On August 1, 2010, China Industrial Steel Inc. (“CIS”), through Northern Steel Inc. (“Northern”) and its wholly owned foreign enterprise, Nuosen (Handan) Trading Co., Ltd (“Nuosen”), entered into an Entrusted Management Agreement, an Exclusive Option Agreement, and a Covenants Agreement (collectively, the “Entrusted Agreements”) with Handan Hongri Metallurgy Co., Ltd. (“Hongri”) and shareholders of Hongri, Hebei Wu’an Yuanbaoshan Industry Group Co., Ltd (“YBS Group”) and Fakei Investment (Hong Kong) Ltd (“Fakei”). The effect of the Entrusted Agreements is to cede control of management and economic benefits of Hongri to Nuosen. As consideration, CIS issued 44,083,529 restricted shares of its common stock, par value $0.0001, to Karen Prudente, a nominee and trustee for shareholders of YBS Group for entering into the Entrusted Agreements with Nuosen. CIS also issued 17,493,463 restricted shares of its common stock to shareholders of Fakei in consideration for Fakei entering into the Entrusted Management Agreement with Nuosen.
The Entrusted Agreements empower CIS, through Northern and Nuosen, with the ability to control and substantially influence Hongri’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholders’ approval. As a result of these entrusted agreements, which obligate CIS to absorb a majority of expected losses of Hongri and enable CIS to receive a majority of expected residual returns from Hongri and because CIS has the power to direct the activities of Hongri that most significantly impact Hongri’s economic performance, CIS, through its wholly-owned subsidiaries, accounts for Hongri as its Variable Interest Entity (“VIE”) under Accounting Standards Codification (“ASC”) subtopic 810-10-05-8, “Consolidation of VIEs”. Accordingly, CIS consolidates Hongri’s operating results, assets and liabilities. The management of the Company currently intends to reinvest all of the income of Hongri for strategic expansion purpose for the foreseeable future.
For accounting purposes, the above transactions were accounted for in a manner similar to a reverse merger or recapitalization, since the former equity shareholders of Hongri now effectively control a majority of CIS’ common stock immediately following the transactions. Consequently, the assets and liabilities and historical operations reflected in the consolidated financial statements prior to the transactions are those of Hongri and are recorded at the historical cost of Hongri. The consolidated financial statements after completion of the transactions include the assets and liabilities of CIS, Northern, Nuosen, and Hongri (collectively, “CIS” or the “Company”), historical operations of Hongri, and operations of CIS, Northern, Nuosen and Hongri from the date of the transaction. The 44,083,529 restricted shares of common stock issued to Karen Prudente and 17,493,463 restricted shares of common stock issued to Fakei were presented as of the beginning of the first period presented in the accompanying consolidated financial statements.
CIS through Hongri, its operating company in China, produces and sells steel plates, steel wires and steel billets. The Company currently operates from its headquarters on approximately 1,000 acres in Handan City, Hebei Province, China. Most of the Company’s products are sold domestically in China.
The Company has an annual steelmaking capacity of 2.3 million metric tons currently. Annualized production of steelmaking to total capacity utilization rate was approximately 64% and 40% for the three months ended June 30, 2013 and 2012, respectively. Annualized production of steelmaking to total capacity utilization rate was approximately 67% and 48% for the six months ended June 30, 2013 and 2012, respectively. In addition to steelmaking capacity, the Company currently has an aggregate of 2.6 million metric tons of annual steel rolling production capacity (including steel plate and steel wire/bar production). Annualized production of steel rolling to total capacity utilization rate was approximately 56% and 50% for the three months ended June 30, 2013 and 2012, respectively. Annualized production of steel rolling to total capacity utilization rate was approximately 57% and 47% for the six months ended June 30, 2013 and 2012, respectively.
There are many factors of our business which are impacted by prevailing market conditions. Specifically, a change in the prices of raw material and energy will influence the Company’s inventory levels and purchasing and selling decisions which will, ultimately, impact the Company’s realized gross margin. The management’s decisions in response to the market will change as market conditions change. The Company does not undertake any hedging strategies to mitigate the fluctuation of market prices as is the common practice in the small-middle sized business in China. Therefore, the fluctuation of commodity prices will have a direct impact on the Company’s operation through the price change in local steel market.
According to Association of Chinese Steel Industry, steel manufactures’ Chinese comprehensive price index of steel products (“CSPI”), an index combining prices of various steel products and an economic indicator of market demand for steel products, decreased continuously since the beginning of 2012. As of December 31, 2012, CSPI was 105.31, a decrease of 13% compared to 120.45 at December 31, 2011. In the meantime, according to IndexMundi, the average monthly price of iron ore was $128.87 per dry metric ton as of December 31, 2012, a decrease of 6% compared to $136.46 per dry metric ton as of December 31, 2011. Though the price of iron ore, coking coal and other materials decreased in the same period, decrease in steel products prices was sharper than the decrease in the prices of raw material. The combination of the unparalleled decrease in selling prices of steel products, excessive steel production capacities and lack of demand for steel products in Chinese domestic market, had a direct negative impact on steel making manufacturers. Many Chinese steel manufacturers incurred losses in the first six months in 2013 and 2012.
The prices of steel products rebounded in the beginning of 2013 but started to decrease continuously after February 2013. CSPI was 100.48 in June 2013, a decrease of 5% compared to 105.31 in December 2012. The decrease in the prices of steel products has had a negative impact on our results of operations in 2013 so far. The recovery of the Chinese steel market is still uncertain and will largely depend on new economic development policy in China and the recovery of the world economy.
For the three months ended June 30, 2013, 75% of the Company’s total purchase was from Hongrong, 8% of the total purchase was from two other related companies, and remaining 17% of the total purchase was from various unrelated parties (none of them over 10%). For the three months ended June 30, 2012, 52% of the total Company’s purchase was from Hongrong, and 41% of the total purchase was from an unrelated party.
