subject to review by higher authorities. We cannot assure you that the PRC tax authorities will not, in the future, deny or elect to discontinue any or all of these preferential tax treatments. In the event the preferential tax treatment for any of our subsidiaries or affiliated PRC entities is discontinued, the entity will become subject to a 33% standard enterprise income tax rate. The discontinuation of any of these preferential tax treatments could materially and adversely affect our business, financial condition and results of operations.

The PRC legal system embodies uncertainties, which could limit the legal protections available to you and us.

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 limited precedential value. In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general. The overall effect of legislation over the past three decades has significantly enhanced the protections afforded to various forms of foreign investment in mainland China. Our PRC operating subsidiaries include several wholly foreign owned enterprises and are subject to laws and regulations applicable to foreign investment in China as well as laws and regulations applicable to foreign-invested enterprises. In particular, they are subject to the laws and regulations governing foreign companies’ ownership and operation of Internet content distribution and advertising businesses. These laws and regulations frequently change, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to us and our investors. In addition, we cannot predict the effect of future developments in the PRC legal system, particularly with regard to the Internet, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws.

We have limited insurance coverage in China. Any business disruption, litigation or natural disaster might result in substantial costs and the diversion of our resources.

The insurance industry in China is still at an early stage of development and PRC insurance companies offer limited business insurance products. As a result, we do not maintain insurance policies covering losses relating to our systems and we do not have business liability, interruption or litigation insurance for our operations in China. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers. Any business disruption, litigation or natural disaster might result in our incurring substantial costs and the diversion of our resources.

 

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Concerns about the security of electronic commerce transactions and confidentiality of information on the Internet may reduce use of our network and impede our growth.

A significant barrier to electronic commerce and communications over the Internet in the PRC has been a public concern over security and privacy, especially the transmission of confidential information. If these concerns are not adequately addressed, they may inhibit the growth of the Internet and other online services generally, especially as a means of conducting commercial transactions. If a well-publicized Internet breach of security were to occur, general Internet usage could decline, which could reduce traffic to our destination sites and impede our growth.

Any future outbreak of avian influenza or severe acute respiratory syndrome in China, or similar health epidemic, may severely disrupt our business and operations.

Our business could be materially and adversely affected by any outbreak of avian influenza, severe acute respiratory syndrome, or SARS, or any other similar health epidemic. Recently, several Asian countries including China have reported occurrences of the H5N1 strain of avian influenza. Although to date the number of cases of avian influenza has been limited, it is possible that in the future a widespread epidemic may occur. The occurrence of such an epidemic could have a significant negative impact on China’s overall economy. Moreover, any related disruptions to transportation or the free movement of persons could hamper our operations and force us to close our offices during the period of the epidemic.

Risks Relating to Our Intellectual Property, Personnel, Technology and Network

We may be unable to adequately protect or enforce our intellectual property rights and may be involved in future litigation over our use of technology rights.

We have acquired a significant amount of intellectual property and we are increasingly developing our own intellectual property. We regard the protection of our trademarks, service marks, copyrights, trade secrets, domain names, and other intellectual property rights as crucial to our success. We rely on a combination of copyright, trade secret and trademark laws, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary information and technology. Copyrights or trademarks held by us, however, may be challenged or determined to be invalid. In addition to the protections generally available to unregistered trademarks under the laws of many jurisdictions, we also seek to protect our trademarks through registration, primarily in the United States and Canada, although we do seek such protection elsewhere in selected key markets. However, adequate protection for our intellectual property may not be available in any, or every country, in which our intellectual property and technology is used. Some countries, such as the PRC, may not protect our proprietary rights to the same extent as in the United States and Canada. In particular, software piracy in the PRC has been an issue of significant concern for many software publishers. Policing the unauthorized use of our licensed technology is difficult as are the steps necessary to prevent the misappropriation or infringement of our licensed technology.

Litigation, which may also ultimately prove to be insufficient, may be necessary to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of our proprietary rights. Any of these claims, with or without merit, could result in costly litigation, divert our management’s time, attention and resources, delay our product shipments or require us to enter into royalty or license agreements.

As part of our confidentiality procedures, we have policies of entering into non-disclosure and confidentiality agreements with our employees, consultants, corporate alliance members, customers,

 

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prospective customers and strategic partners. We also enter into license agreements with respect to our technology, documentation and other proprietary information. These licenses are non-exclusive and generally perpetual. We provide for source code escrow arrangements under some of our license agreements. Despite the efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain the use of our products or technology that we consider proprietary and third parties may attempt to develop similar technology independently.

Most of our products do not contain the functionality to allow us to accurately track the numbers of users of our products at a particular customer site. Because some of our license agreements are for named-user licenses in which only a certain limited number of named individuals are permitted to use the software for which the license is granted, if our customers do not accurately report the number of users using our products or we cannot accurately track the number of users of our products at a customer site, we face the potential of lost revenues if the customer has a greater number of users than for which they have purchased licenses. License agreement provisions, such as those requesting or requiring customers to perform annual self audits of the number of users at a customer site, provide only limited protection and are retrospective.

We also currently sub-license and distribute the intellectual property and technology of third parties. As we continue to develop intellectual property and introduce new products and services that require new technology, we anticipate that we may need to obtain licenses for additional third-party technology. These existing and additional technology licenses may cease to be available to us on commercially reasonable terms, or at all. In addition, it is possible that, in the course of using new technology, we or our agents acting on our behalf may inadvertently breach the technology rights of third parties and face liability for our breach. Our inability to obtain these technology licenses or avoid breaching third-party technology rights could require us to obtain substitute technologies of lower quality or performance standards or at greater cost which could delay or compromise the introduction of new products and services, and could materially and adversely affect our business, results of operations and financial condition.

Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.

We regard our copyrights, trademarks, trade secrets, domain names and other intellectual property as important to our business. Unauthorized use of such intellectual property, whether owned by us or licensed to us, may adversely affect our business and reputation. We rely on intellectual property laws and contractual arrangements with our key employees and certain of our clients, collaborators and distributors and others to protect our intellectual property rights. Policing unauthorized use of intellectual property is difficult and expensive. Despite our precautions, it may be possible for third parties to obtain and use the intellectual property used in our business without authorization. The validity, enforceability and scope of protection of intellectual property in Internet-related industries in China are uncertain and still evolving. In particular, the laws and enforcement procedures of the PRC and certain other countries are uncertain or do not protect intellectual property rights to the same extent as do the laws and enforcement procedures in the United States. Moreover, we may have to resort to litigation to enforce our intellectual property rights. Any future litigation could result in substantial costs and diversion of our resources, and could significantly disrupt our business, as well as have a material adverse effect on our financial condition and results of operations.

We may be subject to infringement claims, which could be time-consuming and costly to defend, divert management’s attention and resources or cause product shipment delays.

We may be subject to an increasing number of infringement claims as the number of products and competitors in our various industry segments grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming and costly to defend, divert management’s attention and resources, cause product shipment delays or require us or our subsidiaries

 

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to enter into royalty or licensing agreements. Any such royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all, and may require the payment of substantial amounts of money. Furthermore, if we are found to have violated the intellectual property rights of others, or any party which licenses intellectual property to us is found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property rights. In the event of a successful product infringement claim against us or our failure or inability to license the infringed or similar technology, our business, results of operations and financial condition could be materially and adversely affected.

If our licensors cannot prevail on future intellectual property rights claims brought against them by third parties, our results of operations may be materially and adversely affected.

With respect to our online games business, we expect to derive most of our online games revenues and profits from Yulgang, Special Force and online games that we may license and launch in the future. Certain technology that is licensed from third parties may also be present in our software applications and licensed and developed online games. Our licensors may be subject to intellectual property rights claims with respect to the online game or games licensed to us. If any of our licensors cannot prevail on the intellectual property rights claims brought against them, we would lose our license from such licensor and may not be able to obtain the license from the legitimate owner of the game on terms acceptable to us, or at all, and our results of operations could be materially and adversely affected.

We could be subject to product liability claims, which could be time-consuming and costly to defend, divert management’s attention and could have a material and adverse effect on our reputation, business, results of operations and financial condition.

Our complex software products may contain errors that may not be detected until after the delivery of the software. Furthermore, errors may also be present in our online games and software that controls or is related to our various mobile applications and services offerings, Any such errors could result in delayed market acceptance or claims against us by customers, which could lead to increased insurance costs or the payment of damages by us. Any such claims, with or without merit, could be time-consuming and costly to defend and divert management’s attention and resources. Contractual provisions we may include in our agreements with third parties to mitigate this risk may not be enforceable in all jurisdictions, and liability insurance may not be available, or coverage for specific claims may be denied. A successful product liability claim brought against us could materially and adversely affect our reputation, business, results of operations and financial condition.

If we lose the services of key employees, it may be costly and time-consuming for us to locate other personnel with the required skills and experience.

Our success depends on the continued efforts of our board members, our senior management and our technical, research and development, services and support, marketing and sales personnel. These persons may terminate their association or employment with us at any time. We have experienced changes in our senior management for a variety of reasons, including restructuring, medical reasons, retirement, and resignations to pursue other career opportunities. Loss of the services of key members of senior management or experienced personnel can be disruptive and causes uncertainty. In particular, we depend upon the services of Mr. Peter Yip, our chief executive officer. Mr. Yip took a leave of absence for medical reasons between February 2005 and April 2006. During that time, two other people who served as our chief executive officer and president resigned. While Mr. Yip believes that he has recovered enough to serve as our chief executive officer, we cannot assure his continued service.

The process of hiring employees with the combination of skills and attributes required to implement our business strategy can be extremely competitive and time-consuming. We compete for a limited number of

 

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qualified individuals with more established companies with greater resources that may offer more attractive compensation or employment conditions. As a result, we may be unable to retain or integrate existing personnel or identify and hire additional qualified personnel.

We recently determined that material weaknesses in our internal controls over financial reporting existed during 2005 and 2006 as a result of, among other things, our inability to attract and retain sufficient resources with the appropriate level of expertise in the accounting and finance departments of our organization to ensure appropriate application of GAAP, particularly in the areas of accounting for income taxes, foreign currency translation adjustments related to goodwill and intangible assets and the accounting for certain of our non-routine transactions. These material weaknesses resulted in the restatement of our financial statements for the years ended December 31, 2005, 2004 and 2003.

An inability to attract or retain additional qualified senior managers or personnel in a timely manner, or the health, family or other personal problems of key personnel could have a material and adverse effect on our business, results of operations and financial condition.

In the past, we have partially relied on options to compensate our employees. In the event employees do not consider their options as valuable compensation, we may need to provide additional compensation at additional expense.

We have granted, and anticipate we will continue to grant, options to purchase our Class A common shares to some of our employees. In the event our employees do not consider their options to be valuable compensation, we may need to provide additional compensation in the form of additional salary, bonuses or equity, in an effort to retain those existing employees. Our inability to retain the employees in our key revenue producing businesses could have a material and adverse effect on our business, results of operations and financial condition.

The computer networks at our CDC Games and China.com business units are vulnerable to hacking, viruses, spamming and other disruptions by third parties, which may cause those businesses to lose key clients, expose us to liability for our clients’ losses, or prevent us from securing future business.

Unauthorized or inappropriate use of Internet services or errors or omissions in processing instructions or data available in computer system or databases at our CDC Games and China.com business units could jeopardize the security of confidential information stored in these computer system, which may cause our CDC Games and China.com business units lose key clients, expose us to liability for our clients’ losses and prevent us from securing future business, any of which could have a material adverse effect on our business, financial condition, results of operations and share price.

Unauthorized or inappropriate use of the Internet includes attempting to gain unauthorized access to information or systems (commonly known as cracking or hacking) and repeated transmission of unsolicited e-mail messages (commonly known as e-mail bombing or spamming). The current policies, procedures and configurations for managing the systems at our CDC Games and China.com business units, including their computer servers, may not be adequate to protect these facilities and the integrity of user and customer information. Although CDC Games and China.com implement security measures to protect their facilities and the integrity of their user and customer information, such measures could be ineffective or circumvented.

Alleviating problems caused by computer viruses or other inappropriate uses or security breaches may require interruptions, delays or cessation in the services our CDC Games and China.com business units, in addition to the outages that occur in these systems from time to time for various reasons, including power interruptions, errors in instructions, equipment inadequacy, capacity and other technical problems. We do not carry errors and omissions or other insurance covering losses or liabilities caused by computer viruses,

 

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security breaches or spamming attacks. Compromises or breaches in the security or integrity of these facilities or customer or user information, or inappropriate use of these Internet services, could subject us, CDC Games and China.com to litigation and could adversely affect our customer base, business, share price, results of operation and financial condition.

 

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Illegal game servers could materially and adversely affect the business, reputation, financial condition and results of operations of our online games segment.

We increasingly face the risks of illegal game servers at our CDC Games business unit. Some Internet cafés have misappropriated our game server installation software. Several competitors have reported instances of Internet cafés installing illegal copies of such competitors’ games on the cafés’ servers and letting their customers play such games on illegal servers without paying for game playing time. Although we have made efforts to shut down illegal game servers across China, the intellectual property enforcement regime in China is not as robust as that of the United States, and we continue to face considerable challenges to enforcing our intellectual property rights. Enforcement actions generally require cooperation from local authorities, which are sometimes unwilling to use their limited resources to enforce the intellectual property rights of national corporations against individuals or companies in their districts. In addition, litigation proceedings are often necessary to enforce intellectual property rights, which can be very expensive. Despite our efforts to shut down illegal game servers, we believe that a significant number of illegal game servers may continue to operate unauthorized copies of our online games. The continued operation of our online games by illegal game servers, or the operation of any new games that we may introduce by illegal game servers, may materially and adversely affect our business, reputation, financial condition and adversely affect our results of operations. We cannot assure you that we will be able to identify and eliminate new illegal game servers and unauthorized character enhancements in a timely manner, or at all.

We rely on software and hardware systems at our CDC Games and China.com business units that are susceptible to failure, and in the event of service operations or other related problems, the operating efficiency and results of operations of these businesses may be adversely affected.

Any system failure or inadequacy that interrupts the services of our CDC Games and China.com business units or increases the response time of these services could reduce user satisfaction, future traffic and our attractiveness to advertisers and consumers. We also depend on Internet service providers and other Web site operators in the PRC and elsewhere that have experienced significant system failures and electrical outages in the past. Our users have experienced difficulties due to system failures that were unrelated to our systems and services. There can be no assurance that our technologies, services and products will not experience interruptions or other related problems, which could affect our operating efficiency and results of operations of these business units.

Many of our servers and routers, including back up servers, are currently hosted by third-party service providers throughout China. We do not maintain insurance policies covering losses relating to our systems and we do not have business interruption insurance. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers.

We also have limited system redundancy, and do not have a disaster recovery plan in the event of damage from fire, natural disasters, power loss, telecommunications failures, break-ins and similar events. We may experience a complete system shut-down if any of these events were to occur. To improve performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers or one or more copies of our Web sites to mirror our online resources. Because we carry property insurance with low coverage limits, our coverage may not be adequate to compensate us for our losses. If we do not increase our capacity and our redundancy, these constraints could have a material adverse effect on our business, results of operations and financial condition.

The successful operation of our online game and internet portal businesses depends upon the performance and reliability of the Internet infrastructure and fixed telecommunications networks in China.

Our online game and internet portal businesses depend on the performance and reliability of the Internet infrastructure in China. Almost all access to the Internet is maintained through state-owned

 

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telecommunication operators under the administrative control and regulatory supervision of China’s Ministry of Information Industry. In addition, the national networks in China are connected to the Internet through international gateways controlled by the PRC government. These international gateways are generally the only channels through which a domestic user can connect to the Internet. We cannot assure you that a more sophisticated Internet infrastructure will be developed in China. We may not have access to alternative networks in the event of disruptions, failures or other problems with China’s Internet infrastructure. In addition, the Internet infrastructure in China may not support the demands associated with continued growth in Internet usage.

Risks Relating to Our Class A Common Shares

Our share price could be adversely affected if our major strategic shareholders materially change their holdings in our shares, particularly if the share holdings are not disposed of in an orderly manner.

As of April 30, 2007, Asia Pacific Online Limited, or APOL, beneficially owned 22,104,588 of our common shares, or approximately 19.2% of our total outstanding share capital and Xinhua, through a wholly-owned subsidiary, owned 7,362,734 of our common shares, or approximately 6.4% of our total outstanding share capital. APOL is owned by the spouse of Mr. Peter Yip, our current chief executive officer and Vice Chairman of the Board of Directors, and by a trust established for the benefit of Mr. Yip’s children. There is no guarantee that APOL or Xinhua will continue to hold our shares going forward for any length of time. If APOL or Xinhua disposes, or if our investors expect Xinhua or APOL to dispose of, a substantial portion of their respective holdings in CDC at any time, it could adversely affect our share price. For more information regarding the shareholdings of APOL, Xinhua and other entities, see Item 7.A., “Major Shareholders and Related Party Transactions – Major Shareholders.”

A small group of our existing shareholders control a significant percentage of our common shares, and their interests may differ from those of our other shareholders.

As of April 30, 2007, APOL owned approximately 19.2% of our common shares, Xinhua, through a wholly-owned subsidiary, owned approximately 6.4% of our common shares and Jayhawk Capital owned approximately 5.3% of our common shares. Accordingly, these shareholders, particularly if they act together, will have significant influence in determining the outcome of any corporate transaction or other matter submitted to shareholders for approval, including:

 

   

mergers, consolidations and other business combinations which under the law of the Cayman Islands requires the approval of at least 75% of the shares voting at the meeting;

 

   

election or non-election of directors which under the law of the Cayman Islands requires the approval of a simple majority of the shares voting at the meeting;

 

 

 

removal of directors which under the law of the Cayman Islands requires the approval of at least 66 2/3% of the shares voting at the meeting; and

 

 

 

amendments to our memorandum and articles of association which under the laws of the Cayman Islands requires the approval of at least 66 2/3% of the shares voting at the meeting.

As a result, these shareholders, if they act together, may be able to effectively prevent a merger, consolidation or other business combination, elect or not elect directors, prevent removal of a director and prevent amendments to our memorandum and articles of association.

For more information regarding the shareholdings of APOL, Xinhua and Jayhawk, see Item 7.A., “Major Shareholders and Related Party Transactions – Major Shareholders.”

 

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Our share price has been, and may continue to be, extremely volatile, which may not be attractive to investors.

The trading price of our common shares has been, and is likely to continue to be, extremely volatile. During the period from July 12, 1999, the date we completed our initial public offering, or IPO, to December 31, 2002, the closing price of our shares ranged from $1.86 to $73.4375, adjusted for our two stock splits. From January 1, 2003 to December 31, 2006, the closing price of our shares ranged from a low of $2.40 per share on April 15, 2005 to a high of $14.46 per share on July 14, 2003. There is no assurance that our share price will not fall below its historic or yearly low.

The trading price of our Class A common shares is subject to significant volatility in response to, among other factors:

 

   

investor perceptions of our business, the market performance of our peer companies in the enterprise software business services, online games, mobile services and applications, Greater China portal and advertising and marketing activities businesses, in general;

 

   

our significant acquisitions, partnerships, joint ventures or capital commitments;

 

   

trends and developments in all the markets in which we compete;

 

   

variations in our operating results;

 

   

our new product or service offerings;

 

   

changes in our financial estimates by financial or industry analysts;

 

   

technological innovations;

 

   

litigation;

 

   

changes in pricing made by us, our competitors or providers of alternative services;

 

   

the depth and liquidity of the market for our shares; and

 

   

general economic and other factors.

In addition, the trading price of our common shares has experienced extreme price and volume fluctuations. These fluctuations often have been unrelated or disproportionate to our operating performance. Broad market, political and industry factors may also decrease the price of our common shares, regardless of our operating performance. Securities class-action litigation and regulatory investigations often have been instituted against companies following steep declines in the market price of their securities.

We issued $168 million of senior exchangeable convertible notes due 2011 which we may not be able to repay in cash, could result in dilution to our current stockholders, dilution of our earnings per share, and which contain negative covenants which may have an adverse effect on our business and financial condition .

In November 2006, we issued an aggregate of $168 million of 3.75% senior exchangeable convertible notes due 2011 to a total of 12 institutional accredited investors in a private placement exempt from registration under the Securities Act. As of December 31, 2006, the face value of outstanding senior exchangeable convertible notes was $168 million.

Upon the occurrence of certain events, we have the right to redeem the notes, and the investors may demand redemption of the notes by us in the event that no qualified initial public offering by either CDC

 

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Software or CDC Games has occurred on the third anniversary following the issuance of the notes. The notes may be redeemed at par value plus all accrued and unpaid interest; provided, however, that the interest rate shall increase to 12.5% per annum and apply retroactively from the issue date to the applicable redemption date. However, we cannot assure you that we will have enough cash on hand or the ability to access cash to pay the notes if presented for redemption, on a redemption date referred to above or at maturity.

In addition, in connection with our issuance of the notes, we became subject to various negative covenants. We agreed that we will not incur any debt, other than permitted debt, unless after giving effect to such debt: our leverage ratio is less than 6.0 to 1 as reflected in our consolidated financial statements for the immediately preceding four fiscal quarters; our aggregate debt does not exceed 50% of our total capitalization on a consolidated basis as reflected in our consolidated financial statements for the immediately preceding four fiscal quarters; or our consolidated cash flow exceeds two times the sum of consolidated interest expense and capital expenditures during the immediately preceding four fiscal quarters.

Furthermore, we also may not create, assume or incur any mortgage, pledge lien, or other security interest except for certain permitted liens, which include existing liens, intracompany liens, liens over assets of CDC Software to secure a credit facility to CDC Software in an amount not exceeding $30 million, liens securing assets acquired or constructed after the closing to secure the cost of such acquisition or construction, provided such liens do not exceed 80% of the fair market value of the asset, or any lien resulting from renewing extending or replacing a lien.

Pursuant to the negative covenants we are also prohibited from paying dividends to our common shareholders (other than dividends of our common shares) or repurchase any shares of our capital stock or any of our subsidiaries, provided, however, that we may purchase voting equity in any non-wholly owned subsidiary or make purchases pursuant to a stock repurchase program.

The note investors are also afforded anti-dilution protection, a right of first refusal if we, CDC Software or CDC Games intend to offer or sell any of its equity or equity equivalent securities prior to a qualified initial public offering, and have received registration rights with respect to the common shares deliverable upon an exchange of the notes. The negative covenants set forth above may have the effect of limiting our ability to operate our businesses and financial affairs in certain manners, which may have a material, adverse effect on our business, financial condition and results of operations.

We are a “foreign private issuer” and have different disclosure obligations from those of other U.S. domestic reporting companies.

We are a foreign private issuer and, as a result, we are not subject to certain of the requirements imposed upon U.S. domestic issuers by the Securities and Exchange Commission. For example, we are not required to issue quarterly reports or proxy statements. We are allowed six months to file our annual report with the Securities and Exchange Commission instead of approximately three, and we are not required to disclose certain detailed information regarding executive compensation that is required from U.S. domestic issuers. Further, our directors and executive officers are not required to report equity holdings under Section 16 of the Securities Act of 1933, as amended. As a foreign private issuer, we are also exempt from the requirements of Regulation FD (Fair Disclosure) which, generally, are meant to ensure that select groups of investors are not privy to specific information about an issuer before other investors. We are, however, still subject to the anti-fraud and anti-manipulation rules of the Securities and Exchange Commission, such as Rule 10b-5.

