| | Three Months ended March 31, | |
| | 2009 | | | 2008 | |
Net income (loss) allocable to common shareholders for basic and diluted net income (loss) per common share | | $ | 646,058 | | | $ | (4,133,923 | ) |
| | | | | | | | |
Weighted average common shares outstanding – basic | | | 44,964,840 | | | | 37,484,504 | |
Effect of dilutive securities: | | | | | | | | |
Series A convertible preferred stock | | | 14,028,189 | | | | - | |
Weighted average common shares outstanding– diluted | | | 58,993,029 | | | | 37,484,504 | |
Net income (loss) per common share - basic | | $ | 0.01 | | | $ | (0.11 | ) |
Net income (loss) per common share - diluted | | $ | 0.01 | | | $ | (0.11 | ) |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
In calculating earnings (loss) per common share for the nine months ended September 30, 2008, the Company’s common stock equivalents were anti-dilutive and are not reflected in diluted earnings per shares, At September 30, 2007, the Company did not have any dilutive securities. The Company's aggregate common stock equivalents at September 30,March 31, 2009 and 2008 include the following:
Warrants | | | 16,436,935 | |
Series A convertible preferred stock | | | 14,028,189 | |
Total | | | 30,465,124 | |
| | 2009 | | | 2008 | |
Warrants | | | 16,571,001 | | | | 18,906,756 | |
Series A preferred stock | | | 14,028,189 | | | | 14,787,135 | |
Total | | | 30,599,190 | | | | 33,693,891 | |
The warrants and series A convertible preferredUsing the treasury stock were issued on March 28, 2008 upon conversion ofmethod, there was no dilution resulting from the notes. The shares of series A preferred stock held in escrow pursuant to an escrow agreement (see Note 6) are not treated as outstanding at September 30, 2008 because the delivery of shares is contingent upon certain events, and any shares not delivered will be returned to the Company for cancellation.warrants.
Accumulated other comprehensive income
The Company follows Statement of Financial Accounting Standards No. 130 (SFAS 130) "“Reporting Comprehensive Income"” to recognize the elements of comprehensive income. Comprehensive income is comprised of net income and all changes to the statements of stockholders' equity, except those due to investments by stockholders, changes in paid-in capital and distributions to stockholders. For the Company, comprehensive income for the ninethree months ended September 30,March 31, 2009 and 2008 and 2007 included net income and unrealized gains from foreign currency translation adjustments.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Related parties
Parties are considered to be related to the Company if the parties that, directly or indirectly, through one or more intermediaries, control, are controlled by, or are under common control with the Company. Related parties also include principal owners of the Company, its management, members of the immediate families of principal owners of the Company and its management and other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests.
Recent Accounting Pronouncements
In June 2007, the Emerging Issues Task Force The Company discloses all related party transactions. All transactions shall be recorded at fair value of the FASB issued EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goodsgoods or Servicesservices exchanged. Property purchased from a related party is recorded at the cost to be Used in Future Research and Development Activities, (“EITF 07-3”) which is effective for fiscal years beginning after December 15, 2007. EITF 07-3 requires that nonrefundable advance payments for future research and development activities be deferred and capitalized. Such amounts will be recognized as an expense as the goods are delivered or the related services are performed. The adoptionparty and any payment to or on behalf of EITF 07-3 did not havethe related party in excess of the cost is reflected as a material impact on the Company’s results of operations, financial position or liquidity.distribution to related party.
Recent accounting pronouncements
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. The Statement also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008.2008, and applies to any business combinations which occur after March 31, 2009. The adoption of SFAS 141(R), effective January 1, 2009, may have an impact on accounting for future business combinations once adopted.combinations.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”), which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the non-controlling interest, changes in a parent’s ownership interest and the valuation of retained non-controlling equity investments when a subsidiary is deconsolidated. The Statement also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company has not determined the effect that the applicationadoption of SFAS No. 160 willdid not have any material impact on the preparation of its consolidated financial statements.
In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities””.. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is currently evaluatingadoption of SFAS No. 161 did not have a material impact on the impactpreparation of adopting SFAS 161 on its consolidated financial statements.
In May 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement). FSP APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon either mandatory or optional conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants. Additionally, FSP APB 14-1 specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s non-convertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The Company will adopthas adopted FSP APB 14-1 beginning in the first quarter of fiscalJanuary 1, 2009, and this standard must be applied on a retrospectiveretroactive basis. The Company is evaluating the impact the adoption of FSP APB 14-1 willdid not have any impact on its consolidated financial position and results of operations.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
In May 2008, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 162, The Hierarchy of Generally Accepted Accounting Principles. This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the U.S. Securities and Exchange Commission (“SEC”) of the Public Company Accounting Oversight Board’s amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company does not expectadoption of SFAS No. 162 todid not have a material impact on the preparation of its consolidated financial statements.
On June 16, 2008, the FASB issued final Staff Position (FSP) No. EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities,” to address the question of whether instruments granted in share-based payment transactions are participating securities prior to vesting. The FSP determines that unvested share-based payment awards that contain rights to dividend payments should be included in earnings per share calculations. The guidance will be effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the requirements of (FSP) No. EITF 03-6-1 as well as the impact of its adoption did not have any impact on the Company’s consolidated financial statements.
In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities” (“FSP FAS 140-4 and FIN 46(R)-8”). FSP FAS 140-4 and FIN 46(R)-8 amends FAS 140 and FIN 46(R) to require additional disclosures regarding transfers of financial assets and interest in variable interest entities. FSP FAS 140-4 and FIN 46(R)-8 is effective for interim or annual reporting periods ending after December 15, 2008. The adoption of FSP FAS 140-4 and FIN 46(R)-8 did not have an impact on its consolidated financial statements.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008position and results of operations.
At its June 25, 2008 meeting, the Financial Accounting Standards Board ratified the consensus reached by the Emerging Issues Task Force Issue 07-5 Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (EITF 07-5). The adoption of EITF 07-5’s requirements will affect accounting for convertible instruments and warrants with down-round provisions. Down-round provisions are designed to protect an investor in the event the issuer issues securities at a lower price or with a lower exercise or conversion price. Convertible instruments and warrants which are derivatives and have such provisions will no longer be recorded in equity. EITF 07-5 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Earlier application by an entity that has previously adopted an alternative accounting policy is not permitted. After reviewing FAS 133 and EITF 07-5, the Company does not believe that EITF 07-5 has a material effect on the Company’s financial condition, results of operations or cash flows.
NOTE 2 – ACCOUNTS RECEIVABLE
At September 30, 2008March 31, 2009 and December 31, 2007,2008, accounts receivable consisted of the following:
| | September 30, 2008 | | December 31, 2007 | |
Accounts receivable | | $ | 4,786,162 | | $ | 2,784,630 | |
Less: allowance for doubtful accounts | | | (843,568 | ) | | (626,218 | ) |
| | $ | 3,942,594 | | $ | 2,158,412 | |
| | March 31, 2009 | | | December 31, 2008 | |
Accounts receivable | | $ | 5,777,128 | | | $ | 5,393,115 | |
Less: allowance for doubtful accounts | | | (877,064 | ) | | | (874,856 | ) |
| | $ | 4,900,064 | | | $ | 4,518,259 | |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 3 - INVENTORIESINVENTORIES
At September 30, 2008March 31, 2009 and December 31, 2007,2008, inventories consisted of the following:
| | September 30, 2008 | | December 31, 2007 | |
Raw materials | | $ | 1,473,589 | | $ | 1,135,697 | |
Work in process | | | 294,500 | | | 454,788 | |
Finished goods | | | 496,791 | | | 413,503 | |
| | | 2,264,880 | | | 2,003,988 | |
Less: Reserve for obsolete inventory | | | (79,159 | ) | | (74,192 | ) |
| | $ | 2,185,721 | | $ | 1,929,796 | |
| | March 31, 2009 | | | December 31, 2008 | |
Raw materials | | $ | 1,073,316 | | | $ | 1,054,182 | |
Work in process | | | 407,241 | | | | 254,960 | |
Finished goods | | | 1,008,435 | | | | 662,118 | |
| | | 2,488,992 | | | | 1,971,260 | |
Less: Reserve for obsolete inventory | | | (79,269 | ) | | | (79,170 | ) |
| | $ | 2,409,723 | | | $ | 1,892,090 | |
NOTE 4 - PROPERTY AND EQUIPMENT
At September 30, 2008March 31, 2009 and December 31, 2007,2008, property and equipment consist of the following:
| | Useful Life | | 2008 | | 2007 | |
Office equipment and furniture | | | 5 Years | | $ | 96,049 | | $ | 78,430 | |
Manufacturing equipment | | | 5 – 10 Years | | | 10,369,583 | | | 3,516,584 | |
Vehicles | | | 5 Years | | | 67,147 | | | 62,933 | |
Construction in progress | | | - | | | 5,243,364 | | | - | |
Building and building improvements | | | 20 Years | | | 6,006,117 | | | 5,629,201 | |
| | | | | | 21,782,260 | | | 9,287,148 | |
Less: accumulated depreciation | | | | | | (3,438,534 | ) | | (2,761,162 | ) |
| | | | | | | | | | |
| | | | | $ | 18,343,726 | | $ | 6,525,986 | |
| | Useful Life | | | 2009 | | | 2008 | |
Office equipment and furniture | | 5 Years | | | $ | 99,686 | | | $ | 99,561 | |
Manufacturing equipment | | 5 – 10 Years | | | | 15,355,800 | | | | 14,754,250 | |
Vehicles | | 5 Years | | | | 79,472 | | | | 79,372 | |
Construction in progress | | | - | | | | 286,612 | | | | 207,605 | |
Building and building improvements | | 20 Years | | | | 14,712,628 | | | | 14,404,419 | |
| | | | | | | 30,534,198 | | | | 29,545,207 | |
Less: accumulated depreciation | | | | | | | (3,785,279 | ) | | | (3,605,611 | ) |
| | | | | | | | | | | | |
| | | | | | $ | 26,748,919 | | | $ | 25,939,596 | |
For the ninethree months ended September 30,March 31, 2009 and 2008, and 2007, depreciation expense amounted to $482,376$175,113 and $450,881,$159,062, respectively, of which $254,187$97,583 and $243,006$83,826, respectively, is included in cost of sales, respectively.sales. Upon completion of the construction in progress, the assets will be classified to its respective property and equipment category.
NOTE 5 – LAND USE RIGHTS
There is no private ownership of land in China. Land is owned by the government and the government grants land use rights for specified terms. The Company’s land use rights are valued at a fixed amount, which is RMB 27,000,795 at September 30, 2008March 31, 2009 and the dollar value of the land use right fluctuates based on the exchange rate. In 2008, in connection with the acquisition of land use rights from a related party, (See Note 8), the Company was grantedreceived the transferredcertificate of land use rights from the government and accordingly,government. At the time the Company received the land use rights, $5,617,000 was carried as a deposit on long-term assets. As a result of the grant of the land use rights, the Company reclassified this amount as follows: (i) approximately $3,300,000 from deposits on long-term assets$3,304,000 to prepaid land use rights and (ii) approximately $2,300,000 has been reclassified$2,313,000 to distributions to related parties which(see Note 8). The distribution to relate parties represents the excess paidamount by which the Company’s purchase price for the land uses right exceeds the cost of the land use rights to related parties over the related parties original costs.parties. The Company’s land use rights have terms of 45 and 50 years and expire on January 1, 2053 and October 30, 2053, respectively.2053. The Company amortizes thesethe land use rights over the term of the respective land use right. For the ninethree months ended September 30,March 31, 2009 and 2008, and 2007, amortization expenseof land use rights amounted to $63,346$21,585 and $7,805,$2,784, respectively.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008March 31, 2009
NOTE 5 – LAND USE RIGHTS (continued)
At September 30, 2008March 31, 2009 and December 31, 2007,2008, land use rights consist of the following:
| | | | | | | | | |
| | Useful Life | | 2008 | | 2007 | | | Useful Life | | 2009 | | | 2008 | |
Land Use Rights | | | 45 - 50 years | | $ | 3,938,790 | | $ | 546,341 | | | 45 - 50 years | | $ | 3,944,256 | | | $ | 3,939,307 | |
Less: Accumulated Amortization | | | | | | (111,309 | ) | | (43,707 | ) | | | | | (154,640 | ) | | | (132,885 | ) |
| | | | | $ | 3,827,481 | | $ | 502,634 | | | | | $ | 3,789,616 | | | $ | 3,806,422 | |
Rent expenseAmortization of land use rights attributable to future periods is as follows:
Period ending September 30: | | | |
2009 | | $ | 84,448 | |
2010 | | | 84,448 | |
2011 | | | 84,448 | |
2012 | | | 84,448 | |
Thereafter | | | 3,489,689 | |
| | $ | 3,827,481 | |
Period ending March 31: | | | |
2010 | | $ | 86,352 | |
2011 | | | 86,352 | |
2012 | | | 86,352 | |
2013 | | | 86,352 | |
Thereafter | | | 3,444,208 | |
| | $ | 3,789,616 | |
NOTE 6 – STOCKHOLDERS’ EQUITY
(a) Common stock
In February 2008,On January 1, 2009, the Company issued 323,00070,000 shares of its common stock pursuant to an exercisefor investor relation services. The Company valued these shares at the fair value of warrants for proceedsthe common shares on date of $187,340.grant of $35,000, or $0.50 per share, and recorded professional fees of $35,000.
On March 28, 2008,3, 2009, the Company issued 25,000232 shares of its common stock to a director in connection with election as a director.for services rendered. The shares were valued at fair value on the date of grant at $1.80 per share. Accordingly,and the Company recorded stock-based compensation of $45,000.$87.
On April 28, 2008,March 31, 2009, the Company issued 15,00013,889 shares of its common stock to a director in connection with his election as a director.its chief financial officer for services rendered pursuant to an employment agreement. The shares were valued at fair value on the date of grant, at $2.00 per share. Accordingly,and the Company recorded stock-based compensation of $30,000.
On June 12, 2008, the Company issued 758,946 shares of its common stock upon the conversion of 758,946 shares of Series A preferred stock.
During the three months ended June 30, 2008, the Company issued 1,150,000 shares of its common stock pursuant to an exercise of warrants for proceeds of $667,000.
