Annual Report — Form 10-K — Sect. 13 / 15(d) – SEA’34 Filing Table of Contents
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Securities registered under Section 12(b) of the Act: common stock, par value $0.001 per share
Securities registered under Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,”“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
Accelerated filer
o
Non-accelerated filer
(Do not check if smaller reporting company)
o
Smaller reporting company
þ
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. Approximately $4,318,000 on June 30, 2012.
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 2,894,586 shares of common stock are issued and outstanding as of April 11, 2013.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
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Item 6.
Selected Financial Data.
27
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
27
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
42
Item 8.
Financial Statements and Supplementary Data.
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Item 9.
Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.
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Item 9A.
Controls and Procedures.
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Item 9B.
Other Information.
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Part III
Item 10.
Directors, Executive Officers and Corporate Governance.
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Item 11.
Executive Compensation
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Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
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Item 13.
Certain Relationships and Related Transactions, and Director Independence.
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Item 14.
Principal Accountant Fees and Services.
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Part IV
Item 15.
Exhibits, Financial Statement Schedules.
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1
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This report contains forward-looking statements. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to, the risk of doing business in the People’s Republic of China (“PRC”), our ability to implement our strategic initiatives, our access to sufficient capital, economic, political and market conditions and fluctuations, government and industry regulation, Chinese and global competition, and other factors. Most of these
factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in connection with any forward-looking statements that may be made herein. Readers are cautioned not to place undue reliance on these forward-looking statements and readers should carefully review this report in its entirety, including the risks described in “Item 1A. - Risk Factors” and “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Except for our ongoing obligations to disclose material information under the federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. These forward-looking statements speak only as of the date of this report, and you should not rely on these statements without also considering the risks and uncertainties associated
with these statements and our business.
OTHER PERTINENT INFORMATION
References in this annual report to “we,”“us,” and words of like import refer to Cleantech Solutions International, Inc., its wholly-owned subsidiaries, and Wuxi Huayang Dyeing Machinery Co., Ltd. (“Dyeing”) and Wuxi Huayang Electrical Power Equipment Co., Ltd. (“Electrical”), both of which are variable interest entities under contractual arrangements with us whose financial statements are consolidated with ours, unless the context specifically states or implies otherwise.
Our reporting currency is the United States dollar. Our business is conducted by our subsidiaries in China, using RMB, the currency of China, and our consolidated financial statements are presented in United States dollars. In this annual report, we refer to assets, obligations, commitments and liabilities in our financial statements in United States dollars. These dollar references are based on the exchange rate of RMB to United States dollars, determined as of a specific date. Changes in the exchange rate will affect the amount of our obligations and the value of our assets in terms of United States dollars which may result in an increase or decrease in the amount of our obligations (expressed in dollars) and the value of our assets, including accounts receivable (expressed in dollars).
We effected a one-for-ten reverse stock split of our common stock on March 6, 2012. All share and per share information in this annual report has been retroactively adjusted to reflect this reverse stock split.
2
PART I
ITEM 1. BUSINESS
We are engaged in two business segments – the forged rolled rings and related components segment, in which we manufacture and sell high precision forged rolled rings, shafts, flanges, and other forged components for the wind power and other industries, and the dyeing and finishing equipment segment, in which we manufacture and sell textile dyeing and finishing machines.
Forged Rolled Rings and Related Components Segment
Through our forged rolled rings and other related products division, we supply the following:
●
We produce precision forged rolled rings and other forged components to the wind and other industries. Our forged rolled rings and other related products are sold for use by manufacturers of industrial equipment. Forged rolled rings and other forged components for the wind industry are used in wind turbines, which are used to generate wind power.
●
Commencing in 2011, we began to manufacture and delivered test subassemblies for solar cell manufacturing equipment, which marked our entry into the solar products market. For the years ended December 31, 2012 and 2011, we generated revenue from the sale of solar industry related products of approximately $1,078,000 and $455,000, respectively.
The demand for products used in manufacturing in general including wind power industries, is uncertain. Although we believe that over the long term, the forged rolled rings and related components segment will expand, and the government of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term other factors, such as economic factors and the fluctuations in the price of oil and coal, may affect the requirements by our customers and potential customers for our products. To the extent that the demand for our forged rolled rings and related components declines, our revenue and net income will be affected.
Chinese wind power developers posted worse-than-expected results for the first half of 2012, with grid operators increasingly reluctant to distribute the costly and unpredictable source of power amid a sharp economic downturn. China aims to expand its installed wind power generating capacity to 100 gigawatts (GW) by 2015 and to 200 GW by 2020. The country currently has 62 GW of capacity. Beijing would force grid operators to buy wind power representing 5 to 15 percent of their total offtake, depending on locations, Xie Changjun, president of Longyuan, the world's second-largest wind power developer, said. The quota system should underpin long-term demand for renewable energy like wind-generated electricity, but the earnings outlook for wind power developers will remain uncertain for the next few years, based on industry reports. Grid construction has so far not kept up with the rise in wind power capacity. In the absence of high-voltage
lines, grid firms are unable to absorb all the wind power under their local networks.
In contrast, according to an article published by Greenpeace East Asia on September 19, 2012, in its latest edition, “China Wind Power Outlook 2012,” a report that presents a joint assessment and analysis of the wind power sector in China in 2011, including a reading of most recent policy trends made by Greenpeace, the Chinese Renewable Energy Industries Association (CREIA), and the Global Wind Energy Council (GWEC), as well as an outlook for the sector’s future development, this annual industry analysis highlights an encouraging trend in the development of the sector. In 2011, apart from the “old market” – namely the Northern, Northeastern and Northwestern areas of China (or the “Sanbei” region) that are rich in wind resources but weak on consumption power, wind power in China saw the emergence of a new market with huge potential. The overwhelming majority of accumulated
and added installment is now still focused on these regions. However, due to the long distance between the power stations and major power user markets, they continue to be plagued by grid connectivity and curtailment problems. In the meantime, a new wind power market located closer to power consumers in the central and eastern provinces has steadily become a vigorous, if not prominent, market in 2011.
3
GTM Media Research and Azure International in their China Wind Market Quarterly for the fourth quarter of 2012 said that China is on target this year to add another 18 GW of installed grid connected wind capacity. Some of the underlying strength seen in the Chinese wind market is due to recent government action to help solve some of the domestic wind industry concerns. This included revamping surcharge revenue and pre-appropriating funding this year. Based on report projections, China will reach 140 GW of installed capacity by 2015, far exceeding expectations in 2011 of 100 GW.
We believe that this market expansion will continue in the near future. The key issues for the wind power sector in the near future will be how to break the intrinsic restrictions on the traditional market and how to take the next step in promoting the emerging markets in eastern and central China. In 2011, China added 17.63 GW of newly installed wind power capacity, slightly less than 2010 (18.93 GW). Total installed wind capacity reached 62.36 GW. After years of rapid growth, China’s wind power market is now entering a period marked by stable growth, but it is still the global leader in terms of total installed capacity.
In 2011 China’s wind energy sector generated 71.5 billion kilowatt hours, or 1.5% of the national total electricity output. Looking at its environmental benefits, wind power has a clear advantage: every 1 kWh generated saves 320 grams of standard coal being burned. That means in 2011 China’s wind power sector saved more than 22 million tons of coal from being burned, in total, reducing sulfur dioxide emissions by 360,000 tons, and carbon dioxide emissions by about 70 million tons. Assuming that the average Chinese household uses 1,500 kWh of electricity every year, China’s wind power sector met the electricity demands of over 47 million households in 2011.
Among all the renewable energies, we believe that wind power is at a mature stage in terms of the technology and possesses the best prospects for large-scale commercial development. We believe that it is becoming more competitive against traditional energy sources as the industry continues to grow and production costs continue to fall. We believe that wind power will see its share of China’s national energy mix gradually increase.
We sustained a decrease in revenue of forged rolled rings and related products for the wind power industry, which declined $9.8 million, or 38.0%, during the year ended December 31, 2012 as compared to the year ended December 31, 2011.
Dyeing and Finishing Equipment Segment
Through our dyeing and finishing segment, we design, manufacture and distribute a line of proprietary high and low temperature dyeing and finishing machinery. Our products feature a high degree of both automation and mechanical-electrical integration. Our products are widely used in dyeing yarns such as pure cotton, cotton-polyester, terylene, polyester wool, poly-acrylic fiber, nylon, cotton ramie, and wool yarn. We continue to utilize our expertise in manufacturing precision products to meet demand in new and existing end markets. We recently shipped a prototype of a new model of after-treatment textile equipment and have another model in the late stages of development.
4
Revenue from our dyeing segment increased $7.5 million, or 42.4% in the year ended December 31, 2012 from the year ended December 31, 2011. We believe that the increase reflects our marketing effort for our new airflow dyeing units, which use air instead of water. Water is used in the traditional dyeing process. We believe that our air-flow technology, which is designed to enable users to meet the stricter environmental standards, results in reduced input costs, fewer wrinkles, less damage to the textile, and reduced emissions. With the growing acceptance of our new dyeing technology and the China government’s mandate to phase out older machinery in China’s textile industry that does not meet the new environmental standards, we expect our revenue from this segment will continue to increase in the near future. Our gross margins from our dyeing
segment increased from 22.1% for the year ended December 31, 2011 to 23.9% for the year ended December 31, 2012.
The factors that affected our revenue, gross margin and net income during the year ended December 31, 2012 may affect our operations in the near future. Our ability to expand our operations and increase our revenue is largely affected by the PRC government’s policy on such matters as the availability of credit, which affects all of our operations, and its policies relating to alternative energy such as wind and solar power, which affect our products for these industries. Our business is also affected by general economic conditions. Because of the nature of our products, our customers’ projection of future economic conditions are an integral part of their decisions as to whether to purchase capital equipment at this time or defer such purchases until a future date.
Organization
We were incorporated in Delaware on June 24, 1987 under the name Malex, Inc. We changed our corporate name to China Wind Systems, Inc. on December 18, 2007. On June 13, 2011, we changed our corporate name to Cleantech Solutions International, Inc.
We are the sole stockholder of Fulland Limited, a Cayman Islands limited liability company organized on May 9, 2007. Fulland owns 100% of the capital stock of Green Power Environment Technology (Shanghai) Co., Ltd. (“Green Power”) and Wuxi Fulland Wind Energy Equipment Co., Ltd. (“Fulland Wind Energy”), which are wholly foreign-owned enterprises organized under the laws of the PRC. We formed Fulland Wind Energy in August 2008. We currently manufacture our forged products, which are sold for use in the wind, steel, solar power industry and other industries through Fulland Wind Energy.
Green Power is a party to a series of contractual arrangements dated October 12, 2007 with the Huayang Companies, both of which are limited liability companies organized under the laws of the PRC, and their stockholders. Our corporate organizational structure, including the contractual arrangements with the Huayang Companies, is designed to comply with certain laws and regulations of the PRC which restrict the manner in which Chinese companies, particularly companies owned by Chinese residents, may raise funds from non-Chinese sources.
5
The following table sets forth our relationship our subsidiaries and the variable interest entities whose financial statements are consolidated with ours.
Name of Entity
Relationship to Us
Nature of Business
Cleantech Solutions International, Inc
N.A.
Holding company
Fulland Limited
100% owned by us
Holding company
Wuxi Fulland Wind Energy Equipment Co., Ltd.
100% owned by Fulland Limited
Manufacture of forged rolled rings and related products at new plant
Green Power Environment Technology (Shanghai) Co., Ltd.
100% owned by Fulland Limited
Operates business of Wuxi Huayang Dyeing Machinery Co., Ltd. and Wuxi Huayang Electrical Power Equipment Co., Ltd. pursuant to contracts
Wuxi Huayang Dyeing Machinery Co., Ltd.
Variable interest entity operated by Green Power pursuant to contracts
Operates dyeing and finishing equipment segment
Wuxi Huayang Electrical Power Equipment Co., Ltd.
Variable interest entity operated by Green Power pursuant to contracts
Operated electric power equipment segment; manufactures and sells forged rolled ring segment pursuant to existing contracts. The business of this entity is being phased out.
The Huayang Companies are both owned by our chief executive officer, Jianhua Wu, and his wife, Lihua Tang.
Our executive offices are located No. 9 Yanyu Middle Road, Qianzhou Village, Huishan District, Wuxi City, Jiangsu Province, China 214181, telephone (86)51083397559.
Contractual Arrangements with the Huayang Companies and their Stockholders
We have contractual arrangements with the Huayang Companies and their stockholders, who are our chief executive officer, Jianhua Wu, and his wife, Lihua Tang, pursuant to which we provide these companies with technology consulting and other general business operation services. Through these contractual arrangements, we also have the ability to substantially influence these companies’ daily operations and financial affairs, appoint their senior executives and approve all matters requiring stockholder approval. As a result of these contractual arrangements, which enable us to control the Huayang Companies, we are considered the primary beneficiary of the Huayang Companies. Accordingly, we consolidate the results, assets and liabilities of the Huayang Companies in our financial statements.
Our relationships with the Huayang Companies and their stockholders are governed by a series of contractual arrangements between Green Power, our wholly foreign owned enterprise in the PRC, and each of the Huayang Companies, which are our operating companies in the PRC. Under PRC laws, each of Green Power, Fulland Wind Energy, Huayang Dyeing Machine and Huayang Electrical Power Equipment is an independent legal person and none of them is exposed to liabilities incurred by the other parties. Other than pursuant to the contractual arrangements between Green Power and the Huayang Companies described below, generally, neither of the Huayang Companies transfers any other funds generated from its operations to any other member of the Huayang Group. On October 12, 2007, we entered into the following contractual arrangements with each of the Huayang Companies.
Consulting Services Agreement. Pursuant to the exclusive consulting services agreements between Green Power and each of the Huayang Companies, Green Power has the exclusive right to provide to the Huayang Companies general business operation services, including advice and strategic planning, as well as consulting services related to the technological research and development of dye and finishing machines, electrical equipment and related products. Under this agreement, Green Power owns the intellectual property rights developed or discovered through research and development, in the course of providing its services under the agreement, or derived from the provision of the services. The Huayang Companies shall pay a quarterly consulting service fees to Green Power that is equal to all of the Huayang Companies’ profits for such quarter. The term of this agreement, as amended on November
1, 2008, is 20 years from October 12, 2007 and may be extended only upon Green Power’s written confirmation prior to the expiration of the agreement, with the extended term to be mutually agreed upon by the parties.
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Operating Agreement. Pursuant to the operating agreement among Green Power, the Huayang Companies and all stockholders of the Huayang Companies, Green Power provides guidance and instruction on the Huayang Companies’ daily operations, financial management and employment issues. The Huayang Companies stockholders must designate the candidates recommended by Green Power as their representatives on the boards of directors of each of the Huayang Companies. Green Power has the right to appoint senior executives of the Huayang Companies. In addition, Green Power agrees to guarantee the Huayang Companies’ performance under any agreements or arrangements relating to the Huayang Companies’ business arrangements with any third party. The Huayang Companies, in return, agrees to pledge their accounts receivable and all of their assets to Green Power. Moreover, the Huayang Companies agree that without the prior consent of Green
Power, the Huayang Companies will not engage in any transactions that could materially affect their respective assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of their assets or intellectual property rights in favor of a third party or transfer of any agreements relating to their business operation to any third party. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended only upon Green Power’s written confirmation prior to the expiration of the this agreement, with the extended term to be mutually agreed upon by the parties.
Equity Pledge Agreement. Under the equity pledge agreement between the Huayang Companies stockholders and Green Power, the Huayang Companies’ stockholders pledged all of their equity interests in the Huayang Companies to Green Power to guarantee the Huayang Companies’ performance of their obligations under the consulting services agreement. If the Huayang Companies or the Huayang Companies’ stockholders breach their respective contractual obligations, Green Power, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. The Huayang Companies stockholders also agreed that upon occurrence of any event of default, Green Power shall be granted an exclusive, irrevocable power of attorney to take actions in the place and stead of the Huayang Companies stockholders to carry out the
security provisions of the equity pledge agreement and take any action and execute any instrument that Green Power may deem necessary or advisable to accomplish the purposes of the equity pledge agreement. The Huayang Companies’ stockholders agreed not to dispose of the pledged equity interests or take any actions that would prejudice Green Power’s interest. The equity pledge agreement will expire two years after the Huayang Companies’ obligations under the consulting services agreements have been fulfilled.
