ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The
following is management’s discussion and analysis of certain significant factors
that have affected our financial position and operating results during the
periods included in the accompanying consolidated financial statements, as
well
as information relating to the plans of our current management. This report
includes forward-looking statements. Generally, the words “believes,”
“anticipates,” “may,” “will,” “should,” “expect,” “intend,” “estimate,”
“continue,” and similar expressions or the negative thereof or comparable
terminology are intended to identify forward-looking statements. Such statements
are subject to certain risks and uncertainties, including the matters set forth
in this report or other reports or documents we file with the Securities and
Exchange Commission from time to time, which could cause actual results or
outcomes to differ materially from those projected. Undue reliance should not
be
placed on these forward-looking statements that speak only as of the date
hereof. We undertake no obligation to update these forward-looking statements.
The
following discussion and analysis should be read in conjunction with our
consolidated financial statements and the related notes thereto and other
financial information contained elsewhere in this Form 10Q.
OVERVIEW
On May
10, 2004, we acquired all of the issued and outstanding equity interests of
Fairford Holdings Limited, a Hong Kong limited liability company (“Fairford”).
Until we acquired Fairford, we had only nominal assets and liabilities and
limited business operations. Although Fairford became a wholly-owned subsidiary
following the acquisition, because the acquisition resulted in a change of
control, the acquisition was recorded as a “reverse merger” whereby Fairford is
considered to be the accounting acquirer. As such, the following results of
operations are those of Fairford.
Fairford
was organized in Hong Kong as a limited liability company on November 3, 2003.
Fairford owns 90% of the equity interest of Ruili Group Ruian Auto Parts Co.,
Ltd., a Sino-foreign joint venture (the “Joint Venture”) established pursuant to
the laws of the People’s Republic of China (“PRC” or “China”). The Joint Venture
is a joint venture between Fairford and Ruili Group Co., Ltd. (the “Ruili
Group”).
The
Ruili Group was incorporated in the PRC in 1987 to specialize in the
development, production and sale of various kinds of automotive parts. Its
headquarter was located in Ruian City of Wenzhou Area, one of the leading
automotive parts manufacturing centers of China with more than 1400 auto parts
manufacturing companies. Its major product lines included valves for air brake
systems, auto metering products, auto electric products, anti-lock brake systems
and retarders. Some of those products were developed and manufactured through
affiliated companies of Ruili Group. Due to its leading position in the
industry, the Chairman of the Ruili Group, Mr. Xiao Ping Zhang, has been elected
as the Chairman of Wenzhou Auto Parts Association, one of the leading auto
parts
trade associations in China. Mr. Zhang is also Chairman and Chief Executive
Officer of the Company. The Joint Venture was established in the PRC as a
Sino-foreign joint venture company with limited liability by the Ruili Group
and
Fairford. Fairford and Ruili Group contributed 90% and 10%, respectively, of
the
paid-in capital in the aggregate amount of approximately $43.4 million.
In
connection with its formation, effective January 19, 2004 the Joint Venture
acquired the business of the Ruili Group relating to the manufacture and sale
of
various kinds of valves for automotive brake systems and related operations
(the
“Transferred Business”). This was accomplished by the transfer from the Ruili
Group to Fairford of the relevant assets and liabilities of the Transferred
Business including trade receivables, inventories and machinery, and the
assumption of short and long term borrowings, at a consideration of
approximately $6.39million.
The
transactions were accounted for as a reverse spin-off in accordance with EITF
02-11 “Accounting for Spin-offs.” Accordingly SORL Auto Parts, Inc. was deemed
to be the “spinnor” for accounting purposes.
In
December 2006, through Fairford, SORL invested a further approximately $32.67
million in its operating subsidiary- the Joint Venture. To maintain its 10%
shareholding in the Joint Venture, the Ruili Group increased its capital
investment by approximately $3.63million. SORL Auto Parts, Inc. continues to
hold a 90% controlling interest in the operating subsidiary.
As a
result of the foregoing, through Fairford’s 90% interest in the Joint Venture,
the Company manufactures and distributes automotive air brake valves and related
components in China and internationally for use primarily in vehicles weighing
over three tons, such as trucks and buses. There are forty categories of valves
with over eight hundred different specifications. Management believes that
it is
the largest manufacturer of automotive brake valves in China.
