UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





Quarterly Report Pursuant to Section 13 or 15(d) of the


Securities Exchange Act of 1934





For the quarterly period ended March 31, 2011





Commission File Number: 001-32503





TELESTONE TECHNOLOGIES CORPORATION


(Exact Name of Registrant as Specified in Its Charter)





Delaware

84-1111224(State or Other Jurisdiction of

(I.R.S. Employer Identification No.)Incorporation or Organization)





Floor 10, China Ruida Plaza


No. 74 Lugu Road


Shi Jingshan District


Beijing, People’s Republic of China 100040


(Address of Principal Executive Offices)





(86 10) 6860-8335


(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 Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least 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 o No  ̈





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.




Large accelerated filer  ̈

Accelerated filer  ̈

Non-accelerated filer  ̈

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 Exchange Act). Yes  ̈ No x





As of May 15, 2011, 12,233,264 shares of the Issuer’s $.001 par value common stock were outstanding.





Except as otherwise indicated by the context, references in this Form 10-Q to:





“TSTC,” the “Company,” “we,” “our,” or “us” are references to Telestone Technologies Corporation


“U.S. Dollar,” “$” and “US$” mean the legal currency of the United States of America.


“RMB” means Renminbi, the legal currency of China.


“China” or the “PRC” are references to the People’s Republic of China.


“U.S.” is a reference to the United States of America.


“SEC” is a reference to the Securities & Exchange Commission of the United States of America.







TELESTONE TECHNOLOGIES CORPORATION





INDEX




PagePART I. FINANCIAL INFORMATIONItem 1. Condensed Financial Statements.

4Condensed Consolidated Statements of Operationsand Other Comprehensive Income, for the three months ended March 31, 2011  and 2010 (unaudited)

4Condensed Consolidated Balance Sheets, as of March 31, 2011 (unaudited) and December 31, 2010

5Condensed Consolidated Statements of Cash Flows, for the three months ended March 31, 2011 and 2010 (unaudited)

6Notes to Condensed Consolidated Financial Statements (unaudited)

7Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

21Item 3. Quantitative and Qualitative Disclosures About Market Risk.

34Item 4. Controls and Procedures.

35PART II. OTHER INFORMATIONItem 1. Legal Proceedings.

36Item 1A. Risk Factors.Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

36Item 3. Defaults Upon Senior Securities.Item 4. (Removed and Reserved).

36Item 5. Other Information.Item 6. Exhibits.

36







Telestone Technologies Corporation




Condensed Consolidated Statements of Operations and Other Comprehensive Income
  Three months ended March 31, 2011 and 2010
 ITEM 1. FINANCIAL STATEMENTS




PeriodsendedMarch31,2011


2010Note


US$’000


US$’000(Unaudited)


(Unaudited)Operating revenues:Net sales of equipment





6,992



5,100Service income





7,480



6,032Total operating revenues





14,472



11,132Cost of operating revenues:Cost of net sales





3,831



2,870Cost of service





4,043



3,323Total cost of operating revenues





7,874



6,193Gross income





6,598



4,939Operating expenses:Sales and marketing





2,131



2,728General and administrative





2,005



2,934Research and development





248



224Depreciation and amortization





102



71Total operating expenses





4,486



5,957Operating income (loss)





2,112



(1,018
)Interest expense





(149
)


(126
)Other income, net





203



335Income (Loss) before income taxes





2,166



(809
)Income taxes


11



(547
)


(321
)Net income (loss)






1,619



(1,130
)Other comprehensive incomeForeign currency translation adjustment






-



-Total comprehensive income (loss)






1,619



(1,130
)Earnings (Loss) per share:


3Weighted average number of common stock outstandingBasic






12,333,264



10,513,268Effect of dilutive warrants and stock options






15,883



-Diluted






12,349,147



10,513,268Net income (loss) per share of common stock





US$


US$Basic






0.13



(0.11
)Diluted






0.13



(0.11
)





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


- 4 -


Telestone Technologies Corporation




Condensed Consolidated Balance Sheets
  As of March 31, 2011 and December 31, 2010


As of

March 31,


As of

December 31,2011


2010Note


US$’000


US$’000(Unaudited)ASSETSCurrent assets:Cash and cash equivalents





26,504



31,020Accounts receivable, net of allowance


5



197,977



192,487Due from related parties


14



1,478



2,018Inventories, net of allowance


10



4,761



3,123Prepayments






1,797



1,748Other current assets






1,929



1,630Total current assets






234,446



232,026Goodwill


6



3,119



3,119Property, plant and equipment, net


7



1,623



1,565Lease prepayments, net


8



2,515



2,5287,257



7,212Total assets






241,703



239,238LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent liabilities:Short-term bank loans


9, 14



11,100



9,846Accounts payable – Trade






42,358



40,685Customer deposits for sales of equipment






2,157



2,089Due to related parties


14



1,763



3,977Income tax payable






14,235



13,760Accrued expenses and other accrued liabilities






51,169



52,031Total current liabilities






122,782



122,388Commitments and contingencies


15Stockholders’ equity:Preferred stock, US$0.001 par value, 10,000,000 shares authorized, no shares issuedCommon stock and paid-in-capital, US$0.001 par value:Authorized – 100,000,000 shares as of March 31, 2011 and December 31, 2010Issued and outstanding – 12,233,264 shares as of March 31, 2011 and December 31, 2010


13



12



12Additional paid-in capital






43,502



43,050Dedicated reserves






5,115



5,115Other comprehensive income






8,437



8,437Retained earnings






61,855



60,236Total stockholders’ equity






118,921



116,850Total liabilities and stockholders’ equity






241,703



239,238





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


- 5 -


Telestone Technologies Corporation




Condensed Consolidated Statements of Cash Flows
  Three months ended March 31, 2011 and 2010


ThreemonthsendedMarch31,2011


2010US$’000


US$’000(Unaudited)


(Unaudited)Cash flows from operating activitiesNet income (loss)


1,619



(1,130
)Adjustments to reconcile net income (loss) to net cash used in operating activities:Depreciation and amortization


102



71Stock-based compensation


452



2,601Changes in assets and liabilities:Accounts receivable


(5,490
)


(1,422
)Inventories


(1,638
)


(619
)Prepayments


(49
)


603Other current assets


(299
)


512Accounts payable


1,673



40Customer deposits for sales of equipment


68



(24
)Due to related parties


(1,674
)


(441
)Income tax payable


475



529Accrued expenses and other accrued liabilities


(862
)


(1,861
)Net cash used in operating activities


(5,623
)


(1,141
)Cash flows from investing activitiesPurchase of property, plant and equipment


(147
)


(81
)Net cash used in investing activities


(147
)


(81
)Cash flows from financing activitiesRepayment of short-term bank loans


(1,212
)


(1,170
)Short term bank loans raised


2,466



1,170Net cash from financing activities


1,254



-Net decrease in cash and cash equivalents


(4,516
)


(1,222
)Cash and cash equivalents, beginning of the period


31,020



11,233Cash and cash equivalents, end of the period


26,504



10,011Supplemental disclosure of cash flow informationInterest received


13



16Interest paid


(143
)


(110
)Tax paid


(72
)


(146
)





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


- 6 -


Telestone Technologies Corporation




Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010
  1.           ORGANIZATION AND PRINCIPAL ACTIVITIES





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





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





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





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





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


- 7 -


Telestone Technologies Corporation




Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010


1.           ORGANIZATION AND PRINCIPAL ACTIVITIES (CONTINUED)





On December 14, 2009, Beijing Telestone established a wholly-owned subsidiary, Guan Telestone Telecommunication Technologies Company Limited (“Guan Telestone”)(note) in Guan, Hebei Province, the PRC with operating period of 20 years until December 13, 2029. Guan Telestone was inactive since its incorporation and management plans to develop a research and development center and a manufacturing plant of telecommunication equipment in Guan County through Guan Telestone. Currently, Guan Telestone holds a land use right in Guan County for future development.