Option Agreement. Under the option agreement between the Huayang Companies Stockholders and Green Power, the Huayang Companies Stockholders irrevocably granted Green Power or its designated person an exclusive option to purchase, to the extent permitted under PRC law, all or part of the equity interests in the Huayang Companies for the cost of the initial contributions to the registered capital or the minimum amount of consideration permitted by applicable PRC law. Green Power or its designated person has sole discretion to decide when to exercise the option, whether in part or in full. The term of this agreement, as amended, is 20 years from October 12, 2007 and may be extended prior to its expiration by written agreement of the parties.
The Forged Rolled Rings and Related Components Segment
The following table represents the Global Wind Energy Council’s outlook and analysis of China’s future wind power potential.
Conservative Scenario
Optimistic Scenario
Positive Scenario
Year
Installed
Capacity GW
Annual newly installed capacity GW
Annual average growth rate
Installed
Capacity GW
Annual newly installed capacity GW
Annual
average
growth rate
Installed
Capacity GW
Annual newly installed capacity GW
Annual
average
growth rate
2008
12.2
6.2
12.2
12.2
2009
25.8
13.6
111.52
%
25.8
13.6
25.8
13.6
2010
35
9.2
35.63
%
37
11.2
43.38
%
40
14.2
55.01
%
2015
80
9
17.98
%
112
15
24.80
%
130
18
26.58
%
2020
150
14
13.40
%
202
18
12.52
%
230
20
12.09
%
2030
250
10
5.24
%
302
10
4.10
%
380
15
5.15
%
2040
350
10
3.42
%
402
10
2.90
%
530
15
3.38
%
2050
450
10
2.54
%
502
10
2.25
%
680
15
2.52
%
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Currently, we believe that China is focusing on wind power for the following reasons:
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China has small oil reserves and depends mainly on high-polluting coal for power;
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According to China National Energy Administration, China investment in coal-fired power projects declined by 11% while investment in wind power increased by 44% in 2009;
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Wind power is considered the most scalable cost effective renewable energy and is cost competitive with coal;
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The Chinese government has announced that it is aggressively driving renewable energy both for energy-independence as well as environmental reasons;
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On July 20, 2010, the Chinese government announced RMB 5 trillion (approximately $758 billion) will be spent on renewable energy over the next 10 years.
●
At the end of 2009, the Chinese government made a political commitment to the international community at the Copenhagen Conference on climate change that nonfossil energy would satisfy 15% of the country’s energy demand by 2020. Meeting this goal will require an unprecedented boost to the scale and pace of future clean energy development, including a new orientation toward wind power development. Wind energy is encouraged by a range of laws and regulations, the most important being the Renewable Energy Law, originally introduced in 2005.
Renewable energy is clean and sustainable. We believe that wind is one of the most competitive and promising renewable energies. Wind energy brings great environmental benefits, but also minor negative side effects, such as noise, visual intrusion, effects on bird migration and electromagnetic radiation. Compared with conventional power generation, however, wind power has few environmental effects, and we believe that these effects can be reduced. On the whole, its advantages outweigh its disadvantages. However, wind power can only be generated in areas where there is a generally consistent wind and there continue to be difficulties is integrating wind power into an electric grid to serve a larger geographic range. However, as discussed under “Forged Rolled Rings and Related Components Segment,” a number of factors have reduced the growth of the wind power industry during the past two years. The factors include:
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An apparent decline in the growth rate for the wind industry, following six years of growth.
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Increased competition among Chinese turbine makers and related parts manufacturers.
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The effects of a 2011 decision by the China central bank to tighten the monetary supply, which reduced the availability of bank financing both for owners of wind farms who require bank loans to purchase equipment and for potential purchasers of heavy equipment.
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Decisions by turbine manufactures to establish vertically integrated operations, thus eliminating the need to purchase components from outside companies such as us.
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A decrease in the installation of windmills due the China’s curbing of construction on land resulting in part from the situation where power-delivery grids for wind power have not matched the significant growth of available wind energy in recent years.
We are manufacturing rolled rings and other related components designed to be used for wind power generation as well as other uses. We employ axial close-die forging technology in producing precision forgings. It is a new technology for producing rotary precision forgings. We made the forging machine, providing a strong advantage in machine maintenance and cost compared to other companies using foreign equipment. Our rolled rings are essentially hollow cylindrical sections forged from a stainless steel stock of varying thickness and height. The rings are called rolled rings because of the nature of the forging process. Forging is a manufacturing process where metal is pressed, pounded or squeezed under great pressure to create high strength parts. Rolled ring forging turns a hollow round piece of metal under extreme pressure against a rotating roller, thereby squeezing out a single-piece ring without any welding required.
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Rings can also be manufactured through machining or casting. We believe that the forging provides increased strength and flexibility for the finished product. A ring’s strength affects its fatigue resistance, and is determined by the orientation of the grain flow of the ring’s metal material. Unlike the machining process, which creates a unidirectional grain flow, or the casting process, which creates no grain flow, the forging process causes alignment and orientation of the grain flow in a direction creating maximum strength, thereby providing maximum fatigue resistance. This high strength property also reduces sectional thickness and overall weight of the ring without compromising the overall integrity of the finished product.
High tangential strength and ductility make forged rings well-suited for torque- and pressure-resistant components, such as gears, engine bearings for aircraft, wheel bearings, couplings, rotor spacers, sealed discs and cases, flanges, pressure vessels and valve bodies. As such, rolled rings have a wide variety of applications. Presently, the majority of Chinese rolled ring producers rely on technologies such as the steam hammer and friction press, which consume large amounts of energy and cause pollution, and which, we believe, generate a less desirable product.
Yaw bearings, which are found in every wind turbine, are made from rolled rings. Essentially, a yaw bearing is a large ring with teeth, all of which are either pointing outward or inward. The teeth allow the yaw bearing to engage with a smaller wheel attached to the yaw motor. The yaw motor turns the wind turbine so that the rotor (to which blades are attached) faces the wind in order to optimize electricity generation. The yaw bearing is used by the yaw motor to turn the wind turbine.
Manufacturing
In 2009, we opened our state-of-the-art forging facility. Our operations feature a 4,500-ton press and a ring-rolling mill, employing our advanced axial close-die forging technology, to manufacture rolled rings measuring up to 6.3 meters in diameter and a cross section up to 700mm and shafts used in wind turbine units, measuring 1MW-3MW. We also have a series of workshops dedicated for fabrication, welding, machining and assembly of high strength materials.
We believe that our expanded forging facility, which is able to meet the quality requirements of our most demanding customers, has an annual capacity of 50,000 tons.
The melting, forging, heat-treating and machining capability at our facility allows for the manufacturing of a wide range of custom-forged products. Multi-diameter shafts, gear blanks, mandrel-forged rings and specialized shapes, are available in a wide range of sizes and weights ranging from a few hundred pounds to over 25,000 pounds. Most popular carbon and alloy AISI/SAE grades such as 1026, 1045, 4140, 4150F, 4340, and 8620 are readily available. We also have experience with the melting and forming of specialized alloys. We believe that we are capable of producing components that meet various industry specifications as well as product-specific specifications.
Our manufacturing site covers over 1.1 million square feet. In addition to our forging operation we have established state-of-the-art fabrication, machining, assembly and finishing workshops to meet the manufacturing needs of our clean technology focused customer base.
We are among the leading specialists in the manufacturing of:
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Large forged rolled rings, yaw bearings, tower flanges and shafts used in large-scale windmills
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Stainless steel pressure vessel/chambers used in the manufacturing of multi-crystalline solar wafers
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Specialty, high tolerance, fabricated components and assemblies used in various clean technology industries
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Other fabricated and machined components, assemblies and equipment requiring high precision manufacturing
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Marketing and Distribution
Based at our facilities in Wuxi, we have a sales team of eight employees for our forged rolled rings and shafts. Our marketing efforts include participation at industrial conferences and trade fairs, sales training, and advertising. Our sales team works closely with our product development and manufacturing teams to coordinate our product development activities, product launches and ongoing demand and supply planning. Our rolled rings and flanges are currently sold to companies in various cities and provinces throughout China including Luoyang, Shenyang, Zhenjiang province, Jiangsu province, Qingdao, Jinan, Shanghai, Chongqing, Beijing and Zhengzhou. We are an ISO9001:2000 certified supplier.
Competition
The markets for products in both of our forged rolled rings and related products are intensely competitive. Many of our competitors have established more prominent market positions, and if we fail to attract and retain customers and establish successful distribution networks in our target markets for our products, we will be unable to increase our sales. Many of our existing and potential competitors have substantially greater financial, technical, manufacturing and other resources than we do. Our competitors’ greater size in some cases provides them with a competitive advantage with respect to manufacturing costs because of their economies of scale and their ability to purchase raw materials at lower prices, as well as securing supplies at times of shortages. Many of our competitors also have greater brand name recognition, more established distribution networks and larger customer bases. In addition, many of our competitors have well-established
relationships with our current and potential distributors and have extensive knowledge of our target markets. As a result, they may be able to devote greater resources to the research, development, promotion and sale of their products or respond more quickly to evolving industry standards and changes in market conditions than we can. Our failure to adapt to changing market conditions and to compete successfully with existing or new competitors may materially and adversely affect our financial condition and results of operations.
We believe there has been an increase in overall competition in the forged product market as industry capacity has increased and the market for the product has slowed. Additionally, we believe some turbine manufacturers that use forged products and are not our customers or potential customers, have built their own forging capacity to save costs by vertical integration and to have better leverage when negotiating with the component suppliers. This may result in downward pressure on our pricing and may indirectly affect our sales as a result of increased competition for a smaller number of potential customers. Our products are sold for use by manufacturers of industrial equipment. The demand for products such as ours which are used both for manufacturing in general and for wind power specifically is uncertain. Although we believe that over the long term, our forged rolled rings and related components segment will expand and the government
of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term other factors have affected the requirements of our customers and potential customers for our products which has had an effect of lessening the demand for products such as ours. To the extent that the demand for our forged rolled rings and related components declines, our revenue and net income will continue to be affected.
We believe that we are well positioned to capitalize on the opportunities provided by the demand for products by the wind power industry and other industry by supplying superior quality, high performance forged products. We believe that we offer:
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High quality manufacturing facilities and production quality;
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A prime location in Jiangsu province near major transportation routes which can provide shipping cost savings and a good response time;
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Strong management, engineering and technical capabilities;
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ISO9001 certification, which covers machining and related service of shaft-shaped forging, ring forging, tubular forging and component assembly.
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The Dyeing and Finishing Segment
In recent years, China has been one of the world’s leading textile producers, and the textile industry has been a pillar in the Chinese national economy, experiencing steady growth over the last few decades. We believe that the textile business has continued to improve due to the tax reimbursement for export incentive given by the PRC government and we believe that the market for dyeing and finishing equipment is improving.
In our dyeing and finishing segment, we design, manufacture and distribute a line of proprietary high and low temperature dyeing and finishing machinery. We believe that we are one of the leading domestic Chinese manufacturers of textile dyeing machines, and our Huayang brand is nationally recognized. We currently have the capacity to manufacture and assemble approximately 550 textile-dyeing machines annually. Our state-of-the-art and automated production line enables us to manufacture our products efficiently, with lower labor and energy costs compared to traditional manufacturing methods. As part of our manufacturing process, we make corrosion-resistant stainless steel pumps and pressure vessels, which are not only critical components for our dyeing and finishing products but have other industrial applications as well.
We have received the “Advanced Enterprise for Progress in Science and Technology Award” from Wuxi City in 1999, and the “Star of Brilliance Medal” from the Wuxi City Bureau of Industrial and Commercial Administration in the same year. In 2002, we were recognized as an “Advanced Enterprise for Technical Reform Input” by Qianzhou, a municipality within Wuxi City for our dyeing products.
We received a new Chinese patent certificate (Patent No. ZL 2012 2 0165878.7) for an innovative production technique enabling more-effective cloth washing in dyeing machines under high temperature and pressure. The new patent was issued by the State Intellectual Property Office of the People’s Republic of China (“SIPO”) in November 2012. The patent will provide us with the exclusive use of this innovative production technique in dyeing equipment for a period of ten years. The patent involves a change in the structure of dyeing equipment so as to create a cooling system that enables more effective cloth washing under high temperature and pressure. This technique has been proven to easily shed debris and cotton husks on the surface of fabric, and cloth can be washed much more cleanly. In addition, washing cloth within the cooling vats reduces the time required for dyeing, thereby reducing energy consumption and emissions.
Our dyeing and finishing products are generally compact in design compared with alternatives on the market and feature a high degree of both automation and mechanical-electrical integration. Our products are used in dyeing yarns such as pure cotton, cotton-polyester, terylene, polyester wool, poly-acrylic fiber, nylon, cotton ramie, and wool yarn. In 2010, we introduced an advanced dyeing technology enabling a quick, economic and environment-friendly operation designed for optimal performance. The liquid pressure and quantity are adjusted to the respective type and quantity of fabric. The special layout of the pressure pump circuit is designed to provide constant and safe operations of the machine reducing resources wastage and enhancing performance.
Recently, we developed a new model of dyeing machine – high (low) temperature airflow dyeing machine. We believe that this new model of dyeing machine is efficient and cost effective and meets the requisite Chinese environmental standards.
Marketing and Distribution
All of our revenue from the textile dyeing machine segment is derived from sales in China. We presently sell our products in Jiangsu and Zhejiang Provinces, both regions with significant textile production, as well as in many of the coastal regions of China such as Shandong and Guangdong provinces.
We market and sell our products through our internal sales force, which is based in our facilities in Wuxi. Our marketing programs include industrial conferences, trade fairs, sales training and advertising. Our sales and marketing groups work closely with our manufacturing groups to coordinate our product development activities, product launches and ongoing demand and supply planning. We sell our products directly to many of China’s largest textile producers, including Haining City Shengda Dyeing & Finishing Co., Ltd. and Tongxiang City Hengfeng Bleaching & Dyeing Co., Ltd. During 2012, no customer accounted for 10% or more of our sales.
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Growth Strategies
According to China’s National Development and Reform Commission, the main focus of the country’s textile industry has shifted from gaining competitive advantages based on labor costs toward the objectives of developing scientific and technological innovation as well as brand creation. Under the auspices of China’s Eleventh Five Year Plan, which was implemented in 2006, the next stage for the textile and dyeing industries in China is the development of textile products that use cleaner production technologies, according to the Bureau of Economic Operation under the National Development and Reform Commission.
In support of this objective, we are continuing our efforts to develop and implement next-generation low energy consumption and high heating efficiency features to our machines. The current emphasis of our efforts continues to be on increasing automation features in our existing products and implementing power line communication technology throughout our production facilities to enable our customers to reduce their use of electricity.
Competition
Because of the importance of the Chinese textile industry in the world market, we face competition from both domestic and foreign suppliers. However, due to the high quality of our products, our competitors are primarily based in foreign countries, including Japan, Germany, Italy and France. Domestically, our chief competitor is Fong’s National Engineering (Shenzhen) Co., Ltd., a subsidiary of Fong’s Industries Company Ltd., a Hong-Kong based conglomerate.
We believe that we can effectively compete with these companies on the basis of the quality and performance of our products, our after-sales service, and cost. We provide one year of maintenance and repair services for all of our products and based on historical we experience, maintenance and repair service calls have been minimal. Moreover, we provide customers in the Jiangsu and Zhejiang Provinces, our top markets, with on-site support which is generally provided within 24 hours of receiving a request. However, many of our competitors have longer operating histories and significantly greater financial or technological resources than we do and presently enjoy greater brand recognition.