CRITICAL
ACCOUNTING POLICIES AND ESTIMATES
Below
is
a description of accounting policies, which we consider critical to the
preparation and understanding of our financial statements. In addition, certain
amounts included in or affecting our financial statements and related disclosure
must be estimated, which requires us to make assumptions with respect to values
or conditions which cannot be known with certainty at the time the financial
statements are prepared. Actual results may differ from these estimates under
different assumptions or conditions. The selection of critical accounting
policies, the judgments and other uncertainties affecting the application of
those policies and the sensitivity of reported results to changes in conditions
and assumptions are factors to be considered when reviewing our consolidated
financial statements.
The
Company uses the accrual method of accounting which recognizes revenues when
earned and expenses when incurred.
Accounts
Receivable and Allowance for Doubtful Accounts
The
Company presents accounts receivable, net of allowance for doubtful accounts.
The allowance is calculated based on review of individual customer accounts.
Inventories
Inventories
are stated at the lower of cost or net realizable value. Cost is calculated
on the weighted-average basis and includes all costs to acquire and other costs
incurred in bringing the inventories to their present location and condition.
The Company evaluates the net realizable value of its inventories on a regular
basis and records a provision for loss to reduce the computed weighted-average
cost if it exceeds the net realizable value.
Income
Taxes
Taxes
are
calculated in accordance with taxation principles currently effective in the
PRC. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred
tax assets and liabilities of a change in tax rates is recognized as income
in
the period that includes the enactment date. A valuation allowance is provided
for the amount of deferred tax assets and liabilities that, based on available
evidence, are not expected to be realized.
Under
a
Tax Holiday in PRC, the Joint Venture was granted an exemption from income
taxes
for two years commencing from the first cumulative profit-making year and a
50%
reduction in the income tax rates for the following three years. Fiscal year
ended December 31, 2004 was the first accumulative profit-making year. The
Joint Venture is entitled to a 50% income tax reduction in the fiscal years
ended December 31, 2006, 2007 and 2008. The statutory income tax rate is 26.4%
in Ruian City which is located in the coastal economic development zones, the
Joint Venture was subject to a tax rate of 13.2% from the years of 2006 to
2008.
In
accordance with the provisions of Staff Accounting Bulletin No. 103, revenue
is
recognized when merchandise is shipped and title passes to the customer and
collectability is reasonably assured. Revenues consist of the invoice value
of
the sale of goods and services net of value added tax, rebates and discounts.
The
Company does not receive revenue for shipping and handling costs to customers.
Shipping and handling expenses incurred by the Company are included in selling
expenses in the accompanying consolidated statements of income.
Concentration
of Credit Risk
Financial
instruments that potentially subject the Company to significant concentrations
of credit risk consist primarily of accounts receivable. The Company performs
ongoing credit evaluations with respect to the financial condition of its
creditors, but does not require collateral. In order to determine the value
of
the Company’s accounts receivable, the Company records a provision for doubtful
accounts to cover probable credit losses. Management reviews and adjusts this
allowance periodically based on historical experience and its evaluation of
the
collectability of outstanding accounts receivable.
Results
of Operations
(1)
Results of operations for the three months ended September 30, 2007 as compared
to the three months ended September 30, 2006.
SALES
|
|
|
Three
Months ended
30-Sep-07
|
|
three
Months ended
30-Sep-06
|
|
|
Air
brake valves & related components
|
|
$
|
22.4
|
M
|
|
75
|
%
|
$
|
15.9
|
M
|
|
75
|
%
|
|
Non-valve
products
|
|
$
|
7.3
|
M
|
|
25
|
%
|
$
|
5.4
|
M
|
|
25
|
%
|
|
Total
|
|
$
|
29.7
|
M
|
|
100
|
%
|
$
|
21.3
|
M
|
|
100
|
%
|
Sales
consist of air brake valves and related components manufactured by SORL and
sold
to domestic original equipment manufacturers (OEM) and aftermarket customers
as
well as distribution of non-valve auto parts sourced from the Ruili Group.
Net
sales
were $29,703,227 and $21,288,002 for the three months ended September 30, 2007
and 2006, respectively. Compared with the same period of 2006, net sales for
the
three months ended September 30, 2007 increased by $8.4 million or 39.4% to
$29.7 million. The increase in sales was mainly from domestic OEM, domestic
aftermarket and the international market. This increase was a result of
the Company’s efforts to develop more customers and penetrate these market
segments.
