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QKLS > SEC Filings for QKLS > Form 10-Q on 14-Nov-2012All Recent SEC Filings

Show all filings for QKL STORES INC.

Form 10-Q for QKL STORES INC.


14-Nov-2012

Quarterly Report


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, 2011.

Overview

We are a regional supermarket chain that currently operates 31 supermarkets, 16 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. We currently have two 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, 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.

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 the first nine months of 2012 that have in the aggregate approximately 5,700 square meters of space

In 2012, we plan to open 2 hypermarkets, supermarkets and department stores having, in the aggregate, approximately 15,000 square meters of space. In the first quarter of 2012, we closed 1 store due to the expiration of the lease contract. In the third quarter of 2012, we closed 1 store due to the expiration of the lease contract and 2 stores due to underperformance. 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.

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 buying card sales.

Expanded Operations

As of September 30, 2012, we operated 31 supermarkets, 16 hypermarkets, 4 department stores, and 2 distribution centers in Harbin and Shenyang. In 2012, we plan to open 2 hypermarkets, supermarkets and department stores having, in the aggregate, approximately 15,000 square meters of space. We closed 2 stores due to the expiration of the lease contract and 2 stores due to underperformance. We are also 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. Based on our previous experience, we believe it takes nine to twelve months for a new store to achieve profitability.

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% and 5.6% of our total revenues for the nine months ended September 30, 2012 and 2011, respectively. 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, 2011, 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 nine months ended September 30, 2012.

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

Three months ended September 30, 2012 compared with three months ended September 30, 2011.

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
                                             September 30, 2012               September 30, 2011
                                                            % of                             % of
                                           Amount         Net Sales         Amount         Net Sales
Net sales                               $ 84,343,510           100.0 %   $ 82,068,788           100.0 %
Cost of sales                             70,189,152            83.2       67,874,242            82.7
Gross profit                              14,154,358            16.8       14,194,546            17.3
Selling expenses                          13,330,045            15.8       13,040,763            15.9
General and administrative expenses        2,074,153             2.5        2,333,267             2.8
Operating loss                            (1,249,840 )           1.5       (1,179,484 )           1.4
Interest income                              111,903             0.1          175,745             0.2
Interest expense                            (295,564 )           0.4          (10,593 )           0.0
Loss before income taxes                  (1,433,501 )           1.7       (1,014,332 )           1.2
Income taxes                                (326,094 )           0.4         (164,822 )           0.2
Net loss                                $ (1,107,407 )           1.3 %   $   (849,510 )           1.0 %

Net Sales - Net sales increased by $2.2 million, or 2.8%, to $84.3 million for the three months ended September 30, 2012 from $82.1 million for the three months ended September 30, 2011. 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 July 1, 2011. Same store (47 stores) sales generated approximately $78.1 million sales in the third quarter of 2012, an increase of $2.7 million, or 3.6% compared with $75.4 million net sales in the third quarter of 2011.

New store sales increased, reflecting the net opening of 4 new stores since July 1, 2011. The new stores generated approximately $4.1 million sales in the third quarter of 2012.

The number of stores including supermarkets/hypermarkets and department stores at September 30, 2012 was 51 versus 53 at September 30, 2011.

Cost of Sales - Our cost of sales for the three months ended September 30, 2012 was approximately $70.2 million, representing an increase of $2.3 million, or 3.4%, from approximately $67.9 million for the same period in 2011. The increase was due to the increase 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 $0.04 million, or 0.3%, to $14.15 million, or 16.8% of net sales, in the third quarter of 2012 from $14.19 million, or 17.3% of net sales, in the third quarter of 2011. The decrease in gross margin was primarily attributable to the increase in competition in Daqing area.

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 increased by $0.3 million, or 2.2%, to $13.3 million, or 15.8% of net sales, in the third quarter of 2012 from $13.0 million, or 15.9% of net sales, in the third quarter of 2011. The change in selling expense was mainly due to increase in labor costs resulting from an increase in the number of store employees and pay increases.

General and Administrative Expense-General and administrative expenses decreased by $0.2 million, or 11.1%, to $2.1 million, or 2.5% of net sales, in the third quarter of 2012 from $2.3 million, or 2.8% of net sales, in the third quarter of 2011. The decrease was mainly due to our control on our headquarter's expenses.

Income Taxes - The provision for income taxes was $(0.3) million for third quarter of 2012 compared with $(0.2) million for third quarter of 2011.

Net Income - For the three months ended September 30, 2012, our net loss was $1.1 million, or $(0.105) per diluted share, compared to $0.8 million, or ($0.082) per diluted share, for the three months ended September 30, 2011.