Source of Supply
Stainless steel is the principal raw material for the manufacture of all of our products. We purchase stainless steel tubes from Wuxi City Zhongtian Stainless Steel Co., Ltd. and stainless steel plates from Wuxi City Fanshun Materials Co., Ltd. In 2012 and 2011, our purchases of steel from Wuxi City Fanshun Materials Co., Ltd accounted for approximately 21% and 13%, respectively, of our total purchases. In both 2012 and 2011 our purchases of steel from Wuxi City Zhongtian Stainless Steel Co., Ltd accounted for less than 10% of our total purchases. While we do not have long-term contracts with these suppliers, we have long-term business relationship with them, and these companies have generally met our supply requirements. For the textile machinery business, the price of steel can have more significant impact. Any significant rise
in the price of or demand for stainless steel could have an adverse affect on our results of operations. Inflation has recently affected raw materials generally, and inflationary pressures could have a significant effect on our business, particularly on our dyeing and finishing segment. To the extent that we are not able to pass along price increases for stainless steel to our forging customers, these factors will affect this segment as well.
Other raw materials, such as stainless steel planks and transducers, are readily available from a number of suppliers on commercially reasonable terms.
Research and Development
We do not conduct any significant research and development, and we did not incur any research and development expense in 2012 or 2011. In our forged rolled rings and related product segment, we plan to concentrate our product development efforts on developing enhancement of rolled rings and related products principally for the wind power and solar power industry.
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Government Regulations
Environmental Regulations
Our manufacturing processes generate noise, waste water, gaseous and other industrial wastes, and we use, generate and discharge toxic, volatile and otherwise hazardous chemicals and wastes in our operations. As a result, we are required to comply with all national and local regulations regarding protection of the environment. Our operations are subject to regulations promulgated by China’s Environmental Protection Administration, Jiangsu Province Environmental Protection Administration and the Wuxi City Environmental Administration. We are also subject to periodic monitoring by local environmental protection authorities in Wuxi. We have installed various types of anti-pollution equipment in our facilities to reduce, treat, and, where feasible, recycle the wastes generated in our manufacturing processes. We believe that our manufacturing facilities and equipment are in substantial compliance with all applicable environmental regulations.
Based on the requirement of present law, we do not expect that any additional measures that may be required to maintain compliance will materially affect our capital expenditures, competitive position, financial position or results of operations.
The Chinese government has expressed a concern about pollution and other environmental hazards. Although we believe that we comply with current national and local government regulations, if it is determined that we are in violation of these regulations, we can be subject to financial penalties as well as the loss of our business license, in which event we would be unable to continue in business. Further, if the national or local government adopts more stringent regulations, we may incur significant costs in complying with such regulations. If we fail to comply with present or future environmental regulations, we may be required to pay substantial fines, suspend production or cease operations. Any failure by us to control the use of or to restrict adequately the discharge of, hazardous substances could subject us to potentially significant monetary damages and fines or suspensions in our business operations.
Business License
Green Power, Fulland Wind Energy and both of the Huayang Companies have been issued business licenses with the appropriate municipal and provincial governments which specifically authorize the companies to operate their respective businesses. All of these business licenses, which are subject to annual review by the issuing agencies, are current as of the date of this annual report. No additional approval or license is required for the manufacturing and sale of the textile dyeing and finishing machines or the rolled rings.
ISO Certification
We received the International Organization for Standardization (ISO) certificate for our new facility in Wuxi City on July 15, 2009. The certificate accredits our quality management system as compliant with ISO9001:2008 and covers machining and related service of shaft-shaped forging, ring forging, tubular forging and component assembly. The certification was renewed in August 2012 and expires on August 12, 2015. We also received the certificate of Level A Pressure Vessel from the General Administration of Quality Supervision, Inspection and Quarantine of the People’s Republic China on August 18, 2009 and covers the manufacturing of pressure vessel pipelines. This certificate expires on August 17, 2013.
Our Dyeing segment also has received the certificate to manufacture D1 and D2 levels of pressure vessels, which includes our current line of dyeing machines, from the Quality and Technical Supervision Bureau of Jiangsu Province. We received the certificate on Dec 7, 2007 and renewed it on November 11, 2011, which expires on December 6, 2015.
Circular 106 Compliance and Approval
On May 31, 2007, the State Administration of Foreign Exchange, or SAFE, issued an official notice known as “Circular 106,” which requires the owners of any Chinese companies to obtain SAFE’s approval before establishing any offshore holding company structure for foreign financing as well as subsequent acquisition matters in China. Accordingly, in early September 2007, the owners of 100% of the equity in the Huayang Companies, namely Jianhua Wu and Lihua Tang, submitted their application to SAFE. On September 19, 2007, SAFE approved their application, permitting them to establish an offshore company, Fulland, as a “special purpose vehicle” for any foreign ownership and capital raising activities by the Huayang Companies. After SAFE’s approval, Mr. Wu and
Ms. Tang became the majority owners of Fulland on October 11, 2007. Fulland was acquired by us in November 2007.
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Intellectual Property Rights
We rely on a combination of trademark, copyright and trade secret protection laws in China and other jurisdictions, as well as confidentiality procedures and contractual provisions to protect our intellectual property and our brand. We recently received a new patent certificate (Patent No. ZL 2012 2 0165878.7) for an innovative production technique enabling more-effective cloth washing in dyeing machines under high temperature and pressure. The new patent was issued by the State Intellectual Property Office of the People’s Republic of China (“SIPO”) and was granted to our subsidiary, Dyeing, in November 2012. The patent provides us with the exclusive use of this innovative production technique in dyeing equipment for a period of ten years. The patent involves a change in the structure of dyeing equipment so as to create a cooling system that enables more effective cloth washing under high temperature and pressure. This technique
has been proven to easily shed debris and cotton husks on the surface of fabric, and cloth can be washed much more cleanly. In addition, washing cloth within the cooling vats reduces the time required for dyeing, thereby reducing energy consumption and emissions. We intend to apply for more patents to protect our core technologies. We also have confidentiality and non-competition policies in place as part of our company employment guideline which is given to each employee, and we enter into nondisclosure agreements with third parties. However, we cannot assure you that we will be able to protect or enforce our intellectual property rights.
Employees
As of March 28, 2013, we had 210 employees, including 205 full time employees and 5 part time employees. Of these, 130 employees are in the dyeing and finishing segment (eight executives, managers and administrative staff, four accounting staff, six quantity control staff, five engineers and technicians, eight marketing and salespeople, four purchasing staff and 95 manufacturing staff) and 80 employees are with our forged rolled rings and related products segment (three executive, managers and administrative staff, three accounting staff, eight salespeople, three purchasing staff, and 56 manufacturing staff, and seven quality control and engineers/technicians).
Our manufacturing employees usually work in two shifts, based upon our manufacturing requirements. We may also send our engineers and technicians to our customers’ work sites to provide after-sale customer service for them.
All of these employees are members of a union, organized by the Union for Huishan District, Wuxi City, as mandated by the PRC Union Law. We have not experienced a work strike. We believe that our relations with our employees are good.
ITEM 1A. RISK FACTORS
An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below, together with all of the other information included in this report, before making an investment decision, and you should only consider an investment in our common stock if you can afford to sustain the loss of your entire investment. You should carefully consider the risks described below together with all of the other information included in this report before making an investment decision with regard to our securities. If any of the following risks actually occurs, our business, financial condition or results of operations could be harmed. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.
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Risks Related to Our Business
We are incurring significant obligations in developing the manufacture of forged rolled rings and solar power machinery for use in the wind power industry, other industries and solar power industry with no assurance that we can or will be successful in this business.
Wind power and solar power account for a small percentage of the power generated in the PRC, and our ability to market to this segment is dependent upon both an increased acceptance of wind power and solar power as an energy source in the PRC and the acceptance of our products. We are making the financial and manpower commitment in our belief that there will be an increased demand for wind power and solar power in China and elsewhere and that the companies that manufacture wind power generation equipment and other equipment that uses our products will purchase our products. We cannot assure you that we will be able to successfully develop this business, and our failure to develop the business will have a material adverse effect on our overall financial condition and the results of our operations.
Our ability to continue to operate profitably is dependent upon our continued development of our dyeing segment and our generation of new revenue from our forged rolled rings and related products division
For the year ended December 31, 2012 our revenue increased approximately $1.6 million, or 2.9%, and our net income decreased approximately $1.6 million, or 27.1%, reflecting a 15.6% decline in revenue from our forged rolled rings and related products and an increase of 42.4% in revenue from our dyeing segment. The decrease in revenue from the forged rolled rings and related products division reflect, among other factors, increased competition, a tightening of the monetary supply by China, which affected wind farm developers and other industrial companies who require financing to purchase capital equipment such as our products, vertical integration by wind power manufactures which reduce the need for outside suppliers such as us, and delays by potential customers reflecting both the tightening of credit and the reduction in the growth of the wind power industry
in China. We cannot assure you that these factors, as well as other factors not presently known to us, will not result in continued declines in revenue or net income.
We will require additional funds to expand our operations.
In connection with any expansion projects for our business, we will incur significant capital and operational expenses. We do not presently have any funding commitments other than our present credit arrangements which we do not believe are sufficient to enable us to expand our business. If we are unable to generate cash flow from operations and obtain necessary bank or other financing to pay for significant capital or operational expenses, we may be unable to finance the growth of our existing business, which may impair our ability to operate profitably. Because of our stock price and the worldwide economic downturn, we may not be able to raise any additional funds that we require on favorable terms, if any. The failure to obtain necessary financing may impair our ability to expanse or business and remain profitable.
Because we sell capital equipment, our business is subject to our customers’ capital budget and we may suffer delays or cancellations of orders and the effects of the recent worldwide economic downturn.
Our customers purchase our equipment as part of their capital budget. As a result, we are dependent upon receiving orders from companies that are either expanding their business, commencing a new business, upgrading their capital equipment or otherwise purchasing capital equipment. Our business is therefore dependent upon both the economic health of these industries and our ability to offer products that meet regulatory requirements, including environmental requirements, of these industries and are cost justifiable, based on potential cost savings in using our equipment in contrast to existing equipment or equipment offered by others. As a result of the worldwide economic downturn and the tightening of credit in China, the market for capital equipment declined, and sales of our products declined. We cannot predict the extent that the market for capital equipment in the wind and solar power industries, the dyeing industry and other industries
will be affected. However, any economic slowdown or continued lack of credit availability in China can affect all purchasers and manufactures of capital equipment, and we cannot assure you that our forged rolled rings business and solar power machinery business will not be significantly impaired as a result of the worldwide economic downturn.
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Further, the textile and apparel industries have historically been subject to substantial cyclical variations and are particularly affected by adverse trends in the general economy. These industries are presently subject to the effects of the worldwide economic downturn and trade policies of other countries which have severely impacted these industries in China. The reduction in demand for textile products has resulted in a reduction in the demand for capital equipment used in these industries. This reduction in demand affects both our sales and our gross margin, which could have a material adverse effect on our results of operations, liquidity and financial condition.
A decrease in supply or increase in cost of the materials used in our products could harm our profitability.
Any restrictions on the supply or the increase in the cost of the materials used by us in manufacturing our products, especially steel, could significantly reduce our profit margins. Efforts to mitigate restrictions on the supply or price increases of materials by entering into long-term purchase agreements, by implementing productivity improvements or by passing cost increases on to our customers may not be successful. However, increased competition may affect our ability to pass on to our customers’ price increases in raw materials, particularly, stainless steel, which is our principal raw material for all of our products. Our profitability depends largely on the price and continuity of supply of the materials used in the manufacture of our products, which in many instances are supplied by a limited number of sources.
Inflationary and competitive pressures may affect our ability to maintain our margins.
In recent years, raw materials, including steel, which is our principal raw material, have been subject to significant price increases. The Chinese government has expressed concern about inflation in certain segments of the economy. We cannot predict the extent or effect of inflationary pressures with respect to steel and steel products. To the extent that we have to raise our prices to maintain our margins, our sales may suffer. If we are unable to raise prices, either because of competitive factors or customer resistance, our margins and net income may suffer. We cannot assure you that our business will not be impaired by inflation.
The nature of our products creates the possibility of significant product liability and warranty claims, which could harm our business.
Customers use some of our products in potentially hazardous applications that can cause injury or loss of life and damage to property, equipment or the environment. In addition, some of our products are integral to the production process for some end-users and any failure of our products could result in a suspension of operations. We cannot be certain that our products will be completely free from defects. Moreover, we do not have any product liability insurance and may not have adequate resources to satisfy a judgment in the event of a successful claim against us. The successful assertion of product liability claims against us could result in potentially significant monetary damages and require us to make significant payments. In addition, because the insurance industry in China is still in its early stages of development, business interruption insurance available in China offers limited coverage compared to that offered in many other
countries. We do not have any business interruption insurance. Any business disruption or natural disaster could result in substantial costs and diversion of resources.
If we fail to introduce enhancements to our existing products or to keep abreast of technological changes in our markets, our business and results of operations could be adversely affected.
Although certain technologies in the industries that we occupy are well established, we believe our future success depends in part on our ability to enhance our existing products and develop new products in order to continue to meet customer demands. In particular, the next generation of wind turbines requires components that are stronger than the present generation. Although we are seeking to address these requirements with our forged products, our failure to introduce and develop a market for these and any other new or enhanced products on a timely and cost-competitive basis, as well as the development of processes that make our existing technologies or products obsolete, could harm our business and results of operations.
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Because we face intense competition from other companies for both of our operating segments, many of which have greater resources than we do, we may not be able to compete successfully and we may lose or be unable to gain market share.
The markets for products in both of our business segments are intensely competitive. Many of our competitors have established more prominent market positions, and if we fail to attract and retain customers and establish successful distribution networks in our target markets for our products, we will be unable to increase our sales. Many of our existing and potential competitors have substantially greater financial, technical, manufacturing and other resources than we do. Our competitors’ greater size in some cases provides them with a competitive advantage with respect to manufacturing costs because of their economies of scale and their ability to purchase raw materials at lower prices, as well as securing supplies at times of shortages. Many of our competitors also have greater brand name recognition, more established distribution networks and larger customer bases. In addition, many of our competitors have well-established relationships
with our current and potential distributors and have extensive knowledge of our target markets. As a result, they may be able to devote greater resources to the research, development, promotion and sale of their products or respond more quickly to evolving industry standards and changes in market conditions than we can. Our failure to adapt to changing market conditions and to compete successfully with existing or new competitors may materially and adversely affect our financial condition and results of operations. Further, from time to time, we have had to adjust the prices of our products to remain competitive.
Compliance with environmental regulations can be expensive, and noncompliance with these regulations may result in adverse publicity and potentially significant monetary damages and fines.
As our manufacturing processes generate noise, wastewater, gaseous and other industrial wastes, we are required to comply with all national and local regulations regarding protection of the environment. If we fail to comply with present or future environmental regulations, we may be required to pay substantial fines, suspend production or cease operations. We use, generate and discharge toxic, volatile and otherwise hazardous chemicals and wastes in our activities. Any failure by us to control the use of or to restrict adequately, the discharge of hazardous substances could subject us to potentially significant monetary damages and fines or suspensions in our business operations. We do not have insurance to cover any liability which we may incur as a result of personal injury or property damages resulting from emissions of toxic material into the environment.
Our products are subject to PRC regulations, which may materially adversely affect our business.
Government regulations influence the design, components or operation of our products. New regulations and changes to current regulations are always possible and, in some jurisdictions, regulations may be introduced with little or no time to bring related products into compliance with these regulations. Our failure to comply with these regulations may restrict our ability to sell our products in the PRC. In addition, these regulations may increase our cost of supplying the products by forcing us to redesign existing products or to use more expensive designs or components. In these cases, we may experience unexpected disruptions in our ability to supply customers with products, or we may incur unexpected costs or operational complexities to bring products into compliance. This could have an adverse effect on our revenues, gross profit margins and results of operations and increase the volatility of our financial results.
The success of our businesses will depend on our ability to effectively develop and implement strategic business initiatives.
In connection with the development and implementation of growth plans, we will incur additional expenses and capital expenditures. The development and implementation of these plans also requires management to divert a portion of its time from day-to-day operations. These expenses and diversions could have a significant impact on our operations and profitability, particularly if our plans for any new initiative prove to be unsuccessful. Moreover, if we are unable to implement any of our plans in a timely manner, or if those plans turn out to be ineffective or are executed improperly, our business and operating results would be adversely affected.
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Failure to successfully reduce our production costs may adversely affect our financial results.