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





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





2.           SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Basis of presentations


These unaudited condensed consolidated financial statements have been prepared based upon Securities and Exchange Commission ("SEC") rules that permit reduced disclosure for interim periods and include, in the opinion of management, all adjustments (consisting of normal recurring adjustments and reclassifications) necessary to present fairly the financial position, results of operations and cash flows as of March 31, 2011 and for all periods presented.





Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("USA") have been condensed or omitted. These unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's Form-10K for the year ended December 31, 2010 filed on March 30, 2011. The results of operations for the three-month period ended March 31, 2011 are not necessarily indicative of the operating results to be expected for the year ending December 31, 2011.





The unaudited condensed consolidated financial statements and accompanying notes are presented in United States dollars and prepared in accordance with generally accepted accounting principles in the USA ("USGAAP") which requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.





Basis of consolidation


The unaudited condensed consolidated financial statements include the accounts of TSTC, its subsidiaries and a VIE. All significant intercompany accounts and transactions have been eliminated upon consolidation.


- 8 -




Telestone Technologies Corporation
  Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010


3.           EARNINGS (LOSS) PER SHARE





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





Basic earnings (loss) per share is computed based on the weighted average number of shares of common stock outstanding during the periods presented.





Diluted earnings (loss) per share is computed based on net income (loss) attributable to stockholders and the weighted average number of shares of common stock outstanding during each period presented, adjusted for the effect of the dilutive common stock equivalents outstanding during the periods presented.





The dilutive effect of warrants and stock options to purchase common stock outstanding during the three-month periods ended March 31, 2011 and 2010 is reflected in the calculation of diluted earnings per share by applying the treasury stock method. Any anti-dilutive effect of the warrants and stock options is excluded from calculation of the earnings per share.





For the period ended March 31, 2011, 40,000 shares of warrants are dilutive and included in the weighted-average number of common stock outstanding for calculation of diluted earnings per share. Another 40,000 shares of warrants and 601,663 shares of stock options are anti-dilutive.





For the period ended March 31, 2010, all warrants outstanding are anti-dilutive, so there is no dilutive effect of warrants in the calculation of diluted earnings per share.




4.           OPERATING RISKS





(a)
Concentration of major customers and suppliers




Three months ended March 31,2011


2010US$’000


US$’000(Unaudited)


(Unaudited)Major customers with revenues of more than 10% of the Company’s salesSales to major customers


13,428



9,993Percentage of sales


93
%


90
%Number


3



2Major suppliers with purchases of more than 10% of the Company’s purchasesPurchases from major suppliers


3,043



456Percentage of purchases


55
%


13
%Number


2



1





Accounts receivable related to the Company’s major customers comprised 89% and 98% of all account receivables as of March 31, 2011 and December 31, 2010 respectively.


- 9 -


Telestone Technologies Corporation
  Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010




4.           OPERATING RISKS (CONTINUED)





(a)
Concentration of major customers and suppliers (Continued)





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





(b)
Country risks





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





(c)
Cash and time deposits





The Company mainly maintains its cash balances with various banks located in the PRC. In common with local practice, such amounts are not insured or otherwise protected should the financial institutions be unable to meet their liabilities. There has been no history of credit losses. There are neither material commitment fees nor compensating balance requirements for any outstanding loans of the Company.




5.           ACCOUNTS RECEIVABLE


As of

March 31,


As of

December 31,2011


2010US$’000


US$’000(Unaudited)Completed contracts


190,696



181,649Retentions


15,144



18,701205,840



200,350Allowance for doubtful accounts


(7,863
)


(7,863
)197,977



192,487





Of the retention balance as of March 31, 2011 and December 31, 2010, approximately US$919,000 and US$888,000 respectively are due to be paid by the trade debtors after one year.


- 10 -


Telestone Technologies Corporation
  Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010




6.           GOODWILL





Goodwill acquired in connection with the acquisition of Guolian and Pan-pacific by BTWTC on July 5, 2008 represented the excess of the purchase cost over the fair value of identifiable net assets acquired at acquisition date. Goodwill is tested at least annually for impairment in accordance with ASC Topic 350, Intangibles – Goodwill and Other.




7.           PROPERTY, PLANT AND EQUIPMENT, NET





Property, plant and equipment is summarized as follows:


Estimated


As of

March 31,


As of

December 31,useful life


2011


2010(in years)


US$’000


US$’000(Unaudited)Buildings


30



323



323Leasehold improvement


5



168



168Plant and machinery


5



822



797Office equipment


5



1,471



1,395Motor vehicles


5



994



9483,778



3,631Accumulated depreciation






(2,155
)


(2,066
)1,623



1,565





8.
LEASE PREPAYMENTS, NET


As of

March 31,


As of

December 31,2011


2010US$’000


US$’000(Unaudited)Prepaid land use rights


2,580



2,580Accumulated amortization


(65
)


(52
)2,515



2,528




Lease prepayment as of March 31, 2011 and December 31, 2010 represented the land use rights for a piece of land located in Guan County, Hebei Province, the PRC. The land use rights will expire in 2059.





The prepaid land use right has been pledged to a bank in the PRC as collateral for short-term bank loans (Note 9).




- 11 -


Telestone Technologies Corporation
 
 Notes to Condensed Consolidated Financial Statements
 
 Three months ended March 31, 2011 and 2010





9.           SHORT-TERM BANK LOANS





As of March 31, 2011 and December 31, 2010, the balance included bank loans of RMB73 million and RMB65 million respectively, equivalent to approximately US$11.10 million and US$9.85 million respectively, bear interest to be charged quarterly at the standard short term borrowing rate as stipulated by the People’s Bank of China on the date of the first withdrawal, wholly repayable within one year, and are secured by guarantee provided by a third party guaranty company.





The guarantee provided by the independent guaranty company is secured by the followings:





(a)
Accounts receivable of the Company with an aggregate carrying value as of March 31, 2011 and December 31, 2010 amounting to RMB217.27 million and RMB95.43 million, equivalent to approximately US$32.91 million and US$14.45 million, respectively;





(b)
Motor vehicles of the Company with an aggregate carrying value as of March 31, 2011 and December 31, 2010 amounting to RMB0.90 million and RMB0.97 million, equivalent to approximately US$0.13 million and US$0.15 million, respectively;





(c)
Land use rights of the Company with carrying value as of March 31, 2011 and December 31, 2010 amounting to RMB16.60 million and RMB16.68 million, equivalent to approximately US$2.52 million and US$2.53 million, respectively;





(d)
Personal guarantee provided by Mr. Daqing Han, Telestone’s Chairman and Chief Executive Officer (“Mr. Han”); and





(e)
Personal real estate property and securities in the Company held by Mr. Han.




10.         INVENTORIES


As of

March 31,


As of

December 31,2011


2010US$’000


US$’000(Unaudited)Inventories consisted of the followings:Raw materials


1



1Finished goods and parts


5,212



3,5745,213



3,575Provision for slow-moving and obsolete items


(452
)


(452
)4,761



3,123


- 12 -


Telestone Technologies Corporation
 
 Notes to Condensed Consolidated Financial Statements
 
 Three months ended March 31, 2011 and 2010





11.         INCOME TAXES





TSTC and its subsidiaries are subject to income taxes on an entity basis on income arising in or derived from the tax jurisdictions in which each entity is domiciled.





TSTC had net operating losses carry-forward for income tax reporting purposes that might be offset against future taxable income. These net operating losses carry-forward are severely limited when TSTC experiences a change in control.  Therefore, following the re-capitalization in August 2005, the amount available to offset future taxable income is limited. No tax benefit has been reported in the financial statements, because TSTC believes that it is more likely than not that the carry-forward will finally expire and therefore cannot be used.  Accordingly, the potential tax benefits of the losses carry-forward are offset by a valuation allowance of the same amount.





