UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended March 31, 2013.

 

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 001-34998

 

QKL STORES INC.

(Exact name of registrant as specified in its charter)

 

Delaware		75-2180652
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

 

4 Nanreyuan Street

Dongfeng Road

Sartu District

Daqing, P.R. China 163311

(Address of Principal Executive Offices including zip code)

 

011-86-459-4607987

(Registrant’s Telephone Number, Including Area Code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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 x No ¨

 

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company

 

Large Accelerated Filer   ¨	Accelerated Filer   ¨	Non-Accelerated Filer ¨	Smaller reporting company   x
		(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act).

Yes  ¨ No x

 

The Registrant had 1,522,326 shares of common stock outstanding on May 10, 2013.

 

 

QKL STORES, INC.

TABLE OF CONTENTS

 

PART I:  FINANCIAL INFORMATION	1
Item 1 – Interim Financial Statements	1
Condensed Consolidated Balance Sheets	1
Condensed Consolidated Statements of Income	2
Condensed Consolidated Statements of Cash Flows	3
Notes to Unaudited Condensed Consolidated Financial Statements	4
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3 – Quantitative and Qualitative Disclosures about Market Risk	18
Item 4 – Controls and Procedures	18
PART II:  OTHER INFORMATION	19
Item 1 – Legal Proceedings	19
Item 1A – Risk Factors	19
Item 2 – Unregistered Sales of Equity Securities and Use Of Proceeds	19
Item 3 – Defaults Upon Senior Securities	19
Item 4 – Mine Safety Disclosures	19
Item 5 – Other Information	19
Item 6 – Exhibits	19
Signatures	21

 

 

PART I. FINANCIAL INFORMATION

Item 1. Interim Financial Statements

 

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

 

		March 31,  2013				December 31, 2012
		(Unaudited)
ASSETS
Cash		$	32,459,219			$	8,479,413
Restricted cash			253				253
Accounts receivable			371,160				796,897
Inventories			43,528,151				59,812,645
Other receivables			17,706,392				18,042,360
Prepaid expenses			9,366,871				11,083,708
Advances to suppliers			3,510,707				9,525,250
Deferred income tax assets			6,827,412				6,327,932
Total current assets			113,770,165				114,068,458
Property, plant and equipment, net			44,336,463				45,439,360
Land use rights, net			719,526				724,760
Goodwill			-				-
Other assets			12,751				12,976
Total assets		$	158,838,905			$	160,245,554
LIABILITIES AND SHAREHOLDERS’ EQUITY
Short-term loans		$	15,919,511			$	15,832,555
Accounts payable			25,779,751				30,900,586
Cash card and coupon liabilities			21,391,561				18,604,188
Customer deposits received			3,233,295				1,248,278
Accrued expenses and other payables			25,277,134				28,097,212
Income taxes payable			88,594				2,726
Total current liabilities			91,689,846				94,685,545
Total liabilities			91,689,846				94,685,545
Shareholders’ equity
Common stock, $0.001 par value per share, authorized 100,000,000 shares, issued and outstanding 1,522,326 and 1,443,948 shares at March 31, 2013 and December 31, 2012* respectively			1,522				1,444
Series A convertible preferred stock, par value $0.01, authorized 10,000,000 shares, issued and outstanding 529,412 and 2,386,110 shares at March 31, 2013 and December 31, 2012 respectively			5,294				23,861
Additional paid-in capital			92,521,489				92,503,000
Retained earnings – appropriated			8,323,312				8,323,312
Retained earnings			(47,438,438	)			(47,841,708	)
Accumulated other comprehensive income			13,735,880				12,550,100
Total shareholders’ equity			67,149,059				65,560,009
Total liabilities and shareholders’ equity		$	158,838,905			$	160,245,554

 

*The number of shares of common stock has been retroactively restated to reflect the 1-for-8 Reverse Stock Split effected on February 4, 2013.

 

See notes to unaudited condensed consolidated financial statements.

 

 

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Income

 

		(Unaudited)
		Three Months Ended March 31,
		2013				2012
Net sales		$	97,057,191			$	112,038,616
Cost of sales			80,417,743				92,983,490
Gross profit			16,639,448				19,055,126
Operating expenses:
Selling expenses			13,324,213				15,130,888
General and administrative expenses			2,518,336				2,375,774
Total operating expenses			15,842,549				17,506,662
Income from operations			796,899				1,548,464
Non-operating expense:
Interest income			193,573				26,528
Interest expense			(297,608	)			(293,909	)
Total non-operating loss			(104,035	)			(267,381	)
Income before income taxes			692,864				1,281,083
Income taxes			289,594				450,482
Net income			403,270				830,601
Comprehensive income statement:
Net income			403,270				830,601
Foreign currency translation adjustment			1,185,780				862,477
Comprehensive income		$	1,589,050			$	1,693,078
Basic earnings per share of common stock		$	0.27			$	0.54
Diluted earnings per share		$	0.27			$	0.54
Weighted average shares used in calculating net income per ordinary share – basic			1,476,735				1,306,025
Weighted average shares used in calculating net income per ordinary share – diluted			1,510,828				1,543,297

 

See notes to unaudited condensed consolidated financial statements.

 

 

QKL STORES INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

 

		(Unaudited)
		Three Months Ended March 31,
		2013				2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	403,270			$	830,601
Depreciation			1,678,164				1,641,431
Amortization			8,036				7,224
Share-based compensation			204,117				216,158
Deferred income tax			(464,414	)			304,196
Loss on disposal of fixed assets			25,491				6,137
Adjustments to reconcile net income to net cash provided by operating activities:
Accounts receivable			429,824				11,978
Inventories			16,601,846				12,704,657
Other receivables			537,181				3,504,787
Prepaid expenses			1,776,872				1,229,951
Advances to suppliers			6,062,785				2,306,768
Accounts payable			(5,286,996	)			(696,663	)
Cash card and coupon liabilities			2,683,392				1,257,931
Customer deposits received			1,976,833				(415,828	)
Accrued expenses and other payables			(2,453,301	)			6,507,064
Income taxes payable			85,795				(8,580	)
Net cash provided by operating activities			24,268,895				29,407,812
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment			(350,987	)			(827,585	)
Decrease of restricted cash			-				-
Net cash used in investing activities			(350,987	)			(827,585	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Bank loan repayment			-				(1,581,103	)
Net cash used in financing activities			-				(1,581,103	)
Effect of foreign currency translation			61,898				41,588
Net increase in cash			23,917,908				26,999,124
Cash – beginning of period			8,479,413				9,037,550
Cash – end of period		$	32,459,219			$	36,078,262
Supplemental disclosures of cash flow information:
Interest paid		$	297,608			$	293,909
Income taxes paid		$	203,799			$	459,062

 

See notes to unaudited condensed consolidated financial statements.