For the six months ended June 30, 2013, 69% of the Company’s total purchase was from Hongrong, 4% of the total purchase was from two other related companies, 11% of the total purchase was from one unrelated party and remaining 16% of the total purchase was from various unrelated parties (none of them over 10%). For the six months ended June 30, 2012, 64% of the total Company’s purchase was from Hongrong, and 32% of the total purchase was from an unrelated party.
For the three months ended June 30, 2013, there were two (2) major customers that accounted for approximately 30% of the Company’s total sales, 16% and 14%, respectively. For the three months ended June 30, 2012, there were two (2) major customers that accounted for approximately 33% of the Company’s total sales, 18% and 15%, respectively.
For the six months ended June 30, 2013 and 2012, there were two (2) major customers that accounted for approximately 35% and 38% of the Company’s total sales, respectively. Each of major customer accounted 18% and 17% of total sales for the six months ended June 30, 2013, and 20% and 18% of total sales for the six months ended June 30, 2012, respectively.
Results of Operations for the Three Months Ended June 30, 2013 and 2012
Comparison of Revenue for the Three Months Ended June 30, 2013 and 2012
|
|
2013
|
|
|
2012
|
|
Products
|
|
Revenue
|
|
|
Quantity (Ton)
|
|
|
Revenue
|
|
|
Quantity (Ton)
|
|
Steel plates
|
|
$
|
98,527,863
|
|
|
|
202,468
|
|
|
$
|
101,296,170
|
|
|
|
182,554
|
|
Steel wires/bars
|
|
|
78,600,204
|
|
|
|
165,843
|
|
|
|
42,007,530
|
|
|
|
70,936
|
|
Byproducts
|
|
|
3,598,367
|
|
|
|
-
|
|
|
|
2,268,669
|
|
|
|
-
|
|
Products Total
|
|
$
|
180,726,434
|
|
|
|
368,311
|
|
|
$
|
145,572,369
|
|
|
|
253,490
|
|
The Company sold 368,311 metric tons steel products in the three months ended June 30, 2013, an increase of 114,821 metric tons, or 45%, compared to 253,490 metric tons in the same period of 2012. Total revenue from sales in the three months ended June 30, 2013 were $180,726,434, an increase of $35,154,065, or 24% compared to $145,572,369 in the comparable period of 2012. The increase in sales was mainly due to the increase in sales of steel wires, offset by the decrease in sales of steel plates and the decrease in unit sales price in the three months ended June 30, 2013. The average unit sales price was $481 per ton, a decrease of $84, or 15%, compared to $565 per ton in the comparable period of 2012.
The Company sold 165,843 metric tons of steel wires, an increase of 94,907 metric tons, or 134%, in the three months ended June 30, 2013, compared to 70,936 in the comparable period of 2012. Revenue from steel wires increased $36,592,674, or 87% to $78,600,204 in the three months ended June 30, 2013, compared to $42,007,530 in the same period of 2012. The increase in the sales of steel wires resulted from the Company’s new 600,000 ton steel wire production line, which commenced production in January 2013. The increase in sales of steel wires was offset by the decrease in the sales price of steel wires. The average unit sales price of steel wires was approximately $474 per ton in the three months ended June 30, 2013, a decrease of $118 per ton, or 20%, compared to $592 in the same period of 2012.
The Company sold 202,468 tons of steel plates in the three months ended June 30, 2013, an increase of 19,914 tons, or 11%, compared to 182,554 tons in the comparable period of 2012. However, the average unit sales price of steel plates decreased $68 per ton, or 12% to $487 per ton in the three months ended June 30, 2013 from $555 per ton in the same period of 2012. The decrease in unit sales price offset the increase in sales quantities and caused a decrease in revenue generated from steel plates. Revenue from steel plates was $98,527,863 in 2013, a decrease of $2,768,307, or 3% compared to $101,296,170 in 2012.
Byproducts and others consist of offcuts of steel plates, steel drop, oxygen gas and others. Byproducts and other sales were $3,598,367 in the three months ended June 30, 2013, an increase of $1,329,698, or 59%, compared to $2,268,669 in the comparable period of 2012. The Company does not sell byproduct in its regular daily sales activities. The selling of byproducts depends on the market condition as byproducts may be reused as raw materials in our production.
Comparison of Cost of Revenue for the Three Months Ended June 30, 2013 and 2012
Costs of Revenue
|
|
2013
|
|
|
2012
|
|
Steel plates
|
|
$
|
98,007,329
|
|
|
$
|
101,522,232
|
|
Steel bars/steel wires
|
|
|
78,874,035
|
|
|
|
39,060,294
|
|
Others
|
|
|
238,332
|
|
|
|
532,943
|
|
Total Cost of Revenue
|
|
$
|
177,119,696
|
|
|
$
|
141,115,469
|
|
|
|
|
|
|
|
|
|
|
Gross Profit Margin
|
|
|
2013
|
|
|
|
2012
|
|
Steel plates
|
|
|
0.53
|
%
|
|
|
-0.22
|
%
|
Steel bars/steel wires
|
|
|
-0.35
|
%
|
|
|
7.02
|
%
|
Total Steel Products Gross Profit Margin
|
|
|
0.14
|
%
|
|
|
1.90
|
%
|
Cost of revenue totaled $177,119,696 in the three months ended June 30, 2013, an increase of $36,004,227, or 26%, compared to $141,115,469 in the comparable period of 2012. The increase in cost of revenue was mainly due to a 45% increase in the sales quantities of steel products in the three months ended June 30, 2013, offset by the decrease in the unit price of raw materials. The average unit price of raw material purchased was $480 per ton in the three months ended June 30, 2013, a decrease of $75, or 14%, compared to $555 per ton in the comparable period of 2012.
The Company does not buy any commodity products to hedge the fluctuation of market price. However, the fluctuation of commodity price will have a direct impact on the Company’s operation through the price changes in the local steel market. The average cost of revenue of steel plates was approximately $484 per ton in the three months ended June 30, 2013, a decrease of $72 per ton, or 13%, from $556 in the comparable period of 2012. The average cost of revenue of steel wires was approximately $476 per ton in the three months ended June 30, 2013, a decrease of $75, or 14%, compared to $551 in the comparable period. The Company actively manages the production volume and the type of steel products manufactured to maximize net profit or reduce loss in response to the fluctuations in market conditions.