No provision for withholding or United States federal or state income taxes or tax benefits on the undistributed earnings and/or losses of the Company’s subsidiaries has been made as the earnings of these subsidiaries, in the opinion of the management, will be reinvested indefinitely.





The Company’s income is principally generated in the PRC by Beijing Telestone, BTWTC, BTCTC, Guolian and Pan-pacific. All these entities are subject to the enterprise income tax (“EIT”) in the PRC at the following applicable rates:





Unified EIT rate


25
%Small scale / low profit enterprises


20
%High / new technology enterprise (“Hi-tech enterprises”)


15
%





Beijing Telestone and BTWTC are qualified as Hi-tech enterprises under the current Enterprise Income Tax Law in the PRC, so they enjoy the preferential tax rate of 15% in the PRC for a three-year period commencing from the year 2009. All other entities including BTCTC, Guolian and Pan-pacific are subject to the unified tax rate of 25% for the three-month periods ended March 31, 2011 and 2010.





Income tax expenses, comprising EIT, have been provided at the applicable rates on the respective subsidiaries’ / VIE’s estimated assessable income arising from the PRC during the periods.




12.         SEGMENT INFORMATION





During the three-month periods ended March 31, 2011 and 2010, all revenues of the Company are from its network installation and optimization services, and trading of wireless telecommunication equipment.  No financial information by business segment is presented.





As the Company operates mainly in the PRC and over 100% and 95% of its revenue during the three-month periods ended March 31, 2011 and 2010 respectively are from the PRC and almost all of the Company’s assets are located in the PRC, no geographical analysis is presented.


- 13 -




Telestone Technologies Corporation
  Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010




13.
COMMON STOCK





TSTC had 12,233,264 shares of outstanding common stock as of March 31, 2011 and December 31, 2010.





On December 31, 2010, the Board of Directors of TSTC approved to grant 100,000 shares of restricted common stock with two years restriction for sale to certain senior officers of the Company as an incentive compensation for their services rendered in previous years in improving the business result of the Company and their contribution to the success of the Company. As of March 31, 2011 and December 31, 2010, the 100,000 shares of restricted common stock are not yet issued.




14.         RELATED PARTY TRANSACTIONS




Summary of related party transactions


As of

March 31,


As of

December 31,Note


2011


2010US$’000


US$’000(Unaudited)Due from related partiesEmployees


a



-



540Ex-stockholders of SMI/Guolian


b



1,478



1,4781,478



2,018Due to related partiesDirectors


a



240



2,454Ex-stockholders of Beijing Telestone/Guolian


b



1,523



1,5231,763



3,977Guarantor of short-term bank loansA director


9



11,100



9,846





Note:





(a)
The amounts due from employees and due to directors represent unsecured advances made to / from those parties from time to time. These amounts are interest free and repayable on demand.


- 14 -




Telestone Technologies Corporation


Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010


14.         RELATED PARTY TRANSACTIONS (CONTINUED)





Note:





(b)
The amounts due to ex-stockholders of Beijing Telestone represented the consideration arising from the consummation of the business combination. The ex-stockholders of SMI had represented that they had fully settled the amount with the ex-stockholders of Beijing Telestone and also undertaken to fully indemnify SMI against any claims from the ex-stockholders of Beijing Telestone (the “Undertaking”). However, an ex-stockholder of Beijing Telestone has initiated to lawsuit against SMI alleging that the consideration has not been settled. The court hearing commenced on May 10, 2006 and finalized on December 19, 2006. A verdict has been issued by the Second Intermediate People’s Court of Beijing (“北京市第二中級人民法院”) and announced that SMI and Beijing Telestone are not required to compensate the ex-stockholder of SMI.  On 23 October 23, 2007 another verdict was issued by the High People’s Court of Beijing (“北京市高級人民法院”) to announcing that the verdict from Second Intermediate People’s Court of Beijing was upheld and SMI was not require to compensate the ex-shareholder.




15.         COMMITMENTS AND CONTINGENCIES





The Company recognizes its revenue upon the completion of contract and has made full tax provision in accordance with relevant national and local laws and regulations of the PRC.  A contract is considered as completed upon completion of all essential contract work and the installation has been accepted by the customer. It is the common practice in the PRC that invoices are not issued to customers until payments are received. The Company follows the practice of reporting its revenue for PRC tax purposes when invoices are issued. All unbilled revenue will become taxable when invoices are issued. For PRC tax reporting purpose, the PRC subsidiaries of the Company recognize revenue on an “invoice basis” instead of when goods are delivered and services are rendered. This is not in strict compliance with the relevant laws and regulations.  Accordingly, despite the fact that the PRC subsidiaries of the Company had made full tax provision in the financial statements, these PRC subsidiaries may be subject to penalties for the deferred reporting of tax obligations. The exact amount of penalties cannot be estimated with any reasonable degree of certainty.  The board of directors considers it is more-likely-than-not that the tax penalties will not be imposed.




16.         STOCK OPTION PLAN





On June 27, 2005, a Stock Option Plan (the “Plan”) was approved at the 2005 annual meeting of stockholders. The purpose of the Plan is to promote the growth and general prosperity of the Company by permitting the Company to grant incentive and nonqualified stock options to purchase common stock and restricted stock of the Company to key employees, non-employee directors, and advisors.  The Plan is designed to help the Company and its subsidiaries and affiliates attract and retain superior personnel for positions of substantial responsibility and to provide key employees, non-employee directors, and advisors with an additional incentive to contribute to the success of the Company.





On November 30, 2010, stock options to subscribe a total of 601,663 shares were granted to certain eligible employees of the Company (Note 17(iii)).


- 15 -




Telestone Technologies Corporation
 Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010


17.         STOCK-BASED COMPENSATION





For the three-month periods ended March 31, 2011 and 2010, a total of US$452,000 and US$2,601,000 were recognized as stock-based compensation in the consolidated statement of operations. The following table sets forth a summary of the nature of stock-based compensation recognized for the three-month periods ended March 31, 2011 and 2010.





ThreemonthsendedMarch31,2011


2010US$’000


US$’000(Unaudited)


(Unaudited)Warrants (i)


-



492Restricted stock (ii)


-



2,109Stock options (iii)


452



-452



2,601





The table below sets forth the functional classification of stock-based compensation recognized for the three-month periods ended March 31, 2011 and 2010.





ThreemonthsendedMarch31,2011


2010US$’000


US$’000(Unaudited)


(Unaudited)Sales and marketing


-



492General and administrative


452



2,109452



2,601





No tax benefit was recognized for the stock-based compensation recorded for the three-month periods ended March 31, 2011 and 2010.




Stock-based compensation to non-employee





(i)        During the period ended March 31, 2011, no warrant was granted by the Company.





During the period ended March 31, 2010, 40,000 shares of warrants were granted to a service provider as part of the cost of services.





For the three-month periods ended March 31, 2011 and 2010, the Company recognized stock-based compensation in relation to warrants granted to non-employee of US$Nil and US$492,000 respectively.


- 16 -




Telestone Technologies Corporation
  Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010




17.         STOCK-BASED COMPENSATION (CONTINUED)





Stock-based compensation to non-employee (Continued)





(i)        The following table summarizes activities of the warrants:


Number of sharesWarrants outstanding and exercisable as of January 31, 2011


165,666Expired on February 19, 2011


(85,666
)Warrants outstanding and exercisable as of March 31, 2011


80,000




The following table sets forth the details of warrants outstanding, vested and exercisable as of March 31, 2011 and December 31, 2010.