In general, many of the disclosure obligations required of us as a foreign private issuer are less stringent than those required by other U.S. domestic reporting companies, our shareholders should not expect to receive an equivalent amount of information from us as from other U.S. domestic reporting companies.

 

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We are however, in general, liable for violations of the rules and regulations of the Securities and Exchange Commission which do apply to us as a foreign private issuer. Violations of these rules could affect our business, results of operations and financial condition.

We may incur significant costs to avoid being considered an investment company under the Investment Company Act of 1940.

Generally, the Investment Company Act of 1940, or the 1940 Act, provides that a company is not an investment company and is not required to register under the 1940 Act as an investment company if:

 

   

the company is primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities; and

 

   

40% or less of the value of the company’s assets (exclusive of cash items and U.S. government securities) is represented by “investment securities” as defined by the 1940 Act.

We believe that we are engaged primarily and directly in the businesses of providing enterprise software and business services through our CDC Software business unit, on online games through our CDC Games business unit and on mobile applications and internet and media services through our China.com business unit. Also, based upon an analysis of our assets at December 31, 2006 and income for the year ended 2006, during 2006, we do not believe we will be considered an investment company. The determination of whether we will be an investment company will be based primarily upon the composition and value of our assets, which are subject to change, particularly when market conditions are volatile. As a result, we could inadvertently become an investment company.

If we were to become subject to the requirements of the 1940 Act, our operations and results would be negatively impacted, including among other possible effects, our inability to raise capital through the offer and sale of our securities in the United States. We could also be subject to administrative or legal proceedings and, among other things, contracts to which we are a party might be rendered unenforceable or subject to rescission. Additionally, we would be unable to continue operating as we currently do and might need to acquire or sell assets that we would not otherwise acquire or sell in order to avoid becoming and "investment company" as defined under the 1940 Act. We may incur significant costs and management time to avoid being considered an investment company under the Investment Company Act of 1940, as amended.

We can give no assurances in the future as to our investment company status under the Investment Company Act of 1940.

We believe, although we cannot assure you, that our Class A common shares should not be treated as stock of a passive foreign investment company, or PFIC, for the taxable year ending December 31, 2006. This belief is different than the determinations we have made in previous years, and we cannot assure you that we will not be treated as a PFIC in the future.

We do not believe that we should be treated as a PFIC for U.S. federal income tax purposes for our taxable year ending December 31, 2006, based upon our analysis of our assets held at the end of each quarter of our taxable year ending December 31, 2006, and our income for our taxable year ended December 31, 2006. However, the PFIC determination is inherently factual and there is limited guidance regarding the application of the PFIC rules. Accordingly, we cannot assure you that the IRS will not successfully contend, or that a court would not otherwise conclude, that we are a PFIC. Accordingly, prospective investors are strongly urged to consult with their tax advisor as to the effects of the PFIC rules.

 

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Further, the PFIC determination is made annually, and therefore may be subject to change in future years. Thus, we can provide no assurance that we will not be classified as a PFIC in 2007 and beyond. The determination of whether we would become a PFIC in a future tax year would be principally based upon:

 

   

the composition of our assets, including goodwill, the amount of which will depend, in part, on our total net assets and the market value of our Treasury portfolio, which is subject to change; and

 

   

the amount and nature of our income over the course of the year.

We have limited control over these variables and therefore, cannot assure you of our PFIC status for future years.

Further, we may consider additional capital markets or corporate finance transactions in the future. Should we proceed with such offerings, we cannot, at this stage, specify with certainty the timing, amounts or the particular uses of the net proceeds. Depending on the usage of any such net proceeds, we could possibly become classified as a PFIC as a result of such transactions.

If we become a PFIC, U.S. holders, as such term is defined in Item 10.E., “Additional Information – Taxation – Tax Consequences of U.S. Holder,” could be subject to adverse U.S. federal income tax consequences. For further discussion regarding our PFIC status, see Item 10.E., “Additional Information – Taxation – Tax Consequences of U.S. Holders – Passive Foreign Investment Company Status.” U.S. holders are strongly urged to consult their own tax advisors regarding the application of the PFIC rules to their particular circumstances.

Substantial amounts of our common shares are eligible for future sale, which could adversely affect the market price of our shares.

Sales of substantial amounts of our Class A common shares in the public market could adversely affect the market price for our shares. As of March 31, 2007, we had 114,944,204 Class A common shares issued and outstanding, substantially all of which may be sold pursuant to an effective registration statement under the Securities Act or an applicable exemption from registration thereunder, including Rule 144, which permits resales of securities subject to limitations (including trading volume) depending on the holding period of such securities.

In addition, as we continue to issue and register shares to fulfill our contractual and acquisition-related obligations, and as our employees and other grantees have been or are granted additional options to purchase our common shares, additional shares will be available-for-sale in the public market. We have also granted options to certain of our shareholders, directors and officers to purchase our shares, the vesting of which options may be accelerated upon an occurrence of a change-of-control event. As a result, additional shares may be available-for-sale in the public market. The availability or perceived availability of additional shares could have a dilutive and negative impact on the market price of our shares.

In the future, we may also issue additional shares, convertible notes or warrants to purchase our shares, in connection with acquisitions and our efforts to expand our business. Shareholders could face further dilution from any such future share issuances.

Anti-takeover provisions in our charter documents may adversely affect the rights of holders of our common shares.

Our memorandum and articles of association include provisions that could limit the ability of others to acquire control of us, modify our structure or cause us to engage in change-of-control transactions. These provisions could have the effect of depriving shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of us, in a tender offer or similar transaction.

 

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For example, our board of directors is divided into three classes, each having a term of three years, with the term of one class expiring each year. These provisions have the effect of delaying the replacement of a majority of our directors and make changes to our board of directors more difficult than if such provisions were not in place. In addition, our board of directors has the authority, without further action by our shareholders, to issue up to 5,000,000 preferred shares in one or more series and to fix their designations, powers, preferences, privileges, relative participating, optional or special rights and the qualifications, limitations or restrictions thereon, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences. Any or all of the foregoing may be superior to the rights afforded to the holders of our Class A common shares. Preferred shares could be issued quickly with terms calculated to delay or prevent a change in control or make removal of management more difficult. If our board of directors issues preferred shares, the price of our Class A common shares may fall and the voting and other rights of the holders of our Class A common shares may be adversely affected.

Our shareholders may face difficulties in protecting their interests because we are incorporated under Cayman Islands law.

Our corporate affairs are governed by our amended and restated memorandum and articles of association, and by the Companies Law and common law of the Cayman Islands. The rights of shareholders to take action against our directors, actions by minority shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law in the Cayman Islands is derived in part from, as compared to the U.S., limited judicial precedent in the Cayman Islands and from English common law. Cayman Islands law in this area may conflict with jurisdictions in the United States. As a result, our public shareholders may face more difficulties in protecting their interests in actions against our management, directors or our controlling shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States. For instance, the ability to bring a class action lawsuit may not be available to our shareholders as a vehicle for litigating securities matters against us in the Cayman Islands. Further, under Cayman Islands law, shareholder derivative actions may generally not be brought by a minority shareholder. In addition, the shareholders of Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States. As a result, our shareholders may have more difficulty in protecting their interests in actions against our management, directors or our shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States, and our ability to protect our interests if we are harmed in a manner that would otherwise enable us to sue in a United States court may be limited.

Additionally, the Cayman Islands have a less developed body of corporate and securities laws than the United States.

The Cayman Islands courts are also unlikely to:

 

   

recognize or enforce against us judgments of courts of the United States based on certain civil liability provisions of U.S. securities laws; or

 

   

impose liabilities against us, in original actions brought in the Cayman Islands, based on certain civil liability provisions of U.S. securities laws that are penal in nature.

There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will generally recognize and enforce a non-penal judgment of foreign court of competent jurisdiction without retrial on the merits.

 

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As a result of the above, our public shareholders may have more difficulty in protecting their interests than they would as public shareholders of a U.S. company.

You may have difficulty enforcing judgments obtained against us.

We are a Cayman Islands company and a substantial majority of our assets are located outside the United States. A substantial portion of our current operations is conducted outside the United States in countries such as Canada, China, Sweden, Australia, the United Kingdom and other countries and territories, and a majority of our directors and officers are nationals and/or residents of countries other than the United States. A substantial portion of any assets these people may hold is located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon, and gain jurisdiction over, these persons. In addition, there is uncertainty as to whether the courts of Canada, China, Sweden, the United Kingdom and other jurisdictions would recognize or enforce judgments of U.S. courts obtained against us or these persons that may be based upon the civil liability provisions of the securities laws of the United States or any state thereof. Furthermore, the courts of these countries may refuse to hear cases brought in Canada, China, Sweden, the United Kingdom, or other jurisdictions against us or such persons predicated upon the securities laws of the United States or any of its states.

If you are not a registered shareholder and do not hold greater than 10,000 shares, you may not receive our proxy materials or other corporate communications.

We are a Cayman Islands company. As such, we are only required to distribute our proxy materials to our registered shareholders, and not to any shareholders who hold our shares beneficially, through a broker or in a brokerage account. We offer electronic delivery of proxy materials to our registered shareholders, and we mail proxy materials to each registered owner who has not opted to receive materials electronically. You are a registered shareholder if you have an account with our transfer agent, The Bank of New York, and if you hold a stock certificate evidencing your ownership of our common shares. You are a beneficial shareholder if a brokerage firm, bank trustee or other agent holds your common shares. However, your name would not appear anywhere on our records, but rather the name of the broker, bank or other nominee appears on our records as retained by our transfer agent, The Bank of New York. Although we only need to distribute our proxy materials to registered shareholders under Cayman Islands law, we also distribute, but are not required to distribute, proxy materials to beneficial shareholders who hold greater than 10,000 of our shares. In an effort to maintain cost effectiveness, we have, and intend to continue to, mail the proxy materials to those beneficial shareholders who hold greater than 10,000 of our shares. If you are not a registered shareholder and do not hold greater than 10,000 of our shares, you will not receive our proxy materials or other corporate communications. Therefore, if you are a beneficial shareholder and want to ensure that you do receive proxy materials, you are urged to become a registered owner.

We do not intend to pay dividends in the foreseeable future and the holders of our class A common shares may not receive any return on their investment from dividends.

We currently intend to retain any future earnings for funding growth. We do not anticipate paying any dividends in the foreseeable future. The holders of our class A common shares may not receive any return on their investment from dividends.

 

ITEM 4. INFORMATION ON THE COMPANY

 

A. History and Development of the Company

Our headquarters and principal executive offices are located at 33/F Citicorp Centre, 18 Whitfield Road, Causeway Bay, Hong Kong, and our telephone number is 852-2893-8200. Our contact telephone

 

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number in Beijing is 011-8610-5129-8700, and in the United States it is (678) 259-8510. We have a website that you may access at http://www.cdccorporation.net. Information contained on our website does not constitute part of this Annual Report.

We were incorporated in June 1997 as China Information Infrastructure Limited, a company limited by shares under the Companies Law of the Cayman Islands and a wholly-owned subsidiary of China Internet Corporation Limited, or CIC, to operate CIC’s Internet portal and related businesses.

In June 1999, CIC distributed its entire interest in our predecessor company to CIC’s shareholders. Upon completion of that transaction, CIC ceased to have any ownership interest in our predecessor company. APOL and a wholly-owned subsidiary of Xinhua provided rights of first refusal to buy the other party’s shares in us in the event either party sought to dispose of its shareholdings. Additionally, APOL received rights to place shares of us owned by the Xinhua subsidiary to prospective buyers on behalf of the Xinhua subsidiary in exchange for a commission.

In July 1999, we completed our IPO of the equivalent of 19,320,000 class A common shares on NASDAQ at the equivalent of a public offering price of $5.00 per share on a stock split adjusted basis. All of the shares registered were sold and net proceeds from the IPO totaled $85.6 million.

In December 1999, our shareholders approved a two-for-one share split.

In January 2000, we completed a second public offering of the equivalent of 9,952,884 class A common shares on NASDAQ at the equivalent of a public offering price equal to $42.50 per share on a stock split adjusted basis. Of the 9,952,884 class A common shares sold, 2,325,000 shares were offered by certain of our shareholders. The selling shareholders received an aggregate of $94.1 million in net proceeds for their shares. All of the shares registered were sold and net proceeds to us from the offering totaled $303.9 million.

In March 2000, we listed our subsidiary, hongkong.com Corporation (which has since been renamed to China.com), on the Growth Enterprise Market, or GEM, of the Hong Kong Stock Exchange, by selling approximately 16% of this subsidiary to the public. We received net proceeds of approximately $168.5 million in connection with this listing and sale. We currently continue to own approximately 77% of China.com.

In April 2000, our shareholders approved a second two-for-one share split.

In addition, in April 2000, our shareholders approved the change of our company name to chinadotcom corporation. In April 2005, our shareholders approved a second change of our company name from chinadotcom corporation to CDC Corporation. Concurrently, in April 2005, the shareholders of hongkong.com Corporation approved a change of its name from hongkong.com Corporation to China.com.

Acquisitions and Divestitures

Our goal is to be a global company focused on enterprise software through our CDC Software business unit, online games through our CDC Games business unit, and mobile applications and internet and media services through our China.com business unit. The evolution of our business model has been achieved in large part through strategic acquisitions and investments during the past three fiscal years. We have spent a significant amount of cash and have issued a significant number of our common shares in connection with the strategic acquisitions and investments mentioned below.

The following is a summary of our strategic acquisitions and investments completed since January 1, 2004 organized by business unit:

 

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CDC Software

Enterprise Software Group

 

Acquisition or Investment

  

Date

  

Description

Pivotal Corporation

   February 2004    Vertical CRM applications.

Ross Systems, Inc.

   August 2004    Extended ERP and SCM applications.

Assets of JRG Software, Inc.

   February 2006    On-demand supply chain solutions for planning and scheduling, delivered as Software as a Service (SaaS).

c360 Solutions, Inc.

   April 2006    Add-on products, solutions and tools for the Microsoft Dynamics CRM platform.

MVI Holdings Limited

   October 2006    Real-time performance management solutions for process manufacturers.

Vis.align, Inc.

   December 2006    Enterprise solutions and IT services provider based in Pennsylvania.

Respond Group Limited

   February 2007    Enterprise class complaints, feedback and customer service solutions.

Saratoga Systems

   April 2007    Enterprise CRM and wireless CRM applications.

Business Services Group

 

Acquisition or Investment

  

Date

  

Description

Assets of Horizon Companies, Inc. (51%)

   February 2006    Outsourced IT support and consulting services provider based in India, Canada and New Jersey.

DB Professionals, Inc.

   June 2006    Outsourced IT support and consulting services provider based in Illinois.

OST International Corporation

   June 2006    Outsourced IT support and consulting services provider based in Oregon.

Vectra Corporation (majority interest)

   May 2007    Information security consulting services, managed services and enterprise security solutions.

CDC Games

Online Games

 

Acquisition or Investment

  

Date

  

Description

Equity Pacific Limited (holds Beijing 17Game Network Technology Co., Ltd.) (1)    March 2006    17game is a leading massive multiplayer online role-playing games (MMORPG) provider in the China market.

 

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Acquisition or Investment

  

Date

  

Description

Gorilla Banana

Entertainment Corp.

   January 2007    Independent online games development company in South Korea (minority equity investment and distribution rights).

Auran Holdings

Pty Ltd

   March 2007    Developer of online games in Australia (minority equity investment and revenue sharing rights).
MGame Corporation    March 2007    Leading developer of online games in South Korea (minority equity investment and distribution rights).
Guangzhou Optic Communications Co., Ltd., or “Optic” (2)    June 2007 (2)    A leading online games company in the PRC.

(1) In March 2006, a subsidiary of China.com acquired the remaining 52% of Equity Pacific Limited, or Equity Pacific, which ultimately owns Beijing 17game Network Technology Co Limited, or 17game, amongst other subsidiaries. 17game was transferred to CDC Games in December 2006 in connection with our internal restructuring.
(2) In June 2007, our subsidiary, CDC Games Holdings Limited entered into a binding term sheet pursuant to which we intend to acquire all of the registered capital of Optic and all of the issued and outstanding capital of its related wholly owned foreign enterprise from Bonarich Enterprises Ltd,, a subsidiary of CITIC Pacific Limited.

 

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China.com

Mobile Services

 

Acquisition or Investment

  

Date

  

Description

Group Team Investments Limited (holds Beijing He He Technology Co. Ltd.)    May 2004    Operates Go2joy, is a mobile value-added services and applications provider in China with partnerships with media companies in China.
Unitedcrest Investments Limited (holds Shenzhen KK Technology Ltd.)    June 2005    Mobile value-added services and applications provider in China which specializes in nation-wide WAP businesses.
Timeheart Science Technology Limited    November 2006    Provider of MVAS products through personal digital assistants (PDAs), wireless application protocol (WAP), multimedia services (MMS), interactive voice response (IVR) and media stream, in China.

We continually seek to acquire companies that support and expand our current business models. Our acquisitions are typically financed through a combination of cash and our common shares.

In July 2006, we filed a Tender Offer Statement on Schedule TO with the Securities and Exchange Commission regarding our proposed public tender offer to purchase all of the outstanding shares of common stock, together with all associated rights, of Onyx Software Corporation for $5.00 per share, net to the seller in cash, subject to certain terms and conditions. On July 25, 2006, we announced that we terminated our previously announced offer.

 

B. Business Overview

CDC Corporation, with facilities in the PRC, Southeast Asia, North America, Europe and Australia, is a global provider of enterprise software, online games, mobile services and applications and internet and media services. We report operating results in five business segments, “Software,” “Business Services,” “Online Games,” “Mobile Services and Applications” and “Internet and Media”. During 2005, we reorganized these segments into two core business units, CDC Software and China.com., and during 2006, we added a third core business unit, CDC Games. The operations of Software and Business Services are included in the CDC Software business unit, the operations of online games are included in the CDC Games business unit and the operations of Mobile Services and Applications and Internet and Media are included in the China.com business unit.

CDC Software Business Unit

Our Business

CDC Software is a leading global provider of specialized enterprise software applications and complementary business services to customers in select industries, which we refer to as our targeted vertical industries. Companies in our targeted vertical industries generally have specific and complex business needs and often are subject to specific and extensive regulatory requirements. We believe that our enterprise software applications address our customers’ critical, industry-specific requirements more reliably and more cost-effectively than conventional enterprise software applications. We also offer a full range of complementary business services, including information technology, or IT, and outsourcing services, that span the lifecycle of our customers’ technology investments.

 

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We conduct our business through our Enterprise Software Group and our Business Services Group. Through our Enterprise Software Group, we offer enterprise software applications that are designed to deliver industry-specific functionality. We believe our products help our customers establish and maintain a competitive advantage by allowing them to reduce the cost of their operations, gain visibility needed for continuous business improvement and ensure their regulatory compliance. Our products can be rapidly deployed, configured and upgraded easily, and are intuitive to learn and use. We believe these factors lower our customers’ total cost of ownership and increase their return on investment.

CDC Software’s principal enterprise software applications include:

 

   

Enterprise and departmental solutions for process manufacturers in the food and beverage, consumer products, pharmaceutical and biotechnology, chemicals, metals and natural products industries. These solutions include enterprise resource planning, or ERP, supply chain management, or SCM, manufacturing operations management, customer relationship management, or CRM, and enterprise performance management; and

 

   

Vertical CRM applications for industries characterized by complex product offerings, business relationships and sales processes, such as the financial services, homebuilding and real estate, general manufacturing and healthcare industries.

Through our Business Services Group, we offer IT and business services to help our customers optimize their business processes and maximize the value of their IT expenditures. Our IT and business service offerings include industry advisory, business process improvement, implementation and outsourced hosting and application management services. Our customers make significant investments when they purchase enterprise software applications, whether from us or other software vendors, to run many critical business processes for years to come. Our broad range of IT and business services helps our customers protect and extend the value of those investments by offering them ways to improve and enhance their IT systems and business processes. We assist our customers in implementing software and in fine-tuning their IT infrastructure, including processes, systems and personnel management.

As of March 31, 2007, products and services had been purchased by over 6,000 companies worldwide. For the year ended December 31, 2006, the CDC Software Business Unit generated total revenues of $240.9 million and net income of $4.0 million. Our Enterprise Software Group and our Business Services Group accounted for 73% and 27%, respectively, of these 2006 revenues.

Enterprise Software Group

Overview

CDC Software’s Enterprise Software Group provides a diverse portfolio of sophisticated enterprise software applications for mid-sized enterprises and divisions of larger enterprises in its targeted vertical industries. Revenues from the Enterprise Software Group were $175.5 million in 2006, which constituted 73% of CDC Software’s total revenues during that period.