During the three months ended September 30, 2008, the Company issued 1,319,821 shares of its common stock upon the exercise of warrants for which it received $1,157,235.$6,944.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008March 31, 2009
NOTE 6 – STOCKHOLDERS’ EQUITY (continued)
(b) Conversion of Convertible Notes; Restatement of Certificate of Incorporation
On November 13, 2007, concurrently with the closing pursuant to the Exchange Agreement, the Company entered into a securities purchase agreement with three accredited investors including Barron Partners LP (the “Investors”).investors. Pursuant to the agreement, the Company issued and sold to the Investors,investors, for $5,525,000, the Company’s 3% convertible subordinated notes in the principal amount of $5,525,000. At the time of the financing, the Company did not have any authorized shares of preferred stock. On March 28, 2008, upon the filing of both a restated certificate of incorporation, which created a series of preferred stock and gave the board of directors broad authority to create one or more series of preferred stock, as well asand a statement of designation that set forth the rights, preferences, privileges and limitations of the holders of the series A convertible preferred stock, these notes were automatically converted into an aggregate of (i) 14,787,135 shares of series A preferred stock and (ii) warrants to purchase 11,176,504 shares of common stock at $0.58 per share, 5,588,252 shares of common stock at $0.83 per share, and 2,065,000 shares at $0.92 per share.
share, subject to adjustment. The restated certificate of incorporation increased the number of authorized shares of capital stock from 75,000,000 to 210,000,000 shares, of which (i) 150,000,000 shares are designated as common stock, par value of $.001 per share, and (ii) 60,000,000 shares are designated as preferred stock, par value of $.001 per share.
(c) Series A Preferred Stock
The series A preferred stock has the following rights, preferences and limitations:
| ● | There are 60,000,000 authorized shares of series A preferred stock. |
| ● | No dividends shall be payable with respect to the series A preferred stock. No dividends shall be declared or payable with respect to the common stock while the series A preferred stock is outstanding. The Company shall not redeem or purchase any shares of Common Stock or any other class or series of capital stock which is junior to or on parity with the Seriesseries A Preferred Stockpreferred stock while the Seriesseries A Preferred Stockpreferred stock is outstanding. |
| ● | The holders of the series A preferred stock have no voting rights except as required by law. However, so long as any shares of series A preferred stock are outstanding, the Company shall not, without the affirmative approval of the holders of 75% of the shares of the series A preferred stock then outstanding, (a) alter or change adversely the powers, preferences or rights given to the series A preferred stock or alter or amend the statement of designations relating to the series A preferred stock, (b) authorize or create any class of stock ranking as to dividends or distribution of assets upon a liquidation senior to or otherwise pari passu with the series A preferred stock, or any of preferred stock possessing greater voting rights or the right to convert at a more favorable price than the series A preferred stock, (c) amend its certificate of incorporation or other charter documents in breach of any of the provisions hereof,of the certificate of designation, (d) increase the authorized number of shares of series A preferred stock or the number of authorized shares of preferred stock, or (e) enter into any agreement with respect to the foregoing. |
| | Upon any liquidation, dissolution or winding-up of the Company, whether voluntary or involuntary, the holders of the series A preferred stock have a liquidated preference of $.374 per share. |
| ● | Each share of series A preferred stock shall be initiallyis convertible (subject to the 4.9% limitations described below) into such number of shares of common stock based on the conversion ratio of one share of series A preferred stock for one share of common stock, subject to adjustment, at the option of the holders, at any time after the original issue date.time. |
| ● | All of the outstanding shares of series A preferred stock shall be automatically converted into common stock upon the close of business on the business day immediately preceding the date fixed for consummation of any transaction resulting in a change of control of the Company, as defined in the statement of designation. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
| ·● | The holders may not convert the series A preferred stock to the extent that such conversion would result in the holder and its affiliates beneficially owning more than 4.9% of the Company’s common stock. This provision may not be waived or amended. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 6 – STOCKHOLDERS’ EQUITY (continued)
(d) Securities Purchase Agreement
Pursuant to the securities purchase agreement in additionrelating to the issuance of the convertible notes:Company’s November 2007 private placement, as amended:
| ·● | The Company agreed to have appointed such number of independent directors that would result in a majority of its directors being independent directors, that the audit committee would be composed solely of not less than three independent directors and the compensation committee would have at least three directors, a majority of which shall be independent directors within 90 days after the closing, which was February 11, 2008. Failure to meetdirectors. The Company is presently in compliance with this date will result in liquidated damages commencing February 12, 2008, until the date on which the requirement is satisfied. Thereafter, ifcovenant. If the Company does not meet these requirements for a period of 60 days for an excused reason, as defined in the Purchase Agreement,securities purchase agreement, or 75 days for a reason which is not an excused reason, thisthe Company would result in the imposition ofbe required to pay liquidated damages. The investors have agreed to waive any liquidated damages related to the initial appointment of independent directors and the establishment of the committees which occurred in March 2008. |
| ·● | The Company agreed to have a qualified chief financial officer who may be a part-time chief financial officer until February 13, 2008.officer. If the Company cannot hire a qualified chief financial officer promptly upon the resignation or termination of employment of a former chief financial officer, the Company may engage an accountant or accounting firm to perform the duties of the chief financial officer. In no event shall the Company either (i) fail to file an annual, quarterthree months or other report in a timely manner because of the absence of a qualified chief financial officer, or (ii) not have a person who can make the statements and sign the certifications required to be filed in an annual or quarterlythree monthly report under the Securities Exchange Act of 1934. |
| ·● | Liquidated damages for failure to comply with the preceding two covenants are computed in an amount equal to 12% per annum of the purchase price, up to a maximum of 12% of the purchase price, which is $663,000, which is payable in cash or series A preferred stock, at the election of the investors. If payment is made isin shares of series A preferred stock, each share is valued at $.374 per share. |
● | | The Company and the investors entered into a registration rights agreement pursuant to which the Company agreed to file, by January 12, 2008, a registration statement covering the common stock issuable upon conversion of the series A preferred stock and exercise of the warrants and to have the registration statement declared effective by June 11, 2008. The failure of the Company to have the registration statement declared effective by June 11, 2008 and other timetables provided in the registration rights agreement would result in the imposition of liquidated damages, which are payable through the issuance of additional shares of series A preferred stock at the rate of 4,860 shares of series A preferred stock for each day, based on the proposed registration of all of the underlying shares of common stock, with a maximum of 1,770,000 shares. The number of shares issuable per day is subject to adjustment if the Company cannot register all of the required shares as a result of the Securities and Exchange Commission’s interpretation of Rule 415. The registration rights agreement also provides for additional demand registration rights in the event that the investors are not able to register all of the shares in the initial registration statement. The Company filed its registration on February 14, 2008 and it was declared effective on June 13, 2008. No liquidated damages were incurred and accordingly, pursuant to FASB Staff Position, or FSP, EITF 00-19-2, Accounting for Registration Payment Arrangements, no liability was recorded. |
The Company filed its registration on February 14, 2008 and it was declared effective on June 13, 2008. No liquidated damages were incurred and accordingly, pursuant to FASB Staff Position, or FSP, EITF 00-19-2, Accounting for Registration Payment Arrangements, no liability was recorded.
| ·● | The Investors have a right of first refusal on future financings. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
| ·● | Until the earlier of November 13, 2011 or such time as the Investors shall have sold all of the underlying shares of common stock, the Company is restricted from issuing convertible debt or preferred stock. |
| ·● | Until the earlier of November 13, 2010 or such time as the Investors have sold 90% of the underlying shares of common stock, the Company’s debt cannot exceed twice the preceding four quarters earnings before interest, taxes, depreciation and amortization. |
| ·● | The Company’s officers and directors agreed, with certain limited exceptions, not to publicly sell shares of common stock for 27 months or such earlier date as all of the convertible securities and warrants have been converted or exercised and the underlying shares of common stock have been sold. |
| · | The Company entered into an escrow agreement pursuant to which the Company issued into escrow its 3% convertible promissory note due March 31, 2008 in the principal amount of $3,000,000. Upon the filing of the Restated Certificate this note automatically was converted into 24,787,135 shares of series A preferred stock. These shares of series A preferred stock are in addition to the 14,787,135 shares of series A preferred stock issued to the investors upon conversion of the convertible notes held by them. The series A preferred stock is to be held in escrow subject to the following. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 6 – STOCKHOLDERS’ EQUITY (continued)
| o | Prior to September 17, 2008, 14,787,135 shares were held pursuant to the following provisions. If, for the year ended December 31, 2008, the Company’s pre-tax earnings per share are less than the target numbers, all or a portion of such shares are to be delivered to the Investors. The agreement also had a target for 2007, which was met, and no shares were delivered with respect to 2007. If the pre-tax earnings are less than 50% of the target, all of the shares are to be delivered to the Investors. If the shortfall is less than 50%, the number of shares to be delivered to the Investors is determined on a formula basis. On September 12, 2008, the Investors agreed to eliminate the provisions of the securities purchase agreement that provided for the delivery of shares held in escrow and a reduction in the warrant exercise price if certain levels of pre-tax income were not reached. Pursuant to this agreement, 14,787,135 shares of Series A preferred stock of the 24,787,135 shares held in an escrow account were returned to the Company, with the remaining 10,000,000 reserved to cover potential tax liabilities for 2007 and 2008. |
| o | The target number for 2008 is $0.13131 per share. The per share numbers are based on all shares that are outstanding or are issuable upon exercise or conversion of all warrants or options, regardless of whether such shares would be used in computing diluted earnings per share under GAAP. |
| o | If the Company does not file its Form 10-K for 2008 within 30 days after the filing is required, after giving effect to any extension permitted by Rule 12b-25 under the Securities Exchange Act of 1934, any shares remaining in escrow shall be delivered to the Investors. |
| o | The remaining 10,000,000 shares of series A preferred stock are to be delivered to the Investors in the event that, based on the Company’s audited financial statements for 2007 and 2008 the Company or certain affiliated companies owes any taxes to the PRC government or any authority or taxing agency of the PRC for any period ended on or prior to September 30, 2007. For each $1.00 of such tax liability, four shares of series A preferred stock are to be delivered to the Investors. At December 31, 2007, the Company did not have any tax liabilities for the period ended on or prior to September 30, 2007. |
| ·● | In connection with the Securities Purchase Agreement,securities purchase agreement, $30,000 was deducted from the gross proceeds and was paid to an investor as reimbursement for due diligence expenses, which was deferredis treated as a debt discount and was amortized over the life of the convertible notes. Other fees incurred in connection with the debt issuance include $25,000 of legal fees, which were treated as a deferred debt issue costs and are being amortized to debt issue cost expense over the life of the notes. The unamortized portion of this debt discount on March 28, 2008, the date on which the convertible notes were automatically converted, was recognized at that time. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
| ·● | With certain exceptions, until the Investors have sold all of the underlying shares of Common Stock, if the Company sells common stock or issues convertible securities with a conversion or exercise price which is less than the conversion price of the preferred stock, the conversion price of the series A preferred stock and the exercise price of the warrants is reduced to the lower price. |
(e) Warrants
On March 23, 2009, in connection with the Company’s sale to two investors of its 18-month, 15% notes in the aggregate principal amount of $250,000, the Company issued five-year warrants to purchase 437,500 shares at an exercise price of $0.40 per share. These warrants were treated as a discount on the secured notes and were valued at $92,985 to be amortized over the 18-month note term. The warrants issued upon conversionfair value of the notes have a term of five years fromthis warrant was estimated on the date of grant using the notes,Black-Scholes option-pricing model in accordance with SFAS 123R using the following weighted-average assumptions: expected dividend yield of 0%; expected volatility of 137.51%; risk-free interest rate of 1.69% and expire on November 13, 2012. The warrants provide a cashless exercise feature; however,an expected holding period of five years.
There was no warrant activity during the holders of the warrants may not make a cashless exercise prior to November 13, 2008 in the case of the $0.58 warrants, and prior to May 13, 2009 in the case of the $0.83 warrants and $0.92 warrants, and after these respective periods only if the underlying shares are not covered by an effective registration statement.
three months ended March 31, 2008. Warrant activitiesactivity for the ninethree months ended September 30, 2008 areMarch 31, 2009 is summarized as follows:
| | Number of | | Weighted average | |
| | shares | | exercise price | |
Outstanding at December 31, 2007 | | | 400,000 | | $ | 0.50 | |
Granted | | | 18,829,756 | | | 0.65 | |
Exercised | | | (2,792,821 | ) | | 0.72 | �� |
Cancelled | | | - | | | - | |
| | | | | | | |
Outstanding at Septemuer30, 2008 | | | 16,436,935 | | $ | 0.68 | |
| | Number of Warrants | | | Weighted Average Exercise Price | |
Balance at beginning of year | | | 16,133,501 | | | $ | 0.50 | |
Granted | | | 437,500 | | | | 0.40 | |
Exercised | | | - | | | | - | |
Balance at end of period | | | 16,571,001 | | | $ | 0.50 | |
| | | | | | | | |
Warrants exercisable at end of period | | | 16,571,001 | | | $ | 0.50 | |
The following table summarizes the shares of the Company's common stock issuable upon exercise of warrants outstanding at September 30, 2008:March 31, 2009:
Warrants Outstanding | | | Warrants Exercisable | |
Range of Exercise Price | | Number Outstanding at March 31, 2009 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | | | Number Exercisable at March 31, 2009 | | | Weighted Average Exercise Price | |
$ | 0.50 | | | 400,000 | | | | 3.62 | | | $ | 0.50 | | | | 400,000 | | | $ | 0.50 | |
| 0.567 | | | 9,232,424 | | | | 3.62 | | | | 0.567 | | | | 9,232,424 | | | | 0.567 | |
| 0.40 | | | 6,938,577 | | | | 3.71 | | | | 0.40 | | | | 6,938,577 | | | | 0.40 | |
| | | 16,571,001 | | | | | | | $ | 0.50 | | | | 16,571,001 | | | $ | 0.50 | |
Warrants Outstanding | | Warrants Exercisable | |
Range of Exercise Price | | Number Outstanding at September 30, 2008 | | Weighted Average Remaining Contractual Life (Years) | | Weighted Average Exercise Price | | Number Exercisable at September 30, 2008 | | Weighted Average Exercise Price | |
$ 0.50 | | | 400,000 | | | 4.12 | | $ | 0.50 | | | 400,000 | | $ | 0.50 | |
0.58 | | | 9,535,858 | | | 4.12 | | | 0.58 | | | 9,535,858 | | | 0.58 | |
0.83 | | | 5,588,252 | | | 4.12 | | | 0.83 | | | 5,588,252 | | | 0.83 | |
0.92 | | | 912,825 | | | 4.12 | | | 0.92 | | | 912,825 | | | 0.92 | |
| | | 16,436,935 | | | | | $ | 0.68 | | | 16,436,935 | | $ | 0.68 | |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
(f) NOTE 6 – STOCKHOLDERS’ EQUITY (continued)Beneficial Conversion Feature; Deemed Dividend
The(f) Beneficial Conversion Feature and Deemed Dividend
In November 2007, the Company evaluated the application of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments” and concluded that the convertible notes havehad a beneficial conversion option Pursuantoption. In fiscal 2007, pursuant to EITF 00-27, Issue 15, the Company computed the intrinsic value of the conversion option at $2,610,938 based on a comparison of (a) the proceeds of the convertible debt allocated to the common stock portion of the conversion option by first allocating the proceeds received from the convertible debt offering to the debt and the detachable warrants on a relative fair value basis, and (b) the fair value at the commitment date of the common stock to be received by the Company upon conversion. The excess of (b) over (a) is the intrinsic value of the embedded conversion option of $2,610,938 that has been recognized by the Company as a discount to the notes wereand amortized using the straight-line method over the shorter (1)stated term; with the term of Notes, (2)unamortized portion being recognized upon the conversion of the notes to common stock, or (3) upon filing by the Company of certificate of designation and immediate conversion of the notes to the series A preferred stock and warrants.notes.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
The Company filed the Restated Certificaterestated certificate of incorporation on March 28, 20082008. Upon filing of the restated certificate of incorporation, the note was automatically converted into 14,787,135 shares of series A preferred stock and accordingly,warrants to purchase 18,829,756 shares of the common stock. As a result of the automatic conversion of the note into shares of series A preferred stock and warrants, as described above, the Company recognized the value of the warrants and any remaining debt discount upon conversion of the debt.note.