Outstanding,VestedandExercisableExercise price

Number of

shares


Weighted

average

remaining

contractual

life


Weighted

average

exercise

priceUS$




Years


US$As of March 31, 20114.95


40,000



2.459.55


10,000



2.6918.47


30,000



2.4580,000



2.48



10.60As of December 31, 20104.95


40,000



2.699.55


10,000



2.9411.60


85,666



0.1418.47


30,000



2.69165,666



1.39



11.11


- 17 -




Telestone Technologies Corporation
  Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010




17.         STOCK-BASED COMPENSATION (CONTINUED)





Stock-based compensation to employee





(ii)
On January 20, 2010, the Board of Directors of TSTC approved to grant 100,000 shares of restricted common stock with three years restriction for sale to certain senior officers of the Company as an incentive compensation for their services rendered in previous years in improving the business result of the Company and their contribution to the success of the Company.





The issuance of 100,000 shares of restricted common stock is accounted for as equity instruments issued in exchange for receipt of services. The stock-based compensation costs are recognized and measured at the quoted price on the date of grant.





For the three-month periods ended March, 2011 and 2010, the Company recognized stock-based compensation in relation to restricted common stock granted to employees of US$Nil and US$2,109,000 respectively.





(iii)
On November 30, 2010, 601,663 shares of stock options were granted to certain eligible employees of the Company as incentive compensation to attract and retain superior personnel for positions of substantial responsibility and to provide them with an additional incentive to contribute to the success of the Company.





The 601,663 shares of stock options are accounted for as equity instruments issued in exchange for receipt of services. Costs are measured at the estimated fair value of the equity instruments issued and recognized as an expense over the employee’s requisite service period.





During the three-month periods ended March 31, 2011 and 2010, no stock option was granted by the Company.





For the three-month periods ended March 31, 2011 and 2010, the Company recognized stock-based compensation in relation to stock options granted to employees of US$452,000 and US$Nil respectively.





A summary of stock option activity as of March 31, 2011 and changes during the three-month periods ended March 31, 2011 is presented below:




Number

of shares


Weighted

average

exercise

priceUS$Outstanding as of March 31, 2011 and December 31, 2010


601,663



11.04Vested and exercisable as of March 31, 2011 and December 31, 2010


179,501



11.06




- 18 -


Telestone Technologies Corporation




Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010


17.         STOCK-BASED COMPENSATION (CONTINUED)





Stock-based compensation to employee (Continued)





(iii)
The following table sets forth the details of stock options outstanding, vested and exercisable as of March 31, 2011 and December 31, 2010.





Outstanding


Vested and exercisableExercise price


Number

of shares


Weighted

average

exercise

price


Weighted

average

remaining

contractual

life


Number

of shares


Weighted

average

exercise

priceUS$


Years





US$As of March 31, 201110.91



529,663



10.91



9.66



155,501



10.9112.00



72,000



12.00



9.66



24,000



12.00601,663



11.04



9.66



179,501



11.06As of December 31, 201010.91



529,663



10.91



9.91



155,501



10.9112.00



72,000



12.00



9.91



24,000



12.00601,663



11.04



9.91



179,501



11.06





The aggregate intrinsic value of all outstanding stock options and exercisable stock options at March 31, 2011 and December 31, 2010 amounted to US$Nil. There were no options exercised during the three-month periods ended March 31, 2011 and 2010. As of March 31, 2011 and December 31, 2010, the Company had total unrecognized compensation amounting to US$2,108,000 and US$2,560,000 respectively under ASC 718. The unrecognized compensation will be recognized over a weighted average period of approximately 3 years.





18.
RECENT ACCOUNTING PRONOUNCEMENTS





In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”). ASU 2009-13 addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services separately rather than as a combined unit and modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. ASU 2009-13 significantly expands the disclosures requirements for multiple-deliverable revenue arrangements. ASU 2009-13 will be effective for the first annual reporting period beginning on or after September 15, 2010, and may be applied retrospectively for all periods presented or prospectively to arrangements entered into or materially modified after the adoption date. Early adoption is permitted, provided that the guidance is retroactively applied to the beginning of the year of adoption. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.


- 19 -


Telestone Technologies Corporation




Notes to Condensed Consolidated Financial Statements
  Three months ended March 31, 2011 and 2010


18.
RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED)





In April 2010, the FASB issued ASU 2010-13, Compensation – Stock Compensation. This ASC provides amendments to FASB ASC 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trade should not be considered to contain a condition that is not a market, performance, or service condition. As a result, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.





In July, 2010, the FASB issued ASU 2010-20, Receivables (Topic 310). The ASC provides updates to FASC ASC 310 to enhance disclosures about the credit quality of financing receivables and the allowance for credit losses. Existing disclosure guidance is amended to require an entity to provide a greater level of disaggregated information about the credit quality of its financing receivables and its allowance for credit losses. In addition, the amendments in this Update require an entity to disclose credit quality indicators, past due information, and modifications of its financing receivables. For public entities, the disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of this ASU does not have a material impact on the Company’s consolidated financial statements.





In January 2011, the FASB issued ASU 2011-01, Receivables (Topic 310), Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in ASU No. 2010-20 (see above). The ASU delays the effective date of the disclosures about troubled debt restructuring the ASU 2010-20. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring and to issue its guidance on the topic currently anticipated for interim and annual periods after June 15, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.





In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310), A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The ASU provide additional guidance or clarification to help the creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purpose of determining whether a restructuring constitutes a troubled debt restricting. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.





19.         SUBSEQUENT EVENT REVIEW





On April 29, 2011, Mr. Han completed an initial purchase of 100,000 shares under his Rule 10b5-1 plan (the “Plan”). In accordance with the Plan, Mr. Han purchased 100,000 shares at an average price under $6.00 during the week April 25 to April 29, 2011.





The Company has evaluated subsequent events up to the date that these consolidated financial statements were approved and authorized for issue by the Board of Directors.


- 20 -


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.





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





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





Overview





We are a leading access-network solution provider serving the Chinese market. Since 1997, we have operated in the Chinese market and in 2006, we expanded our marketing efforts to include Vietnam, Indonesia, Malaysia, Thailand and India. In 2007, Beijing Telestone Communication Technology Corp. Ltd. was established as one of our subsidiaries focusing on developing and managing our overseas businesses. Currently, our marketing efforts have expanded to 29 countries around the world, including the U.S., Vietnam, Mexico, Brazil, Russia, India, the Philippines, Thailand, Ireland, Ecuador, Mongolia, South Africa, Turkey, Indonesia, Colombia, Costa Rica, Argentina, the Ukraine, Kazakhstan, Singapore, South Korea, Hong Kong (SAR), Saudi Arabia, New Zealand, Bangladesh, the UAE, Canada and Iceland. Continuous expansion outside of China is one of our core strategies. We believe that the quality of our products and services will allow Telestone to be increasingly competitive internationally.





Our access-network solutions include the research and development (“R&D”) and application of access-network technology. In addition to our homegrown access-network equipment, which includes repeaters, antennas and radio-frequency peripherals, we also offer project design, project management, installation, maintenance and other after-sales services required by our customers. Our access-network solutions were created to further enhance the coverage of mobile telecommunications networks; this is done to improve the quality of reception for mobile phone users. The solutions we provide to the telecommunications industry cover indoor and outdoor environments, including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels.





In 2008, we launched WFDSTM (as defined below), a new generation of wireless distribution system. WFDSTM is an all-optical network that combines the technologies of both wireless and optical telecommunications. This system supports all mobile telecom networks and various other networks, including WLAN, FTTH, traditional telephone, and video surveillance systems. In 2010, we began generating revenues from WFDSTM installations, and we had completed 316 WFDSTM installations as of December 31, 2010. In addition, our WFDSTM technology provides several important benefits for Telestone and its investors: revenue from WFDSTM has raised our revenue growth rate above that of the past three years; WFDSTM offers an opportunity for us to diversify our customer base; and WFDSTM generates gross margins above our corporate average, in the range of 45% to 50%. WFDSTM also targets a different customer base — property developers and managers — rather than large telecom carriers, and these customers tend to make payments more quickly, which should, over time, reduce our accounts-receivable days’ sales outstanding (“DSOs”), as WFDSTM grows as a percentage of our revenues. Finally, WFDSTM is a technology platform, and we have a pipeline of WFDSTM technologies slated for launch over the next several years.