CDC Software’s integrated suite of enterprise software applications help its customers improve efficiencies and profitability through company-wide integration of business and technical information across multiple divisions and organizational boundaries, such as finance, general manufacturing, logistics, human resources, marketing, sales and customer service. While most of our products are available as licensed applications installed at our customers’ facilities, some of our products are available on a subscription basis over the Internet. Over time, we intend to make more of our products available in a SaaS format. We complement our products with a range of business services that promote a lower total cost of ownership and faster return on investment. The following chart summarizes our vertically focused products and services:

 

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LOGO

 

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CDC Software’s products and services are designed to meet the specific needs of its targeted vertical industries by addressing the unique challenges facing those industries. Some of our industry-specific solutions include:

 

Selected Targeted

Vertical Industry

  

CDC Software Industry-Specific Solutions

Financial services   

•        Help differentiate product offerings

•        Increase sales effectiveness by managing indirect relationships with deal influencers

•        Build customer loyalty by offering unique, personalized services

•        Improve customer experience with coordinated interactions across all departments

•        Measure and track expenses and profitability of individual agents and brokers

•        Increase data accuracy and accessibility

•        Streamline time-intensive processes to reduce costs

•        Manage customer complaints to improve customer satisfaction and retention, and ensure regulatory compliance

Homebuilding and real estate   

•        Attract more high-quality leads

•        Shorten sales cycles by simplifying and streamlining the sales process

•        Enable delivery of high-quality customer service during the sales process

•        Facilitate the management of warranty claims and repairs

•        Drive measurable increases in referrals and repeat business

Food and beverage   

•        Streamline operations and SCM functions to reduce costs and improve profits

•        Cost-effectively respond to increasing demands of big-box retailers and large distributors

•        Manage complex sales and distribution networks

•        Streamline regulatory compliance

•        Ensure consistent safety and quality of product

•        Ensure brand protection

•        Manage recalls and mock recalls

•        Increase product line profitability

•        Optimize production and inventory planning

•        Provide customer self-service

•        Manage recipes

•        Control inventory

•        Facilitate complex product costing

Pharmaceutical and biotechnology   

•        Streamline regulatory compliance

•        Monitor, track, control, validate and audit critical resources and activities across the manufacturing and distribution processes

•        Maintain control and ensure product safety and quality while taking advantage of the industry trend toward outsourced and offshore manufacturing

•        Ensure brand protection

•        Manage recalls and mock recalls

•        Optimize production and inventory planning

•        Provide customer self-service

•        Manage customer complaints to improve customer satisfaction and retention, and ensure regulatory compliance

 

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Selected Targeted

Vertical Industry

  

CDC Software Industry-Specific Solutions

Chemicals   

•        Streamline operations and SCM functions to reduce costs and improve profits

•        Optimize production and inventory planning

•        Manage complex sales and distribution networks

•        Facilitate automated monitors and reporting to efficiently demonstrate compliance

•        Maintain control and ensure product safety and quality while taking advantage of the industry trend toward toll processing and outsourced and offshore manufacturing

•        Optimize value of capital investments in production equipment and warehouse capacity

General manufacturing   

•        Accelerate time to market for new products

•        Increase sales effectiveness by managing indirect relationships with deal influencers, such as doctors

•        Increase margins through improved price quoting and discounting

•        Coordinate the management of extended sales teams including direct, wholesales and distributors

Healthcare   

•        Gain insight into individual client requirements and expectations

•        Improve data quality and management visibility

•        Improve the profit potential of each client

•        Coordinate services more consistently and effectively across all departments

•        Manage customer complaints to improve customer satisfaction and retention, and ensure regulatory compliance

Metals and natural products (forest and agricultural products)   

•        Streamline operations and SCM functions to reduce costs and improve profits

•        Minimize operating costs and maintain control while taking advantage of the industry trend toward outsourced and offshore manufacturing

•        Respond to increasing need to outsource to meet cyclical demands

•        Enhance customer service as a differentiator

•        Improve productivity

•        Optimize value of capital investments in production equipment and warehouse capacity

Enterprise Software Applications and Services

CDC Software’s enterprise software applications and services include the following:

Enterprise Resource Planning (ERP). Our ERP products help provide the control and visibility needed throughout a customer’s operations to improve profitability and fulfill customer demand. For companies that produce and package products through recipe and formula-based processes, our ERP solutions help process manufacturers manage manufacturing operations with dynamic forecasting and scheduling, formula-based production and yield management, quality control, inventory management, complex product costing, and streamlined regulatory compliance.

 

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Supply Chain Management (SCM). Our SCM products enable process manufacturers to plan and forecast proactively, optimize production schedules for low-cost and high-quality customer service, minimize inventory investments, and streamline distribution operations. We also offer a complete set of SCM products for distribution intensive companies that support demand-driven fulfillment in multi-company, multi-site, multi-channel environments, such as for retailers (grocery stores, specialty goods and direct merchant retailers), wholesalers (pharmaceutical and over-the-counter drug distributors) and consumer goods manufacturers, which have high volumes of order transactions and fast-moving products.

Customer Relationship Management (CRM). Our CRM products help our customers establish and maintain profitable long-term business relationships with their customers by integrating information from the entire enterprise and increasing efficiencies within the sales, marketing and service functions to create one unified business network connecting employees, partners and customers. Our products are highly configurable, enabling companies to cost-effectively adapt and integrate the application to fit their unique business processes.

Manufacturing Operations. Our manufacturing operations applications help companies optimize the efficiency and effectiveness of their factories. These applications are integrated with and complement our ERP and SCM products, and also fill the manufacturing operations void in ERP, SCM and manufacturing execution systems from our competitors. Our manufacturing operations applications combine finite factory scheduling with real-time performance management and business intelligence to enable continuous improvement, optimization of operational resources and change management for manufacturing operators, engineers, technicians and management personnel.

Human Resource Payroll (HRP). Our HRP solutions, which are currently only offered in China, focus on automating processes to enable an organization to improve business results and increase workforce performance by leveraging technology and applications to manage and mobilize a unified, global workforce. Our HRP solutions streamline the human resource management process, increase work efficiency, and support strategic decision-making. Our customers are able to automate routine daily tasks such as payroll processing, attendance, and benefits tracking, giving them more time and information to implement strategies that align the workforce with their organization’s strategic goals.

Business Analytics (BA). Our BA applications help to empower organizations with convenient access to information, reporting and analysis capabilities, and budget and planning systems. These tools help to convert large volumes of data collected and stored by the business into meaningful and multi-dimensional reports and analyses for use in decision-making. These applications are sold as complementary applications to our ERP, SCM, CRM and manufacturing operations solutions.

 

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The following table sets forth the core components of CDC Software’s various solutions:

 

ERP

 

SCM

 

CRM

 

Manufacturing
Operations

 

HR Payroll

(China)

 

BA

•        Financial Management

 

•        Manufacturing Management

 

•        Quality Management

 

•        Regulatory Compliance

 

•        Materials Management

 

•        Inventory Control

 

•        Maintenance Management

 

•        Business Analytics

 

•        Data Collection

 

•        Supplier Management

 

•        Demand Planning

 

•        Replenishment Planning

 

•        Vendor Managed Inventory

 

•        Sales and Operations Planning

 

•        Production Scheduling

 

•        Radio Frequency Identification (RFID)

 

•        Planning

 

•        Execution

 

•        Analytics

 

•        Sales

 

•        Marketing

 

•        Service

 

•        Partner Management

 

•        Analytics

 

•        Mobile CRM

 

•        Complaint and Feedback Management

 

•        Add-on products to Microsoft Dynamics CRM

 

•        Finite Factory Scheduling

 

•        Real-Time Performance Management

 

•        Reporting and Analytics

 

•        Human Resources

 

•        Payroll Administration

 

•        Attendance Tracking

 

•        Employee Self-Service

 

•        Reporting

 

•        Analysis

 

•        Budget

 

•        Planning

Professional Services

Our Enterprise Software Group offers a variety of professional services to customers that use our enterprise software applications. These services cover the full range of business optimization requirements, including industry advisory services, business process improvement services, traditional implementation services, tuning/optimization services and outsourced hosting/application management services.

The following diagram illustrates the range of professional services we are able to offer to match up with the continuum of customer needs.

 

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The Professional Services Continuum

 

   “What industry best practices should we adopt?”    “Please assist us in designing our business processes.”    “Please lead the overall implementation effort.”    “My system isn’t running well; help me figure out what is wrong.”    “Take care of our CDC Software solution for me.” “Can you manage my other applications?”  
                
                
Business Optimization Spectrum

×

   Strategy    Design    Implement    Enhance    Outsource   Ø
                
                
  

Industry

Advisory

Services

  

Business

Process

Improvement

Services

  

Software

Implementation

Services

  

Tuning and

Optimization

Services

  

Hosting and

Application

Management

 

Generally, these professional services are offered on a time and expense reimbursement basis, although there has been an increasing trend to perform such services for a fixed fee.

 

   

Industry Advisory Services. Industry advisory services involve working with clients to understand their business issues and to identify and document achievable technical solutions to provide tangible business improvements, often by identifying and implementing industry best practices as part of the clients’ processes. Utilizing professionals with specific industry expertise, we offer independent analysis and advice to help customers plan, evaluate and select the processes necessary to form an effective business solution. This process often requires us to become involved in other aspects of our clients’ businesses, such as business planning, financial modeling and defining and documenting business requirements.

 

   

Business Process Improvement Services. Business process improvement services involve working with clients to design and document business processes that drive tangible business improvements. Our business consultants work with clients to produce an in-depth analysis of the client’s specific needs and prepare detailed plans that list the step-by-step procedures that will form a business process.

 

   

Software Implementation Services. Software implementation services seek to achieve timely and successful implementation of business systems usually involving one or more of our software products. These services include evaluating and managing the client’s needs by supplying custom application systems, custom interfaces, data conversions and system conversions. Our consultants participate in a wide range of activities, including software design and development. In addition, we also provide implementation services focused on networking and database administration.

 

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Tuning and Optimization Services. Tuning and optimization services focus on improving the coordination and operation of our clients’ disparate business systems so that all of the processes are seamless, smooth and efficient, and the system provides all of the business information that clients require quickly and accurately. As part of these services, we typically assist clients in the integration of multiple software products across multiple existing systems. Because businesses have often deployed disparate enterprise systems over time to support sales, services, accounting, manufacturing, human resources and order processing, our tuning and optimization services seek to unify the multiple systems and unlock the information in these separate databases.

 

   

Hosting and Application Management. Hosting and application management involves offering clients a variety of managed IT services, including outsourcing, facilities management and hosting strategic business processes. Hosting and application management offers a practical alternative for organizations wanting to concentrate on core business activities rather than devote limited resources to IT matters. Specific services we offer include hosting enterprise software applications for clients on our servers, providing outsourced desktop and data management services, providing help desk support to a client’s employees, leasing and supporting IT assets such as computers and printers, and acting as a strategic source for certain segments of a client’s IT infrastructure (such as second level support beyond the help desk). In addition, we provide outsourced application development services to our clients, including designing, developing, testing and deploying custom software applications.

Other Professional Services Provided by the Enterprise Software Group

To enable our customers to get the most out of our enterprise software applications, we also offer client support and education services to our customers.

Customer Support. We seek to ensure that our customers quickly and easily find answers to questions or issues related to their enterprise software applications. We provide customer support through a variety of media, including web-based support, e-mail, telephone support, technical publications and product support guides. These media allow our customers to conveniently and effectively acquire the information they desire. Customer support works closely with our customers’ internal support teams to assist our customers in their use of our solutions. Generally, our customer support is provided under the maintenance provisions in our license agreements for an annual fee, which is based on a percentage of the software license fees. Customers are typically required to purchase customer support for at least one or two years when they enter into a license agreement. Standard maintenance agreements generally entitle a customer to certain product upgrades and product enhancements, as well as access to our staff. In addition to standard support, we continue to expand our offerings to include remote services and extended technical support.

Education Services. We seek to ensure that our customers effectively adopt and use their enterprise software applications by delivering education and training services that fit each customer’s business needs. Education services are offered to customers as standard or customized classes at our education facilities or at the customer’s location.

Business Services Group

Overview

CDC Software’s Business Services Group provides many of the same business optimization services offered by our Enterprise Software Group to customers that do not use our enterprise software applications. The Business Services Group assists customers to achieve the highest value for their IT expenditures by either providing our customers with more value-added services for the same cost or the same value-added services

 

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for a lower cost. These services are generally offered on a regional basis in the United States and Australia. In order to provide more cost-effective services while maintaining a high quality of service, our Business Services Group utilizes both locally based professional services staff who can interact with a customer’s staff on-site, as well as “off-shore” professional services staff typically located in India or China. By offering these services, we form relationships with these customers and often identify needs that can be addressed with our enterprise software applications.

Revenues from CDC Software’s Business Services Group were $65.3 million in 2006. As a percentage of total revenues, revenues from the Business Services Group constituted 27% of CDC Software’s total revenues in 2006.

Customers

CDC Software’s enterprise software customers operate in process-intensive industries, such as the food and beverage, pharmaceutical and biotechnology, chemicals, metals and natural products industries, and in other industries that are characterized by complex customer relationships, such as the financial services, homebuilding and real estate, general manufacturing and healthcare industries. We believe customers in these industries benefit from vendor solutions that address their industry and business specific needs, such as the ability to make modular purchase decisions, the availability of risk-mitigating implementation services and strong configuration support. As a result, our products often suit mid-sized enterprises and divisions of larger enterprises in our targeted vertical industries. As of March 31, 2007, over 6,000 customers worldwide had purchased our products.

Within the Business Services Group, we target “Fortune 1000” and other large companies doing business in the telecommunications, chemical, oil and gas, pharmaceutical, consumer product, utility, insurance, banking and finance, entertainment and IT sectors. Because many of our target customers for business services are also in our targeted industries for enterprise software, we seek to cross-sell both enterprise software applications and business services between the two customer bases in addition to leveraging our industry expertise and knowledge gained between the two lines of business.

During 2006, CDC Software’s top ten (10) customers accounted for 15% of its total revenues. No customer accounted for more than 10% of CDC Software’s total revenues in 2005 or 2006.

Sales

We sell our products and services through a variety of methods, including our direct sales force, our channel partners and distributors, and, for certain products, through our websites. Our direct sales force is organized by vertical industry and is primarily concentrated in the United States and Western Europe. As of February 28, 2007, we had approximately 250 employees engaged in direct sales.

In addition to our direct sales force, we sell our products through partners and distributors. These partners include value-added resellers, original equipment manufacturers, consulting and professional services companies, progressive product development organizations, and regional consulting and sales agents that meet certain criteria. Our partners and distributors pay us royalties on the sales of products and maintenance services. As of February 28, 2007, we had approximately 20 distributors, principally located outside the United States, that distribute our enterprise software products. In addition, we sell add-on products, solutions and tools for the Microsoft Dynamics CRM platform both directly through an online store and through more than 600 authorized reseller partners worldwide.

 

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Franchise Partner Program

CDC Software has established a Franchise Partner Program, or FPP, and has allocated an aggregate of $20 million for investment in channel partners to establish strategic relationships to accelerate mutual business expansion. We select participating partners in high-growth geographies including Eastern Europe, the Middle East, Latin America, India and China. For participation in the FPP, we seek partners with long-standing, successful track records in ERP, SCM and CRM. Additionally, we consider the more than 600 authorized distribution partners of CRM add-on products, industry-specific CRM solutions and CRM development tools for Microsoft Dynamics CRM. Our investments, made through equity investments, lines of credit or a combination of these, are used to help these partners grow their businesses through expanded marketing and sales programs, accelerated product localization and improved local support and services.

To date, we have entered into agreements under the FPP with Business T&G Group and CMT Latin America, in Latin America, and have also acquired Brilliant Training and Consulting in Australia.

Marketing

In support of our sales force, partners and distributors, we conduct a variety of marketing programs, including telemarketing, direct mailings, online and print advertising, seminars, trade shows, public relations and on-going customer communication. We are engaged in a significant marketing effort using online channels including web-based seminars, online newsletters, and electronic direct mail. Additionally, we participate in industry, customer and analyst events, and hold local events to better meet the needs of prospects, partners, distributors and customers around the world. We also hold an annual global users conference as a forum to bring together users of our products to present upcoming products and releases, share success stories and best practices and obtain feedback from our customer base on the quality of our products and services, as well as ideas for improvements and future upgrades.

We also conduct communications programs to establish and maintain relationships with key trade press and industry analysts. We have customer marketing teams targeted at working directly with our customers to obtain feedback and to track ongoing customer success stories. We also hold joint web events with marketing partners and others, co-author business papers, and create and publish other materials that are of value to our customers and partners in making a decision to purchase one of our products.

Product Development

To meet the increasingly sophisticated needs of our customers in our targeted vertical industries and address potential new markets, we strive to invest in, and enhance the functionality of, our existing product offerings and related services and develop new product solutions. During 2006, CDC Software spent $18.1 million on research and development activities.

Our development process involves a system where we obtain product input from a variety of sources, including product and design forums, specialty industry groups, market trends, changes in industry and regulatory requirements and customer surveys. The input is conveyed through internal product boards, made up of technical, sales and marketing personnel, that provide advice to the product manager who then produces a product plan. Generally, under the product plans, specific major new releases are made every 12 to 18 months, with minor product releases on a six-month basis.

Under this product development model, decisions regarding the direction of CDC Software’s product lines are made locally, with the actual development work being increasingly moved off-shore. Generally, the expert knowledge of the functionality of our products and the needs of our customers is located in Atlanta, Georgia for the enterprise and departmental solutions for process manufacturers and in Vancouver, British Columbia, Canada for the vertical CRM products. Our software development capabilities, however, are located principally in China and India. We have established a software development center in Shanghai, China

 

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to develop its enterprise and departmental solutions for process manufacturers and a software development center in Bangalore, India to develop its vertical CRM products, both of which have achieved Microsoft Gold Certification. As of February 28, 2007, CDC Software’s software development centers in China and India employed approximately 115 and 113 development personnel and 52 and 91 consultant personnel, respectively. This shift has enabled CDC Software to expand the breadth of product development and accelerate delivery schedules while reducing overall development costs. By managing its own internal development centers, rather than outsourcing to third parties (as is frequently practiced in the software industry), we believe we have maintained better control over product quality and development schedules.

Development activity during 2006 covered a range of evolving functionality enhancements to present releases of CDC Software’s products, including the following:

 

   

Q1 2006. New products launched supported the growing need for mobility among our customers. A new CRM handheld solution provided mobile access to CRM data and functionality via BlackBerry Wireless Handheld devices. The extended ERP application was enabled with additional mobile support to streamline automated collection of manufacturing and inventory information using PocketPC devices. Additionally, the inventory and warehouse management applications were enabled with radio frequency identification, or RFID, support for customers in the food, pharmaceutical and consumer products industries.

 

   

Q2 2006. New products launched furthered our commitment to providing leading applications for our targeted vertical industries. These new applications include CRM 5.9, which provided greater usability for end users to quickly navigate to the information they need, and increased flexibility for tailoring the solution to implement complex business practices. Additionally, CRM 5.9 included a BlackBerry Wireless Handheld mobile application, Call Scripting for automating customer interactions, and other significant customer-driven enhancements. Homebuilding 5.7 and Manufacturing 2.1 were also launched to address additional industry-specific requirements. An Enterprise Performance Management, or EPM, application relating to our inventory module was launched to provide our process manufacturing customers with visibility into key inventory performance indicators and business drivers. This added to the EPM sales and EPM manufacturing applications that had been previously launched. Additionally, version 5 of the OnePlan SaaS planning and scheduling applications was made available, which added and improved functionality to increase visibility, improve scheduling and add collaborative features.

 

   

Q3 2006. New products launched included Warehouse Voice, a software package for voice recognition technology applied to warehouse operations, which provides advanced, hands-free voice-driven picking functionality suited for fast-paced, high-volume and harsh environments, such as cold storage. Also released was a new version of a SCM solution that included enhancements for global supply chain planning, simplifying configuration and reducing implementation time and improving synchronization between planning and execution.

 

   

Q4 2006. International versions of the CRM products were released, including French and Japanese versions of Pivotal 5.9, and a French version of our latest applications for the financial services vertical industries. Also, version 10 of the IMI suite was released. This latest version includes performance and usability improvements in IMI Replenishment, and new applications for transportation and analytics that assist companies with distribution-intensive operations to create competitive advantages based on improved productivity, operational reliability and cross-enterprise visibility.

 

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Competition

Enterprise Software Group

The enterprise software industry is very competitive and subject to rapid technological change. A number of companies offer products that are similar to our products and target the same vertical industries as us. In addition to competing with the internal IT departments of our customers, our major competitors in each of our targeted vertical industries include:

 

   

For extended ERP and SCM in the food and beverages, consumer products, pharmaceutical and biotechnology, chemicals, metals and natural products industries: Epicor, Infor, Lawson, Manhattan Associates, Microsoft, Oracle, QAD, Sage, SAP and various other small vendors.

 

   

For vertical CRM in the financial services, homebuilding and real estate, general manufacturing, and healthcare industries: Made2Manage, Microsoft, NetSuite, Oracle, Sage, Salesforce.com, SalesLogix, SAP and various other small vendors.

 

   

For SCM in the distribution industries: i2, Infor, Logility, Manhattan Associates, Oracle and SAP.

 

   

For HRP: Oracle, SAP, Taleo and various local providers in the Greater China market, including Cityray Technology, BenQ Group, Kingdee International Software Group, Shanghai Kayang Information System, Strategy Software Systems, UFIDA Software and Vanguard Software.

Business Services Group

The IT services industry is highly competitive and rapidly changing as customers’ needs are constantly evolving. We compete with firms that range from large global IT consulting firms such as Cambridge Technology Partners, Infosys, Syntel and Wipro, to IT services divisions of large diversified technology companies such as IBM Global Services. In addition, we also compete with the internal IT departments of our customers, as well as several niche services providers that specialize in a geographic market or vertical segments.

CDC Software’s Competitive Strengths

We believe the principal competitive strengths of CDC Software include the following:

We have developed sophisticated products for our targeted vertical industries. We believe that sophisticated buyers seek solutions that are closely tailored to their industry-specific requirements. We believe this demand creates significant advantages for us relative to our competitors that offer generalized enterprise software applications that require significant customization. Our enterprise software applications are industry-specific and allow businesses to immediately benefit because our solutions do not require extensive, costly customizations in order to meet an individual customer’s industry-specific business needs. We believe these competitive advantages have led to our competitive win rates which, in 2006, ranged from 40% to 60% in our targeted vertical industries, namely financial services, homebuilding and real estate, food and beverage, pharmaceutical and biotechnology and chemicals. This compares favorably to typical competitive win rates, which we believe range from 20% to 25% for generalized enterprise software applications vendors.

Our products can be implemented rapidly, configured and upgraded easily, and are intuitive to use, which helps lower our customers’ total cost of ownership and increase their return on investment. Because our enterprise software applications incorporate the unique functionality required by customers in our targeted vertical industries, they can be implemented without the significant customization that is typically required for conventional enterprise software applications. Our applications often require limited configuration, resulting

 

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in significant time and cost savings, particularly for mid-sized companies that do not have large IT staffs or budgets for software customization. Beyond initial implementation, our products provide benefits over the lifespan of our customers’ IT systems. An enterprise software application typically undergoes four to five major release upgrades during its eight to ten year lifecycle. Conventional enterprise software applications that have been highly customized typically require rebuilding and retesting with each upgrade. The effort and cost of these upgrades for the customer may rival those of the initial implementation. Because our enterprise software applications require less customization during initial implementation, the complexity of subsequent upgrades is greatly reduced, saving time and money for customers and enabling them to take advantage of software updates. Furthermore, because our applications are designed to meet industry-specific requirements, end-user training requires fewer staff and is less expensive and time-consuming. We believe our products are also more intuitive to use than conventional enterprise software applications, which helps to lower start-up training and deployment costs.

Our products are scalable to meet the needs of growing businesses. Many of our customers require products that support growing numbers of employees, customers and partners. Our enterprise software applications are designed to enable our customers to expand their use of our products as their businesses grow by adding servers without having to re-implement software or retrain personnel. This improves product performance, enables our products to support larger numbers of concurrent users at lower cost, thereby protecting our customers’ original investment in our products and provides us with ongoing revenue streams as our customers grow.

Our sales and marketing personnel have significant industry expertise in our targeted vertical industries. In the current market environment, we believe buyers are not only seeking tailored solutions, but also long-term business partners who understand and are familiar with the unique and evolving challenges of their industries. In order to address this need and to more effectively develop, enhance and sell our industry-specific solutions, we have sought to attract and retain personnel with substantial experience in the industries we target. Our industry experts understand our customers’ specific business concerns, resulting in a more effective sales force than those of our competitors who sell their products through a generalist sales force. Additionally, due to our focus on offering industry-specific solutions, we believe that our marketing programs are significantly more cost-effective than those of our generalist competitors.

