10-K 1 v179295_10k.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION 
Washington, D.C. 20549 

FORM 10-K
 
(Mark One)
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2009

or
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from __________ to __________

COMMISSION FILE NUMBER: 001-32503

TELESTONE TECHNOLOGIES CORPORATION
(Name of Small Business Issuer Specified in Its Charter)
 
Delaware
 
84-1111224
(State of incorporation)
 
(IRS Employer Identification Number)
 
Floor 6, Saiou Plaza, No. 5 Haiying Road, Fengtai Technology
Park, Beijing, China 100070
(Address of principal executive offices) (Zip Code)

86-10-8367-0088
(Issuer's telephone number, including area code)

Securities registered under Section 12(b) of the Exchange Act:
 
Common Stock, $.001 Par Value
 
The Nasdaq Global Market
(Title of Class)
 
(Name of each exchange on which registered)

Securities registered under Section 12(g) of the Exchange Act:  none.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨ No þ
  
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ¨ No þ
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 þ No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨   No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer ¨
Accelerated filer ¨
Non-accelerated filer ¨
(Do not check if a smaller
reporting company)
Smaller reporting
company þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act):
Yes ¨ No þ

 The aggregate market value of the  6,366,550 shares of voting and non-voting common equity stock held by non-affiliates of the registrant was $ 25,338,869.00 as of June 30, 2009, the last business day of the registrant’s most recently completed second fiscal quarter, based on the last sale price of the registrant’s common stock on such date of $3.98 per share, as reported by The NASDAQ Stock Market, Inc.

As of March 29, 2010, there were 10,548,264 shares of common stock of Telestone Technologies Corporation outstanding.
 

 
PART I
  3  
       
ITEM 1. BUSINESS.
  3  
Corporate History
  3  
Current Business Operations
  5  
Our Business Strategies
  6  
Competitive Advantages
  6  
Description of Products & Services
  8  
Research & Development
  9  
Competition
  9  
Government Regulation
  9  
Intellectual Property and Proprietary Rights
  10  
       
ITEM 1A RISK FACTORS
  11  
ITEM 1B UNRESOLVED STAFF COMMENTS
     
       
ITEM 2. PROPERTIES.
  21  
       
ITEM 3. LEGAL PROCEEDINGS
  21  
       
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
  21  
       
PART II
  21  
       
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
  21  
       
ITEM 6  SELECTED FINANCIAL DATA
  22  
       
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION.
     
AND RESULTS OF OPERATION
   22  
       
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  29  
 
     
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
  29  
       
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
  30  
       
ITEM 9A. CONTROLS AND PROCEDURES.
  30  
       
ITEM 9B. OTHER INFORMATION.
  32  
       
PART III
  32  
       
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
  32  
Indemnification of Officers and Directors
     
Involvement in Certain Legal Proceedings
  34  
Compliance with Section 16(a) of the Securities Exchange Act of 1934
  34  
Meetings and Certain Committees of the Board
  35  
Stockholder Communications
  36  
Compensation of Directors
  36  
       
ITEM 11. EXECUTIVE COMPENSATION.
  36  
       
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
  37  
       
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
  38  
       
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
  38  
       
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
  39  
       
SIGNATURES
  40  
 

 
    PART I
 
ITEM 1.         BUSINESS. 
 
Corporate History
 
Unless otherwise indicated, or unless the context otherwise requires, all references in this Annual Report to the terms "Company," "Telestone," "we," "our," or "us" shall mean Telestone Technologies Corporation, a Delaware corporation.
 
We were organized under the laws of the State of Colorado in February 1987 under the name Shield Enterprises, Inc.

On January 3, 2002, we entered into an exchange agreement with EliteAgents Mortgage Services, Inc. (formerly Elite Agents, Inc.) ("Elite"), a licensed mortgage banker. As a result of the exchange, Elite became our wholly-owned subsidiary, and we had 80,000,000 shares of common stock outstanding, of which 72,000,000 shares were owned by the former stockholders of Elite and 8,000,000 shares were owned by our existing stockholders. Elite continued its mortgage banking activities and other financial services subsequent to the exchange. In addition, effective May 8, 2002, we formed a wholly-owned subsidiary, Elite Agents Leasing Services, Inc. ("Leasing"), for the purpose of establishing equipment financing and leasing operations.

On September 26, 2003, we and Elite (the "Debtors") each filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of New Jersey (the “Court”) (Case Nos. 03-41805 and 03-41806). The two voluntary petitions of the Debtors were consolidated for administrative purposes only on October 20, 2003. On December 30, 2003, the Bankruptcy Court authorized the Debtors to sell substantially all of their assets.

On March 24, 2004, the Court authorized the Debtors to sell both designation rights for a plan of reorganization and 25 million common shares, which were nondilutable under any capitalization, to Focus Tech Investments, Inc. or its designee ("Focus") for a purchase price of $65,000.00. In addition, 14 creditors agreed to advance an aggregate of $50,000.00, as a non-recourse claim, under the terms of convertible promissory notes ("Notes") pursuant to Section 1145 of the Bankruptcy Code, to the Debtors, to fund fees and expenses of the Debtors' and related committee's professionals for a plan of reorganization. The Notes were convertible into a total of 4,000,000 common shares and 1,000,000 warrants issued pursuant to Section 1145 of the Bankruptcy Code. The transaction was exempt from the registration requirements of Section 5 of the Securities Act of 1933 as well as state and local law statutes requiring registration for an offer or sale of a security.

On August 10, 2004, the Court approved the Plan and entered the order entitled "Order Approving Disclosure Statement and Confirming First Amended Plan of Liquidation and Authorizing and Directing Certain Actions In Connection Therewith" (the "Order"). Pursuant to the Plan, all prior operational assets were liquidated and the proceeds were paid, per the approved claim schedule, to creditors and for the administration of the estate. Pursuant to the Plan, all of the property of the Debtor's estate vested in the Plan Trustee, free and clear of all claims, liens, encumbrances, charges or other interests, and all executory contracts and unexpired leases were rejected. The Court also placed an injunction against all entities that may have held, currently hold, or may hold a debt, claim or other liability or interest against the Debtors, dischargeable upon confirmation of the Plan, and permanently enjoined any action on account of such debt, claim, liability, interest or right. The Court further terminated all claims arising or related to stock, stock options, stock plans for employees, officers and directors, warrants and convertible provisions within the debt instruments by creditors. The Court ordered that our common stock be diluted by a reverse stock split of our issued and outstanding common shares. Under the Order, each share of our common stock issued and outstanding was reclassified on a one (1) for 822 basis at a $0.001 par value.

The Court then ordered that we:

 
¨
reincorporate and redomicile from the State of Colorado to the State of Delaware;

 
¨
that the name of the Company be changed to Telestone Technologies Corporation;

 
¨
that the company's board of directors be authorized under the Plan to issue common stock pursuant to an exchange agreement at the time of closing or in escrow, in which effective control or majority ownership of the Company is given to the acquired or acquiring business entity without the need of stockholder approval; and
 
3

 
 
¨
that the Board of Directors be authorized to amend the Company's By-Laws and amend the Company's fiscal year to a date established and set forth in an exchange agreement without the need of stockholder approval.

Pursuant to the Order, we reincorporated in the State of Delaware under the name Telestone Technologies Corporation on August 13, 2004 by filing a Certificate of Incorporation with the State of Delaware. We are now authorized to issue a total of 110,000,000 shares with 100,000,000 being shares of common stock with a par value of $0.001, and 10,000,000 being shares of preferred stock with a par value of $0.001.

Pursuant to the Order, we approved the reverse stock split of issued and outstanding common shares. Under the Order, our issued and outstanding common stock was reclassified on a one (1) for 822 basis at a par value of $0.001. A Certificate of Amendment was filed with the Delaware Secretary of State on August 17, 2004.

On August 23, 2004, we completed a share exchange transaction with the stockholders of Success Million International Limited, a company incorporated under the laws of Hong Kong ("SMI"). The share exchange was consummated under Delaware law and pursuant to the terms of that certain Securities Exchange Agreement, dated effective as of August 23, 2004 (the "Exchange Agreement").

Pursuant to the Exchange Agreement, we issued 4.1 million shares of our common stock to the stockholders of SMI, representing approximately 97.6% of our issued and outstanding common stock, immediately upon the consummation of the exchange transaction, in exchange for 100% of the outstanding capital stock of SMI. Immediately after giving effect to the exchange, we had 4,199,917 shares of common stock outstanding. Pursuant to the exchange, SMI became our wholly-owned subsidiary. For accounting purposes, the exchange is treated as a reverse acquisition, as the stockholders of SMI own a majority of the issued and outstanding shares of our common stock. Due to the issuance of the 4.1 million shares of our common stock, a change in control occurred on August 23, 2004, the date of the consummation of the exchange. We now carry on the business of SMI's wholly-owned subsidiary, Beijing Telestone Technologies Co., Ltd. ("Beijing Telestone").

On June 17, 2005, Beijing Telestone, with an operational period of 20 years, established Beijing Telestone Wireless Telecommunication Company Limited ("BTWTC") in Beijing, the People's Republic of China (the "PRC"). Beijing Telestone controls BTWTC through contractual arrangements. The registered capital of BTWTC amounts to RMB10 million (approximately US$1.2 million). BTWTC was established to engage in the business of wireless telecommunication networking and system integration.
 
On July 5, 2007, BTWTC, Shandong Guolian Telecommunication Technology Limited (“Guolian”) and owners of Guolian entered into a Share Transfer Agreement (the “Agreement”). Under the Agreement, 100% equity ownership interests in Guolian and its wholly owned subsidiary, Pan-pacific Telecommunication Company Limited (“Pan-pacific”), was transferred by all of the owners of Guolian to BTWTC. Guolian and Pan-pacific were established in Jinan, Shandong Province, the PRC on February 9, 1999 and October 22, 1999 respectively. The principal business activities of Guolian and Pan-pacific are design, development, production and installation and trading of wireless telecommunication coverage system equipment.
 
On October 8, 2007, BTWTC formed a subsidiary named Beijing Telestone Communication Technology Corp. Ltd (the "Subsidiary") which focuses on developing and managing Telestone's overseas businesses. The Subsidiary will be responsible for all of Telestone's international businesses and focuses on the Company's international expansion efforts. The move is intended to simplify current command and reporting lines. The Subsidiary will also seek to identify new opportunities to ensure consistent growth in Telestone's overseas businesses.
 
Our executive offices are those of Beijing Telestone Technologies Co., Ltd. and are located at Floor 6, Saiou Plaza, No. 5 Haiyang Road, Fengtai Technology Park, Beijing China 100070. Our telephone number is 86-10-83670088.
 
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Business Operations 

We are a leading access network solutions provider serving the Chinese market.  Since 1997, we have operated in the Chinese market and in 2006, we expanded marketing efforts to Vietnam, Indonesia, Malaysia, Thailand and India. Since 2007, Beijing Telestone Communication Technology Corp. Ltd was established as one of our subsidiaries focusing on developing and managing our overseas businesses. Currently, marketing has expanded to 28 countries in the world, including the U.S., Vietnam, Mexico, Brazil, Russia, India, The Philippines, Thailand, Ireland, Ecuador, Mongolia, South Africa, Turkey, Indonesia, Colombia, Costa Rica, Argentina, Ukraine, Kazakhstan, Singapore, South Korea, Hong Kong (SAR), Saudi Arabia, New Zealand, Bangladesh, the UAE, Canada and Iceland. Continuous expansion outside of China is one of our core strategies. We believe that the quality of our products and services will allow Telestone to be increasingly competitive internationally.

Our access network solutions include research and development and application of access network technology. In addition to our homegrown access network equipment which includes repeaters, antennas and radio frequency peripherals, we also offer project design, project management, installation, maintenance and other after-sales services required by our customers. Our access network solutions are created to further enhance the coverage of mobile telecommunications networks; this is done to improve the quality of reception for mobile phone users. The solutions we provide to the telecommunications industry cover indoor and outdoor environments, including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels. In 2006, having successfully completed commercial trials and deployment of our 3D solution, a third generation indoor coverage solution researched and developed by us, we expanded our services to telecommunication technologies markets, including the 3D solution, which utilizes fiber technology in the radio frequency signal distribution to transmit high speed data signals, and the PHS system optimization solution, which transitioned to network optimization phase from network maintenance phase, to address four major issues of wireless networks: network coverage, network planning, network capacity and network disturbance. Our TD-SCDMA repeaters application solutions have flexible network grouping, low construction cost, and convenient and fast equipment installation and removal. Our TD-SCDMA repeaters application solutions can be applied in signal coverage of blind spots such as blocked signal areas, tunnels and temporary meeting rooms. Because the TD-SCDMA system works in 2GHz frequency bands, it has weak penetrability compared with the 800MHz and the 900MHz frequency band of the 2G network. This weak penetrability will cause many blind signal spots and TD-SCDMA repeaters can be used to cover these blind signal spots. We anticipate that the TD-SCDMA repeaters application solutions will be marketable in the PRC as the development of the TD-SCDMA network will be completed in the PRC.