A
breakdown of net sales revenue for our three market segments, domestic OEM,
domestic aftermarket and the international market, for the three months ended
September 30, 2007 and 2006 is as follows:
|
|
|
Three Months
ended
30-Sep-07
|
|
%
|
|
Three Months
ended
30-Sep-06
|
|
%
|
|
|
|
|
(U.S.
dollars in million)
|
|
|
China
OEM market
|
|
$
|
9.2
|
|
|
31
|
%
|
$
|
6.7
|
|
|
32
|
%
|
|
China
Aftermarket
|
|
$
|
7.7
|
|
|
26
|
%
|
$
|
5.2
|
|
|
24
|
%
|
|
International
market
|
|
$
|
12.8
|
|
|
43
|
%
|
$
|
9.4
|
|
|
44
|
%
|
|
Total
|
|
$
|
29.7
|
|
|
100
|
%
|
$
|
21.3
|
|
|
100
|
%
|
During
the three months ended September 30, 2007, the Chinese commercial vehicle
segment continued to develop rapidly. To expand its OEM market share, the Joint
Venture took advantage of its established relationship with major OEM customers
and continued with new product R&D while enhancing unit production
efficiency, lowering the product defect ratio and shortening the overall
logistic cycle. In this quarter, the Company’s sales to the OEM market increased
by approximately $2.5 million or 37.3% for the third quarter ended September
30,
2007, as compared with the third quarter ended September 30, 2006.
As
of September 30 , 2007, the Joint Venture had 28 authorized distributors
covering nearly all regions in China, who in turn sold our products to over
800
sub-distributors. Based on the well established sales networks as well as
increased production capacity, the Joint Venture achieved total revenue of
$7.7
million in domestic aftermarket sales for the three months ended September
30,
2007, an increase of $2.5 million, or 48.1% as compared to the same period
of
last year.
Export
sales grew by $3.4 million or approximately 36.2% for the three months ended
September 30, 2007, as compared to $9.4 million for the same period of
2006. This increase reflects our continued focus on customer service,
strong execution, introduction of new products, increased productivity of our
expanded contract sales force, more efficient targeted marketing spending on
our
catalogs, web sites and international trade shows as well as the continued
success of our customer acquisition and retention efforts resulting from
improved service levels in this market segment.
COST
OF SALES
Cost
of sales for the three months ended September 30, 2007 increased to $23.1
million from $ 16.5 million for the same period of 2006, a $6.6 million or
40 %
increase which was consistent with the increase in revenues.
GROSS
PROFIT
For
the three months ended September 30, 2007, gross profit was $6,638,503, as
compared to $4,776,659 for the same period of 2006, an increase of $1,861,844
or
39%. Gross margin was 22.3% for the three months ended September 30, 2007,
slightly down 0.1% from 22.4% for the same period of 2006.
In
view
of the increase of primary raw materials price and the negative impact
associated with the appreciation of RMB against the U.S. dollar , during the
three
months ended September 30, 2007, the Joint Venture took various measures to
lower the cost per product,. Those measures included selecting the suppliers
which are physically close to the Joint Venture to reduce the cost of
transportation; reducing inventories of raw material in excess of those required
to meet production when the market price is volatile; having short-term pricing
agreements with some of our suppliers that reduce our exposure to raw material
price increases; and optimizing production techniques to reduce raw material
consumption. In the remaining three months of 2007, the Joint Venture plans
to
improve gross margin by economies of scale, shift of products mix and the
introduction of new valve products with higher profit margins.
SELLING
EXPENSES
Selling
expenses were $1,928,763 for the three months ended September 30, 2007, as
compared to $1,163,077 for the same period of 2006, an increase of $765,686
or
65.8%. The increase was mainly due to the effect of the following
factors:
|
|
(1)
|
Increased
transportation expenses for domestic sales: Because of the shorter
lead
time resulting from the delivery requirements of the OEM
’
s,
products
needed to be shipped more frequently in smaller quantities. Accordingly,
the associated transportation expenses increased by $ 261,746 for
the
three months ended September 30, 2007, as compared to $196,821 for
the
same period of 2006, even though the Company had taken many steps
to
optimize its shipping
management. , .
|
|
|
(2)
|
Packaging
costs were $ 484,539 for the three months ended September 30, 2007,
an
increase of $162,467 as compared with the same period of 2006 , as
a
result of the increase in international sales which generally require
a
higher standard for packaging material.
|
|
|
(3)
|
Advertising
costs were $ 106,437 for the three months ended September 30, 2007,
as
compared to $1,335 for the same period of 2006, an increase of
$105,102.
|
GENERAL
AND ADMINISTRATIVE EXPENSES
General
and administrative expenses were $1,682,071 for the three months ended September
30, 2007, as compared to $1,028,862 for the same period of 2006, an increase
of
$653,209 or 63.5%. The increase was mainly due to the following
factors:
|
|
(1)
|
The
expansion of economic activities, facilities and workforce resulted
in
increased depreciation, office expenses, staff salary and welfare,
travel
expenses, supplies and utilities totaling $ 479,420, as compared
to the
same period of 2006.