 

 

QKL STORES INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION AND BUSINESS OPERATIONS

 

QKL Stores Inc. (“Store”) was incorporated under the laws of the State of Delaware on December 2, 1986. Store currently operates through a wholly owned subsidiary in the British Virgin Islands: Speedy Brilliant Group Ltd. (“Speedy Brilliant (BVI)”), wholly owned subsidiary of Speedy Brilliant (BVI) located in Mainland China: Speedy Brilliant (Daqing) Ltd. (“Speedy Brilliant (Daqing)” or “WFOE”), operating company located in Mainland China: Daqing Qingkelong Chain Commerce & Trade Co., Ltd. (“Qingkelong Chain”), which Store controls, through contractual arrangements between WFOE and Qingkelong Chain, as if Qingkelong Chain were a wholly owned subsidiary of Store, wholly owned operating subsidiary of Qingkelong Chain located in Mainland China:  Daqing Qinglongxin Commerce & Trade Co., Ltd (“Qinglongxin Commerce”) and wholly owned operating company located in Mainland China: Daqing Longqing Microcredit Co., Ltd. (“QKL-LQ”), which Qingkelong Chain controls, through arrangement that absorbs operations risk, as if QKL-LQ were a wholly-owned subsidiary of Qingkelong Chain.

 

The Store and its subsidiaries (hereinafter, collectively referred to as the “Company”) are engaged in the operation of retail chain stores in the PRC. The principal business activity of QKL-LQ is money lending.

 

The Company is a regional supermarket chain that currently operates 28 supermarkets, 14 hypermarkets and 4 department stores in northeastern China and Inner Mongolia. The Company’s supermarkets and hypermarkets sell a broad selection of merchandise including groceries, fresh food and non-food items. A supermarket offers various daily necessities on a self-service basis and averages 2,500 square meters in sales area. A hypermarket is similar to a supermarket but has a larger operating scale, and is typically over 4,500 square meters in sales area. The Company currently has three distribution centers servicing its supermarkets. 

 

The Company is the first supermarket chain in northeastern China and Inner Mongolia that is a licensee of the Independent Grocers Alliance, or IGA, a United States-based global grocery network. As a licensee of IGA, the Company is able to engage in group bargaining with suppliers and have access to more than 2,000 private IGA brands, including many that are exclusive IGA brands.

 

Principles of Consolidation and Presentation

 

The condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).  The condensed consolidated financial statements include the financial statements of QKL Stores Inc., and its wholly owned subsidiaries.  All intercompany accounts, transactions, and profits have been eliminated upon consolidation.

 

The accompanying interim unaudited condensed consolidated financial statements (“Interim Financial Statements”) of the Company and its wholly owned subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and are presented in accordance with the requirements of Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these Interim Financial Statements do not include all of the information and notes required by GAAP for complete financial statements. These Interim Financial Statements should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2012 included in the Company’s Form 10-K. In the opinion of management, the Interim Financial Statements included herein contain all adjustments, including normal recurring adjustments, considered necessary, in management’s opinion, to present fairly the Company’s financial position, the results of operations and cash flows for the interim periods presented.  The operating results and cash flows of the interim periods presented herein are not necessarily indicative of the results to be expected for any other interim period or the full year. 

 

 

QKL STORES INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires 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 the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

 

Segment Reporting

 

The Company operates in one industry segment, operating retail chain stores.  ASC 280, Segment Reporting, establishes standards for reporting information about operating segments. Given the economic characteristics of the similar nature of the products sold, the type of customer and the method of distribution, the Company operates as one reportable segment as defined by ASC 280, Segment Reporting.

 

Revenue Recognition

 

The Company earns revenue by selling merchandise primarily through its retail stores. Revenue is recognized when merchandise is purchased by and delivered to the customer and is shown net of estimated returns during the relevant period. The allowance for sales returns is estimated based upon historical experience.

 

Cash received from the sale of cash cards (aka “gift cards”) is recorded as a liability, and revenue is recognized upon the redemption of the cash card or when it is determined that the likelihood of redemption is remote (“cash card breakage”) and no liability to relevant jurisdictions exists. The Company determines the cash card breakage rate based upon historical redemption patterns and recognizes cash card breakage on a straight-line basis over the estimated cash card redemption period.  The Company recognized approximately nil in cash card breakage revenue for the three months ended March 31, 2013 and 2012.

 

The Company records sales tax collected from its customers on a net basis, and therefore excludes it from revenue as defined in ASC 605, Revenue Recognition.

 

Included in revenue are sales of returned merchandise to vendors specializing in the resale of defective or used products, which accounted for less than 0.5% of net sales in each of the periods reported.

  

Cost of Sales

 

Cost of sales includes the cost of merchandise, related cost of packaging and shipping cost, and the distribution center costs.

 

Selling Expenses

 

Selling expenses include store-related expense, other than store occupancy costs, as well as advertising, depreciation and amortization, utilities, labour costs, preliminary expenses and certain expenses associated with operating the Company’s corporate headquarters.

 

Advertising Costs

 

Advertising costs are expensed as incurred. Advertising expense, net of reimbursement from suppliers, amounted to $97,172 and $30,576 for the three months ended March 31, 2013 and 2012, respectively. Advertising expense is included in selling expenses in the accompanying condensed consolidated statements of income. The Company receives co-operative advertising allowances from vendors in order to subsidize qualifying advertising and similar promotional expenditures made relating to vendors’ products. These advertising allowances are recognized as a reduction to selling expenses when the Company incurs the advertising cost eligible for the credit. Co-operative advertising allowances recognized as a reduction to selling expenses amounted to nil for the three months ended March 31, 2013 and 2012.

 

 

Vendor Allowances

 

The Company receives allowances for co-operative advertising and volume purchase rebates earned through programs with certain vendors. The Company records a receivable for these allowances which are earned but not yet received when it is determined the amounts are probable and reasonably estimable, in accordance with ASC 605. Amounts relating to the purchase of merchandise are treated as a reduction of inventory cost and reduce cost of goods sold as the merchandise is sold. Amounts that represent a reimbursement of costs incurred, such as advertising, are recorded as a reduction in selling and administrative expense. The Company performs detailed analyses to determine the appropriate amount of vendor allowances to be applied as a reduction of merchandise cost and selling expenses.

 

Inventories

 

Inventories primarily consist of merchandise inventories and are stated at lower of cost or market and net realizable value. Cost of inventories is calculated on the weighted average basis which approximates cost.