In 2008, we launched a new generation of wireless distribution system, WFDSTM. Combining the technologies of wireless telecom and fiber telecom, WFDSTM is an all-optical network. This system supports all mobile telecom networks and various other networks, including WLAN, FTTH, telephone networks, and video surveillance system. In addition, we believe that WFDSTM can be quickly installed and simply maintained, which realizes for customers the coverage with comparatively low cost. In 2009, WFDSTM has further been applied in our business. We have finished 43 WFDSTM installations to date as of December 31, 2009. And in September 2009, WFDSTM technology successfully passed all FCC testing procedures. The FCC certification will not only apply to the U.S. market, but also to Telestone's WFDSTM products in Central and South America.

We believe the fact that the Chinese telecom restructuring and the issuance of 3G licenses in China with an investment in the construction of the 3G system of approximately $ 70 billion over 2009 to 2011, an average of approximately $23 billion per year, presents an excellent opportunity for our business development. With our advanced technologies, close relationships with the telecom operators in China and strong management team, we believe that we will continue to demonstrate increasingly robust growth in the future.
 
5

 
On January 13, 2010, the State Council issued a directive to accelerate the integration of telecommunications, TV & radio broadcasting and internet access networks into one with a 5-year plan and supporting policies.  The meeting further stated that the integration of the three systems will provide China with a better platform for information sharing and stimulate the economy. The meeting confirmed that they will support local companies to meet the directive's integration goals. Dozens of the companies in the sector trading in the Chinese stock exchanges had trading halts (10% price moves in one day trading) or significant price appreciations after the announcement of the directive. Telestone anticipated such policy moves and has positioned its technologies strategically to benefit such moves— Unification Network Solution.

Since the establishment of Telestone in 1997, we have developed business relationships with both China Mobile Communications Corporation ("China Mobile") and China Unicom Limited ("China Unicom"), along with China Telecom. China Unicom was our main customer in 2006, and this business association accounted for approximately 35.65% of total sales in 2006. In 2007, our main customers were China Mobile and China Unicom, and the revenues from them were 41.92% and 38.69%, respectively. In 2008, our main customers were also China Mobile and China Unicom, and the revenues from them were 47.32% and 42.34%, respectively. In 2009, our main customers were also China Mobile and China Unicom, and the revenues from them were 45.40% and 45.48%. Over three years, our business has grown steadily, and we believe there is a strong potential for further growth.
 
Revenues Generated in 2007, 2008 and 2009

   
2007
   
2008
   
2009
 
   
$'000
   
% of
revenue
   
$'000
   
% of
revenue
   
$'000
   
% of
revenue
 
China Mobile
    14,076       41.92 %     16,719       47.32 %     32,634       45.40 %
China Unicom
    12,993       38.69 %     14,958       42.34 %     32,688       45.48 %
China Netcom
    1,407       4.19 %     413       1.17 %     -       - %
China Telecom
    4,101       12.21 %     2,123       6.01 %     5,324       7.41 %
Others
    1,001       2.99 %     1,116       3.16 %     1,233       1.71 %
Total
    33,578               35,329               71,879          

We are committed to the research and development of wireless communication related technology. Over 90% of our technology is developed in-house at our research and development center. We employ an experienced and highly trained professional staff of scientists and engineers that concentrate on the invention and further advances in wireless communication technology, and we have over 100 R&D specialists, some industry experts in telecommunications— all have bachelor’s degree, 40% have master’s degree or above. Since its introduction, our WFDSTM technology as an innovative product has received recognition in the telecommunications industry and has won commendations from several telecommunications carriers.

We have offices in 26 provinces across the PRC, offering sales, project survey, design, project management and installation and maintenance services. We believe that this sales and service strategy enriches our capability to increase our existing customer base in the PRC and enable us to provide timely response to customers’ inquires as well as technical and maintenance service upon our customers' request. Our sales efforts are not focused in or dependent upon any particular regions or provinces of the PRC.

Our Competitive Strengths
 
We believe that the following competitive strengths enable us to compete effectively and to capitalize on the growth opportunities of our markets:
 
6

 
Strong research and development capability
 
¨
Our R&D capability is ranked as one of the leaders in technology in the telecommunications industry in the PRC. We have a dependable engineering project management system and an experienced engineering team. Our research and development center is equipped with the latest equipment and testing facilities which give our research and development personnel the tools they require to make significant advances into access network technologies. In addition, we provide our employees with continuing education administered through internal programs. Our proprietary WFDSTM product is one of the leading indoor access network products in China. Compared with other traditional wireless distribution systems, the WFDSTM system has many advantages. Firstly, WFDSTM adopts fiber to transport signals. Based on the low signal loss characteristic of fiber, through which signals can transmit long distances, the main unit (MU) can be placed closer to the signal source and the remote unit (RU) can be placed closer to subscribers.  Therefore, a micro power signal source can be used, which reduces interference and noise, purifies the electromagnetic environment, and expands the coverage area. Secondly, due to the input port of the MU connecting to the signal combiner, WFDSTM systems can support multiple signals access and network integration. WFDSTM provides all communication services access in 500kHz~3GHz broadband bandwidth for subscribers. Thirdly, due to the fact that each node of the system has the same bandwidth and flow characteristics, WFDSTM provides the same communication services for every subscriber. WFDSTM systems are also convenient and flexible for implementing expansion and upgrading of the systems with minimum cost.  Our R&D capabilities are recognized and affirmed by the PRC government and has won accolades such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. We are focused on increasing our research and development efforts to develop superior and proprietary technologies.

Broad and diverse market base

¨
Our business covers a wide region. We have 26 branches in most of the provinces in China and our business covers approximately 28 countries worldwide.

Experienced marketing staff

¨
We employ a group of experienced telecommunication experts and experienced and technologically savvy marketing staff in China.

Strong customer relations

¨
We have maintained long-term relationships with China Unicom, China Mobile, China Telecom and China Netcom as customers for approximately 13 years.

Governmental support

¨
As a high-tech enterprise with an established track record, our company enjoys the stimulus plans offered by both China’s industry governmental authorities and by local authorities, including the Ministry of Science and Technology, the Ministry of Industry and Information Technology, the Beijing municipal government and the Administrative Committee of Z-Park.
 
Business Outlook
 
Based on (i) our performance in 2009, where our revenues increased over 100% from our 2008 revenues, (ii) our expectation that the integration of telecommunications, TV & radio broadcasting and internet access networks in China will start to be implemented in 2010 and (iii) our belief that we have advanced technology and production capabilities and strong R&D capability, we currently expect to increase significantly our income for the year 2010.  We expect that the higher percentage of systems installed by the Company in 2010 will be WFDS systems which command a higher margin, and therefore, our annual gross margin will be the same as or higher for 2010 than our annual gross margin for 2009, which is around 42%, even though our gross margin decreased for the 3rd and 4th quarter of 2009 as a result of the increase of 2G systems installed.  Although there are many factors, including without limitation, changes in the macro economic environment in China and the Chinese government policies related to the telecom industry, that may impact our estimates, we currently expect our revenues for 2010 to increase by 50% compared to that of 2009.  See “Risk Factors” and “Forward Looking Statements”.
 
7

 
Our Strategies
 
In order to maintain our position as one of the leading companies in the PRC’s access network solutions sector, and expand and diversify our revenue streams, we have adopted the following strategies:
 
Continue to focus on research and development

We plan to continue to invest in research and development for our key technologies and our products to enhance our leading position in access network technology and take full advantage of the PRC’s investment in the 3G networks. We have dedicated research and development to access network solutions for the continued development of our business.
 
Seek selective acquisitions and strategic investments

In the domestic market, we intend to maintain strong relationships with Chinese mobile carriers and potentially make selective acquisitions in major provincial markets where we do not have leading market share. Our potential targets are companies that enjoy a leading market position and have strong business networks in their provincial markets, that have strong production capabilities and companies that own applicable value-added products whose customer premises network platform adapts to WFDS. We believe that we will further our penetration of provincial markets and raise our overall market share through selective acquisitions and the promotion of new solutions.
 
Strengthen international market presence

We plan to also focus on increasing our presence in markets outside of the PRC. We will continue to strengthen our presence overseas by leveraging our expertise and leading access network products and solutions. In the United States, we plan to seek cooperation with peers that have strong research and development ability, and develop technology and products that fit the market of the PRC. However, we also find partners within the integration business and sell our products, as our products have a significant cost advantage. In developing countries, we only seek cooperation with local integration partners to deliver our access network solution technologies, whom we then work with to set up our local products distribution channels

Description of Products & Engineering Services
 
We design and sell electronic equipment used to provide access network solutions for our customers. Many of these types of equipment are highly specialized active microwave components designed to meet the needs of our customers, including WFDSTM products, RFPA products, passive components and base station antenna for 2G, 3G, Broadband access and CATV networks.

In addition to designing and selling our products, we also provide systems integration services for our customers. The primary systems integration services provided to our customers are project design and engineering, specifically, the development and design of indoor (living quarters, hospital systems, and hotels) and outdoor (expressways, railways and blind areas) wireless signal complementary coverage solutions and its applied products. This includes the design of the required equipment, implementation, project quality evaluation as well as after-sale maintenance and optimization for system integration products, constructive products for engineering design projects and wireless network optimization products.
 
8

 
Research & Development 
 
We maintain a research and development center where the majority of our products are designed by our staff of engineers and scientists. Our research and development center is equipped with the latest equipment and testing facilities which give our research and development personnel the tools they require to make significant advances into access network technologies. The center comprises several professional research departments including our Wire-less Device Department, Active Parts Department, Antenna & Passive Products Department, Computer Application Department and Mechanical Structure Department. We seek to remain at the forefront of current and future technologies, paying close attention on a constant basis to evolving development trends in domestic and international technologies. Our R&D capabilities are recognized and affirmed by the PRC government and has won accolades such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. Currently the research center has one department that is focusing on technology standards and system solutions and another department that is focusing on the research and development of fiber and RF equipment. These two departments work on designing new products to meet the expected increased demand for 3G wireless products in the PRC.
 
Competition 
 
Our main domestic competitors are Guangdong Comba, Wuhan Hongxin and China GrenTech.

¨
Guangdong Comba is one of the first Chinese domestic telecom manufacturers. The company is listed on the Hong Kong Stock Exchange under the stock symbol: 2342.HK

¨
China GrenTech, formerly Powercom Holdings Limited, was founded in 1999 and is based in Shenzhen. China GrenTech is listed on the Nasdaq Global Market under the symbol GRRF.

¨
Wuhan Hongxin, originally a state-owned enterprise under the management of Wuhan Post & Telecom Academy, has a strong technical background and sales network. Wuhan Hongxin is a large company with a diverse group of products outside of the wireless coverage sector.

Our potential international competitors include Powerwave Technologies and Andrew Corporation. We believe that our overseas competitors are not key threats to Telestone because they have no competitive advantage with respect to product costs and are not accustomed to the marketplace of the PRC.

¨
Powerwave Technologies, Inc. is a global provider of end-to-end wireless infrastructure solutions for use in wireless communications networks. They offer OEMs (Original Equipment Manufacture), operators and network providers in the wireless communications industry a portfolio of Antenna Systems, Base Station Systems and Coverage Systems.

¨
Andrew Corporation is a global designer, manufacturer, and supplier of communications equipment, services and systems. Andrew products and expertise are found in communications systems throughout the world, including wireless and distributed communications, land mobile radio, cellular and personal communications, broadcast, radar and navigation.
 
Government Regulation 
 
The following is a summary of the principal governmental laws and regulations that are or may be applicable to our operations in the PRC. The scope and enforcement of many of the laws and regulations described below are uncertain. We cannot predict the effect of further developments in the Chinese legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement of laws.
 