|
|
|
(2)
|
R&D
expense, which is included in general and administrative expenses,
increased by $ 152,696, as compared to the same period of 2006, as
discussed below.
|
|
|
(3)
|
Additionally, there
was an increase in professional fees of $69,281. The professional
fees included audit and legal fees associated with SEC filings, related
consulting fees, stock transfer fees and other items associated with
the
costs of being a public entity. The aforementioned increases were
partly
offset by a decreased stock-based compensation expenses at
$43,555.
|
RESEARCH
AND DEVELOPMENT EXPENSE
Research
and development expense was $381,502 for the three months ended September 30,
2007, as compared to $228,806 for the same period of 2006, an increase of
$152,696, as a result of the Company’s investment in new R&D instrument
purchases and the establishment of a team to develop new innovative
products.
DEPRECIATION
AND AMORTIZATION
Depreciation
and amortization expense increased to $447,548 for the three months ended
September 30, 2007, compared with that of $266,058 for the same period of 2006,
an increase of $181,490, as a result of new investments in fixed assets, mainly
production equipment and tools.
FINANCIAL
EXPENSE
Financial
expense for the three months ended September 30, 2007 increased by $89,496
to
$349,056 from $259,587 for the same period of 2006. Financial expense
mainly consists of interest expense and exchange loss. The interest expense
decreased by $87,389 to $76,473 for the three months ended September 30, 2006,
compared with $163,862 for the same period of 2006, mainly due to the lower
outstanding average debt balance during current period. The funds were mainly
used for new equipment purchases, as well as working capital purposes. Because
a
large part of our accounts receivable arose from export sales denominated in
US
dollars, the appreciation of the RMB against the U.S. dollar resulted in
a larger exchange loss during the third quarter ended September 30,
2007.The Company recognized the exchange losses of $297,570 and $95,809 for
the
third quarters of 2007 and 2006, respectively.
OTHER
INCOME
Other
income was $118,334 for the three months ended September 30, 2007, as compared
to $ 24,280 for the three months ended September 30, 2006, an increase of
$94,054.The increase was mainly due to $ 63,466 of subsidy income from local
governments for the three months ended September 30, 2007. These subsidies
were
provided to the Company as economic incentives to secure business commitments
and no repayment by the Company is required.
INCOME
TAX
There
was
no income tax expense for the fiscal year ended December 31, 2005 and
2004. As a result of the Joint Venture obtaining its Sino-foreign joint
venture status in 2004, in accordance with applicable PRC tax regulations,
the
Joint Venture was exempted from PRC income tax in both fiscal 2004 and
2005. Thereafter, the Joint Venture is entitled to a tax concession of 50%
of the applicable income tax rate of 26.4% for the three years ended December
31, 2006, 2007, and 2008. Income tax expense of $434,139 and $311,208 was
recorded for the third quarter ended September 30, 2007 and 2006, respectively.
STOCK—BASED
COMPENSATION
On
January 5, 2006 the Company issued 100,000 warrants for the financial services
to be provided by Maxim Group LLC and Chardan Capital Markets, LLC, with an
exercise price of $6.25 per share and a contractual term of four years. In
accordance with the common stock purchase warrant agreement, the warrants became
vested and exercisable immediately on the date thereof. Total deferred
stock-based compensation expenses related to the 100,000 warrants amounted
to
$299,052. This amount is amortized over one year in a manner consistent
with Financial Accounting Standards Board Interpretation No. 123 (R). The
amortization of deferred stock-based compensation for these equity arrangements
was $ 74,763 for the three months ended September 30, 2006.
On
March 1, 2006, the Board of Directors approved a total of 60,000 options to
be
issued to the four independent members of the Board of Directors. The
contractual term of the options is three years. Total deferred stock-based
compensation expenses related to stock options amounted to $178,904. This
amount is amortized over the three year vesting period in a manner consistent
with Financial Accounting Standards Board Interpretation No. 123R.
The
amortization of deferred stock-based compensation for these equity arrangements
was $ 14,909 for each of the three months ended
September
30, 2007 and 2006.
Although
the Company anticipates future issuances of stock awards to have a material
impact on net income, in future financial statements, we do not expect these
transactions to have a material impact on future cash flow.
MINORITY
INTEREST
Minority
interest represents a 10% non-controlling interest in the Joint
Venture. Minority interest in income amounted to $ 239,867 and $ 196,236
for the three months ended September 30, 2007 and 2006, respectively.