While we expanded our product portfolio from one purely consisting of RF-based wireless products to one including our Unified Local-Access Solution (“ULAN”) products, our traditional RF-based products still remain a strong growth driver for Telestone, and we received more than 70% of our revenues from RF-based products in 2010. In order to provide a speedy response and a high level of service to our customers, we have established more than 30 locations throughout China.





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


- 21 -




We have offices in 30 locations across the PRC, offering sales, project survey, design, project management and installation and maintenance services. We believe that this sales and service strategy enriches our capability to increase our existing customer base in the PRC and enables us to provide timely responses to customers’ inquiries as well as technical and maintenance service upon our customers’ requests. Our sales efforts are neither focused in nor dependent upon any particular region or province of the PRC.





Industry Background





As the mobile market in China continues to mature, mobile operators have begun to invest in the future. In particular, the Chinese telecommunications industry has witnessed accelerated development in recent years with a rapid rollout of 3G network investments as well as commitments to introduce 4G technology by 2011. Such is also evidenced by China Mobile, China Telecom, and China Unicom’s €1.178 billion EUR ($1.625 billion USD) purchase of network and application solutions, and integration and maintenance services from Alcatel-Lucent on November 5, 2010 during the visit of Chinese President Hu Jintao to France.





We also believe that disparate technologies used by mobile carriers in the United States, the continued roll-out of 3G, and the future roll-out of 4G also provide a conducive environment for creating potential demand for our WFDSTM enabled equipment and solutions in the United States.





The Rapid Growth of Wireless Subscribers in China





China has repeatedly expressed a commitment to continuing economic growth, aimed at improving the living standards of its population and at expanding its middle class. This growth has led to increasing urbanization among the Chinese population with migrant workers moving to cities. There is now a growing demand among both enterprises and households in China for improved wireless bandwidth and network performance. China is the largest wireless market in the world with approximately 747 million mobile subscribers. While this number is large, there is still opportunity to expand as the mobile user penetration rate in China is currently relatively low.





The number of wireless subscribers in China across both 2G and 3G platforms is projected to grow from 747 million at the end of 2009 to 925 million by the end of 2011, a compound annual growth rate (CAGR) of 11%. According to the Ministry of Industry and Information Technology, or MIIT, the number of 3G wireless subscribers is expected to grow at a 216% CAGR, increasing from 15 million to 150 million during the same period.





Wireless Infrastructure Growth Drivers in China





During the 2G era, the majority of mobile traffic was comprised of voice, and hence network coverage mainly focused on breadth rather than on depth. However, as we enter into the 3G era in China, approximately 70% of the 3G traffic is comprised of data. As a result, in-depth network coverage has become 3G operators’ first priority and we believe that the demand for wireless enhancement equipment has become much more important than in the past. We believe that the room for growth in such demand is evident as the population coverage levels of existing 3G networks are still below 70% in most cities currently covered, and less than half of China’s 650 major cities support 3G.





Chinese Government Sponsored 3G Build-Out





Telecommunication capital expenditure is expected to continue to grow in the coming years as the Big-3 (China Unicom, China Mobile, and China Telecom) plan to build out their 3G coverage networks through Chinese government support and incentives. According to MIIT, the Chinese government announced plans to contribute $58.6 billion in 3G upgrades from 2009 to 2011, with $23.6 billion already contributed in 2009, in an effort to extend 3G wireless coverage across nearly all of China. With the Chinese government’s assistance, the Big- 3 have budgeted $70 billion of spending from 2009 to 2011 to deploy 3G networks.


- 22 -




Significant Construction of New Residential and Commercial Properties





In recent years, the real estate market in China has grown at a fast rate – total real estate investment increased at a CAGR of 23% from 1998 – 2009. Demand for new real estate construction is expected to remain healthy going forward as evidenced by an anticipated shortage of supply in 2010. According to China’s National Bureau of Statistics, in 2009, 702 million square meters of commercial and residential properties were constructed, while 937 million square meters of new property rights were sold.  no updates in this part


The Chinese government encourages fair competition among the Big- 3 and cable service providers to give consumers viable choices. As a result, property owners install hardware platforms for the Big-3’s 2G and 3G technologies, cable and Internet networks. This often results in numerous devices being deployed on-site, which is inefficient and costly for property owners. As a result, it is expected that there will be increasing demand by properties owners for equipment that can integrate coverage from the Big- 3 and also provide integrated services in a single platform.





Growth in Mobile Subscribers





Growth in the wireless infrastructure market is also driven by the significant increase in the number of mobile subscribers and in the amount of data transmitted over wireless networks through smart phones in China. This growth results in increasing burdens being placed on the carriers’ wireless infrastructure that can overload the network. Overworked wireless networks result in poor wireless service, slow data transfer rates and dropped calls. In order to alleviate the burdens being put on the wireless infrastructure and to increase wireless network capacity, the Big- 3 continue to deploy and upgrade wireless infrastructure equipment.





Integration of the Three Networks





There is continued growth in the number of users of the Internet, mobile phones and cable/digital TV in China. This trend is causing legacy telecom, Internet, TV/radio networks to become more dependent on each other to provide services to their respective customers. For example, TV networks are integrating with Internet networks to offer IPTV, cable networks are integrating with Internet networks to offer cable Internet, and TV networks are integrating with wireless networks to deliver mobile TV. According to the IChina Research Center, $15.2 billion is expected to be spent on telecommunication upgrades to support the integration.  it’s unclear so we prefer this part to remain the same.





“The Internet of Things”





In China, a budding phenomenon has developed, referred to as “The Internet of Things” in organizations and businesses. The Internet of Things literally translates into “the connection of things”, whether they are products, components or systems, so that individuals can communicate intelligently with one another and can communicate remotely with their home and office computers and home appliances. Everything from home appliances, public infrastructure and facilities, to logistic processes will be assigned an IP address and connected to the Internet of Things through a wireline or wireless connection. This demand is expected to increase the need for wireless infrastructure.





Digital Cable Network Construction





Last year marked the sixth year in the digitization of cable television in China. At the end of 2009, cable subscribers numbered more than 174 million, and digital cable subscribers accounted for about 36% of the total, reaching 62 million. Concurrent with the technology spending required to deliver extras such as HDTV and programming on demand, an emphasis has been placed on innovating cost-effective cables.  2009





Increasing and Evolving Need for Indoor Wireless Coverage





Historically, “indoor wireless” meant only Wi-Fi enabled laptops, but currently, mobile users in China also rely on mobile and smart phones, BlackBerry devices, PDAs, and two-way radios to communicate. All of these devices require indoor wireless coverage to operate effectively. However, while many residential and commercial properties in China may have wireless local-area networks (LAN networks), the vast majority do not have indoor wireless cellular coverage for mobile or smart phones. In order to better serve the needs of their tenants, we expect that property owners will increasingly look to deploy indoor wireless coverage solutions.


- 23 -




Our Solution





We design, engineer and sell RF-based local-access network solutions for indoor and outdoor wireless coverage and WFDSTM solutions for unified local access network coverage. In the past, our focus has been on RF-based local access network solutions, but in the future we expect to leverage our WFDSTM technology to transition our customers to a unified local access network solution. Our WFDSTM solutions are designed for use by property owners of all types of buildings including enterprises, municipalities, small businesses and homes. Our unified local access network WFDSTM solutions integrate multiple access services, have a lower total cost of ownership and provide better wireless coverage.