9

 
The telecommunications industry, including certain access network solution provider services, is highly regulated in the PRC. Regulations issued or implemented by the State-owned Assets Supervision and Administration Commission of the State Council, Ministry of Information Industry of PRC and other relevant government authorities cover many aspects of telecommunications network operations, including entry into the telecommunications industry, the scope of permissible business activities, interconnection and transmission line arrangements, tariff policy and foreign investment.
 
The principal regulations governing the telecommunications services business in the PRC include:

¨
Telecommunications Regulations (2000), (the “Telecom Regulations”). The Telecom Regulations categorize all telecommunications businesses in the PRC as either infrastructure telecommunications businesses or value-added telecommunications businesses. Under the Telecom Regulations, certain services are classified as being of a value-added nature and require the commercial operator of such services to obtain an operating license, including telecommunication information services, online data processing and translation processing, call centers and Internet access. The Telecom Regulations also set forth extensive guidelines with respect to different aspects of telecommunications operations in the PRC.

¨
Regulations for the Administration of Foreign-Invested Telecommunications Enterprises (2002), (the “FI Telecom Regulations”). The FI Telecom Regulations set forth detailed requirements with respect to capitalization, investor qualifications and application procedures in connection with the establishment of a foreign-invested telecom enterprise.

¨
Foreign Exchange Controls. The principal regulations governing foreign exchange in the PRC are the Foreign Exchange Control Regulations (1996) and the Administration of Settlement, Sale and Payment of Foreign Exchange Regulations (1996), (“the Foreign Exchange Regulations”). Under the Foreign Exchange Regulations, Renminbi (“RMB”) is freely convertible into foreign currency for current account items, including the distribution of dividends. Conversion of RMB for capital account items, such as direct investment, loans and security investment, however, is still subject to the approval of the State Administration of Foreign Exchange (“SAFE”). Under the Foreign Exchange Regulations, foreign-invested enterprises are required to open and maintain separate foreign exchange accounts for capital account items. In addition, foreign-invested enterprises may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from SAFE.
 
Intellectual Property and Proprietary Rights 
 
We rely primarily on a combination of copyright laws and contractual restrictions to establish and protect our intellectual property rights. We require our employees to enter into agreements requiring them to keep confidential all information relating to our customers, methods, business and trade secrets during and after their employment with us. Our employees are required to acknowledge and recognize that all inventions, trade secrets, works of authorship, developments and other processes, whether or not patentable or copyrightable, made by them during their employment are our property. They also sign agreements to substantiate our sole and exclusive right to those works and to transfer any ownership that they may claim in those works to us.

While we actively take steps to protect our proprietary rights, including obtaining patent protection where applicable, such steps may not be adequate to prevent the infringement or misappropriation of our intellectual property. This is particularly the case in the PRC where the laws may not protect our proprietary rights as fully as in the United States. Infringement or misappropriation of our intellectual property could materially harm our business.
 
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We have registered our corporate logo as a trademark with the Trademark Office of the PRC. The corporate logo depicts our name in English as well as Mandarin Chinese. China's trademark law utilizes a "first-to-file" system for obtaining trademark rights. As a result, the first applicant to file an application for registration of a mark will preempt all other applicants. Prior use of unregistered marks, except "well known" marks, is generally not a basis for legal action in the PRC. We may not be able to successfully defend or claim any legal rights in any trademarks for which we apply in the future.

Many parties are actively developing and seeking patent protection for wireless services-related technologies. We expect these parties to continue to take steps to protect these technologies, including seeking patent protection. There may be patents issued or pending that are held by others and that cover significant parts of our technology, business methods or services. Disputes over rights to these technologies are likely to arise in the future. We cannot be certain that our products do not or will not infringe valid patents, copyrights or other intellectual property rights held by third parties. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others.

We have obtained 13 patent certificates. Currently, 22 of our filed patent applications are under review, of which 17 have received the notification of acceptance of the application from the State Intellectual Property Office of the People's Republic of China. Our company will continue to put great effort towards protecting our intellectual property rights.
 
ITEM 1A. RISK FACTORS

CAUTIONARY STATEMENT REGARDING FUTURE RESULTS, FORWARD-LOOKING INFORMATION AND CERTAIN IMPORTANT FACTORS
 
In this Annual Report we make, and from time to time we otherwise make, written and oral statements regarding our business and prospects, such as projections of future performance, statements of management’s plans and objectives, forecasts of market trends, and other matters that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Statements containing the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimates,” “projects,” “believes,” “expects,” “anticipates,” “intends,” “target,” “goal,” “plans,” “objective,” “should” or similar expressions identify forward-looking statements, which may appear in documents, reports, filings with the Securities and Exchange Commission, news releases, written or oral presentations made by officers or other representatives made by us to analysts, stockholders, investors, news organizations and others, and discussions with management and other of our representatives. For such statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Our future results, including results related to forward-looking statements, involve a number of risks and uncertainties. No assurance can be given that the results reflected in any forward-looking statements will be achieved. Any forward-looking statement speaks only as of the date on which such statement is made. Our forward-looking statements are based upon assumptions that are sometimes based upon estimates, data, communications and other information from suppliers, government agencies and other sources that may be subject to revision. Except as required by law, we do not undertake any obligation to update or keep current either (i) any forward-looking statement to reflect events or circumstances arising after the date of such statement, or (ii) the important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or which are reflected from time to time in any forward-looking statement.

In addition to other matters identified or described by us from time to time in filings with the SEC, there are several important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or results that are reflected from time to time in any forward-looking statement. Some of these important factors, but not necessarily all important factors, include the following:
 
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Risks Related to Our Business and Operations

Current economic conditions may adversely impact demand for our products, reduce access to credit and cause our customers and others with which we do business to suffer financial hardship, all of which could adversely impact our business, results of operations, financial condition and cash flows.
 
Our business, financial condition and results of operations have and may continue to be affected by various economic factors. The worldwide economy is undergoing a period of slowdown and the future economic environment may continue to be less favorable than that of recent years. This slowdown has, and could further lead to, reduced consumer and business spending in the foreseeable future, including by our customers. Reduced access to credit has and may continue to adversely affect the ability of consumers to purchase our products and system solutions.  In addition, economic conditions, including decreased access to credit, may result in financial difficulties leading to restructurings, bankruptcies, liquidations and other unfavorable events for our customers, suppliers and other service providers. If such conditions continue or further deteriorate, our industry, business and results of operations may be severely impacted.
 
We rely on a small number of significant customers.
 
Our success depends substantially upon retaining our significant clients, such as China Unicom and China Mobile. We cannot guarantee that we will be able to retain long-term relationships or secure renewals of short-term relationships with our significant clients in the future. If we were to lose such customers, it is unclear if we would be able to replace them or how long it would take to do so. Accordingly, our revenues and profitability would be negatively impacted.
 
We have not entered into any long term contracts with our customers. 
 
All of our agreements with our customers are for short term projects or sales of equipment. While we believe that our significant relationships with China Unicom and China Mobile will likely provide additional sales agreements in the future, none of our customers are contractually bound to purchase any products or services from us in the future.  If our customers do not continue to purchase products or services from us in the future, our business, financial condition and results of operations could be adversely affected.

We depend on a limited number of suppliers. 
 
We rely on certain suppliers to provide us various pieces of telecommunications equipment. If we were to lose our relationship with those suppliers, we may experience difficulties finding a suitable replacement for our equipment needs, and our business and operations could be adversely affected.
 
We face intense competition. 
 
The market for access network solutions services is intensely competitive in the People’s Republic of China. There are numerous other access network service providers with which we compete for business. There are low barriers to entry for new competitors in our market and our business may experience a negative impact as a result of increased competition. In addition, our existing or potential competitors may in the future achieve greater market acceptance and gain additional market share, which in turn could reduce our revenues and operations.
 
We depend on key personnel for the success of our business.

Our business may be severely disrupted if we lose the services of our key executives and employees or fail to add new senior and middle managers to our management. Our future success is heavily dependent upon the continued service of our key executives, particularly Han Daqing, our Chief Executive Officer and President, Li Hong, our Chief Financial Officer and Yong Shiqin, our Chief Operating Officer. Our future success is also dependent upon our ability to attract and retain qualified senior and middle managers to our management team. If one or more of our current or future key executives and employees are unable or unwilling to continue in their present positions, we may not be able to easily replace them, and our business may be severely disrupted. In addition, if any of these key executives or employees joins a competitor or forms a competing company, we could lose customers and suppliers and incur additional expenses to recruit and train personnel. Each of our executive officers has entered into an employment agreement with us.
 
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We also rely on a number of key technology staff for the operation of our Company. Given the competitive nature of our industry, the risk of key technology staff leaving our Company is high and could disrupt our operations.

We rely on a third party production center. 
 
We utilize a third party production center for the manufacture of the products we sell to our customers. Although we are parties to a memorandum of cooperation regarding such manufacturing arrangement, we cannot be assured that such cooperation will continue indefinitely. Should we be required to utilize a different source for our manufactured products our costs could be adversely affected.
 
Rapid growth and a rapidly changing operating environment may strain our limited resources. 
 
We will need to increase our investment in our technology infrastructure, facilities and other areas of operations, in particular our product development, in order to facilitate our growth. If we are unable to manage our growth and expansion effectively, the quality of our products and services, and in turn, our customer support, could deteriorate and our business and results of operations may suffer. Our future success will depend on, among other things, our ability to:

·
continue to develop through our research and development facilities new technologies acceptable to the PRC market;

·
continue training, motivating and retaining our existing employees and attract and integrate new employees, including our senior management;

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

·
maintain adequate controls and procedures to ensure that our periodic public disclosure under applicable laws, including U.S. securities laws, is complete and accurate.

We may not be able to adequately protect our intellectual property, and we may be exposed to infringement claims by third parties. 
 
We rely primarily on a combination of copyright laws and contractual restrictions to establish and protect our intellectual property rights. Monitoring unauthorized use of our information services is difficult and costly, and we cannot be certain that the steps we take will effectively prevent misappropriation of our technology and content. Our management may determine in the future to register for copyrights, trademarks or trade secret protection if management determines that such protection would be beneficial and cost-effective.
 
From time to time, we may have to resort to litigation to enforce our intellectual property rights, which could result in substantial costs and diversion of our resources. In addition, parties may initiate litigation against us for alleged infringement of their proprietary rights. In the event of a successful claim of infringement and our failure or inability to develop non-infringing technology, content or license the infringed or similar technology or content on a timely basis, our business could suffer. Moreover, even if we are able to license the infringed or similar technology or content, license fees that we pay to licensors could be substantial or uneconomical.
 
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We have limited business insurance coverage. 
 
The insurance industry in the PRC is still at an early stage of development. Insurance companies in the PRC offer limited business insurance products, and do not, to our knowledge, offer business liability insurance. As a result, we do not have any business liability insurance coverage for our operations. Any business disruption, litigation or natural disaster might result in substantial costs and diversion of resources.
 
Risks Related To Doing Business in China

A downturn in the Chinese economy may slow down our growth and profitability. 
 
The growth of the Chinese economy has been uneven across geographic regions and economic sectors. There can be no assurance that growth of the Chinese economy will be steady or that any downturn will not have a negative effect on our business. Our profitability will decrease if expenditures for wireless services decrease due to a downturn in the Chinese economy. In addition, increased penetration of wireless services in the less economically developed central and western provinces of the PRC will depend on those provinces achieving certain income levels, so that mobile phones and related services become affordable to a significant portion of the population.

Government regulation of the telecommunications industry may become more complex.

Government regulation of the telecommunications industry is highly complex. New regulations could increase our costs of doing business and prevent us from efficiently delivering our services. These regulations may stop or slow down the expansion of our user base and limit the access to our services.

Our ability to generate revenues could suffer if the Chinese market for access network solutions services does not develop as anticipated.

The wireless services market in the PRC has evolved rapidly over the last four years, with the introduction of new services, development of consumer preferences, market entry by new competitors and adaptation of strategies by existing competitors. We expect each of these trends to continue, and we must continue to adapt our strategy to successfully compete in our market.

In particular, we currently offer a wide range of access network solutions services for mobile phones using 2G technologies including GSM/CDMA/PHS/WLAN and are developing access network solutions for 3G mobile phones. There can be no assurance, however, that any of these 2G or 3G technologies and any services compatible with them will be accepted by consumers or promoted by the mobile operators. Accordingly, it is extremely difficult to accurately predict consumer acceptance and demand for various existing and potential new offerings and services, and the future size, composition and growth of this market.
 