The unit sales price decreased 15% in the three months ended June 30, 2013 while the unit cost decreased 14%, which had a negative impact on the Company’s gross profit margin. The gross profit margin of steel products was 0.14% in the three months ended June 30, 2013, a decrease of 1.76 percentage points, compared to 1.90% in the comparable period of 2012.
Comparison of Selling and General and Administrative Expenses for the Three Months Ended June 30, 2013 and 2012
Selling and general and administrative expenses consist of allowance for bad debts, selling expenses, professional service fees and other general and administrative expenses. The aggregate selling and general and administrative expenses were $916,087 in the three months ended June 30, 2013, a decrease of $85,716, or 9%, compared to $1,001,803 in the comparable period of 2012. Selling and general and administrative expenses – non related parties were $662,236 in the three months ended June 30, 2013, an increase of $366,259, or 124%, compared to $295,977 in 2012. The increase in selling and general and administrative expenses – non related parties was mainly due to a $210,220 increase in allowance for doubtful accounts receivable and impairment of advance to vendors, a $192,196 increase in business taxes, and offset by a decrease in US professional fees. The Company incurred $58,250 of professional service and consulting fees in the three months ended June 30, 2013, a decrease of $94,920, or 62% compared to $153,170 in the same period of 2012.
Selling and general and administrative expenses – related parties were $253,851 in the three months ended June 30, 2013, a decrease of $451,975, or 64%, compared to $705,826 in the comparable period of 2012. The selling and general and administrative expenses – related parties represented service fees charged by YBS Group. YBS Group owns 70% of the equity interest of Hongri. It provides various services to its subsidiaries, including market and industrial information, public relationship, various government agents’ relationship, coordination of recycling of byproducts among the subsidiaries and executive officers’ salaries. YBS Group charged a service fee based on countable expenses and fixed service fee. Commencing in 2010, YBS Group charged Hongri a fixed service fee of 0.1% of Hongri’s annual revenue. Service fees consisted of management salaries, trainings, consultations, common areas charges and other fees. The management believes that 0.1% of revenue is reasonable. The Company estimated that service fee would be similar or marginally higher than the current fees charged by YBS Group if the services were provided by third parties. In addition to the fixed service fee, YBS Group will charge itemized services and expenses to the Company if such service and expenses are incurred. Among the services fees, $73,125 and $560,254 for the three months ended June 30, 2013 and 2012, respectively, was an itemized charge in connection with the refinancing of the loan from Raiffeisen Bank International AG Beijing Branch (“Raiffeisen Bank”). Executive officers’ salaries were stand-alone expenses. Such expenses were $16,294 and $15,741 for the three months ended June 30, 2013 and 2012, respectively.
Comparison of Other Expenses for the Three Months Ended June 30, 2013 and 2012
Other expenses consist of interest expense and interest income. Total net other expenses were $1,218,543 in the three months ended June 30, 2013, a decrease of $24,035, or 2% compared to $1,242,578 in the comparable period of 2012. Interest expense for bank borrowings was $1,096,661 in the three months ended June 30, 2013, an increase of $175,484, or 19%, compared to $921,177 in the comparable period of 2012. The increase of interest expense for bank loan borrowings resulted from the increase in bank interest charges for bank notes receivables.
Comparison of Income Tax for the Three Months Ended June 30, 2013 and 2012
The provision for income tax was $403,628 and $364,002 for the three months ended June 30, 2013 and 2012, respectively. The incurred provision for income tax was foreign income tax and paid to the Chinese tax authority. The Company is subject to the PRC’s 25% standard enterprise income tax commencing on 2013. The income tax rate was 12.5% for 2012 due to a foreign investment enterprise exemption.
Comparison of Net Income for the Three Months Ended June 30, 2013 and 2012
Net income was $1,068,480 in the three Months ended June 30, 2013, a decrease of $780,037, or 42%, compared to $1,848,517 in the comparable period of 2012. The decrease in net income was mainly due to the decrease in gross profit, which in turn was a direct result of an unparalleled decrease in unit selling price of steel products (15%) and unit purchase price of raw material (14%).
Results of Operations for the Six Months Ended June 30, 2013 and 2012
Comparison of Revenue for the Six Months Ended June 30, 2013 and 2012
|
|
2013
|
|
|
2012
|
|
Products
|
|
Revenue
|
|
|
Quantity (Ton)
|
|
|
Revenue
|
|
|
Quantity (Ton)
|
|
Steel plates
|
|
$
|
193,024,372
|
|
|
|
392,698
|
|
|
$
|
165,592,905
|
|
|
|
296,376
|
|
Steel wires/bars
|
|
|
169,538,335
|
|
|
|
351,631
|
|
|
|
104,954,351
|
|
|
|
181,571
|
|
Steel billets
|
|
|
-
|
|
|
|
-
|
|
|
|
47,067,680
|
|
|
|
85,602
|
|
Byproducts
|
|
|
6,527,424
|
|
|
|
-
|
|
|
|
4,986,081
|
|
|
|
-
|
|
Products Total
|
|
$
|
369,090,131
|
|
|
|
744,329
|
|
|
$
|
322,601,017
|
|
|
|
563,549
|
|
The Company sold 744,329 metric tons steel products in the six months ended June 30, 2013, an increase of 180,780 metric tons, or 32%, compared to 563,549 metric tons in the same period of 2012. Total revenues in the six months ended June 30, 2013 were $369,090,131, an increase of $46,489,114, or 14%, compared to $322,601,017 in the comparable period of 2012. The increase in sales was mainly due to the increase in sales of steel plates and steel wires, offset by the decrease in sales of steel billets and the decrease in unit sales price in the six months ended June 30, 2013. The average unit sales price was $487 per ton, a decrease of $77, or 14%, compared to $564 per ton in the comparable period of 2012.