 

Management regularly reviews inventories and records valuation reserves for damaged and defective returns, inventories with slow-moving or obsolescence exposure and inventories with carrying value that exceeds market value. Because of its product mix, the Company has not historically experienced significant occurrences of obsolescence.

 

Inventory shrinkage is accrued as a percentage of revenues based on historical inventory shrinkage trends. The Company performs physical inventory count of its stores once per quarter and cycle counts inventories at its distribution centers once per quarter throughout the year. The reserve for inventory shrinkage represents an estimate for inventory shrinkage for each store since the last physical inventory date through the reporting date.

 

These reserves are estimates, which could vary significantly, either favorably or unfavorably, from actual results if future economic conditions, consumer demand and competitive environments differ from expectations.

 

Income Taxes

 

The Company follows ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

 

The Company adopted ASC 740-10-25 on January 1, 2007, which provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax position.  The Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The Company did not recognize any additional liabilities for uncertain tax positions as a result of the implementation of ASC 740-10-25.

 

Fair Value Measurements

 

ASC 820 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.

 

ASC 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.  ASC 820 establishes three levels of inputs that may be used to measure fair value:

 

 

·

Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company holds. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

 

·

Level 2 – Valuation based on quoted prices in markets that are not active for which all significant inputs are observable, either directly or indirectly.

 

·

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

The Company adopted ASC 820, Fair Value Measurements and Disclosures, on January 1, 2008 for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis (at least annually). ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The Company has also adopted ASC 820, on January 1, 2009 for non financial assets and non financial liabilities, as these items are not recognized at fair value on a recurring basis. The adoption of ASC 820 for all financial assets and liabilities and non-financial assets and non-financial liabilities did not have any impact on the Company’s consolidated financial statements.

 

Financial instruments include cash, accounts receivable, prepayments and other receivables, short-term borrowings from banks, accounts payable and accrued expenses and other payables. The carrying amounts of cash, accounts receivable, prepayments and other receivables, short-term loans, accounts payable and accrued expenses approximate their fair value due to the short-term maturities of these instruments. See footnote 7 regarding the fair value of the Company’s warrants, which are classified as Level 3 liabilities in the fair value hierarchy.

 

Recently Issued Accounting Guidance

 

In January 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. This ASU clarifies that ordinary trade receivables and receivables are not in the scope of ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. Specifically, ASU 2011-11 applies only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in the FASB Accounting Standards Codification™ (Codification) or subject to a master netting arrangement or similar agreement. The FASB undertook this clarification project in response to concerns expressed by U.S. stakeholders about the standard’s broad definition of financial instruments. After the standard was finalized, companies realized that many contracts have standard commercial provisions that would equate to a master netting arrangement, significantly increasing the cost of compliance at minimal value to financial statement users. An entity is required to apply the amendments in ASU 2013-01 for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented. The effective date is the same as the effective date of ASU 2011-11.

 

In February 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This ASU improves the transparency of reporting these reclassifications. Other comprehensive income includes gains and losses that are initially excluded from net income for an accounting period. Those gains and losses are later reclassified out of accumulated other comprehensive income into net income. The amendments in this ASU do not change the current requirements for reporting net income or other comprehensive income in financial statements. All of the information that this ASU requires already is required to be disclosed elsewhere in the financial statements under U.S. GAAP.

 

The new amendments will require an organization to:

 

¨         Present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income - but only if the item reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period.

 

¨         Cross-reference to other disclosures currently required under U.S. GAAP for other reclassification items (that are not required under U.S. GAAP) to be reclassified directly to net income in their entirety in the same reporting period. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is initially transferred to a balance sheet account (e.g., inventory for pension-related amounts) instead of directly to income or expense.

 

The amendments apply to all public and private companies that report items of other comprehensive income. Public companies are required to comply with these amendments for all reporting periods (interim and annual). A private company is required to meet the reporting requirements of the amended paragraphs about the roll forward of accumulated other comprehensive income for both interim and annual reporting periods. However, private companies are only required to provide the information about the effect of reclassifications on line items of net income for annual reporting periods, not for interim reporting periods. The amendments are effective for reporting periods beginning after December 15, 2012, for public companies and are effective for reporting periods beginning after December 15, 2013, for private companies. Early adoption is permitted.

 

 

In February 2013, FASB issued Accounting Standards Update (ASU) No. 2013-03, Financial Instruments (Topic 825). This ASU clarifies the scope and applicability of a disclosure exemption that resulted from the issuance of Accounting Standards Update No. 2011-04,Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendment clarifies that the requirement to disclose"the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2, or 3)" does not apply to nonpublic entities for items that are not measured at fair value in the statement of financial position, but for which fair value is disclosed. This ASU is the final version of Proposed Accounting Standards Update 2013-200—Financial Instruments (Topic 825) which has been deleted. The amendments are effective upon issuance.

 

In February 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-04, Liabilities (Topic 405): Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date. This ASU provides guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this ASU is fixed at the reporting date, except for obligations addressed within existing guidance in U.S. GAAP. The guidance requires an entity to measure those obligations as the sum of the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors and any additional amount the reporting entity expects to pay on behalf of its co-obligors. The guidance in this ASU also requires an entity to disclose the nature and amount of the obligation as well as other information about those obligations. The amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2014, and interim periods and annual periods thereafter. The amendments in this ASU should be applied retrospectively to all prior periods presented for those obligations resulting from joint and several liability arrangements within the ASU’s scope that exist at the beginning of an entity’s fiscal year of adoption. An entity may elect to use hindsight for the comparative periods (if it changed its accounting as a result of adopting the amendments in this ASU) and should disclose that fact. Early adoption is permitted.

 

In March 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-05, Foreign Currency Matters (Topic 830). This ASU resolve the diversity in practice about whether Subtopic 810-10, Consolidation—Overall, or Subtopic 830-30, Foreign Currency Matters—Translation of Financial Statements, applies to the release of the cumulative translation adjustment into net income when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business (other than a sale of in substance real estate or conveyance of oil and gas mineral rights)within a foreign entity. In addition, the amendments in this Update resolve the diversity in practice for the treatment of business combinations achieved in stages (sometimes also referred to as step acquisitions) involving a foreign entity. This ASU is the final version of Proposed Accounting Standards Update EITF11Ar—Foreign Currency Matters (Topic 830), which has been deleted. The amendments in this Update are effective prospectively for fiscal years (and interim reporting periods within those years) beginning after December 15, 2013. For nonpublic entities the amendments in this Update are effective prospectively for the first annual period beginning after December 15, 2014, and interim and annual periods thereafter. The amendments should be applied prospectively to derecognition events occurring after the effective date. Prior periods should not be adjusted. Early adoption is permitted. If an entity elects to early adopt the amendments, it should apply them as of the beginning of the entity’s fiscal year of adoption.