FINANCIAL
CONDITION
Liquidity
and Capital Resources
OPERATING
- Net cash provided in operating activities was $ 5,914,614 for the third
quarter ended September 31, 2007 compared with
$529,368
of
net
cash provided in operating activities in the same period in 2006, an increase
of
$ 5,385,246.
Our
primary cash flows from net income were realized through the sale of automotive
parts. The timely collection of account receivables will improve our liquidity.
In the third quarter of 2007, cash flow from account receivables and notes
receivables increased by $ 5.8 million as compared with the same period of
2006.
In accordance with the increase of sales orders, the Company maintained a higher
level of inventory to meet the requirements from OEM and overseas customers
and
required more raw materials to keep its production capacity
.
This
resulted in a negative cash flow of approximately $ 0.4 million. Additionally,
cash flows contributed from account payables and notes payables decreased by
approximately $1.0 million for the three months ended September 30, 2007 as
compared to the same period of 2006.
As
of
September 30, 2007, the Company had cash and cash equivalents of $1,972,825,
as
compared to cash and cash equivalents of $11,137,501 at December 31,
2006.
The
Company had working capital of $ 41,233,833 at September 30, 2007, as compared
to working capital of $47,195,220 at December 31, 2006, reflecting current
ratios of 4.09:1 and 7.58:1, respectively.
INVESTING
- During the three months ended September 30, 2007, the Company expended net
cash of $ 12,904,287 in investing activities, mainly for acquisition of a plant,
land use rights and new equipments to support the growth of business. For
the three months ended September 30, 2006, the Company utilized $ 1,189,727
in
investing activities.
FINANCING
-Net cash provided by financing activities was $3,159,176 for the three months
ended September 30, 2007 compared to $632,227 used in financing activities
in
the same period in 2006. In the third quarter of 2007, the cash inflows were
mainly attributable to a $3,159,176 increase in proceeds from borrowing due
to
one new secured loan for new equipment purchases and working capital. During
the
three months ended September 30, 2006, the Company paid down its outstanding
debt by $3,251,788, while receiving an aggregate of $2,619,561 in bank loans
under its credit facilities.
Management
of the Company has taken a number of steps to restructure its customer base
and
phase out the accounts which had failed to make prompt payments. The Company
also placed more emphasis on receivable collection. During the three months
ended September 30, 2007, the Company continued developing higher profit margin
new products, and adopting steps for further cost saving such as improving
material utilization rate. Meanwhile, the Company maintains good relationships
with local banks. We believe that our current cash and cash equivalents and
anticipated cash flow generated from operations and our bank lines of credit
will be sufficient to finance our working capital requirements for the
foreseeable future.
(
2) Results of operations for the nine months ended September 30, 2007 as
compared to the nine months ended September 30, 2006.
|
|
|
Nine
Months ended
30-Sep-07
|
|
Nine
Months ended
30-Sep-06
|
|
|
Air
brake valves & related components
|
|
$
|
63.7
|
M
|
|
76
|
%
|
$
|
44.6
|
M
|
|
73
|
%
|
|
Non-valve
products
|
|
$
|
19.6
|
M
|
|
24
|
%
|
$
|
16.2
|
M
|
|
27
|
%
|
|
Total
|
|
$
|
83.3
|
M
|
|
100
|
%
|
$
|
60.8
|
M
|
|
100
|
%
|
Sales
consist of air brake valves and related components manufactured by SORL and
sold
to domestic original equipment manufacturers (OEM) and aftermarket customers
as
well as distribution of non-valve auto parts sourced from the Ruili Group.
Net
sales
were $83,309,788 and $60,824,588 for the nine months ended September 30, 2007
and 2006, respectively. Compared with the same period of 2006, net sales for
the
nine months ended September 30, 2007 increased by $22.5 million or 37.0% to
$83.3 million,. The increase in sales was mainly from domestic OEM, domestic
aftermarket and the international market. This increase was a result of
the Company’s efforts to develop more customers and penetrate these market
segments.