The Company sold 392,698 tons of steel plates in the six months ended June 30, 2013, an increase of 96,322 tons, or 32%, compared to 296,376 tons in the comparable period of 2012. Revenue from sale of steel plates was $193,024,372 in the six months ended June 30, 2013, an increase of $27,431,467, or 17%, compared to $165,592,905 in the comparable period of 2012. The 17% of increase in revenue was lower than a 32% increase in quantity of products sold resulted from continuing declined steel products prices. The average unit sales price of steel plates was $492 per ton in the six months ended June 30, 2013, a decrease of $67 per ton, or 12%, compared to $559 per ton in the six months ended June 30, 2012.
The Company sold 351,631 metric tons of steel wires in the six months ended June 30, 2013, an increase of 170,060 metric tons, or 94%, compared to 181,571 tons in the comparable period of 2012. Revenue from sale of steel wires was $169,538,335 in the six months ended June 30, 2013, an increase of $64,583,984, or 62%, compared to $104,954,351 in the same period of 2012. The increase in the sales of steel wires resulted from the Company’s new 600,000 ton steel wire production line, which commenced production in January 2013. The increase in sales of steel wires was offset by the decrease in the sales price of steel wires. The average unit sales price of steel wires was $482 per ton in the six months ended June 30, 2013, a decrease of $96 per ton, or 17%, compared to $578 per ton in the same period of 2012.
Revenue from steel billets was $0 and $47,067,680 in the six months ended June 30, 2013 and 2012, respectively. Steel billets are semi-finished products that can be used to produce steel plates, steel bars and steel wires with further processing, or they can be sold directly in the market. The Company did not sell steel billets in the six months ended June 2013 because of internal needs for production of steel plates and steel bars.
Byproducts and others consist of offcuts of steel plates, steel drop, oxygen gas and others. Byproducts and other sales were $6,527,424 in the six months ended June 30, 2013, an increase of $1,541,343, or 31%, compared to $4,986,081 in the comparable period of 2012. The Company does not sell byproduct in its regular daily sales activities. The selling of byproducts depends on the market condition as byproducts may be reused as raw materials in our production.
Comparison of Cost of Revenue for the Six Months Ended June 30, 2013 and 2012
Costs of Revenue
|
|
2013
|
|
|
2012
|
|
Steel plates
|
|
$
|
191,931,819
|
|
|
$
|
167,211,256
|
|
Steel bars/steel wires
|
|
|
167,501,605
|
|
|
|
98,669,634
|
|
Steel billets
|
|
|
-
|
|
|
|
42,308,554
|
|
Others
|
|
|
1,175,433
|
|
|
|
1,130,590
|
|
Total Cost of Revenue
|
|
$
|
360,608,857
|
|
|
$
|
309,320,034
|
|
|
|
|
|
|
|
|
|
|
Gross Profit Margin
|
|
|
2013
|
|
|
|
2012
|
|
Steel plates
|
|
|
0.57
|
%
|
|
|
-0.98
|
%
|
Steel bars/steel wires
|
|
|
1.20
|
%
|
|
|
5.99
|
%
|
Steel billets
|
|
|
-
|
|
|
|
10.11
|
%
|
Total Steel Products Gross Profit Margin
|
|
|
0.86
|
%
|
|
|
2.97
|
%
|
Cost of revenue totaled $360,608,857 in the six months ended June 30, 2013, an increase of $51,288,823, or 17%, compared to $309,320,034 in the comparable period of 2012. The increase in cost of revenue was mainly due to a 32% increase in the sales quantities of steel products in the six months ended June 30, 2013, offset by the decrease in the unit price of raw materials purchased. The average unit price of cost of revenue was $483 per ton in the six months ended June 30, 2013, a decrease of $64, or 12%, compared to $547 per ton in the comparable period of 2012.
The Company does not buy any commodity products to hedge the fluctuation of market price. However, the fluctuation of commodity price will have a direct impact on the Company’s operation through the price changes in the local steel market. The average cost of revenue of steel plates was approximately $489 per ton in the six months ended June 30, 2013, a decrease of $75 per ton, or 13%, from $564 in the comparable period of 2012. The average cost of revenue of steel wires was $476 per ton in the six months ended June 30, 2013, a decrease of $67, or 13%, compared to $543 in the comparable period. The Company actively manages the production volume and the type of steel products manufactured to maximize net profit or reduce loss in response to the fluctuations in market conditions.
The unit sales price decreased 13% in the six months ended June 30, 2013 while the unit cost decreased 12%, which had a negative impact on the Company’s gross profit margin. The gross profit margin of steel products was 0.86% in the six months ended June 30, 2013, a decrease of 2.11 percentage points, compared to 2.97% in the comparable period of 2012.
Comparison of Selling and General and Administrative Expenses for the Six Months Ended June 30, 2013 and 2012
Selling and general and administrative expenses consist of allowance for bad debts, selling expenses, professional service fees and other general and administrative expenses. The aggregate selling and general and administrative expenses were $2,146,462 in the six months ended June 30, 2013, a decrease of $97,503, or 4%, compared to $2,243,965, in the comparable period of 2012. Selling and general and administrative expenses – non related parties were $1,631,937 in the six months ended June 30, 2013, an increase of $270,881, or 20%, compared to $1,361,056 in 2012. The increase in selling and general and administrative expenses – non related parties was mainly due to a $174,456 increase in allowance for doubtful accounts receivable and impairment of advance to vendors, a $269,359 increase in business taxes, and offset by a decrease in US professional fees. The Company incurred $199,857 of professional service and consulting fees in the six months ended June 30, 2013, a decrease of $229,908, or 53%, compared to $429,765 in the same period of 2012.