We have a global, diverse and growing base of highly satisfied customers. Our enterprise software applications have been purchased by over 6,000 companies worldwide as of February 28, 2007, and our customer base is growing. We believe that the industry focus and expertise of our personnel, combined with the fact that our applications are designed to meet the specific requirements of our targeted vertical industries, have led to competitive win rates with new customers that are significantly higher than those of our generalist competitors. During 2006, we signed 55, 61, 68 and 90 new enterprise software customers during the first, second, third and fourth quarters of the year, respectively, which accounted for approximately 43%, 49%, 46% and 54% of our total software license revenues during those periods. We believe that this organic growth and high percentage of software revenues from new customers is unusual among established enterprise software companies and is an important building block for our continued success. During 2006, approximately 56.4% of CDC Software total revenues were generated in North America, approximately 27.4% in Europe, the Middle East and Africa and approximately 16.2% in the Asia/Pacific region. Our global and diverse customer base helps ensure that we are not dependent on any single customer, industry or geographic region. Existing customers accounting for approximately 90% of our maintenance revenue in 2006 renewed their maintenance contracts. We leverage this high degree of satisfaction to support our marketing and sales programs through customer case studies, media interviews, speaking engagements and sales references to generate additional leads and sales.

Our business services address a wide spectrum of IT and business needs, create additional cross-selling opportunities and enable us to become a strategic consultant to our software customers and other

 

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companies, which helps to build lasting relationships. Our business services offerings extend beyond software implementation, support and maintenance services typically offered by software companies. In addition to these basic services, we also offer industry advisory services, business process improvement services and outsourcing services, such as help desk support, desktop management, enterprise software application management, asset management and custom software development. We also proactively sell additional IT and business consulting services to them. Through these services, we develop advisory relationships with our customers, increasing the value we provide and strengthening our competitive position with each account. We also gain early insight into additional software requirements of our customers and create opportunities to cross-sell additional enterprise software applications.

CDC Software’s Growth Strategy

Our goal is to be an integrated global enterprise solutions company offering a complete range of software products to meet the needs of large and mid-sized enterprises in our targeted vertical industries. We also seek to provide high quality, affordable value-added services that complement our product offerings and enable our customers to enhance their IT use. The key elements of our growth strategy are to grow our business organically and through selective acquisitions. Specifically, we intend to:

Continue to expand and enhance our industry-specific products and expertise to strengthen our competitive advantages. We will continue to focus on offering high-quality solutions to our customers to address their specialized business, industry and regulatory requirements at an affordable cost. While our software license revenues from new customers averaged between 40% to 50% of our total software revenues during 2005 and 2006, we intend to leverage our industry expertise to increase the percentage of software sales from new customers. As a result, we intend to:

 

   

develop broader and deeper product functionality to address our customers’ expanding requirements;

 

   

attract and retain employees with business and product expertise in our targeted vertical industries;

 

   

develop additional geographically-specific functionality to address the increasingly local requirements of our customers and enable their expansion on a global basis; and

 

   

provide additional delivery models, such as Software as a Service, or SaaS, to address the preferences of our customers, so that applications suitable for delivery in this manner can be accessed over the Internet on a subscription basis.

Capitalize on cross-selling opportunities into CDC Software’s installed customer base. As of February 28, 2007, CDC Software’s enterprise software applications and services had been purchased by over 6,000 companies worldwide. However, because the licensing and implementation of software solutions involve a significant capital investment, many customers may not purchase all of the modules or applications offered to optimize their business at one time. Therefore, CDC Software’s large, global customer base provides a significant opportunity to sell new software products, upgrades for existing applications and complementary business services. CDC Software’s sales force has specific sales and marketing personnel dedicated to penetrating its installed customer base. In addition, CDC Software’s business services customers include many companies that are not currently customers of the enterprise software applications, which presents opportunities to sell enterprise software applications to business services customers in targeted vertical industries.

Enhance customer relationships. With the broad range of services offered by the Business Services Group, CDC Software seeks to enhance customer relationships. CDC Software offers capabilities to address

 

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the broader strategic issues its customers face as their industries evolve, such as identifying leading industry practices and designing such processes into their systems. CDC Software also offers additional technical capabilities to enhance its customers’ existing systems or even operate their IT systems on an outsourced basis. We believe this expanded relationship with customers across the spectrum of their IT needs will increasingly become the trend and expectation of purchasers of strategic IT systems.

Selectively pursue acquisitions. We intend to continue to selectively pursue acquisitions to expand our product and service offerings, extend our geographic reach and grow our customer base. Since 2003, we have consummated over 15 acquisitions, many of which have added additional capabilities and functionalities to our software products.

Target emerging markets for enterprise software applications. We believe that lower cost geographies, such as China and India, represent strong growth markets for enterprise software applications as many companies continue to relocate their operations to those regions due to lower overhead and labor costs. CDC Software intends to target opportunities in these emerging markets, as well as opportunities in Latin America and Eastern Europe. In particular, we believe CDC Software is well positioned to take advantage of the experience and infrastructure of our family of companies in China. We believe CDC Software’s enterprise software applications will have competitive advantages in its targeted vertical industries in these emerging markets.

Expand CDC Software’s in-house software development, services and support centers located in China and India. CDC Software performs increasing amounts of its software development, services, and support functions at its in-house development centers located in China and India. While CDC Software’s product development decisions are made locally, the actual development work has been increasingly moved offshore. Specifically, CDC Software has established a software development center in Shanghai, China to develop its enterprise and departmental solutions for process manufacturers and a software development center in Bangalore, India to develop its vertical CRM applications, both of which have achieved Microsoft Gold Certification. This shift has enabled CDC Software to expand the breadth of product development and accelerate delivery schedules while reducing overall development costs. By establishing these offshore development centers, we believe that CDC Software maintains better control over product quality and development schedules than its competitors that have outsourced their development work to third parties. Additionally, locating some of CDC Software’s service and support activities offshore allows CDC Software to provide those functions more cost effectively while maintaining quality levels.

Expand into new vertical industries. CDC Software has been successful by focusing on its targeted vertical industries, and intends to expand into new vertical industries where it can establish a competitive advantage. Such expansion may either occur through strategic acquisitions or through internal product development. We expect that these new target vertical industries will have characteristics similar to existing vertical industries, such as those characterized by complex customer and partner relationships, intricate regulatory requirements and/or sophisticated processes and procedures.

CDC Games Business Unit

Overview

Our CDC Games business unit pioneered the “free-to-play, pay for virtual merchandise” business model for online games in China, and is a leading operator of online games in China. CDC Games’ online game, Yulgang, was the first free-to-play, pay-for-virtual merchandise online role playing game launched in China. Since its launch in July 2005, Yulgang has reached approximately 348,000 peak concurrent users and grown to approximately 42.9 million registered users as of December 31, 2006.

 

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CDC Games has experienced significant revenue and earnings growth since it was formed in the third quarter of 2005. Online game revenues were $26.8 million for the year ended December 31, 2006 and net income from our online games segment was $10.6 million for the year ended December 31, 2006. The revenue of Equity Pacific, the operating arm of CDC Games was approximately $32.6 million in 2006, which represented an increase of 420% from approximately $6.3 million in 2005.

As a percentage of total revenues, revenues from our online games segment constituted 8.7% of total revenues in 2006.

CDC Games’ Products

CDC Games offers massive multiplayer online role playing games, or MMORPGs and massive multiplayer online games, or MMOGs, which are online games that allow thousands of users to interact with one another in a virtual world by assuming ongoing roles or characters with different features. The interactive and group-oriented nature of these games along with the size of our user base significantly contributes to retaining our current users and attracting new users. These features allow our games to attract a high degree of user loyalty as the games require a significant amount of time to learn and master.

Our MMORPGs and MMOGs are action-adventure based, and draw upon fantasy, martial arts and combat themes. Typical features of our games include the following:

 

   

Players assume the ongoing role, or alter-ego, of a particular game character, each with different strengths and weaknesses;

 

   

Each game character may gain experience and, depending upon the game, may collect or purchase from us certain game features, such as weapons, armor, uniforms and magical power, which increases the status of the game character and, in the process, builds a strong game identity which makes the character unique in the virtual game world;

 

   

Although each game character may be unique, groups of players may, and often must, form teams or alliances to fulfill certain game objectives. Players may communicate with each other through instant messaging or chat rooms during the game;

 

   

Special events are held from time to time to stimulate group interest, such as “fortress raids” where players are encouraged to form groups and attack a particular fortress at a specified time; and

 

   

The game is ultimately never won or lost, but instead continues through a game story that does not have a natural ending.

In preparation for the commercial launch of a new game, we conduct closed beta testing of the game in an effort to eliminate technical problems. This closed beta testing is followed by open beta testing in which we allow registered users to play without charge in open market conditions to ensure performance consistency and stability of the game platform and systems.

Current Games

Yulgang

Yulgang is a fantasy martial arts based MMORPG based upon a popular comic book series in Korea. The game creates a precise, rich and colorful cartoon-like virtual gaming world for online users using 2.5D

 

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graphics. In the game, players become martial artists and journey through a mythical realm learning martial arts, completing tasks and mastering skills. As they progress, players may choose factions to join and participate in massive battles for the honor of their factions. Players select a character class to play among bladesman, swordsman, archer, healer and spearman, and accumulate abilities and skills which can be carried over to next higher game levels. The game was awarded the “Top 10 Most Popular Games” award at the China Game Industry Annual Conference in both 2005 and 2006.

Yulgang has reached approximately 348,000 peak concurrent users and grown to approximately 42.9 million registered users as of December 31, 2006. In measuring weekly peak concurrent users, CDC Games determines the number of users logged on at 15-minute intervals during that week. The highest among the data for each 15 minute-interval during a particular week is the number of peak concurrent users for that week.

Yulgang can be accessed from any location with an Internet connection. Substantially all of the players in China access the game servers either from PCs at home or Internet cafe outlets equipped with multiple personal computers that have Internet access. Currently, a significant portion of CDC Games’ users access the game through Internet cafes throughout China.

Travia

Travia is an online game developed by E-net Corporation in Korea. Travia has adopted an advanced 3D engine, which we believe creates a colorful and enjoyable virtual world. Travia also includes a rich game content and a powerful service engine, which can support thousands of concurrent players. We believe that Travia players can fully express their personal characters in this virtual world, which in turn brings vibrate life into the game.

Special Force

Special Force, which was developed by, and which we have licensed from, Dragonfly GF Co., Ltd., is a first person shooter online game that originated in Korea. The game allows players to create their own elite military units with customized weapons and equipment selected from those used by special forces from around the world. Special Force has advanced 3D graphics and advanced special effects, and allows users nationwide to play against each other in teams and compete in competitions.

In June 2007, we launched our open beta program for Special Force, which we intend will encourage broad public usage among gamers to complete final testing of the user experience, as well as testing of deployment and scalability, prior to general release. We also intend that, as with Yulgang, Special Force will be "free-to-play, pay-for-merchandise".

Additional Licensed Games

In addition to Yulgang, Travia and, Special Force, we have also licensed the following games which are in our pipeline for release:

 

Game

 

Licensor

 

Description

Stone Age 2   Digipark, Inc.   Stone Age 2 is a MMORPG set in the stone age, and the sequel to Stone Age 1, which was one of the first MMORPGs to be successful in China during 2003 and 2004. Stone Age 2 is set in the pre-historic era where players roam a world of volcanoes, deserts and jungle populated by dinosaurs and spirits. The game encourages cooperation between players by rewarding teamwork.

 

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Game

 

Licensor

 

Description

    Players work together to build villages, capture and raise dinosaurs and look for treasure. We intend that, as with Yulgang, Stone Age 2 will be "free-to-play, pay-for-merchandise".
Lord of the Rings   Turbine, Inc.   Lord of the Rings is a MMORPG set in the Lord of the Rings universe and is currently in beta testing in the United States. The Lord of the Rings Online is the first and only MMORPG based on the literary works of J.R.R. Tolkien. The Lord of the Rings Online allows players to explore the most famous fantasy world of all time, fight the evil minions of the Dark Lord Sauron, and advance their heros by adventuring through the vast reaches of Middle-earth. Gamers can adventure solo or choose from thousands of players online to forge their own fellowships. We intend that The Lord of the Rings Online will be a time-based game.
Chaosgem   Uniana Co., Ltd.   Chaosgem is a "free-to-play, pay-for-merchandise" and full 3-D side scroller game with elements of a role playing game, or RPG. Chaosgem is currently in open beta testing in Korea.
Deco   HyonCorp.   Deco is a "free-to-play, pay-for-merchandise" MMORPG. Deco Online has been operating in commercial service in Japan since April 2006, and in Indonesia since May 2006.
Xeros   Hi-Win Co. Ltd.   Xeros is a "free-to-play, pay-for-merchandise" MMORPG and is currently in its third closed beta testing in Korea.
Gemsfighter   Gretech Corporation   Gemsfighter is a "free-to-play, pay-for-merchandise" 3-D Multiplayer Online Action Game. Gemsfighter features a range of martial arts skills (Taekwondo, Kung Fu, Boxing, Kobudo), and also contains simple gameplay with support for gamepad input devices. Game modes include Team Play, Battle Mode, and Rumble Mode. The game is currently in commercial service in Korea.
Street Gear   NFlavour Corp.   Street Gear is a "free-to-play, pay-for-merchandise" 3-D roller blading Multiplayer Online Action Game.
Freezonair   Gretech Corporation   Freezonair is a "free-to-play, pay-for-merchandise" fast-paced, 3-D snow boarding experience Multiplayer Online Action Game.

 

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Wind Forest Fire

Mountain

(WFFM)

  MGame Corp.   WFFM is a combat MMORPG.

Game Licensing

MGame Corporation

In December 2003, we entered into our original game license agreement with MGame Corporation for Yulgang, which was subsequently supplemented in June 2004 to extend the term of our license to Yulgang to December 2007 and provide a 21% royalty on our revenue derived from Yulgang to MGame.

Furthermore, in March 2007, we entered into an additional supplementary agreement with MGame pursuant to which we extended our exclusive license to Yulgang in China (excluding Hong Kong) through 2010 in exchange for a payment of $500,000 in April 2007, an additional payment of $1.5 million by July 2007 and a license fee of $3.0 million by March 2008. The foregoing amounts payable under the supplementary agreement are creditable against revenue-sharing royalty payments of 25% of our gross revenue for Yulgang we are required to make.

Additionally, in March 2007, we entered into an exclusive game license agreement with MGame pursuant to which we received exclusive rights to distribute the simplified Chinese version of MGame’s next MMORPG, Wind Forest Fire Mountain, or WFFM, in the PRC (including Hong Kong and Macau) until 2010.

Other Licensors and Developers

In addition to our license agreement with MGame for Yulgang, to date, we have obtained our content through licensing arrangements with developers and other third parties. We monitor the markets to identify and source new online games, particularly the markets in South Korea, Japan and the United States. The cost of licensing games from developers generally consists of an upfront licensing fee, which we generally pay in installments, and ongoing licensing fees, which are equal to a percentage of our revenues from the relevant licensed game. The ongoing royalties for games which have been licensed range from 17% to 27% of total sales before distributor discount. Each of these licenses provides us with the exclusive right to operate the game in Mainland China, and in some instances, certain other territories, including India. Generally, the MMORPG developers agree to timely provide, without any additional charge, with updates, enhancements and improvements developed for the games licensed to us. The majority of our game licenses require the licensors to provide technical support.

 

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Game Development

While we do not currently have an in-house game development capacity, we are considering either internally developing or acquiring a research and development program.

Game Developer Program. We have introduced a Game Developer Program which includes US$20 million allocated for investment in selected strategic online game developer partners. We plan to select participating developers from Japan, Korea, China and the United States as well as Europe, India and Australia with long-standing, successful track records in the development of top quality and successful online games, and the vision and innovative skill to develop games from the ground up that will be cultural attractive to the China gaming user base. Under the program we seek to make investments in these developers through direct cash investments, equity investments, lines of credit or a combination of these. The investments will be used to help these partners build China culturally aware titles, and will be complemented by market research and game research from us.

CDC Games Studio. In March 2007, we formed CDC Games Studio which represented an expansion of our online games developer program announced in August 2006. CDC Games Studio seeks to make strategic investments with selected game developers and also support emerging game developers with the resources they need to develop innovative new games. CDC Games Studio seeks to attract talented games development companies around the world, including in Korea, the United States, Europe and China, which may already have operations in China or are seeking to relocate or expand into China to take advantage of the market demand for new games, talent in China available for games development and tax incentives available to companies developing games for domestic distribution as well as for export. CDC Games Studio looks to fund the creation of new online games, as well as acquire rights to develop game titles in China, with the goal of publishing and distributing them on a global scale. As of March 31, 2007, CDC Games has entered into definitive agreements for three investments under this program.

 

   

Gorilla Banana. In December 2006, we entered into a subscription agreement pursuant to which we made an investment of KRW1.5 billion (approximately $1.6 million), payable in two installments, in Gorilla Banana Entertainment Corp., an independent online games development company in Korea. This investment, which was subject to certain regulatory approvals, was closed, and consideration was exchanged, upon receipt of these required approvals in first quarter of 2007. In connection with this investment, we acquired a minority equity stake in Gorilla Banana and options to increase our minority stake in the company during the 18 month period following closing. Furthermore, we also acquired the exclusive right to distribute Gorilla Banana’s game, Red Blood, based on a popular comic book series in Korea, in India and China, in exchange for the payment of a royalty on gross revenues we may receive for this game. In addition, we also entered into a shareholders’ agreement with the existing shareholders of Gorilla Banana pursuant to which the parties agreed to certain uses of funding, preemptive and maintenance rights, rights of first refusal, restrictions on share transfers and sales, board representation rights, information rights and other matters. The founders and executives of Gorilla Banana are experienced developers and executives, including former game directors at NCsoft, one of the largest online game publishers in South Korea, the founding chairman of the Korea Game Developers Association from 1999 to 2005, and former executives at Grigon Entertainment.

 

   

Auran. In March 2007, we entered into a subscription agreement pursuant to which we made an investment of approximately $3 million in Auran, a leading developer of online games in Australia. In connection with this investment, we acquired a minority equity stake in Auran and options to increase our minority stake in the company during the 6 month period following closing. Under our agreements with Auran, we paid approximately $1.5 million in cash at closing in exchange for 50% of our minority stake and are required to pay, in exchange for the final 50% of our minority stake, approximately $1.5 million within 15 days of the occurrence of Open Beta testing (as defined therein)

 

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for Fury. We also entered into: (i) a facilitation agreement pursuant to which we obtained rights to receive, for a period of 8 years from the Effective Date (as defined therein) a percentage of net revenues received by Auran relating to its online game, Fury, which is being developed, or any XBLA game (Microsoft’s Xbox Live Arcade) developed by Auran, in exchange for our providing certain advisory services to Auran; and (ii) a shareholders’ agreement with the existing shareholders of Auran pursuant to which the parties agreed to certain uses of funding, restrictions on share issuances and transfers, pre-emptive rights, rights of first refusal, board representation rights, information rights and other matters. Fury is an innovative game that blends MMORGP (massively multiplayer online role playing game) and FPS (first person shooter) genres.

 

   

MGame. In March 2007, we entered into a subscription agreement pursuant to which we made an investment of approximately $5 million in MGame Corporation, one of South Korea’s leading developers of online games, including our current game, Yulgang. In connection with this investment, we acquired a minority equity stake in MGame, for which we paid MGame $5.0 million at closing. We also obtained rights relating to our access to information on MGame, observation rights on MGame’s board of directors, pre-emptive and anti-dilution rights, as well as a right for us to consent prior to the issuance of new debt by MGame over certain monetary thresholds. Additionally, in March 2007, we entered into an exclusive game license agreement with MGame pursuant to which we received exclusive rights to distribute the simplified Chinese version of MGame’s next MMORPG, Wind Forest Fire Mountain, or WFFM, in the PRC (including Hong Kong and Macau) until 2010. Over 50 different games are in service on MGame’s portal site with 19 million registered members.

Pricing

To date, we have adopted a “free-to-play and pay for virtual merchandise” business model for our existing online game, Yulgang, and anticipate that many of the games in our pipeline will operate on a similar business model. Under this model, game players are not charged for time spent in the virtual game world, but rather for purchasing value-added virtual merchandise and services through the online game shop, such as weapons, armor, uniforms and magical power. While such a business model has been previously utilized in Korea, Yulgang represents the first instance of such a business model being adopted for a large scale MMORPG in China.

Charges for such virtual merchandise and services range from RMB 1 to RMB 58. During December 2006, an average of 232,500 items of virtual merchandise were sold per day.

Setting prices for virtual items is generally formulated as part of the underlying economic model for the game during its development. However, we have the ability to adjust prices for virtual items as part of tuning the game, although care must be taken that we will not upset the underlyng economic model. We generally look at pricing curves to set and adjust prices for virtual merchandise offered. Pricing curves are developed primarily based on internal game factors such as the popularity of an item and the nature of the enhancing characteristics the item provides, as well as external game factors such as game cost, user game playing and the pricing of competing games in the market. Once a pricing of virtual merchandise is set, it is difficult to make significant adjustments to the prices during the game’s commercial lifecycle. We have generally maintained stable pricing curves for our games.

Payment

While our games are free to play, in order purchase virtual merchandise for the game, users must purchase pre-paid points which are sold in both physical card form or can be purchased electronically online and through mobile sales partners. Each pre-paid card, purchased in physical form or electronically, contains a unique access code and password that enables users to add value to their account for our online games. As users purchase virtual merchandise in the gaming world, charges are deducted against the value in their account.

 

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Distribution

We distribute pre-paid cards through an offline distribution system of physical pre-paid cards. We generally sell pre-paid cards to a group of regional distributors from whom we generally collect payment on a prepaid basis. These distributors resell the cards to sub-distributors that, in turn, distribute the cards directly to Internet cafes and other retail points of sale, such as software stores and newspaper booths. Our sales policies and distributor incentive systems generally discourage our regional distributors from distributing pre-paid cards of other online game operators. In 2006, we offered sales discounts that averaged between approximately 13% and 15% to our distributors. The sales discount represents the difference between the price at which we sell game cards to distributors and the face value of the game cards. For our physical cards, we estimate that our network reaches over 200,000 retail points of sale throughout China, over 75% of which are Internet cafes, which are the primary venue for users to play online games in China.

Due to the limited availability of online payment systems in China, most of our points are sold through direct sales of our prepaid cards. We also have both online and mobile sales partners to distribute points for our games. Our mobile sales partners include China Mobile, China Unicom and China Netcom. Points may also be purchased online through numerous popular Chinese websites, such as 1717gm.com, 51gw.com and 15173.com by charging payment directly to a credit or debit card.

Customer Service

Since our inception, we have focused on providing excellent customer service in order to retain our existing customers, as well as attract new customers.

Game Masters. We have in-game game masters to constantly monitor our games to maintain an effective and fair gaming environment. Our game masters are responsible for organizing in-game events, troubleshooting and actively and continuously monitoring the online game environment. Game masters are always available to respond to players' inquiries, initiate the bug reporting and removal process, as well as identify, record and deal with players' inappropriate behavior such as cheating and fighting. We believe that utilizing game masters to monitor the gaming environment is an important element in maintaining customer loyalty and efficiently addressing technical problems as they arise.