A
breakdown of net sales revenue for our three market segments, domestic OEM,
domestic aftermarket and the international market, for the nine months ended
September 30, 2007 and 2006 is as follows:
|
|
|
Nine
Months
ended
30-Sep-07
|
|
%
|
|
Nine
Months
ended
30-Sep-06
|
|
%
|
|
|
|
|
(U.S.
dollars in million)
|
|
|
China
OEM market
|
|
$
|
30.1
|
|
|
36
|
%
|
$
|
18.5
|
|
|
30
|
%
|
|
China
Aftermarket
|
|
$
|
21.1
|
|
|
25
|
%
|
$
|
17.9
|
|
|
29
|
%
|
|
International
market
|
|
$
|
32.1
|
|
|
39
|
%
|
$
|
24.4
|
|
|
41
|
%
|
|
Total
|
|
$
|
83.3
|
|
|
100
|
%
|
$
|
60.8
|
|
|
100
|
%
|
During
the nine months ended September 30, 2007, the Chinese commercial vehicle segment
experienced a high growth. In response to this growth, the Joint Venture
installed new equipment to increase production capacity and to meet the growing
demand. In addition, the Joint Venture took advantage of its established
relationship with major OEM customers and continued with new product R&D
while enhancing unit production efficiency, lowering the product defect ratio
and shortening the overall logistic cycle. The Joint Venture further expanded
its OEM market share in the three quarters of 2007.The Joint Venture’s sales to
the OEM market increased by approximately $11.6 million or 62.7% for the nine
months ended September 30, 2007, as compared with the nine months ended
September 30, 2006.
As
of
September 30 , 2007, the Joint Venture had 28 authorized distributors covering
nearly all regions in China, who in turn sold our products to over 800
sub-distributors. Based on the well established sales networks as well as
increased production capacity, the Joint Venture achieved total revenue of
$21.1
million in domestic aftermarket sales for the nine months ended September 30,
2007, an increase of $3.2 million, or 17.9% as compared to the same period
of
last year.
Export
sales grew by $7.7 million or approximately 31.6% for the three months ended
September 30, 2007, as compared to $24.4 million for the same period of
2006. This increase reflects our continued focus on customer service,
strong execution, introduction of new products, increased productivity of our
expanded contract sales force, more efficient targeted marketing spending on
our
catalogs, web sites and international trade shows as well as the continued
success of our customer acquisition and retention efforts resulting from
improved service levels in this market segment.
COST
OF SALES
Cost
of sales for the nine months ended September 30, 2007 increased to $64.6 million
from $47 million for the same period of 2006, a $17.6 million or 37.4% increase
which was consistent with the increase in revenue.
GROSS
PROFIT
For
the nine months ended September 30, 2007, gross profit was $ 18,689,725, as
compared to $ 13,811,761 for the same period of 2006, an increase of $ 4,877,964
or 35.3%. Gross margin was 22.4% for the nine months ended September 30,
2007, slightly down0.3% from 22.7% for the same period of 2006.
In
view
of the increase of primary raw materials price and the negative impact
associated with the appreciation of RMB against the U.S. dollar , during the
nine
months ended September 30, 2007, the Joint Venture took various measures to
lower the cost per product,. Those measures included selecting the suppliers
which are physically close to the Joint Venture to reduce the cost of
transportation; reducing inventories of raw material in excess of those required
to meet production when the market price is volatile; having short-term pricing
agreements with some of our suppliers that reduce our exposure to raw material
price increases; and optimizing production techniques to reduce raw material
consumption. In the remaining three months of 2007, the Joint Venture plans
to
improve gross margin by economies of scale, shift of products mix and the
introduction of new valve products with higher profit margins.
SELLING
EXPENSES
Selling
expenses were $4,444,053 for the nine months ended September 30, 2007, as
compared to $3,407,535 for the same period of 2006, an increase of $ 1,036,518
or 30.4%. The increase was mainly due to the effect of the following factors:
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|
(1)
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Increased
transportation expenses for domestic sales
:
Because of the shorter lead time resulting from the delivery requirements
of the OEM
’
s,
products
needed to be shipped more frequently in smaller quantities.
Accordingly, the associated transportation expenses increased by $$
473,121 for the nine months ended September 30, 2007, as compared
to
$451,377 for the same period of 2006, even though the Company had
taken
many steps to optimize its shipping management.
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(2)
|
Packaging
costs were $ 1,386,103 for the nine months ended September 30, 2007,
an
increase of $804,890 as compared with the same period of 2006 , as
a
result of the increase in international sales which generally require
a
higher standard for packaging material.
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|
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(3)
|
Advertising
costs were $ 107,023 for the nine months ended September 30, 2007,
as
compared to $23,358 for the same period of 2006, an increase of
$83,682.
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(4)
|
The
Company recorded product warranty expenses at $ 912,623 for the nine
months ended September 30, 2006, as compared to $1,174,437 for the
same
period of 2006, a decrease of $261,814. During the nine months ended
September 30, 2006, there was one large amount of a one-time
indemnification payment to an OEM customer, resulting from
miscommunication in certain technical parameters for the
products.