A significant portion of our strategy relies upon our ability to successfully rationalize and improve the efficiency of our operations. If we are not able to implement cost reduction measures, especially in times of either an economic downturn or inflationary pressures, or if these efforts do not generate the level of cost savings that we expect going forward or result in higher than expected costs, there could be a material adverse effect on our business, financial condition, results of operations or cash flows.
If we are unable to make necessary capital investments or respond to pricing pressures, our business may be harmed.
In order to remain competitive, we need to invest in product development, manufacturing, customer service and support, and marketing. We do not have any significant research and development activities. We may not have available sufficient financial or other resources to continue to make investments necessary to maintain our competitive position. Currently, our research and development is not significant.
Unforeseen or recurring operational problems at our facilities may cause significant lost production, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our manufacturing processes could be affected by operational problems that could impair our production capability. Our facilities contain complex and sophisticated machines that are used in our manufacturing process. Disruptions at our facilities could be caused by maintenance outages; prolonged power failures or reductions; a breakdown, failure or substandard performance of any of our machines; the effect of noncompliance with material environmental requirements or permits; disruptions in the transportation infrastructure, including railroad tracks, bridges, tunnels or roads; fires, floods, earthquakes or other catastrophic disasters; labor difficulties; or other operational problems. Any prolonged disruption in operations at our facilities could cause significant lost production, which would have a material adverse effect on our business, financial condition, results of operations and cash flows.
Our officers and directors own a substantial portion of our outstanding common stock, which will enable them to influence many significant corporate actions and in certain circumstances may prevent a change in control that would otherwise be beneficial to our shareholders.
As of March 28, 2013, our officers and directors and members of their families beneficially owned approximately 40.1% of our outstanding voting shares. These stockholders, acting together, could have a substantial impact on matters requiring the vote of the shareholders, including the election of our directors and most of our corporate actions. This control could delay, defer or prevent others from initiating a potential merger, takeover or other change in our control, even if these actions would benefit our shareholders and us. This control could adversely affect the voting and other rights of our other shareholders and could depress the market price of our common stock.
Our business depends substantially on the continuing efforts of our executive officers and our ability to maintain a skilled labor force, and our business may be severely disrupted if we lose their services.
Our future success depends substantially on the continued services of our executive officers, especially Mr. Jianhua Wu, our chief executive officer and the chairman of our board of directors. We do not maintain key man life insurance on any of our executive officers. If one or more of our executive officers are unable or unwilling to continue in their present positions, we may not be able to replace them readily, if at all. Therefore, our business may be severely disrupted, and we may incur additional expenses to recruit and retain new officers. In addition, if any of our executives joins a competitor or forms a competing company, we may lose some of our customers. Our chief executive officer is a party to contractual agreements as described elsewhere in our annual report.
18
A significant portion of our business is conducted through the Huayang Companies, which are owned by our chief executive officer and his wife.
A significant portion of our forged rolled rings and related products and all of our dyeing and finishing equipment business is conducted by the Huayang Companies, which are variable interest entities that are owned by our chief executive officer and his wife and whose financial results are included with ours because the Huayang Companies are deemed as variable interest entities and we are the sole beneficiary of their operations. The variable interest entity relationship is derived from a series of agreements between us and our chief executive officer and his wife, as the sole stockholders of the Huayang Companies. Pursuant to these agreements, we are responsible for the operations of the Huayang Companies and receive the benefits of those operations. However, in the event that we have to seek to enforce these agreements, such enforcement would be sought in Chinese courts, and we cannot assure you that we will prevail or that we will
be able to obtain the benefits intended by these agreement. Any inability to enforce our rights under these agreements would materially impair our operations, financial position and cash flows.
If we are unable to attract, train and retain technical and financial personnel, our business may be materially and adversely affected.
Our future success depends, to a significant extent, on our ability to attract, train and retain technical and financial personnel. Recruiting and retaining capable personnel, particularly those with expertise in our industries and in the industries to which we market, are vital to our success. There is substantial competition for qualified technical and financial personnel, and there can be no assurance that we will be able to attract or retain our technical and financial personnel. If we are unable to attract and retain qualified employees, our business may be materially and adversely affected.
Our failure to protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights or defend against third-party allegations of infringement may be costly.
We rely primarily on trade secret and contractual restrictions to protect our intellectual property. Nevertheless, these afford only limited protection and the actions we take to protect our intellectual property rights may not be adequate and we may not be able to protect our intellectual property under Chinese laws. As a result, third parties may infringe or misappropriate our proprietary technologies or other intellectual property rights, which could have a material adverse effect on our business, financial condition or operating results. In addition, policing unauthorized use of proprietary technology can be difficult and expensive. Litigation may be necessary to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others and the enforcement of intellectual property rights in China may be difficult. We cannot assure you that the outcome of any litigation
will be in our favor. Intellectual property litigation may be costly and may divert management attention as well as expend our other resources away from our business. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, prospects and reputation. In addition, we have no insurance coverage against litigation costs and would have to bear all costs arising from such litigation to the extent we are unable to recover them from other parties. The occurrence of any of the foregoing could have a material adverse effect on our business, results of operations and financial condition.
Implementation of China’s intellectual property-related laws has historically been lacking, primarily because of ambiguities in China’s laws and difficulties in enforcement. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other countries.
We do not have business liability or disruption insurance coverage.
The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited business insurance products. We do not have any business liability or disruption insurance coverage for our operations in China. Any business disruption, litigation or natural disaster may result in our incurring substantial costs and the diversion of our resources.
19
You may suffer significant dilution if we raise additional capital.
If we need to raise additional capital to expand or continue operations, it may be necessary for us to issue additional equity or convertible debt securities. If we issue equity or convertible debt securities, our net tangible book value per share may decrease, and the percentage ownership of our current stockholders would be diluted, and any equity securities we may issue may have rights, preferences or privileges senior or more advantageous to our common stockholders.
Risks Related to Conducting Business in the PRC
PRC laws and regulations governing our businesses and the validity of certain of our contractual arrangements are uncertain. If we are found to be in violation, we could be subject to sanctions. In addition, changes in such PRC laws and regulations may materially and adversely affect our business.
There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including, but not limited to, the laws and regulations governing our business, or the enforcement and performance of our contractual arrangements with our affiliated Chinese entities, the Huayang Companies, and its shareholders. We are considered a foreign person or foreign invested enterprise under PRC law. As a result, we are subject to PRC law limitations on foreign ownership of Chinese companies. These laws and regulations are relatively new and may be subject to change, and their official interpretation and enforcement may involve substantial uncertainty. The effectiveness of newly enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance by foreign investors. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively.
The PRC government has broad discretion in dealing with violations of laws and regulations, including levying fines, revoking business and other licenses and requiring actions necessary for compliance. In particular, licenses and permits issued or granted to us by relevant governmental bodies may be revoked at a later time by higher regulatory bodies. We cannot predict the effect of the interpretation of existing or new PRC laws or regulations on our businesses. We cannot assure you that our current ownership and operating structure would not be found in violation of any current or future PRC laws or regulations. As a result, we may be subject to sanctions, including fines, and could be required to restructure our operations or cease to provide certain services. Any of these or similar actions could significantly disrupt our business operations or restrict us from conducting a substantial portion of our business operations, which could
materially and adversely affect our business, financial condition and results of operations.
The PRC government restricts foreign investment in businesses in China. Accordingly, we operate our business in China through the Huayang Companies and, recently through a wholly-owned subsidiary which is a wholly foreign owned entity known as a WFOE. The Huayang Companies and the subsidiary hold the licenses and approvals necessary to operate our businesses in China. We have contractual arrangements with the Huayang Companies and its shareholders that allow us to substantially control the Huayang Companies. We cannot assure you, however, that we will be able to enforce these contracts.
Although we believe we comply with current PRC regulations, we cannot assure you that the PRC government would agree that these operating arrangements comply with PRC licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. If the PRC government determines that we do not comply with applicable law, it could revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, impose restrictions on our business operations or on our customers, or take other regulatory or enforcement actions against us that could be harmful to our business.
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If we become directly subject to the recent scrutiny, criticism and negative publicity involving U.S.-listed Chinese companies, we may have to expend significant resources to investigate and resolve the matter which could harm our business operations, stock price and reputation.
Recently, U.S. public companies that have substantially all of their operations in China, particularly companies like us which have completed so-called reverse merger transactions, have been the subject of intense scrutiny, criticism and negative publicity by investors, financial commentators and regulatory agencies, such as the SEC. Much of the scrutiny, criticism and negative publicity has centered on financial and accounting irregularities and mistakes, a lack of effective internal controls over financial accounting, inadequate corporate governance policies or a lack of adherence thereto and, in many cases, allegations of fraud. As a result of the scrutiny, criticism and negative publicity, the publicly traded stock of many U.S. listed Chinese companies has sharply decreased in value and, in some cases, has become virtually worthless. Many of these companies are now subject to shareholder lawsuits and SEC enforcement actions and are
conducting internal and external investigations into the allegations. It is not clear what effect this sector-wide scrutiny, criticism and negative publicity will have on us, our business and our stock price. If we become the subject of any unfavorable allegations, whether such allegations are proven to be true or untrue, we will have to expend significant resources to investigate such allegations and/or defend our company. This situation will be costly and time consuming and distract our management from developing our growth. If such allegations are not proven to be groundless, we and our business operations will be severely affected and you could sustain a significant decline in the value of our stock.
The disclosures in our reports and other filings with the SEC and our other public pronouncements are not subject to the scrutiny of any regulatory bodies in the PRC.
We are regulated by the SEC and our reports and other filings with the SEC are subject to SEC review in accordance with the rules and regulations promulgated by the SEC under the Securities Act and the Exchange Act. Our SEC reports and other disclosure and public pronouncements are not subject to the review or scrutiny of any PRC regulatory authority. For example, the disclosure in our SEC reports and other filings are not subject to the review by China Securities Regulatory Commission, a PRC regulator that is responsible for oversight of the capital markets in China. Accordingly, you should review our SEC reports, filings and our other public pronouncements with the understanding that no local regulator has done any review of us, our SEC reports, other filings or any of our other public pronouncements.
Our contractual arrangements with the Huayang Companies and its shareholders may not be as effective in providing control over these entities as direct ownership.
Since the law of the PRC limits foreign equity ownership in companies in China, we operate a significant portion of our business through the Huayang Companies. The equity in these companies is owned by our chief executive officer and his wife, and we have no equity ownership interest in the Huayang Companies. We rely on contractual arrangements to control and operate such businesses. These contractual arrangements may not be effective in providing control over the Huayang Companies as direct ownership. For example, the Huayang Companies could fail to take actions required for our businesses despite its contractual obligation to do so. If the Huayang Companies fail to perform under their agreements with us, we may have to incur substantial costs and resources to enforce such arrangements and may have to rely on legal remedies under the law of the PRC, which may not be effective. In addition, we cannot assure you that the Huayang Companies’
shareholders would always act in our best interests.
Adverse changes in political and economic policies of the Chinese government could have a material adverse effect on the overall economic growth of China, which could reduce the demand for our products and materially and adversely affect our competitive position.
21
All of our business operations are conducted and all of our revenues are made in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The Chinese economy differs from the economies of most developed countries in many respects, including:
●
the amount of government involvement;
●
the level of development;
●
the growth rate;
●
the control of foreign exchange; and
●
the allocation of resources.
While the Chinese economy has grown significantly in the past 20 years, the growth has been uneven, both geographically and among various sectors of the economy, and the worldwide economic downturn has affected China. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall Chinese economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us.
The Chinese economy has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the Chinese government has implemented measures emphasizing the utilization of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of the productive assets in China is still owned by the Chinese government. The continued control of these assets and other aspects of the national economy by the Chinese government could materially and adversely affect our business. The Chinese government also exercises significant control over Chinese economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Efforts by the Chinese government
to slow the pace of growth of the Chinese economy could result in decreased capital expenditure by our customers and potential customers, which in turn could reduce demand for our products. Furthermore, in response to the worldwide economic downturn, the Chinese government may seek to increase its control over businesses which could affect our business.
Any adverse change in the economic conditions or government policies in China could have a material adverse effect on the overall economic growth and the level of renewable energy investments and expenditures in China, which in turn could lead to a reduction in demand for our products and consequently have a material adverse effect on our businesses.
Uncertainties with respect to the Chinese legal system could have a material adverse effect on us.
We conduct substantially all of our business through our Chinese subsidiaries and affiliates, which are generally subject to laws and regulations applicable to foreign investment in China and, in particular, laws applicable to wholly foreign-owned enterprises. China’s legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. Since 1979, Chinese legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since these laws and regulations are relatively new and China’s legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit legal protections available
to us. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.
We rely on dividends and working capital advances paid by our subsidiaries and VIEs for our cash needs
We conduct substantially all of our operations through our subsidiaries and variable interest entities. We rely on dividends and working capital advances from our subsidiaries for our cash needs, including the funds necessary to pay any dividends which we may declare and other cash distributions to our shareholders, to service any debt we may incur and to pay our operating expenses. The payment of dividends and working capital advances by entities organized in China is subject to limitations. Regulations in China currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. Each subsidiary and VIE entity is also required to set aside at least 10% of its after-tax profit based
on China’s accounting standards each year to its general reserves until the accumulated amount of such reserves reach 50% of its registered capital. These reserves are not distributable as cash dividends. Our subsidiaries are also required to allocate a portion of their after-tax profits to their staff welfare and bonus funds, which may not be distributed to equity owners except in the event of liquidation. In addition, if our subsidiaries incur debt, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us.
22
China’s Unified Corporate Income Tax Law also imposes a withholding income tax of 10% on dividends distributed by a foreign invested enterprise to its immediate holding company outside of China, if such immediate holding company is considered as a non-resident enterprise without any establishment or place within China or if the received dividends have no connection with the establishment or place of such immediate holding company within China, unless such immediate holding company’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement.
Fluctuation in the value of the Renminbi may have a material adverse effect on your investment.
The change in value of the Renminbi against the U.S. dollar and other currencies is affected by, among other things, changes in China’s political and economic conditions. On July 21, 2005, the Chinese government changed its decade-old policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in appreciation of Renminbi against U.S. dollar. While the international reaction to the Renminbi revaluation has generally been positive, there remains significant international pressure on the Chinese government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the Renminbi against the U.S. dollar. As a portion of our costs and expenses is
denominated in Renminbi, the revaluation in July 2005 and potential future revaluation has and could further increase our costs. Any significant revaluation of the Renminbi may have a material adverse effect on our revenues and financial condition, and the value of, and any of our dividends payable on our ordinary shares in foreign currency terms.
Restrictions on currency exchange may limit our ability to receive and use our revenues effectively.
Under China’s existing foreign exchange regulations, our Chinese subsidiaries are able to pay dividends in foreign currencies without prior approval from SAFE by complying with certain procedural requirements. However, we cannot assure you that the Chinese government will not take further measures in the future to restrict access to foreign currencies for current account transactions. Foreign exchange transactions by our Chinese subsidiaries under the capital account continue to be subject to significant foreign exchange controls and require the approval of China’s governmental authorities, including the SAFE. In particular, if a subsidiary borrows foreign currency loans from us or other foreign lenders, these loans must be registered with the
SAFE, and if we finance the subsidiary by means of additional capital contributions, these capital contributions must be approved by certain government authorities including the Ministry of Commerce or its local counterparts. These limitations could affect the ability of our subsidiaries to obtain foreign exchange through debt or equity financing.
Failure to comply with PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident stockholders to personal liability, limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially adversely affect us.