Customer Service Center. Our centralized customer service center is located in Beijing, China, and is operated 24 hours a day, seven days a week. Customers may call or e-mail our customer service center any time and receive timely responses. As of December 31, 2006, we employed approximately 118 full time personnel in our call center as customer service specialists. In general, our customer service representatives are able to immediately handle approximately 67% of the inquiries from our customers, and provide solutions within 24 to 48 hours with respect to requests that cannot be resolved at the time of the initial customer call. All of our customer service representatives have participated in a formal training program before commencing work. We have implemented detailed performance measures to monitor our calls to ensure that our customers will receive quality service. We periodically review staffing needs and train our representatives to provide excellent customer service.

We also maintain a reception area in our offices in Beijing that is open to the public for customer service purposes.

Marketing

Our overall marketing strategy is to rapidly attract new customers and increase revenues from recurring customers.

 

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We employ a variety of traditional and online marketing programs and promotional activities to build our brand and to attract new customers, including advertising in many game magazines and online game sites that are updated regularly. In addition, we engage in on-site promotions, such as distributing free game related posters at selected Internet cafes, and in-game marketing from time to time, including player competitions in Internet cafes across the country and online adventures for prizes. We also conduct communications programs to establish and maintain relationships with key trade press and industry analysts.

Technology

We aim to build a reliable and secure technology infrastructure to fully support our operations. Our current technology infrastructure consists of the following:

 

   

over 57 server groups and over 108 network devices located at 5 Internet data centers, in different sites regions throughout China. As of December 31, 2006, we owned most of the servers in the server network used for our game operations, and we leased the remainder from telecommunications operators. All of the servers in the server network for our game operations are located on the premises of our hosting telecommunications operators.

 

   

proprietary software and game monitor tools that are integrated with our websites and customer service center operations; and

 

   

hardware platform primarily consisting of Lenovo, Hewlett-Packard/Compaq, Dell and IBM servers.

We have direct access the Internet backbone. CDC Games also has contracts with reputable vendors such as Hewlett-Packard Company and Dell Inc. for warranty services for our hardware platform. As of December 2006 we employed 61 technical support staff to maintain our current technology infrastructure and develop new software features to further enhance the functionality of our membership management and payment system.

CDC Games has a network operation team responsible for stability and security of our network. The team follows the workflow for problem detecting, recording, analyzing and solving. The primary responsibilities of the team members consist of monitoring system performance, troubleshooting, detecting system error, random sample testing on servers, maintaining equipment, and testing, evaluating and installing hardware and software. In addition, we frequently upgrade our game server software to ensure the stability of our operation and reduce hacking risks.

Competition

The online game market in China is increasingly competitive. A significant number of competitors have entered the online game business in China and we expect more companies to do the same in the future. Additionally, we expect a wider range of online games to be introduced to the China market. Competition from other online game operators, both based in China as well as overseas, is likely to increase in the future. As the online game industry in China is relatively new and constantly evolving, our current or future competitors may compete more successfully as the industry matures. In particular, any of these competitors may offer products and services that provide significant performance, price, creativity or other advantages over those offered by us. Some of our existing and potential competitors have significantly greater financial and marketing resources than we do.

We compete principally with the following four groups of competitors in China:

 

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online game operators in China, including Shanda Interactive Entertainment Limited (which operates Actoz Soft's “Legend of Mir 2”), The9 Entertainment Limited (which operates Blizzard’s “World of Warcraft”) and Guangzhou Optisp's (which operates Wemade's “Legend of Mir 3”);

 

   

major Internet portal operators in China, including publicly-listed companies such as NetEase (which operates “Westward Journey Online”) and Sohu (which operates “Knight Online”), all of which leverage their existing strength in aggregating content, and marketing and cross-selling among their established Internet user base to promote online games;

 

   

overseas online game providers including Enix Softstar Inc. (which operates “Crossgate”) and Gamania (which operates “Laghaim”); and

 

   

domestic online game developers in China, including Kingsoft (which has developed “JX Online”), Perfect World (which has developed “Perfect World Online”) and Zhengtu.

In addition, we compete for users against various offline games, such as console games, arcade games and handheld games, as well as various other forms of traditional or other online entertainment.

CDC Games’ Competitive Strengths

We believe CDC Games’ principal competitive strengths include the following:

Ability to localize games from leading and emerging international developer partners. We have partnered with leading global online game developers and successfully localized their products for the Chinese market. Through our network of relationships we have entered into licensing agreements to distribute, market and operate proven, high-quality titles at low cost, leveraging the significant investments our partners have made in game development. We believe that our localization capabilities, vast distribution network, large established user base, and extensive knowledge of the Chinese market make us well-positioned to obtain future licenses for leading online games in China and other rapidly growing Asian markets.

Substantial product pipeline and portfolio across game genres. We have secured an substantial product pipeline across online gaming genres which we believe will offer our community of users one of the most diverse game portfolios of online game operators in China. We believe that a diversified approach allows us to reduce the effect of “hit or miss” games, particularly as many of our titles have been tested and widely played in other countries. We believe that our diversification of leading titles positions us well to attract users in different genres, which we believe is important to address emerging consumer tastes and evolving PRC regulations.

Pioneer and leader in the “Free-to-Play” business model in China. As there is no charge to play in our “Free-to-Play” business model, we believe that more prospective players are attracted to try our games. When combined with the high quality of the games we offer, we believe that players are often drawn to continue playing the game and to enhance their skill level and maximize their gaming experience by purchasing virtual items. As the pioneer of the free-to-play, pay-for-virtual-merchandise business model, we believe we have developed expertise not easily replicable by understanding both the art and science of the in-game item sales model, which includes understanding what items to sell, when to sell and who to sell to. In addition, through our leadership position in free-to-play games, intend to continue to attract game developers to license high-quality games to us for distribution and operation in China.

Extensive nationwide sales and marketing network. In order to play our online games, users must purchase prepaid points which are sold in physical form or can be purchased electronically online and through

 

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mobile sales partners. We have built a nationwide network in China to distribute our prepaid points and market our games through local media and Internet cafés. For our physical prepaid cards, we estimate that our network reaches over 200,000 retail points of sale throughout China, over 75% of which are Internet cafés, which are a key venue for online gamers in China. In addition, we have formed partnerships with China Mobile, China Unicom and China Netcom for mobile points card sales, and numerous Chinese websites, such as 1717gm.com, 51gw.com and 15173.com for online points card sales.

Advanced technology platform. We maintain an extensive national server network to host our online games. Due to the real-time interaction among thousands of users, the stable operation of an online game requires advanced data centers with numerous interconnected servers and continuous connectivity, representing significant capital investment and resources to grow and maintain. As of December 31, 2006, our nationwide server network in China consists of approximately 57 servers groups with the capacity to accommodate approximately 300,000 concurrent online users. Due to China’s large geographical area and technological limitations, we have located servers for our online games in a number of regions throughout China. As a result, we believe that our users can play our games using servers located in their region and without exchanging data across the national network, thereby increasing the speed at which our games operate and enhancing the user experience. Additionally, we have developed and maintained proprietary security software which helps us combat unauthorized access to or use of our games by local hackers.

Scalable, high-margin business model. Our online games business is highly scalable with relatively low incremental operating costs. After incurring initial licensing and localization costs for our online games, we can deliver such products and services to a large online games audience quickly and at a low cost. Additional users can be accommodated and revenues generated without incurring significant costs other than those associated with implementing additional servers.

CDC Games’ Goals and Strategies

Our goal is to become one of the world’s leading providers of online games. Our strategies for achieving this objective include the following:

Utilizing our strategic investment program to strengthen ties to emerging and leading online game developers which we believe will enhance our game pipeline. We have introduced CDC Games Studio, through which we intend to make investments in selected strategic online game developer partners. We plan to partner with developers that have successful track records in the development of top quality and commercially successful online games. Under the program we seek to make strategic investments in these developers through direct cash investments, equity investments, lines of credit or a combination of these methods. We intend that these investments will be used to help these partners develop titles localized for the Chinese consumer and other markets we plan to target, and will be complemented by market and game research we will provide. For example, we made one of our first investments securing a minority stake in an independent, online game development company in South Korea, known as Gorilla Banana. The founders and executives of Gorilla Banana have proven development expertise from their prior experiences with some of the largest online game publishers in South Korea.

Continue to significantly expand and diversify our user and revenue base by continually adding new content and features to our existing portfolio of games while also introducing different genres of online games. We believe that one of our greatest assets is the large number of registered users we have been able to attract to our games. By releasing new versions of our existing games, updating items available for sale and adding new chapters, we believe that we can keep existing users interested in playing our games and can further expand our user base, thereby improving revenues per user and consequently overall game revenues. For example, in December 2006, we launched the v170 upgrade of Yulgang which provided gamers the ability to acquire virtual pets to enhance their gaming experiences. More than one million registered users upgraded to the new version immediately. During the first week of the v170 launch, the average daily revenue was

 

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US$160,000, up 72% from the daily average revenue in the third quarter of 2006. In addition to the diversification of offerings within our current games, we intend to introduce different genres of online games into the market such as casual as well as different types of MMOGs outside of the traditional fantasy-based role-playing genre in order to reach the broadest audience possible.

Pursue cross-selling opportunities and diversify our sources of revenue. We intend to pursue cross-selling opportunities to expand and diversify our sources of revenues, such as seeking to generate advertising revenue from our online games. We believe the combination of our online games platform, our large registered user base and the large number of concurrent users playing our games will provide an established marketing platform for advertisers. Advertising opportunities include sponsorships, banner advertising, sponsored community events, contests and other activities. While we have not sought to grow our advertising revenues to date, we believe that such diversified sources of revenues represent a significant opportunity for us in the future.

Continue to expand our distribution, sales and marketing capabilities to further support our game offerings. We intend to continue to build our sales, marketing and distribution network in China and other targeted high-growth markets to reach the broadest audience possible. We plan to expand our partnerships with physical-point card distributors providing access to distribution points at software stores, Internet cafés, newspaper booths and other local media outlets while also increasing our partnerships with online and mobile distribution providers to ensure as many users across as many distribution channels as possible have knowledge of and access to our games. We plan to use our own CDC Games local ground marketing teams to complement our distribution partnerships by coordinating on-site promotional activities with administrators of Internet cafés and other locations where gamers spend a significant amount of time and initiate marketing campaigns with local media outlets to introduce our products to potential users. We also intend to develop innovative new marketing campaigns across other forms of media such as television to further promote our online game offerings and attract new users to try our games.

Continue to expand through acquisitions of online game companies in China and overseas markets as such opportunities arise. We intend to pursue this strategy by making a combination of minority-stake investments, joint ventures, acquisitions and organic development. We intend to complement our current content acquisition strategy by evaluating potential strategic acquisitions that we believe will further diversify our product portfolio, secure in-house development expertise and/or accelerate our expansion into foreign markets. We evaluate our product portfolio on a regular basis and will look for opportunities to acquire companies with a portfolio of titles that will broaden our community of users and provide differentiated product offerings for our current user base. For example, we believe casual games such as card games, board games and tile games, have a lower level of complexity and require less time to play, providing less experienced online game players with a means to become familiar with both game playing and the online game culture without making substantial commitments of time and resources. In addition to genre expertise we actively research strategic opportunities that will accelerate our international expansion efforts either through the acquisition of a localized product portfolio or an operating platform that will allow for the delivery and management of games in high-growth foreign markets.

Seek to expand our online game offerings into other international markets. We intend to expand into other online gaming markets exhibiting similar growth and user base characteristics to China. We hope to accomplish this through leveraging the current portfolio of titles and developer partnerships we have generated and by establishing operations in other territories by sub-licensing titles to proven online game operators in the key markets we have identified as expansion opportunities. We also intend to opportunistically partner with or acquire key developers and/or operators that provide a strong entrée into these targeted online games markets.

 

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China.com Business Unit

Our China.com business unit is engaged in providing mobile services and applications and direct marketing and Internet products and services. The China.com business unit is comprised of two segments, “Mobile Services and Applications” and “Internet and Media”.

Our Mobile Services and Applications segment provides popular news and mobile applications services targeting the consumer market in China. We offer wireless services including Short Message Service, or SMS, Multimedia Message Service, or MMS, Wireless Application Protocol, or WAP and Interactive Voice Response, or IVR. We have established strong local direct connectivity with provincial mobile network operators in 31 provinces, which facilitates the marketing and promotional activities of our wireless services. Our mobile services and applications business is primarily operated through our Newpalm, Go2joy, Shenzhen KK and Timeheart subsidiaries, all of which are held through our subsidiary, China.com.

Our Internet and Media segment is focused on online entertainment and Internet products and services that target users in China and Chinese communities worldwide via our portal network (www.china.com and www.hongkong.com). This segment also includes our Singapore-based travel trade publisher and organizer serving the travel and tourism industry in the Asia Pacific region.

Products and Services

Mobile Services and Applications segment. We currently offer a comprehensive suite of mobile data applications, including dating, chatting, entertainment, information-related content and community services to mobile subscribers in China utilizing SMS, MMS, WAP and IVR services.

Revenues from our mobile services and applications segment for the year ended December 31, 2006 were $31.7 million compared to $34.4 million for the year ended December 31, 2005, representing a decrease of approximately 7.8%. As a percentage of total revenues, revenues from our mobile services and applications segment constituted 10.2% of total revenues in 2006 and 14% of total revenues in 2005.

Services. Our mobile data application products are available through a variety of services, including the following:

 

   

SMS. SMS is a communications protocol which allows users to access, download and communicate information consisting of fairly simple and short text messages through mobile phones.

 

   

MMS. MMS uses General Packet Radio Service technology, or GPRS technology, and has a greater capacity than SMS. MMS transmits more data in a single message, enabling users to access and download color pictures, multi-tonal sounds and Flash files.

 

   

WAP. WAP is a set of communications protocols that standardizes the manner in which wireless devices (such as mobile phones) are used for Internet access. WAP allows users with WAP enabled handsets 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 also uses GPRS technology, enabling users to access and download color pictures, multi-tonal sounds and Flash files.

 

   

IVR. IVR provides users with voice content, such as celebrity voice greetings and news information.

Products. Some of our more popular products available through the different services, include:

 

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Mobile Dating. Our mobile dating services are subscription-based community services that provide dating and chatting platforms through which subscribers may meet and socialize, or arrange to meet in person, by sending wireless messages. Users can select a particular geographic location to meet friends and set criteria, including age, gender, hobbies and qualifications, for the friends they would like to meet. Some services combine a mobile platform with our Internet portals so that subscribers can conduct chat sessions with online subscribers or mobile subscribers. In addition, certain subscribers can record and upload video clips and/or photos onto online websites, which enhances the communication among our online and mobile subscribers.

Mobile subscribers can access mobile dating services through SMS, WAP and IVR.

 

   

Jokes. We offer jokes on both a subscription and on-demand basis. Users can subscribe to a fixed number of jokes to be delivered each day, or they can order on a per-joke basis, which is delivered on demand. We develop our daily jokes internally or select jokes submitted by users.

Mobile subscribers can access jokes through SMS, MMS, WAP and IVR.

 

   

Mobile Games. We offer mobile games to subscribers. For Java based mobile games, subscribers can download these games to their handsets and play them with their handsets repeatedly. We offer these games through third party game developers. We also offer interactive network games of various types that we develop ourselves.

Mobile subscribers can access mobile games through SMS, WAP and IVR.

 

   

Information-Related Services. We offer current information, such as stock quotes, news and local weather conditions, and entertainment related products such as music and celebrity voice greetings to subscribers on a subscription and on-demand basis. Most of the information distributed from our mobile platform is aggregated from content partners through revenue sharing arrangements.

Mobile subscribers can access information-related services through SMS, MMS, WAP and IVR.

 

   

Pictures and Ringtones. We provide ringtone, picture and logo downloads through China.com’s portal and through a subscriber’s mobile handsets on a subscription and per download basis.

Mobile subscribers can access pictures and ringtones through SMS, MMS, WAP and (for ringtones) IVR.

Internet and Media segment. Our Internet and Media segment is focused on online entertainment and Internet products and services that target users in China and Chinese communities worldwide via our portal network (www.china.com and www.hongkong.com). This segment also includes a Singapore-based travel trade publisher and organizer serving the travel and tourism industry in the Asia Pacific region. Internet and Media segment offers the following products and services.

Revenues from our internet and media segment for the year ended December 31, 2006 were $10.1 million compared to $9.0 million for the year ended December 31, 2005, representing an increase of approximately 12.2%. As a percentage of total revenues, revenues from our internet and media segment constituted 3% of total revenues in 2006 and 4% of total revenues in 2005.

Portal. The services and products of our portal include online advertisement, search, enterprise service and mail services.

Travel and Trade Services. TTG publishes literature for the travel industry and organizes industry events. It is one of Southeast Asia’s most established information and access providers to the travel and tourism industry. TTG offers a wide range of travel and tourism media products, including publications,

 

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exhibitions, database management and Internet products. TTG also offers integrated marketing solutions and a platform for customers to showcase their products and services in the travel and tourism industry. TTG sells its products and provides services directly to its customers, such as travel associations and government agencies.

Internet Video. In November 2006, we announced that China.com launched a new service, v.china.com, which allows people to watch video clips from that site. We believe the v.china.com site is different from many other video sharing websites because its content comes from self-developed or co-developed video films or authorized pieces provided by contracted partners. We believe this approach helps address certain copyright issues which have long plagued the video sharing industry.

Sales

Our China.com business unit is focused on enhancing our relationships with China Mobile, China Unicom, China Telecom and China Netcom, and launching promotions both through our portals and the general media. Currently, we have approximately 100 sales and marketing personnel who are located throughout China, including in Beijing, Nanjing, Shandong, Guangdong and Hangzhou, and maintain our relationships with China’s mobile operators at the national and local provincial level. Our primary sales and marketing initiatives in mobile services and applications include promotional activities through mobile operators, bundled access through partnerships with mobile operators and handset manufacturers, direct marketing through consumer portals like www.china.com, which is not part of this Annual Report, and general media advertising in traditional media, including point-of-purchase promotions, newspaper and magazine advertisements, radio and TV advertisements.

Our Mobile Services and Applications segment relies on mobile network operators in China to bill mobile phone users for our subscription fees. We have revenue sharing arrangements with China Mobile and China Unicom under which we receive 70% to 85% of the subscription fee collected from a mobile subscriber, with the balance being retained by the mobile operators. In addition to our charges, the mobile operators separately charge their subscribers RMB0.05 to RMB0.25 for every SMS, MMS or WAP message sent. These amounts are collected by the mobile operators and are not shared with us.

Competition

Our China.com business unit also operates in an increasingly competitive environment. Several companies currently provide mobile services and applications, such as wireless services including SMS, MMS, WAP and IVR in China. We face increasing competition for subscribers, mobile services and applications, and content from companies such as: Sina Corporation, Sohu.com Inc., NetEase.com Inc., Tom Online Inc., Tencent.com Technology Limited, Linktone Ltd., Mtone Wireless Corporation, KongZhong Corp., Hurray! Holding Co., Ltd., as well as a number of smaller companies that serve China’s mobile services and applications market. In addition, in our portal business, our competition for user traffic, ease of use and functionality include Chinese and/or English language based Web search and retrieval companies, including AltaVista Co., Apple Daily, ChinaByte, FindWhat.com, HotBot, HotWired Ventures, Lycos, Inc., Mingpao.com, MSN, Netease.com, Inc., Netvigator.com, Overture Services, Inc. (acquired by Yahoo!, Inc.), Shanghai Online, Sina Corporation, Sohu.com, Inc., Tom Online Inc. and Yahoo!, Inc. We also encounter increased competition from Internet service providers, Web site operators and providers of Web browser software, including Microsoft Corporation or Netscape Communications Corporation, that incorporate search and retrieval features in their products.

China.com’s Competitive Strengths

We believe China.com’s principal competitive strengths include the following:

 

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Integrated mobile and portal platforms. We offer a broad range of mobile products and services in China through our integrated mobile and portal platforms. We intend to leverage our global exposure to introduce advanced mobile services and applications and to expand and enhance our product selections in China. In addition, we have made recent strategic investments, such as in Shenzhen KK and Timeheart, to further enhance our capability to expand our product offerings and develop new products internationally.

Scalable, high-margin business model. Our mobile services and applications business is highly scalable with relatively low incremental operating costs. We have developed a cost-effective development and distribution platform. After incurring initial research and development costs for mobile services and applications, we believe we can deliver these products to a large mobile subscriber base quickly and at a low cost.

Extensive China-wide network coverage with direct local connectivity. Our mobile services and applications are accessible to China’s large mobile subscriber base through a nationwide network of coverage. We have direct local connectivity with China Mobile in 28 provinces and with China Unicom in 26 provinces. We believe our nationwide coverage facilitates our promotional activities. We also believe that our coverage contributes to our high success rate for SMS, MMS, WAP and IVR messages sent, which enhances our revenues and financial position.

Recognized brand names in China. We believe our China.com brand is recognized throughout China, and we operate the www.china.com portal. As of April 5, 2006, Alexa, a subsidiary of Amazon.com, ranked www.china.com as 78th of all websites globally, and also ranked www.china.com as 14th among all simplified Chinese character websites, as measured by user traffic.

China.com’s Goals and Strategy

Our goal for our China.com business unit is to become one of the dominant providers of mobile services and applications in China and to emerge as a major competitor in the mobile services and applications sector. Further, we aim to be a leading portal and online game company in China. Our strategies to achieve these goals include the following:

Pursue selective strategic acquisitions and investments to achieve greater scale. We intend to pursue selective strategic acquisitions and investments aimed at complementing our existing suite of operations.

Expand our product selection and integrate new services and applications. We intend to expand our existing products and services. We also intend to leverage our existing operation, interactive media and marketing platforms to identify and develop new services and applications with the potential to generate significant consumer demand. We plan to introduce new products and innovative technology from various international markets to capitalize on the long term growth opportunities in China. We also intend to access developed markets to source advanced and innovative technologies and applications from these markets to the China market.

Broaden our customer base. We have maintained strong relationships with leading mobile network operators in China, at both the national and local provincial levels, and our existing marketing channels. We intend to further develop these relationships to expand our existing products, broaden our customer base and increase our average revenue per unit. We also intend to use a variety of traditional media, including television, radio, newspaper and magazine advertisement, in addition to our existing marketing channels to enhance our marketing efforts.

Expand and develop our portal network. In 2006, we placed, and intend to continue to place, renewed emphasis on the development of our www.china.com portal network, which is not part of this Annual Report. We believe the portal network will play a critical role in driving synergies among our other related businesses, including our mobile services and applications and online games businesses, and will serve as a strategic and

 

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core business platform. We have begun to implement a repositioning strategy for the portal network to sharpen its vertical focus, and extend the depth of its product offerings in channels such as military, automobile and sports. We intend to explore cross-selling and cooperation opportunities between our business divisions in the areas of marketing and promotion, community building and mobile services and applications product sales.