Our ability to compete on a nationwide scale may be impaired due to state-owned competitors.

Although we believe our strongest competitors are other privately held Chinese companies, we face direct competition with telecommunications companies which are either state-owned or state-run. In certain circumstances, these state-owned competitors may receive preferential treatment, particularly in the awarding of governmental contracts.
 
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The uncertain legal environment in China could limit the legal protections available to you.

The Chinese legal system is a civil law system based on written statutes.  Unlike common law systems, it is a system in which precedents set in earlier legal cases are not generally used.  The overall effect of legislation enacted over the past 20 years has been to enhance the protections afforded to foreign invested enterprises in China.  However, these laws, regulations and legal requirements are relatively recent and are evolving rapidly and their interpretation and enforcement involves uncertainties.  In addition, the PRC legal system is based in part on government policies and internal rules (some of which are not published on a timely basis or at all) that may have a retroactive effect.  As a result, we may not be aware of our violation of these policies and rules until some time after the violation.  These uncertainties could limit the legal protections available to foreign investors, such as the right of foreign invested enterprises to hold licenses and permits such as requisite business licenses.  In addition, all of our executive officers and our directors are residents of China, and substantially all the assets of these persons are located outside the U.S.  As a result, it could be difficult for investors to effect service of process in the U.S., or to enforce a judgment obtained in the U.S. against us or any of these persons.

Changes in the PRC’s political and economic policies could harm our business.

The economy of the PRC has historically been a planned economy subject to governmental plans and quotas and has, in certain aspects, been transitioning to a more market-oriented economy. Although we believe that the economic reform and the macroeconomic measures adopted by the Chinese government have had a positive effect on the economic development of the PRC, we cannot predict the future direction of these economic reforms or the effects these measures may have on our business, financial position or results of operations. In addition, the Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development (the “OECD”). These differences include:

·
Economic structure;
 
 
·
Level of government involvement in the economy;

·
Level of development;

·
Level of capital reinvestment;

·
Control of foreign exchange;

·
Methods of allocating resources; and

·
Balance of payments position.
 
As a result of these differences, our business may not develop in the same way or at the same rate as might be expected if the Chinese economy were similar to those of the OECD member countries.

Restrictions on currency exchange may limit our ability to receive and use our revenues effectively. 
 
Because almost all of our future revenues may be in the form of RMB, any future restrictions on currency exchanges may limit our ability to use revenue generated in RMB to fund any future business activities outside the PRC or to make dividend or other payments in U.S. dollars. Although the Chinese government introduced regulations in 1996 to allow greater convertibility of the RMB for current account transactions, significant restrictions still remain, including primarily, the restriction that foreign invested enterprises may only buy, sell or remit foreign currencies, after providing valid commercial documents, at those banks authorized to conduct foreign exchange business. In addition, conversion of RMB for capital account items, including direct investment and loans, is subject to governmental approval in the PRC, and companies are required to open and maintain separate foreign exchange accounts for capital account items. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB, especially with respect to foreign exchange transactions.
 
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The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.

China only recently has permitted provincial and local economic autonomy and private economic activities. Chinese government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to taxation, import and export tariffs, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of these jurisdictions may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations. Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties.
 
Future inflation in China may inhibit our ability to conduct business in China.

In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the rate of inflation in China has been as high as 20.7% and as low as -2.2%. These factors have led to the adoption by Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. While inflation has been more moderate since 1995, high inflation may in the future cause Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.
  
Cessation of the preferential rate of income tax may have an adverse impact on our net income.

China passed a new PRC Enterprise Income Tax Law and its implementing rules, both of which became effective on January 1, 2008. The PRC Enterprise Income Tax Law (“EIT Law”)  reduces the statutory rate of enterprise income tax from 33% to 25%, and permits companies established before March 16, 2007 to continue to enjoy their existing tax incentives, adjusted by certain transitional phase-out rules. Administrative regulations shall gradually become subject to the New EIT Law rate over a five-year transition period starting from the date of effectiveness of the New EIT Law. However, certain qualifying high-technology enterprises may still benefit from a preferential tax rate of 15% if they are enterprises in certain State-supported high-tech industries to be later specified by the government. As a result, if Telestone’s PRC subsidiaries qualify as “high-technology enterprises,” they will continue to benefit from the preferential tax rate of 15%, subject to transitional rules implemented from January 1, 2008. Otherwise, the applicable tax rate of its PRC subsidiaries may gradually increase to the unified tax rate of 25% by January 1, 2013 under the New EIT Law and the Implementing Rules. If its PRC subsidiaries cease to qualify as “high-technology enterprises”, Telestone’s financial condition and results of operations could be materially and adversely affected. 
 
A new Chinese law may impact our ability to make acquisitions of Chinese businesses.

On August 8, 2006, six PRC regulatory agencies namely, the PRC Ministry of Commerce, the State Assets Supervision and Administration Commission (“SASAC”), the State Administration for Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission (“CSRC”), and the State Administration of Foreign Exchange (“SAFE”), jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “New M&A Rule”), which became effective on September 8, 2006. The New M&A Rule purports, among other things, to require offshore special purpose vehicles, or SPVs, formed after the effective date, for overseas listing purposes, through acquisitions of PRC domestic companies and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange.
 
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The Company intends to make acquisitions of Chinese businesses in the future. There are uncertainties regarding the interpretation and application of current or future PRC laws and regulations, including the New M&A Rule and there uncertainties could make it difficult or impossible to make acquisitions of Chinese businesses in the future.

The fluctuation of the Renminbi may materially and adversely affect your investment.
 
        The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC’s political and economic conditions. Any significant revaluation of the Renminbi may materially and adversely affect our cash flows, revenues and financial condition. For example, to the extent that we need to convert U.S. dollars we receive from this offering of our common stock into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar could have a material adverse effect on our business, financial condition and results of operations.
 
        Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of making payments for dividends on our common shares or for other business purposes and the U.S. dollar appreciates against the Renminbi, the U.S. dollar equivalent of the Renminbi we convert would be reduced. Any significant devaluation of Renminbi may reduce our operation costs in U.S. dollars but may also reduce our earnings in U.S. dollars. In addition, the depreciation of significant U.S. dollar denominated assets could result in a charge to our income statement and a reduction in the value of these assets.
 
        Since 1994 the PRC has pegged the value of the Renminbi to the U.S. dollar. We do not believe that this policy has had a material effect on our business. There can be no assurance that Renminbi will not be subject to devaluation. We may not be able to hedge effectively against Renminbi devaluation, so there can be no assurance that future movements in the exchange rate of Renminbi and other currencies will not have an adverse effect on our financial condition.
 
        In addition, there can be no assurance that we will be able to obtain sufficient foreign exchange to pay dividends or satisfy other foreign exchange requirements in the future.

Any recurrence of severe acute respiratory syndrome, (“SARS”), or another widespread public health problem, could adversely affect our business and results of operations.

A renewed outbreak of SARS or another widespread public health problem in the PRC, where all of our revenue is derived, and in Beijing where our operations are headquartered, could have a negative effect on our operations. Our operations may be impacted by a number of health-related factors, including the following:

·
Quarantines or closures of some of our offices which would severely disrupt our operations;

·
The sickness or death of our key officers and employees; and

·
A general slowdown in the Chinese economy.

Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business and results of operations.
 
You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited. All of our subsidiaries are incorporated in non-U.S. jurisdictions, we conduct substantially all of our operations in China, and all of our officers reside outside the United States.

We conduct substantially all of our operations in China through our wholly owned subsidiaries in China. All of our officers reside outside the United States and some or all of the assets of those persons are located outside of the United States. As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in China in the event that you believe that your rights have been infringed under the securities laws or otherwise. Even if you are successful in bringing an action of this kind, the laws of the PRC may render you unable to enforce a judgment against our assets or the assets of our directors and officers. As a result of all of the above, our public stockholders may have more difficulty in protecting their interests through actions against our management, directors or major stockholders than would stockholders of a corporation doing business entirely within the United States.
 
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Risks Related To Our Shares

The market price for our common stock is volatile. 

The market price for our common stock is highly volatile and subject to wide fluctuations in response to factors including the following:

·
Actual or anticipated fluctuations in our quarterly operating results;

·
Announcements of new products and services by us or our competitors;

·
Changes in financial estimates by securities analysts;

·
Changes in the economic performance or market valuations of other companies providing similar products and services;

·
 Announcements by our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
 
 
·
 Additions or departures of key personnel;

·
 Potential litigation;

·
 Conditions in the mobile phone market; or

·
 Weak liquidity.

In addition, the securities markets have from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also materially and adversely affect the market price of our common stock.

The value of our securities will be affected by the foreign exchange rate between U.S. dollars and Renminbi. 

The value of our common stock will be affected by the foreign exchange rate between U.S. dollars and Renminbi. For example, to the extent that we need to convert U.S. dollars into Renminbi for our operational needs and should the Renminbi appreciate against the U.S. dollar at that time, our financial position and the price of our common stock may be adversely affected. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of declaring dividends on our ordinary shares or for other business purposes and the U.S. dollar appreciates against the Renminbi, the U.S. dollar equivalent of our earnings from our subsidiaries in the PRC would be reduced.

Stockholders could experience substantial dilution.

We may issue additional shares of our capital stock to raise additional cash for working capital or for other purposes. If we issue additional shares of our capital stock, our stockholders will experience dilution in their respective percentage ownership in the company and may experience dilution in the value of their shares.
 
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We have no present intention to pay dividends. 

We have never paid dividends or made other cash distributions on our common stock, and do not expect to declare or pay any dividends in the foreseeable future. We intend to retain future earnings, if any, for working capital and to finance current operations and expansion of our business.
 
A large portion of our common stock is controlled by a small number of stockholders. 

A large portion of our common stock is held by a small number of stockholders. As of March 29, 2010, our directors and officers collectively owned approximately 30.62% of the company’s outstanding common stock. As a result, these stockholders are able to influence the outcome of stockholder votes on various matters, including the election of directors and extraordinary corporate transactions including business combinations. This concentration of ownership could have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which in turn could have a material and adverse effect on the market price of the common stock or prevent our stockholders from realizing a premium over the market prices for their shares of common stock.  In addition, the occurrence of sales of a large number of shares of our common stock, or the perception that these sales could occur, may affect our stock price and could impair our ability to obtain capital through an offering of equity securities. Furthermore, the current ratios of ownership of our common stock reduce the public float and liquidity of our common stock which can in turn affect the market price of our common stock.
 
There is no assurance of an established public trading market, which would adversely affect the ability of investors in our company to sell their securities in the public markets.

        Although our common stock trades on the NASDAQ’s automated quotation system (the “NASDAQ Stock Market”), a regular trading market for the securities may not be sustained in the future. Market prices for our common stock will be influenced by a number of factors, including:

·
the issuance of new equity securities;

·
changes in interest rates;

·
competitive developments, including announcements by competitors of new products or services or significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;

·
variations in quarterly operating results;

·
change in financial estimates by securities analysts;

·
the depth and liquidity of the market for our common stock;

·
investor perceptions of our company and the technologies industries generally; and

general economic and other national conditions.
 
The limited prior public market and trading market may cause volatility in the market price of our common stock.
 
        Our common stock is currently traded on the NASDAQ under the symbol “TSTC.” The quotation of our common stock on the NASDAQ does not assure that a meaningful, consistent and liquid trading market currently exists, and in recent years such market has experienced extreme price and volume fluctuations that have particularly affected the market prices of many smaller companies like us. Our common stock is thus subject to volatility. In the absence of an active trading market:
 
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·
investors may have difficulty buying and selling or obtaining market quotations;

·
market visibility for our common stock may be limited; and

·
a lack of visibility for our common stock may have a depressive effect on the market for our common stock.

We do not anticipate paying dividends on our common stock.

        We have never paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future. Our directors intend to follow a policy of retaining all of our earnings, if any, to finance the development and expansion of our business.

Broker-dealer requirements may affect trading and liquidity.
 
        Section 15(g) of the Securities Exchange Act of 1934, as amended, and Rule 15g-2 promulgated thereunder by the SEC require broker-dealers dealing in penny stocks to provide potential investors with a document disclosing the risks of penny stocks and to obtain a manually signed and dated written receipt of the document before effecting any transaction in a penny stock for the investor’s account.
 