23
In October 2005, the PRC State Administration of Foreign Exchange, or SAFE, issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, generally referred to as Circular 75, which required PRC residents to register with the competent local SAFE branch before establishing or acquiring control over an offshore special purpose company for the purpose of engaging in an equity financing outside of China on the strength of domestic PRC assets originally held by those residents. Internal implementing guidelines issued by SAFE, which became public in June 2007 (known as Notice 106), expanded the reach of Circular 75 by (i) purporting to cover the establishment or acquisition of control by PRC residents of offshore entities which merely acquire “control” over domestic companies or assets, even in the absence of legal ownership;
(ii) adding requirements relating to the source of the PRC resident’s funds used to establish or acquire the offshore entity; (iii) covering the use of existing offshore entities for offshore financings; (iv) purporting to cover situations in which an offshore special purpose vehicle establishes a new subsidiary in China or acquires an unrelated company or unrelated assets in China; and (v) making the domestic affiliate of the special purpose vehicle responsible for the accuracy of certain documents which must be filed in connection with any such registration, notably, the business plan which describes the overseas financing and the use of proceeds. Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations, and Notice 106 makes the offshore special
purpose vehicle jointly responsible for these filings. In the case of an special purpose vehicle which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, a retroactive SAFE registration was required to have been completed before March 31, 2006; this date was subsequently extended indefinitely by Notice 106, which also required that the registrant establish that all foreign exchange transactions undertaken by the special purpose vehicle and its affiliates were in compliance with applicable laws and regulations. Failure to comply with the requirements of Circular 75, as applied by SAFE in accordance with Notice 106, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions. Any such failure could also result in the
special purpose vehicle’s affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the special purpose vehicle, or from engaging in other transfers of funds into or out of China. We cannot provide any assurances that their existing registrations have fully complied with, and they have made all necessary amendments to their registration to fully comply with, all applicable registrations or approvals required by Circular 75. Moreover, because of uncertainty over how Circular 75 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies.
Risks Related to our Common Stock
Our stock price has been and may continue to be volatile.
The trading price of our common stock has been and is expected to continue to be highly volatile as well as subject to wide fluctuations in price in response to various factors, some of which are beyond our control. These factors include:
●
Quarterly variations in our results of operations.
●
Announcements by us or our competitors of acquisitions, new products, significant contracts, commercial relationships or capital commitments.
●
Our ability to develop and market new and enhanced products on a timely basis.
●
Changes in governmental regulations or in the status of our regulatory approvals.
●
Changes in earnings estimates or recommendations by securities analysts.
●
Market reaction to problems encountered by other Chinese companies that became public companies in the United States through the reverse merger process.
●
Market reaction to the slowdown in the Chinese wind power industry.
●
General economic conditions and slow or negative growth of related markets.
These broad market and industry factors may seriously affect the market price of our Common Stock, regardless of our actual operating performance.
Any failure to meet the Nasdaq continued listing requirements may result in our delisting.
During 2011, our stock failed to meet the Nasdaq continued listing requirement resulting from our failure to maintain a $1.00 bid price and our failure to maintain a minimum market value of publicly held common stock. In order to maintain our listing on Nasdaq we transferred our listing from the Nasdaq Global Market to the Nasdaq Capital Market, and we effected a one-for-ten reverse split. In the event that our stock price falls below $1.00 per share, we may not be able to maintain our Nasdaq listing, which could have a material adverse effect on the market for and the market price of our common stock.
24
If we fail to maintain the adequacy of our internal controls, our ability to provide accurate financial statements and comply with the requirements of the Sarbanes-Oxley Act of 2002 could be impaired, which could cause our stock price to decrease substantially.
Prior to November 2007, the Huayang Companies operated as private companies without public reporting obligations, and they committed limited personnel and resources to the development of the external reporting and compliance obligations that would be required of a public company. We are continuing to institute changes to satisfy our obligations in under the Sarbanes-Oxley Act. In Item 9A of this annual report, we report that our disclosure controls and procedures and our internal controls over financial reporting were not adequate at December 31, 2012. We are continuing to institute changes to satisfy our obligations under the Sarbanes-Oxley Act. Any failure of our internal controls or our ability to provide accurate financial statements could cause the trading price of our common stock to decrease substantially.
We do not anticipate paying any cash dividends.
We presently do not anticipate that we will pay any dividends on any of our capital stock in the foreseeable future. We presently intend to retain all earnings, if any, to implement our business plan; and we do not anticipate the declaration of any dividends in the foreseeable future.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2. PROPERTIES
Our main office and our manufacturing facilities are located in Wuxi, China, in seven buildings with approximately 215,000 square feet. We have been issued a land use right certificate for the land until June 7, 2015 by the municipal government of Wuxi City, which may be renewed at our option with no expected capital requirement. The seven buildings are an office building, warehouse, raw material processing hall, metal processing hall, assembling hall, laboratory and quality control, and guard house. We believe that our existing facilities are well maintained and in good operating condition.
In 2003, we acquired land use rights to a plot of land approximately 5.1 acres from the local government of the Town of Qianzhou in Wuxi City. This land, along with the land use rights acquired from a related party as discussed in the following paragraph, house our new factory and employee housing facilities. The land lease has a term of 50 years, expiring October 30, 2053.
During 2008, we completed the purchase of land use rights for an approximately 100,000 square foot factory, employee housing facilities and other leasehold improvements from a related party, Wuxi Huayang Boiler Company, Ltd. (“Huayang Boiler”) for approximately $10.9 million. The land use rights expire on January 1, 2053. In March 2009, we received the title to the buildings.
ITEM 3. LEGAL PROCEEDINGS.
There are no material legal proceedings pending against us.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information.
Our common stock has traded on The NASDAQ Capital Market under the symbol “CLNT” since December 29, 2011. Our stock was previously traded on The NASDAQ Global Market under the symbol “CLNT” from June 16, 2011 to December 28, 2011 and under the symbol “CWS” from December 24, 2009 until June 15, 2011. Prior to December 24, 2009, it was traded on the OTC Bulletin Board under the symbol “CHWY” from October 13, 2009 until December 23, 2009, and prior to October 13, 2009, it
was traded under the symbol “CWSI.” The following table sets forth, for the periods indicated, the reported high and low closing bid quotations for our common stock by calendar quarters during 2011 and 2012 and reflect the one-for-ten reverse split which became effective on March 16, 2012. These prices reflect inter-dealer quotations, do not include retail markups, markdowns or commissions and do not necessarily reflect actual transactions.
2011
2012
High
Low
High
Low
First quarter
$
44.70
$
30.50
$
4.00
$
1.88
Second quarter
31.40
9.20
5.71
1.98
Third quarter
11.40
4.00
3.38
2.08
Fourth quarter
$
4.60
$
2.10
$
4.86
$
2.54
On March 28, 2013, the last sale price of our common stock as reported by NASDAQ was $3.82 per share.
Shareholders
As of March 28, 2013, we had approximately 1,117 record holders of our common stock.
Transfer Agent
The transfer agent for the common stock is Empire Stock Transfer Inc. The transfer agent’s address is 1859 Whitney Mesa Dr., Henderson, Nevada89014, and its telephone number is (702) 818-5898.
Dividend Policy
We have not paid cash dividends on our common stock since we became public through reverse acquisition. We intend to keep any future earnings to finance the expansion of our business, and we do not anticipate that any cash dividends will be paid in the foreseeable future. The securities purchase agreement with the investors in the November 2007 private placement prohibits the payment of dividends on our common stock or the purchase of common stock while the series A preferred stock is outstanding.
In addition, due to various restrictions under PRC laws on the distribution of dividends by our PRC operating companies, we may not be able to pay dividends to our shareholders. The Wholly Foreign Owned Enterprise Law (1986), as amended and The Wholly Foreign Owned Enterprise Law Implementing Rules (1990), as amended and the Company Law of the PRC (2006) contain the principal regulations governing dividend distributions by wholly foreign owned enterprises. Under these regulations, wholly foreign owned enterprises may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, such companies are required to set aside a certain amount of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends except
in the event of liquidation and cannot be used for working capital purposes.
The PRC government also imposes controls on the conversion of RMB into foreign currencies and the remittance of currencies out of the PRC. Therefore, we may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency for the payment of dividends from the Company’s profits. Furthermore, if our subsidiaries and affiliates in China incur debt on their own in the future, the instruments governing the debt may restrict its ability to pay dividends or make other payments. If we or our subsidiaries and affiliates are unable to receive all of the revenues from our operations through the current contractual arrangements, we may be
unable to pay dividends on our common stock.
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Equity Compensation Plan Information
The following table summarizes the equity compensation plans under which our securities have been or may be issued as of December 31, 2012.
Plan Category
Number of
securities to
be issued upon exercise
of outstanding options
and warrants
Weighted-average
exercise price of
outstanding options and
warrants
Number of securities
remaining available for future issuance under equity compensation
plans
Equity compensation plans approved by security holders
0
$
0
52,009
Equity compensation plan not approved by security holders
0
$
0
-
The 2010 long-term incentive plan is the equity compensation plan that was approved by stockholders.
We did not have any equity compensation plans that were not approved by stockholders.
Unregistered Sales of Equity Securities and Use of Proceeds
There were no unregistered of securities that were not previously reported on a Form 10-Q or a Form 8-K during the fourth quarter of 2012.
ITEM 6. SELECTED FINANCIAL DATA
As a smaller reporting company, we are not required to provide the information called for by Item 6 of Form 10-K.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Overview
We are engaged in two business segments – the forged rolled rings and related components segment, in which we manufacture and sell high precision forged rolled rings, shafts, flanges, and other forged components for the wind power and other industries as well as equipment for the solar power industry, and the dyeing and finishing equipment segment, in which we manufacture and sell textile dyeing and finishing machines.
The following table sets forth information as to revenue of our forged rolled rings and related components and dyeing and finishing equipment segments in dollars and as a percent of revenue (dollars in thousands):
Forged Rolled Rings and Related Components Segment
Through our forged rolled rings and other related products division
●
We produce precision forged rolled rings and other forged components to the wind and other industries. Our forged rolled rings and other related products are sold for use by manufacturers of industrial equipment. Forged rolled rings and other forged components for the wind industry are used in wind turbines, which are used to generate wind power.
●
Commencing in 2011, we began to manufacture and delivered test subassemblies for solar cell manufacturing equipment, which marked our entry into the solar products market. For the years ended December 31, 2012 and 2011, we generated revenue from the sale of solar industry related products of approximately $1,078,000 and $455,000, respectively.
The demand for products used in manufacturing in general including wind power industries, is uncertain. Although we believe that over the long term, the forged rolled rings and related components segment will expand, and the government of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term other factors, such as economic factors and the fluctuations in the price of oil and coal, may affect the requirements by our customers and potential customers for our products. To the extent that the demand for our forged rolled rings and related components declines, our revenue and net income will be affected.
Chinese wind power developers posted worse-than-expected results for the first half of 2012, with grid operators increasingly reluctant to distribute the costly and unpredictable source of power amid a sharp economic downturn. China aims to expand its installed wind power generating capacity to 100 gigawatts (GW) by 2015 and to 200 GW by 2020. The country currently has 62 GW of capacity. Beijing would force grid operators to buy wind power representing 5% to 15% of their total offtake, depending on locations, Xie Changjun, president of Longyuan, the world's second-largest wind power developer, said. The quota system should underpin long-term demand for renewable energy like wind-generated electricity, but the earnings outlook for wind power developers will remain obscure for the next few years, people in the industry say. Grid construction has so far not kept up with the rise in wind power capacity. In the absence of high-voltage lines,
grid firms are unable to absorb all the wind power under their local networks.
In contrast, according to an article published by Greenpeace East Asia on September 19, 2012, in its latest edition, “China Wind Power Outlook 2012,” a report that presents a joint assessment and analysis of the wind power sector in China in 2011, including a reading of most recent policy trends made by Greenpeace, the Chinese Renewable Energy Industries Association (CREIA), and the Global Wind Energy Council (GWEC), as well as an outlook for the sector’s future development, this annual industry analysis highlights an encouraging trend in the development of the sector. In 2011, apart from the “old market” – namely the Northern, Northeastern and Northwestern areas of China (or the “Sanbei” region) that are rich in wind resources but weak on consumption power, wind power in China saw the emergence of a new market with huge potential. The overwhelming majority of accumulated
and added installment is now still focused on these regions. However, due to the long distance between the power stations and major power user markets, they continue to be plagued by grid connectivity and curtailment problems. In the meantime, a new wind power market located closer to power consumers in the central and eastern provinces has steadily become a vigorous, if not prominent, market in 2011.
We believe that this market expansion will continue into 2013, although the expansion may be slow and uneven. The key issues for the wind power sector in 2012 will be how to break the intrinsic restrictions on the traditional market and how to take the next step in promoting the emerging markets in eastern and central China as well as to develop an integrated grid system to enable the wind power generated to be made available over longer distances that at present. In 2011, China added 17.63 GW of newly installed wind power capacity, slightly less than 2010 capacity of 18.93 GW. Total installed wind capacity reached 62.36 GW. After years of rapid growth, China’s wind power market is now entering a period marked by stable growth, but it is still the global leader in terms of total installed capacity.
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In 2011, China’s wind energy sector generated 71.5 billion kilowatt hours, or 1.5% of the national total electricity output. Looking at its environmental benefits, wind power has a clear advantage: every 1 kWh generated saves 320 grams of standard coal being burned. That means in 2011 China’s wind power sector saved more than 22 million tons of coal from being burned, in total, reducing sulfur dioxide emissions by 360,000 tons, and carbon dioxide emissions by about 70 million tons. Assuming that the average Chinese household uses 1,500 kWh of electricity every year, China’s wind power sector met the electricity demands of over 47 million households in 2011.
Among all the renewable energies, we believe that wind power is at a mature stage in terms of the technology and possesses the best prospects for large-scale commercial development. We believe that it is becoming more competitive against traditional energy sources as the industry continues to grow and production costs continue to fall. We believe that wind power will see its share of China’s national energy mix gradually increase.
We sustained a decrease in revenue for forged rolled rings and related products for the wind power industry, which declined $9.8 million, or 38.0%, during the year ended December 31, 2012 as compared to the year ended December 31, 2011. We believe that the decline in our revenue of forged rolled rings and related products for the wind power industry reflects:
●
An apparent decline in the growth rate for the wind industry, following six years of growth.
●
Increased competition among Chinese turbine makers and related parts manufacturers.
●
The effects of a 2011 decision by the China central bank to tighten the monetary supply, which reduced the availability of bank financing both for owners of wind farms who require bank loans to purchase equipment and for potential purchasers of heavy equipment.
●
Decisions by turbine manufactures to establish vertically integrated operations, thus eliminating the need to purchase components from outside companies such as us.
●
A decrease in the installation of windmills due to China’s curbing of construction on land resulting in part from the situation where power-delivery grids for wind power have not matched the significant growth of available wind energy in recent years.
Dyeing and Finishing Equipment Segment
Revenue from our dyeing segment increased $7.5 million, or 42.4%, in the year ended December 31, 2012 from the year ended December 31, 2011. We believe that the increase reflects our marketing effort for our new airflow dyeing units, which use air instead of water which is used in the traditional dyeing process. We believe that our air-flow technology, which is designed to enable users to meet the stricter environmental standards, with reduced input costs, fewer wrinkles, less damage to the textile, and reduced emissions. With the growing acceptance of our new dyeing technology and the China government’s mandate to phase out obsolete machinery in China’s textile industry, we expect our revenue from this segment will continue to increase in the near future. Our gross margins from our dyeing segment increased from 22.1% for the year ended
December 31, 2011 to 23.9% for the year ended December 31, 2012.
The factors that affected our revenue, gross margin and net income in both of our segments during the year ended December 31, 2012 may continue to affect our operations in the near future. Our ability to expand our operations and increase our revenue is largely affected by the PRC government’s policy on such matters as the availability of credit, which affects all of our operations, and its policies relating to alternative energy such as wind and solar power, which affect our products for these industries. Our business is also affected by general economic conditions. Because of the nature of our products, our customers’ projection of future economic conditions are an integral part of their decisions as to whether to purchase capital equipment at this time or defer such purchases until a future date.
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Inventory and Raw Materials
A major element of our cost of revenues is raw materials, principally steel as well as other metals. These metals are subject to price fluctuations, and recently these fluctuations have been significant. In times of increasing prices, we need to try to fix the price at which we purchase raw materials in order to avoid increases in costs which we cannot recoup through increases in sales prices. Similarly, in times of decreasing prices, we may have purchased metals at prices which are high in terms of the price at which we can sell our products, which also can impair our margins. Three major suppliers provided approximately 51% of our purchases of raw materials for the year ended December 31, 2012.