As discussed above, upon filing of the Company’s restated certificate of incorporation on March 28, 2008, the Company issued warrants to purchase 18,829,756 shares of the common stock. At November 13, 2007, the fair value of the warrants used to calculate the intrinsic value of the conversion option was estimated at $2,884,062 and was computed using the Black-Scholes option-pricing model based on the assumed issuance of the warrants on the date the notes were issued. Variables used in the option-pricing model include (1) risk-free interest rate at the date of grant (3.84%), (2) expected warrant life of 5 years, (3) expected volatility of 150%, and (4) 0% expected dividend.
As the series A preferred stock does not require redemption by the Company or have a finite life, upon issuance of the warrants on March 28, 2008, a one-time preferred stock deemed dividend of $2,884,062 was recognized immediately as a non-cash charge aton March 28, 2008. The non-cash, deemed dividend did not have an effect on net earnings or cash flows for the ninethree months ended September 30,March 31, 2008. The estimated fair market value of the warrants of $2,884,062 has been recorded as additional paid-in capital and a reduction to retained earnings.
DuringFor the ninethree months ended September 30,March 31, 2008, amortization of debt issue costs was $21,429 and included any remaining balance of debt issue costs that was expensed upon conversion of the convertible debtnotes to the series A preferred stock. At December 31, 2007, deferred debt costs of $21,429 were included in prepaid expensesstock and other on the consolidated balance sheets.warrants. The amortization of debt discounts for the ninethree months ended September 30,March 31, 2009 and 2008 was $1,500 and $2,263,661, respectively, which has been included in interest expense on the accompanying statementstatements of operations andincome. For the three months ended March 31, 2008, amortization of debt discounts included any remaining balance of the debt discount that was expenseexpensed upon conversion of the convertible debt to the series A preferred stock, which occurred on March 28, 2008.
In November 2007, the Company evaluated whether or not the convertible notes contain embedded conversion options, which meet the definition of derivatives under SFAS 133 “Accounting for Derivative Instruments and Hedging Activities” and related interpretations. The Company concluded that since the convertible notes had a fixed conversion rate of $0.374, the convertible notes were not derivative instruments. The Company analyzed this provision under EITF 05-04 and, although the debt is unconventional, the reset provision is deemed within the Company’s control and therefore it qualified as equity under EITF 00-19
The convertible notes payable is as follows at September 30, 2008 and December 31, 2007:
| | September 30, | | December 31, | |
| | 2008 | | 2007 | |
Convertible notes payable | | $ | - | | $ | 5,525,000 | |
Less: unamortized discount on notes payable | | | - | | | (2,263,661 | ) |
Convertible notes payable, net | | $ | - | | $ | 3,261,339 | |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008March 31, 2009
NOTE 6 – STOCKHOLDERS’ EQUITY (continued)
Since there is no net settlement provision in the contract and no market mechanism that facilitates net settlement that would cause the contract to meet the criteria in paragraphs 9(a) and 9(b), we analyzed paragraph 9(c) of Statement 133 which provides that a contract that requires delivery of the assets associated with the underlying has the characteristic of net settlement if those assets are readily convertible to cash. Footnote 5 to that paragraph makes explicit reference to the use of the phrase readily convertible to cash in paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises.
An asset (whether financial or nonfinancial) can be considered to be readily convertible to cash, as that phrase is used in paragraph 9(c), only if the net amount of cash that would be received from a sale of the asset in an active market is either equal to or not significantly less than the amount an entity would typically have received under a net settlement provision
At the time of the November 2007 private placement, there was no market for the Company’s common stock. Prior to the financing the Company was a blank check shell with no business. At the time that the convertible notes were converted into preferred stock and warrants, there was still no active market in the Company’s common stock.
On March 28, 2008, in connection with the conversion of the convertible notes and warrants, the Company issued to the investors warrants to purchase a total of more than 18,800,000 shares of common stock. On that date there were approximately 37,400,000 shares of common stock outstanding. Thus, the warrants, at the time of issuance, represented more than 50% of the outstanding common stock.
Since the (i)the number of shares issuable upon exercise of the warrants, (ii) the relationship between the number of warrants and the outstanding common stock, (iii) the lack of an active market in the stock, (iii) the fact that the common stock is not listed on an exchange and was not so listed at the time the warrants were issued, (iv) the fact that the underlying common stock was not registered with the Securities and Exchange Commission, and (v) the fact that relatively modest sales would have a depressing effect on the market price of the common stock demonstrate that the net settlement test is not met and the warrants are not considered a derivative instrument..
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 7 – LOANS PAYABLE
At September 30, 2008March 31, 2009 and December 31, 2007,2008, loans payable consisted of the following:
| | 2008 | | 2007 | |
Loan payable to Transportation Bank of China, due on January 29, 2009 with annual interest of 7.45% secured by assets of the Company. | | $ | 291,754 | | $ | 273,444 | |
| | | | | | | |
Loan payable to Transportation Bank of China, due on June 10, 2008 with annual interest of 7.23% secured by assets of the Company. | | | - | | | 410,167 | |
| | | | | | | |
Loan payable to Transportation Bank of China, due on December 10, 2008 with annual interest of 7.78% secured by assets of the Company. | | | 437,630 | | | - | |
| | | | | | | |
Loan payable to Industrial and Commercial Bank of China, due on February 4, 2009 with annual interest of 7.56% secured by assets of the Company. | | | 291,754 | | | 136,722 | |
| | | | | | | |
Total Current Loans Payable | | $ | 1,021,138 | | $ | 820,333 | |
| | 2009 | | | 2008 | |
Loan payable to Bank of Communications, due on June 16, 2009 with annual interest at March 31, 2009 of 6.05% secured by assets of the Company. | | $ | 292,158 | | | $ | 291,792 | |
| | | | | | | | |
Loan payable to Bank of Communications, due on June 10, 2009 with annual interest at March 31, 2009 of 6.05% secured by assets of the Company. | | | 438,238 | | | | 437,688 | |
| | | | | | | | |
Loan payable to Industrial and Commercial Bank of China, due on December 16, 2009 with annual interest at March 31, 2009 of 6.42% secured by assets of the Company. | | | 292,159 | | | | 291,792 | |
| | | | | | | | |
Loan payable to Industrial and Commercial Bank of China, due on November 18, 2009 with annual interest at March 31, 2009 of 6.1065% the rate being adjusted quarterly based on People’s Bank of China’s base rate plus 1.5% secured by assets of the Company. | | | 146,079 | | | | - | |
| | | | | | | | |
Loan payable to individual, due on January 9, 2010, with annual interest of 10% per annum. | | | 146,079 | | | | - | |
| | | | | | | | |
Principal amount of loan payable to investors, due on September 23, 2010, with annual interest of 15% per annum (see (a) below). | | | 250,000 | | | | - | |
Total loans payable | | | 1,564,713 | | | | 1,021,272 | |
| | | | | | | | |
Less: current portion of loans payable | | | (1,314,713 | ) | | | (1,021,272 | ) |
Long-term loans payable | | | 250,000 | | | | - | |
| | | | | | | | |
Less: debt discount (a) | | | (91,485 | ) | | | - | |
| | | | | | | | |
Long-term loans payable – net | | $ | 158,515 | | | $ | - | |
| (a) | In March 2009, the Company sold to two investors its 18-month, 15% notes in the aggregate principal amount of $250,000 and warrants to purchase 437,500 shares at an exercise price of $0.40 per share. Pursuant to the related purchase agreements, our chief executive officer placed 1,531,250 shares of common stock into escrow. The note holders have the right to take these shares, valued at $0.20 per share, if the Company does not pay the interest on or principal of the notes before such failure becomes an event of default. Pursuant to the loan documents, in the event of that Leo Wang ceases to be employed by the Company as its chief financial officer, the holders of not less than $126,000 principal amount of the notes, shall have the right, on not less than 60 days’ notice, to declare the notes in default. If Mr. Wang ceases to be employed by the Company as a result of his death, disability or a termination for cause, than the Company shall have 60 days to replace Mr. Wang with a chief financial officer acceptable to investors. The debt discount of $91,485 represents the value of the warrants issued in connection with this note. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2009
NOTE 8 – RELATED PARTY TRANSACTIONS
Due from related partiesparty
From time to time, the Company advanced funds to companies partially owned by the Company for working capital purposes. These advances are non-interest bearing, unsecured and payable on demand. Through monthly payments, the affiliated companies intend to repay these advances.
At September 30, 2008March 31, 2009 and December 31, 2007,2008, due from related parties was due from the following:
Name | | Relationship | | September 30, 2008 | | December 31, 2007 | |
Wuxi Huayang Yingran Machinery Co. Ltd. | | | 5% cost method investee which was sold in March 2008 | | $ | - | | $ | 139,524 | |
| | | | | $ | - | | $ | 139,524 | |
Name | | Relationship | | March 31, 2009 | | | December 31, 2008 | |
| | | | | | | | |
Wuxi Anyida Machinery Co. Ltd | | Company owned by sibling of CEO (1) | | | - | | | | 437,688 | |
| | | | | | | | | | |
| | | | $ | - | | | $ | 437,688 | |
Due to related parties(1) | This loan was made in December 2008 and repaid in January 2009 without interest. Although the Company does not believe that this loan violates the proscription against loans to directors or executive officers contained in Section 402 of the Sarbanes-Oxley Act of 2002, it is possible that a court might come to a different conclusion. |
The chief executive officerPurchase of the Company and his spouse,assets from time to time, provided advances to the Company for operating expenses. At September 30, 2008 and December 31, 2007, the Company did not have any payable to the chief executive officer and his spouse. These advances were short-term in nature and non-interest bearing.
Wuxi Huayang Boiler, a company related through common ownership, from time to time, provided advances to the Company for working capital purposes. At September 30, 2008 and December 31, 2007, the Company had a payable to Boiler of $0 and $98,541, respectively. These advances were short-term in nature and non-interest bearing.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
Deposits on long-term assets –related party and other
In July 2007, the Company agreed to acquire long-term assetsproperty from Boiler for an aggregate price of 89,282,500 RMB, or approximately $12,207,000. ThisThe Company had previously been a 33% owner of Boiler and, in 2007, the Company sold its interest in Boiler to a related party. The original purchase price was reduced by 9,196,341RMB, or approximately $1,257,000, which represents the Company’s 33% ofinterest in the appreciation in the long-term assets attributable to Boilerproperty prior to the Company’s salessale of itsthe Company’s interest in Boiler.The long-term assets consistBoiler, resulting in a net purchase price of i)80,086,159 RMB, or approximately $10,950,000. The property consists of an approximately 100,000 square foot factory, which was substantially completed in 2005, ii) land use rights, iii) employee housing facilities and iv) other leasehold improvements. As of September 30, 2008 andThe purchase price was fully paid by December 31, 2007,2008. Prior to payment of the purchase price, the Company treated its payments totaling 80,086,159 RMB and 79,458,230 RMB or approxmately $11,682,000 and $10,864,000, respectively, had been madeas deposits on long-term assets, which amounted to Boiler, adjusted by$11,538,000. During 2008, the foreign exchange rate. In 2008, in connection withCompany received the acquisitioncertificate of land use rights from a related party,but as of December 31, 2008 had not received the Company was grantedcompleted title to the transferredbuildings until March 2009. During 2008, upon the receipt of the land use rights fromand the government and accordingly,full payment of the purchase price, the Company reclassified approximately $3,300,000 from deposits on long-term assets$3,304,000, representing Boiler’s cost of the land use rights to land use rights (See Note 5), reclassified approximately $5,517,000, which represents Boiler’s cost of constructing the factory and the remaining amount of $2,300,000,related leasehold improvements and employee housing facilities, to property and equipment, and reclassified approximately $2,717,000, which represents the excess of amountamounts paid by the Company for the land use rights and factory facilities over the original cost of the land use rights has been reflected asand factory facilities acquired, to a distribution to related parties. As of September 30, 2008,The difference between the Company has not received title to the facilitiestotal payments, $11,538,000, and the property has not been placed in service. The Company has initiated the transferpurchase price of the title to the facilities and the transfer$10,950,000 is expected to be completed in the fourth quarter of 2008 at which time the deposit on long-term assets will be reclassified to property and equipment. In connection with the remaining deposit on long-term assets, the Company reclassified approximately $404,000 fromtreated as a deposit on long-term assets to a distribution to related parties, which represents the excess of amount paid for the facilities including the factory and other buildings, over the original cost of the facilities.foreign currency translation adjustment.
At September 30, 2008 and December 31, 2007, deposits on long-term assets are as follows:
| | 2008 | | 2007 | |
Factory building and related leasehold improvements – related party | | $ | 5,603,128 | | $ | 10,863,706 | |
| | $ | 5,603,128 | | $ | 10,863,706 | |
NOTE 9 – INCOME TAXES
The Company accounts for income taxes under Statement of Financial Accounting Standards No. 109, ‘‘Accounting for Income Taxes’’ (‘‘SFAS 109’’). SFAS 109 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statements and the tax basis of assets and liabilities, and for the expected future tax benefit to be derived from tax losses and tax credit carryforwards. SFAS 109 additionally requires the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Realization of deferred tax assets, including those related to the U.S. net operating loss carryforwards, are dependent upon future earnings, if any, of which the timing and amount are uncertain. Accordingly, the net deferred tax asset related to the U.S. net operating loss carryforward has been fully offset by a valuation allowance. The Company is governed by the Income Tax Law of the People’s Republic of China and the United States.