 

The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on results of operations, financial condition, or cash flows, based on current information.

 

NOTE 3 – OTHER RECEIVABLES

 

Other receivables consisted of the following:

 

		March 31, 2013  (Unaudited)				December 31, 2012
Deposits		$	2,953,642			$	2,860,232
Purchase deposits			248,018				240,174
Input value added tax receivables			4,564,820				4,420,456
Rebates receivables			2,443,807				2,366,521
Loans to customers			7,175,406				7,844,421
Others			320,699				310,556
Total other receivables		$	17,706,392			$	18,042,360

 

 

NOTE 4 – PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment consisted of the following:

 

		March 31, 2013 (Unaudited)				December 31, 2012
Buildings		$	6,810,513			$	6,773,312
Shop equipment			19,809,567				19,483,024
Office equipment			4,259,003				4,243,396
Motor vehicles			1,468,347				1,460,327
Car park			20,504				20,392
Leasehold improvements			27,299,271				27,150,156
Construction in progress			10,060,449				10,008,740
Total property, plant and equipment			69,727,654				69,139,347
Less:  accumulated depreciation and amortization			(25,391,191	)			(23,699,987	)
Total property, plant and equipment, net		$	44,336,463			$	45,439,360

 

The depreciation expenses for the period ended March 31, 2013 and 2012 were $1,678,164 and $1,641,431, respectively.

 

NOTE 5 – ACCRUED EXPENSES AND OTHER PAYABLES

 

Accrued expenses and other payables consisted of the following:

 

		March 31, 2013 (Unaudited)				December 31, 2012
Accrued expenses		$	20,224,289			$	16,146,809
VAT and other PRC tax payable			168,443				134,483
Shop equipment and leasehold improvements payables			626,613				500,280
Amount due to a director – unsecured, interest free and no repayment date(1)			-				7,916,277
Deposit from vendors and employees			4,257,789				3,399,363
Total accrued expenses and other payables		$	25,277,134			$	28,097,212

 

(1)

The amount was used for the incorporation of QKL-LQ and was fully repaid in March 2013.

 

NOTE 6 – EARNINGS PER SHARE

 

The Company calculates earnings per share in accordance with ASC 260, Earnings Per Share, which requires a dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of shares outstanding during the fiscal year. Potentially dilutive common shares consist of convertible preferred stock (using the if-converted method) and exercisable warrants and stock options outstanding (using the treasury method). Holder of Series A convertible preferred stock participate in dividends of the Company on the same basis as holders of the Company’s common stock and is therefore included in the calculation of basic earnings per share using the two class method.

 

 

The following table sets forth the computation of basic and diluted net income per common share:

 

		(Unaudited)
		Three Months Ended March 31,
		2013				2012
Net income to QKL Stores, Inc. for computing basic net income per share			403,270				830,601
Undistributed earnings allocated to Series A Convertible Preferred Stock			9,100				127,700
Net income attributable to ordinary shareholders for computing basic net income per ordinary share			394,170				702,901
Weighted-average shares of common stock outstanding in computing net income per common stock
Basic			1,476,735				1,306,025
Dilutive shares:
Conversion of Series A Convertible Preferred Stock			34,093				237,272
Dilutive effect of stock warrants and options
Anti-dilutive effect of preferred stock
Diluted			1,510,828				1,543,297
Basic earnings per share of common stock		$	0.27			$	0.54
Diluted earnings per share		$	0.27			$	0.54

 

The 490,369 shares of stock warrants and 84,708 options were not included in the computation of diluted net earnings per share as their effects would have been anti-dilutive since the average share price for the three months ended March 31, 2013 and 2012 were lower than the options and warrants exercise price.

 

NOTE 7 – STOCK WARRANTS

 

Series A and Series B Stock Warrants

 

As a result of a completed sale of 9,117,647 units for cash proceeds of $15,500,000 on March 28, 2008, the Company issued Series A stock warrants of 242,611 and Series B stock warrants of 241,705 which can be converted on a one-for-one basis into shares of the Company’s common stock. The stock warrants have a five year life and the Series A warrants are exercisable at an equivalent price of $81.60 per share and the Series B are exercisable at an equivalent price of $102.00 per share. These stock warrants expired on March 28, 2013 pursuant to the warrant agreements.

 

The Company used the Black-Scholes option pricing model to determine the fair value of the Series A and B stock warrants on March 28, 2008 (assumptions used – expected life of 5 years, volatility of 89%, risk free interest rate of 2.51%, and expected dividend yield of 0%).

 

Effective January 1, 2009, the Company adopted the provisions of FASB ASC Topic 815, “Derivatives and Hedging” (“ASC 815”) (previously EITF 07-5, “Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity’s Own Stock”). As a result of adopting ASC 815, warrants to purchase 484,315 of the Company’s common stock previously treated as equity pursuant to the derivative treatment exemption were no longer afforded equity treatment as there was a down-round protection (full-ratchet down round protection).   As a result, the warrants were not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of these warrants were recognized in earnings until such time as the warrants are exercised or expire.  The Company reclassified the fair value of these warrants from equity to liability, as if these warrants were treated as a derivative liability. On January 1, 2009, the Company recorded as a cumulative effect adjustment of decreasing additional paid-in capital of $6,020,000 and beginning retained earnings of $2,792,017 and $8,812,017 to warrant liabilities to recognize the fair value of such warrants. The fair value of the warrants was $44,304,034 on December 31, 2009. The Company recognized $35,492,017 loss from the change in fair value of warrants for the year ended December 31, 2009.

 

 

The Company amended Series A and Series B stock warrant agreements deleting the down-round protection (full-ratchet down round protection) provision on March 24, 2010. As a result of this amendment, the Company is no longer required to treat Series A and Series B warrants as a liability and was reclassified to equity as of March 24, 2010 (assumption used – expected life of 3 years, volatility of 57%, and risk free interest rate of 1.67%, and expected dividend yield of 0%). Based on the revaluation, the Company recognized $7,801,649 of income related to this transaction and reclassified $36,502,385 to equity for the year ended December 31, 2010.

 

Warrant C

 

On January 22, 2010, the Company issued a warrant (“Warrant C”) to a non-related individual in exchange for consulting services relating to operational and managerial experience. Warrant C can be converted into 8,333 shares of the Company’s common stock at an exercise price of $120 per share. Warrants C has a five year term and became exercisable 180 days from the date of issuance of Warrant C.

