CHINA DIGITAL ANIMAT (OTC:CHDA)

CHINA DIGITAL ANIMATION DEVELOPMENT, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
		For the Three Months Ended								For the Six Months Ended
		December 31,								December 31,
		2011				2010				2011				2010
						(Restated)								(Restated)
REVENUE		$	312,924			$	2,014,129			$	771,353			$	3,819,988
COST OF REVENUE			144,962				2,395,229				655,474				4,214,410
GROSS PROFIT (LOSS)			167,962				(381,100	)			115,879				(394,422	)
OPERATING EXPENSES:
Selling, general and administrative			223,730				156,578				426,912				694,454
Total Operating Expenses			223,730				156,578				426,912				694,454
LOSS FROM OPERATIONS			(55,768	)			(537,678	)			(311,033	)			(1,088,876	)
OTHER INCOME:
Interest income			6				7,121				503				9,136
Other income			1,744				-				4,939				-
Total Other Income			1,750				7,121				5,442				9,136
LOSS FROM OPERATIONS BEFORE PROVISION FOR INCOME TAXES			(54,018	)			(530,557	)			(305,591	)			(1,079,740	)
PROVISION FOR INCOME TAXES			5,190				339,616				5,190				615,787
NET LOSS		$	(59,208	)		$	(870,173	)		$	(310,781	)		$	(1,695,527	)
COMPREHENSIVE INCOME:
OTHER COMPREHENSIVE INCOME:
Unrealized foreign currency translation gain			75,375				288,924				192,213				406,318
COMPREHENSIVE INCOME (LOSS)		$	16,167			$	(581,249	)		$	(118,568	)		$	(1,289,209	)
NET LOSS PER COMMON SHARE:
Basic and diluted		$	(0.00	)		$	(0.04	)		$	(0.02	)		$	(0.08	)
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic and diluted			20,290,000				20,125,978				20,287,391				20,072,989

All of our revenue in the three and six months periods ended December 31, 2011 and 2010 was earned by our animation developers. Our investments in media projects will not produce revenue until calendar year 2012. The 80% reduction in our revenue from the first half of fiscal 2011 to the first quarter of fiscal 2012 and the 84% reduction in our revenue from the second quarter of fiscal 2011 to the second quarter of fiscal 2012, however, reflect our decision to significantly reduce our involvement in the animation development industry.

On December 28, 2011 Sheng Zhai resigned from his position as a member of the Company’s Board of Directors and from his position as the Chairman, Chief Executive Officer and President of the Company.

Recently we re-assessed our position in the animation development marketplace. Our perception was that the animation industry in China has grown to a point at which we will soon be no longer able to compete effectively. In recent years, however, due to the emphasis that the Chinese government has placed on the development of the animation industry, the market has become thick with competition. Despite the funds and efforts that we devoted to marketing, in fiscal 2011 we found it impossible to secure the quantity of contracts that we required at bid prices that would yield profits to us. Moreover, due to constant and rapid improvements in the equipment and software used in our industry, to remain competitive would require us to devote continual capital expenditures for upgrades and additions to our animation production facilities. Management’s decision, therefore, was to re-orient our business model from one based on utilization of a state-of-the-art in-house capacity, to one in which we utilize our long-standing customer contacts and project management skills to obtain and manage project contracts while outsourcing most of the actual development work. With this new business model, we will be able to more selectively choose the projects we work on, as we will no longer have the need to make constant use of an extended staff and expensive facilities. To reorient our business model in this manner, during fiscal year 2011 we liquidated a large portion of our animation development property and equipment, and reduced our animation development staff to a modest crew. As a result, in the first quarter of fiscal year 2012, we had much lower selling, general and administrative expenses than in the first quarter of the prior fiscal year.

On May 27, 2011 Fu Qiang resigned from his position as a member of the Company’s Board of Directors and from his position as the Chairman and Chief Executive Officer of the Company.

In connection with his resignation, Fu Qiang entered into a Resignation and Stock Transfer Agreement with Ieong Waifong and the Company. Pursuant to the Agreement, Fu Qiang transferred to Ieong Waifong five million shares of the Company’s common stock, representing 24.7% of the outstanding shares. Fu Qiang transferred the shares to Ieong Waifong without compensation. However, in the same Agreement Ieong Waifang granted to the Company an option to purchase the shares for a price of $.001 per share. The Company may exercise the option at any time prior to December 31, 2020.

On June 1, 2011 the Company’s Board of Directors appointed Sheng Zhai to serve as Chairman and Chief Executive Officer of the Company. Sheng Zhai has been employed as the Company’s President since February 8, 2010.

Third Quarter Results:

• Revenue for the third quarter of fiscal 2011 increased 29.2% to $2.2 million compared to $1.7 million for the same period last year.
• Gross profit for the third quarter of fiscal 2011 was $1.5 million versus $1.0 million for the same period last year.  
• The company's income from operations for the third quarter of fiscal 2011 was $1.2 million compared to $855 thousand for the third quarter of fiscal 2010. 
• Net income for the third quarter of fiscal 2011 was $859 thousand or $0.04 per share, versus $691 thousand, or $0.03 per share in the same period last year.

Mr. Fu Qiang, Chairman and Chief Executive Officer, commented, "We are pleased to report another quarter of strong growth. Within our animation segment alone, revenue increased 79% compared to the same period last year. We have rapidly expanded our animation development business over the past two years and our customers now span the movie, television and online industries. Market growth is due in part to increasing demand for high end special effects, including 3-D animation. We also offer animated products for commercial customers used in advertising, branding and education purposes, which we see as an important avenue for growth going forward."