In 20082009 and 2007,2008, under the Income Tax Laws of PRC, Chinese companies are generally subject to an income tax at an effective rate of 25% and 33%, respectively, on income reported in the statutory financial statements after appropriate tax adjustments. The Company’s VIE, Dyeing isand Electric are subject to these statutory rates. In 2007, pursuant to local taxing regulations, the Company’s VIE, Electric, paid tax under a simplified method of recording under the following formula: (Net revenues x 5% x 33%). China Wind Systems, Inc. was incorporated in the United States and has incurred net operating losses of approximately $100,000 for income tax purposes for the year ended December 31, 2007 subject to the Internal Revenue Code Section 382, which places a limitation on the amount of taxable income that can be offset by net operating losses after a change in ownership. The net operating loss carries forward for United States income taxes, which may be available to reduce future years’ taxable income. These carry forwards will expire, if not utilized, through 2027. Management believes that the realization of the benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. Management will review this valuation allowance periodically and make adjustments as warranted.
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
The table below summarizes the differences between the U.S. statutory federal rate and the Company’s effective tax rate and as follows for the nine months ended September 30, 2008 and 2007:
| | 2008 | | 2007 | |
U.S statutory rates | | | 34.0 | % | | 34.0 | % |
US effective rate in excess of China tax rate | | | (16.1 | )% | | (0.4 | )% |
China income tax exemptions | | | 0.0 | % | | (21.3 | )% |
Non-deductible interest | | | 20.9 | % | | 0.0 | % |
US valuation allowance | | | 6.2 | % | | 0.0 | % |
| | | | | | | |
Total provision for income taxes | | | 45.0 | % | | 12.3 | % |
Income tax expense for the nine months ended September 30, 2008 and 2007 was $1,651,331 and $1,315,094, respectively.March 31, 2009
NOTE 10 - SEGMENT INFORMATION
The following information is presented in accordance with SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information. For the three and nine months ended September 30,March 31, 2009 and 2008, and 2007, the Company operated in two reportable business segments - (1) the manufacture of dyeing and finishing equipment and (2) the manufacture of forged rolled rings and other components for the wind power and other industries and electric power auxiliary apparatuses (including coking equipment). The Company's reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations. All of the Company’s operations are conducted in the PRC.
Information with respect to these reportable business segments for the three month ended March 31, 2009 and nine months ended September 30, 2008 and 2007 is as follows:
| | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, | |
| | 2008 | | 2007 | | 2008 | | 2007 | |
Revenues: | | | | | | | | | |
Dyeing and finishing equipment | | $ | 5,958,627 | | $ | 6,287,788 | | $ | 17,125,918 | | $ | 14,487,221 | |
Forged rolled rings and electric power equipment | | | 5,811,535 | | | 1,622,505 | | | 14,274,268 | | | 2,102,254 | |
| | | 11,770,162 | | | 8,000,293 | | | 31,400,186 | | | 16,589,475 | |
Depreciation and amortization: | | | | | | | | | | | | | |
Dyeing and finishing equipment | | | 94,967 | | | 87,198 | | | 293,662 | | | 273,011 | |
Forged rolled rings and electric power equipment | | | 64,487 | | | 64,232 | | | 188,714 | | | 177,870 | |
| | | 159,454 | | | 151,430 | | | 482,376 | | | 450,881 | |
Interest expense: | | | | | | | | | | | | | |
Dyeing and finishing equipment | | | - | | | - | | | - | | | - | |
Forged rolled rings and electric power equipment | | | 20,427 | | | 9,946 | | | 55,932 | | | 31,360 | |
Other (a) | | | - | | | - | | | 2,242,942 | | | - | |
| | | 20,427 | | | 9,946 | | | 2,298,874 | | | 31,360 | |
Net income (loss): | | | | | | | | | | | | | |
Dyeing and finishing equipment | | | 988,906 | | | 7,007,814 | | | 2,780,281 | | | 8,337,148 | |
Forged rolled rings and electric power equipment | | | 1,039,993 | | | 1,113,478 | | | 2,169,855 | | | 1,072,160 | |
Other (a) | | | (168,037 | ) | | - | | | (2,927,950 | ) | | - | |
| | | 1,860,862 | | | 8,121,292 | | | 2,022,186 | | | 9,409,308 | |
Identifiable assets at September 30, 2008 and December 31, 2007: | | | | | | | | | | | | | |
Dyeing and finishing equipment | | $ | 17,660,956 | | $ | 17,914,593 | | | | | | | |
Forged rolled rings and electric power equipment | | | 17,222,834 | | | 7,455,095 | | | | | | | |
Other (a) | | | 101,782 | | | 3,126,745 | | | | | | | |
| | $ | 34,985,572 | | $ | 28,496,433 | | | | | | | |
| | 2009 | | | 2008 | |
Revenues: | | | | | | |
Dyeing and finishing equipment | | $ | 3,529,441 | | | $ | 4,653,138 | |
Forged rolled rings and electric power equipment | | | 4,331,426 | | | | 3,793,936 | |
| | | 7,860,867 | | | | 8,447,074 | |
Depreciation: | | | | | | | | |
Dyeing and finishing equipment | | | 100,107 | | | | 97,838 | |
Forged rolled rings and electric power equipment | | | 75,006 | | | | 61,224 | |
| | | 175,113 | | | | 159,062 | |
Interest expense: | | | | | | | | |
Dyeing and finishing equipment | | | - | | | | - | |
Forged rolled rings and electric power equipment | | | 21,264 | | | | 16,752 | |
Other (a) | | | 2,407 | | | | 2,242,942 | |
| | | 23,671 | | | | 2,259,694 | |
Net income (loss): | | | | | | | | |
Dyeing and finishing equipment | | | 464,503 | | | | 704,386 | |
Forged rolled rings and electric power equipment | | | 424,036 | | | | 640,949 | |
Other (a) | | | (242,481 | ) | | | (2,595,196 | ) |
| | | 646,058 | | | | (1,249,861 | ) |
Identifiable assets at March 31, 2009 and December 31, 2008 by segment: | | | | | | | | |
Dyeing and finishing equipment | | $ | 17,595,919 | | | $ | 17,884,877 | |
Forged rolled rings and electric power equipment | | | 20,709,971 | | | | 19,415,748 | |
Other (a) | | | 31,334 | | | | 31,132 | |
| | $ | 38,337,224 | | | $ | 37,331,757 | |
| | | | | | | | |
Identifiable assets at March 31, 2009 and December 31, 2008 by geographical location: | | | | | | | | |
China | | $ | 38,306,030 | | | $ | 37,321,465 | |
United States | | | 31,194 | | | | 10,292 | |
| | $ | 38,337,224 | | | $ | 37,331,757 | |
| (a) | The Company does not allocate any general and administrative expenses of its US activities to its reportable segments, because these activities are managed at a corporate level. Additionally, other identifiable assets represents assets located in the United States and Hong Kong and are not allocated to reportable segmentssegments. |
CHINA WIND SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008March 31, 2009
The Company is required to make appropriations to reserve funds, comprising the statutory surplus reserve, statutory public welfare fund and discretionary surplus reserve, based on after-tax net income determined in accordance with generally accepted accounting principles of the People’s Republic of ChinaPRC (the “PRC GAAP”). Appropriation to the statutory surplus reserve should be at least 10% of the after tax net income determined in accordance with the PRC GAAP until the reserve is equal to 50% of the entities’ registered capital or members’ equity. Appropriations to the statutory public welfare fund are at a minimum of 5% of the after tax net income determined in accordance with PRC GAAP. Commencing on January 1, 2006, the new PRC regulations waived the requirement for appropriating retained earnings to a welfare fund. As of DecemberMarch 31, 2006,2009, the Company appropriated the required maximum 50% of its registered capital to statutory reserves for Dyeing.
Our revenues are derived from two unrelated businesses – (1) the manufacture of dyeing and& finishing equipment and (2) the manufacture of forged rolled rings and other components for the wind power and other industries and electric power auxiliary apparatuses (including coking equipment). We market products from these two segments with independent marketing groups to different customer bases.
In our forged rolled rings and electrical power equipment segment, we manufacture high precision forged rolled rings for the wind power industry and other industries. Additionally, we also manufacture specialty equipment used in the production of coal generated electricity. Revenue from our forged rolled rings and electrical power equipment segment accounted for 49.4%55.1% of revenue for the three months ended September 30, 2008, 45.5% of revenues for the nine months ended September 30, 2008, and 18.9% of revenues for the year ended December 31, 2007 and is summaries as follows:
We expect that rolled rings will become a more significant percentage of total revenues in the future, and, in this connection we arehave expanding our manufacturing facilities to enable us to manufacture forged rolled rings with a larger diameter in order to meet the perceived needs of the wind power industry. We experienced a decrease in revenues from forged rolled rings – other industries as discussed below in results of operations,
Our products are sold for use by manufacturers of industrial equipment. Because of the recent decline in oil prices and the general international economic trends, the demand for products used in manufacturing in general in the dyeing and finishing as well asincluding wind power industries, may beis uncertain. Although we believe that over the long term, the wind power segment will expand, and the government of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term these factors may affect the requirements by our customers and potential customers for our products. To the extent that the demand for our forged rolled rings declines, our revenue and net income will be affected.
A major element of our cost of sales is raw materials, principally steel and other metals. These metals are subject to fluctuation prices,price fluctuations, and recently these fluctuations have been significant. In times of increasing prices, we need to try to fix the price at which we purchases raw materials in order to avoid increases in costs which we cannot recoup through increases in sales prices. Similarly, in times of decreasing prices, we may have purchased metals at prices which are high in terms of the price at which we can sell our products, which also can impair our margins. During both the three and nine month periods ended September 30, 2008, are gross margins decreased from the prior year largely as a result of increases in the price of steel and other metals that we were not able to pass on to our customers.
Critical Accounting Policies and Estimates
Use of Estimates
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our consolidatedthese financial statements requires us to make estimates and assumptionsjudgments that affect the reported amounts of assets, liabilities, revenues and liabilitiesexpenses, and therelated disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported net sales and expenses during the reporting periods. On an ongoing basis, weliabilities. We continually evaluate our estimates, including those related to bad debts, inventories, recovery of long-lived assets, income taxes, and assumptions.the valuation of equity transactions. We base our estimates on historical experience and on various other factorsassumptions that we believe arebelieved to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying valuevalues of assets and liabilities that are not readily apparent from other sources. Any future changes to these estimates and assumptions could cause a material change to our reported amounts of revenues, expenses, assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. SignificantWe believe the following critical accounting policies affect our more significant judgments and estimates used in 2008 and 2007 include the allowance for doubtful accounts,preparation of the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, and accruals for taxes due.financial statements
Variable Interest Entities
Pursuant to Financial Accounting Standards Board Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities - an Interpretation of ARB No. 51” (“FIN 46R”) we are required to include in our consolidated financial statements the financial statements of variable interest entities. FIN 46R requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss for the variable interest entity or is entitled to receive a majority of the variable interest entity’s residual returns. Variable interest entities are those entities in which we, through contractual arrangements, bear the risk of, and enjoy the rewards normally associated with ownership of the entity, and therefore we are the primary beneficiary of the entity.
The accounts of the Huayang Companies are consolidated in the accompanying financial statements pursuant to FIN 46R. As a VIE, the Huayang Companies sales are included in our total sales, its income from operations is consolidated with our, and our net income includes all of the Huayang Companies net income. We do not have any non-controlling interest and accordingly, did not subtract any net income in calculating the net income attributable to us. Because of the contractual arrangements, we have pecuniary interest in the Huayang Companies that require consolidation of our financial statements and the Huayang Companies financial statements with our financial statements.
Accounts receivable
We have a policy of reserving for uncollectible accounts based on our best estimate of the amount of probable credit losses in our existing accounts receivable. We periodically review our accounts receivable and other receivables to determine whether an allowance is necessary based on an analysis of past due accounts and other factors that may indicate that the realization of an account may be in doubt. Account balances deemed to be uncollectible are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
As a basis for accurately estimating the likelihood of collection has been established, we consider a number of factors when determining reserves for uncollectable accounts. We believe that we use a reasonably reliable methodology to estimate the collectability of our accounts receivable. We review our allowances for doubtful accounts on at least a quarterly basis. We also consider whether the historical economic conditions are comparable to current economic conditions. If the financial condition of our customers or other parties that we have business relations with were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Should we become unable to reasonably estimate the collectability of our receivables, our results of operations could be negatively impacted.
Inventories
Inventories, consisting of raw materials and finished goods related our products are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, we will record additional reserves for the difference between the cost and the market value. These reserves are recorded based on estimates. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory, if necessary. If the results of the review determine that a write-down is necessary, we recognize a loss in the period in which the loss is identified, whether or not the inventory is retained. Our inventory reserves establish a new cost basis for inventory and are not reversed until we sell or dispose of the related inventory. Such provisions are established based on historical usage, adjusted for known changes in demands for such products, or the estimated forecast of product demand and production requirements.
Property and equipment
Property and equipment are stated at cost less accumulated depreciation. In 2008, in connection with the acquisition of a factory, leasehold improvement and employee facilities from a related party, we reclassified approximately $5,517,000, which represents the related party’s cost of constructing the factory and related leasehold improvements and employee housing facilities to property and equipment and reclassified approximately $404,000, which represents the excess of amounts paid by the Company for the factory facilities over the original cost of the factory facilities acquired, to a distribution to related parties. These amounts have previously been classified as deposits of long-term assets – related party. Depreciation is computed using straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are as follows:
| | Useful Life | |
Building and building improvements | | | 20 Years | | Years |
Manufacturing equipment | | | 5 – 10 Years | | Years |
Office equipment and furniture | | | 5 Years | | Years |
Vehicle | | | 5 Years | | Years |
The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition.
Long-livedIncluded in property and equipment is construction-in-progress which consists of factories and office buildings under construction and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are reviewed periodically or more often if circumstances dictate, to determine whethercompleted and ready for their carrying value has become impaired. We consider assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. We also re-evaluate the amortization periods to determine whether subsequent events and circumstances warrant revised estimates of useful lives.intended use.
In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we examine the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable. We recognize an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.
Land use rights
There is no private ownership of land in the PRC. All land in the PRC is owned by the government and cannot be sold to any individual or company. The government grants a land use right that permits the holder of the land use right to use the land for a specified period. Our land use rights were granted forwith a term of 45 or 50 years. Any transfer of the land use right requires government approval. We have recorded as land use rightsan intangible asset the costs paid to acquire a land use rights.right. The land use rights are amortized on the straight-line method over the land use right termsterms. In 2008, in connection with the acquisition of land use rights from a related party, we received the certificate of land use rights from the government. At the time we received the land use rights, $5,617,000 was carried as a deposit on long-term assets – related party. As a result of the grant of the land use rights, we reclassified this amount as follows: (i) approximately $3,304,000 to land use rights and (ii) approximately $2,313,000 to distributions to related parties. The distribution to related parties represents the amount by which range from 45 to 50 years.our purchase price for the land use right exceeds the cost of the land use rights by the related parties.