 

The Company recognized share-based compensation cost based on the grant-date fair value estimated in accordance with ASC 505-50 “equity based payments to non-employees”. The fair value of these stock warrants on the date of grant was estimated using the Black-Scholes method (assumption used – expected life of 2.75 years, volatility of 54%, and risk free interest rate of 1.25%, and expected dividend yield of 0%). The Company recognized $558,180 of compensation expense related to this transaction. 

 

A summary of the Company’s stock warrant activities are as follows:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term
Balance – December 31, 2012			490,369			$	92.24			$	0.27
Exercised			-				-				-
Cancelled			-				-				-
Balance – March 31, 2013			490,369			$	92.24			$	0.00

 

NOTE 8 – SHARED BASED COMPENSATION

 

Under the 2009 Omnibus Securities and Incentive Plan, on September 14, 2009, the Company entered into stock option agreements with its three independent directors, granting each director options to purchase 833 shares of the Company’s common stock at an exercise price of $192.00 per share. The options vest in approximately equal amounts on the three subsequent anniversary dates of the grant and expire on the fifth anniversary of the date of agreement of or the date the option is fully exercised. On January 30, 2010, the Company entered into amendment agreements with its three directors to correct the exercise price to $180.00, which was the fair market value on the date of the grant. The correction of this error was considered immaterial.

 

Under the 2009 Omnibus Securities and Incentive Plan, on June 26, 2010, the Company granted its Chief Operating Officer, Alan Stewart and 20 employees options to acquire 86,250 shares of the Company's common stock at an exercise price of $105.60 per share. The options vest in approximately equal amounts on the four subsequent anniversary dates of the grant and expire on the eighth anniversary of the date of agreement of or the date the option is fully exercised. On June 17, 2011, Mr. Alan Stewart resigned from his position as Chief Operating Officer of QKL Stores Inc. This has no material impact on the Company’s consolidated financial statements.

 

Under the 2009 Omnibus Securities and Incentive Plan, on December 2, 2010, the Company granted its Chief Financial Officer, Tsz-Kit Chan options to acquire 4,167 shares of the Company's common stock at an exercise price of $82.08 per share. The options vest in approximately equal amounts on the four subsequent anniversary dates of the grant and expire on the eighth anniversary of the date of agreement of or the date the option is fully exercised. 

 

 

The Company accounts for its share-based compensation in accordance with ASC 718 and recognizes compensation expense using the fair-value method on a straight-line basis over the requisite service period for share option awards and non-vested share awards granted which vested during the period.  The fair value for these awards was estimated using the Black-Scholes option pricing model on the date of grant with the following assumptions:

 

		September 14,  2009				June 26,  2010				December 2,  2010
Expected life (years)			3.5				3.25				3.25
Expected volatility			41.2	%			53	%			44.9	%
Risk-free interest rate			1.69	%			1.49	%			0.96	%
Dividend yield			-				-				-

 

The expected volatilities are based on the historical volatility of the Company’s common stock.  The observation is made on a weekly basis.  The observation period covered is consistent with the expected life of the options.  The expected life of stock options is based on the minimum vesting period required.  The risk-free rate is consistent with the expected terms of the stock options and is based on the United States Treasury yield curve in effect at the time of grant.

 

Stock-based compensation expenses recognized was $204,117 for the three months months ended March 31, 2013. A summary of the Company’s stock options activities under the 2009 Omnibus Securities and Incentive Plan are as follows:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term(Years)				Intrinsic Value
Outstanding – December 31, 2012			84,708			$	106.64				1.46			$	-
Granted			-				-				-				-
Exercised			-				-				-				-
Forfeited			-				-				-				-
			-				-				-				-
Outstanding– March 31, 2013			84,708			$	106.64				1.21			$	-
Exercisable – March 31, 2013			51,825			$	108.08				1.18			$	-

 

As of March 31, 2013, there was $1,020,308 of total unrecognized compensation cost related to non-vested share option awards granted.  Such cost is expected to be recognized over a weighted-average period of 1-2 years.

 

NOTE 9 - COMMITMENTS AND CONTINGENCIES

 

Operating Leases

 

Certain of our real properties and equipment are operated under lease agreements. Rental expense under operating leases was as follows:

 

		(Unaudited)
		Three Months Ended March 31
		2013				2012
Rent expense		$	2,048,374			$	2,763,837
Less: Sublease income			(496,774	)			(585,032	)
Total rent expense, net		$	1,551,600			$	2,178,805

 

Annual minimum payments under operating leases are as follows:

 

As of March 31,		Minimum Lease Payment				Sublease Income				Net Minimum Lease Payment
2014		$	8,476,722			$	1,104,591			$	7,372,131
2015			8,473,768				4,104				8,469,664
2016			8,378,781				-				8,378,781
2017			8,180,653				-				8,180,653
2018			7,980,562				-				7,980,562
Thereafter			73,394,690				-				73,394,690
Total		$	114,885,176			$	1,108,695			$	113,776,481

 

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis of the QKL Stores Inc. and subsidiaries (“we”, “our”, “us”) financial condition and results of operations includes information with respect to our plans and strategies for our business and should be read in conjunction with our interim unaudited condensed consolidated financial statements and related notes (“Interim Financial Statements”) included herein and our consolidated financial statements and related notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K for the fiscal year ended December 31, 2012.

 

Overview

 

We are a regional supermarket chain that currently operates 28 supermarkets, 14 hypermarkets and 4 department stores in northeastern China and Inner Mongolia. Our supermarkets and hypermarkets sell a broad selection of merchandise including groceries, fresh food and non-food items. A supermarket offers various daily necessities on a self-service basis and averages 2,500 square meters in sales area. A hypermarket is similar to a supermarket but has a larger operating scale, and is typically over 4,500 square meters in sales area. We currently have three distribution centers servicing our supermarkets.

 

We are the first supermarket chain in northeastern China and Inner Mongolia that is a licensee of the Independent Grocers Alliance, or IGA, a United States-based global grocery network. As a licensee of IGA, We are able to engage in group bargaining with suppliers and have access to more than 2,000 private IGA brands, including many that are exclusive IGA brands.

 

Our expansion strategy emphasizes growth through geographic expansion in northeastern China and Inner Mongolia, where we believe local populations can support profitable supermarket operations, and where we believe competition from large foreign and national supermarket chains, which generally have resources far greater than ours, is limited.  Our strategies for profitable operations include buy-side initiatives to reduce supply costs; focusing on merchandise with higher margins, such as foods we prepare ourselves and private label merchandise; and increasing reliance on the benefits of membership in the international trade group IGA.