        Potential investors in our common stock are urged to obtain and read such disclosure carefully before purchasing any shares that are deemed to be “penny stock.” Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approve the account of any investor for transactions in such stocks before selling any penny stock to that investor. This procedure requires the broker-dealer to (i) obtain from the investor information concerning his or her financial situation, investment experience and investment objectives; (ii) reasonably determine, based on that information, that transactions in penny stocks are suitable for the investor and that the investor has sufficient knowledge and experience as to be reasonably capable of evaluating the risks of penny stock transactions; (iii) provide the investor with a written statement setting forth the basis on which the broker-dealer made the determination in (ii) above; and (iv) receive a signed and dated copy of such statement from the investor, confirming that it accurately reflects the investor’s financial situation, investment experience and investment objectives. Compliance with these requirements may make it more difficult for holders of our common stock to resell their shares to third parties or to otherwise dispose of them in the market or otherwise.
 
Shares eligible for future sale may adversely affect the market price of our common stock, as the future sale of a substantial amount of our restricted stock in the public marketplace could reduce the price of our common stock.
 
        From time to time, certain of our stockholders may be eligible to sell all or some of their shares of common stock by means of ordinary brokerage transactions in the open market pursuant to Rule 144, promulgated under the Securities Act (“Rule 144”), subject to certain limitations. The SEC has recently adopted amendments to Rule 144 which became effective on February 15, 2008. Under these amendments, a person who has beneficially owned restricted shares of our common stock or warrants for at least six months would be entitled to sell their securities provided that (i) such person is not deemed to have been one of our affiliates at the time of, or at any time during the three months preceding, a sale and (ii) we are subject to the Exchange Act periodic reporting requirements for at least three months before the sale.
 
        Persons who have beneficially owned restricted shares of our common stock or warrants for at least six months but who are our affiliates at the time of, or at any time during the three months preceding, a sale, would be subject to additional restrictions, by which such person would be entitled to sell within any three-month period only a number of securities that does not exceed the greater of either of the following:
 
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·
1% of the total number of securities of the same class then outstanding; or

·
the average weekly trading volume of such securities during the four calendar weeks preceding the filing of a notice on Form 144 with respect to the sale;
 
provided, in each case, that we are subject to the Exchange Act periodic reporting requirements for at least three months before the sale.
 
Such sales both by affiliates and by non-affiliates must also comply with the manner of sale, current public information and notice provisions of Rule 144.
 
ITEM 2.
PROPERTIES

We currently occupy 46 offices, including one branch office in which we maintain certain ownership rights. The balance of our office space is leased by us under lease arrangements we deem to be satisfactory. In addition we lease 48 buildings used by us as warehouses and dormitories in the PRC and one building as our research and development center. We lease our headquarters, located at Floor 6 and Floor 5, Saiou Plaza, No. 5 Haiying Road, Fengtai Technology Park, Beijing, PRC 100070, for $237,881 per year, pursuant to an operating lease that expires in June 2011.

ITEM 3. 
LEGAL PROCEEDINGS 

None
 
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.   
 
Our current report on Form 8-K filed with the SEC on November 24, 2009 is incorporated by reference herein in its entirety.

PART II
 
ITEM 5. 
MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES.
 
The shares of our common stock are currently traded on the NASDAQ Global Market under the trading symbol “TSTC”. The shares of our common stock were traded on the American Stock Exchange from May 2005 to September 2006. In late September 2006, we were transferred from AMEX and our shares of common stock began trading on the NASDAQ Capital Market.

On January 30, 2007 the NASDAQ Stock Market approved Telestone’s transfer from its NASDAQ Capital Market listing to a NASDAQ Global Market listing. Our shares of common stock continue to trade under the trading symbol “TSTC”.
 
Holders. As of March 29, 2010, we had 227 holders of shares of common stock of record.
 
The following table sets forth the quarterly average high and low bid prices per share for the common stock for the past two years:
 
21

   
   
Common Stock
 
Fiscal Year Ended December 31, 2008
 
High
   
Low
 
First Quarter
 
$
6.61
   
$
4.00
 
Second Quarter
 
$
5.10
   
$
3.22
 
Third Quarter
 
$
4.25
   
$
1.00
 
Fourth Quarter
 
$
2.87
   
$
0.63
 

   
Common Stock
 
Fiscal Year Ended December 31, 2009
 
High
   
Low
 
First Quarter
 
$
2.38
   
$
0.92
 
Second Quarter
 
$
4.60
   
$
1.43
 
Third Quarter
 
$
7.25
   
$
3.66
 
Fourth Quarter
 
$
21.67
   
$
6.71
 

Such quotations are without retail mark-ups, mark-downs or commissions, and may not represent actual transactions and have not been adjusted for stock dividends or splits. 
 
Dividends. We have never declared or paid any cash dividends or distributions on our common stock. We currently intend to retain our future earnings to support operations and to finance future growth and expansion and, therefore, do not anticipate paying any cash dividends on our common stock in the foreseeable future.

Transfer Agent and Registrar. Our transfer agent is Corporate Stock Transfer, located at 3200 Cherry Creek Drive South, Suite 430, Denver, Colorado 80209. Their telephone number is (303) 282-4800.
 
Securities Authorized for Issuance Under Equity Compensation Plans. As of the fiscal year ended December 31, 2009, we have no shares of our common stock or preferred stock that are issued under compensation plans approved by our security holders.

Outstanding Warrants.  In February 2007, we sold in a private placement an aggregate of 133,888 warrants to purchase shares of our common stock to certain investors.  The investor warrants are exercisable for a period of four years, beginning six months after the date of issuance until August 23, 2011 at an exercise price of $11.60 per share.  The exercise price for the investor warrants is subject to an adjustment upon certain issuances by the Company of its common stock below the price per share paid by the investors; provided, however, that the exercise price may not be adjusted below $10.10 per share. The warrants certain cashless exercise feature.  In addition, we issued our placement agent in connection with private placement a warrant to purchase 43,515 shares of our common stock. The agent warrant is on the same terms as the investor warrants. In January 2010, certain investors of the warrants and the agent exercised the warrants pursuant to the cashless exercise terms. In March 2010, we issued 40,000 warrants to our corporate publicist. The warrant has an exercise price of $18.73 per share and exercisable until September 9, 2013. It does not contain a cashless exercise feature. Currently, there are 125,666 such warrants outstanding.

ITEM 6. 
SELECTED FINANCIAL DATA. 

Not required.
 
ITEM 7. 
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. 
 
The following is management's discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. This report includes forward-looking statements. Generally, the words "believes," "anticipates," "may," "will," "should," "expect," "intend," "estimate," "continue," and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents we file with the SEC from time to time, which could cause actual results or outcomes to differ materially from those projected. Undue reliance should not be place on these forward-looking statements which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements.
 
22

 
The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Annual Report on Form 10-K.

Overview

We are a leading access network solutions provider serving the Chinese market.  Since 1997, we have operated in the Chinese market and in 2006, we expanded marketing efforts to Vietnam, Indonesia, Malaysia, Thailand and India. Since 2007, Beijing Telestone Communication Technology Corp. Ltd was established as one of our subsidiaries focusing on developing and managing our overseas businesses. Currently, marketing has expanded to 28 countries in the world, including the U.S., Vietnam, Mexico, Brazil, Russia, India, The Philippines, Thailand, Ireland, Ecuador, Mongolia, South Africa, Turkey, Indonesia, Colombia, Costa Rica, Argentina, Ukraine, Kazakhstan, Singapore, South Korea, Hong Kong (SAR), Saudi Arabia, New Zealand, Bangladesh, the UAE, Canada and Iceland. Continuous expansion outside of China is one of our core strategies. We believe that the quality of our products and services will allow Telestone to be increasingly competitive internationally. Our access network solutions business comprises research, development and application of access network technology. In addition to sales of our internally designed wireless communication equipment, including repeaters, antennas and radio frequency accessories, we also provide project design, project management, installation, maintenance and other after-sales services in accordance with our customers' requirements. Since the establishment of Telestone in 1997, we have gradually developed business relationships with China Mobile, China Unicom, China Telecom (the“Big 3”), which currently are our main customers. During 2009, we saw a significant improvement in revenue from sales of our products and services to China Mobile, China Unicom and China Telecom. Furthermore, consolidate relationships with the Big 3 by providing technically advanced products and infrastructure solutions for 3G upgrade. Meanwhile, we improved our business relationships with wireless system equipment vendors within China.
 
 In 2009, our benchmark technology WFDS has further been applied in our business. We have finished 43 WFDS installations as of December 31, 2009. This 3G technology provides higher margins than the old 2G RFPA technology, which has more competition due to its maturity and wider applications in the market place. Internationally WFDS technology passed the U.S. FCC certification in September 2009. This has cleared the last hurdle for the Company to apply this advanced technology in North and South American markets. Due to its superior performance, substantial cost savings to carriers, easy installation and minimal intrusion to property owners, as well as its low-power low-radiation environment-friendly characteristics, we expect that our WFDS technology will expand our market share.

In 2009, due to the high technology content in our business and continued efforts in developing our market leading technologies, we have been receiving many awards, certifications and top ratings in advanced technology development by  China’s local and central government agencies and organizations, which promote technology development in the national and local markets. Most recently BTWTC has been certified as a “High and New Technology Enterprise” by the Beijing Municipal Government. In addition, our trademark has been recognized as a well-known trademark of Beijing by local Industry and Commerce Bureau.  In addition, we have won the title of A-Rated Good Credit enterprise which entitles us to credits guaranteed by Beijing Z-Park Sci-tech Guarantee Co. funded by the Chinese government.
 
23

 
SIGNIFICANT ACCOUNTING POLICIES AND MANAGEMENT ESTIMATES
 
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 based 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. We believe critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008 reflect the more significant judgments and estimates used in preparation of our financial statements. We believe there have been no material changes to our critical accounting policies and estimates for the year ended December 31, 2009 compared to those discussed in our Annual Report on Form 10-K for the year ended December 31, 2008.
  
Results of Operation

Our operating results are presented on a consolidated basis for the fiscal year ended December 31, 2009, as compared to the fiscal year ended December 31, 2008.

For the year ended December 31, 2008 and 2009, a tabular summary of results of operations is as follows:

Item
 
2008
   
2009
   
Comparisons
 
   
$'000
   
% of revenue
   
$'000
   
% of revenue
   
$'000
   
%
 
Revenue
    35,329             71,879             36,550       103.46 %
Equipment and services costs
    17,133       48.50 %     41,402       57.60 %     24,269       141.65 %
Gross profit
    18,196       51.50 %     30,477       42.40 %     12,281       67.49 %
Sales and marketing expenses
    4,620       13.08 %     10,607       14.76 %     5,987       129.59 %
General and administrative expenses
    3,810       10.78 %     1,999       2.78 %     -1,811       -47.53 %
Research and development expenses
    527       1.49 %     1,768       2.46 %     1,241       235.48 %
Depreciation and Amortization
    295       0.84 %     326       0.45 %     31       10.51 %
Interest expenses
    298       0.84 %     290       0.40 %     -8       -2.68 %
Other income, net
    177       0.50 %     405       0.56 %     228       128.81 %
Net Income before income tax
    8,823       24.97 %     15,892       22.11 %     7,069       80.12 %
Income tax
    1,774       5.02 %     3,354       4.67 %     1,580       89.06 %
Net income
    7,049       19.95 %     12,538       17.44 %     5,489       77.87 %

We derive our revenues primarily from capital expenditures made by the PRC’s telecommunications carriers. Our operating revenues are composed of sales of wireless equipment and service sales that include system integration, engineering services, technical support, wireless network optimization and network maintenance.

Our consolidated net income increased by 77.87% to $12,538,000 for the year ended December 31, 2009, as compared to the prior fiscal year of 2008. This increase is attributable to an increase in revenue of 103.46% in fiscal year 2009 as compared to fiscal year 2008. For the year ended December 31, 2009, our net income before income tax increased by 80.12% to $15,892,000, as compared to $8,823,000 in 2008.
 
