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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our interim condensed consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q.

Certain statements in this section contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements contained in this report and not clearly historical in nature are forward-looking, and the words “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “intends,” “potential,” and similar expressions (as well as other words or expressions referencing future events, conditions or circumstances) generally are intended to identify forward-looking statements. Any statements in this report that are not historical facts are forward-looking statements. Actual results may differ materially from those projected or implied in any forward-looking statements. Such statements involve risks and uncertainties, including but not limited to those relating to product and customer demand, market acceptance of our products, the ability to create new products, the ability to achieve a sustainable profitable business, the effect of economic conditions, the ability to protect our intellectual property rights, competition from other providers and products, risks in product development, our ability to raise capital to fund continuing operations, and other factors discussed from time to time in our filings with the Securities and Exchange Commission. We undertake no obligation to update or revise any forward-looking statement for events or circumstances after the date on which such statement is made except as required by law. Amounts in this section are in thousands, unless otherwise indicated.

Overview

We specialize in the design, manufacture and direct sale of customized technical endurance apparel for the cycling, triathlon, running and Nordic skiing markets across Asia, Europe and North America. Our made-to-order, just-in-time (“JIT”) process vertically integrates design, manufacturing, sales and distribution of sporting apparel products.

The chart below illustrates our company’s current organizational structure:

For the purpose of streamlining its manufacturing operations in China, Rider Sportsfashion (LangFang) took over the operations of two other branches. The deregistration process for these two branches was completed in December 2017 and April 2018, respectively.

Our global sporting apparel business is currently comprised of three core business units: inline retail, which consists of products produced and sold as part of a collection (“Inline”), OEM contract manufacturing (“OEM”) and custom order. (“Custom Order”). Our Inline, OEM and Custom Order businesses currently account for 8%, 25% and 67%, respectively, of our sales revenue for the three months ended March 31, 2019, comparing with 11%, 28%, and 61% for the three months ended March 31, 2018.

The two primary sales channels for our Inline and Custom Order business are direct to consumer (“DTC”), and wholesale. DTC currently generates 71% of our revenues for the three months ended March 31, 2019, compared to 69% for the three months ended March 31, 2018. Under the DTC model, we sell and fulfill our products directly to end consumers exclusively online through e-commerce platforms. In China, DTC sales are processed through online retailers such as TMall and JD.com. Sales in North America and Europe are processed through our proprietary Jakroo e-commerce and licensed e-commerce systems. The Jakroo e-commerce platform allows customers to easily log onto our platform, complete their designs or submit design requests to our Pro designers and place purchase orders. Wholesale represented 29% of our revenue for the three months ended December 31, 2019 compared to 31% for the three months ended March 31, 2018. We act as both retailer and wholesaler of our products through our proprietary Jakroo e-commerce platform as well as through large online retailers in China. Sales through both channels are executed with payments made directly to us online prior to the production and shipment of products.

In order to target customers in major markets, we have established sales offices in the United States, Canada, Austria, and China that provide localized sales, marketing and customer service support to our regional markets. As of the date of the report, we have approximately 186 employees worldwide.

The purchase of our 6,300 square feet U.S. headquarters facility in Pleasanton, California in the first quarter of 2017 was a major step in further strengthening our sales, marketing and innovation teams. During the three months ended March 31, 2019, our California based design team created 4,803 Pro Custom designs, compared to 5,456 Pro Custom designs during the same period in 2018, representing a 12% decrease in Pro Design requests. We attribute the decrease in pro design projects to a combination of inclement weather conditions across our core markets and a shift by some customers from utilizing our pro design service to utilizing the new Jakroo Express self-design platform. During the latter half of October 2018, we launched a beta version of our new Jakroo Express Design Center and subsequently released the platform to live at the end of December 2018. Using Jakroo Express, customers are able to create their own designs without the assistance of a Pro Designer. We recorded 645 new user sign-ups during the three months ended March 31, 2019 compared to 50 new user sign-ups during the same period in 2018 on the previous platform representing a 1190% increase in new customer acquisition. We anticipate that the number of new user sign-ups on the Jakroo Express platform will continue to grow as we target certain customer personas that prefer a self-directed design experience. New user visits across our US, Canadian, and European informational websites increased 6.7% during the three months ended March 31, 2019 as compared to the same period in 2018. The increase can be attributed to investments in our social media and search engine marketing campaigns focused on increasing awareness for the Jakroo brand.