 

We completed the initial steps in the execution of our expansion plan in March 2008, when we raised financing through the combination of our reverse merger and private placement and also raised additional financing in our public offering in the fourth quarter of 2009. Under our expansion plan, we opened:

 

·

ten new stores in 2008 that have in the aggregate approximately 42,000 square meters of space

 

·

seven new stores in 2009 that have, in the aggregate, approximately 32,000 square meters of space

 

·

nine new stores in 2010 that have in the aggregate approximately 74,189 square meters of space

 

·

fourteen new stores in the 2011 that have in the aggregate approximately 101,000 square meters of space

 

·

one new store in 2012 that has approximately 5,700 square meters of space

 

We are making improvements to our logistics and information systems to support our supermarkets. We expect to finance our expansion plan from funds generated from operations, bank loans and proceeds from our public offering in the fourth quarter of 2009.

 

On March 28, 2012, QKL-China formed QKL-LQ for money lending business. Currently, the business activity of QKL-LQ is immaterial.

 

On June 11, 2012, we completed a 1-for-3 reverse stock split of our common stock (the “2012 Stock Split”), such that for each three shares outstanding prior to the 2012 Stock Split there was one share outstanding after the 2012 Stock Split.

 

On February 4, 2013, we completed a 1-for-8 reverse stock split of our common stock (the “2013 Stock Split”), such that for each eight shares outstanding prior to the 2013 Stock Split there was one share outstanding after the 2013 Stock Split.

 

Our Operations in China

 

Our headquarters and all of our stores are located in the provinces of northeastern China and Inner Mongolia. The economy of this area has grown rapidly over the last four to five years and we believe that the national government is committed to enhancing economic growth in the region. In December 2003, a major economic-development plan for northeastern China, the “Plan for Revitalizing Northeast China,” was announced by an office of the national government’s State Council.

 

Based on our own research, we believe there are approximately 200 to 300 small and medium-sized cities in northeast China without modern supermarket chains. We believe the number of supermarket customers and the demand for supermarkets in these cities are likely to grow significantly over the next several years as the region continues to experience urbanization.

 

 

Our Strategy for Growth and Profitability

 

Our strategic plan includes the following principal components:  expanding by opening stores in new strategic locations, and improving profitability by decreasing the cost through resource purchase, setting up distribution centers and increasing the percentage of our sales attributable to private label merchandise, membership sales and gift card sales.

 

Expanded Operations

 

As of March 31, 2013, we operated 28 supermarkets, 14 hypermarkets, 4 department stores, and 3 distribution centers, one in Daqing, one in Shenyang and one in Harbin. We are making improvements to our logistics and information systems to support our supermarkets. We expect to finance our expansion plan from funds generated from operations and bank loans.

 

Private Label Merchandise

 

Some of the merchandise we sell is made to our specifications by manufacturers using the QKL brand name.  We refer to such merchandise as “private label” merchandise.  With private label merchandise, we entrust the manufacturer to make the product and to select the name and design.  Under our agreements with the private label manufacturer, the private label manufacturers cannot sell the product to any other party. Sales of private label merchandise accounted for approximately 6.0% of our total revenues for the first three months ended March 31, 2013 and 2012. In June 2008, we established a specialized department for designing and purchasing private label merchandise, in which 7 full-time employees currently work. Our goal is to increase private label sales to 20% of our total revenues.

 

Principal Factors Affecting Our Results

 

The following factors have had, and we expect they will continue to have, a significant effect on our business, financial condition and results of operations.

 

Seasonality – Our business is subject to seasonality, with increased sales in the first quarter and fourth quarter, due to increases in shopping and consumer activity as a result of the holidays such as New Year (January 1), Chinese Lunar New Year (January or February), the Dragon Festival (February 2), Women’s Day (March 8), the Back to  School Day (March 1), National Day (October 1), Mid-Autumn Festival (September or October) and Christmas (December 25).

 

Timing of New Store Openings – Growth through new store openings is a fundamental part of our strategy. Our new stores typically operate at a loss for approximately three months due to start-up inventory and other costs, promotional discounts and other marketing costs and strategies associated with new store openings, rental expenses and costs related to hiring and training new employees.  Our operating results, and in particular our gross margin, have and will continue to vary based in part on the pace of our new store openings.

 

Locations for New Store – Good commercial space that meets our standards, in locations that meet our needs, may be scarce in some of the cities we wish to enter. One option for entering certain target markets within our intended timeframe may be to begin operations in a location that is not optimal and wait for an opportunity to move to a better location. Alternatively, we may seek to enter into a target market through acquisitions. As such, the timing and costs associated with entry into new markets can be difficult to predict.  Identifying and pursuing opportunities will be a resource-intensive challenge, and if we do not perform or if actual costs of entering new markets exceed our expectations, our total revenues, cash flows, and liquidity could suffer.

 

Logistics of Geographic Expansion – Opening additional stores in cities further from our headquarters in Daqing will mean that the transportation of our supplies and personnel among our stores will become more difficult and subject to disruption. To alleviate this, we have opened a new distribution center in Shenyang in November 2011. We started using our regional purchasing systems in 2008. All fresh food is ordered by individual stores based on their needs from local vendors designated by our headquarters or regional purchasing department and is delivered directly by the local vendors to individual stores. A portion of our non-perishable food and non-food items are distributed from our distribution center to our different stores, and the remaining portion is purchased by our regional purchasing department or headquarters and delivered directly to individual stores. Long-distance transportation for both food and non-food items from our distribution center to our stores can be challenging in the winter as the roads can be covered with snow. As we expand in territories further from our existing or planned distribution facilities, the costs of delivering food and merchandise may become less predictable and more volatile.

 

 

Human Resources – In our experience, it takes approximately three months to train new employees to operate a new store. Training and supervision is organized by experienced teachers in our training school. The management team for a new store is hired first and is trained in our training school, where they learn our culture and operations. Employees are hired afterwards, and are trained by both our teachers and the management team. In addition, the management team and the employees are sent to existing stores to get practical training from the employees and management team members in those stores. Eventually, local employees must learn to perform the training and supervisory roles themselves. If we do not perform well in response to these challenges, our operating costs will rise and our margins will fall.

 

Shortages of Trained Staff in Our New Locations – Opening stores in locations with little or no competition from other large supermarkets is a major part of our strategy. However, there are disadvantages to this approach, which relate to human resources. Where competitors operate supermarkets nearby, their trained staff is a potential source for our own human resources needs, especially if we offer a superior compensation package. Cities that have no large supermarkets also have no sources of trained employees. Although we believe we have a good training school, from time to time we have to send experienced management team members from our headquarters or other stores to new stores to provide assistance. This increases our cost of operating and decreases our gross margin.