China.com and CDC Mobile Strategic Partnerships, Agreements and Investments

Jiangsu Wuxi Mobile. In April 2007, we announced that our CDC Mobile business unit entered into a mobile content agreement with Jiangsu Wuxi Mobile, a subsidiary of China Mobile. In connection with this partnership, we intend that CDC Mobile will provide the carrier with rich MMS and WAP content, including ring tones, graphics, weather forecast, and more. We also intend that CDC Mobile will also send this content on the carrier's behalf to designated mobile subscribers. It is anticipated that the carrier then will pay CDC Mobile for the mobile content as well as the content delivery.

Meetic. In November 2006, we announced that China.com had partnered with Meetic (Paris: MEET.PA) to launch an online dating service in the China market.

Google. In August 2006, we announced that China.com had expanded its existing strategic partnership with Google. In connection with this expanded partnership, we intend that Google will provide search engine technology for China.com to support searches of its English and traditional Chinese content by its users in Greater China. We intend that this partnership with Google will further enhance the user experience for China.com's expanding base of domestic and international users. In order to maximize the benefits of this partnership, China.com and Google intend to cooperate across several areas including branding, content and advertising operations.

3G Content Partner Program. In January 2007, we announced the creation of a US $100 million investment program whereby our subsidiary, CDC Mobile, intends to seek strategic investment opportunities in leading 3G content providers in North Asia and Europe as well as the creation of new original content for the 3G marketplace. CDC Mobile intends to initially target its investment program to the North Asian countries of China, Japan and Korea, where Japan and Korea are already early adopters of 3G. Further, CDC Mobile intends to seek, to invest in and partner with, innovative content providers that are leveraging the rollout of the 3G infrastructure to develop new content distribution channels, mobile communities, and offer rich content that previously was not possible in a 2G world. We also intend that CDC Mobile will leverage its current subscriber base, customer support and development infrastructure, deep marketing and sales relationships with the mobile operators in China, and its understanding of the China market to develop 3G in China.

Nokia. In January 2007, we announced that CDC Mobile had entered into an agreement with Nokia to allow Nokia to pre-install CDC Mobile's proprietary software in selected Nokia cell phones sold in China.

Our Intellectual Property

We have acquired a significant amount of intellectual property and we are increasingly developing our own intellectual property. We regard the protection of our trademarks, service marks, copyrights, trade secrets, domain names, and other intellectual property rights as crucial to our success. We rely on a combination of copyright, trade secret and trademark laws, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary information and technology. Copyrights or trademarks held by us, however, may be challenged or determined to be invalid. In addition to the protection generally available to unregistered trademarks under the laws of many jurisdictions, we also protect our trademarks through registration primarily in the United States and Canada, although we do seek such protection elsewhere in selected key markets. However, protection may not be available in every country in which our intellectual

 

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property and technology is used. Some countries, such as China, may not protect our proprietary rights to the same extent as in the United States and Canada. In particular, software piracy has been an issue in China for many software publishers. Policing the unauthorized use of our licensed technology is difficult as are the steps necessary to prevent the misappropriation or infringement of our licensed technology. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of our proprietary rights. Any of these claims, with or without merit, could result in costly litigation, divert our management’s time, attention and resources, delay our product shipments or require us to enter into royalty or license agreements.

As part of our confidentiality procedures, we have policies of entering into non-disclosure and confidentiality agreements with our employees, consultants, corporate alliance members, customers and prospective customers. We also enter into license agreements with respect to our technology, documentation and other proprietary information. These licenses are non-exclusive and generally perpetual. We provide for source code escrow arrangements under some of our license agreements. Despite the efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain the use of our products or technology that we consider proprietary and third parties may attempt to develop similar technology independently.

Most of our products do not contain the functionality to allow us to accurately track the numbers of users of our products at a customer site. Because some of our license agreements are for named-user licenses in which only a certain limited number of named individuals are permitted to use the software for which the license is granted, if our customers do not accurately report the number of users using our products or we cannot accurately track the number of users of our products at a customer site, we face the potential of lost revenues if the customer has a greater number of users than for which they have purchased licenses. License agreement provisions, such as requesting customers to perform annual self audits of the number of users at a customer site, provide only limited protection and are retrospective.

We currently sub-license and distribute the intellectual property and technology of third parties. As we continue to develop intellectual property and introduce new products and services that require new technology, we anticipate that we may need to obtain licenses for additional third-party technology. These existing and additional technology licenses may cease to be available to us on commercially reasonable terms, or at all. In addition, it is possible that, in the course of using new technology, we or our agents acting on our behalf may inadvertently breach the technology rights of third parties and face liability for our breach. Our inability to obtain these technology licenses or avoid breaching third-party technology rights could require us to obtain substitute technologies of lower quality or performance standards or at greater cost which could delay or compromise the introduction of new products and services, and could materially and adversely affect our business, results of operations and financial condition.

Legal Proceedings

As of May 31, 2007, other than as set forth below, there is no material litigation pending against us. From time to time, we and our subsidiaries are a party to other litigation and claims incident to the ordinary course of business. While the results of such litigation and claims cannot be predicted with certainty, we believe that the final outcome of such other matters will not have a material adverse effect on our financial position, results of operations or cash flows.

Vertical Computer Systems / NOW Solutions LLC. In February 2003, Vertical Computer Systems (on behalf of itself and on behalf of NOW Solutions) filed a civil action in the state court in New York, New York, against our subsidiaries Ross Systems, Inc. and others alleging, among other things, breach of contract, claims under contractual indemnifications and fraud arising from the sale of Ross’s HR/Payroll division to NOW Solutions in an amount of $3.5 million. In April 2003, Ross filed a motion to dismiss the complaint, which was

 

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granted in November 2003. The plaintiff appealed and its appeal was granted in October 2004. The matter has been remanded to the trial court for adjudication. In May 2006, both Vertical and Ross filed a summary motion against each other. In November 2006, the Court denied these summary motions, finding that factual issues existed to be resolved at trial. A jury trial took place in April 2007 following which the Court directed certain verdicts in favor of NOW, and certain verdicts in favor of Ross, although final judgment taking into account of attorney’s fees is yet to be entered. Given the net result of the verdicts and the amount of attorneys’ fees likely to be payable by Ross, we believe that it is likely that Ross would have a judgment in the range of $2.5 to $2.9 million entered against it. The time within which the parties may respectively appeal any of the Court’s trial rulings has yet to expire and we are conferring with outside counsel as to whether or not to file an appeal. As a result of the directed verdict, however, the Company made a pre-tax accounting reserve in the fourth quarter of 2006 to cover the anticipated potential costs of this matter.

On February 27, 2007, NOW Solutions, Inc, the alleged successor-by-merger to NOW Solutions, LLC, filed an action in the state court in New York, New York, against Ross, although Ross has yet been served with the Complaint. In this action, NOW Solutions, Inc. asserts claims for breach of contract and attorney’s fees based upon facts similar to those in the above action, seeking $4.1 million in damages. We believe that this action filed in February 2007 is duplicative of the claims that have already been litigated through trial as referred to above, is without merit, and intend to vigorously defend the same.

Harry Edelson In October 2003, Harry Edelson, a former member of our board of directors, brought an action at the District Court for the Northern District of Illinois against us and Dr. Raymond Ch’ien and Mr. Peter Yip, two members of our board of directors, seeking injunctive relief and monetary damages in connection with alleged violations of the Securities Exchange Act of 1934, as amended, in connection with his failure to be re-elected to the board at our 2003 annual general meeting. In February 2004, Mr. Edelson filed an appeal to a decision by the District Court to dismiss the action. The appeal was denied in April 2005 by the Courts of Appeal for the Seventh Circuit. In May 2005, Mr. Edelson petitioned for a re-hearing en banc at the Courts of Appeals. The petition was subsequently denied. In October 2005, Mr. Edelson petitioned to the Supreme Court for a Writ of Certiorari to the Courts of Appeal’s decision and in February 2006 the Supreme Court denied to hear the petition. In February 2004, Mr. Edelson brought an amended action at the District Court against us based upon the same allegations seeking monetary damages. In June 2005, we filed a motion for summary judgment at the District Court, and in November 2005, the motion was granted in our favor. We are not aware of any further developments with respect to this matter since November 2005.

Class Action Lawsuit. A class action lawsuit was filed in the United States District Court, Southern District of New York on behalf of purchasers of our securities between July 12, 1999 (the date of our IPO) and December 6, 2000, inclusive. The complaint charges us and the underwriters in our IPO with violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint alleges that the prospectus used in our IPO was materially false and misleading because it failed to disclose, among other things, that (i) the underwriters had solicited and received excessive and undisclosed commissions from certain investors, in exchange for which the underwriters allocated to those investors material portions of the restricted numbers of our shares issued in connection with the IPO; and (ii) the underwriters had entered into agreements with customers whereby the underwriters agreed to allocate our shares to those customers, in exchange for which the customers agreed to purchase additional shares in the aftermarket at pre-determined prices. In June 2003, the plaintiffs in the consolidated IPO class action lawsuits currently pending against us and over 300 other issuers who went public between 1998 and 2000, announced a proposed settlement with us and the other issuer defendants. The proposed settlement provides that the insurers of all settling issuers will guarantee that the plaintiffs recover $1 billion from non-settling defendants, including the investment banks that acted as underwriters in those offerings. In the event that the plaintiffs do not recover $1 billion, the insurers for the settling issuers will make up the difference. Under the proposed settlement, the maximum amount that could be charged to our insurance policy in the event that the plaintiffs recovered nothing from the investment banks would be approximately $3.9 million. We believe that we have sufficient insurance coverage to cover the maximum

 

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amount that we may be responsible for under the proposed settlement. The independent members of our board of directors approved the proposed settlement at a meeting held in June 2003. As of March 2005, outside counsel advised that the court has granted preliminary approval of the settlement, subject to certain conditions. We are awaiting final approval of the settlement, pending satisfaction and waiver of such conditions, although the timing of such final approval is uncertain.

Lam, Po Chiu Mark. In December 2003, Mr. Mark Lam filed a civil action in the High Court of Hong Kong against our subsidiary Ion Global (BVI) Limited alleging breach of contract in relation to a put option agreement under a share purchase agreement in an amount of $741,937. Pleadings closed in April 2004 when Mr. Lam filed his reply to the defense filed by Ion Global. The case was largely dormant until late 2005 when the plaintiff sought and was granted leave to amend his statement of claim and to join the Company as a party. The Company was joined in July 2006. In January 2007, Mr. Lam also joined a member of our board of directors, Mr Peter Yip, to the proceedings. We believe that this action is without merit and we intend to vigorously defend such action.

Herkemij & Partners Knowledge. In April 2004 Herkemij & Partners Knowledge B.V., or Herkemij Knowledge, filed a civil action against our subsidiaries Ross and Ross Nederland alleging Ross and Ross Nederland developed a software program named iProject using documentation and source code from Herkemij Knowledge’s copyrighted Project Administration and Control System. The action includes counts for copyright infringement, misappropriation of trade secrets, and unfair competition and seeks, among other things, injunctive relief, damages totaling $5.0 million to $10.0 million, and payment of royalties. In September 2004, the case against Ross Nederland was dismissed for lack of personal jurisdiction, and in February 2005, a hearing was held in which the judge refused to dismiss the case against Ross, but transferred the case to the Northern District Court of Georgia in Atlanta. In August 2005 the Northern District Court of Georgia granted Herkemij’s motion to amend the complaint. Based on representations of Ross made to the Court in October 2005, Herkemij sought to dismiss all claims without prejudice. Ross then filed its response seeking dismissal with prejudice and costs. In late 2006 the Court dismissed the case without prejudice and ordered Herkemji to reimburse Ross for part of its legal costs.

Adding Value to Business Pty Ltd trading as Countrywide Systems Network. In December 2004, Adding Value filed a civil action against our subsidiary Praxa Limited, alleging breach of contract, misleading and deceptive conduct, and seeking various equitable remedies and damages in an amount of $993,000 plus interest and costs. Praxa Limited has since filed its defense and a cross-claim against Adding Value. In June 2007, the action was fully settled pursuant to a deed of settlement.

ManTech International Corporation and ManTech Australia International Inc. In October 2005, ManTech International Corporation and ManTech Australia International Inc, filed a civil action against our subsidiaries CDC Australia Limited and CDC Australia (Praxa) Pty Ltd alleging that CDC Australia failed to pay $3.7 million that was retained as part of the consideration for the acquisition of Praxa Limited. In late 2005, CDC Australia Limited and CDC Australia (Praxa) Pty Ltd filed and served a request for further and better particulars of the statement of claim and a request for the filing of security of costs. The plaintiffs answered the requests for further and better particulars, and further directions as to the conduct of the action were given by the Court soon after plaintiff made payment of security for costs in January 2007. Discovery and interrogatories are due to be filed and served by July 2007. We believe that the $3.7 million was rightfully retained by CDC Australia in accordance with the terms of the acquisition agreement, and the action is without merit. We intend to vigorously defend such action.

 

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C. Organizational Structure

CDC Corporation was incorporated in June 1997. The following table sets forth our significant subsidiaries organized by business unit as of April 30, 2007. Please note that the following table does not include our intermediate holding companies.

LOGO

 

•        Ross Systems, Inc.

 

•        Pivotal Corporation

 

•        Industri-Matematik International Corp (51%)

 

•        Saratoga Systems Inc.

 

•        Vectra Corporation (majority interest)

 

•        MVI Holdings Limited

 

•        Respond Group Limited

 

•        Vis.align, Inc.

 

•        DB Professionals, Inc.

 

•        OST International Corporation

 

•        c360 Solutions Incorporated

 

•        Platinum China Holdings Inc. (holds OpusOne)

 

•        Assets acquired from JRG Software, Inc.

 

•        Praxa Limited

 

•        Software Galeria, Inc. (51%) (holds Ascent and the assets of Horizon)

 

•        PK Information Systems Pty Ltd.

 

•        Ion Global (BVI) Limited

 

•        MEZZO Business Databases Pty Limited

  

•        Beijing 17Game Network Technology Co., Ltd.

  

•        TTG Asia Media Pte Limited*

 

•        chinadotcom Portals Limited*

 

•        hongkong.com Portals Limited*

 

•        CDC Mobile Media Corporation (90%)*

 

•      NewPalm (China) Information Technology Co. Ltd. (held by Palmweb Inc.) **

 

•      Beijing He He Technology Co. Ltd. (held by Group Team Investments) (operates Go2joy) **

 

•      Shenzhen KK Technology Ltd (held by United Crest Limited) **

 

•      TimeHeart Science Technology Limited **


(  ) Denotes percentage ownership, if less than 100%
* Subsidiaries held under our 77% owned subsidiary, China.com, which is listed on the Growth Enterprise Market of The Stock Exchange of Hong Kong Limited, or GEM.
** Subsidiaries Held Under CDC Mobile Media Corporation, a 90% Owned Subsidiary Of China.Com, which is listed on the Growth Enterprise Market of The Stock Exchange of Hong Kong Limited, or GEM.

 

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Corporate Structure in China for our CDC Games and China.com Business Units

Overview

Internal Restructuring. In December 2006, we completed our plans for an internal restructuring of CDC Games pursuant to which CDC Games was moved from within China.com to become a direct business unit of CDC Corporation. The independent shareholders of China.com, present in person or by proxy at China.com's shareholders meeting, approved the restructuring.

In connection with the restructuring, CDC Games entered into a stock purchase agreement whereby it acquired all issued and outstanding shares of its common stock for a purchase price of $110 million. Of such amount, $50 million was paid in cash at closing and $60 million was funded through CDC Games’ issuance of a note bearing interest at 5% per annum, due June 28, 2008. Additionally, CDC Games agreed to pay up to an additional $25 million to China.com in the event it completes a successful listing of its shares on certain recognized stock exchanges before December 29, 2007, and its market capitalization on such exchange or exchanges is greater than $110 million during such time.

Businesses. As of March 31, 2007, CDC Games operates in the online games business segment in China through 17game. As of March 31, 2007, China.com, a 77% owned subsidiary of CDC Corporation, operates our Mobile Services and Applications and Internet and Media business segments in China.

CDC Games and China.com make investments in each of these business units mainly through offshore holding vehicles registered in the British Virgin Islands or Cayman Islands.

Trust Deed Arrangements

To comply with legal and regulatory considerations in China, each of CDC Games and China.com conducts a significant portion of the operations of these business units through domestically registered companies in China, referred as ICPs, which are held under trust deed arrangements. Under these trust deed arrangements, the trustees are employees of CDC Games or China.com who are Chinese nationals and the 100% beneficiaries of the trusts are offshore holding vehicles registered in the British Virgin Islands or Hong Kong.

With respect to our Newpalm business, we have formed two ICPs, Beijing Newpalm Technology Co., Ltd., or Beijing Newpalm, and Beijing Wisecom Technology Co., Ltd., or Beijing Wisecom. Two of China.com’s employees, Mr. Wang and Ms. He, each own 50% of Beijing Newpalm and Mr. Wang and Mr. Fang each own 50% of Beijing Wisecom. Beijing Newpalm and Beijing Wisecom are held under trust deed arrangements under which Mr. Wang, Ms. He and Mr. Fang also serve as trustees of the trusts. China.com Corp. Limited is the holding vehicle of China.com incorporated in Hong Kong which is the 100% beneficiary of the trusts.

With respect to our Shenzhen business, the ICP is Shenzhen KK Technology Ltd., or Shenzhen KK. Two of China.com’s employees have ownership interests in Shenzhen KK with Mr. Wang and Ms. each owning 50% of Shenzhen KK. Shenzhen KK is held under trust deed arrangements under which Mr. Wang and Ms. He also serve as trustees of the trusts. Unitedcrest Investments Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.

With respect to our TimeHeart business, the ICP is Beijing TimeHeart Information Technology Limited, or Beijing Timeheart. Two of China.com’s employees have ownership interests in Beijing TimeHeart with Ms. Huang owning 50% of Beijing TimeHeart and Ms. Zhao owning 50% of Beijing TimeHeart. Beijing TimeHeart is held under trust deed arrangements under which Ms. Huang and Ms. Zhao also serve as trustees of the trusts, and TimeHeart Science Technology Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.

 

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With respect to our China.com Portal business, the ICP is Beijing China.com Technology Services Co., Ltd., or Beijing China.com. Three of China.com’s employees have ownership interests in Beijing China.com with Mr. Wang and Mr. Fang each owning 40% of Beijing China.com and Ms. Wu owning 20% of Beijing China.com. Beijing China.com is held under trust deed arrangements under which Mr. Wang, Mr. Fang and Ms. Wu also serve as trustees of the trusts, and chinadotcom Portals Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.

With respect to our Go2joy business, the ICP is Beijing He He Technology Co., Ltd., or Beijing He He. Two of China.com’s employees have ownership interests in Beijing He He with Ms. He and Ms. Wu each owning 50% of Beijing He He. Beijing He He is held under trust deed arrangements under which Ms. Wang and Ms. Wu also serve as trustees of the trusts, and Double Keen Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.

With respect to our 17game business, the ICP is Beijing Hulian Jingwei Technology Development Co., Ltd., or Beijing Inter Connected. Two of China.com’s employees have ownership interests in Beijing Inter Connected with Mr. Wang owning 70% of Inter Connected and Mr. Xu owning 30% of Inter Connected. Inter Connected is held under trust deed arrangements under which Mr. Wang and Mr. Fan also serve as trustees of the trusts, and Equity Pacific Limited is the offshore holding vehicle of China.com registered in the British Virgin Islands which is the 100% beneficiary of the trusts.

Licenses and Agreements

The ICPs each hold various types of licenses required by the regulatory authorities in China with respect to operating their respective businesses.

 

   

Beijing Newpalm, Beijing Wisecom, Beijing He He and Shenzhen KK each hold a license to provide SMS, MMS, IVR, WAP and other mobile services and applications to public subscribers in the PRC.

 

   

Beijing Newpalm, Beijing He He, Shenzhen KK and Beijing TimeHeart each hold a nationwide license to provide mobile value added services, or MVAS in the PRC.

 

   

Beijing TimeHeart holds an Internet Content Provider license in the PRC.

During 2006, Beijing Newpalm continued to serve as the primary ICP within Newpalm. Previously, Beijing Newpalm had entered into agreements with China Mobile to provide services on China Mobile’s network and Beijing Wisecom had entered into agreements with China Unicom to provide services on China Unicom’s network. As the primary ICP within Newpalm, Beijing Newpalm continues to enter into various agreements with China Mobile to provide services on China Mobile’s network, and except for a few provinces, Beijing Newpalm has replaced Beijing Wisecom to renegotiate with China Unicom to provide services on China Unicom’s network.

Beijing He He has entered into agreements with China Mobile and China Unicom to provide MVAS services using either China Mobile’s or China Unicom’s network.

Shenzhen KK has entered into agreements with China Mobile to provide MVAS services using China Mobile’s network.

Beijing China.com holds an Internet Content Provider License and has been authorized to operate an Internet portal with the URL www.china.com. Beijing China.com also holds various licenses which are attached to the Internet Content Provider License, such as an Internet advertisement license and an Internet news reporting license.

 

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Beijing Inter Connected holds one Internet content provider license and has been authorized to operate two Internet portals with the URL www.17game.com and the URL www.yxwz.com for all its online games. Beijing Inter Connected also holds various licenses which are attached to the Internet content provider license which are particularly applied for each game imported into and operated in China.

With respect to our online games business, we also hold various licenses in the PRC for the import and licensing of Yulgang, Travia and Special Force.

Use of Wholly Foreign Owned Enterprises

The ICPs Beijing Newpalm and Beijing Wisecom (for Newpalm), Beijing China.com (for the China.com Portal) and Beijing He He (for Go2joy) and Beijing Timeheart (for TimeHeart) act as the primary revenue generating entities of each business unit. In order to provide, among other things, more effective controls over these ICPs, each of the respective beneficiaries of the trusts, under the trust deed arrangements for these business units, has formed and invested in a wholly foreign owned enterprise, or WFOE, to act as a long term exclusive partner of the ICP. WFOEs are limited liability companies established under the Chinese Company Law, the shareholders of which are permitted to be 100% foreign (not Chinese nationals).

As the long term exclusive partner of the ICP, the respective WFOE for the ICP provides technical and logistical support for the day to day operations of the ICP, including sales and marketing, billing, and administrative services. To facilitate the delivery of the technical and logistical support, the WFOE owns the physical assets, including servers, switches and computers, and employs the technical, sales and administrative personnel necessary to deliver these services. In exchange for such services, the WFOE charges the ICP a fee.

The WFOE formed to provide services for Beijing Newpalm, Beijing Wisecom and Shenzhen KK is Newpalm (China) Information Technology Co., Limited, and such WFOE charges a fee of approximately 90% of the gross revenue of each of Beijing Newpalm, Beijing Wisecom and Shenzhen KK for its services.

The WFOE formed to provide services for Beijing TimeHeart is TimeHeart (Beijing) Network Technology Limited. This WFOE did not charge Beijing TimeHeart any fees in 2006.

The WFOE formed to provide services for Beijing China.com is Chinadotcom Communications Technology Development (Beijing) Limited This WFOE charged fees averaging approximately 49% and 41% of the gross revenue of Beijing China.com for its services during each of 2005 and 2006, respectively.