Selling and general and administrative expenses – related parties were $514,525 in the six months ended June 30, 2013, a decrease of $368,384, or 42%, compared to $882,909 in the comparable period of 2012. The selling and general and administrative expenses – related parties represented service fees charged by YBS Group. YBS Group owns 70% of the equity interest of Hongri. It provides various services to its subsidiaries, including market and industrial information, public relationship, various government agents’ relationship, coordination of recycling of byproducts among the subsidiaries and executive officers’ salaries. YBS Group charged a service fee based on countable expenses and fixed service fee. Commencing in 2010, YBS Group charged Hongri a fixed service fee of 0.1% of Hongri’s annual revenue. Service fees consisted of management salaries, trainings, consultations, common areas charges and other fees. The management believes that 0.1% of revenue is reasonable. The Company estimated that service fee would be similar or marginally higher than the current fees charged by YBS Group if the services were provided by third parties. In addition to the fixed service fee, YBS Group will charge itemized services and expenses to the Company if such service and expenses are incurred. Among the services fees, $145,436 and $560,254 for the six months ended June 30, 2013 and 2012, respectively, was an itemized charge in connection with the refinancing of the loan from Raiffeisen Bank. Executive officers’ salaries were stand-alone expenses. Such expenses were $32,319 and $31,620 for six months ended June 30, 2013 and 2012, respectively.
Comparison of Other Expenses for the Six Months Ended June 30, 2013 and 2012
Other expenses consist of interest expense and interest income. Total net other expenses were $2,774,700 in the six months ended June 30, 2013, a decrease of $323,365, or 10%, compared to $3,098,065 in the comparable period of 2012. Interest expense for bank borrowings was $2,486,743 in the six months ended June 30, 2013, an increase of $620,658, or 33%, compared to $1,866,085 in the comparable period of 2012. The increase of interest expense for bank loan borrowings resulted from the increase in bank interest charges for bank notes receivables. Interest expense for the related parties was $341,630 in the six months ended June 30, 2013, a decrease of $944,959, or 73%, compared to $1,286,589 in the same period of 2012. The decrease in interest expense paid to related parties resulted from partial paid off of related party equipment loans in 2012.
Comparison of Income Tax for the Six Months Ended June 30, 2013 and 2012
The provision for income tax was $1,137,793 and $1,384,392 for the six months ended June 30, 2013 and 2012, respectively. The incurred provision for income tax was foreign income tax and paid to the Chinese tax authority. The Company is subject to the PRC’s 25% standard enterprise income tax commencing on 2013. The income tax rate was 12.5% for 2012 due to a foreign investment enterprise exemption.
Comparison of Net Income for the Six Months Ended June 30, 2013 and 2012
Net income was $2,422,319 in the six Months ended June 30, 2013, a decrease of $4,132,242, or 63%, compared to $6,554,561 in the comparable period of 2012. The decrease in net income was mainly due to the decrease in gross profit, which in turn was a direct result of an unparalleled decrease in unit selling price of steel products (14%) and unit purchase price of raw material (12%).
Liquidity and Capital Resources
The cash flow generated from our operations can support our daily operations currently. Nevertheless, it may not be enough to support our operations in the future if the deterioration of the steel market continues. The Company is facing rigorous challenges in 2013, including unfavorable steel industry cycles, unforeseeable recovery of world economy and uncertainty of political environment resulting from change of leadership in China. All those factors may continue to have a negative impact on our operations and cash flows. It is difficult to predict and mitigate these unfavorable trends. Management will continuously monitor these negative factors and determine the production based on the demand of market, cash on hand and available credit facilitates.
In addition, the Company plans to add a new value added production line to adapt to the market demand. To implement this expansion strategy, the Company may require external financial sources to support the capital investment. Management believes that the Company’s available cash will not be sufficient to fund its expansion requirements and therefore, the Company will look for external sources such as debt or equity financings. However, there is no assurance that any such funds from external sources will be available on attractive terms or that they will not have a significant dilutive effect on the Company’s existing stockholders. If such funds from outside sources are limited, or not available, the Company will adjust its expansion plan accordingly.
The Company has relied on related parties at its early stage of development. The Company’s internal and immediate sources of liquidity will be loans from YBS Group, Hongri’s parent company and Hongrong Iron and Steel Co. Ltd. (“Hongrong”). YBS Group and Hongrong had previously made loans to the Company for acquisition of equipment. On the other hand, the Company may advance cash surplus, if any, to YBS Group or other related parties when requested and available. Those cash advances will be used as a credit and offset the liabilities due to YBS Group and other related parties.
Relevant PRC statutory laws and regulations restrict certain payments, such as dividends, loans or advances, from the Company’s registered capital. Such restricted capital amounted to approximate $14,799,000 as of June 30, 2013 and December 31, 2012. The Company is also required to allocate a portion of its after-tax profits to the statutory reserve. Annual appropriations to the statutory reserve are required to be at least 10% of the enterprise’s after-tax net income determined under Chinese GAAP. When the surplus reserve account balance is equal to or greater than 50% of the Company’s paid-in capital, no further allocation to the surplus reserve account is required. The Company’s surplus reserve is over 50% of the paid-in capital and does not need more surplus reserve in the future. As of June 30, 2013 and December 2012, the Company’s reserve fund totaled $6,530,869. In addition, our ability to use revenue generated in RMB to fund any future business activities outside of China or to make dividend or other payments in U.S. dollars is limited due to the regulations of PRC’s currency exchange. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB in the future.
The Company currently intends to retain all earnings, if any, for use in its business operations. We have no plan to repurchase our common stock, nor declare any dividends in the near future.
The Company will have obligations to pay expenses in US dollars in connection with its status as a US public company, including audit, legal, contracted CFO and other SEC filing related service fees. These service fees are usually wired to the Company’s US bank account or paid to vendors directly from China to satisfy the Company’s obligations, which is allowed under the current PRC regulations. Other than these service fees, the Company currently has no significant obligations outside the PRC. The Company had cash of $1,930,922 and $1,710,887 as of June 30, 2013 and December 31, 2012, respectively. Most of the Company’s funds are kept in financial institutions in China, which do not provide insurance for deposits.