24

 
For the years ended December 31, 2008 and 2009, a tabular summary of our revenue is as follows:

   
2008
   
2009
   
Growth
 
   
$'000
   
% of revenue
   
$'000
   
% of revenue
   
$'000
   
%
 
Product sales
    17,132       48.89 %     30,162       41.96 %     13,030       76.06 %
Service sales
    18,197       51.51 %     41,717       58.04 %     23,520       129.25 %
Total
    35,329               71,879               36,550       103.46 %

Our revenue for the year ended December 31, 2009 was $71,879,000, representing an increase of approximately 103.46% from the prior year of 2008. Product sales for the year ended December 31, 2009 were $30,162,000, representing an increase of 76.06% from the prior year of 2008. Service sales for the year ended December 31, 2009 was $41,717,000, representing an increase of 129.25% from the prior year of 2008. The increase in our product sales is primarily due to the telecom carriers increasing their investments in 3G fixed assets. We benefited from ongoing transition from 2G to 3G technologies, with more opportunities for our equipment sales.

During the year ended December 31,2009, our service sales increased significantly resulting from telecommunications operators in China implementing 2G reformation and 3G construction on a wide scale. We utilized this business opportunity to obtain more service projects.

   
2008
   
2009
   
Growth
 
    $’000    
% of revenue
    $’000    
% of revenue
    $ ’000    
%
 
China Mobile
    16,719       47.32 %     32,634       45.40 %     15,915       95.19 %
China Unicom
    14,958       42.34 %     32,688       45.48 %     17,730       118.53 %
China Telecom
    2,123       6.01 %     5,324       7.41 %     3,201       150.78 %
Others
    1,116       3.16 %     1,233       1.71 %     117       10.48 %
China Netcom
    413       1.17 %     -       -       -413       -100 %
Total
    35,329               71,879               36,550          

Revenues from the wireless telecom carriers were the Company’s major source of revenue during the year ended December 31, 2009, and the majority of such revenues were generated from China Mobile and China Unicom.
 
For the year ended December 31, 2009, our revenues generated from China Mobile accounted for 45.40% of our total revenue in 2009, representing an increase of 95.19% compared to that of last year. The increased revenue from China Mobile were mainly attributable to the fact that we won several large integrated service bids from the third phase of China Mobile's TD-SCDMA construction in Chongqing City, Shandong Province and other provinces.

Our revenue generated from China Unicom accounted for 45.48% of total revenue in 2009, representing an increase of 118.53% compared to that of 2008. We won several centralized bids for the sale of equipment to China Unicom.

Our revenue generated from China Telecom accounted for 7.41% of our total revenue in 2009, representing an increase of 150.78% compared to that of 2008. The increased revenues from China Telecom were mainly attributable to China Telecom’s increasing investments in the 3G sector. China Telecom is a late comer in China’s wireless telecommunications industry. It is traditionally a fixed line telecommunication service provider. However, it is expanding into the wireless market with its own standards and large investments.
 
Sales to overseas and other customers accounted for 1.71% of total revenue in 2009, representing an increase of 10.48% compared to that of 2008.
 
25

 
Gross profit. Our gross profit on product sales and service sales was $30,477,000 in 2009, representing an increase of 67.49% as compared to $18,196,000 in 2008.

For the years ended December 31, 2008 and 2009, a tabular summary of the condensed statement of operations is presented below:

   
2008
 
2009
 
Growth
 
   
$’000
 
% of revenue
 
$'000
 
% of revenue
 
$'000
 
%
 
Revenue
 
35,329
       
71,879
       
36,550
 
103.46
Equipment and services costs
 
17,133
   
48.50
%
41,402
   
57.60
24,269
 
141.65
Gross profit
 
18,196
   
51.50
%
30,477
   
42.40
12,281
 
67.49

During 2009, our gross profit increased due to an increase in revenues.

Gross profit margin. Our gross profit margin on product and service sales was 42.40% in 2009, as compared to 51.50% in 2008. Our gross margin decreased as compared with the prior year of 2008 due to the increase of costs of equipment and services than revenue. Price was depressed due to centralized purchase by telecommunication operators and the rapid growth in the telecommunication market generated fierce competition. Therefore, costs of construction works increased accordingly

 Net income. Our consolidated net income increased by 77.87% to $12,538,000 for the year ended December 31, 2009, as compared to 2008. This increase is attributable to an increase in revenue of 103.46% in 2009. For the year ended December 31, 2009, our net income before income tax increased by 80.12% to $15,892,000, compared to $8,823,000 in 2008.

Equipment and service costs. Equipment and service costs were approximately $41,402,000 or 57.60% of revenue for the year ended December 31, 2009, as compared to $17,133,000, or 48.50% of revenue for 2008. For the year ended December 31, 2009, our equipment and services costs increased by 141.65%, compared to 2008.

Sales and Marketing expenses. Sales and marketing expenses were approximately $10,607,000 or 14.76% of our revenue for the year ended December 31, 2009 and were $4,620,000, or 13.08% of our revenue for the year ended December 31, 2008. The increase in sales and marketing expenses is due to our increase in sales.

General and Administrative expenses. General and administrative expenses were $1,999,000 or 2.78% of our revenue for the year ended December 31, 2009, as compared to $3,810,000 or 10.78% of revenue for 2008. Through our budgetary control practices in 2009, we reduced our general and administrative expenses.
 
Research and Development expenses. Research and development expenses were $1,768,000 or 2.46% of revenues for the year ended December 31, 2009, as compared to $527,000, or 1.49% of revenues in 2008. The main reason for this increase is that we focused on R&D to keep our industry leadership position and high margins. Thus, we increased our investments in R&D activities in order to finished approximately fifteen research and development projects in 2009.
 
26

 
Liquidity and Capital Resources

We generally finance our operations from cash flow generated internally and from bank loans. As of December 31, 2009, we had current assets of $112,440,000. Current assets comprised inventories of $4,442,000, accounts receivable of $89,005,000, prepayments of $1,223,000, other current assets of $4,574,000, due from related parties of $1,963,000, and cash and cash equivalents of $11,233,000. Current liabilities comprised accounts payable of $15,678,000, customer deposits for sales of equipment of $1,582,000, tax payables of $7,132,000, short-term loan $5,850,000 due to related parties of $4,947,000 and other payables and accruals of $16,473,000.

Our net cash inflow from operating activities was $865,000 for the year ended December 31, 2009. At December 31, 2009, cash and cash equivalents were $11,233,000. Current assets were $112,440,000 and current liabilities were $51,662,000, reflecting a current ratio (current assets/current liabilities) of 2.18:1.

Our trading terms with our customers are mainly on credit. The credit period is generally less than one year. The accounts receivable turnover period for the year ended December 31, 2009 was 358 days compared to 553 days for the year ended December 31, 2008. Inventory turnover period for the year ended December 31, 2009 was 114 days, compared to 278 days in 2008.

Our account receivables in terms of days of sales has decreased substantially despite the large increase in revenue in the year ended December 31, 2009 as compared to the year of 2008. The primary reason for the reduction in our account receivables turnover days is that a large portion of the account receivables that was put on hold due to the restructuring of the access network industry in China has been received as the carriers completed their reorganizations and resumed normal payments.

We experienced a longer accounts receivable turnover period than some of our competitors, due to traditionally long payment periods from China’s state-controlled telecom carriers. Telestone continues to believe that all of our outstanding accounts receivables will be paid as our major customers, China Mobile, China Unicom, and China Telecom, are state owned and we have not experienced any significant bad debts from them in the past.

Our inventory turnover period decreased for the year ended December 31, 2009 as compared to the year ended December 31, 2008 due to internal improvements in our inventory control measures.

As of December 31, 2009, our cash and bank balances are mainly denominated in RMB and United States dollars while our bank borrowings are mainly denominated in RMB. Our revenue, expenses, assets and liabilities are mainly denominated in RMB and United States dollars. Recently, the exchange rate fluctuations in the PRC have led to an appreciation of currency. This may result in certain exchange risks.

Capital structure and solvency. We have cash and cash equivalents in the amount of $11,233,000 for the year ended December 31, 2009. As of December 31, 2009, our total assets were $116,740,000 and our total liabilities were $51,662,000, reflecting a gearing ratio of 79.38%. Our gearing ratio, calculated as total liabilities over equity, was 79.38% and 66.96% as of December 31, 2009 and 2008, respectively. The increase in our gearing ratio is due to the increase in accounts payable and bank financing.

Asset utilization and efficiency. As of December 31, 2009, our total assets were $116,740,000 and our operating revenue was $71,879,000 for the year ended December 31,2009, reflecting a total asset turnover of 61.57%.

Accounts Receivable
As of December 31, 2009, our accounts receivables were $89,005,000 as compared to $62,136,000 for the year ended December 31, 2008.
 
27

 
The credit period is generally for a period of six to nine months. Accounts receivable are stated at the amount billed to customers. Accounts receivables are presented net of an allowance for doubtful accounts. Our estimate of allowance for doubtful account is based on a variety of factors, including historical collection experiences, existing economic conditions and a review of the current status of the receivable. For the year ended December 31, 2009 and 2008, allowance for doubtful accounts were $6,174,000 and $5,776,000 respectively. Our long credit period is because our major customers are the three major players in China telecom market (“China Mobile”, “China Unicom” and “China Telecom”). Due to their monopoly in China’s telecom market, we are at a disadvantage in negotiations regarding payments/credit period.

We have made attempts to adequately address accounts receivable turn-over problems and have made efforts to shorten the collection period. As a result, accounts receivable turnover days have been shortened to 358 days.

The Company paid particular attention to lowering the turnover period of our accounts receivable balances and have taken the following measures:
(1) The provincial branch managers and the headquarters district managers are in charge of the collection of the account receivables, which form an important element of their performance evaluation.
(2) The Company keeps in touch with the management and the key department (such as the financial department and the planning department) of the carriers in headquarters as well as the provincial branches to monitor the collection of the account receivables.
(3) Our business strategy is to encourage sales to the branches of China Mobile, China Telecom, China Unicom who have good payment records such as Shandong Unicom, Tianjin Unicom, and Beijing Unicom. We believe these measures will optimize the structure of our account receivables and minimize our financial risks in the future.

Major Milestones of 2009

The U.S. Federal Communications Commission Approved WFDSTM Technology—the WFDSTM system had a successful debut at the April 2009 CTIA trade show in Las Vegas. After the trade show, Telestone assembled a team for the sole purpose of completing the FCC certification process for the system's equipment. In September 2009, Telestone's proprietary WFDSTM technology, which provides for indoor multi-services access networks, successfully passed all FCC testing procedures. The FCC certification license will not only apply to the U.S. market, but also to Telestone's WFDSTM products in Central and South America. Coupled with successful installations for this new fiber-optic equipment in China, we believe  that this approval is a significant milestone in the Company's efforts to gain market share in North and South American markets.

Beijing Municipal Enterprise Technology Center Approved Telestone Technologies Corporation in 2009. Telestone was selected as the 12th group of the Beijing Municipal Enterprise Technology Center. In March 2009, Telestone entered into the selection. After over three months of selection, Telestone obtained approval with other 53 other enterprises. In recent years, in order to promote the independent innovation and long-term development, Telestone continued to invest investing in proprietary research an development. We believe that being certified by the Beijing Municipal Enterprise Technology Center is an approval of Telestone’s technology innovation capability and also approval of Telestone as  an enterprise in a leadership position in the telecommunications industry.

In July of 2009, Telestones won bids from the third stage construction of China Mobile’s TD-SCDMA. We believe that this further support Telestone's leading position in providing indoor coverage systems and indoor distribution system integration programs.

Off-Balance Sheet Arrangements

We do not currently have any off-balance sheet arrangements.
 
28

 
Contingent Liabilities. We recognize our revenue upon the completion of contracts and have made full tax provision in accordance with relevant national and local laws and regulations of the PRC. A contract is considered completed upon completion of all essential contract work and when installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. We follow the practice of reporting our revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. Despite the fact that we have made full tax provision in the financial statements, we may be subject to surcharge and penalty for the deferred reporting of tax obligations. The Board of Directors considers it is unlikely that the tax surcharge and penalty will be imposed.

Remuneration Policies
We offer competitive remuneration schemes to our employees based on industry practices as well as the employees and our performance.

ITEM 7A. 
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. 

Not required.

ITEM 8. 
FINANCIAL STATEMENTS. 
 