The WFOE formed to provide services for Beijing He He is Beijing He He IVR Mobile Technology Ltd. This WFOE did not charge Beijing He He any fees in 2005 or 2006.

The WFOE formed to provide services for Beijing Inter Connected is Beijing 17game Network Technology Co., Ltd. This WFOE is able to directly sell the final online game products to the consumers instead of charging a service fee via Beijing Inter Connected.

 

D. Property, Plants and Equipment

Facilities

As of May 31, 2007, we owned no real estate and our major leased facilities included our:

 

   

principal executive offices in Hong Kong, where we have leased approximately 13,600 square feet, approximately 40% of which we occupy pursuant to the terms of a Services Agreement;

 

   

corporate, research and development, sales, marketing, consulting and support facilities in Atlanta, Georgia, where we lease approximately 36,200 square feet;

 

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sales, marketing and support facilities in Northampton, England, where we lease approximately 11,500 square feet;

 

   

service, sales and support facilities in San Francisco, California, and Sydney and Melbourne, Australia where we lease approximately 10,278, 13,210 and 12,426 square feet, respectively;

 

   

professional services, education and research and development facilities in Vancouver, British Columbia, where we lease approximately 133,812 square feet, approximately 96,801 square feet of which is currently sublet;

 

   

product development facilities and Nordic service, sales, marketing and support facilities in Stockholm, Sweden, where we lease approximately 13,500 square feet;

 

   

product development centers in Bangalore, India, where we lease approximately 40,000 square feet and Shanghai, China, where we lease approximately 9,563 square feet;

 

   

local support facilities in Paris, France, where we lease approximately 11,808 square feet, and in Globen, Linköping and Hässleholm, Sweden, where we lease approximately 39,000 square feet;

 

   

service, sales, marketing and support facilities for our Business Services Group in King of Prussia, Pennsylvania, where we lease approximately 21,000 square feet;

 

   

operational facilities for certain of our enterprise software subsidiaries, located in Campbell, CA, where we lease approximately, 29,126 square feet; and

 

   

operational and support facilities for our China.com and CDC Games businesses in Beijing where we lease approximately 60,216 square feet of office space.

We and our subsidiaries also lease additional office space in various other locations in the United States, Canada, Europe, Asia and Australia. These locations include:

 

   

in the United States: Addison, TX; Bala Cynwyd, PA; Bethesda, MD; Dallas, TX; Des Plaines, IL; Edison, NJ; Fairfield, NJ; Miami, FL; Mt. Laurel, NJ; Naperville, IL; Portland, OR; San Francisco, CA; Westborough, MA; and White Plains, NY;

 

   

in Canada: Toronto, Ontario;

 

   

in Europe: Vantaa, Finland; Paris, France; Unterfohring, Germany; Dublin, Republic of Ireland; Zeist, The Netherlands; Barcelona, Spain; Binfield, Berkshire, UK; Milton Keynes, UK; and Solna, Sweden;

 

   

in Asia: China (including Guangzhou, Chengdu, Shenzhen, Shanghai, Hangzhou, Henan, Nanjing, Shandong, Shanxi and Tianjin); Mumbai, India; Tokyo, Japan; and Seoul, Korea; and

 

   

in Australia: Milton, Brisbane.

During 2006 and 2007, we elected to continue to expand our remote work model to reduce our overall reliance on leased facilities. The amount of cost benefit from this reduction in leased facilities will depend upon the success of our sublease program.

Furthermore, in December 2006, China.com entered into contracts to acquire approximately 376,740 square feet of land in Nanjing, China for an aggregate of approximately US$550,000 payable in installments. We intend that these premises will be utilized as corporate facilities for us and our subsidiaries.

 

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ITEM 4A. UNRESOLVED STAFF COMMENTS

On August 31, 2006, the staff of the Securities and Exchange Commission provided comments to our Annual Report on Form 20-F for the year ended December 31, 2005 and various Current Reports on Form 6-K, including a comment requesting us to consider whether separate financial statements and notes related thereto of Equity Pacific Limited, its subsidiaries and its variable interest entity (collectively, “17game Group”) were required pursuant to the disclosure requirements of Item 8 of Form 20-F and Item 3-09 of Regulation S-X. After correspondence with the staff of the Securities and Exchange Commission, we agreed to amend our 2005 Annual Report on Form 20-F to include separate consolidated balance sheets for 17game Group as of December 31, 2004 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flows for the year ended December 31, 2005 and for the five month period from August 1 to December 31, 2004 and the accompanying audit report of Deloitte Touche Tohmatsu CPA Ltd. (collectively, the “17game Group Financial Statements”). On July 2, 2007, we filed such amendment with the Securities and Exchange Commission. While we believe that the filing of the amendment resolves the comments received from the staff in their August 31, 2006 comment letter, we cannot assure you that the staff of the Securities and Exchange Commission will not raise additional comments relating to the 17game Group Financial Statements or our amended 2005 Annual Report on Form 20-F.

 

ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

Cautionary Statement

You should read the following discussion of our financial condition and results of operations together with our consolidated financial statements and the related notes included elsewhere in this Annual Report on the Form 20-F. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from those anticipated in these forward-looking statements as a result of factors including, but not limited to, those set forth under Item 3.D. of this Annual Report on the Form 20-F, “Key Information – Risk Factors” and Item 11 of this Annual Report, “Quantitative and Qualitative Disclosures About Market Risk”.

 

A. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Products and Services

CDC Corporation is a global provider of enterprise software, mobile services and internet and media services and the development and operation of online games. The Company offers the following products and services to customers around the world:

 

   

Software. We are a global provider of enterprise software applications and related services. Our products are designed to support and automate the processes of an organization to achieve company-wide integration of business and technical information across multiple divisions and organizational boundaries, such as finance, manufacturing, logistics, human resources, marketing, sales and customer service, by utilizing common databases and programs that share data real time across multiple business functions. Our products and services seek to help companies worldwide fulfill their business growth objectives through increased operational efficiencies, improved profitability, strengthened customer relationships and improved regulatory compliance. The software suite includes Enterprise Resource Planning, or ERP, Customer Relationship Management, or CRM, Supply Chain Management, or SCM, Order Management Systems, or OMS, Human Resources and Payroll Management, or HRM, and Business Intelligence, or BI, products.

 

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Business Services. The Company’s business services offerings include information technology services, eBusiness consulting, web development and outsourcing in Hong Kong, Australia, Korea, and the U.S., and a marketing database and marketing support service offered principally in Australia and New Zealand. The Company’s business services companies provide program management, outsourcing services, application development and ongoing support services using a wide range of technologies.

 

   

CDC Games. Our Games business is principally derived from online game services in the China. We operate our Massively Multiplayer Online Role-Playing Games, or MMORPGs, under two models. The first model is the traditional subscription based pay-to-play, where users purchase pre-paid cards, or the PP-Cards, to play for a fixed number of hours. The second model is free-to-play, under which players are able to access the games free of charge but may choose to purchase in-game merchandise or premium features to enhance their game playing experience, such purchases can only be made through the use of PP-Cards.

 

   

Mobile Services and Applications. Our mobile services and applications business provides news and mobile applications services targeting the consumer market in China. It offers wireless services including Short Message Service, or SMS, Interactive Voice Response, or IVR, Multimedia Message Service, or MMS and Wireless Application Protocol, or WAP. We have established strong local direct connectivity with provincial mobile network operators in 29 provinces in the PRC, which facilitates the marketing and promotional activities of our wireless services. Our mobile services and applications business is primarily operated through Newpalm and Go2joy, both of which are held through our subsidiary, China.com.

 

   

Internet and Media. Our Internet and Media business encompasses a range of businesses, including our Internet media business which is focused on online entertainment and Internet products and services that target users in China via our portal network (www.china.com and www.hongkong.com) and a Singapore-based travel trade publisher and organizer serving the travel and tourism industry in the Asia Pacific region operated by TTG.

Effect of acquisitions

During 2004 and 2006, we made the following significant business acquisitions, by business segment, the results of which have been consolidated from the respective dates of acquisition. There were no significant acquisitions during 2005.

 

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Software

 

Acquired company

   Date

Pivotal Corporation (“Pivotal”)

   Feb-04

Ross Systems, Inc. (“Ross”)

   Aug-04

Business Services

 

Acquired company

   Date

D B Professionals, Inc. ("DBPI")

   Jul-06

Vis.align, Inc. (“Vis.align”)

   Dec-06

Mobile Services and Applications

 

Acquired company

   Date

Group Team Investments Limited (holds Beijing He He Technology Co. Ltd. (“Go2joy”))

   May-04

TimeHeart Science Technology Limited (the “TimeHeart Group”)

   Nov-06

CDC Games

 

Acquired company

   Date

Equity Pacific Limited (the “17game Group”).

   Mar-06

For a list of all acquisitions, see Item 4 – “Information on the Company.”

Operating Segments and Discontinued Operations

We report results in five business segments, “Software,” “Business Services,” Mobile Services and Applications,” ”Internet and Media” and “CDC Games.”

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, goodwill and intangible assets, business combinations, valuation of derivative financial instruments, fair value of investments not actively traded, capitalization of software costs, investments, accounts receivable and allowance for doubtful accounts, deferred tax valuation allowance, stock based compensation, and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies are described in “Note 2- Summary of Significant Accounting Policies” in Item 18- Financial Statements.

 

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We believe the following critical accounting policies are some of the more critical judgment areas in the application of our accounting policies that affect our financial condition and results of operations.

Revenue Recognition

We generally recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectibility is probable. If an acceptance period is required, revenues are recognized upon the earlier of customer acceptance or the expiration of the acceptance period. The Company’s agreements with its customers, resellers and distributors do not contain product return rights. If the fee is not fixed or determinable due to the existence of extended payment terms, revenue is recognized periodically as payments become due, provided all other conditions for revenue recognition are met.

We generate revenues from five primary sources: Software, Business Services, Mobile Services and Applications, Internet and Media services and CDC Games. We recognize revenue in accordance with US GAAP. The specific literature that the Company follows in connection with its revenue recognition policy includes the Securities and Exchange Commission’s Staff Accounting Bulletin 104, “Revenue Recognition”, the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions”, Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) 00-21, “Revenue Arrangements with Multiple Deliverables” EITF 00-3 “Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware”, and in certain instances EITF 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”, and SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”.

In addition to these basic criteria, the following are the specific revenue recognition policies we follow for each major stream of revenue by reporting segment.

Software

We generate software revenues from the sale of software licenses, and the maintenance and services for such software licenses. Such sales often include a combination of software consulting and integration services, implementation training and maintenance services. We allocate the arrangement fee in these multi-element arrangements to each individual element using its relative fair value as based on vendor specific objective evidence (“VSOE”). VSOE of fair value is typically determined by the customary price charged for each element when sold separately after the application of any standard approved discount. In the case of an element not yet sold separately, VSOE of fair value is the price established by authorized management if it is probable that the price, once established, will not change before market introduction. Where fair value exists for all undelivered elements of the arrangement but not the delivered elements, we apply the “residual” method of accounting and defer revenue allocated to the undelivered elements while recognizing the residual revenue allocated to the delivered elements. In the absence of VSOE of fair value for any undelivered element, we defer the entire arrangement fee and recognize revenue when all undelivered elements are delivered assuming all other basic criteria for revenue recognition have been met. We generally recognize revenues from services separately from license fees revenues because the service arrangements qualify as "service transactions" as defined by SOP 97-2. The factors considered in determining whether the revenues should be accounted for separately include the nature of the services and whether the services are essential to the functionality of the licensed product, availability of services from other vendors, and the impact of payment timing on the realizability of the software license fee.

Software license revenues are normally generated through licensing with end-users, value-added resellers (“VARs”) and distributors, and through the sale of the software with or incorporating third-party products. VARs and distributors do not have rights of return, price protections, rotation rights, or other features that would preclude revenue recognition. When software licenses are sold indirectly to end-users through

 

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VARs, we recognize as revenue only the net fee receivable upon sell-through to the end-user. License revenues from distributors are calculated at an agreed upon percentage of the distributors’ net selling price to the end-user. We typically do not earn any portion of fees for services provided by the distributor to the end-user. We earn maintenance fees based on an agreed upon percentage of the maintenance fees that the distributor earns from the end-user.

When software licenses incorporating third-party software products are sold or sold with third-party products that complement our software, we recognize as revenue the gross amount of sales of third-party products. The recognition of gross revenue is in accordance with criteria established in EITF 99-19 because we are ultimately responsible for the fulfillment and acceptability of the products purchased, have full latitude in establishing pricing and assume all credit and general inventory risks.

Revenues related to consulting and integration services and the provision of training services for software products are deferred and recognized as the services are delivered, assuming all other basic criteria for revenue recognition have been met.

Revenues related to maintenance agreements on software products are deferred and recognized ratably over the terms of the agreements which are normally one year.

We make provisions for discounts and rebates to customers and other adjustments in the same period in which the related revenues are recorded. Such provisions are calculated after considering relevant historical data.

Recognition of revenues from the licensing of our software products requires management judgment with respect to determination of fair values and in determining whether to use the gross versus net method of reporting for certain types of revenue. The timing of our revenue recognition could differ materially if we were to incorrectly determine the fair value of the undelivered elements in an arrangement for which we are using the “residual” method. The composition of revenues and cost of revenues would change if we made a different assessment on the gross versus net method of reporting sales of software licenses which incorporate third-party software products.

Business Services

We generate business services revenues from information technology services, eBusiness consulting, web development and outsourcing.

We recognize revenues from time and materials outsourcing contracts as the services are delivered assuming all other basic criteria for revenue recognition have been met.

We recognize revenues from the design, development and integration of Internet web sites and mobile phone devices using contract accounting based on either client acceptance of completed milestones or using the cost-to-cost percentage-of-completion method. We use the cost-to-cost method based on hours incurred as a percentage of the total estimated hours to complete the project because our historical experience has demonstrated that it produces a reliable indication of the progress on each engagement. We regularly reevaluate estimates of total projected contract costs and revise them if appropriate. Any adjustments to revenues due to changes in estimates are accounted for in the period of the change in estimate. When estimates indicate that a loss will be incurred on a contract upon completion, a provision for the expected loss is recorded in the period in which the loss becomes evident. Historically, we have not experienced material losses on fixed-price contracts. The majority of our contracts are short term in duration, and the use of the completed contract method would not result in a material difference in the timing of revenue recognition. Some projects include acceptance clauses requiring customers’ sign-off at the conclusion of the projects. Historically, we have not experienced projects where sign-off or acceptance has been withheld by a customer resulting in a material loss on a project. Recognition of revenues using contract accounting requires judgment with respect to the method used. The

 

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timing of our revenue recognition could differ if we were to use a different methodology for estimating progress to completion, such as an output method based on milestones for contracts where we currently use an input method such as hours incurred.

Revenues from Internet web site maintenance agreements are deferred and recognized ratably over the terms of the related agreements, which are usually for periods of six months or one year.

Database and marketing support services include list rental, database development and supply, data analysis and call center services. Revenue is recognized when the service or list has been delivered assuming all other basic criteria for revenue recognition have been met.

Advertising revenues arising from direct mailing or placement of print advertising are recognized when the advertisements are sent or published, assuming all other basic criteria for revenue recognition have been met.

We derive advertising and marketing services revenues from consulting services, marketing database and support services, online and print advertising, and our Internet media business which is focused on online entertainment and Internet products services that target users in China via our portal network.

Advertising and marketing consulting services revenues for fixed price contracts are recognized upon completion of contractual milestones which are specified in the contracts along with pricing, payment terms and project timetable. Revenues from time and materials outsourcing contracts are recognized as the services are delivered, assuming all other basic criteria for revenue recognition have been met.

Mobile Services and Applications

We generate mobile services and applications revenues from a comprehensive suite of mobile data applications, including dating, chatting, fortune telling, entertainment, information-related content and community services to mobile subscribers in China utilizing SMS, MMS, WAP and IVR services. We rely on mobile network operators in China to bill mobile phone users for our subscription fees. We have revenue sharing arrangements with China Mobile and China Unicom under which we receive 70% to 85% of the subscription fee collected from a mobile subscriber, with the balance being retained by the mobile operators. In addition to our charges, the mobile operators separately charge their subscribers RMB0.10 to RMB1.00 for every SMS, MMS or WAP message sent. These amounts are collected by the mobile operators and are not shared with us.

Mobile services and applications revenues are recognized in the month in which the services are performed, provided that all other basic criteria for revenue recognition have been met. The mobile operators provide statements after month-end indicating the amount of fees that were charged to users for mobile services and applications services that we provided during that month and the portion of fees that are due to us in accordance with our contractual arrangements with the mobile operators. We typically receive these statements within 30 to 90 days following month-end, and we typically receive payment within 30 to 90 days following receipt of the statement. We also maintain an internal system that records the number of messages sent to and messages received from mobile users. Generally, there are differences between the expected value of delivered messages based on our system records and our portion of the fees confirmed by the mobile operators for the delivered messages. These differences may result from the user’s phone being turned off, problems with the mobile operators’ networks or our billing system or other issues which prevent delivery of our services to users. These are known in the industry as billing and transmission failures. We do not recognize revenues for services which result in billing and transmission failures. Billing and transmission failures can vary significantly from month to month, province to province and between mobile operators. At the end of each reporting period, where an operator fails to provide us with a monthly statement confirming the amount of charges billed to their mobile phone users for that month, we use the information generated from our internal system and historical data to make estimates of the billing and transmission failures and accrue as revenue the estimated amount of collectable mobile services and applications fees. If an actual discrepancy varies significantly from our estimate, it could result in an overstatement or understatement of revenues and costs of revenues.

 

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We are also required to pay some of our content providers either monthly fee or a percentage of the revenue received from or confirmed by the mobile operators, with or without a minimum guaranteed payment, with respect to services incorporating the content providers’ products. In calculating the fees payable to these providers, we reduce the amount of the fee payable by our estimate of account billing and transmission failures which may have been applicable to the services incorporating these products. If we receive confirmation of billing or transmission failures which differ from our estimate after we make payments, we do not ask for refunds, make additional payments, or make adjustments with respect to fees payable for future periods. If the assumptions we use in making such estimates prove inaccurate, we may have paid, and may continue to pay, fees to such providers which are disproportionate to the amount we have been paid for the services.

Prior to 2005, we recognized mobile services and applications revenues net of the mobile phone operator’s share of revenue and uncollectible amounts because we considered the mobile operators to be the primary obligors based on the fact that the mobile operators set maximum prices that we could charge and that the mobile operators also had the right to set requirements and procedures associated with using their platform. Prior to 2004, we relied on the mobile operators to advertise our services, and customers were not necessarily aware the services to which they were subscribing were being provided by us because they did not receive confirmations after subscribing to such services. This situation changed in 2005 as a result of (i) beginning in 2005, a large portion of our revenues are being generated on a new transmission platform which requires direct confirmation of every service ordered by customers and makes it clear to customers that we are responsible for providing such services; (ii) a substantial increase in direct advertising of our services; (iii) enhanced ability to select suppliers due to a shift from primarily using internally-produced content to purchasing content; and (iv) changes in mobile operators’ practices such as shifting their credit risk to us by taking an additional percentage of revenues from the arrangement to cover expected bad debts. Based on these recent changes, we changed our revenue presentation to the gross method on a prospective basis as of January 1, 2005.

Recognition of mobile services and applications revenues requires judgment with respect to the estimation of revenues not yet confirmed by the mobile operators at the end of a period, and whether to use the gross versus net method of reporting revenue. The company regularly re-evaluates its EITF 99-19 assessment as the mobile services environment continues to evolve with the transition to new platforms and significant changes in the operating practices of the network operators. The composition of revenues and cost of revenues would change if we made a different assessment on the gross versus net basis of reporting. Our estimates also rely to some extent on our historical experience. We believe we have the ability to make reasonable estimates. However, material differences in the amount and timing of our revenue and cost of revenue could result during any period because of differences between the actual billing and transmission failure rate per the mobile operators’ statements and our estimates based on our internal records and historical experience, or if we were to use a different methodology for estimating the billing and transmission failure rate applicable to unconfirmed revenues. In the future we may also change our estimation methodology based on future experience or if there are changes in the manner in which the mobile operators confirm revenue.

Internet and Media

Revenue from internet and media mainly represents revenue from advertising, which is recognized on a straight-line basis over the period in which the advertisement is displayed, and when collection of the resulting receivable is probable, provided that no significant obligations of the Company remain. Advertising service fees from direct mailings are recognized when each advertisement is sent to a target audience.

CDC Games

CDC Games revenues are principally derived from the provision of online game services in China. The Company operates its MMORPGs under two models. The first revenue model is the traditional subscription based pay-to-play, where users purchase PP-Cards to play for a fixed number of hours. The second revenue

 

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model is free-to-play, under which players are able to access the games free of charge but may choose to purchase in-game merchandise or premium features to enhance their game playing experience, such purchases can only be made through the use of PP-Cards.

The end users are required to activate their PP-Cards by using access codes and passwords to exchange the value of these cards to game points and deposit into their personal accounts. They consume points for online game services by trading them either for a pre-specified length of game playing time or in-game merchandise or premium features sold at online game stores. All prepaid fees received from distributors are initially recognized as deferred revenue and revenue is recognized when the registered points are consumed for the Company’s online game services, i.e., when game playing time occurs or in-game merchandise or premium features are delivered, or when the end customers are no longer entitled to access the online game services after the expiration of the PP-Cards.

Goodwill and Intangible Assets

Our long-lived assets include goodwill and other intangible assets. Goodwill represents the excess of cost over the fair value of net intangible assets of businesses acquired. Goodwill and indefinite lived intangible assets are not amortized. All other intangible assets are amortized over their estimated useful lives.

Goodwill is assigned to reporting units based on the reporting unit classification of the entity to which the goodwill is attributable. We have determined our reporting units based on an analysis of our operating segments. In 2004, after acquiring Ross and Pivotal, we performed an assessment of our businesses and sub-divided our reporting units into additional reporting units based on (a) the nature of products and services; (b) the nature of the production process; (c) the type and class of customers; (d) the method to distribute products or provide services; and (e) the nature of regulatory environment. We reallocated goodwill among the new reporting units based on the relative fair value of each new reporting unit compared to the fair value of the reporting unit in which it was classified before the sub-division.

Intangible assets represent trademarks and service marks, uniform resource locators (“URLs”), software applications and programs, customer base and contracts, and business licenses and partnership agreements. Intangible assets are carried at cost less accumulated amortization. Amortization is computed using the straight-line method over the estimated useful lives of the respective assets.

The estimated useful lives of the intangible assets are as follows:

 

Trademarks

  

Indefinite

URLs

   20 years

Software applications and programs

   2 to 5 years

Customer base and contracts

   1 to 10 years

Business licenses and partnership agreements

   1 to 7 years

We test goodwill and intangible assets with an indefinite useful life for impairment on an annual basis as of December 31. This testing, carried out using the guidance and criteria described in SFAS No. 142, “Goodwill and Other Intangible Assets,” compares carrying values to fair values at the reporting unit level and, when appropriate, the carrying value of these assets is reduced to fair value. Factors that could trigger an impairment charge include, but are not limited to, significant changes in our overall business or in the manner or use of the acquired assets, underperformance against projected future operating results, and significant negative industry or economic trends. Any impairment losses recorded in the future could have a material adverse impact on our financial condition and results of operations for the periods in which such impairments occur.