 

Critical Accounting Estimates

 

As discussed in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, we consider our estimates on revenue recognition, vendor allowances, and inventory valuation to be the most critical in understanding the judgments that are involved in preparing our consolidated financial statements. There have been no significant changes to these estimates in the three months ended March 31, 2013.

 

 

Recently Issued Accounting Guidance

 

See Note 2 to condensed consolidated financial statements included in Item 1, Financial Information, of this Quarterly Report on Form 10-Q.

 

 

Results of Operations

 

 

The following table sets forth selected items from our condensed consolidated statements of income by dollar and as a percentage of our net sales for the periods indicated:

 

		(Unaudited)								(Unaudited)
		Three Months Ended								Three Months Ended
		March 31, 2013								March 31, 2012
		Amount				% of Net Sales				Amount				% of Net Sales
Net sales		$	97,057,191				100.0	%		$	112,038,616				100.0	%
Cost of sales			80,417,743				82.9				92,983,490				83.0
Gross profit			16,639,448				17.1				19,055,126				17.0
Selling expenses			13,324,213				13.7				15,130,888				13.5
General and administrative expenses			2,518,336				2.6				2,375,774				2.1
Operating income			796,899				0.8				1,548,464				1.4
Interest income			193,573				0.2				26,528				0.0
Interest expense			(297,608	)			0.3				(293,909	)			0.3
Income before income taxes			692,864				0.7				1,281,083				1.1
Income taxes			289,594				0.3				450,482				0.4
Net income		$	403,270				0.4	%		$	830,601				0.7	%

 

Net Sales – Net sales decreased by $14.9 million, or 13.4%, to $97.1 million for the three months ended March 31, 2013 from $112.0 million for the three months ended March 31, 2012. The change in net sales was primarily attributable to the following:

 

§

Same store sales represents sales from stores that were opened for at least one year before the beginning of the comparison period, or by January 1, 2012. Same store (45 stores) sales generated approximately $93.6 million in sales in the first quarter of 2013, a decrease of $5.5 million, or 5.6% compared with $99.1 million in net sales in the first quarter of 2012.

 

§

New store sales increased, reflecting the opening of one new store since January 1, 2012. The store generated approximately $1.1 million in sales in the first quarter of 2013.

 

§

The number of stores including supermarkets/hypermarkets and department stores at March 31, 2013 was 46 versus 53 at March 31, 2012.

 

Cost of Sales – Our cost of sales for the three months ended March 31, 2013 was approximately $80.4 million, representing a decrease of $12.6 million, or 13.5%, from approximately $93.0 million for the same period in 2012. The decrease was due to the decrease in volume of sales. Our cost of sales primarily consists of the cost for our merchandise; it also includes costs related to packaging and shipping and the distribution center costs.

 

Gross Profit – Gross profit, or total revenue minus cost of sales, decreased by $2.4 million, or 12.7%, to $16.6 million, or 17.1% of net sales, in the first quarter of 2013 from $19.1 million, or 17.0% of net sales, in the first quarter of 2012. The change in gross profit was primarily attributable to a decrease in net sales of $14.9 million in the first quarter of 2013 compared to the first quarter of 2012.

 

We believe that our gross margin is likely to be between 16.8% and 17.3%, over the next few business quarters. New stores tend to be less profitable during their early months of operation. In addition, China’s retail industry in general, and its supermarket industry in particular, are becoming more competitive every year. In this competitive marketplace, it is likely that we will focus on providing our customers with low prices in order to increase our market share and long-term sales volume.

 

Selling Expenses –Selling expenses decreased by $1.8 million, or 11.9%, to $13.3 million, or 13.7% of net sales, in the first quarter of 2013 from $15.1 million, or 13.5% of net sales, in the first quarter of 2012. The change in selling expenses was mainly due to a decrease in labor costs resulting from a decrease in the number of store employees, and a decrease in rent expense in the three months ended March 31, 2013 compared to the same period in 2012. In specific, labor costs decreased by $1.0 million or 19.1%, to $4.4 million in the first quarter of 2013 from $5.4 million in the first quarter of 2012. Rent expenses decreased by $0.6 million, or 28.5%, to $1.6 million in the first quarter of 2013 from $2.2 million in the first quarter of 2012. 

 

 

General and Administrative Expense –General and administrative expenses increased by $0.1 million, or 6.0%, to $2.5 million, or 2.6% of net sales, in the first quarter of 2013 from $2.4 million, or 2.1% of net sales, in the first quarter of 2012. The increase was mainly due to expenses incurred by the new money lending business.

 

Income Taxes –The provision for income taxes was $0.3 million for the first quarter of 2013 compared with $0.5 million for the first quarter of 2012. Our effective tax rate was 41.8% for the three months ended March 31, 2013, compared with 35.2% for the same period in 2012.

 

Net Income – Our net income for the first three months of 2013 decreased by 51.5% to $0.4 million, or $0.27 per diluted share, from $0.8 million, or $0.54 per diluted share in the prior year period. The number of shares used in the computation of diluted EPS was 1,510,828 and 1,543,297 for the first three months of 2013 and 2012, respectively.

 

Liquidity and Capital Resources

 

Our principal liquidity requirements are for working capital and capital expenditures. We fund our liquidity requirements primarily through cash on hand, cash flow from operations and borrowings from our revolving credit facility. We believe our cash on hand, future funds from operations and borrowings from our revolving credit facility will be sufficient to fund our cash requirements for at least the next twelve months. There is no assurance, however, that we will be able to generate sufficient cash flow or that we will be able to maintain our ability to borrow under our revolving credit facility.

 

At March 31, 2013, we had $32.5 million of cash compared to $36.1 million at March 31, 2012. The following table sets forth a summary of our cash flows for the periods indicated:

 

		(Unaudited)
		Three Months Ended March 31,
		2013				2012
Net cash provided by operating activities		$	24,268,895			$	29,407,812
Net cash used in investing activities			(350,987	)			(827,585	)
Net cash used in financing activities			-				(1,581,103	)
Effect of foreign currency translation			61,898				41,588
Net increase in cash		$	23,979,806			$	27,040,712

 

Seasonality

 

The seasonality of our business historically provides greater cash flow from operations during the holiday and winter selling season, with the fourth quarter net sales traditionally generating the strongest profits of each year. Typically, we use operating cash flow and borrowings under our revolving credit facility to fund inventory increases in anticipation of the holidays and our inventory levels are at their highest in the months leading up to Chinese Spring Festival. As holiday sales significantly reduce inventory levels, this reduction, combined with net income, historically provides us with strong cash flow from operations at the end of each year.