It has been the intent of the management to accelerate repayments of equipment loans, which were due to the related parties. During 2012, the Company repaid $42,037,885 equipment loans to YBS Group by offsetting its advances to related parties. The Company repaid $16,545,106 equipment loans to Hongrong by offsetting its advances to related parties in 2012. The remaining equipment loan balance to YBS group is $4,033,018 as of June 30, 2013.
It is common practice in China that a vendor or supplier requires an advanced payment before shipment of merchandise. The Company’s advances to the related parties enable these related parties to pay partial amounts in advance to their vendors or suppliers. Hongri purchased raw materials from Hongrong, a related party, in its routine business operations. The Company is in favor of Hongrong as its primary molten iron supplier because it reduces transportation cost and steel making cost since Hongrong is located nearby Hongri. Hongrong has a new blast furnace with a capacity to supply all molten iron needs for the production of Hongri, However, because the new blast furnace is still in test stage and the quality of molten iron is not stable, the Company may purchase part of its iron supplies from third parties in addition to the purchases from Hongrong. The balance of advances to Hongrong was $99,534,560 and $183,633,559 as of June 30, 2013 and December 31, 2012, respectively. The amount advanced to Hongrong approximated to 9 weeks and 18 weeks purchase of molten iron used in production, respectively, as of June 30, 2013 and December 31, 2012. The decrease in advance to Hongrong was primarily because that Hongri used more molten iron supplied by Hongrong in 2013. However, in the event that Hongrong’s new blast furnace cannot operate normally, or the demand to Hongri’s steel products is lower, or there are further price reductions on raw materials already purchased, the assets advanced to Hongrong could be impaired and/or the gross profit margin may be negatively impacted.
For the three months ended June 30, 2013, the Company purchased $121,465,500 (329,957 metric tons) molten iron and steel iron and $16,179,883 gas, electricity and other materials from Hongrong. For the six months ended June 30, 2013, the Company purchased $227,591,215 (612,587 metric tons) molten iron and steel iron and $18,054,583 gas, electricity and other materials from Hongrong. For the three months ended June 30, 2012, the Company purchased $62,387,883 (145,856 metric tons) molten iron and steel iron and $7,891,309 gas, electricity and other materials from Hongrong. For the six months ended June 30, 2012, the Company purchased $174,040,917 (403,752 metric tons) molten iron and steel iron and $12,877,915 gas, electricity and other materials from Hongrong.
The Company’s accounts payable were $57,094,085 as of June 30, 2013, a decrease of $35,134,076, or 38% compared $92,228,161 as of December 31, 2012. The decrease in accounts payable resulted from a $35 million decrease in accounts payable balance to one major steel pig iron supplier of the Company. The Company will pay these payables from cash generated from its operation. If the deterioration of steel market continues and the sales prices further decrease, the Company’s ability to pay these payables from its operation would be very limited. The Company may look for a debt or equity financing, if needed, after taking into consideration the impact of the advances to related parties, the advances from customers and current debt requirements.
Advance from customers was $70,711,357 as of June 30, 2013, a decrease of $6,563,970, or 8% compared to $77,275,327 as of December 31, 2012. During the six months ended June 30, 2013, two major customers decreased approximately $15.5 million deposits in aggregate in the Company’s account. The sales prices of steel products are fluctuated daily. Timing of buying and selling is one of the keys for profit. In order to ensure availability of the Company’s products in the event that the prices of steel products go up, the customers will deposit certain amounts of money in the Company’s account. Advances from customers are short term in nature and are interest free. If the deterioration of steel market continues and the sales prices are further decreased, some of the customers may recall their deposits. If it happens, it will have a negative impact on the Company’s cash flows and the Company may look for debt or equity financing if needed, after taking into consideration the impact of the advances to related parties, accounts payable and current debt requirements.
Net cash provided by operating activities was $53,899,261 for the six months ended June 30, 2013, an increase of $19,046,984, or 55%, compared to $34,852,277 for the comparable period of 2012. The increase was due to the increase in adjustment of change in working capital components offset by the decrease of net income of $4,132,242. The changes in working capital components primarily contributing to the increase in cash flow provided in operating activities were: (i) a decrease in advance to related parties ($81,478,823 decrease in 2013 and $83,568,612 increase in 2012), offset by (ii) a decrease in accounts payable ($36,228,798 decrease in 2013 and $67,605,548 increase in 2012), (iii) a decrease in advances from customers ($7,670,020 decrease in 2013 and $17,293,865 increase in 2012), (iv) an increase in accounts receivable ($2,117,566 increase in 2013 and $8,715,479 decrease in 2012), (v) an increase in inventory ($1,934,161 increase in 2013 and $2,196,447 decrease in 2012).
Net cash used in investing activities was $19,898,160 and $8,442,814, respectively, in the six months ended June 30, 2013 and 2012, an increase of $11,455,346, or 136%. Those expenditures were primarily related to the construction of steel wire production lines and replacement, or modification of current production line equipment.
Net cash used in financing activities was $33,823,829 in the six months ended June 30, 2013 as compared to $27,902,367 in the same period in 2012, an increase of $5,921,462 or 21%. In the six months ended June 30, 2013, the Company repaid an aggregate of $16,159,500 and renewed and borrowed an aggregate of $16,159,500 from Raiffeisen Bank pursuant to a revolving loan agreement (the “Raiffeisen Loan Agreement”) with Raiffeisen Bank signed on June 28, 2011 and amended on July 23, 2012 and September 18, 2012 subsequently. The Amended Agreement II (as defined herein below) provides for a revolving credit facility in an aggregate principal amount of $16,159,500 (RMB 100,000,000) which shall be used as working capital only and could not exceed 180 days. The Company repaid a $3,070,305 (RMB 19,000,000) short-term borrowing and borrowed same amount from Credit Union in the six months ended June 30, 2013. The Company acquired a letter of credit loan from the Industrial and Commercial Bank of China (“ICBC”) in the amount of $1,551,312 and repaid $3,910,599 in the six months ended June 30, 2013. The Company repaid $31,834,215 to customer financing and received $696,313 customer financing in the six months ended June 30, 2013. The Company paid $326,640 to related parties for obligation under capital lease in the six months ended June 30, 2013. Net cash used in financing activities was 27,902,367 in six months ended June 30, 2012. The Company repaid an aggregate of $37,972,800 and renewed and borrowed an aggregate of $28,479,600 from Raiffeisen Bank pursuant to a revolving loan agreement. The Company repaid $3,006,180 (RMB 19,000,000) to Credit Union and acquired same amount of $3,006,180 from Credit Union. The Company received a short term loan of $1,423,980 (RMB 9,000,000) from Credit Union and returned this short term loan in April 2012. During six months ended June 30, 2012, the Company repaid equipment loans of $16,513,794 to Hongrong. The Company received $2,667,589 short term loan from related parties and returned $3,616,909 to related parties. The Company made $1,898,640 deposit to bank as additional collateral for bank notes payable. The Company paid $297,351 to obligation under capital lease in 2012.