During the year ended December 31, 2012, our inventory increased by approximately $1.6 million and our advance from customers was approximately $2.0 million at December 31, 2012. This increase in inventory was attributable to an increase in steel inventory to secure steel pricing for anticipated forging orders, an increase in work-in-process for dyeing machinery to meet increased customers’ orders, and an increase in inventory related to our solar products. A significant portion of the inventory increase relates to products for our solar customer, for which we received advance payments. At the request of the customer we have kept the products in our warehouse. This sale will be recognized when the last step of the sale, which is passing Chinese customs, is completed. Upon the completion of the sale, the advances from this customer will be
recognized as revenues and our inventory will be reduced by the products sold. We expect to recognize this sale in the near future.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to bad debts, inventories, recovery of long-lived assets, income taxes, and the valuation of equity transactions. We base our estimates on historical experience and on various other assumptions that we believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Any
future changes to these estimates and assumptions could cause a material change to our reported amounts of revenues, expenses, assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the financial statements.
Exchange of Warrants
On May 4, 2012, our board of directors approved a previously negotiated agreement with Barron Partners LP, dated February 7, 2012, pursuant to which Barron Partners, as the holder of warrants to purchase 55,158 shares of common stock at $12.00 per share and 165,000 shares of common stock at $16.98 per share, agreed to exchange or convert such warrants into (i) 2,201,582 shares of series A preferred stock which were convertible into 73,386 shares of common stock, and (ii) warrants to purchase 73,386 shares of this Corporation’s common stock at $2.70 per share, which was the market price of the common stock on February 7, 2012, the date the terms of the exchange were negotiated. The 2,201,582 shares of series A preferred stock were valued at the closing price of the underlying common stock on
February 7, 2012 of $2.70 per share, and we recorded it as warrant modification expense of $197,408.
As a result of the transaction, we revalued the fair market value of the original warrants by using the Black-Scholes option-pricing model. The total fair market value of the original warrants was estimated to be $52,896 on February 7, 2012. The fair market value of the newly issued exchanged warrants was estimated to be $90,621 using the Black-Scholes option-pricing model. In connection with the Black-Scholes option pricing calculation, the following weighted-average assumptions were used: stock price of $2.70; expected dividend yield 0%; risk-free interest rate of 0.15%; volatility of 139.58% and an expected term of 0.77 year. We recorded the difference between the fair market value of original warrants of $52,896 and the fair market value of exchanged warrants of $90,621 amounting to $37,725 as a warrant modification expense with a corresponding credit of additional paid-in capital in
2012.
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Variable Interest Entities
Pursuant to ASC Topic 810 and related subtopics related to the consolidation of variable interest entities, we are required to include in our consolidated financial statements the financial statements of variable interest entities (“VIEs”). The accounting standards require a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE’s residual returns. VIEs are those entities in which we, through contractual arrangements, bear the risk of, and enjoy the rewards normally associated with ownership of the entity, and therefore we are the primary beneficiary of the entity.
The Huayang Companies are considered VIEs, and we are the primary beneficiary. On November 13, 2007, we entered into agreements with the Huayang Companies pursuant to which we shall receive 100% of the Huayang Companies’ net income. In accordance with these agreements, the Huayang Companies shall pay consulting fees equal to 100% of its net income to our wholly-owned subsidiary, Green Power, and Green Power shall supply the technology and administrative services needed to service the Huayang Companies.
The accounts of the Huayang Companies are consolidated in the accompanying financial statements. As VIEs, the Huayang Companies sales are included in our total sales, their income from operations is consolidated with ours, and our net income includes all of the Huayang Companies’ net income, and their assets and liabilities are included in our consolidated balance sheets. The VIEs do not have any non-controlling interest and, accordingly, we did not subtract any net income in calculating the net income attributable to us. Because of the contractual arrangements, we have pecuniary interest in the Huayang Companies that require consolidation of the Huayang Companies financial statements with our financial statements.
Accounts Receivable
We have a policy of reserving for uncollectible accounts based on our best estimate of the amount of probable credit losses in our existing accounts receivable. We periodically review our accounts receivable to determine whether an allowance is necessary based on an analysis of past due accounts and other factors that may indicate that the realization of an account may be in doubt. Account balances deemed to be uncollectible are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.
As a basis for estimating the likelihood of collection has been established, we consider a number of factors when determining reserves for uncollectable accounts. We believe that we use a reasonably reliable methodology to estimate the collectability of our accounts receivable. We review our allowances for doubtful accounts on at least a quarterly basis. We also consider whether the historical economic conditions are comparable to current economic conditions. If the financial condition of our customers or other parties that we have business relations with were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Inventories
Inventories, consisting of raw materials, work-in-process and finished goods, are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, we will record additional reserves for the difference between the cost and the market value. These reserves are recorded based on estimates. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory, if necessary. If the results of the review determine that a write-down is necessary, we recognize a loss in the period in which the loss is identified, whether or not the inventory is retained. Our inventory reserves establish a new cost basis for inventory and are not reversed until we sell or dispose
of the related inventory. Such provisions are established based on historical usage, adjusted for known changes in demands for such products, or the estimated forecast of product demand and production requirements.
Advances to Suppliers
Advances to suppliers represent the cash paid in advance for the purchase of raw material from suppliers. The advance payments are intended to ensure preferential pricing and delivery.
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Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are as follows:
Useful Life
Building and building improvements
20
Years
Manufacturing equipment
5 – 10
Years
Office equipment and furniture
5
Years
Vehicle
5
Years
The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in disposition.
Included in property and equipment is construction-in-progress which consists of factories and office buildings under construction and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use.
We examine the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable. We recognize an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.
Equipment Held for Sale
Long-lived assets are classified as held for sale when certain criteria are met. These criteria include: management’s commitment to a plan to sell the assets; the availability of the assets for immediate sale in their present condition; an active program to locate buyers and other actions to sell the assets has been initiated; the sale of the assets is probable and their transfer is expected to qualify for recognition as a completed sale within one year; the assets are being marketed at reasonable prices in relation to their fair value; and it is unlikely that significant changes will be made to the plan to sell the assets. We measure long-lived assets to be disposed of by sale at the lower of carrying amount or fair value, less associated costs to sell. At December 31, 2012, we reflected certain electro-slag re-melted (“ESR”) equipment that was used to produce forged products
for the high performance components market as equipment held for sale on the accompanying consolidated balance sheet.
Land Use Rights
There is no private ownership of land in the PRC. All land in the PRC is owned by the government and cannot be sold to any individual or company. The government grants a land use right that permits the holder of the land use right to use the land for a specified period. Our land use rights were granted with a term of 45 or 50 years. Any transfer of the land use right requires government approval. We have recorded as an intangible asset the costs paid to acquire a land use right. The land use rights are amortized on the straight-line method over the land use right terms.
Revenue Recognition
We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. We recognize revenue from the sale of dyeing and finishing equipment upon shipment and transfer of title. The other elements may include installation and generally a one-year warranty.
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Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally close to the date of delivery of the equipment. For the years ended December 31, 2012 and 2011, the amounts allocated to installation revenues were minimal.
Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period. For the years ended December 31, 2012 and 2011, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.
All other product sales, including the forged rolled rings, with customer specific acceptance provisions, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.
Research and Development
Research and development costs are expensed as incurred. We incurred minimal research and development expenses in the years ended December 31, 2012 and 2011. Product development expenses, which primarily consist of cost of material used and salaries paid for the development of our products and fees paid to third parties, are included in general and administrative expenses.
Income Taxes
We are governed by the income tax laws of the PRC and the United States. Income taxes are accounted for pursuant to accounting standards, which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. The charge for taxes is based on the results for the year as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.
Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit. In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probably that taxable profit will be available against which deductible temporary differences can be utilized.
Deferred tax is calculated using tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it is related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity. Deferred tax assets and liabilities are offset when they related to income taxes levied by the same taxation authority and we intend to settle its current tax assets and liabilities on a net basis.
Stock-based Compensation
Stock based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award. The Accounting Standards Codification also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.
Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the period of services or the vesting period, whichever is applicable. Until the measurement date is reached, the total amount of compensation expense remains uncertain. We record compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated based on the then current fair value, at each subsequent reporting date.
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Recent Accounting Pronouncements
In August 2012, the FASB issued Accounting Standards Update (“ASU”) 2012-03, “Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (SAB) No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB Accounting Standards Update 2010-22 (SEC Update)” in Accounting Standards Update No. 2012-03. This update amends various SEC paragraphs pursuant to the issuance of SAB No. 114. The adoption of ASU 2012-03 is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.
In October 2012, the FASB issued ASU 2012-04, “Technical Corrections and Improvements” in Accounting Standards Update No. 2012-04 ("ASU 2012-04"). The amendments in this update cover a wide range of topics in the Accounting Standards Codification. These amendments include technical corrections and improvements to the Accounting Standards Codification and conforming amendments related to fair value measurements. The amendments in this update will be effective for fiscal periods beginning after December 15, 2012. The adoption of ASU 2012-04 is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.
Other accounting standards that have been issued or proposed by FASB that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption. We do not discuss recent pronouncements that are not anticipated to have an impact on or are unrelated to our financial condition, results of operations, cash flows, or disclosures.
Currency Exchange Rates
Our functional currency is the U.S. dollar, and the functional currency of our operating subsidiaries and VIEs is the RMB. All of our sales are denominated in RMB. As a result, changes in the relative values of U.S. dollars and RMB affect our reported levels of revenues and profitability as the results of our operations are translated into U.S. dollars for reporting purposes. In particular, fluctuations in currency exchange rates could have a significant impact on our financial stability due to a mismatch among various foreign currency-denominated sales and costs. Fluctuations in exchange rates between the U.S. dollar and RMB affect our gross and net profit margins and could result in foreign exchange and operating losses.
Our exposure to foreign exchange risk primarily relates to currency gains or losses resulting from timing differences between signing of sales contracts and settling of these contracts. Furthermore, we translate monetary assets and liabilities denominated in other currencies into RMB, the functional currency of our operating subsidiaries. Our results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in our statement of shareholders’
equity. We have not used any forward contracts, currency options or borrowings to hedge our exposure to foreign currency exchange risk. We cannot predict the impact of future exchange rate fluctuations on our results of operations and may incur net foreign currency losses in the future.
Our financial statements are expressed in U.S. dollars, which is the functional currency of our parent company. The functional currency of our operating subsidiaries and affiliates is RMB. To the extent we hold assets denominated in U.S. dollars, any appreciation of the RMB against the U.S. dollar could result in a charge in our statement of operations and a reduction in the value of our U.S. dollar denominated assets. On the other hand, a decline in the value of RMB against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results.
The following table sets forth the results of our operations for the years ended December 31, 2012 and 2011 indicated as a percentage of net revenues (dollars in thousands):
The following table sets forth information as to the gross margin for our two business segments for the years ended December 31, 2012 and 2011 (dollars in thousands).
Revenues. For the year ended December 31, 2012, we had revenues of $57,199,000, as compared to revenues of $55,579,000 for the year ended December 31, 2011, an increase of approximately 2.9%. The increase in revenue was attributable to the increase in revenue from our forged rolled rings and related products for other industries and the increase in revenue from dyeing segment, offset by the decrease in revenue from our forged rolled rings and related products for wind power industry, and was summarized as follows (dollars in thousands):
Although we saw an increase of $3.9 million or 32.0% in revenues from the sale of forged rolled rings and related products to other industries, including revenues generated from our solar products, for 2012, revenue from forged rolled rings and related products for the wind power industry decreased by $9.8 million or 38.0% as compared to 2011.
The decrease in revenue from forging of rolled rings and related products for wind power industry for 2012 as compared to 2011 was primarily attributable to:
●
An apparent decline in the market for capital equipment, including products for the wind power industry, as well as the reduced demand for wind power products and the difficulties facing the wind power industry in China as discussed under “Industry Outlook”. Although we have been experiencing a decrease in the sale of forged products during 2012, we believe that, on a long-term basis, the demand for forged products in the wind industry in China will continue. As discussed in our industry outlook, the Chinese government has reported that it is still committed to the development of alternative energy sources, including wind power.
●
Notwithstanding the Chinese government’s commitment to wind power development, the ability and willingness of manufacturing companies and wind power companies to purchase equipment was affected by a 2011 decision by the China central bank to tighten the monetary supply, which reduced the availability of bank financing both for owners of wind farms who require bank loans to purchase equipment and for potential purchasers of heavy equipment.
●
Decisions by turbine manufactures to establish vertically integrated operations, thus eliminating the reducing the potential market for our wind power products.
●
The cancellation in 2012 by government of China of a number of preferential policies for forged rolled rings and related products for wind power industry, such as government’s subsidies and tax rebates.
The demand for products such as ours which are used for wind power specifically is uncertain. We believe that over the long term, our forged rolled rings and related components for wind power industry will expand since the government of the PRC has announced its desire to increase the use of wind power as an energy source. We are currently seeking to expand into other industries including oil and natural gas, although we can give no assurances that the expansion will be successful.
The increase in revenue from forging of rolled rings and related products for other industries was primarily attributable to our increased sales efforts.
In 2011, we began to manufacture and delivery test subassemblies for solar cell manufacturing equipment, which marked our entry into the solar products market. This equipment is being marketed and manufactured in our forged rolled rings segment. We are seeking to use our technical knowledge to manufacture and market solar components used in production of multi crystalline and mono crystalline silicon wafers. Solar industry capabilities include the manufacture of complex pressure vessels and chamber, high temperature vessels, and thick-walled vessels. For 2012 and 2011, we generated revenue from the sale of solar industry related products of approximately $1,078,000 and $455,000, respectively. Additionally, at December 31, 2012, we have deposits from our international solar customer amounting to $1,591,000.
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Dyeing and finishing equipment segment
The increase in revenue from the sale of dyeing and finishing equipment was primarily attributable to the effects of the policies of the PRC local governments to encourage the purchase of low-emission airflow dyeing machine which are intended to reduce pollution from the dyeing process. With the growing acceptance of our new dyeing technology and the China government’s mandate to phase out obsolete machinery in China’s textile industry, we expect our revenue from this segment will continue to increase in the near future.
Cost of revenues. Cost of revenues includes the cost of raw materials, labor, depreciation and other overhead costs. For 2012, cost of revenues was $44,063,000 as compared to $42,276,000 for 2011, an increase of $1,787,000, or 4.2%. Cost of revenues related to the manufacture of forged rolled rings and related products was $24,852,000 for 2012 as compared to $28,469,000 for 2011. Cost of revenues for the dyeing and finishing equipment segment was $19,211,000 for 2012, as compared to $13,807,000 for 2011.
Gross profit and gross margin. Our gross profit was $13,136,000 for 2012 as compared to $13,303,000 for 2011, representing gross margins of 23.0% and 23.9%, respectively.
Gross profit from forged rolled rings and related products segment was $7,089,000 for 2012 as compared to $9,377,000 for 2011, representing gross margins of approximately 22.2% and 24.8%, respectively. The decrease in our gross margin for the forged rolled rings and related products segment for 2012 as compared to 2011 was mainly attributed to the decline in operational and cost efficiencies, including the allocation of fixed costs primarily consisting of depreciation, to cost of revenues as we operated at lower production levels. We expect that we can improve our gross margin from forged rolled rings and related products segment to the extent that we can become more efficient and be able to produce larger quantities for inventory and revenues.
Gross profit for the dyeing and finishing equipment segment was $6,047,000 for 2012 as compared to $3,926,000 for 2011, representing gross margins of approximately 23.9% and 22.1%, respectively. For 2012, the significant portion of our revenue for the dyeing and finishing equipment segment is from airflow dyeing machinery. For 2011, the primary portion of our revenue for the dyeing and finishing equipment segment is from traditional dyeing machinery. Our airflow dyeing machinery uses air flow rather than water which is used in the traditional dyeing process. The technology used in airflow machinery results in reduced input costs, fewer wrinkles, less damage to the textile and reduced emissions. Our unit sale price for airflow dyeing machinery is a little higher than our unit sale price for traditional dyeing machinery, and our gross margins for the dyeing and finishing equipment segment for 2012 increased from 2011.