Telestone Technologies Corporation

Index to Consolidated Financial Statements

 
   
Page
 
       
Report of Independent Registered Public Accounting Firm
 
F-1
 
       
Consolidated Statements of Operations and other comprehensive income
 
F-2
 
       
Consolidated Balance Sheets
 
F-3
 
       
Consolidated Statements of Changes in Stockholders’ Equity
 
F-4
 
       
Consolidated Statements of Cash Flows
 
F-5
 
       
Notes to Consolidated Financial Statements
 
F-6 – F-22
 
 
29

 
Telestone Technologies Corporation
 
Report of Independent Registered Public Accounting Firm

To the Audit Committee, Stockholders and Board of Directors
Telestone Technologies Corporation

We have audited the accompanying consolidated balance sheets of Telestone Technologies Corporation and its subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations and other comprehensive income, changes in stockholders' equity and cash flows for each of the years then ended.  These consolidated financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing auditing procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  Our audits also included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the years then ended in conformity with accounting principles generally accepted in the United States of America.

Mazars CPA Limited
Certified Public Accountants
Hong Kong
Date: March 31, 2010

 
F-1

 

Telestone Technologies Corporation

Consolidated Statements of Operations and Other Comprehensive Income
Years ended December 31, 2009 and 2008 


         
Years ended December 31,
 
         
2009
   
2008
 
     
Note
   
US$’000
 
 
US$’000
 
Operating revenues:
                 
Net sales of equipment
          30,162       17,132  
Service income
          41,717       18,197  
                       
Total operating revenues
          71,879       35,329  
                       
Cost of operating revenues:
                     
Cost of net sales
          19,697       10,415  
Cost of service
          21,705       6,718  
                       
Total cost of operating revenues
          41,402       17,133  
                       
Gross income
          30,477       18,196  
                       
Operating expenses:
                     
Sales and marketing
          10,607       4,620  
General and administrative
          1,999       3,810  
Research and development
          1,768       527  
Depreciation and amortization
          326       295  
                       
Total operating expenses
          14,700       9,252  
                       
Operating income
          15,777       8,944  
                       
Interest expense
          (290 )     (298 )
Other income, net
          405       177  
                       
Income before income taxes
          15,892       8,823  
                       
Income taxes
 
10
      (3,354 )     (1,774 )
                       
Net income
          12,538       7,049  
                       
Other comprehensive income
                     
Foreign currency translation adjustment
          109       2,556  
                       
Comprehensive income
          12,647       9,605  
                       
Earnings per share:
 
3
                 
                       
Weighted average number of common stock outstanding
                     
Basic
          10,404,550       10,404,550  
Dilutive effect of warrants
          -       31,578  
                       
Diluted
          10,404,550       10,436,128  
                       
Net income per share of common stock
       
US$
   
US$
 
                       
Basic
          1.21       0.68  
                       
Diluted
          1.21       0.68  

The accompanying notes are an integral part of these consolidated financial statements.

 
F-2

 

Telestone Technologies Corporation

Consolidated Balance Sheets
As of December 31, 2009 and 2008


         
As of December 31,
 
         
2009
   
2008
 
   
Note
   
US$’000
 
 
US$’000
 
Current assets:
                 
Cash and cash equivalents
          11,233       7,866  
Accounts receivable, net of allowance
 
5
      89,005       62,136  
Due from related parties
 
14
      1,963       1,826  
Inventories, net of allowance
 
9
      4,442       7,843  
Prepayment
          1,223       2,347  
Other current assets
          4,574       1,352  
                       
Total current assets
          112,440       83,370  
                       
Goodwill
 
7
      3,119       3,119  
Property, plant and equipment, net
 
6
      1,181       1,050  
                       
            4,300       4,169  
                       
Total assets
          116,740       87,539  
                       
LIABILITIES AND STOCKHOLDERS’ EQUITY
                     
                       
Current liabilities:
                     
Short-term bank loans
 
8, 14
      5,850       2,918  
Accounts payable – Trade
          15,678       11,776  
Customer deposits for sales of equipment
          1,582       739  
Due to related parties
 
14
      4,947       1,673  
Income tax payable
          7,132       6,805  
Accrued expenses and other accrued liabilities
          16,473       11,197  
                       
Total current liabilities
          51,662       35,108  
                       
Commitments and contingencies
 
15
                 
                       
Stockholders’ equity:
                     
Preferred stock, US$0.001 par value, 10,000,000 shares authorized, no shares issued
                     
Common stock and paid-in-capital, US$0.001 par value: Authorized - 100,000,000 shares as of December 31, 2009 and 2008
                     
Issued and outstanding – 10,404,550 shares as of December 31, 2009 and 2008
 
12
      11       11  
Additional paid-in capital
          18,989       18,989  
Dedicated reserves
 
13
      4,807       3,787  
Other comprehensive income
          5,682       5,573  
Retained earnings
          35,589       24,071  
                       
Total stockholders’ equity
          65,078       52,431  
                       
Total liabilities and stockholders’ equity
          116,740       87,539  
 
The accompanying notes are an integral part of these consolidated financial statements.

 
F-3

 

Telestone Technologies Corporation

Consolidated Statements of Changes in Stockholders' Equity
Years ended December 31, 2009 and 2008


   
Common stock issued
     
Additional
         
Other
compre-
             
   
Number
of shares
   
Amount
   
paid-in
capital
   
Dedicated
reserves
   
hensive
income
   
Retained
earnings
   
Total
 
         
US$’000
   
US$’000
   
US$’000
   
US$’000
   
US$’000
   
US$’000
 
                                           
Balance at January 1, 2008
    10,404,550       11       18,989       3,199       3,017       17,610       42,826  
Net income
    -       -       -       -       -       7,049       7,049  
Foreign currency translation adjustment
    -       -       -       -       2,556       -       2,556  
Transfer to dedicated reserves
    -       -       -       588       -       (588 )     -  
                                                         
Balance at December 31, 2008
    10,404,550       11       18,989       3,787       5,573       24,071       52,431  
                                                         
Balance at January 1, 2009
    10,404,550       11       18,989       3,787       5,573       24,071       52,431  
Net income
    -       -       -       -       -       12,538       12,538  
Foreign currency translation adjustment
    -       -       -       -       109       -       109  
Transfer to dedicated reserves
    -       -       -       1,020       -       (1,020 )     -  
                                                         
Balance at December 31, 2009
    10,404,550       11       18,989       4,807       5,682       35,589       65,078  

The accompanying notes are an integral part of these consolidated financial statements.

 
F-4

 

Telestone Technologies Corporation

Consolidated Statements of Cash Flows
Years ended December 31, 2009 and 2008


 
       
Years ended December 31,
 
   
Note
 
2009
   
2008
 
       
US$’000
   
US$’000
 
Cash flows from operating activities
               
Net income
        12,538       7,049  
Adjustments to reconcile net income to net cash provided by operating activities:
                   
Depreciation and amortization
        326       295  
Allowance for doubtful accounts
        408       1,341  
Allowance for inventories
        436       -  
Profit on disposal of property, plant and equipment, net
        -       (14 )
Changes in assets and liabilities:
                   
Accounts receivable
        (27,123 )     (15,654 )
Inventories
        2,978       731  
Due from related parties
        (133 )     88  
Prepayment
        1,128       (1,116 )
Other current assets
        (3,213 )     71  
Accounts payable
        3,866       3,706  
Due to related parties
        3,264       (813 )
Customer deposits for sales of equipment
        840       467  
Income tax payable
        310       1,772  
Accrued expenses and other accrued liabilities
        5,240       3,544  
                     
Net cash provided by operating activities
        865       1,467  
                     
Cash flows from investing activities
                   
Purchase of property, plant and equipment
        (414 )     (169 )
Proceeds from disposal of property, plant and equipment
        -       61  
                     
Net cash used in investing activities
        (414 )     (108 )
                     
Cash flows from financing activities
                   
Proceeds from short-term bank loans
        5,850       2,918  
Repayment of short-term bank loans
        (2,953 )     (2,189 )
                     
Net cash provided by financing activities
        2,897       666  
                     
Net increase in cash and cash equivalents
        3,348       2,025  
                     
Cash and cash equivalents, beginning of year
        7,866       5,473  
Effect on exchange rate changes
        19       368  
                     
Cash and cash equivalents, end of year
        11,233       7,866  
                     
Supplemental disclosure of cash flow information
                   
Interest received
        32       42  
Interest paid
        (150 )     (220 )
Income tax paid
        (3,010 )     (56 )
 
The accompanying notes are an integral part of these consolidated financial statements.

 
F-5

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008

 
1. 
ORGANIZATION AND PRINCIPAL ACTIVITIES

Telestone Technologies Corporation (“TSTC”), formerly known as Milestone Capital, Inc., was organized under the laws of the State of Colorado in February 1987 under the name Shield Enterprises, Inc.  In August 2004, TSTC reincorporated in the State of Delaware under the name Telestone Technologies Corporation.

Success Million International Limited (“SMI”), a company established in the Hong Kong Special Administrative Region of the People’s Republic of China (the “PRC”) on August 23, 2004, is a wholly owned subsidiary of TSTC and had no business operations since incorporation. Beijing Telestone Technology Company Limited (“Beijing Telestone”), a wholly-owned subsidiary of SMI established in Beijing, the PRC with an operating period until April 12, 2024, is engaged in the business of design, development, installation and trading of wireless telecommunication coverage system equipment.

Beijing Telestone Wireless Telecommunication Company Limited (“BTWTC”)(note), a company established in Beijing, the PRC with tenure of 20 years from June 17, 2005 to June 16, 2025 for provision of wireless telecommunication networking and system integration services, is owned by certain key management personnel of the Company (the “Owners”).  Contractual agreements have been entered into between the Owners and Beijing Telestone so as to give effect that Beijing Telestone is the beneficial owner of BTWTC. Beijing Telestone does not hold the ownership interests in BTWTC directly because Beijing Telestone is considered as a foreign entity under the PRC laws. Due to the restrictions on foreign ownership to provide and engage in certain wireless telecommunication networking services in the PRC, Beijing Telestone, through loans to the Owners, established BTWTC with a view to conduct such operations without violating the relevant PRC rules and regulations.  As a result of the above contractual arrangement, Beijing Telestone has obtained control and interest over BTWTC.  Beijing Telestone is considered as the primary beneficiary of BTWTC and therefore BTWTC is considered as a variable interest entity (“VIE”) of Beijing Telestone so that the financial statements of BTWTC are consolidated into the financial statements of Beijing Telestone for all periods presented in accordance with ASC Topic 810 – Consolidation (ASC 810).

On July 5, 2007, BTWTC, Shandong Guolian Telecommunication Technology Limited (“Guolian”)(note) and owners of Guolian entered into a Share Transfer Agreement (the “Agreement”). Under the Agreement, 100% equity ownership interests in Guolian and its wholly owned subsidiary, Pan-pacific Telecommunication Company Limited (“Pan-pacific”)(note), had been transferred by the owners of Guolian to BTWTC. Guolian and Pan-pacific were established in Jinan, Shandong Province, the PRC on February 9, 1999 and October 22, 1999 respectively. The principal business activities of Guolian and Pan-pacific are design, development, production and installation and trading of wireless telecommunication coverage system equipment.

On October 8, 2007, BTWTC has established a wholly-owned subsidiary company, Beijing Telestone Communication Technology Corporation Limited (“BTCTC”)(note), with operating period of 20 years until October 7, 2027. The principal activity of BTCTC is developing and managing the business operation of the Company outside the PRC.

In this report, TSTC, SMI, Beijing Telestone, BTWTC, Guolian, Pan-pacific and BTCTC are collectively referred to as the “Company”.

Note:
These are direct translation of name in Chinese for identification purpose only and are not the official name in English.

 
F-6

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008

 
2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Accounting Principles
 
The consolidated financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America (“USGAAP”).
 
Basis of consolidation
 
The consolidated financial statements include the accounts of TSTC, its subsidiaries and a VIE.  The results of the subsidiaries acquired or disposed of during the year are consolidated from the effective dates of acquisition or to the effective dates of disposal, respectively.
 
All significant intercompany accounts and transactions have been eliminated upon consolidation.
 
Revenue recognition
Net sales of equipment represent the invoiced value of goods, net of value-added tax (“VAT”) and returns.  The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery occurs, the fee is fixed or determinable, and collectibility is probable.  Service revenue is recognized when the service is performed and accepted by the customer. The Company has a policy of including handling costs incurred for finished goods, which are not significant, in the sales and marketing expenses.
 