Revenue recognition
We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. We account for the product sales as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. We recognize revenue from the sale of dyeing and electric equipment upon shipment and transfer of title. The other elements may include installation and generally a one-year warranty.
Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally within a close to the date of delivery of the equipment.
Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period. For the three and nine months ended September 30,March 31, 2009 and 2008, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.
All other product sales, including the forging of parts, with customer specific acceptance provisions, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.
Research and development
Research and development costs are expensed as incurred, and are included in general and administrative expenses. These costs primarily consist of cost of material used and salaries paid for the development of our products and fees paid to third parties. Our totalWe had no research and development expense through September 30, 2008 has not been significant.expenses during the three months ended March 31, 2009 and 2008.
Income taxes
We are governed by the Income Tax Law of the PRC. Income taxes are accounted for under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. The charge for taxes is based on the results for the year as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.
Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit. In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probably that taxable profit will be available against which deductible temporary differences can be utilized.
Deferred tax is calculated using tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it is related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity.
Deferred tax assets and liabilities are offset when they related to income taxes levied by the same taxation authority and the Company intends to settle its current tax assets and liabilities on a net basis.
We adopted FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), as of January 1, 2007. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The adoption had no affect on our financial statements.
Recent accounting pronouncements
In June 2007, the Emerging Issues Task Force of the FASB issued EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to be Used in Future Research and Development Activities, (“EITF 07-3”) which is effective for fiscal years beginning after December 15, 2007. EITF 07-3 requires that nonrefundable advance payments for future research and development activities be deferred and capitalized. Such amounts will be recognized as an expense as the goods are delivered or the related services are performed. The adoption of EITF 07-3 did not have a material impact on our results of operations, financial position or liquidity.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. The Statement also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The adoption of SFAS 141(R) may have an impact on accounting for future business combinations once adopted.combinations.
In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”), which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the non-controlling interest, changes in a parent’s ownership interest and the valuation of retained non-controlling equity investments when a subsidiary is deconsolidated. The Statement also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We have not determined the effect that the applicationThe adoption of SFAS No. 160 willdid not have a material impact on the preparation of our consolidated financial statements.
In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities””.. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We are currently evaluating theThe adoption of SFAS No. 161 did not have a material impact of adopting SFAS 161 on our consolidated financial statements.
In May 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement). FSP APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon either mandatory or optional conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants. Additionally, FSP APB 14-1 specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s non-convertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The Company will adopt FSP APB 14-1 beginning in the first quarter of fiscal 2009, and this standard must be applied on a retrospectiveretroactive basis. The Company is evaluating the impact the adoption of FSP APB 14-1 willdid not have an effect on itsour consolidated financial position and results of operations.
In May 2008, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 162, The Hierarchy of Generally Accepted Accounting Principles. This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the U.S. Securities and Exchange Commission (“SEC”) of the Public Company Accounting Oversight Board’s amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company does not expectadoption of SFAS No. 162 todid not have a material impact on the preparation of itsour consolidated financial statements.
On June 16, 2008, the FASB issued final Staff Position (FSP) No. EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities,” to address the question of whether instruments granted in share-based payment transactions are participating securities prior to vesting. TheAs provided in the FSP, determines that unvested share-based payment awards that contain rights to dividend payments should be included in earnings per share calculations. The guidance will be effective commencing in the three months ended December 31, 2009. The adoption of the requirements of EITF 03-6-1 did not have a material impact on our consolidated financial statements.
In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities” (“FSP FAS 140-4 and FIN 46(R)-8”). FSP FAS 140-4 and FIN 46(R)-8 amends FAS 140 and FIN 46(R) to require additional disclosures regarding transfers of financial assets and interest in variable interest entities. FSP FAS 140-4 and FIN 46(R)-8 is effective for interim or annual reporting periods ending after December 15, 2008. The adoption of FSP FAS 140-4 and FIN 46(R)-8 did not have an impact on our consolidated financial position and results of operations.
At its June 25, 2008 meeting, the Financial Accounting Standards Board ratified the consensus reached by the Emerging Issues Task Force Issue 07-5 Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (EITF 07-5). The adoption of EITF 07-5’s requirements will affect accounting for convertible instruments and warrants with down-round provisions. Convertible instruments and warrants which are derivatives and have down-round protection will no longer be recorded in equity. EITF 07-5 is effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company is currently evaluating2008, and interim periods within those fiscal years. After reviewing FAS 133 and EITF 07-5, we do not believe that EITF 07-5 has a material effect on the requirementsCompany’s financial condition, results of (FSP) No. EITF 03-6-1operations or cash flows.
Currency Exchange Rates
All of our sales are denominated in RMB. As a result, changes in the relative values of U.S. Dollars and RMB affect our reported levels of revenues and profitability as wellthe results are translated into U.S. Dollars for reporting purposes. In particular, fluctuations in currency exchange rates could have a significant impact on our financial stability due to a mismatch among various foreign currency-denominated sales and costs. Fluctuations in exchange rates between the U.S. dollar and RMB affect our gross and net profit margins and could result in foreign exchange and operating losses.
Our exposure to foreign exchange risk primarily relates to currency gains or losses resulting from timing differences between signing of sales contracts and settling of these contracts. Furthermore, we translate monetary assets and liabilities denominated in other currencies into RMB, the functional currency of our operating business. Our results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People’s Bank of China at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in our statement of shareholders’ equity. We have not used any forward contracts, currency options or borrowings to hedge our exposure to foreign currency exchange risk. We cannot predict the impact of future exchange rate fluctuations on our results of operations and may incur net foreign currency losses in the adoptionfuture. As our sales denominated in foreign currencies, such as RMB and Euros, continue to grow, we will consider using arrangements to hedge our exposure to foreign currency exchange risk.
Our financial statements are expressed in U.S. dollars but the functional currency of our operating subsidiary is RMB. The value of your investment in our stock will be affected by the foreign exchange rate between U.S. dollars and RMB. To the extent we hold assets denominated in U.S. dollars, any appreciation of the RMB against the U.S. dollar could result in a change to our statement of operations and a reduction in the value of our U.S. dollar denominated assets. On the other hand, a decline in the value of RMB against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results, the value of your investment in our company and the dividends we may pay in the future, if any, all of which may have a material adverse effect on its consolidated financial statements.
RESULTS OF OPERATIONS
The following table sets forth the results of our operations for the periods indicated as a percentage of net revenues:
| | Three Months Ended September 30, | | Nine Months Ended September 30, | |
| | 2008 | | 2007 | | 2008 | | 2007 | |
| | ($) | | (%) | | ($) | | (%) | | ($) | | (%) | | ($) | | (%) | |
Net Revenues | | | 11,770,162 | | | 100.0 | | | 8,000,293 | | | 100.0 | | | 31,400,186 | | | 100.0 | | | 16,589,475 | | | 100.0 | |
Cost of Revenues | | | 8,816,389 | | | 74.9 | | | 5,633,977 | | | 70.4 | | | 23,508,720 | | | 74.8 | | | 11,831,546 | | | 71.3 | |
Gross Profit | | | 2,953,773 | | | 25.1 | | | 2,366,316 | | | 29.6 | | | 7,891,466 | | | 25.2 | | | 4,757,929 | | | 28.7 | |
Operating Expenses | | | 483,790 | | | 4.1 | | | 291,771 | | | 3.7 | | | 1,909,366 | | | 6.1 | | | 773,981 | | | 4.7 | |
Income from Operations | | | 2,469,983 | | | 21.0 | | | 2,074,545 | | | 25.9 | | | 5,982,100 | | | 19.1 | | | 3,983,948 | | | 24.0 | |
Other Income (Expenses) | | | (18,352 | ) | | (0.2 | ) | | 6,761,587 | | | 84.5 | | | (2,308,584 | ) | | (7.4 | ) | | 6,740,454 | | | 40.6 | |
Income Before Provision for Income Taxes | | | 2,451,631 | | | 20.8 | | | 8,836,132 | | | 110.4 | | | 3,673,516 | | | 11.7 | | | 10,724,402 | | | 64.6 | |
Provision for Income Taxes | | | 590,769 | | | 5.0 | | | 714,840 | | | 8.9 | | | 1,651,331 | | | 5.3 | | | 1,315,094 | | | 7.9 | |
Net Income | | | 1,860,862 | | | 15.8 | | | 8,121,292 | | | 101.5 | | | 2,022,185 | | | 6.4 | | | 9,409,308 | | | 56.7 | |
Other Comprehensive Income: | | | | | | | | | | | | | | | | | | | | | | | | | |
Foreign Currency Translation Adjustment | | | 67,269 | | | 0.6 | | | 299,690 | | | 3.7 | | | 1,679,553 | | | 5.4 | | | 523,986 | | | 3.2 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Comprehensive Income | | | 1,928,131 | | | 16.4 | | | 8,420,982 | | | 105.2 | | | 3,701,738 | | | 11.8 | | | 9,933,294 | | | 59.9 | |
| | Three Months Ended March 31, | |
| | 2009 | | | 2008 | |
| | Dollars | | | Percent | | | Dollars | | | Percent | |
NET REVENUES | | $ | 7,860,867 | | | | 100.0 | % | | $ | 8,447,074 | | | | 100.0 | % |
| | | | | | | | | | | | | | | | |
COST OF REVENUES | | | 6,264,218 | | | | 79.7 | % | | | 6,272,826 | | | | 74.3 | % |
| | | | | | | | | | | | | | | | |
GROSS PROFIT | | | 1,596,649 | | | | 20.3 | % | | | 2,174,248 | | | | 25.7 | % |
| | | | | | | | | | | | | | | | |
OPERATING EXPENSES | | | 578,478 | | | | 7.3 | % | | | 694,588 | | | | 8.2 | % |
| | | | | | | | | | | | | | | | |
INCOME FROM OPERATIONS | | | 1,018,171 | | | | 13.0 | % | | | 1,479,660 | | | | 17.5 | % |
| | | | | | | | | | | | | | | | |
OTHER INCOME (EXPENSES) | | | (35,452 | ) | | | 0.5 | % | | | (2,275,490 | ) | | | (26.9 | )% |
| | | | | | | | | | | | | | | | |
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES | | | 982,719 | | | | 12.5 | % | | | (795,830 | ) | | | (9.4 | )% |
| | | | | | | | | | | | | | | | |
PROVISION FOR INCOME TAXES | | | 336,661 | | | | 4.3 | % | | | 454,031 | | | | 5.4 | % |
| | | | | | | | | | | | | | | | |
NET INCOME (LOSS) | | | 646,058 | | | | 8.2 | % | | | (1,249,861 | ) | | | (14.8 | )% |
| | | | | | | | | | | | | | | | |
OTHER COMPREHENSIVE INCOME | | | | | | | | | | | | | | | | |
Foreign currency translation adjustment | | | 41,540 | | | | 0.5 | % | | | 1,007,245 | | | | 11.9 | % |
| | | | | | | | | | | | | | | | |
COMPREHENSIVE INCOME (LOSS) | | $ | 687,598 | | | | 8.7 | % | | $ | (242,616 | ) | | | (2.9 | )% |
The following table sets forth information as to the gross margin for our two lines of business for the three and nine months ended September 30, 2008March 31, 2009 and 2007.2008.
| | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, | |
| | 2008 | | 2007 | | 2008 | | 2007 | |
Dyeing and finishing equipment: | | | | | | | | | |
Net revenues | | $ | 5,958,627 | | $ | 6,287,788 | | $ | 17,125,918 | | $ | 14,487,221 | |
Cost of sales | | | 4,388,985 | | | 4,419,881 | | | 12,655,396 | | | 10,259,754 | |
Gross profit | | | 1,569,642 | | | 1,867,907 | | | 4,470,523 | | | 4,227,467 | |
Gross margin | | | 26.3 | % | | 29.7 | % | | 26.1 | % | | 29.1 | % |
Forged rolled rings and electric power equipment | | | | | | | | | | | | | |
Net revenues | | $ | 5,811,535 | | $ | 1,712,505 | | $ | 14,274,268 | | $ | 2,102,254 | |
Cost of sales | | | 4,427,404 | | | 1,214,096 | | | 10,853,324 | | | 1,571,792 | |
Gross profit | | | 1,384,131 | | | 498,409 | | | 3,420,944 | | | 530,462 | |
Gross margin | | | 23.8 | % | | 29.1 | % | | 24.0 | % | | 25.2 | % |
| | Three Months Ended December 31, | |
| | 2009 | | | 2008 | |
Dyeing and finishing equipment: | | | | | | |
Revenue | | $ | 3,529,441 | | | $ | 4,653,138 | |
Cost of sales | | | 2,778,325 | | | | 3,439,227 | |
Gross profit | | | 751,116 | | | | 1,213,911 | |
Gross margin | | | 21.3 | % | | | 26.1 | % |
| | | | | | | | |
Forged rolled rings and electric power equipment: | | | | | | | | |
Revenue | | $ | 4,331,426 | | | $ | 3,793,936 | |
Cost of sales | | | 3,485,893 | | | | 2,833,599 | |
Gross profit | | | 845,533 | | | | 960,337 | |
Gross margin | | | 19.5 | % | | | 25.3 | % |
Revenues. For the three months ended March 31, 2009, we had revenues of $7,860,867, as compared to revenues of $8,447,074 for the three months ended March 31, 2008, a decrease of approximately 6.9%. The decrease in total revenue was attributable to decrease in Dyeing revenues offset by an increase in revenue from forged rolled rings and is summarized as follows:
Nine Months Ended September 30, 2008 and 2007 | | For the Three Months Ended March 31, 2009 | | | For the Three Months Ended March 31, 2008 | | | Increase (Decrease) | | | Percentage Change | |
Dyeing and finishing equipment | | $ | 3,529,441 | | | $ | 4,653,138 | | | $ | (1,123,697 | ) | | | (24.1 | )% |
Forged rolled rings - wind power industry | | | 2,724,131 | | | | 961,290 | | | | 1,762,841 | | | | 183.4 | % |
Forged rolled rings – other industries | | | 1,607,295 | | | | 2,242,976 | | | | (635,681 | ) | | | (28.3 | )% |
Electrical equipment | | | - | | | | 589,670 | | | | (589,670 | ) | | | (100.0 | )% |
| | | | | | | | | | | | | | | | |
Total net revenues | | $ | 7,860,867 | | | $ | 8,447,074 | | | $ | (586,207 | ) | | | 6.9 | % |
Revenues. ForThe decrease in revenues from the nine months ended September 30, 2008, we had revenuessale of $31,400,186, as compared to revenues of $16,589,475 for the nine months ended September 30, 2007, an increase of approximately 89.3%. The increase in total revenuedyeing and finishing equipment was attributable to increases from bothdecreased sales of our segmentsequipment to the textile industry due to the impact that the global recession had on the textile industry in China. We have experienced, and is summarizedwe are continuing to experience, a decline in orders for our textile dyeing machines and domestic competition have required us to lower our selling prices to compete with other companies in China that sell similar products. We are currently evaluating the market and cannot predict when the textile market will recover from this downturn. Although we believe that recent policy measures initiated by the Chinese government may stimulate the textile industry and we have seen an increase in orders for textile equipment, we are experienced pricing pressures from other suppliers. We cannot predict the level of revenues associated with the lowering of our sale price as follows:we continue to evaluate profitability. However, we do not plan to seek or accept orders at prices which we do not believe will generate an acceptable margin.