Depreciation. Depreciation was $6,519,000 and $5,351,000 for 2012 and 2011, respectively. Depreciation for 2012 and 2011 was included in the following categories (dollars in thousands):
The increase in depreciation expense for cost of revenues is attributable to the increase in our depreciable production equipment.
During 2012, we recorded depreciation expense related to ESR production equipment in operating expenses (rather than in cost of revenues) since we did not perform any production for ESR products and we did not use the equipment in 2012. During the first quarter of 2011, we recorded depreciation expense related to ESR production equipment in cost of revenues since we generated production activities for ESR products in the first quarter of 2011 and we recorded depreciation expense related to ESR equipment in operating expense in the rest of 2011. Accordingly, for 2012, depreciation included in operating expenses increased by approximately $423,000 as compared to 2011.
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Impairment loss. During the year ended December 31, 2012, we recognized $2,206,000 of impairment charge as a result of writing down the carrying value of equipment to its estimated fair value based on an impairment assessment conducted on the equipment held for sale at December 31, 2012. We did not record any impairment loss during the year ended December 31, 2011.
Selling, general and administrative expenses. Selling, general and administrative expenses totaled $3,051,000 for 2012, as compared to $4,008,000 for 2011, a decrease of $957,000 or approximately 23.9%.
Selling, general and administrative expenses for 2012 and 2011 consisted of the following (dollars in thousands):
Professional fees for 2012 decreased by $61,000, or 15.6%, as compared to 2011. The decrease was primarily attributable to a decrease in fees incurred and paid for investor relations of approximately $32,000 and a decrease in other miscellaneous service fees of approximately $29,000.
●
For 2012, we had a net bad debt recovery of approximately $47,000, while for 2011, we had bad debt expense of approximately $720,000. Based on our periodic review of accounts receivable balances, we adjusted the allowance for doubtful accounts after considering management’s evaluation of the collectability of individual receivable balances, including the analysis of subsequent collections, the customers’ collection history, and recent economic events.
●
Payroll and related benefits for 2012 decreased by $103,000, or 13.2%, as compared to 2011. The decrease was mainly attributable to a decrease in stock-based compensation of approximately $196,000 which reflected a drop in our average stock price used to value shares issued as compensation during 2012 as compared to 2011, offset by an increase in compensation and related benefits of approximately $93,000 in our forged rolled rings and related products segment and dyeing and finishing equipment segment resulting from increased salaries incurred and paid to management.
●
Travel and entertainment expense for 2012 decreased by $47,000, or 18.9%, as compared to 2011. The decrease for 2012 is primarily related to the decrease in travel for investor road shows and conferences.
●
Shipping expense for 2012 decreased by $67,000, or 5.6%, as compared to 2011 as a result of export sales in 2012. Approximately 7% of our 2012 sales by our forged rolled rings and related products segment were export sales, on which we were not responsible for shipping charges. We did not have any significant export sales in 2011.
●
Other selling, general and administrative expenses for 2012 increased by $88,000, or 13.0% as compared to 2011. The increase was primarily attributable to the payment of Delaware franchise taxes in March 2012 of approximately $67,000 for fiscal years of 2011 and 2010 which had not been previously accrued, and an increase in other miscellaneous items of approximately $21,000.
Income from operations. For 2012, income from operations amounted to $6,344,000, as compared to $8,183,000 for 2011, a decrease of $1,839,000 or 22.5% primarily as a result of the impairment loss described above.
Other income (expense). Other income (expense) includes interest expense, nominal foreign currency transaction gain, warrant modification expense, interest income and other income. For 2012, total other expense amounted to $444,000 as compared to $82,000 for 2011, an increase of $362,000. The increase was primarily attributable to the warrant modification expense of approximately $235,000 and an increase in interest expense of approximately $112,000 attributable to an increase in debt and capital lease obligations.
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Income tax expense. Income tax expense was $1,701,000 for 2012, as compared to $2,340,000 for 2011, a decrease of $639,000, or 27.3%. The decrease in income tax expense was attributable to the decrease in taxable income generated by our operating entities.
Net income. As a result of the foregoing, our net income was $4,199,000, or $1.65 per share (basic) and $1.58 per share (diluted), for 2012, as compared with $5,761,000, or $2.94 per share (basic) and $2.30 per share (diluted), for 2011, a decrease of $1,562,000 or 27.1%.
Foreign currency translation gain. The functional currency of our subsidiaries and variable interest entities operating in the PRC is the Chinese Yuan or Renminbi (“RMB”). The financial statements of our subsidiaries are translated to U.S. dollars using period end rates of exchange for assets and liabilities, and average rates of exchange (for the period) for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations. As a result of these translations, which are a non-cash adjustment, we reported a foreign currency translation gain of $543,000 for 2012, as compared to $2,549,000 for 2011. This non-cash gain had the effect
of increasing our reported comprehensive income.
Comprehensive income. As a result of our foreign currency translation gains, we had comprehensive income for 2012 of $4,742,000, compared to $8,310,000 for 2011.
Liquidity and Capital Resources
Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations and otherwise operate on an ongoing basis. At December 31, 2012 and 2011, we had cash balances of approximately $1,446,000 and $1,153,000, respectively. These funds are located in financial institutions located as follows (dollars in thousands):
The following table sets forth information as to the principal changes in the components of our working capital from December 31, 2011 to December 31, 2012 (dollars in thousands):
Accounts receivable, net of allowance for doubtful accounts
10,079
7,088
2,991
42.2
%
Inventories, net of reserve for obsolete inventory
5,898
4,276
1,622
37.9
%
Advances to suppliers
593
219
374
170.4
%
Prepaid value-added taxes on purchase
542
1,512
(970
)
(64.2
)%
Prepaid expenses and other current assets
428
111
317
287.0
%
Current liabilities:
Short-term bank loans
2,217
2,357
(140
)
(5.9
)%
Bank acceptance notes payable
-
314
(314
)
(100.0
)%
Accounts payable
5,474
4,997
477
9.6
%
Accrued expenses
987
772
215
27.9
%
Capital lease obligations – current portion
251
245
6
2.7
%
Advances from customers
1,852
1,167
685
58.7
%
VAT and service taxes payable
207
-
207
100.0
%
Income taxes payable
822
592
230
38.8
%
Working capital:
Total current assets
$
19,074
$
14,727
$
4,347
29.5
%
Total current liabilities
11,810
10,444
1,366
13.1
%
Working capital:
$
7,264
$
4,283
$
2,981
69.6
%
39
Our working capital increased $2,981,000 to $7,264,000 at December 31, 2012 from $4,283,000 at December 31, 2011. This increase in working capital is primarily attributable to an increase in cash and cash equivalents of approximately $293,000, an increase in accounts receivable, net of allowance for doubtful accounts, of approximately $2,991,000 due to the increase in revenues during 2012, an increase in inventories, net of reserve for obsolete inventory, of approximately $1,622,000, an increase in advances to suppliers of approximately $374,000, an increase in prepaid expenses and other current assets of approximately $317,000, a decrease in short-term bank loans of approximately $140,000, a decrease in bank acceptance notes payable of approximately $314,000, offset by a decrease in restricted cash of approximately $314,000,
a decrease in prepaid VAT on purchases of approximately $970,000, an increase in accounts payable of approximately $477,000, an increase in accrued expenses of approximately $215,000, an increase in advances from customers of approximately $685,000, an increase in VAT and service taxes payable of approximately $207,000, an increase in income taxes payable of approximately $230,000.
Net cash flow provided by operating activities was $10,635,000 for 2012 as compared to $10,448,000 for 2011, an increase of $187,000. Because the exchange rate conversion is different for the balance sheet and the statements of cash flows, the changes in assets and liabilities reflected on the statements of cash flows is not necessarily identical with the comparable changes reflected on the balance sheet.
Net cash flow provided by operating activities for 2012 was mainly due to:
●
net income of $4,199,000 and the add-back of non-cash items primarily including depreciation of $6,519,000, the amortization of land use rights of $94,000, loss on impairment of equipment of $2,206,000, the warrant modification expense of $235,000, and stock-based compensation of $168,000, and,
●
changes in operating assets and liabilities such as: a decrease in prepaid value-added taxes on purchases of $981,000, an increase in accounts payable of $439,000, an increase in accrued expenses of $210,000, an increase in VAT and service taxes payable of $206,000, an increase in advances from customers of $676,000,
offset by:
●
an increase in accounts receivable of $2,888,000, an increase in inventories of $1,550,000, an increase in advance to suppliers of $372,000 and a decrease in income tax payable of $326,000.
Net cash flow provided by operating activities for 2011 was mainly due to:
●
net income of $5,761,000 and the add-back of non-cash items, such as depreciation of $5,351,000, amortization of land use rights of $91,000, the increase in allowance for doubtful accounts of $720,000 and stock-based compensation expense of $356,000, and,
●
changes in operating assets and liabilities, including a decrease in accounts receivable of $694,000 due to a reduction in revenues, a decrease in prepaid VAT taxes on purchases of $1,332,000 related to the netting of current VAT against amounts prepaid, a decrease in advances to suppliers of $125,000, an increase in accrued expenses of $224,000, an increase in advances from customers of $906,000 primarily related to deposits on future solar equipment orders, offset by an increase in inventories of $761,000 primarily related to future solar equipment orders, a decrease in accounts payable of $3,425,000 and a decrease in income taxes payable of $778,000.
40
Net cash flow used in investing activities, which reflected the purchase of property and equipment of $10,744,000 and $11,116,000 for 2012 and 2011, respectively.
We finance our working capital requirements with short term bank loans. As a result, our cash from financing activities typically reflects these borrowings and repayments. See Note 7 of Notes to Consolidated Financial Statements. Net cash flow provided by financing activities was $406,000 for 2012 as compared to net cash flow provided by financing activities $832,000 for 2011. During 2012, we received proceeds from bank loans of $3,481,000, offset by repayments of bank loans of $3,639,000, proceeds from decrease in restricted cash of $316,000, proceeds from sale of common stock – related parties of $613,000, and proceeds from exercise of warrants of $198,000, offset by the repayments of principal on capital lease obligations of $246,000 and decrease in bank acceptance notes payable of $316,000. During 2011, we received proceeds from loans of $4,325,000, proceeds from sale of common stock of $125,000, proceeds from exercise of common stock
warrants of $400,000 and made repayment of bank loans of $3,862,000 and repayments of principal on capital lease obligations of $157,000.
Our capital requirements for the next twelve months relate to purchasing machinery for the manufacture of products for the solar industry as well as additional investment in our forged rolled rings division. We also expect to incur modest expenses in maintaining our dyeing business. We believe that our cash flow from operations will be sufficient to meet our anticipated cash requirements for the next twelve months.
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual Obligations
We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows. The following tables summarize our contractual obligations as of December 31, 2012 (dollars in thousands), and the effect these obligations are expected to have on our liquidity and cash flows in future periods.
Payments Due by Period
Contractual obligations:
Total
Less than 1 year
1-3 years
3-5 years
5+ years
Bank loans (1)
$
2,217
$
2,217
$
-
$
-
$
-
Capital lease obligations (2)
384
251
133
-
-
Total
$
2,601
$
2,468
$
133
$
-
$
-
(1)
Bank loans consisted of short term bank loans. Historically, we have refinanced these bank loans for an additional term of one year and we expect to continue to refinance these loans upon expiration.
(2)
Capital lease obligations include the interest portion, security deposit due and present value of net minimum lease payment.
41
Off-balance Sheet Arrangements
We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.
Foreign Currency Exchange Rate Risk
We produce and sell almost all of our products in China. Thus, most of our revenues and operating results may be impacted by exchange rate fluctuations between RMB and US dollars. For 2012, we had unrealized foreign currency translation gain of $543,415, because of the change in the exchange rate.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable for smaller reporting companies
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements begin on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not Applicable.
ITEM 9A. CONTROLS AND PROCEDURES.
Disclosure Controls and Procedures
As required by Rule 13a-15 under the Exchange Act, our management, including Jianhua Wu, our chief executive officer, and Adam Wasserman, our chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2012.
Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating and implementing possible controls and procedures.
Management conducted its evaluation of disclosure controls and procedures under the supervision of our chief executive officer and our chief financial officer. Based on that evaluation, Mr. Wu and Mr. Wasserman concluded that our disclosure controls and procedures were not effective as of December 31, 2012.
42
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act. Our management is also required to assess and report on the effectiveness of our internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2012. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. During our assessment of the effectiveness of internal control over financial reporting as of December 31, 2012, management identified significant deficiencies
related to (i) the U.S. GAAP expertise of our internal accounting staff, (ii) our internal audit functions and (iii) a lack of segregation of duties within accounting functions. Although management believes that these deficiencies do not amount to a material weakness, our internal controls over financial reporting were not effective at December 31, 2012.
A major hurdle of our internal control efforts was the segregation of duties and installation of a company-wide Enterprise Resource Planning (“ERP”) system which are important parts of a good internal control system. During 2012, due to both our financial performance and working capital requirements, and the lack of local professionals with the necessary experience in implementing the ERP system, we postponed the hiring of professional staff to implement ERP system. We have found that engaging professionals who are based outside of Wuxi is very costly and we have not been able to find qualified personnel in the Wuxi area.
We plan on expanding our ERP system in 2013 by implementing further ERP modules to manage inventory and to expand existing ERP systems to other areas of our factory.
Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. As a result, we have not been able to take steps to improve our internal controls over financial reporting during 2012. However, to the extent possible, we are implementing procedures to assure that the initiation of transactions, the custody of assets and the recording of transactions will be performed by separate individuals.
A material weakness (within the meaning of PCAOB Auditing Standard No. 5) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.
In light of this significant deficiency, we performed additional analyses and procedures in order to conclude that our financial statements for the year ended December 31, 2012 included in this Annual Report on Form 10-K were fairly stated in accordance with GAAP. Accordingly, management believes that despite our significant deficiency, our consolidated financial statements for the year ended December 31, 2012 are fairly stated, in all material respects, in accordance with GAAP.
Auditor Attestation
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.
Changes in Internal Controls over Financial Reporting
There were no changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
None.
43
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCES
3 Member of the corporate governance/ nominating committee.
Jianhua Wu has been our chief executive officer, chairman and a director since the completion of the reverse acquisition in November 2007. Mr. Wu founded our predecessor companies, Wuxi Huayang Dyeing Machinery Co., Ltd. and Wuxi Huayang Electrical Power Equipment Co., Ltd., in 1995 and 2004, respectively, and was executive director and general manager of these companies prior to becoming our chief executive officer. Mr. Wu is a certified mechanical engineer. Mr. Wu is qualified to serve as a director because of his experience with us as our chief executive officer.
Adam Wasserman has been our chief financial officer since December 10, 2012. Mr. Wasserman served as our vice president of financial reporting from 2008 until his appointment as chief financial officer in December 2012. Mr. Wasserman is chief executive officer for CFO Oncall, Inc. and CFO Oncall Asia, Inc. (collectively “CFO Oncall”), in both of which he is the controlling stockholder. CFO Oncall provides chief financial officer services to various companies. Currently, Mr. Wasserman also serves as the chief financial officer of Oriental Dragon Corp, a position he has held since June 2010, Apps Genius Corp since January 2011, Yew Bio-Pharm Group, Inc. since September 2011, Universal Tech Corp since November 2012 and Wally World Media, Inc. since November 2012. Mr. Wasserman also served as chief financial
officer for Gold Horse International, Inc. from July 2007 to September 2011, Transax International Limited from May 2005 to December 2011, and other companies all under the terms of consulting agreements with CFO Oncall. Mr. Wasserman holds a bachelor of science from the State University of New York at Albany. He is a member of The American Institute of Certified Public Accountants, is a director, treasurer and an executive board member of Gold Coast Venture Capital Association.
Tianxiang Zhou has been a director since July 2010. Mr. Zhou served as lead engineer in Wuxi Angyida Mechanism Limited Company since 2004. From 1998 to 2004, he was general engineer in Wuxi Huayang Dye Machinery Equipment Limited. From 1994 to 1998 Mr. Zhou worked for Wuxi Chemicals Holdings as chief engineer of its design division. Mr. Zhou received his bachelor degree in engineering from Nanjing Institute of Chemical Technology in August 1961. Mr. Zhou’s engineering background and his experience in the manufacturing business are important qualifications for his service as a director.