Short-term Borrowings
Bank Notes Payable
The bank notes payable do not have a stated interest rate, but carry a specific due date usually within six months. These notes are negotiable documents issued by financial institutions on the Company’s behalf to vendors. These notes can either be endorsed by the vendor to other third parties as payment, or prior to becoming due, factored to other financial institutions. These notes are short-term in nature, and as such, the Company does not calculate imputed interest with respect to them. These notes are collateralized by the Company’s restricted bank deposits. The Company has to maintain 100% or 50% of the balance of the bank notes payable to ensure future credit availability.
Bank Loans Payable
Bank loans at June 30, 2013 and December 31, 2012 consisted of the following:
|
|
|
|
2013
|
|
|
2012
|
|
To Credit Union
|
|
|
|
|
|
|
|
|
Interest at 11.40%, payable September 24, 2013
|
|
(a)
|
|
$
|
3,095,860
|
|
|
$
|
3,049,690
|
|
Interest at 7.28%, payable April 7, 2013
|
|
(b)
|
|
|
-
|
|
|
|
3,049,690
|
|
Interest at 7.28%, payable October 10, 2013
|
|
(b)
|
|
|
3,095,860
|
|
|
|
-
|
|
To Raiffeisen Bank International AG Beijing Branch
|
|
|
|
|
|
Interest at 7.31%, due varied from January to February 2013
|
|
(c)
|
|
|
-
|
|
|
|
16,051,000
|
|
Interest at 7.31%, due varied from July to August 2013
|
|
(c)
|
|
|
16,294,000
|
|
|
|
-
|
|
To a ICBC Letter of Credit Loan
|
|
|
|
|
|
|
|
|
|
|
Interest at 0%, payable May 16, 2013
|
|
(d)
|
|
|
-
|
|
|
|
3,884,342
|
|
Interest at 6.44%, payable August 14, 2013
|
|
(e)
|
|
|
1,564,224
|
|
|
|
-
|
|
Total Short Term Bank Loans
|
|
|
|
$
|
24,049,944
|
|
|
$
|
26,034,722
|
|
|
(a) The Company borrowed $3,095,860 (RMB 19,000,000 translated at June 30, 2013 exchange rate) loan on September 25, 2012. The loan is a “working capital” loan that bears interest at 11.40% per annum and due on September 24, 2013. The loan is secured by the equipment of Hongrong, a related party.
|
|
(b) On October 8, 2012 the Company received a $3,049,690 (RMB 19,000,000 translated at December 31, 2012 exchange rate) short-term borrowing from Credit Union. The loan was a “working capital” loan that bore interest at 7.28% per annum and was due by April 7, 2013. On April 7, 2013, the Company repaid a $3,049,690 (RMB 19,000,000) short-term borrowing and borrowed $3,095,860 (RMB 19,000,000 translated at June 30, 2013 exchange rate). New borrowing bears interest at 7.28% per annum and is due by October 10, 2013. The loan was secured by the equipment of Hongrong, a related party.
|
|
(c) On September 18, 2012, Hongri entered into a second amendment agreement (the “Amendment Agreement II”) with Raiffeisen Bank. The Amendment Agreement II provides for a revolving credit facility in an aggregate principal amount of $16,294,000 (RMB 100,000,000 translated at June 30, 2013 exchange rate) which is used as working capital only. Each borrowing could not exceed 180 days or days the Bank agreed during the Amendment Agreement period. The Amendment Agreement II is to be terminated on January 31, 2014.
|
Current loan balance of $16,294,000 (RMB 100,000,000 translated at June 30, 2013 exchange rate) was renewed from the end of January and the beginning of February 2013 and was due varied from July to August 2013. During July 2013, the Company renewed $16,294,000 credit line to January 2014 in the same term.
Pursuant to the Amendment Agreement II, borrowings will bear interest at 130.6% of the benchmark rates of similar loans published by the People’s Bank of China. Current benchmark interest rate for a six months loan is 5.6% revised on July 6, 2012. The borrowing interest is 7.31% currently. The interest is calculated on the daily basis and shall be paid on the 20th of the last month of each quarter.
The borrowings are secured substantially by the following: all machinery and equipment of Hongri acquired before 2012. The net value of these machinery and equipment is approximately $159 million as of December 31, 2012, a security deposit of $1,629,400 (RMB 10,000,000) into the Raiffeisen bank as a collateral; corporate guaranty from YBS group, a majority shareholder of Hongri; and personal guaranty from Mr. Beifang Liu, Chairman of YBS group and Mr. Shenghong Liu, Chairman and Chief Executive Officer of the Company.
|
(d) On December 4, 2012, the Company borrowed a $3,884,342 (RMB 24,200,000 translated at December 31, 2012 exchange rate) short-term collateral loan from Industrial and Commercial Bank of China (“ICBC”). The loan was collaterated by a letter of credit in the same amount held by the Company, which was recorded as other assets in the balance sheet. The collateral loan was interest free and repaid by Mary 15, 2013.
|
|
(e) On February 26, 2013, the Company borrowed a $1,564,224 (RMB 9,600,000 translated at June 30, 2013 exchange rate) short-term loan from ICBC. The loan is collaterated by a letter of credit in the same amount held by the Company, which is recorded as other assets in the balance sheet. The loan bears interest at 6.44% per annum and due by August 15, 2013.
|
Short Term Loan Payable – Related Party
On June 28, 2012, the Company borrowed $162,940 (RMB 1,000,000) from Mr. Beifang Liu, director of the Company, and $651,760 (RMB 4,000,000) from Mr. Maisheng Liu, brother of the CEO of the Company. These payables are interest free and due on demand.