During the quarter ended March 31, 2019, our new customer sales decreased 3.8% while our number of returning customer sales increased 8%, compared to the same period in 2018. This resulted in a decrease in revenue from our Custom Order segment of approximately 2.6% across our North American and European operating segments compared to the same period last year. We attribute the decrease in revenue to a slowdown in consumer demand as a result of inclement weather affecting much of our core markets across the United States and Canada.

We lease a 64,000 square feet manufacturing facility at the border of Beijing and Hebei province in China. The facility has annual capacity to produce 500,000 jerseys and manufactures all of our products. We consider our centralized manufacturing facility both a competitive advantage and a key driver behind our ability to maintain high quality and industry leading short delivery times. During the quarter ended March 31, 2019, we processed approximately 11,978 micro-production lots with a total production quantity of 29,321 units, compared to 11,726 lots and 30,778 units respectively during the same period in 2018. 96% of these products were produced and shipped in 14 days or less and 61% were produced and shipped in 7 days or less for the first quarter 2019 compared to 99% of products produced in 14 days or less and 83% produced and shipped in 7 days or less during the same period in 2018. During both fiscal periods, the average production lot quantity of 3pcs remained constant.

Our operating segments include North America, China and Europe.

We believe there is increasing recognition of the health benefits of an active lifestyle through cycling, triathlon and running. We believe this trend provides us with an expanding potential consumer base for our products. We also believe there continues to be an increasing number of individuals participating in cycling, triathlon and running activities, thus creating an increased demand for athletic apparel from leisure, pre-athlete and amateur participants. We plan to continue to grow our business over the long term through increased sales of our apparel via our made-to-order, JIT process, and our expansion in international markets.

Although we believe these trends will facilitate our growth, we also face potential challenges that could limit our ability to take advantage of these opportunities, including, among other things, the risk of general economic or market conditions that could affect consumer spending and the financial health of our retail customers. In addition, we may not be able to effectively manage our growth as our business becomes a larger and more complex global business. We may not consistently be able to anticipate consumer preferences or develop new and innovative products that meet changing consumer needs and preferences in a timely manner. Furthermore, our industry is very competitive, and competition pressures could cause us to reduce the prices of our products or otherwise affect our profitability.

General

Revenues are comprised of the sales of our technical endurance apparel products, which include OEM, inline collection and custom made to order, with the custom made to order assuming the highest percentage of sales of the three segments.

Cost of revenues consists primarily of fabrics, other raw materials, overhead, manufacturing costs, inbound raw material freight and outbound duty and freight costs required to make our products floor-ready to customer specifications.

We include outbound freight costs associated with shipping goods to customers as cost of goods sold.

Our selling, general and administrative expenses consist of costs related to marketing, selling, product innovation, supply chain and corporate services. Personnel costs are included in these categories based on each employee’s function. Personnel costs include salaries, benefits and incentives.

Results of Operations

Three Months Ended March 31, 2019 compared to Three Months Ended March 31, 2018

The following table sets forth key components of our results of operations for the periods indicated, both in dollars and as a percentage of net revenues:

The decrease in net revenue was primarily driven by decreases in our OEM and Inline business units’ revenues which decreased by $125,981 or 17.0% and $80,157 or 28.0%, respectively. We attribute the decrease in our OEM and Inline business units’ net revenue largely to the reduced orders from OEM customers and increased competition on the e-commerce platforms such as TMall and JD.com in China.

Our Custom Order unit’s revenue increased slightly by $15,573, or 1.0%, to approximately $1.65 million for the three months ended March 31, 2019 from approximately $1.63 million during the same period in 2018. Our Custom Order unit accounted for approximately 66.8% and 61.4% of total revenue for the three months ended March 31, 2019 and 2018, respectively. During the three months ended March 31, 2019, Custom Order sales in North America experienced a decline of approximately 4.6% compared to the same period in 2018. Custom Order Sales in Europe increased 30% during the three months ended March 31, 2019 compared to the same period in 2018 as a result of new customer acquisition. Revenue generated from Custom Orders sales in China increased 133% for the three months ended March 31, 2019 compared to the same period in 2018 primarily due to the implementation of promotional campaigns and a new personal fit service which is designed to improve the online ordering process and provide a better fitting product.