During 2005 and 2006, we performed the required impairment tests on goodwill and intangibles with an indefinite useful life and were not required to record any impairment. Management judgment is required with respect to the identification of reporting units based on our internal reporting structure that reflects the way we

 

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manage our business or operations, assigning assets and liabilities to reporting units, and assigning goodwill to reporting units. Significant judgment is also required to estimate the fair value of reporting units including estimating future cash flows, determining appropriate discount rates, estimating the applicable tax rates, projecting future industry trends and market conditions, and making other assumptions. The use of different estimates and assumptions could materially affect the determination of fair value for each reporting unit. If we change our estimates and assumptions in the future based on changes in our overall business or in the manner or use of the acquired assets, underperformance against projected future operating results, or significant negative industry or economic trends, such changes might result in an impairment charge.

We also annually review and adjust the carrying value of amortized intangible assets if facts and circumstances suggest they may be impaired. If this review indicates that amortized intangible assets may not be recoverable, as determined based on the undiscounted cash flows of the entity acquired over the remaining amortization period, the carrying value of intangible assets will be reduced by the estimated shortfall in discounted cash flows. Management judgment is required in the assessment of useful lives of amortized intangibles, and our estimates of future cash flows require judgment based on our historical and anticipated results and are subject to many factors including our assessment of the discount rate used and the amounts and timing of future cash flows. During 2005 and 2006, we performed the required impairment reviews and were not required to record any material impairment on amortized intangible assets. The use of different estimates and assumptions might have resulted in an impairment charge, or might result in an impairment charge in the future. As of December 31, 2006, $96.1 million of our identifiable intangible assets were subject to amortization.

Business Combinations

We have made a number of acquisitions and may make strategically important acquisitions in the future. When recording an acquisition, we allocate the purchase price of the acquired company to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. For significant acquisitions we have obtained independent appraiser valuation reports to assist in determining the fair values of identifiable intangibles, including acquired technology, customer lists and trademarks. These valuations require us to make significant estimates and assumptions which include future expected cash flows from license sales and customer contracts and acquired technologies, discount rates, and assumptions regarding the period of time the acquired technology or customer relationships will continue. Such assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions and estimates.

In addition, acquired deferred revenue is recognized at fair value to the extent it represents a legal obligation assumed by us in accordance with EITF 01-03, “Accounting in a Business Combination for Deferred Revenue of an Acquiree.” We consider service contracts and post-contract customer support contracts to be legal obligations of the acquired entity. We estimate the fair value of acquired deferred revenue based on prices paid by willing participants in recent exchange transactions. At December 31, 2005 and 2006 we had deferred revenue balances of $37.2 million and $46.0 million, respectively, which are primarily related to our acquisitions during 2005 and 2006. Management judgment is also required in determining an appropriate fair value for deferred revenue. If the fair values we determined for deferred revenues acquired in prior years were lower, our revenue for the year would have been lower.

Capitalization of Software Costs

We capitalize computer software product development costs incurred in developing a product once technological feasibility has been established and until the product is available for general release to customers in accordance with SFAS No. 86, “Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed.” We evaluate realizability of the capitalized amounts based on expected revenues from the product over the remaining product life. Where future revenue streams are not expected to cover remaining unamortized amounts, we either accelerate amortization or expense the remaining capitalized amounts. Amortization of such costs is computed as the greater of the amount calculated based on (1) the ratio of current product revenues to projected current and future product revenues or (2) the straight-line basis over the expected economic life of the

 

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product (not to exceed five years). Software costs related to the development of new products incurred prior to establishing technological feasibility or after general release are expensed as incurred. When technological feasibility of the underlying software is not established until substantially all product development is completed, including the development of a working model, we expense the costs of such development because the impact of capitalizing such costs would not be material.

Management judgment is required with respect to the determination of technological feasibility and the determination of the expected product revenues used to assess realizability of the capitalized amounts. If we were to determine that technological feasibility occurs at a different stage of the process, we may capitalize more or less software development costs. If our assumptions about realizability were to change, our reported operating expenses could increase in the short-term by any amounts we write off. As of December 31, 2005 and 2006, capitalized software development costs were $10.5 million and $20.9 million respectively, and related accumulated amortization totaled $1.3 million and $4.5 million respectively.

Investments

Debt and equity investments designated as available-for-sale are stated at fair value. Unrealized holding gains or losses, net of tax, on available-for-sale are reported in accumulated other comprehensive income (loss) and as a separate component of shareholders’ equity. Realized gains and losses and any declines in fair value judged to be other-than-temporary on available-for-sale securities are included in gain (loss) on disposal and impairment, respectively, in our consolidated statements of operations. Gains or losses on the sale of investments and amounts reclassified from accumulated other comprehensive income (loss) to the statement of operations are computed based upon specific identification. Interest on securities classified as available-for-sale securities is included in interest income.

Debt investments, where the Company has the positive intent and ability to hold the securities to maturity, are designated as held to maturity securities and are stated at amortized cost.

When determining whether an impairment of investments exists or a decline in value of an available-for-sale security is other-than-temporary, we evaluate evidence to determine whether the realizable value is less than the current market price for the securities. Such information may include the investment’s financial performance, the near term prospects of the investment, the current and expected future financial condition of the investment’s issuer and industry, and our investment intent. Management judgment is required in determining fair value of investments, and in determining whether an impairment is other-than-temporary. The use of different estimates and assumptions could affect the determination of fair value for each investment, and could result in an impairment charge. For investments not actively traded, the company reviews a variety of information including financial performance, comparisons to recently traded comparable securities, advice of investment professionals, and financial modeling to determine the fair market value as well as determine in the case of declines in value if the decline is an other than temporary decline in fair value.

All other equity investments for which we do not have the ability to exercise significant influence (generally, when we have an investment of less than 20% ownership and no representation on the company’s board of directors) and for which there is not a readily determinable fair value, are accounted for using the cost method. Dividends and other distributions of earnings from equity investees or investments, if any, are included in income when declared. We periodically evaluate the carrying value of our investments accounted for under the cost method of accounting and any other than temporary impairment is included in the consolidated statement of operations.

Derivative Instruments

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as modified by SFAS No. 149, “Amendment of SFAS 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”), requires all contracts which meet the definition of a derivative to be recognized in the

 

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Company’s consolidated financial statements as either assets or liabilities and recorded at fair value. Changes in the fair value of derivative financial instruments are either recognized periodically in the Company’s consolidated statement of operations or in the Company’s consolidated statement of shareholders’ equity as a component of accumulated other comprehensive income (loss) depending on the use of the derivative and whether it qualifies for hedge accounting. Changes in fair values of derivatives not qualified as hedges are reported in the Company’s consolidated statement of operations. The estimated fair values of derivative instruments are determined at discrete points in time based on the relevant market information. These estimates are calculated with reference to the market rates using the industry standard valuation techniques.

Deferred Tax Valuation Allowance

The Company records a valuation allowance on its deferred tax assets in an amount that is sufficient to reduce the deferred tax assets to an amount that is more likely than not to be realized. In reaching this determination, the Company considers the future reversals of taxable temporary differences, future taxable income, exclusive of taxable temporary differences and carryforwards, taxable income in prior carryback years and tax planning strategies. As of December 31, 2005 and 2006, the Company has provided a valuation allowance of $77.1 million and $59.0 million against its net deferred tax assets. For its calendar year ended December 31, 2006 the valuation allowance decreased by $18.1 million which is the result of the tax effects of the Company's operations as well as the Company's determination of the amount that will be realized. A maximum of $32.9 million of the valuation allowance for which tax benefits are subsequently recognized will be allocated to reduce the goodwill. The portion of the change in the valuation allowance resulting in a decrease in goodwill principally relates to the Company’s recovery of deferred tax assets acquired in business combinations for which a valuation allowance was recorded at the time of acquisition.

Stock-based Compensation

On January 1, 2006, the Company adopted SFAS No. 123(R), “Share Based Payment” (“SFAS 123(R)”). Prior to January 1, 2006, the Company accounted for share-based employee compensation arrangements under the recognition and measurement principles of Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations, and complied with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under APB 25, share compensation expense was recognized by utilizing the accelerated expense attribution method over the vesting period of the share options based on the difference, if any, between the fair value of the underlying the Company’s shares at the date of grant and the exercise price of the share options.

Prior to the adoption of SFAS 123(R), cash flows resulting from the tax benefit related to equity-based compensation was required to be presented in the operating cash flows, along with other tax cash flows, in accordance with the provisions of EITF 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option”, (“EITF 00-15”). SFAS 123(R) superseded EITF 00-15, amended SFAS No. 95, “Statement of Cash Flows”, and requires tax benefits relating to excess equity-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows.

The Company adopted SFAS 123(R) using the modified prospective method. SFAS 123(R) requires measurement of compensation cost for all share based awards at fair value on the date of grant and recognition of compensation over the service period for awards expected to vest. The recognized expense is net of expected forfeitures and the restatement of prior periods is not required.

The fair value of restricted shares is determined based on the number of shares granted and the quoted market price of the Company’s common shares. SFAS 123(R) did not change the accounting guidance for share-based payment transactions with parties other than employees as originally issued by EITF 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF 96-18”). The fair value of options is determined using the Black-Scholes valuation model, which is consistent with the Company’s valuation techniques previously utilized for options in footnote

 

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disclosures under Statement of SFAS 123, as amended by SFAS No. 148, “Accounting for Stock Based Compensation – Transition and Disclosure” (“SFAS 148”). On March 29, 2005, the Securities and Exchange Commission (“SEC”) published Staff Accounting Bulletin No. 107 (“SAB 107”), which provides the Staff’s views on a variety of matters related to share based payments. SAB 107 requires that share based compensation be classified in the same expense line items as cash compensation.

The effect of adopting SFAS 123(R) on the Company’s income from operations, income before income taxes, net income, net cash provided by operating activities, and basic and diluted earnings per share for the year ended December 31, 2006 was a reduction of $6.9 million, $6.9 million, $6.6 million, $6.6 million, $0.05 and $0.05, respectively and an increase of our net cash provided by financing activities of Nil.

Contingencies

We regularly assess the estimated impact and probability of various uncertain events, or contingencies, and account for such events in accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS 5”). Under SFAS 5, contingent losses must be accrued if available information indicates it is probable that the loss has been or will be incurred given the likelihood of the uncertain event, and the amount of the loss can be reasonably estimated.

Management judgment is required in deciding the amount and timing of accrual of a contingency. For example, legal proceedings are inherently uncertain, and in order to determine the amount of any reserves required, we assess the likelihood of any adverse judgments or outcomes in pending and threatened litigation, as well as potential ranges of probable losses. As of December 31, 2006, we had $3.5 million accrued for legal fees and contingencies. We use internal and external experts, as necessary, to help estimate the probability that a loss has been incurred and the amount or range of the loss. A determination of the amount of loss accrual required for these contingencies is made after analysis of each individual matter. The amount of such accruals may change in the future due to changes in approach or new developments in each case.

Impact of Certain Recently Issued Accounting Standards

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140” (“SFAS 155”). It allows financial instruments that have embedded derivatives that otherwise would require bifurcation from the host to be accounted for as a whole, if the holder irrevocably elects to account for the whole instrument on a fair value basis. Subsequent changes in the fair value of the instrument would be recognized in earnings. The standard also clarifies which interest-only strips and principal-only strips are not subject to the requirement of SFAS 133; establishes a requirement to evaluate interest in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued by the Company after January 1, 2007. The Company is evaluating the effect of the adoption of SFAS 155. It is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109. FIN 48 clarifies the application of SFAS 109 by defining criteria that an individual tax position must meet for any part of the benefit of that position to be recognized in the financial statements. Additionally, FIN 48 provides guidance on the measurement, derecognition, classification and disclosure of tax positions, along with accounting for the related interest and penalties. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Management is currently evaluating the impact this new standard will have on its financial statements.

 

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In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (“SFAS 157”). SFAS 157 defines fair value, expands disclosures about fair value measurements, establishes a framework for measuring fair value in generally accepted accounting principles, and establishes a hierarchy that categorizes and prioritizes the sources to be used to estimate fair value. The Company is required to adopt SFAS 157 effective January 1, 2008 on a prospective basis. Management is currently evaluating the impact this new standard will have on its financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. Specifically, SAB 108 requires that public companies utilize a “dual-approach” to assessing quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. SAB 108 did not have an effect on our financial position, cash flows or results of operations for the year ended December 31, 2006.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 is effective for fiscal years beginning after November 15, 2007. Management is currently evaluating the impact this new standard will have on its financial statements.

Results of Operations

In June 2007, we amended and restated our Annual Report on Form 20-F for the year ended December 31, 2005, to restate our consolidated financial statements and notes related thereto for the years ended December 31, 2003, 2004 and 2005, and provide separate financial statements and notes related thereto of Equity Pacific Limited, its subsidiaries and its variable interest entity.

All historical amounts relating to our financial information for the years ended December 31, 2003, 2004 and 2005 refer to such amended and restated amounts.

 

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The following table summarizes our historical results of operations in U.S. dollars and as percentages of total revenues for the years ended December 31, 2004, 2005 and 2006:

 

     Year ended December 31,  
     2004     2005     2006  
     (in thousands, except percentage data)  

Revenues

            

Software

   $ 107,648     59 %   $ 158,804     65 %   $ 175,374     57 %

Licenses

     28,581     16 %     38,541     16 %     46,260     15 %

Maintenance and consulting services

     79,067     43 %     120,263     49 %     129,114     42 %

Business Services

     42,927     24 %     42,686     17 %     65,447     21 %

IT products

     2,083     1 %     2,079     1 %     3,038     1 %

Consulting services

     37,308     20 %     37,139     15 %     59,315     19 %

Advertising

     3,536     2 %     3,468     1 %     3,094     1 %

Mobile Services and Applications

     23,694     13 %     34,389     14 %     31,862     10 %

Internet and Media

     8,183     4 %     8,995     4 %     10,064     3 %

CDC Games

     —       0 %     —       0 %     26,780     9 %
                                          
     182,452     100 %     244,874     100 %     309,528     100 %
                                          

Cost of revenues

            

Software

     (46,725 )   26 %     (68,070 )   28 %     (74,532 )   24 %

Licenses

     (3,486 )   2 %     (6,750 )   3 %     (8,408 )   3 %

Maintenance and consulting services

     (39,754 )   22 %     (55,792 )   23 %     (61,115 )   20 %

Amortization of purchased technologies

     (3,485 )   2 %     (5,528 )   2 %     (5,009 )   2 %

Business Services

     (28,076 )   15 %     (27,168 )   11 %     (45,200 )   15 %

IT products

     (1,879 )   1 %     (1,671 )   1 %     (1,834 )   1 %

Consulting services

     (24,871 )   14 %     (24,338 )   10 %     (42,388 )   14 %

Advertising

     (1,326 )   1 %     (1,159 )   0 %     (978 )   0 %

Mobile Services and Applications

     (4,597 )   3 %     (15,262 )   6 %     (13,004 )   4 %

Internet and Media

     (3,319 )   2 %     (3,449 )   1 %     (4,095 )   1 %

CDC Games

     —       0 %     —       0 %     (10,631 )   3 %
                                          
     (82,717 )   45 %     (113,949 )   47 %     (147,462 )   48 %
                                          

Gross margin and gross margin %

     99,735     55 %     130,925     53 %     162,066     52 %

Selling, general and administrative expenses

     (80,326 )   44 %     (100,549 )   41 %     (125,500 )   41 %

Research and development expenses

     (13,825 )   8 %     (22,605 )   9 %     (19,981 )   6 %

Depreciation and amortization expenses

     (8,919 )   5 %     (9,937 )   4 %     (10,976 )   4 %

Restructuring expenses

     (3,760 )   2 %     (1,667 )   1 %     (1,974 )   1 %
                                          

Total operating expenses

     (106,830 )   59 %     (134,758 )   55 %     (158,431 )   51 %
                                          

Operating income (loss)

     (7,095 )   4 %     (3,833 )   2 %     3,635     1 %
                                          

Interest income

     9,654     5 %     8,156     3 %     10,680     3 %

Interest expense

     (1,895 )   1 %     (1,257 )   1 %     (3,038 )   1 %

Gain on disposal of available-for-sale securities

     167     0 %     525     0 %     344     0 %

Gain on disposal of subsidiaries and cost investments

     892     0 %     483     0 %     3,087     1 %

Other non-operating gains

     —       0 %     —       0 %     —       0 %

Other non-operating losses

     —       0 %     —       0 %     531     0 %

Impairment of cost investments and available-for-sale securities

     (1,362 )   1 %     —       0 %     —       0 %

Share of loss in equity investees

     (468 )   0 %     (1,172 )   0 %     976     0 %
                                          

Total other income

     6,988     4 %     6,735     3 %     12,579     4 %
                                          

Income before income taxes

     (107 )   0 %     2,902     1 %     16,214     5 %

Income tax expense

     (3,375 )   2 %     (4,957 )   2 %     (3,062 )   1 %
                                          

Income (loss) before minority interests

     (3,482 )   2 %     (2,055 )   1 %     13,152     4 %

Minority interests in income of consolidated subsidiaries

     (925 )   1 %     (1,409 )   1 %     (2,312 )   1 %
                                          

Income (loss) from continuing operations

     (4,407 )   2 %     (3,464 )   1 %     10,840     4 %

Discontinued operations

            

Loss from operations of discontinued subsidiaries, net of related tax benefit

     (610 )   0 %     (47 )   0 %     —       0 %

Loss on disposal/dissolution of discontinued subsidiaries, net

     (950 )   1 %     (3 )   0 %     —       0 %
                                          

Net income (loss)

   $ (5,967 )   3 %   $ (3,514 )   1 %   $ 10,840     4 %
                                          

Year ended December 31, 2006 Compared to Year ended December 31, 2005

 

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Net Revenues

Consolidated. Consolidated net revenues increased 26%, or approximately $64.6 million, from $244.9 million in 2005 to $309.5 million in 2006. Consolidated net revenues increased primarily as a result of additional revenues received from acquired software and business services companies and increased sales volumes in certain key products discussed below. The table below sets forth the revenues from our principal business segments and revenues as percentages of our total revenues for the periods presented:

 

     Year ended December 31,  
     2005     2006  
     (in thousands, except percentage data)  

Revenues

          

Software

   $ 158,804    65 %   $ 175,374    57 %

Licenses

     38,541    16 %     46,260    15 %

Maintenance and consulting services

     120,263    49 %     129,114    42 %

Business Services

     42,686    17 %     65,447    21 %

IT products

     2,079    1 %     3,038    1 %

Consulting services

     37,139    15 %     59,315    19 %

Advertising

     3,468    1 %     3,094    1 %

Mobile Services and Applications

     34,389    14 %     31,862    10 %

Internet and Media

     8,995    4 %     10,064    3 %

CDC Games

     —      0 %     26,780    9 %
                          
   $ 244,874    100 %   $ 309,528    100 %
                          

The following table sets forth the revenues contributed for the year ended December 31, 2006 by subsidiaries acquired in 2006, by principal business segment:

 

     Year ended December 31, 2006
     (in thousands)

Software - MVI, C360, JRG

     3,944

Business Services - OSTI, Vis.align, DBPI, Horizon

     22,664

Mobile Services and Applications - Timeheart Group

     336

CDC Games - Equity Pacific

     26,780
      
   $ 53,724
      

Our top 10 customers accounted for 18% and 15% of our revenues for 2005 and 2006, respectively. No single customer accounted for 10% or more of the revenues during any of 2005 or 2006.

Software. Software revenues increased from $158.8 million in 2005 to $175.4 million in 2006 primarily due to increases in our customer base during 2006, additional sales of software to existing customers and the acquisitions during 2006 of MVI, c360 and JRG which contributed approximately $3.9 million of the aggregate software revenue increase of $16.6 million for 2006. As a percentage of total revenues, the software segment generated 57% of the total in 2006, decreasing from 65% in 2005.

License revenues increased from $38.5 million in 2005 to $46.3 million in 2006, an increase of $7.8 million, primarily due to increases in our customer base during 2006 and 2006 acquisitions in our Software segment. In 2006, our Software segment grew by approximately 300 new customers. New customers represented approximately 40% of total license revenues while repeat customers represented approximately 60% of total license revenues. New software sales were strong in global vertical industries including financial services, discrete and process manufacturing, and homebuilding. Maintenance and consulting services revenues

 

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in our software segment increased from $120.3 million in 2005 to $129 million in 2006, an increase of $8.7 million, primarily associated with installation and professional services associated with a larger customer base. As a percentage of total software revenues, license revenues comprised 26% of Software revenues in 2006 compared to 24% in 2005, and maintenance and consulting services revenues comprised 74% of the total in 2006 compared to 76% in 2005.

Business Services. Business Services revenues increased from $42.7 million in 2005 to $65.4 million in 2006 primarily as a result of acquisitions in our Business Services segment made during 2006 As a percentage of total revenues, this segment generated 21% of the total in 2006, increasing from 17% in 2005 mainly due to acquisitions related to our Business Services segment.

IT product revenues increased from $2.1 million to $3.0 million in 2005 and 2006, respectively, based primarily on increases in selling hardware and software solutions in our Australian subsidiary. The Business Services segment as a whole, however, continued to focus on providing services rather than a mix of product and service sales. Consulting services revenues increased from $37.1 million in 2005 to $59.3 million in 2006, an increase of $22.2 million. This increase was primarily a result of acquisitions in our Business Services segment made during 2006. As a percentage of total Business Services revenues, IT product revenues comprised 5% of the total in 2006 compared to 5% in 2005, and consulting services revenues comprised 91% of the total in 2006 compared to 87% in 2005.

Revenues from advertising services decreased from $3.5 million to $3.1 million in 2005 and 2006, respectively, as our Business Services segment continued to focus on providing software services rather than advertising services.

Mobile Services and Applications. Mobile services and applications revenues decreased from $34.4 million in 2005 to $31.9 million in 2006, a decrease of $2.5 million, primarily due to a decrease in volume as a result of regulatory rule changes related to billing methods and other factors promulgated by China’s Ministry of Information Industry. As a percentage of total revenues, this segment generated 10% of the total in 2006, decreasing from 14% in 2005.

Internet and Media. Internet and Media segment revenues increased from $9.0 million in 2005 to $10.0 million in 2006, an increase of $1.0 million. Such increase was primarily due to the increased Portal revenue as a result of targeted investments made in 2004 to establish the Portal as an influential player in China. As a percentage of total revenues, this segment generated 3% and 4% of the total in 2006 and 2005, respectively.

CDC Games. During 2006, we had revenues of $26.8 million. We are a leading operator of online “free-to play, pay for virtual merchandise” games in China. Currently we operate one game called Yulgang which had approximately 42.9 million registered users as of Dec 31, 2006. We intend to launch additional games in this category in 2007 and be