| | For the Nine Months Ended September 30, 2008 | | For the Nine Months Ended September 30, 2007 | | Increase | | Percentage Change | |
Dyeing and finishing equipment | | $ | 17,125,918 | | $ | 14,487,221 | | $ | 2,638,697 | | | 18.2 | % |
Forged rolled rings - wind power industry | | | 5,124,872 | | | 75,619 | | | 5,049,253 | | | * | |
Forged rolled rings – other industries | | | 7,419,590 | | | 293,836 | | | 7,125,754 | | | * | |
Electrical equipment | | | 1,729,806 | | | 1,732,799 | | | (2,993 | ) | | 0.1 | % |
| | | | | | | | | | | | | |
Total net revenues | | $ | 31,400,186 | | $ | 16,589,475 | | $ | 14,810,711 | | | 89.3 | % |
* Because the salesRevenues from forging of rolled rings for the ninewind power industry amounted to $2,724,131 and revenues from other forging operations amounted to $1,607,295. Due to the deliberate shift in focus of our sales effort to the wind segment, we increased sales of forged rolled rings to the wind power industry by 183% in the quarter compared to the same quarter in 2008, while we experienced a 28% decline in forging revenues from other industries such as the railway, heavy machinery manufacturing, petrochemical, metallurgical, sea port machinery, and defense and radar industry. As the wind power industry continues to grow, we expect the shortage of key components such as gearboxes and bearings to continue. As a result, we expect to see continued demand for our forged products coming from the wind power industry. As described under “Overview,” we did not generate any revenue from auxiliary electric power equipment during the three months ended September 30, 2007 was minimal,March 31, 2009. As China continues to promote renewable energy and environmental sustainability while seeking to expand its economy, we expect to gradually move away from the percentage increase is not meaningful.
Ourauxiliary electric power equipment business (which generated about 5.5% of our revenue increases were attributable to:in 2008) and focus more on the forging business, particularly for the wind power industry.
| · | The increase in revenues from the sale of dyeing and finishing equipment was attributable to continued strong sales of our equipment to the textile industry. However, the recent economic slowdown has affected various countries, especially the export sector in China. We expect to see a decreasing trend in our dyeing and finishing equipment business as we see the textile industry impacted by recessions in other countries. Yet, we remain confident with the outlook of our forging business for the wind power industry as the Chinese government is committed to supporting wind power in order to reduce the Country’s reliance on coal. |
| · | We have experienced an increase in revenues from the sale of forged rings to the other industries such as the railway, heavy machinery manufacturing, petrochemical, metallurgical, sea port machinery, and defense and radar industry. This source of revenue was nominal for the nine months ended September 30, 2007. |
| · | Revenue from the sale of forged rings to the wind power industry, which was nominal in the nine months ended September 30, 2007 increased to $5 million and is attributable to the demand for our forged rolled rings that will be used in the production of wind turbine components such as gear boxes and yaw bearings. During the period, the wind power industry experienced tremendous growth and the industry faced a serious shortage of various components, principally gearboxes and bearings. |
| · | The change in revenues from the sale of standard and custom auxiliary equipment for use in the power industry in China was minimal and is attributable to the continued sale of additional pieces of equipment to the power industry. |
Cost of sales. Cost of sales for the ninethree months ended September 30, 2008 increased $11,677,174March 31, 2009 decreased $8,608, or 98.7%0.1%, from $11,831,546$6,272,826 for the ninethree months ended September 30, 2007March 31, 2008 to $23,508,720$6,264,218 for the ninethree months ended September 30, 2008.March 31, 2009. Cost of goods sold for Dyeing was $12,655,396$2,778,325 for the ninethree months ended September 30, 2008,March 31, 2009, as compared to $10,259,754$3,439,227 for the nine months ended September 30, 2007.same period year in 2008. Cost of sales related to the manufacture of forged rolled rings and other components and electric power generating equipment and was $10,853,324$3,485,893 for the ninethree months ended September 30, 2008March 31, 2009 as compared to $1,571,792$2,833,599 for the nine months ended September 30, 2007.same period year 2008.
Gross profit and gross margin. Our gross profit was $7,891,466$1,596,649 for the ninethree months ended September 30, 2008March 31, 2009 as compared to $4,757,929$2,174,248 for the nine months ended September 30, 2007,same period in 2008, representing gross margins of 25.2%20.3% and 28.7%25.7%, respectively. Gross profit for Dyeing was $4,470,523$751,116 for the ninethree months ended September 30, 2008March 31, 2009 as compared to $4,227,467$1,213,911 for the nine months ended September 30, 2007,comparable period in 2008, representing gross margins of approximately 26.1%21.3% and 29.1%26.1%, respectively. The modest decrease in our gross margin for Dyeing was attributable to an increase in the cost of raw material costsmaterials, such as steel and other metals, which could not be passed on to our customers during that period.period as well as a reduction of our sales price due to stronger competition resulting from the downturn in the textile industry in China. Gross profitsprofit from forged rolled rings and electric power equipment segment were $3,420,944was $845,533 for the ninethree months ended September 30, 2008March 31, 2009 as compared to $530,462$960,337 for the nine months ended September 30, 2007,same period in 2008, representing gross margins of approximately 24.0%19.5% and 25.2%25.3%, respectively. The decrease in our gross margin for forging was attributable to an increase in the cost of raw materials, such as steel and other metals, which could not be passed on to our customers, and operational inefficiencies as we operated at low production levels, as we manufactured sample units for customers, but incurred significant start-up costs in addition to the normal fixed-costs associated with operating our new forging facilities. Some of the costs incurred in the first quarter related to costs of test production runs, utilities to power our new production ovens, and payroll costs. We expect gross margins to improve as we become more efficient and produce larger quantities for inventory.
Depreciation. Depreciation and amortization expense. Forwas $175,113 for the ninethree months ended September 30,March 31, 2009 and $159,062 for the comparable period in 2008, and 2007, depreciation expense amounted to $482,376 and $450,881, of which $254,187$97,583 in the 2009 quarter and $243,006$81,042 in the 2008 quarter is included in cost of sales and $228,189$77,530 in the 2009 quarter and $207,875$78,020 in the 2008 quarter is included in operating expenses, respectively. The overall increaseexpenses. Commencing in the second quarter of 2009, we will commence depreciation on our new factory building and amortization reflects additionrelated equipment, which we purchased.will increase our depreciation expense.
Selling, general and administrative expenses. Selling, general and administrative expenses totaled $1,681,177$500,948 for the ninethree months ended September 30, 2008,March 31, 2009, as compared to $566,106$616,568 for the nine months ended September 30, 2007, an increasesame period in 2008, a decrease of $1,115,071$115,620 or approximately 197.0%18.8%. Selling, general and administrative expenses consisted of the following:
| | Nine Months Ended September 30, 2008 | | Nine Months Ended September 30, 2007 | |
Professional fees | | $ | 398,724 | | $ | - | |
Payroll and related benefits | | | 334,314 | | | 55,166 | |
Travel | | | 175,199 | | | 130,249 | |
Bad debt expense | | | 171,816 | | | 182,882 | |
Other | | | 601,124 | | | 197,809 | |
| | $ | 1,681,177 | | $ | 566,106 | |
| | 2009 | | | 2008 | |
Professional fees | | $ | 147,559 | | | $ | 241,705 | |
Bad debt | | | 1,109 | | | | - | |
Compensation and related benefits | | | 102,664 | | | | 119,816 | |
Travel | | | 38,268 | | | | 82,392 | |
Other | | | 211,348 | | | | 172,655 | |
| | $ | 500,948 | | | $ | 616,568 | |
| ·● | Since the share exchange in November 2007, we have incurred professional fees, principally as a result of our status as a public company. For the ninethree months ended September 30,March 31, 2008, professional fees amountedwe incurred additional legal expense of approximately $110,000 related to $398,724 as compared to $0 in the 2007 period. Our professional fees consisted primarilyfiling of legal feesa registration statement covering stock issuable upon exercise of $165,027, audit fees of $103,020, investor relation fees of $108,055, and other professional fees.warrants. |
| ·● | PayrollBad debt increased by $1,109. In 2008, we did not have any bad debt expense. Based on our periodic review of accounts receivable balances, we recorded bad debt expense and increased the allowance for doubtful accounts after considering management’s evaluation of the collectability of individual receivable balances, including the analysis of subsequent collections, the customers’ collection history, and recent economic events. |
| ● | Compensation and related benefits increaseddecreased for the ninethree months ended September 30, 2008March 31, 2009 by $279,148,$17,152, or 506.0%14.3%, as compared to the ninesame period in 2008. For the three months ended September 30, 2007. In November 2007,March 31, 2009, we hired additional personnel in accounting, our chief financial officer, a translator, and administration staff due to our increased operations and additional workload in connection with being a public company. Additionally, thehad an increase in payrollcompensation and related benefits reflected stock based compensation of $75,000$8,317 in both our dying and rolled rings operations resulting from the issuanceexpansion of common stock to two independent directors,our rolled rings operations, and net decrease in compensation for our unallocated overhead of $25,469 consisting of a decrease in stock-based compensation of $37,969 offset by an increase in executive compensation of $12,500. |
| ·● | Travel expense for the ninethree months ended September 30, 2008 increasedMarch 31, 2009 decreased by $44,950,$44,124, or 34.5%53.6%, as compared to the nine months ended September 30, 2007.same period in 2008. The increasedecrease is related to increaseda decrease in travel by sales personnel and engineers as well as increaseddecreased travel due tofor investor road shows. |
| · | Bad debts expenses decreased by $11,066 for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 based on our analysis of accounts receivable balances. |
| ·● | Other selling, general and administrative expenses increased by $403,315$38,693 for the ninethree months ended September 30, 2008March 31, 2009 as compared towith the nine months ended September 30, 2007 due to increased operations, increasessame period in insurance expense due to our directors’ and officers’ liability policy, and increase in rent expense related to our land use rights.2008. |
Income from operations. For the ninethree months ended September 30, 2008,March 31, 2009, income from operations was $5,982,100$1,018,171, as compared to $3,983,948$1,479,660 for the ninethree months ended September 30, 2007, an increaseDecember 31, 2008, a decrease of $1,998,152$461,489 or 50.2%31.2%.
Other income (expenses). For the ninethree months ended September 30, 2008,March 31, 2009, other expense amounted to $2,308,584$35,452 as compared to other incomeexpense of $6,740,454$2,275,490 for the ninesame period in year 2008. For the three months ended September 30, 2007. March 31, 2009, other income (expense) included:
| ● | interest expense of $23,671, consisting of non-cash interest expense of $1,500 from the amortization of debt discount arising from our March 2009 financing and interest expense of $22,171 incurred on our outstanding loans:; |
| ● | amortization of debt issuance costs of $12,000; and |
| ● | nominal foreign currency losses and interest income. |
For the ninethree months ended September 30,March 31, 2008, other expenses included i) interest expense of $2,298,874 consisting of non-cash interest expense of $2,263,661 from the amortization of the balance of debt discount arising from the valuation of the beneficial conversion features recorded in connection with our November 2007 private placement offset by the reversal of accrued interest of $20,719 and ii) amortization of debt issuance costs of $21,429 and iii) interest income of $11,719. For the nine months ended September 30, 2007, other income consisted of interest expense of $31,360 offset by interest income of $372.included:
Additionally, in the 2007 period, other income includes a gain from the forgiveness of income and value-added taxes of $6,771,442 and reflects the reversal of tax accruals previously made resulting from the grant by the local tax agency to the Huayang Companies of a special tax exemption and release from any unpaid corporate income tax and value added tax liabilities and any related penalties through September 30, 2007. This waiver covered all tax reporting periods through September 30, 2007.
| ● | non-cash interest expense of $2,263,661from the amortization of the balance of debt discount arising from the valuation of the beneficial conversion features recorded in connection with our November 2007 private placement offset by the reversal of accrued interest of $20,719; |
| ● | amortization of debt issuance costs of $21,429, and |
| ● | interest income of $5,633. |
. Income tax expense. Income tax expense increased $336,237decreased $117,370, or approximately 25.5% during25.8%, for the ninethree months ended September 30,March 31, 2009 as compared to the comparable period in 2008 primarily as a result of the increasedecrease in taxable income generated by our operating entities.
Net income (loss).For the nine months ended September 30, 2008, we recorded net income of $2,022,185 as compared to net income of $9,409,308 for the nine months ended September 30, 2007. For the nine months ended September 30, 2008, we recorded a deemed beneficial dividend related to the fair value of warrants granted in March 2008 as As a result of the automaticfactors described above, our net income for the three months ended March 31, 2009 was $646,058, or $0.01 per share (basic and diluted). For the three months ended March 31, 2008, we had a net loss of $1,249,861. The conversion of our convertible debtnotes into shares of series A preferred stock and warrants uponin the amendmentfirst quarter of our certificate of incorporation to create2008 resulted in a class ofdeemed preferred stock anddividend of $2,884,923, representing the creationvalue of the series A preferred stock. This deemed dividend reducedwarrants issued to the investors. As a result, the net income availableloss attributable to common stockholders. Accordingly, for the nine months ended September 30, 2008, we generated a net loss available to common stockholders of $861,877shareholders was $4,133,923, or $(0.02)$(0.11) per share (basic and diluted) as compared to net income per common share of $0.26 (basic and diluted) for the nine months September 30, 2007..