Cost of Revenues

Cost of revenues for our products includes the expenses incurred from our purchase of raw materials, direct labor fees and manufacturing overhead.

For the three months ended March 31, 2019, our total cost of revenues amounted to approximately $1.15 million, or 46.5% of total revenues, as compared to approximately $1.27 million, or 47.8% of net revenues in the three months ended March 31, 2018. The decrease in cost of revenues as a percentage of total revenue was primarily driven by an increase of Custom Order sales which have a higher gross margin. The Customer Order revenue as percentage of net revenue increased 5.4% to 66.8% for the three months ended March 31, 2019, compared to 61.4% for the same period in 2018.

Gross profit

Gross profit decreased by $67,450, or 4.9%, to approximately $1.32 million for the three months ended March 31, 2019 from approximately $1.39 million for the same period in 2018. Gross profit as a percentage of net revenues, or gross margin, increased by 1.3% to approximately 53.5% in the three months ended March 31, 2019 compared to approximately 52.2% in the same period in 2018. The increase in gross margin percentage was primarily driven by the increase of Custom Order sales which have a higher gross margin.

Selling, general and administrative expenses

Our selling, general and administrative expenses consist of costs related to marketing, selling, new product development and auditing and legal services. For the three months ended March 31, 2019, selling, general and administrative expenses slightly decreased by $16,430 to approximately $1.34 million from approximately $1.35 million for the same period in 2018. As a percentage of net revenues, selling, general and administrative expenses increased by 3.2% to 54.1% in the three months ended March 31, 2019 from 50.9% for the same period in 2018. The increase was primarily attributable to a decrease of net revenue for the three months ended March 31, 2019.

Provision for income taxes

Provision for income taxes increased $9,761 to $15,710 in the three months ended March 31, 2019 from $5,949 during the same period in 2018. The increase is directly attributed to the income taxes paid in China and Canada in the three months ended March 31, 2019 compared to the same period in 2018.

Other Comprehensive Income (loss)/Foreign Currency Translation Adjustment

Other comprehensive income foreign currency translation adjustment changed $55,873 to an income of $72,006 in the three months ended March 31, 2019 from an income of $127,879 in the same period in 2018. These changes were primarily attributable to the increase in the US Dollar to RMB exchange rate in the three months ended March 2019 as compared to the same period in 2018.

Segment Results of Operation

The revenues and income (loss) before income taxes associated with our segments are summarized in the following tables.

Three Months Ended March 31, 2019 compared to Three Months Ended March 31, 2018

Revenues by segment are summarized below:

Net revenues from our North America operating segment decreased by $162,809, or 10.2%, to approximately $1.44 million in the three months ended March 31, 2019 from approximately $1.60 million during the same period in 2018. The decrease was primarily attributed to the realignment of OEM business to China after the first quarter of 2018 and the decrease of revenue from our Custom Order business due to the severe weather condition in North America in the three months ended March 31, 2019. Net revenues in China decreased by $54,475, or 5.6%, to $922,832 in the three months ended March 31, 2019 from $977,307 during the same period in 2018. This decrease was primarily due to a decrease of revenue from our OEM and Inline business units in China. Net revenue generated from the European market shows an increase of $26,719 to $113,545, or 30.8%, in the three months ended March 31, 2019 from $86,826 during the same period in 2018. This increase was primarily driven by the better marketing strategy with lower discount to customers.

Income (loss) before income taxes by segment is summarized below:

Our North America operating segment shows an increase of operating loss of $86,212, or 123.5%, to $155,997 for the three months ended March 31, 2019 from a $69,785 operating loss during the same period in 2018. The increase of the operating loss was primarily due to a decrease of $162,809, or 10.2%, in net revenue and increases of amortization and maintenance expenses related to our Jakroo e-commerce platform for the three months ended March 31, 2019 compared to the same period in 2018.