 

Operating Activities –Net cash provided by operating activities for the three months ended March 31, 2013 and 2012 was $24.3 million and $29.4 million, respectively. The decrease in cash provided by operating activities for the three months ended March 31, 2013 compared to the same period in 2012 primarily reflects the decrease in net sales for the three months ended March 31, 2013.

 

Investing Activities – Net cash used in investing activities for the first three months of 2013 was $0.4 million and net cash used in investing activities for the first three months of 2012 was $0.8 million. Capital expenditures represented substantially all of the net cash used in investing activities for each period. Our capital spending is primarily for new store openings and store-related remodeling.

 

 

Financing Activities – Net cash used in financing activities for the first three months of 2013 and 2012 was nil and $1.6 million, respectively. Cash used in financing activities was used to repay short-term bank loans.

 

Loan Facility – On July 6, 2011, QKL Chain entered into a working capital agreement with Longjiang Commercial Bank. Under this agreement, QKL Chain has a credit line up to approximately $7.7 million (RMB50.0 million). The term of any loan under the agreement is one year after the date the loan is issued, with the annual interest rate of 6.941%. The loan under this financing agreement is secured by buildings with apprasial value of approximately $11.9 million (RMB 77.0 million). 

 

On July 6, 2011, Qinglongxin Commerce also entered into a working capital agreement with Longjiang Commercial Bank. Under this agreement, Qinglongxin Commerce has a credit line up to approximately $7.7 million (RMB50.0 million). The term of any loan under the agreement is one year after the date the loan is issued, with the annual interest rate of 7.544%. The loan under this financing agreement is guaranteed by QKL Chain. 

 

Future Capital Requirements – We had cash on hand of $32.5 million as of March 31, 2013. We expect capital expenditures for the remainder of 2013 primarily to fund the opening of new stores, store-related remodeling and relocation.

 

We believe we will be able to fund our cash requirements, for at least the next 12 months from cash on hand, operating cash flows and borrowings from our revolving credit facility. However, our ability to satisfy our cash requirements depends upon our future performance, which in turn is subject to general economic conditions and regional risks, and to financial, business and other factors affecting our operations, including factors beyond our control. There is no assurance that we will be able to generate sufficient cash flow or that we will be able to maintain our ability to borrow under our credit facility.

 

If we are unable to generate sufficient cash flow from operations to meet our obligations and commitments, we will be required to refinance or restructure our indebtedness or raise additional debt or equity capital. Additionally, we may be required to sell material assets or operations, suspend or further reduce dividend payments or delay or forego expansion opportunities. We might not be able to implement successful alternative strategies on satisfactory terms, if at all.

 

Off-Balance Sheet Arrangements and Contractual Obligations – Our material off-balance sheet arrangements are operating lease obligations. We excluded these items from the balance sheet in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Operating lease commitments consist principally of leases for our retail store facilities and distribution center. These leases frequently include options which permit us to extend the terms beyond the initial fixed lease term. With respect to most of those leases, we intend to renegotiate those leases as they expire.

 

In the ordinary course of business, we enter into arrangements with vendors to purchase merchandise in advance of expected delivery. Because most of these purchase orders do not contain any termination payments or other penalties if cancelled, they are not included as outstanding contractual obligations.

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1).

 

Item 4.  Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures –We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules13a15(e) and 15d15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this report. Based on such evaluation, our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures are not effective, at a reasonable assurance level, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are not effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

 

In particular, we did not maintain effective controls over the financial reporting process due to an insufficient complement of personnel with a level of accounting knowledge, experience and training in the application of U.S. GAAP commensurate with the Company’s financial requirements. Also, there is an insufficient quantity of dedicated resources and experienced personnel involved in the general controls over information technology on our new ERP system implementation. The lack of sufficient and adequately trained personnel resulted in ineffective top level review, which in turn may affect the timeliness of our periodic financial reporting.

 

 

The conclusion that our internal control over financial reporting was not effective was based on material weaknesses we identified in relation to our financial closing process.

 

Remediation Measures for Material Weaknesses – We have begun to take steps to remediate the material weaknesses described above in “Evaluation of Disclosure Controls and Procedures” and plan to implement the new measures described below in our ongoing efforts to address the internal control deficiencies described above. We plan to further develop policies and procedures governing the hiring and training of personnel to better ensure sufficient personnel with the requisite knowledge, experience and training in the application of generally accepted accounting principles commensurate with our financial reporting and U.S. GAAP requirements. We plan to utilize qualified internal control consultants and supervisors to ensure that our staff has adequate professional knowledge and to monitor the need for additional or better qualified staff. In addition, we plan to utilize appropriate training programs on accounting principles and procedures to better ensure the adequacy of our accounting and finance personnel. We plan to continue to develop our corporate culture toward emphasizing the importance of internal controls and to ensure that all personnel involved in maintaining proper internal controls recognize the importance of strictly adhering to accounting principles accepted in the United States of America. We plan to continue to provide additional training to the Company’s internal audit staff on appropriate controls and procedures necessary to document and evaluate our internal control procedures.

 

Changes in Internal Control over Financial Reporting – During the first quarter ended March 31, 2013, no changes occurred with respect to our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

ITEM 1.  LEGAL PROCEEDINGS

 

None.

 

ITEM 1A.  RISK FACTORS

 

As a smaller reporting company, the Company is not required to make disclosures under this Item 1A.

 

ITEM 2:  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4.  MINE SAFETY DISCLOSURES

 

Not applicable.

 

ITEM 5.  OTHER INFORMATION

 

None.

 

ITEM 6:  EXHIBITS

 

The exhibits listed on the Exhibit Index are provided as part of this report.

 

 

EXHIBIT INDEX

 

Exhibit No.		Name of Exhibit
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101		The following financial statements from QKL Stores Inc.’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2013 formatted in XBRL (eXtensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets; (ii) the Condensed Consolidated Statements of Income; (iii) the Condensed Consolidated Statements of Cash Flows; and (iv) the Notes to Unaudited Condensed Consolidated Financial Statements, tagged in detail.

 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	QKL STORES INC.
Dated: May 14, 2013	By:	/s/ Zhuangyi Wang
		Zhuangyi Wang
		Chief Executive Officer
		(Principal Executive Officer)
	By:	/s/ Tsz-Kit Chan
		Tsz-Kit Chan
		Chief Financial Officer
		(Principal Financial and Accounting Officer)