Nine months ended September 30, 2012 compared with nine months ended September 30, 2011

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)
                                              Nine Months Ended                 Nine Months Ended
                                             September 30, 2012                 September 30, 2011
                                                             % of                              % of
                                           Amount          Net Sales         Amount          Net Sales
Net sales                               $ 279,603,670           100.0 %   $ 266,833,256           100.0 %
Cost of sales                             231,825,748            82.9       219,918,263            82.4
Gross profit                               47,777,922            17.1        46,914,993            17.6
Selling expenses                           40,878,831            14.6        38,327,459            14.4
General and administrative expenses         6,539,428             2.3         6,483,350             2.4
Operating income                              359,663             0.1         2,104,184             0.8
Interest income                               216,674             0.1           629,131             0.2
Interest expense                             (691,212 )           0.2           (41,693 )           0.0
(Loss) income before income taxes            (114,875 )           0.0         2,691,621             1.0
Income taxes                                  152,320             0.1           986,869             0.4
Net (loss) income                       $    (267,195 )           0.1 %   $   1,704,752             0.6 %

Net Sales - Net sales increased by $12.8 million, or 4.8%, to $279.6 million for the nine months ended September 30, 2012 from $266.8 million for the nine months ended September 30, 2011. 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, 2011. Same store (36 stores) sales generated approximately $224.7 million sales in the first nine months of 2012, an increase of $8.7 million, or 4.1% compared with $216.0 million net sales in the first nine months of 2011.

New store sales increased, reflecting the net opening of 15 new stores since January 1, 2011. The new stores generated approximately $42.4 million sales in the first nine months of 2012.

The number of stores including supermarket/hypermarket and department stores at September 30, 2012 was 51 versus 53 at September 30, 2011.

Cost of Sales - Our cost of sales for the nine months ended September 30, 2012 was approximately $231.8 million, representing an increase of $11.9 million, or 5.4%, from approximately $219.9 million for the same period in 2011. The increase was due to the increase 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, increased by $0.9 million, or 1.8%, to $47.8 million, or 17.1% of net sales, in the first nine months of 2012 from $46.9 million, or 17.6% of net sales, in the first nine months of 2011. The decrease in gross margin was primarily attributable to the increase in competition in Daqing area.

Selling Expenses - Selling expenses increased by $2.6 million, or 6.7%, to $40.9 million, or 14.6% of net sales, in the first nine months of 2012 from $38.3 million or 14.4% of net sales in the first nine months of 2011. The change in selling expense was mainly due to an increase in labor costs resulting from an increase in the number of store employees and pay increases.

General and Administrative Expense - General and administrative expenses increased by $0.06 million, or 0.9%, to $6.54 million, or 2.3% of net sales, in the first nine months of 2012 from $6.48 million, or 2.4% of net sales, in the first nine months of 2011. There was no material change in the expenses. .

Income Taxes - The provision for income taxes was $0.2 million for first nine months of 2012, compared with $1.0 million for first nine months of 2011. The decrease was primarily due to lower taxable income.

Net Income - Net loss for the first nine months of 2012 was $0.3 million, or $(0.025) per diluted share, from net income of $1.7 million, or $0.138 per diluted share, in the prior year period. This decrease was due to lower gross margin, higher selling expenses and higher staff costs in the first nine months of 2012. The number of shares used in the computation of diluted EPS decreased by 14.6% to 10.5 million shares from 12.3 million shares for the same period during 2011 because of the anti-dilutive effect of preferred stock in 2012.

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 September 30, 2012, we had $27.4 million of cash compared to $28.0 million at September 30, 2011. The following table sets forth a summary of our cash flows for the periods indicated:

                                                     (Unaudited)
                                                  Nine Months Ended
                                                    September 30,
                                                2012             2011
Net cash provided by operating activities   $ 17,438,324     $  27,363,950
Net cash used in investing activities         (3,648,874 )     (20,617,003 )
Net cash provided by financing activities      4,744,515         3,074,081
Effect of foreign currency translation          (184,433 )         701,027
Net increase in cash                        $ 18,349,532     $  10,522,055

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 nine month ended September 30, 2012 and 2011 was $17.4 million and $27.4 million, respectively. The decrease in cash provided by operating activities for the nine month ended September 30, 2012 compared to the same period in 2011 primarily reflects net cash inflow caused by a decrease of inventories and other receivables. The decrease of inventories was caused by reducing the inventory after the peak Chinese New Year season. The decrease of other receivables is largely attributable to the recovery of money from vendors.

Investing Activities - Net cash used in investing activities for the first nine months of 2012 was $3.6 million and net cash used in investing activities for the first nine months of 2011 was $20.6 million. Capital expenditures represented substantially all of the net cash used in investing activities for each period. Capital expenditures were higher in the first nine months of 2011 due to substantially more new store openings. Our capital spending is primarily for new store openings and store-related remodeling.

Financing Activities - Net cash provided by financing activities for the first nine months of 2012 and 2011 were $4.7 million and $3.0 million, respectively which were generated from 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 appraisal 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 6.941%. The loan under this financing agreement is guaranteed by QKL Chain.

Future Capital Requirements - We had cash on hand of $27.4 million as of September 30, 2012. We expect capital expenditures for the remainder of 2012 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 . . .

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