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GENERAL
AND ADMINISTRATIVE EXPENSES
General
and administrative expenses were $4,402,694 for the nine months ended September
30, 2007, as compared to $ 2,212,113 for the same period of 2006, an increase
of
$ 2,190,581 or 99%.The increase was mainly due to the following
factors:
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|
(1)
|
The
expansion of economic activities, facilities and workforce resulted
in
increased depreciation, office expenses, staff salary and welfare,
travel
expenses, supplies and utilities totaling $708,993, as compared to
the
same period of 2006.
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(2)
|
R&D
expense, which is included in general and administrative expenses,
increased by $ 466,232, as compared to the same period of 2006, as
discussed below.
|
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|
(3)
|
Stock-based
compensation expenses decreased by $ 191,149, as compared to $259,077
for
the same period of 2006.
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(4)
|
During
the nine months ended September 30, 2006, the Joint Venture reversed
a bad
debt provision resulting from collecting a significant portion of
accounts
receivable with aging over one year, which had been reflected as
a
reduction to general and administrative expenses. Compared with the
negative $869,463 of bad debt provision for the nine month ended
September
30, 2006, the bad debt provision included in general and administrative
expenses was $23,623 for the nine months ended September 30, 2007,
an
increase of by $893,086.
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RESEARCH
AND DEVELOPMENT EXPENSE
Research
and development expense was $ 935,174 for the nine months ended September 30,
2007, as compared to $ 468,942 for the same period of 2006, an increase of
$466,232, as a result of the Company’s investment in new R&D instrument
purchases and the establishment of a team to develop new innovative
products..
DEPRECIATION
AND AMORTIZATION
Depreciation
and amortization expense increased to $1,157,942 for the nine months ended
September 30, 2007, compared with that of $783,053 for the same period of 2006,
an increase of $ 374,889 or 47.9%, as a result of new investments in fixed
assets, mainly production equipment and tools.
FINANCIAL
EXPENSE
Financial
expense for the nine months ended September 30, 2007 decreased by $ 160,542
to $
606,492 from $ 767,034 for the same period of 2006. Financial expense
mainly consists of interest expense and exchange loss. The interest expense
decreased by $475,759 to $ 89,387 for the nine months ended September 30, 2007,
compared to the $ 565,146 for the same period of 2006, mainly due to the lower
outstanding average debt balance during the year. The funds were used for new
equipment purchases, as well as working capital. Because a large part of our
accounts receivable arose from export sales denominated in US dollars, the
appreciation of the RMB against the U.S dollar resulted in a larger
exchange loss during the nine months ended September 30, 2007. The Company
recognized the exchange losses of $578,704 and $140,306 for the nine months
ended September 30, 2007 and 2006 respectively.
OTHER
INCOME
Other
income was $502,606 for the nine months ended
September
30,
2007, as compared to $92,976 for the nine months ended
September
30,
2006, an increase of $409,630.The increase was mainly due to $329,204 of subsidy
income from local governments for the nine months ended
September
30,
2007. These subsidies were provided to the Company as economic incentives to
secure business commitments and no repayment by the Company is required.
INCOME
TAX
There
was
no income tax expense for the fiscal year ended December 31, 2005 and 2004.
As a
result of the Joint Venture obtaining its Sino-foreign joint venture status
in
2004, in accordance with applicable PRC tax regulations, the Joint Venture
was
exempted from PRC income tax in both fiscal 2004 and 2005. Thereafter, the
Joint
Venture is entitled to a tax concession of 50% of the applicable income tax
rate
of 26.4% commencing the three years ended December 31, 2006, 2007, and 2008.
In
accordance with China's relevant regulations of income taxes, the Joint Venture
has a benefit of a refund of 40% of domestic equipment purchases from increased
income taxes for the purchasing year over those of the previous year. During
the
second quarter ended June 30, 2007, the Joint Venture received an income tax
benefit of $991,133 for purchase of domestic equipment, which has been reflected
as a reduction to current income tax expense. As a result, income tax expense
was $373,883 for the nine months ended September 30, 2007 compared with $898,713
for the nine months ended September 30, 2006, a decrease of $524,830.
STOCK—BASED
COMPENSATION
On
January 5, 2006 the Company issued 100,000 warrants for the financial services
to be provided by Maxim Group LLC and Chardan Capital Markets, LLC, with an
exercise price of $6.25 per share and a contractual term of four years. In
accordance with the common stock purchase warrant agreement, the warrants became
vested and exercisable immediately on the date thereof. Total deferred
stock-based compensation expenses related to the 100,000 warrants granted
amounted to $299,052. This amount is amortized over one year in a manner
consistent with Financial Accounting Standards Board Interpretation No. 123
(R). The amortization of deferred stock-based compensation for these equity
arrangements was $ 224,289 for the nine months ended September 30, 2006.