Unified Local Access Network WFDSTM Solution





We plan to leverage our first-mover advantage with our WFDSTM technology in order to increase our penetration in China and to strengthen our relationships with the Big-3 for whom we believe our WFDSTM solution is a critical component to remain aligned with industry trends and government-sponsored initiatives.





Key benefits of our unified local access network WFDS solution include:





 ̈
Compatibility with the Big-3’s technologies and integrated services. Our WFDSTM solution is the industry’s first solution capable of providing integrated services on a single integrated platform. Our unified solution approach as well as our commitment to research and development, have strategically positioned us to be a benefactor of the Chinese government’s directive for network convergence.





 ̈
Reduction in capital expenditures. The combination of integrating services along with the use of our patented fiber-optic technology should enable the Big-3 to significantly reduce their wireless infrastructure capital expenditures.





 ̈
Reduction in space required. Utilizing our WFDSTM technology, property owners can reduce the installation space required for mobile wireless cable and Internet service by consolidating eleven devices into one. In a single compact, all-optical platform, we offer customers integrated solutions streamlined to meet our customer’s requirements.





 ̈
Easy to install, use and maintain. Our WFDSTM solution enables a property owner to deploy a single multi-functional platform in a simple and consolidated form factor. WFDSTM is easy to install and is centrally managed, is compatible with 2G and 3G services, and is forward compatible with 4G services.





RF-based Local Access Network Solutions





We provide RF-based local access network solutions to the telecommunications industry for environments including hotels, residential estates, office buildings, airports, exhibition centers, underground stations, highways and tunnels. Our suite of products that we deploy as part of these solutions includes base station and tower mounted amplifiers, antennas, couplers and splitters. Our RF-based products support various 2G and 3G transmission standards, including CDMA, W-CDMA, GSM and TD-SCDMA.





Our Competitive Strengths





We believe that the following competitive strengths enable us to compete effectively and to capitalize on the growth opportunities in our markets:





Strong Research and Development Capabilities





Our R&D capabilities rank among the best in the PRC’s telecommunications industry. We have a robust engineering project- management system and an experienced engineering team. Our research and development center is equipped with the latest equipment and testing facilities, which give our research and development personnel the tools they require to make significant advances in access-network technologies. In addition, we provide our employees with continuing education administered through internal programs. Our R&D team developed our proprietary WFDSTM product, which is one of the leading indoor access-network products in China.


- 24 -




Compared with other traditional wireless distribution systems, our WFDSTM system has many advantages. Firstly, WFDSTM uses optical fiber to transport signals. Based on the low signal-loss characteristic of fiber, through which signals can be transmitted over long distances, the main unit (“MU”) can be placed closer to the signal source, and the remote unit (“RU”) can be placed closer to the subscribers. Therefore, a micro-power signal source can be used, which reduces interference and noise, generates low electromagnetic interference, and expands the coverage area. Secondly, due to the input port of the MU connecting to the signal combiner, WFDSTM systems can support multiple signals’ access and network integration. WFDSTM can provide all broadband communication services access in the 500kHz to 3GHz band for subscribers. Thirdly, due to the fact that each node of the system has the same bandwidth and flow characteristics, WFDSTM can provide the same communication services for every subscriber. WFDSTM systems are also easy to manage and flexible for implementing expansion and upgrades of systems with minimum cost. Our R&D capabilities are recognized and approved by the PRC government and have won accolades such as the Project Certificate of National-level Torch Program and the Project Certificate of Nation-level Spark Program. In addition, a number of our products and systems, several of which have been patented or are patent pending, have been awarded various science and technology honors by PRC provincial and municipal governments. We are focused on increasing our research and development efforts to develop superior and proprietary technologies.  no need to move





Broad and diverse market base





Our business covers a wide region. We have 30 branches throughout China and our business covers approximately 29 countries worldwide.





Experienced marketing staff





We employ a group of experienced telecommunications experts and an experienced and technologically savvy marketing staff in China.





Strong customer relations





We have maintained long-term relationships with China Unicom, China Mobile, China Telecom and China Netcom (which merged with China Unicom in 2008) as customers for approximately 13 years.





Governmental support





As a high-tech enterprise with an established track record, our company enjoys the stimulus plans offered by both China’s industry governmental authorities and by local authorities, including the Ministry of Science and Technology, the Ministry of Industry and Information Technology, the Beijing municipal government and the Administrative Committee of Z-Park.





Our Growth Strategy





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





Continue to focus on research and development





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


- 25 -


Seek selective acquisitions and strategic investments





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





Strengthen international market presence





We plan to focus on increasing our presence in markets outside of the PRC. We will continue to strengthen our presence overseas by leveraging our expertise and leading access-network products and solutions. In the United States, we plan to seek cooperation with peers that have strong research and development abilities, and develop technology and products that are suitable for PRC market. However, we also find partners within the integration business to sell our products, as our products are cost-effective. In developing countries, we only seek cooperation with local integration partners to deliver our access-network solution technologies, whom we utilize as our local product distribution channels.





Description of Products and Engineering Services





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





In addition to designing and selling our products, we also provide systems integration services for our customers. The primary systems integration services provided to our customers are project design and engineering, specifically, the development and design of indoor (living quarters, hospital systems, and hotels) and outdoor (expressways, railways and no coverage zones) wireless signal complementary coverage solutions and their applied products. This includes the design of the required equipment, implementation, project quality evaluation as well as after-sale maintenance and optimization for system integration products, constructive products for engineering design projects and wireless network optimization products.





Research & Development





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





Competition





Our main domestic competitors are Guangdong Comba, Wuhan Hongxin and China GrenTech.





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


- 26 -




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





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





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





 ̈
Powerwave Technologies, Inc. is a global provider of end-to-end wireless infrastructure solutions for use in wireless communications networks. They offer OEMs (Original Equipment Manufacture), operators and network providers in the wireless communications industry a portfolio of antenna systems, base station systems and coverage systems.





 ̈
Andrew Corporation (“Andrew”) is a global designer, manufacturer, and supplier of communications equipment, services and systems. Andrew’s products and expertise are found in communications systems throughout the world, including wireless and distributed communications, land mobile radio, cellular and personal communications, broadcast, radar and navigation.





Government Regulation





The following is a summary of the principal governmental laws and regulations that are or may be applicable to our operations in the PRC. The scope and enforcement of many of the laws and regulations described below are uncertain. We cannot predict the effect of further developments in the Chinese legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement of laws.





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





The principal regulations governing the telecommunications services business in the PRC include:





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





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





 ̈
Foreign Exchange Controls. The principal regulations governing foreign exchange in the PRC are the Foreign Exchange Control Regulations (1996) and the Administration of Settlement, Sale and Payment of Foreign Exchange Regulations (1996), (“the Foreign Exchange Regulations”). Under the Foreign Exchange Regulations, Renminbi (“RMB”) is freely convertible into foreign currency for current account items, including the distribution of dividends. Conversion of RMB for capital account items, such as direct investment, loans and security investment, however, is still subject to the approval of the State Administration of Foreign Exchange (“SAFE”). Under the Foreign Exchange Regulations, foreign-invested enterprises are required to open and maintain separate foreign exchange accounts for capital account items. In addition, foreign-invested enterprises may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from SAFE.


- 27 -


Gross Margin





Our gross margin has been, and will continue to be, affected by a variety of factors, including:





·
product mix and average selling prices;


·
new product introductions and enhancements both by us and by our competitors;


·
demand for our products and services;


·
our ability to attain volume manufacturing pricing from Shijiazhuang Spectrum and our other component suppliers;


·
losses associated with excess and obsolete inventory; and


·
growth in our headcount and other related costs incurred in our professional services organization.