The weighted average short term loan balance consisting of financial institution and private loans and Binchang Liu, Beifang Liu and Maisheng Liu loans was $13,171,418 and $18,174,535 for the six months ended June 30, 2013 and 2012, , respectively. The weighted average interest rate for short term loan was 7.43% and 8.81% for the six months ended June 30, 2013 and 2012, respectively.
Credit Guarantee to Customers and Customer financing
The Company is sometimes requested to provide a short term credit guarantee to vendors or customers for them to get bank loans or bank notes during the routine of business. As of June 30, 2013, the Company’s credit guarantee to vendors or customers totaled to $32,913,880 (RMB 202,000,000 translated at June 30, 2013 exchange rate). Among the amount of credit guarantee, $9,776,400 (RMB 60,000,000 translated at June 30, 2013 exchange rate) was to a related party, who supplies coke and electricity to the Company.
The customers who received bank loans guaranteed by the Company will advance cash receipt from the bank to the Company as a prepayment for the goods. The Company will record such prepayment as “customer financing” until advanced customer prepayment be returned to the customers or Company’s products be delivered to the customers. As of June 30, 2013 and December 31, 2012, the customer financing was $702,108 and $31,620,470, respectively.
Critical Accounting Policies and Estimates
In Note 2 to our audited consolidated financial statements for the years ended December 31, 2012 and 2011 included in the Form 10K, the Company discusses those accounting policies that are considered to be significant in determining the results of operations and its financial position. The Company believes that the accounting principles utilized by it conform to accounting principles generally accepted in the United States of America (U.S. GAAP). The Company applies the following critical accounting policies related to revenue recognition in the preparation of its financial statements.
Use of Estimates
In preparing the consolidated financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting year. Significant estimates, required by management, include bad debt allowance, recoverability of long-lived assets and the valuation of inventories. Actual results could differ from those estimates.
Revenue Recognition
The recognize revenue from the sales of products. The Company recognizes revenues under FAS ASC Topic 605 “Revenue Recognition”. Revenue is recognized when all of the following have occurred: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the price is fixed or determinable, and (iv) the ability to collect is reasonably assured. These criteria are generally satisfied at the time of delivery for sales when risk of loss and title passes to the customer. Revenue is reported net of all value added taxes. Other income is recognized when it is earned. The Company does not routinely permit customers to return products and historically, customer returns have been immaterial. The Company will replace the original product with a similar product if the customer is not satisfied with the quality of product.
Fair Value of Financial Instruments
The Company’s financial instruments consist of bank notes receivable, accounts receivable, net, advances to suppliers, VAT tax recoverable, advance to related parties, current portion of equipment loan payables, short term loan payable – related party, accrued liabilities, bank notes payable, accounts payable, accrued liabilities, tax payables, advances from customers, and accounts payable - related parties. The fair value of these financial instruments approximate their carrying amounts reported in the balance sheets due to their short-term maturity or by comparison to other instruments with similar terms.
Foreign Currency Translation
The Company’s financial information is presented in U.S. dollars. The functional currency of the US parent company and US subsidiaries is the US dollar. The functional currency of the Company’s subsidiaries in the PRC is the RMB. Subsidiary transactions, which are denominated in currencies other than RMB, are translated into RMB at the exchange rate quoted by the People’s Bank of China prevailing at the dates of the transactions. Exchange gains and losses resulting from transactions denominated in a currency other than the RMB are included in statements of income as foreign currency transaction gain or loss.
The consolidated financial statements of the Company have been translated into U.S. dollars in accordance with ASC 830, “Foreign Currency Matters”. The financial information is first prepared in RMB and then is translated into U.S. dollars at period-end exchange rates for assets and liabilities and average exchange rates for revenue and expenses. Capital accounts are translated at their historical exchange rates when the capital transactions occurred. The effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income (loss) in stockholders’ equity.
Off-Balance Sheet Arrangements
The Company is sometimes requested to provide a short term credit guarantee to vendors or customers for them to get bank loans or bank notes during the routine of business. As of June 30, 2013, the Company’s credit guarantee to vendors or customers totaled to $32,913,880 (RMB 202,000,000 translated at June 30, 2013 exchange rate). Among the amount of credit guarantee, $9,776,400 (RMB 60,000,000 translated at June 30, 2013 exchange rate) was to a related party, who supplies coke and electricity to the Company.
Contractual Obligations
At June 30, 2013, our significant contractual obligations were as follows:
|
|
Less than
One Year
|
|
|
One to
Three Years
|
|
|
Three to
Five Years
|
|
|
More Than
Five Years
|
|
|
Total
|
|
Equipment loan
|
|
$
|
2,928,595
|
|
|
$
|
1,104,423
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
4,033,018
|
|
Capital Leases
|
|
|
683,615
|
|
|
|
1,526,250
|
|
|
|
1,380,474
|
|
|
|
2,494,288
|
|
|
|
6,084,627
|
|
Interest on Capital Leases
|
|
|
462,398
|
|
|
|
765,776
|
|
|
|
525,960
|
|
|
|
2,275,085
|
|
|
|
4,029,219
|
|
Interest on Equipment loan
|
|
|
201,651
|
|
|
|
55,221
|
|
|
|
-
|
|
|
|
-
|
|
|
|
256,872
|
|
Bank loans
|
|
|
24,049,944
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
24,049,944
|
|
|
|
$
|
28,326,203
|
|
|
$
|
3,451,670
|
|
|
$
|
1,906,434
|
|
|
$
|
4,769,373
|
|
|
$
|
38,453,680
|
|
ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.