Foreign currency translation gain. The functional currency of our subsidiaries operating in the PRC is the Chinese Yuan or Renminbi (“RMB”). The financial statements of our subsidiaries are translated to U.S. dollars using period end rates of exchange for assets and liabilities, and average rates of exchange (for the period) for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations. As a result of these translations, which are a non-cash adjustment, we reported a foreign currency translation gain of $1,679,553$41,540 for the ninethree months ended September 30, 2008March 31, 2009 as compared to $523,986$1,007,245 for comparablethe same period in 2007.year 2008. This non-cash gain had the effect of increasing our reported comprehensive income.
Comprehensive income (loss). income. For the ninethree months ended September 30, 2008,March 31, 2009, comprehensive income of $3,701,738$687,598 is derived from the sum of our net income of $2,022,185$646,058 plus foreign currency translation gains of $3,701,738.$41,540.
Three Months Ended September 30, 2008 and 2007Non-GAAP Information
Revenues. ForWe believe that net income, as adjusted for certain non-cash expenses, which is a non-GAAP performance measure, is reasonable means of understanding our business in view of the three months ended September 30,significant non-cash charges which we believe do not relate to the operation of our business. In connection with our November 2007 private placement, we issued 3% convertible notes to the investors in the principal amount of the $5,525,000. Because of the favorable conversion terms, the debt was issued deemed issued as a discount of $2,610,938. Upon the conversion of the debt into equity in March 2008, we had revenuesthe unamortized debt discount of $11,770,162,$2,263,661 was fully amortized and treated as comparedadditional interest, and the relative fair value of the warrants granted in March 2008 related to revenuesour November 2007 private placement of $8,000,293$2,884,062 was classified as a deemed dividend to the holders of the series A preferred stock. The amortization of the debt discount and the deemed dividend are non-cash events which do not affect our operations. The following table shows the relationship between net income (loss) allocable to common shareholders and net income, as adjusted, for the three months ended September 30, 2007, an increase of $3,769,869 or approximately 47.1%. The increase in total revenue was attributable to increases from both of our segmentsMarch 31, 2009 and is summarized as follows:2008.
| | For the Three Months Ended September 30, 2008 | | For the Three Months Ended September 30, 2007 | | Increase | | Percentage Change | |
Dyeing and finishing equipment | | $ | 5,958,627 | | $ | 6,287,788 | | $ | (329,161 | ) | | (5.2 | )% |
Forged rolled rings - wind power industry | | | 2,494,123 | | | 66,994 | | | 2,427,129 | | | * | |
Forged rolled rings – other industries | | | 2,764,328 | | | 267,973 | | | 2,496,355 | | | * | |
Electrical equipment | | | 553,084 | | | 1,377,538 | | | (824,454 | ) | | (59.8 | )% |
| | | | | | | | | | | | | |
Total net revenues | | $ | 11,770,162 | | $ | 8,000,293 | | $ | 3,769,869 | | | 47.1 | % |
* Because the sales for the three months ended September 30, 2007 was minimal, the percentage increase is not meaningful. | | Three Months Ended March 31, | |
| | 2009 | | | 2008 | |
Net income (loss) allocable to common shareholders | | $ | 646,058 | | | $ | (4,133,923 | ) |
Add back of: | | | | | | | | |
Deemed dividend to preferred stockholders | | | - | | | | 2,884,062 | |
Non-cash interest from amortization of debt discount | | | 23,671 | | | | 2,263,661 | |
Amortization of debt issuance costs | | | - | | | | 21,429 | |
Reversal of accrued interest | | | | | | | (20,719 | ) |
| | | | | | | | |
Net income, as adjusted | | $ | 669,729 | | | $ | 1,014,510 | |
| · | Increases in revenues for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 are attributable to similar explanations provided in our discussion of results of operations for the nine month period. We had a decrease in revenues of dyeing and finishing machines. The recent economic slowdown has affected various countries, especially the export sector in China. We expect to see a decreasing trend in our dyeing and finishing equipment business as we see the textile industry impacted by recessions in other countries. Yet, we remain confident with the outlook of our forging business for the wind power industry as the Chinese government is committed to supporting wind power in order to reduce the China’s reliance on coal. For the three months ended September 30, 2007, we had recognized increased revenues from the shipment of more units of electrical equipment as compared to the three months ended September 30, 2008. |
CostFor the reasons discussed under “Results of sales. Cost of salesOperations,” our net income, as adjusted, decreased from $1,014,510, or $0.027 per share (basic) and $0.016 (diluted), for the three months ended September 30,March 31, 2008 increased $3,182,412to $669,729, or 56.4%$0.01 per share (basic and diluted), from $5,633,977 for the three months ended September 30, 2007 to $8,816,389 for the three months ended September 30, 2008. Cost of goods sold for Dyeing was $4,388,985 for the three months ended September 30, 2008, as compared to $4,419,881 for the three months ended September 30, 2007. Cost of sales related to the manufacture of forged rolled rings and other components, and electric power generating equipment and was $4,427,404 for the three months ended September 30, 2008 as compared to $1,214,096 for the three months ended September 30, 2007.March 31, 2009.
Gross margin. Our gross profit was $2,953,773 for the three months ended September 30, 2008 as compared to $2,366,316 for the three months ended September 30, 2007, representing gross margins of 25.1% and 29.6%, respectively. Gross profit for Dyeing was $1,569,642 for the three months ended September 30, 2008 as compared to $1,867,907 for the three months ended September 30, 2007, representing gross margins of approximately 26.3% and 29.7%, respectively. Gross profit related to the forged rolled rings and electric power equipment was $1,384,131 for the three months ended September 30, 2008 as compared to $498,409 for the three months ended September 30, 2007, representing gross margins of approximately 23.8% and 29.1%, respectively. The decrease in our gross margin was attributable to an increase in raw material costs such as steel and other metals which could not be passed on to our customers during that period as well as a decrease in revenues.
Depreciation and amortization expense. Depreciation and amortization amounted to $159,454 for the three months ended September 30, 2008 and $151,430 for the three months ended September 30, 2007, of which $89,742 and $82,823 is included in cost of sales and $69,712 and $68,607 is included in operating expenses, respectively. The overall increase in depreciation and amortization reflects addition equipment which we purchased.
Selling, general and administrative expenses. Selling, general and administrative expenses totaled $483,790 for the three months ended September 30, 2008, as compared to $291,771 for the three months ended September 30, 2007, an increase of $192,019 or approximately 86%. Selling, general and administrative expenses consisted of the following:
| | Three Months Ended September 30, 2008 | | Three Months Ended September 30, 2007 | |
Professional fees | | $ | 18,204 | | $ | - | |
Payroll and related benefits | | | 111,793 | | | 32,537 | |
Travel | | | 73,003 | | | 46,281 | |
Bad debt | | | 1,792 | | | 49,190 | |
Other | | | 209,286 | | | 95,156 | |
| | $ | 414,078 | | $ | 223,164 | |
| · | Since the share exchange in November 2007, we have incurred professional fees, principally as a result of our status as a public company. For the three months ended September 30, 2008, professional fees amounted to $18,204 as compared to $0 in the 2007 period. |
| · | Payroll and related benefits increased for the three months ended September 30, 2008 by $79,256, or 243.6%, as compared to the three months ended September 30, 2007. In November 2007, we hired additional personnel in accounting, our chief financial officer, a translator, and administration staff due to our increased operations and additional workload in connection with being a public company. |
| · | For the three months ended September 30, 2008, travel expense increased by $26,722, or 57.7%, as compared to the three months ended September 30, 2007 as a result of increased travel by sales personnel as well as increased travel for investor road shows. |
| · | Bad debts expenses increased by $1,792 for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 based on our analysis of accounts receivable balances. |
| · | Other selling, general and administrative expenses increased by $114,130 for the three months ended September 30, 2008 as compared with the three months ended September 30, 2007 primarily resulting from an increase in insurance expense and rent expense related to prepaid land use rights. |
Income from operations. For the three months ended September 30, 2008, income from operations was $2,469,983 as compared to $2,074,545 for the three months ended September 30, 2007, an increase of $395,438 or 19.1%.
Other income (expenses). For the three months ended September 30, 2008, other expense amounted to $18,352 as compared to other income of $6,761,587 for the three months ended September 30, 2007. For the three months ended September 30, 2008, other expenses reflected interest expense of $20,427 offset by interest income of $2,075. For the three months ended September 30, 2007, other income consisted of interest expense of $9,946 offset by interest income of $91. Additionally, for the three months ended September 30, 2007, other income includes a gain from the forgiveness of income and value-added taxes of $6,771,442 and reflects the reversal of tax accruals previously made resulting from the grant by the local tax agency to the Huayang Companies of a special tax exemption and release from any unpaid corporate income tax and value added tax liabilities and any related penalties through September 30, 2007. This waiver covered all tax reporting periods through September 30, 2007.
Income tax expense. Income tax expense decreased $124,071 or approximately 17.4% during the three months ended September 30, 2008 primarily as a result of the increase in taxable income generated by our operating entities offset by a reduction in the statutory rate from 33% to 25%.
Net income.For the three months ended September 30, 2008, we recorded net income of $1,860,862, or $0.05 per share (basic) and $0.03 per share (diluted) as compared to net income of $8,121,292, or $0.22 per share (basic and diluted) for the three months ended September 30, 2007.
Foreign currency translation gain. The functional currency of our subsidiaries operating in the PRC is the Chinese Yuan or Renminbi (“RMB”). The financial statements of our subsidiaries are translated to U.S. dollars using period end rates of exchange for assets and liabilities, and average rates of exchange (for the period) for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations. As a result of these translations, which are a non cash adjustment, we reported a foreign currency translation gain of $67,269 for the three months ended September 30, 2008 as compared to $299,690 for comparable period in 2007. This non-cash gain had the effect of increasing our reported comprehensive income.
Comprehensive income. For the three months ended September 30, 2008, comprehensive income of $1,928,131 is derived from the sum of our net income of $1,860,862 plus foreign currency translation gains of $67,269.
Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations and otherwise operate on an ongoing basis. At September 30, 2008March 31, 2009 and December 31, 2007,2008, we had cash balances of $744,885$107,910 and $5,025,434,$328,614, respectively. These funds are located in financial institutions located as follows:
| | September 30, 2008 | | December 31, 2007 | |
Country: | | | | | | | | | | | | | |
United States | | $ | 29,308 | | | 3.9 | % | $ | 171,121 | | | 3.4 | % |
China | | | 715,577 | | | 96.1 | % | | 4,854,313 | | | 96.6 | % |
Total cash and cash equivalents | | $ | 744,885 | | | 100.0 | % | $ | 5,025,434 | | | 100.0 | % |
| | March 31, 2009 | | | December 31, 2008 | |
Country: | | | | | | | | | | | | |
United States | | $ | 11,759 | | | | 10.9 | % | | $ | 832 | | | | 0.3 | % |
China | | | 96,151 | | | | 89.1 | % | | | 327,782 | | | | 99.7 | % |
Total cash and cash equivalents | | $ | 107,910 | | | | 100.0 | % | | $ | 328,614 | | | | 100.0 | % |
The following table sets forth information as to the principal changes in the components of our working capital from December 31, 2008 to March 31, 2009 (dollars in thousands):
| | | | | December 31, 2008 to March 31, 2009 | |
Category | | 2009 | | | 2008 | | | Change | | | Percent Change | |
Current assets: | | | | | | | | | | | | |
Cash and cash equivalents | | $ | 108 | | | $ | 329 | | | | (221 | ) | | | (67.2 | ) % |
Notes receivable | | | 200 | | | | 270 | | | | (70 | ) | | | (25.9 | )% |
Accounts receivable, net | | | 4,900 | | | | 4,518 | | | | 382 | | | | 8.5 | % |
Inventory | | | 2,410 | | | | 1,892 | | | | 518 | | | | 27.4 | % |
Advances to suppliers | | | 102 | | | | 118 | | | | (16 | ) | | | (13.5 | ) % |
Due from related party | | | - | | | | 437 | | | | (437 | ) | | | (100.0 | )% |
Prepaid expenses and other current assets | | | 79 | | | | 22 | | | | 57 | | | | 259.1 | % |
Current liabilities: | | | | | | | | | | | | | | | | |
Loans payable | | | 1,315 | | | | 1,021 | | | | 294 | | | | 28.8 | % |
Accounts payable | | | 2,446 | | | | 2,485 | | | | (39 | ) | | | (1.6 | )% |
Accrued expenses | | | 234 | | | | 188 | | | | 46 | | | | 24.5 | % |
VAT and service taxes payable | | | - | | | | 97 | | | | (97 | ) | | | (100.0 | ) % |
Advances from customers | | | 100 | | | | 46 | | | | 54 | | | | 117.4 | % |
Income tax payable | | | 337 | | | | 569 | | | | (232 | ) | | | (40.8 | )% |
Working capital: | | | | | | | | | | | | | | | | |
Total current assets | | | 7,799 | | | | 7,586 | | | | 213 | | | | 2.8 | % |
Total current liabilities | | | 4,431 | | | | 4,406 | | | | 25 | | | | * | |
Working capital | | | 3,368 | | | | 3,180 | | | | 188 | | | | 5.9 | % |
Our working capital position decreased $1,112,090increased approximately $188,000 to $2,073,185$3,368,000 at September 30, 2008March 31, 2009 from working capital of $3,185,275$3,179,265 at December 31, 2007.2008. This decreaseincrease in working capital is primarily attributable to a decrease in cash of $4,280,549 and an increase in accounts payable of $1,356,837 offset by a net increase into.
At March 31, 2009, our accounts receivable were $4,900,064, of $1,784,182which $1,960,910 were generated from our Dyeing segment and $2,939,153 were generated by our forged rolled rings segment. We believe that our collection remains strong and that our reserves for bad debts reflect the conversionrisk of convertible debt of $3,261,339 into shares ofnonpayment by our series A preferred stock and warrants.customers. However, the worldwide economic downturn may affect our customers’ ability to pay, particularly in the Dyeing segment.