Operating Expenses





Operating expenses consist of sales and marketing expenses, general and administrative expenses, and research and development expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, benefits and other compensation for our employees. We had approximately 1200 full-time employees as of March 31, 2011.





Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of sales and marketing expenses, including all related expenses and compensation for sales personnel and travel expenses related to sales of products and market development. We expense sales and marketing expenses as incurred.





We plan to continue to invest strategically in sales and marketing with the intent of adding new customers and increasing penetration within our existing customer base, expanding our domestic and international sales and marketing activities, build brand awareness and sponsor additional marketing events. We expect future sales and marketing expenses to continue to be our most significant operating expenses.





General and administrative expenses primarily consist of compensation for personnel, travel expenses, materials expenses related to ordinary administration, fees for professional services, and provisions for doubtful accounts.  .





Research and development expenses primarily consist of compensation for research and development staff, material expenses, travel expenses and facility expenses. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest in our research and development efforts because we believe they are essential to maintaining our competitive position. The dollar amount invested in our research and development activities will increase as we continue to increase our revenue. However, as a percentage of revenue, research and development costs are expected to remain relatively low.





Interest Expense





Interest expense includes interest we pay on our short-term bank loans.




- 28 -





Other Income (Expense), net





Other income (expense), net includes interest income on cash balances, gain or loss from disposal of assets, gains or losses on conversion of non-Renminbi transactions into Renminbi, and gains from governmental subsidy. Cash has historically been invested in highly liquid investments with original maturities of three months or less.





Income Tax Expense





Income tax expense is computed based on pre-tax income included in the condensed consolidated statement of operations. Income taxes have been provided, using the liability method, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities and their reported amounts. The tax consequences of those differences are classified as current or non-current based upon the classification of the related assets or liabilities in the condensed consolidated financial statements.





Critical Accounting Policies





Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). These accounting principles require us to make estimates and judgments that affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, foreign currency translation, inventory valuation, allowances for doubtful accounts, and goodwill.





Revenue Recognition





Our revenue is derived primarily from two sources: (1) product revenue and  (2)  professional services revenue.





Product revenue represents the contracted value of goods, net of value-added tax (“VAT”) and returns. The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery occurs, the fee is fixed or determinable, and collectability is probable. Professional service revenue is recognized when the service is performed and accepted by the customer.





As part of professional services, the Company provides installation services for certain sales of equipment under fixed-price contracts. Revenues from these fixed-price service contracts are recognized on the completed-contract method. Under the completed-contract method, revenue and costs of individual contracts are included in operations in the year during which they are completed. Losses expected to be incurred on contracts in progress are recognized in the period such losses are determined. This method is used because the contract is completed within a short period of time, and the financial position and results of operations do not vary significantly from those that would result from using the percentage-of-completion method. A contract is considered completed upon completion of all essential contract work and once the installation has been accepted by the customer.





Foreign Currency Translation





All major subsidiaries of the Company consider Renminbi as their functional currency as a substantial portion of their business activities is conducted in Renminbi. However, the Company has chosen the United States dollar as its reporting currency.





Transactions in currencies other than the functional currency during the year are translated into the functional currency at the applicable rates of exchange prevailing at the time of the transactions. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at the applicable rates of exchange in effect at the balance sheet date. Exchange gains and losses are recorded in the condensed consolidated statements of operations.


- 29 -


For translation of financial statements into the reporting currency, assets and liabilities are translated at the exchange rate at the balance sheet date, equity accounts are translated at historical exchange rates, and revenue, expenses, gains and losses are translated at the weighted average rates of exchange prevailing during the period. A translation adjustment, when material, resulting from this process is recorded in accumulated other comprehensive income within stockholders’ equity.





Inventory Valuation





Inventory consists of equipment and related component parts and is stated at the lower of weighted average cost or market. We record inventory write-downs for potentially excess inventory based on forecasted demand, economic trends and technological obsolescence of our products. If future demand or market conditions are less favorable than our projections, additional inventory write-downs could be required and would be reflected in cost of product revenue in the period the revision is made. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.





Allowances for Doubtful Accounts





We record a provision for doubtful accounts based on historical experience and a detailed assessment of the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, our management considers, among other factors, (1) the aging of the accounts receivable, including trends within and ratios involving the age of the accounts receivable, (2) our historical write-offs, (3) the credit-worthiness of each customer, (4) the economic conditions of the customer’s industry, and (5) general economic conditions. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected.





Goodwill





We apply ASC Topic 350 – Goodwill and Other Intangibles and perform an annual goodwill impairment test, or test more frequently if events or changes in circumstances indicate that the carrying value may be impaired. Goodwill is allocated to cash-generating units for the purpose of impairment test and determination of gain or loss on disposal.





Goodwill on acquisition of businesses, being the excess of the cost of the acquisition over the Company’s share of the fair value of the identifiable assets, liabilities and contingent liabilities, is recognized as a separate asset. Goodwill is carried at cost less accumulated impairment losses. An impairment loss on goodwill is not reversed. We did not recognize impairment charges in any of the periods presented.


- 30 -


RESULTS OF OPERATIONS





Our operating results are presented for the quarter ended March 31, 2011, as compared to the quarter ended March 31, 2010.





The following is the statement of our operations for the three months ended March 31, 2011 and 2010.





Item

2011 Q1


2010 Q1


Comparisons$'000


% of revenue


$'000


% of revenue


$'000


%Revenue


14472






11132






3340



30.0
%Equipment and services costs


7874



54.41
%


6193



55.63
%


1681



27.1
%Gross profit


6598



45.59
%


4939



44.37
%


1659



33.6
%Sales and marketing expenses


2131



14.72
%


2728



24.51
%


-597



-21.9
%General and administrative expenses


2005



13.85
%


2934



26.36
%


-929



-31.7
%Research and development expenses


248



1.71
%


224



2.01
%


24



10.7
%Depreciation and Amortization


102



0.70
%


71



0.64
%


31



43.7
%Interest expenses


149



1.03
%


126



1.13
%


23



18.3
%Other income, net


203



1.40
%


335



3.01
%


-132



-39.4
%Net Income before income tax


2166



14.97
%


-809



-7.27
%


2975



367.7
%Income tax


547



3.78
%


321



2.88
%


226



70.4
%Net income


1619



11.19
%


-1130



-10.15
%


2749



243.3
%





Revenue





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





For the three months ended March 31, 2011, our revenue was $14.5 million, representing an increase of 30% from the same period in 2010.





Revenue Breakdown





Three months ended March 31, 2011 and 2010:





2011 Q1


2010 Q1


Growth$'000


% of revenue


$'000


% of revenue


$'000


%Product sales


6992



48.3
%


5100



45.8
%


1892



37.1
%Service sales


7480



51.7
%


6032



54.2
%


1448



24.0
%Total


14472







11132







3340



30.0
%





For the three months ended March 31, 2011, revenue generated from product sales was $7.0 million, representing an increase of 37.1% from the same period in 2010. The increase in product revenue was primarily attributable to increases in sales of WFDSTM systems. WFDSTM system sales continue to grow as our WFDSTM solutions continue to gain market traction and as the associated projects tend to be relatively large.


- 31 -




For the three months ended March 31, 2011, revenue generated from professional services was $7.5 million, representing an increase of 24.0% from the same period in 2010. Our marketing performance is developing at a steady rate.





Breakdown by Customers





Three months ended March 31, 2011 and 2010:





2011 Q1


2010 Q1


Growth$’000


% of revenue



$’000


% of revenue



$’000


%China Mobile


6260



43.2
%


8910



80.0
%


-2650



-29.7
%China Unicom


5409



37.4
%


1083



9.8
%


4326



399.4
%China Telecom


895



6.2
%


947



8.5
%


-52



-5.5
%Others


1876



13
%


0



0
%


1876



—Overseas


32



0.2
%


192



1.7
%


-160



-83.3
%Total


14472







11132







3340



30.0
%





Revenues from the wireless telecom carriers were the Company’s major source of revenue during the three months ended March 31, 2011, and the majority of such revenues were generated from China Mobile and China Unicom.