The Company provides installation services for certain sales of equipment under fixed-price contracts.  Revenues from these fixed-price service contracts are recognized on the completed-contract method. Under the completed-contract method, revenue and costs of individual contracts are included in operations in the year during which they are completed.  Losses expected to be incurred on contracts in progress are recognized in the period such losses are determined.  This method is used because the contract is completed within a short period of time, and the financial position and results of operations do not vary significantly from those that would result from using the percentage-of-completion method.  A contract is considered completed upon completion of all essential contract work and the installation has been accepted by the customer.
 
Income taxes
Income tax expense is computed based on pre-tax income included in the consolidated statement of operations. Income taxes have been provided, using the liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases assets and liabilities and their reported amounts.  The tax consequences of those differences are classified as current or non-current based upon the classification of the related assets or liabilities in the consolidated financial statements.
 
Research and development
All costs of research and development activities are expensed as incurred.

 
F-7

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008

 
2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 
Inventories
All inventories are stated at the lower of weighted average cost or market. Potential losses from obsolete and slow-moving inventories are provided for when identified.
 
Goodwill
Goodwill on acquisition of businesses, being the excess of the cost of the acquisition over the Company’s share of the fair value of the identifiable assets, liabilities and contingent liabilities, is recognized as a separate asset. Goodwill is carried at cost less accumulated impairment losses, which is tested for impairment annually or more frequently if events or changes in circumstances indicate that the carrying value may be impaired. Goodwill is allocated to cash-generating units for the purpose of impairment test and determination of gain or loss on disposal. An impairment loss on goodwill is not reversed.
 
Property, plant and equipment
Property, plant and equipment are stated at original cost less accumulated depreciation and amortization.
 
The cost of an asset comprises its purchase price and any directly attributable costs of bringing the asset to its present working condition and location for its intended use.  Expenditures incurred after the assets have been put into operation, such as repairs and maintenance, overhaul and minor renewals and betterments, are normally charged to operating expenses in the period in which they are incurred.  In situations where it can be clearly demonstrated that the expenditure has resulted in an increase in the future economic benefits expected to be obtained from the use of the assets, the expenditure is capitalized.
 
When assets are sold or retired, their costs and accumulated depreciation are eliminated from the consolidated financial statements and any gain or loss resulting from their disposal is recognized in the year of disposition as an element of other income, net.
 
Depreciation is provided to write off the cost of property, plant and equipment using the straight-line method at rates based on their estimated useful lives from the date on which they become fully operational and after taking into account their estimated residual values.
 
Accounting for the impairment of long-lived assets
The long-lived assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. It is reasonably possible that these assets could become impaired as a result of technology or other industry changes. Determination of recoverability of assets to be held and used is by comparing the carrying amount of an asset to future net undiscounted cash flows to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
 
Cash equivalents
The Company considers short-term, highly liquid investments with original maturities of three months or less to be cash equivalents.

 
F-8

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008

 
2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 
Foreign currency translation and other comprehensive income
 
All major subsidiaries of the Company consider Renminbi as their functional currency as a substantial portion of their business activities is based in Renminbi.  However, the Company has chosen the United States dollar as its reporting currency.
 
Transactions in currencies other than the functional currency during the year are translated into the functional currency at the applicable rates of exchange prevailing at the time of the transactions.  Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at the applicable rates of exchange in effect at the balance sheet date.  Exchange gains and losses are recorded in the consolidated statements of operations.
 
For translation of financial statements into the reporting currency, assets and liabilities are translated at the exchange rate at the balance sheet date, equity accounts are translated at historical exchange rates, and revenues, expenses, gains and losses are translated at the weighted average rates of exchange prevailing during the period.  Translation adjustments, when material, resulting from this process are recorded in accumulated other comprehensive income within stockholders’ equity.
 
Comprehensive income
 
ASC Topic 220, Comprehensive Income, requires the presentation of comprehensive income, in addition to the existing statements of operations.  Comprehensive income is defined as the change in equity during the year from transactions and other events, excluding the changes resulting from investments by owners and distributions to owners.
 
Use of estimates
 
The preparation of the consolidated financial statements in conformity with USGAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reported periods.  Actual amounts could differ from those estimates.  Estimates are used for, but not limited to, the accounting for certain items such as allowance for doubtful accounts, depreciation and amortization, impairment, inventory allowance, taxes and contingencies.
 
Operating leases
Leases where substantially all the rewards and risks of ownership of assets remain with the leasing company are accounted for as operating leases. Rental payables under operating leases are recognized as expenses on the straight-line basis over the lease term.
 
Allowance for doubtful accounts
Accounts receivable are stated at the amount billed to customers.  The Company recognizes an allowance for doubtful accounts to ensure trade and other receivables are not overstated due to uncollectibility. The Company’s estimate is based on a variety of factors, including historical collection experience, existing economic conditions and a review of the current status of the receivable. Accounts receivable are presented net of an allowance for doubtful accounts of US$6,174,000 and US$5,776,000 as of December 31, 2009 and 2008 respectively.

 
F-9

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008


 
2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Related parties
 
Parties are considered to be related if one party has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operating decisions.  Parties are also considered to be related if they are subject to common control or common significant influence.

Fair Value of Financial Instruments
SFAS No. 107, Disclosures about Fair Value of Financial Instruments, included in the Codification as ASC 825, Financial Instruments, requires that the Company discloses estimated fair values of financial instruments. The carrying amounts reported in the balance sheets for current assets and current liabilities qualifying as financial instruments are a reasonable estimate of fair value.

Fair value measurements
The Company adopted ASC Topic 820 – Fair Value Measurements and Disclosures (ASC 820.)  The adoption of ASC 820 did not have a material impact on our consolidated financial statements. ASC 820 establishes a three-tier fair value hierarchy to prioritize the inputs used in measuring fair value.  The hierarchy gives the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable inputs (Level 3).  The three levels are defined as follows:

 
Level 1:
Observable inputs, such as unadjusted quoted market prices in active markets for the identical asset or liabilities.

 
Level 2:
Inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument.

 
Level 3:
Unobservable inputs reflecting the entity’s own assumptions in measuring the asset or liability at fair value.

The Company’s financial instruments consist principally of cash deposits, accounts and other receivables, accounts payable, accrued liabilities, and short-term bank loans that generally approximate their fair values based on the short-term maturity of these instruments.

Recent accounting pronouncements
In May 2009, the FASB issued guidance, currently included in ASC Topic 855, Subsequent Events, which established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued (formerly SFAS No. 165, Subsequent Events). This guidance requires disclosure of the date through which subsequent events have been evaluated, as well as whether that is the date the financial statements were issued or the date the financial statements were available to be issued. The provisions of this guidance were effective for interim or annual financial periods ending after June 15, 2009.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 
F-10

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008


2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Recent accounting pronouncements (Continued)
In June 2009, the FASB issued an accounting standard, currently included in ASC Topic 105, Generally Accepted Accounting Principles (“ASC 105”), which established only two levels of GAAP, authoritative and nonauthoritative (formerly SFAS No. 168, The FASB Accounting Standards Codification TM  and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162 ). The FASB ASC became the only source of authoritative nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants.  All other nongrandfathered, non-SEC accounting literature not included in the ASC will become nonauthoritative.  ASC 105 was effective for financial statements issued in interim or annual reporting periods ending after September 15, 2009.  The ASC was not intended to change or alter existing GAAP, consequently the adoption of ASC 105 did not have a material impact on the Company’s consolidated financial statements.

In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”).  ASU 2009-13 addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services separately rather than as a combined unit and modifies the manner in which the transaction consideration is allocated across the separately identified deliverables.  ASU 2009-13 significantly expands the disclosures requirements for multiple-deliverable revenue arrangements.  ASU 2009-13 will be effective for the first annual reporting period beginning on or after June 15, 2010, and may be applied retrospectively for all periods presented or prospectively to arrangements entered into or materially modified after the adoption date.  Early adoption is permitted, provided that the guidance is retroactively applied to the beginning of the year of adoption. The Company is currently evaluating the impact this update will have on its consolidated financial statements.

In December 2009, FASB issued ASU No. 2009-16, Accounting for Transfers of Financial Assets. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140. The amendments in this Accounting Standards Update improve financial reporting by eliminating the exceptions for qualifying special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, the amendments require enhanced disclosures about the risks that a transferor continues to be exposed to because of its continuing involvement in transferred financial assets. Comparability and consistency in accounting for transferred financial assets will also be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.

 
F-11

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008


 
2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Recent accounting pronouncements (Continued)
In December, 2009, FASB issued ASU No. 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R). The amendments in this Accounting Standards Update replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which reporting entity has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. An approach that is expected to be primarily qualitative will be more effective for identifying which reporting entity has a controlling financial interest in a variable interest entity. The amendments in this Update also require additional disclosures about a reporting entity’s involvement in variable interest entities, which will enhance the information provided to users of financial statements. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.

In January 2010, FASB issued ASU No. 2010-01- Accounting for Distributions to Shareholders with Components of Stock and Cash. The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In January 2010, FASB issued ASU No. 2010-02 regarding accounting and reporting for decreases in ownership of a subsidiary. Under this guidance, an entity is required to deconsolidate a subsidiary when the entity ceases to have a controlling financial interest in the subsidiary.  Upon deconsolidation of a subsidiary, and entity recognizes a gain or loss on the transaction and measures any retained investment in the subsidiary at fair value.  In contrast, an entity is required to account for a decrease in its ownership interest of a subsidiary that does not result in a change of control of the subsidiary as an equity transaction.  This ASU clarifies the scope of the decrease in ownership provisions, and expands the disclosures about the deconsolidation of a subsidiary or de-recognition of a group of assets.  This ASU is effective for beginning in the first interim or annual reporting period ending on or after December 31, 2009. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.

In January 2010, FASB issued ASU No. 2010-02 – Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification. The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity.  The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. The Company is currently evaluating the impact this update will have on its consolidated financial statements.

 
F-12

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008 


 
2. 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Recent accounting pronouncements (Continued)
In January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers.  2)  Activity in Level 3 fair value measurements.  In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number).  This update provides amendments to Subtopic 820-10 that clarify existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3.  The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company is currently evaluating the impact this update will have on its consolidated financial statements.

3. 
EARNINGS PER SHARE

The Company reports earnings per share in accordance with ASC Topic 260 – Earnings Per Share (ASC 260). ASC 260 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share.

Basic earnings per share is computed based upon the weighted average number of shares of common stock outstanding during each period.

Diluted earnings per share is computed based on net income for the periods presented attributable to shareholders on the weighted average number of common stock outstanding during the periods presented, adjusted for the effect of the dilutive common stock equivalents outstanding during the periods presented. The dilutive effect of warrants to purchase common stock which were outstanding during the year ended December 31, 2008 is reflected in diluted earnings per share by application of the treasury stock method.  Since the warrants outstanding as of December 31, 2009 are anti-dilutive, there is no dilutive effect of warrants in the calculation of diluted earnings per share for the year ended December 31, 2009.

 
F-13

 

Telestone Technologies Corporation

Notes to Consolidated Financial Statements
Years ended December 31, 2009 and 2008


4. 
OPERATING RISKS

 
(a)
Concentration of major customers and suppliers
   
Years ended December 31,
 
   
2009
   
2008
 
   
US$’000
   
US$’000
 
Major customers with revenues of more than 10% of the Company’s sales
           
Sales to major customers
    65,322       31,677  
Percentage of sales
    90 %     90 %
Number
    2       2  
                 
Major suppliers with purchases of more than 10% of the Company’s purchases
               
Purchases from major suppliers
    2,950       2,921  
Percentage of purchases
    18 %     27 %
Number
    1       1  

Accounts receivable related to the Company’s major customers comprised 91% and 96% of all account receivables as of December 31, 2009 and 2008 respectively.

Credit risk represents the accounting loss that would be recognized at the reporting date if counter parties failed to perform as contracted. Concentrations of credit risk (whether on or off balance sheet) that arise from financial economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The major concentrations of credit risk arise from the Company’s accounts receivable. Even though the Company has major concentrations, it does not consider itself exposed to significant risk with regards to the related receivables.

 
(b)
Country risks

The Company may also be exposed to the risks as a result of its principal operation being primarily in the PRC. These include risks associated with, among others, the political, economic and legal environmental and foreign currency exchange. The Company’s results may be adversely affected by change in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things. The Company’s management does not believe these risks to be significant. There can be no assurance, however, those changes in political and other conditions will not result in any adverse impact.

(c)