On
March 1, 2006, the Board of Directors approved a total of 60,000 options to
be
issued to the four independent members of the Board of Directors. The
contractual term of the options is three years. Total deferred stock-based
compensation expenses related to stock options amounted to $178,904. This
amount is amortized over the three year vesting period in a manner consistent
with Financial Accounting Standards Board Interpretation No. 123R. The
amortization of deferred stock-based compensation for these equity arrangements
was $ 44,727 for the nine months ended September 30, 2007 ,as compared to $
34,788 for the same period ended September 30, 2006.
On
June
20, 2007, the Company granted to its previous senior manager of investor
relations, David Ming He, options to purchase 4,128 shares of its common stock
with an exercise price of $7.25 per share. In accordance with the agreement,
the
options became vested and exercisable imme diately on the date thereof. Total
deferred stock-based compensation expenses related to the 4,128 stock options
granted amounted to $23,201. This amount was charged to G&A during six
months ended June 30, 2007.
Although
the Company anticipates future issuances of stock awards to have a material
impact on net income, in future financial statements we do not expect these
transactions to have a material impact on future cash flow.
MINORITY
INTEREST
Minority
interest represents a 10% non-controlling interest in the Joint Venture.
Minority interest in income amounted to $ 936,986 and $ 638,677 for the nine
months ended September 30, 2007 and 2006, respectively.
FINANCIAL
CONDITION
Liquidity
and Capital Resources
OPERATING
- Net cash provided in operating activities was $4,220,538 for the nine months
ended September 30, 2007, as compared to $6,996,576 of net cash provided by
operating activities for the nine months ended September 30, 2006, a decrease
of
$2,776,038.
Our
primary cash flows from net income were realized through the sale of automotive
parts. The timely collection of account receivables will improve our liquidity.
Cash flows from accounts receivable and notes receivables decreased by
approximately $1.6 million for the nine months ended September 30, 2007 as
compared with the same period of 2006, as a result of a high level of accounts
receivable and notes receivables as of September 30, 2007. The increase of
accounts receivable was primarily due to the increase of sales volumes. The
ending balance of accounts receivables as of September 30, 2007 was consistent
with the Joint Venture’s normal practice. During the nine months ended September
30,2007, most of the accounts receivable were collected by bank acceptance,
hence the increase in notes receivables. In accordance with the increase in
sales orders, the Company maintained a higher level of inventory to meet the
requirements from OEM and overseas customers and required more raw materials
to
keep its production capacity. This resulted in a decreased negative cash flow
of
approximately $ 4.2 million. Additionally, cash flows contributed from
prepayments and account payables and notes payables decreased by approximately
$0.8 million for the nine months ended September 30, 2007 as compared to the
same period of 2006.
As
of
September 30, 2007, the Company had cash and cash equivalents of $1,972,825,
as
compared to cash and cash equivalents of $11,137,501 at December 31,
2006. The Company had working capital of $ 41,233,833 at September 30,
2007, as compared to working capital of $47,195,220 at December 31, 2006,
reflecting current ratios of 4.09:1and 7.58:1, respectively.
INVESTING
– During the nine months ended September 30, 2007, the Company expended net cash
of $18,259,563 in investing activities, mainly including the funds for
acquisition of plant, land use rights and new equipment to support the growth
of
business. For the nine months ended September 30, 2006, the Company
utilized $2,063,307 in investing activities.
FINANCING
-Net cash provided by financing activities was $4,644,122 for the nine months
ended September 30, 2007 compared to $5,152,615 used in financing activities
in
the same period in 2006. During the nine months ended September 30, 2006, the
Company received aggregate bank loans in the amount of $ 9,733,125 under its
credit facilities, and the Company repaid $ 15,030,530 on its outstanding debt.
During the nine months ended September 30, 2007, the cash inflows were mainly
attributable to a $4,644,122 increase in proceeds from borrowing due to a short
term bank loan being secured for new equipment purchases and working capital
requirements .
Management
of the Company has taken a number of steps to restructure its customer base
and
phase out the accounts which had failed to make prompt payments, the Company
also placed more emphasis on receivable collection. During the quarter, the
Company continued to develop high profit margin new products, as well as
adopting steps for further cost saving such as improving material utilization
rate. While we believe that funds generated from operations and our revolving
bank lines of credit will be sufficient to finance our working capital
requirements for the foreseeable future, we continue our efforts to raise
capital to finance further expansion of production, build our international
sales networks in new markets, strengthen our R&D workforce, and supplement
our working capital.