Net cash flow provided by operating activities was $5,039,650$188,547 for the ninethree months ended September 30, 2008March 31, 2009 as compared to net cash flow provided byused in operating activities was $6,168,220of $2,096,821 for the ninethree months ended September 30, 2007, a decreaseMarch 31, 2008, an increase of $1,128,570.$2,285,368. Net cash flow provided by operating activities for the ninethree months ended September 30, 2008March 31, 2009 was mainly due to net income of $2,022,185,$646,058, the add-back of non cash items such as depreciation of $175,113 the amortization of debt discount of $1,500, the amortization of land-use rights of $21,585 and stock-based compensation of $42,031, a decrease in notes receivable of $70,041, a decrease in due from related party of $438,174, an increase of accrued expense of $45,669 and an increase in advances from customers of $54,282, offset by an increase in inventory of $515,182, a decrease in income tax payable of $233,343 and an increase in accounts receivable of $377,183. For the three months ended March 31, 2008, net cash flow used in operating activities was mainly due to the decrease in accounts payable of $1,225,962, an increase in accounts receivable of $1,263,740 and an increase in inventories of $1,136,507, which was offset by the add-back of non-cash items of depreciation and amortization of $482,376,$159,062, the amortization of debt discount of $2,263,661, the amortization of deferred debt costs of $21,429 the increase in our allowance for bad debt of $171,816, non-cash rent expense associated with prepaid land use rights of $63,346, and the add-back of stock-based compensation of $75,000, the decrease in prepaid and other assets of $280,762 and advances to suppliers of $726,728 and an increase in accounts payable of $1,189,915 offset by an increase in accounts receivable of $1,777,797, inventories of $124,107, and the payment of VAT and service taxes of $389,946. Net cash flow provided by operating activities for the nine months ended September 30, 2007 was mainly due to our net income of $9,409,308, a decrease in inventories of $426,386, and increase in accounts payable of $1,153,705, an increase in VAT and services taxes payable of $1,011,064, an increase in income taxes payable of $957,899, and increase in advanced from customers of $1,830,260, and the add-back of non-cash items of depreciation and amortization of $450,881 offset by an increase in accounts receivable of $2,538,272, increases in advances to suppliers of $127,886, and the add back of other income from forgiveness of income and VAT taxes of $6,771,442.
Net cash flow used in investing activities was $11,537,578$951,736 for the ninethree months ended September 30, 2008March 31, 2009, as compared to net cash used in investing activities of $6,269,587$694,629 for the ninethree months ended September 30, 2007.March 31, 2008. For the ninethree months ended September 30,March 31, 2009, we used cash to purchase of property and equipment of $951,736. For the three months ended March 31, 2008, we received cash from the repayment of amounts due from related parties of $145,808$96,650 and from the sale of our cost-method investee of $35,720$34,840 offset by the purchase of property and equipment of $11,629,385$3,907 and the payment of deposits on factory equipment of $89,721. For the nine months ended September 30, 2007, we used cash for advances for amounts due from related parties of $486,032 and for the purchase of property and equipment of $17,581, and cash used deposits on long-term assets – related party of $5,792,030.$822,212.
Net cash flow provided by financing activities was $2,051,476$542,116 for the ninethree months ended September 30, 2008March 31, 2009 as compared to net cash provided by financing activities of $260,561$226,259 for the ninesame period in 2008. For the three months ended September 30, 2007.March 31, 2009, we received gross proceeds from our loans payable of $542,116. For the ninethree months ended September 30,March 31, 2008, we received proceeds from short-term bank loans of $142,880,$139,360, and proceeds from the exercise of warrants of $2,011,575$187,340 offset by the repayment of related party advances of $102,979. For the nine months ended September 30,$100,441.
On November 13, 2007, we receivedraised gross proceeds from short-term bank loans of $260,561.
In July 2007, in connection with the expansion of our forged rolled ring and electrical power equipment segment to develop and market forged rolled rings and related equipment to the wind power industry, we acquired a factory, together with the related land use rights, employee housing facilities and other leasehold improvements$5,525,000 from a related party for a net price of approximately $10,500,000. As of September 30, 2008, the amount was paid in full. We also incurred additional construction and improvement costs and acquired new equipment of approximately $11.6 million for our planned expansion of our rolled ring business to enable us to manufacture larger rolled rings and other components.
At September 30, 2008, we required approximately $2,000,000 in order for us to continue the planned expansion of our business. We raised funds in October 2008 through the sale of debt and equity securities. On October 17, 2008, we entered into a purchase agreement with Eos Holdings LLC for the sale of a 17.4% subordinated note, due six months from the date of issuance (the “Note”)our 3% convertible notes in the principal amount of $575,000, for a$5,525,000. On March 28, 2008, the notes were automatically converted into an aggregate of 14,787,135 shares of series A preferred stock and warrants to purchase price of $575,000. Under the terms of the purchase agreement and the Note, we may prepay the Note, in whole or in part, at any time prior to the maturity date of the Note upon five days’ notice to Eos Holdings. On November 14, 2008, we repaid the principal balance of $575,000 in full.
As a condition to the sale of the Note, the purchase agreement requires that Eos Holdings exercise certain common stock purchase warrants having a total exercise price of not less than $175,000, at a per share exercise price of $.58. On October 17, 2008, Eos Holdings purchased the Note and exercised the warrants.
Payment of our obligations of the Note were initially secured by a pledge of and conversion right with respect to 959,000 shares (the “Pledged Shares”) of the Company’s common stock owned by Jianhua Wu, the Company’s chief executive officer and principal beneficial owner of common stock. The pledge and conversion right enables Eos Holdings to convert any or all of the principal amount of the Note into Pledged Shares at any time or from time to time until the Note shall be paid in full or until Eos Holdings shall have exercised the conversion right in full, at an initial conversion price of $.60 per share (the “Conversion Price”). The number of Pledged Shares to be delivered shall be determined by dividing the principal amount of the Note being converted by the Conversion Price, with any fractional shares to be rounded to the nearest whole share. The Pledged Shares shall be held in escrow.
On October 23, 2008, pursuant to a restated pledge and conversion right agreement, the number of Pledged Shares was increased to 1,437,50011,176,504 shares of common stock at $0.58 per share, 5,588,252 shares of common stock at $0.83 per share, and 2,065,000 shares of common stock at $0.92 per share upon the Conversion Pricefiling of the restated certificate of incorporation and a statement of designations setting forth the rights of the holders of the series A convertible preferred stock. In November 2008, as a result of our sale of common stock at $0.40 per share, the exercise price of warrants to purchase 6,501,077 shares of common stock was reduced to $0.40 per share.
share, and the exercise price of warrants to purchase 9,232,424 was reduced to $0.567 per share, which was further reduced to $0.566 as a result of the issuance of warrants in our March 2009 debt financing.
In connection with2008, we received $2,187,566 from the issuanceexercise of warrants to purchase 3,096,255 shares of common stock. As of the Note, on October 17, 2008, we entered into a consulting agreement with Eos Asia Investments Ltd., an affiliate of Eos Holdings, for the provision of consulting services. Pursuant to the consulting agreement, we shall pay consulting fees at a rate of $31,662.50 per month until the Company repays the Note in full or until Eos Holdings LLC exercises its right to receive the Pledged Shares. Assuming the Note is paid on the maturity date of April 20, 2009,this report, the total payments made by usmarket price for our common stock is less than the exercise price of the warrants and we have not registered the shares of common stock underlying the warrants. As a result, we do not anticipate that we will receive any proceeds from the exercise of the warrants issued in the November private placement unless the market price of the stock is greater than the exercise price, as interest onto which we can give no assurance, and we have registered the $575,000 Note and as consulting fees under the consulting agreement would total $240,000. On November 14, 2008, we repaid the principal balance of $575,000 in full.underlying common stock.
During the period from October 23, 2008 through November 7, 2008,In March 2009, we sold anto two investors our 18-month, 15% notes in the aggregate principal amount of 3,400,000$250,000 and warrants to purchase 437,500 shares of the Company’s common stock at a purchasean exercise price of $0.40 per share. Pursuant to the related purchase agreements, our chief executive officer placed 1,531,250 shares of common stock into escrow. The note holders have the right to take these shares, valued at $0.20 per share, in payment of the interest or principal, as the case may be, if we do not pay the interest on or principal of the note before it becomes an event of default. Pursuant to the loan documents, in the event of that Leo Wang ceases to be employed by us as our chief financial officer the holders of not less than $126,000 principal amount of the notes, shall have the right, on not less than 60 days’ notice, to declare the notes in default. If Mr. Wang ceases to be employed by us as a result of his death, disability or a termination for an aggregatecause, than we shall have 60 days to replace Mr. Wang with a chief financial officer acceptable to investors.
We are currently engaged in negotiating the terms of $1,360,000.a loan of RMB 6 million to RMB 10 million (approximately $875,000 to $1.5 million) from a bank in Wuxi, using our newly completed forging facility and the land it sits on as collateral. We can give no assurance that we will be able to obtain such financing. We are also looking into ways to speed up the collection of our accounts receivable to improve our cash flow. If we are unable to obtain such financing, we may need to seek financing from other sources. During the fourth quarter of 2008 and the first quarter of 2009 we raised funds through the sale of equity and the issuance of notes on terms that were not favorable. In the event that we require additional financing, we cannot assure you we will be able to obtain funding on favorable terms, if any. We expect that any equity financing would result in dilution to our stockholders.
Certain of the investors had previously signed subscription agreements for the purchase of shares at a price of $0.60 per share. These investors signed a restated subscription agreement that reflected the $0.40 per share purchase price.
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual Obligations
We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows.
The following tables summarize our contractual obligations as of September 30, 2008,March 31, 2009, and the effects ofeffect these obligations are expected to have on our liquidity and cash flows in future periods.
| | Payments Due by Period | |
| | Total | | Less than 1 year | | 1-3 Years | | 3-5 Years | | 5 Years + | |
Contractual Obligations : | | | | | | | | | | | | | | | | |
Bank indebtedness (1) | | $ | 1,021,138 | | $ | 1,021,138 | | $ | - | | $ | - | | $ | - | |
Equipment purchases | | | 2,000,000 | | | 2,000,000 | | | | | | | | | | |
Total Contractual Obligations: | | $ | 3,021,138 | | $ | 3,021,138 | | $ | - | | $ | - | | $ | - | |
| Payments Due by Period | |
| Total | | Less than 1 year | | 1-3 Years | | 3-5 Years | | 5 Years + | |
| | |
Contractual Obligations : | | | | | | | | | | |
Bank indebtedness (1) | | $ | 1,168,634 | | | $ | 1,168,634 | | | $ | - | | | $ | - | | | $ | - | |
Loans payable | | | 396,079 | | | | 146,079 | | | | 250,000 | | | | - | | | | - | |
Total Contractual Obligations: | | $ | 1,564,713 | | | $ | 1,314,713 | | | $ | 250,000 | | | $ | - | | | $ | - | |
(1)Bank indebtedness includes short term bank loans and notes payable. | (1) | Bank indebtedness consists of short term bank loans. |
Off-balance Sheet Arrangements
We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.
Foreign Currency Exchange Rate Risk
We produce and sell almost all our products in China. Thus, most of our revenues and operating results may be impacted by exchange rate fluctuations between RMB and US dollars. For the three months ended March 31, 2009, we has unrealized foreign currency translation gain of $41,540, because of the change in the exchange rate.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Foreign Currency Exchange Rate RiskNot required for smaller reporting companies.
We produce and sell almost all our products in China. Thus, most of our revenues and operating results may be impacted by exchange rate fluctuations between RMB and US dollars. For the nine months ended September 30, 2008, we has unrealized foreign currency translation gain of $1,679,553, because of the change in the exchange rate.
As required by Rule 13a-15 under the Exchange Act, our management, including our Chief Executive Officer,chief executive officer and our Chief Financial Officer,chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2008.March 31, 2009.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act. Our management is also required to assess and report on the effectiveness of our internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2007.2008. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. During our assessment of the effectiveness of internal control over financial reporting as of December 31, 2007,2008, management identified significant deficiencies related to (i) the U.S. GAAP expertise of our internal accounting staff, (ii) our internal audit functions and and (iii) a lack of segregation of duties within accounting functions.
Although we wereWe became a black check shellreporting company prior toin November 13, 2007 with reporting obligations, our present business did not become subject to the reporting requirements of the Exchange Act until November 13, 2007. We began preparing to be in compliance with the internal control obligations, including Section 404, for our fiscal year ending December 31, 2007. During most of 2007 our internal accounting staff was primarily engaged in ensuring compliance with PRC accounting and reporting requirements for our operating affiliates and was not required to meet or apply U.S. GAAP requirements. We addressed this condition byAs a result, with the exception of certain additional persons hired at the end of 2007 to address these deficiencies, including the hiring of our chief financial officer, whoour current internal accounting department responsible for our financial reporting, on a consolidated basis, is familiar withrelatively new to U.S. GAAP and under his supervision, we are implanting the related internal control procedures required of U.S. public companies, including providingcompanies. Although our accounting staff is professional and experienced in accounting requirements and procedures generally accepted in the PRC, management has determined that they require additional training and assistance of our accounting staff in U.S. GAAP matters. We also have elected independent directors and have established an audit committee which meets with management and our independent auditors. Management has determined that our internal audit function is also significantly deficient due to insufficient qualified resources to perform internal audit functions, and we are seeking to address this deficiency.functions.
DueIn order to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, tocorrect the extent possible,foregoing deficiencies, we will implement procedures to assure thathave taken the initiation of transactions, the custody of assets and the recording of transactions will be performed by separate individuals. following remediation measures:
| · | In late 2007, we engaged Adam Wasserman, a senior financial executive from the U.S. to serve as our chief financial officer on a part-time basis. In December 2008, we hired Leo Wang as our chief financial officer on a full-time basis and Mr. Wasserman became vice president of financial reporting. Mr. Wasserman has extensive experience in internal control and U.S. GAAP reporting compliance, and, together with our chief executive and financial officers will oversee and manage our financial reporting process and required training of the accounting staff. |
| · | We have committed to the establishment of effective internal audit functions, however, due to the scarcity of qualified candidates with extensive experience in U.S. GAAP reporting and accounting in the region, we were not able to hire sufficient internal audit resources before March 31, 2009. However, we will increase our search for qualified candidates with assistance from recruiters and through referrals. |
| · | Since 2008, we have elected independent directors to serve on our audit committee and we have set up a compensation committee to be headed by one of our independent directors. |
| · | Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, to the extent possible, we will implement procedures to assure that the initiation of transactions, the custody of assets and the recording of transactions will be performed by separate individuals. |
We believe that the foregoing steps have significantly remediatedwill remediate the deficiencies previously reported,significant deficiency identified above, and we will continue to monitor the effectiveness of these steps and make any changes that our management deems appropriate.
A material weakness (within the meaning of PCAOB Auditing Standard No. 5) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting.
Our management is not aware of any material weaknesses in our internal control over financial reporting, and we are addressing the significant weaknesses in internal controls over financial reporting. Nothingnothing has come to the attention of management that causes them to believe that any material inaccuracies or errors exist in our financial statement as of September 30, 2008.March 31, 2009. The reportable conditions and other areas of our internal control over financial reporting identified by us as needing improvement have not resulted in a material restatement of our financial statements. WeNor are notwe aware of any instance where such reportable conditions or other identified areas of weakness have resulted in a material misstatement of omission in any report we have filed with or submitted to the Commission.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.
Auditor Attestation
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.
Changes in Internal Controls over Financial Reporting
There were no changes in our internal controls over financial reporting during the thirdfirst quarter of fiscal year 20082009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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.