For the three months ended March 31, 2011, our revenues generated from China Mobile accounted for 43.2% of our total revenue. Our revenue generated from China Unicom accounted for 37.4% of total revenue, representing an increase of 399.4% compared to the same period in 2010. The increased revenues from China Unicom were mainly attributable to the significant increase of revenue from Beijing Unicom, Hebei Unicom, Gansu Unicom and our new customer Anhui Unicom during the first three months in 2011.





Breakdown by Type of technology





2011 Q1


2010 Q1


Growth$’000


% of revenue


$'000


% of revenue


$'000


%WFDSTM product


3330



23.00
%


2930



26.32
%


400



13.65
%Traditional product


11142



77.00
%


8202



73.68
%


2940



35.85
%Total


14472



100
%


11132



100
%


3340



30.00
%





For the three months ended March 31, 2011, the revenue of our most competitive WFDSTM product was $3,330,000, contributing 23.0% of the total revenues in Q1, representing an increase in sales of 13.65%, compared to the same period of 2010.


Sales of our WFDSTM product are developing at a steady rate.





Gross Profit





Our gross profit was $6,598,000 in the three months ended March 31, 2011, representing an increase of 33.6% as compared to the same period in 2010.





For the three months ended March 31, 2010 and 2011, a tabular summary of our gross profit is presented below:





2011Q1


2010 Q1


Growth$’000


% of revenue


$'000


% of revenue


$'000


%Revenue


14472






11132






3340



30
%Equipment and services costs


7874



54.41
%


6193



55.63
%


1681



27.1
%Gross profit


6598



45.59
%


4939



44.37
%


1659



33.6
%





- 32 -





Equipment and service costs.





Equipment and service costs were approximately $7,874,000 or 54.41% of revenue for the three month ended March 31, 2011, as compared to $6,193,000, or 55.63% of revenue for the same period in 2010, an increase of approximately 27.1%.





Gross profit ratio.





Our gross profit ratio was 45.59% in the first quarter of 2011, as compared to 44.37% in the first quarter of 2010. Our gross profit ratio was stable.





Operating Expenses





Three months ended March 31, 2011 and 2010:





2011Q1


2010 Q1


Growth$’000


% of revenue


$'000


% of revenue


$'000


%Sales and Marketing expenses


2131



14.72
%


2728



24.51
%


-597



-21.9
%General and Administrative expenses


2005



13.85
%


2934



26.36
%


- 929



-31.7
%Research and Development expenses


248



1.71
%


224



2.01
%


24



10.7
%Depreciation and Amortization


102



0.70
%


71



0.64
%


31



43.7
%Total


4486



30.98
%


5957



53.52
%


-1471



-24.7
%





Operating expenses mainly include sales and marketing expenses, general and administrative expenses and research and development expenses.





Sales and Marketing expenses.





Sales and marketing expenses were approximately $2,131,000 or 14.72% of our revenue for the three months ended March 31, 2011, as compared to $2,728,000, or 24.51% of our revenue for the same period in 2010. The decrease of sales and marketing was mainly due to a decrease in stock-based compensation expenses of approximately $492,000.





General and Administrative expenses.





General and administrative expenses were $2,005,000 or 13.85% of our revenue for the three months ended March 31, 2011, as compared to $2,934,000 or 26.36% of revenue for the same period in 2010.





The decrease in general and administrative expenses was mainly due to the decrease in stock-based compensation expenses from the issuance of shares in 2010 amounting to $2,109,000, partly offset by the stock option expense recognized in this quarter of $452,000 and the increase in rental expenses following the relocation of the Company’s headquarter in late 2010.





Research and Development expenses.





Research and development expenses were $248,000 or 1.71% of revenues for the three months ended March 31, 2011, as compared to $224,000, or 2.01% of revenues for the same period in 2010. The R&D expenses increased by 10.7%, but the proportion of R&D expenses to revenue remained at a relatively low level.




- 33 -




Interest Expense





2011 Q1


2010 Q1


Growth$’000


% of revenue


$'000


% of revenue


$'000


%Interest expenses


149



1.03
%


126



1.13
%


23



18.3
%




The increase of the interest expense in 2011 was due to more interest paid on short-term loans. The Company’s short-term loans totaled $11,100,000 as of March 31, 2011, as compared to $5,850,000 as of March 31, 2010, an increase of 89.74%.





Net Income





The net profit margin was 11.19% for the three month ended March 31, 2011, as compared to (10.15)% in 2010. The increase of the net profit margin was mainly due to the effect caused by the lack of stock-based compensation during the first quarter of 2010 from the issuance of shares and warrants that the Company incurred during the same period of 2010.





LIQUIDITY AND CAPITAL RESOURCES





We generally finance our operations from cash flow generated internally and short-term bank loans. As of March 31, 2011, we had current assets of $234,446,000. Our current assets were comprised of: inventories of $4,761,000, accounts receivable of $197,977,000, prepayments of $1,797,000, other current assets of $1,929,000, and cash and cash equivalents of $26,504,000. Current liabilities were comprised of: accounts payable of $42,358,000, tax payables of $14,235,000, short-term loans of $11,100,000, customer deposits for sales of equipment of $2,157,000, amounts due to related parties of $1,763,000 and other payables and accruals of $51,169,000.





Our net cash used in operating activities was $5,623,000 for the three months ended March 31, 2011. As of March 31, 2011, cash and cash equivalents were $26,504,000, current assets were $234,446,000 and current liabilities were $122,782,000, reflecting a current ratio (current assets/current liabilities) of 1.91:1.





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





As of March 31, 2011, our cash and bank balances are mainly denominated in RMB and U.S. Dollars, while our bank borrowings are mainly denominated in RMB. Our revenue, expenses, assets and liabilities are mainly denominated in RMB and U.S. Dollars.





OFF-BALANCE SHEET ARRANGEMENTS





We do not have any off-balance sheet arrangements.





CONTINGENT LIABILITIES





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





Item 3. Quantitative and Qualitative Disclosures About Market Risk





Not required for smaller reporting company.


- 34 -


Item 4. Controls and Procedures





(a) Evaluation of disclosure controls and procedures





Under supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”); and whether any change has occurred in the Company’s internal control over financial reporting pursuant to Exchange Act Rules 13a-15(d) and 15d-15(d). Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. This information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were not effective due to the fact that the material weaknesses in the Company’s internal control over financial reporting described in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 have not been remediated as of the Evaluation Date, although steps have been taken toward remediation during the quarter ended March 31, 2011.





It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.





(b) Changes in internal control over financial reporting





During the quarter ended March 31, 2011, there were no changes to our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


- 35 -


PART II





OTHER INFORMATION





Item 1.  Legal Proceedings.





None.





Item 1A. Risk Factors.





Not required.





Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.





None.





Item 3.  Defaults Upon Senior Securities.





None.





Item 4.  (Removed and Reserved).





Item 5.   Other Information.





None.





Item 6.   Exhibits.





The following documents are filed as part of this report:





31.1

Chief Executive Officer Certification furnished pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2

Chief Financial Officer Certification furnished pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1

Chief Executive Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2

Chief Financial Officer Certification furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002




- 36 -




SIGNATURES




In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.





TELESTONE TECHNOLOGIES

CORPORATIONDate: May 16, 2011
By:
/s/ Han DaqingHan Daqing, Chief Executive Officer(Principal Executive Officer)





Date: May 16, 2011
By:
/s/ Yu XiaoliYu Xiaoli, Chief Financial Officer(Principal Financial Officer)


- 37 -