Second Quarter Highlights:

Mr. Fu Qiang, Chairman and Chief Executive Officer, commented, "We are pleased to report another strong quarter and a growing portfolio of notable projects. Revenue for the second quarter of fiscal 2011 grew 63% to $2.0 million compared to the second quarter of fiscal 2010 and we achieved gross margins of 82% for the quarter versus 44% for the same period last year. Streamlining our focus on digital animation is proving to be a winning strategy for the company and our shareholders."

To meet demand for its animation services, China Digital put a significant amount of new equipment into service over the past few months and expects to make additional upgrades to its facilities in the coming year.

• Revenue for the second quarter of fiscal 2011 increased 63% to $2.0 million compared to $1.2 million for the same period last year.
• Gross profit for the second quarter of fiscal 2011 was $1.7 million versus $537 thousand for the same period last year.
• The company's income from operations for the second quarter of fiscal 2011 was $1.3 million compared to $271 thousand for the second quarter of fiscal 2010.
• Net income for the second quarter of fiscal 2011 was $919 thousand or $0.05 per share, versus $251 thousand, or $0.01 per share in the same period last year.

As of December 31, 2010, the company had cash and cash equivalents of $9.3 million, working capital of $9.4 million, no long-term debt and shareholders' equity of $17.4 million

10Q excerpts:

Because our current operations are focused on service industries, we record a low cost of goods sold. We currently have a staff of over 130 employees dedicated to the animation development business, and their salaries are accounted for as cost of goods sold. In addition, a portion of our depreciation and amortization expense is also accounted for as cost of goods sold. Nevertheless, during the three months ended December 31, 2010, our animation development projects yielded a gross margin of 82%, an improvement over the 44% gross margin achieved in the three months ended December 31, 2009. During the six months ended December 31, 2010, our animation development projects yielded a gross margin of 81%, an improvement over the 61% gross margin achieved in the six months ended December 31, 2009. Our gross margin will vary from one period to another, depending on our success in pricing the animation contracts we perform. In general, however, we expect our gross margin ratio to remain high.

We expect the improvement in our operating results to continue in the foreseeable future, since our animation business is already producing better and more profitable revenue.

Because our current operations are focused on service industries, we record a low cost of goods sold, compared to the cost of goods sold recorded by our now-discontinued network engineering business. During the three months ended September 30, 2010, our animation development projects yielded a gross margin of 87%, an improvement over the 81% gross margin achieved in the three months ended September 30, 2009. Our gross margin will vary from one period to another, depending on our success in pricing the animation contracts we perform. In general, however, we expect our gross margin ratio to remain high.

On the other hand, the overhead required to maintain an animation development business is greater than that required by the network engineering business. We currently have a staff of over 130 employees dedicated to the animation development business, and their salaries are accounted for as general and administrative expense. In addition, within the past year we have put in service a significant expansion of our animation equipment, which we must now depreciate. As a result, our depreciation and amortization expense for the three months ended September 30, 2010 increased by $232,600 over the same category of expense in the three months ended September 30, 2009. Our operating expenses for the three months ended September 30, 2010, therefore, increased by $297,045 (127%) over the same period of the prior year. We expect general and administrative costs to continue to increase, as we plan to continue to upgrade our equipment.

Our bottom line operating result for the three months ended September 30, 2010 was net after-tax income of $763,762, a 32% improvement over net income in the three months ended September 30, 2009. We expect the improvement in our operating results to continue in the foreseeable future, since our animation business is already producing better and more profitable revenue

To date, our operations have been funded by capital contributions from Hairong’s management and employees. Approximately 54% of the capital contribution has been made by members of management and their business associates. The remaining 46% was contributed by the employees, acting through a trustee. The Company expects that in the future it will issue equity to the employees to compensate them for their financial contributions to the growth of Hairong, and to incentivize them for future loyalty to Hairong.

This program of internal financing has left us with a balance sheet that, at September 30, 2010, included no debt, either short-term or long-term, other than a $286,000 loan payable to one of our shareholders. It also left us with working capital of $7,910,313 at September 30, 2010, an improvement of $1,212,672 during the quarter. Included in our working capital at September 30, 2010 was $7,550,458 in cash. Since our operations have been cash positive in each of the past three fiscal years - providing $5,277,646 in cash during the 2010 fiscal year, $819,226 in cash during the 2009 fiscal year, and $2,030,233 in cash during the 2008 fiscal year - we believe that our cash resources are adequate to fund our operations for the foreseeable future.

We expect to fund additional upgrades to our film and animation production facilities during the next twelve months. We expect the overall cost of these capital improvements to be approximately 27 million RMB (approximately $4 million). At present, we anticipate that we will finance these projects from our capital resources. However, if we are able to obtain financing on favorable terms, we may use external financing for one or more of the projects. Currently we have fixed assets with a book value of $8,137,196 on which there is no lien. This provides us the ability to obtain secured debt financing, if we decided to preserve our working capital. Based on this experience, we anticipate that our capital resources will be adequate to fund our operations for the foreseeable future.

We expect to fund additional upgrades to our film and animation production facilities during the next twelve months. We expect the overall cost of these capital improvements to be approximately 27 million RMB (approximately $4 million). At present, we anticipate that we will finance these projects from our capital resources. However, if we are able to obtain financing on favorable terms, we may use external financing for one or more of the projects. Currently we have fixed assets with a book value of $8,331,630 on which there is no lien. This provides us the ability to obtain secured debt financing, if we decided to preserve our working capital. Based on this experience, we anticipate that our capital resources will be adequate to fund our operations for the foreseeable future.