Our China operating segment shows a decrease of operating income of $7,623, or 6.6%, to $107,906 for the three months ended March 31, 2019 from $115,529 in the same period in 2018. The decrease of operating income are primarily due to a decrease of $54,475, or 5.6%, in revenue in this segment during three months ended March 31, 2019 compared to the same period in 2018 and effects of the increase in the US Dollar to RMB exchange rate in the three months ended March 2019 as compared to the same period in 2018.

Our Europe operating segment shows an operating income of $14,241 for the three months ended March 31, 2019 from a $29,560 operating loss in the same period in 2018. The turnaround from operating losses to operating income in the three months ended March, 31, 2019 was primarily attributed to an increase of revenue and better marketing strategy with lower discount to customers.

Liquidity and Capital Resources

Our cash requirements have principally been for working capital and capital expenditures. We fund our working capital, inventory and capital investments from cash flows from operating activities, cash and cash equivalents on hand. Our working capital requirements generally reflect the growth in our business. Our capital investments have included purchasing factory machinery, leasehold improvements for our offices and factory, land and building, and making investments and improvements in information technology systems.

We believe our cash, cash equivalents on hand and cash from operations are adequate to meet our liquidity needs and capital expenditure requirements for at least the next 12 months. Although we believe we have adequate sources of liquidity over the long term, an economic recession, a slow growth period, decrease in demand for our products, or the need for liquidity to engage in strategic opportunities could adversely affect our business and liquidity or increase our need for liquidity. If and when needed, no assurances can be given that funding will be available to us on acceptable terms, if at all. In addition, instability in or a tightening of the capital markets could adversely affect our ability to obtain additional capital to grow our business on terms acceptable to us or at all.

Cash Flows

The following table presents the major components of net cash flows used in and provided by operating, investing and financing activities for the periods presented:

Three Months Ended March 31, 2019 compared to Three Months Ended March 31, 2018

Operating Activities

Operating activities consisted primarily of net income (loss) adjusted for certain non-cash items. Adjustments to net income for non-cash items included depreciation and amortization, share-based compensation, deferred taxes and loss on disposals of property and equipment. In addition, operating cash flows included the effect of changes in operating assets and liabilities, principally inventories, accounts receivable, income taxes payable, prepaid expenses and other assets, accounts payable, advance from customers, and accrued expenses.

Cash flows provided by operating activities increased by $108,247 to $150,808 for the three months ended March 31, 2019 from $42,561 during the same period in 2018. The increase in cash from operating activities was due to increased net cash flows from operating assets and liabilities of $160,961, a decrease in net income of $59,795, and an increase resulting from adjustments to net income for non-cash items, which increased by $7,081 in the three months ended March 31, 2019 compared to the same period in 2018.

Investing Activities

Cash used in investing activities increased by $75,596 to $83,531 in the three months ended March 31, 2019 from $7,935 in the same period in 2018, primarily due to higher capital expenditure related to the proprietary Jakroo e-commerce platform. Total capital expenditure was $83,531 and $7,935 in the three months ended March 31, 2019 and 2018, respectively.

Financing Activities

Financing activities during the three months ended March 31, 2019 consisted primarily of cash repayment to related parties of $37,055, repayment of the mortgage for $18,157. We also received cash of $149,999 from private issuances of Common Stock in the three months ended March 31, 2019.

Repayment of mortgage loan was $18,157 in the three months ended March 31, 2019, compared with $17,464 for the same period in 2018.

Off-Balance Sheet Arrangements

In connection with various contracts and agreements, we have agreed to indemnify counterparties against certain third party claims relating to the infringement of intellectual property rights and other items. Generally, such indemnification obligations do not apply in situations in which our counterparties are grossly negligent, engage in willful misconduct or act in bad faith. Based on our historical experience and the estimated probability of future loss, we have determined the fair value of such indemnifications is not material to our financial position or results of operations.

Recently Issued Accounting Standards

From time to time, new accounting pronouncements are issues by the Financial Accounting Standards Board or other standard bodies that may have an impact on our accounting and reporting. We believe that any recently issued accounting pronouncements and other authoritative guidance for which the effective date is in the future either will not have an impact on our accounting or reporting or that such impact will not be material to our financial position, results of operations, and cash flows when implemented.