Xi Liu has been a director since November 2007. Mr. Liu has an extensive background in material engineering, being a 1989 graduate of Jiangsu University of Technology with a degree in metal material and heat treatment, and having been trained at the Volvo facilities in Penta, Sweden in 1999. Immediately after graduating from university, Mr. Liu worked at China FAW Group Corporation, the oldest and one of largest Chinese automakers, as an engineer, before leaving in 2005 as an assistant manager in the purchasing department of the Wuxi Diesel Engine Works plant. He then joined WAM Bulk Handling Machinery (Shanghai) Co., Ltd., part of the Italian industrial giant WAMGROUP, as a purchasing and sourcing manager, which is his current position. Mr. Liu’s background in engineering and his practical industrial experience is important to us as we plan and develop our business.
Baowen Wang has been a director since July 2012. Mr. Wang works as a senior engineer at the National 559th factory research center, a state-owned precision optical research center, a position he has held since 2005, when he retired as head of the Wuxi HuGuang Instrument Research Institute, a position he has held since 1979. Mr. Wang graduated from NanJing University, majoring in weather station and radar. Mr. Wang’s background in engineering and his practical industrial experience is important to us as we plan and develop our business.
44
Furen Chen has been a director since July 2012. Mr. Chen is general manger and chairman of the board of Wuxi City ZhengCheng Accounting Services, Ltd., a position he has held since February 2000. From 1990 until February 2000, Mr. Chen was accounting manager at Qian Zhou Agricultural Financial Co., Ltd. Mr. Chen is a certified public accountant in China. Mr. Chen’s finance and accounting experience background is important to us as we improve our financial accounting controls.
Committees
Our business, property and affairs are managed by or under the direction of the board of directors. Members of the board are kept informed of our business through discussion with the chief executive and financial officers and other officers, by reviewing materials provided to them and by participating at meetings of the board and its committees.
Our board of directors has three committees - the audit committee, the compensation committee and the corporate governance/nominating committee. The audit committee is comprised of Baowen Wang, Xi Liu and Furen Chen, with Mr. Baowen Wang serving as chairman. The compensation committee is comprised of Tianxiang Zhou, Baowen Wang and Furen Chen, with Mr. Tianxiang
Zhou as chairman. The corporate governance/nominating committee is comprised of Xi Liu, Baowen Wang, and Tianxiang Zhou, with Mr. Xi Liu as chairman.
Our audit committee is involved in discussions with our independent auditor with respect to the scope and results of our year-end audit, our quarterly results of operations, our internal accounting controls and the professional services furnished by the independent auditor. Our board of directors has adopted a written charter for the audit committee which the audit committee reviews and reassesses for adequacy on an annual basis.
The compensation committee oversees the compensation of our chief executive officer and our other executive officers and reviews our overall compensation policies for employees generally. If so authorized by the board of directors, the committee may also serve as the granting and administrative committee under any option or other equity-based compensation plans which we may adopt. The compensation committee does not delegate its authority to fix compensation; however, as to officers who report to the chief executive officer, the compensation committee consults with the chief executive officer, who may make recommendations to the compensation committee. Any recommendations by the chief executive officer are accompanied by an analysis of the basis for the recommendations. The committee will also discuss compensation policies for employees who are not officers with the chief executive officer and other responsible officers. We are in the process
of amending our compensation committee charter to meet the requirements of Nasdaq. We will include provisions which give the compensation committee specific responsibilities and authority relating to the retention, compensation, oversight and funding of compensation consultants, legal counsel and other compensation advisers, as well as the requirement to consider six independence factors before selecting, or receiving advice from, such advisers. We expect to have the amended charter in place prior to July 1, 2013, when we are required by Nasdaq to have these provisions in effect.
The corporate governance/nominating committee is involved in evaluating the desirability of and recommending to the board any changes in the size and composition of the board, evaluation of and successor planning for the chief executive officer and other executive officers. The qualifications of any candidate for director will be subject to the same extensive general and specific criteria applicable to director candidates generally.
The board and its committees held the following number of meetings during 2012:
Board of directors
4
Audit committee
4
Compensation committee
0
Nomination committee
0
The meetings include meetings that were held by means of a conference telephone call, but do not include actions taken by unanimous written consent.
45
Each director attended at least 75% of the total number of meetings of the board and those committees on which he served during the year.
Our non-management directors did not meet in executive session during 2012.
Compensation Committee Interlocks and Insider Participation
Aside from his/her service as director, no member of our compensation committee had any relationship with us as of December 31, 2012. Except for Adam Wasserman, our chief financial officer, none of our executive officers served as a director or compensation committee member of another entity.
Section 16(a) Compliance
Section 16(a) of the Securities Exchange Act of 1934, requires our directors, executive officers and persons who own more than 10% of our common stock to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other of our equity securities. During the year ended December 31, 2012, Mr. Chen and Mr. Wang were delinquent in making Form 4 filings.
ITEM 11. EXECUTIVE COMPENSATION.
The following summary compensation table indicates the cash and non-cash compensation earned during the years ended December 31, 2012 and 2011 by each person who served as chief executive officer and chief financial officer. No other executive officer received compensation equal or exceeding $100,000.
Mr. Wu’s 2012 compensation consisted of salary of $23,735 and 10,000 shares of common stock, valued at $28,000. Mr. Wu’s 2011 compensation consisted of 4,800 shares of common stock, valued at $98,740.
(2)
Mr. Wasserman has been our chief financial officer since December 2012. Mr. Wasserman served as our vice president of financial reporting from 2008 until his appointment as chief financial officer in December 2012. Mr. Wasserman’s compensation is paid to CFO Oncall Inc. where he serves as chief executive officer. Mr. Wasserman’s 2012 compensation included salary of $42,556 and 9,634 shares of common stock, valued at $28,051. Mr. Wasserman’s 2011 compensation included salary of $42,000 and 1,500 shares of common stock, valued at $12,220.
(3)
Ms. Xu served as our chief financial officer since March 2012 and she resigned in December 2012. Ms. Xu served as the financial controller of Electrical and Dyeing from 2009 until her appointment as chief financial officer in March 2012. Ms. Xu’s 2012 compensation was salary of $6,685 and her 2011 compensation was salary of $5,969.
(4)
Mr. Liu served as our chief financial officer during 2011 and he resigned in December 2011. Mr Liu’s 2011 compensation included salary of $77,238 and 3,000 shares of common stock, valued at $59,700. Mr. Liu served as our consultant during 2012 and his 2012 compensation was 6,800 shares of common stock, valued at $19,040.
46
Employment Agreement
Pursuant to an employment agreement dated December 10, 2012, Adam Wasserman receives compensation at the annual rate of $52,000. In addition, Mr. Wasserman was granted 19,603 shares of common stock pursuant to our long-term incentive plan. The agreement has a term commencing December 10, 2012 through March 31, 2014.
Compensation of Directors
Except for Mr. Li, we do not have any agreements or formal plan for compensating our directors for their service in their capacity as directors, although our board may, in the future, award stock options to purchase shares of common stock to our directors. For services as a director, we paid Mr. Li an annual fee of $6,000, payable quarterly, and in 2011, we issued to Mr. Li 438 shares of common stock, which represents $6,000 divided by the closing price of our common stock on the date of his election.
The following table provides information concerning the compensation of each member of our board of directors whose compensation is not included in the Summary Compensation Table for his or her services as a director and committee member for 2012. The value attributable to any stock grants is computed in accordance with ASC Topic 718.
Mr. Bernstein was a director during a portion of 2012.
(2)
Mr. Li was a director during a portion of 2012.
2010 Long-Term Incentive Plan
In January 2010, the board of directors adopted, and in March 2010, the stockholders approved the 2010 long-term incentive plan, covering 200,000 shares of common stock. The 2010 plan provides for the grant of incentive and non-qualified options and stock grants to employees, including officers, directors and consultants. The 2010 plan is to be administered by a committee of not less than three directors, each of whom is to be an independent director. In the absence of a committee, the plan is administered by the board of directors. The board has granted the compensation committee the authority to administer the 2010 plan. Members of the committee are not eligible for stock options or stock grants pursuant to the 2010 plan unless such stock options or stock grant are granted by a majority of our independent directors other than the proposed grantee. As of December 31, 2012, the
Company had issued a total of 147,991 shares of common stock pursuant to this plan.
47
The following table sets forth information as options outstanding on December 31, 2012.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The following table provides information as to shares of common stock beneficially owned as of March 28, 2013, by:
●
each current director;
●
each current officer named in the summary compensation table;
●
each person owning of record or known by us, based on information provided to us by the persons named below, to own beneficially at least 5% of our common stock; and
●
all current directors and executive officers as a group.
All current officers and directors as a group (two persons owning stock)
818,564
28.3
%
* less than 1%.
(1)
Jianhua Wu and Lihua Tang, who are husband and wife, are majority stockholders of Maxworthy International Ltd. Mr. Wu is also managing director of Maxworthy. The shares reflected as being owned by Mr. Wu and Ms. Tang represent (i) 544,267 shares owned by Maxworthy and (ii) 175,425 shares owned by Mr. Wu and (iii) 78,983 shares owned by Ms. Tang. Each of Mr. Wu and Ms. Tang disclaims beneficial ownership in the shares of beneficially owned by the other. The address for Maxworthy is P.O. Box 957, Offshore Incorporations Centre, Road Town, Tortola, British Virgin Islands.
48
(2)
Yunxia Ren and Haoyang Wu are the daughter-in-law and son of Jianhua Wu and Lihua Tang. Ms. Ren owns 273,822 shares of common stock and Mr. Wu owns 68,252 shares of common stock. Each of Ms. Ren and Mr. Wu disclaims ownership of the shares owned by the other.
(3)
Address is No. 9 Yanyu Middle Road, Qianzhou Village, Huishan District, Wuxi City, Jiangsu Province, PRC
(4)
Address is No. 25 Jin Xiu Second Village, Qianzhou Town Huishan District, Wuxi City, Jiangsu Province, PRC.
(5)
19,603 shares are held by Adam Wasserman and 286 shares are held in the name of CFO Oncall Asia, Inc. of which Mr. Wasserman is chief executive officer.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
Director Independence
Four of our directors, Furen Chen, Baowen Wang, Xi Liu, and Tianxiang Zhou, are independent directors, using the Nasdaq definition of independence. Each of these directors serves on at least two of our board committees. The audit committee is comprised of Baowen Wang (chair), Xi Liu and Furen Chen, the compensation committee is comprised of Tianxiang Zhou
(chair), Baowen Wang, and Furen Chen, and the corporate governance/nominating committee is comprised of Xi Liu (chair), Baowen Wang, and Tianxiang Zhou. Our board has determined that Mr. Wang is an audit committee financial expert.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The following table sets forth the fees billed by our principal independent accountants, RBSM LLP, and its predecessor, Sherb and Co., LLP, for each of our last two fiscal years for the categories of services indicated.
Years Ended December 31,
Category
2012
2011
Audit Fees
$
105,500
$
105,500
Audit Related Fees
$
0
$
0
Tax Fees
$
3,500
$
7,500
All Other Fees
$
0
$
0
Audit fees. Consists of fees billed for the audit of our annual financial statements, review of our Form 10-K, review of our interim financial statements included in our Form 10-Q and services that are normally provided by the accountant in connection with year-end statutory and regulatory filings or engagements.
Audit-related fees. Consists of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements and are not reported under “Audit Fees”, review of our forms 10-Q and 8-K and services that are normally provided by the accountant in connection with non-year-end statutory and regulatory filings or engagements.
Tax fees. Consists of professional services rendered by a company aligned with our principal accountant for tax compliance, tax advice and tax planning.
Other fees. The services provided by our accountants within this category consisted of advice and other services relating to SEC matters, registration statement review, accounting issues and client conferences.
49
Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors
The audit committee’s policy is to pre-approve all audit and permissible non-audit services provided by the independent registered public accounting firm. These services may include audit services, audit-related services, tax services and other services. The independent registered public accounting firm and management are required to periodically report to the audit committee regarding the extent of services provided by the independent registered public accounting firm in accordance with this pre-approval, and the fees for the services performed to date. The audit committee may also pre-approve particular services on a case-by-case basis. All services since October 1, 2008 were pre-approved by the audit committee.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the dates indicated. Each person whose signature appears below hereby authorizes Jianhua Wu as his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution for him or her and in his or her name, place and stead, in any and all capacities to sign any and all amendments to this report, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission.
Consolidated Statements of Income and Comprehensive Income for the Years ended December 31, 2012 and 2011
F-5
Consolidated Statements of Changes in Stockholders’ Equity for the Years ended December 31, 2012 and 2011
F-6
Consolidated Statements of Cash Flows for the Years ended December 31, 2012 and 2011
F-7
Notes to Consolidated Financial Statements
F-8 to F-27
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Cleantech Solutions International, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheet of Cleantech Solutions International, Inc. and Subsidiaries (the "Company") as of December 31, 2012 and the related consolidated statements of operations and comprehensive income, changes in stockholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cleantech Solutions International, Inc. and Subsidiaries as of December 31, 2012 and the results of their operations and their cash flows for the year then, in conformity with accounting principles generally accepted in the United States of America.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Cleantech Solutions International, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Cleantech Solutions International, Inc. and Subsidiaries (the "Company") as of December 31, 2011 and the related consolidated statements of operations and comprehensive income, stockholders' equity and cash flows for the years ended December 31, 2011. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2011 and the results of their operations and their cash flows for the years ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.
Accounts receivable, net of allowance for doubtful accounts
10,078,623
7,087,958
Inventories, net of reserve for obsolete inventory
5,897,555
4,276,090
Advances to suppliers
593,104
219,347
Prepaid VAT on purchases
542,032
1,512,213
Prepaid expenses and other
428,326
110,670
Total Current Assets
19,073,397
14,726,538
PROPERTY AND EQUIPMENT - net
59,436,100
64,042,079
OTHER ASSETS:
Deferred tax asset
551,890
-
Equipment held for sale
7,118,555
-
Land use rights, net
3,756,342
3,820,536
Total Assets
$
89,936,284
$
82,589,153
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term bank loans
$
2,216,558
$
2,356,749
Bank acceptance notes payable
-
314,233
Accounts payable
5,474,479
4,997,109
Accrued expenses
986,824
771,597
Capital lease obligation - current portion
251,413
244,747
Advances from customers
1,851,987
1,166,942
VAT and service taxes payable
206,527
-
Income taxes payable
822,082
592,202
Total Current Liabilities
11,809,870
10,443,579
OTHER LIABILITIES:
Capital lease obligation - net of current portion
132,756
381,235
Total Liabilities
11,942,626
10,824,814
STOCKHOLDERS' EQUITY:
Preferred stock ($0.001 par value; 10,000,000 shares authorized and 0 share issued and outstanding at December 31, 2012; 30,000,000 shares authorized and designated as series A convertible preferred stock and 10,995,807 shares issued and outstanding at December 31, 2011)
-
10,996
Common stock ($0.001 par value; 50,000,000 shares authorized; 2,894,586 and 2,101,849 shares issued and outstanding at December 31, 2012 and 2011, respectively)
2,894
2,102
Additional paid-in capital
28,987,128
27,489,600
Retained earnings
38,401,734
34,618,341
Statutory reserve
2,479,738
2,064,551
Accumulated other comprehensive gain - foreign currency translation adjustment
8,122,164
7,578,749
Total Stockholders' Equity
77,993,658
71,764,339
Total Liabilities and Stockholders' Equity
$
89,936,284
$
82,589,153
See notes to consolidated financial statements
F-4
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
Cleantech Solutions International, Inc. (the “Company”) was incorporated in Delaware on June 24, 1987 under the name of Malex, Inc. On December 18, 2007, the Company’s corporate name was changed to China Wind Systems, Inc., and on June 13, 2011, the Company’s corporate name was changed to Cleantech Solutions International, Inc. On August 7, 2012, the Company was converted into a Nevada corporation.
Through its affiliated companies and subsidiaries, the Company manufactures and sells forged products and fabricated products to a range of clean technology customers including high precision forged rolled rings and related products for the wind power industry and other industries and equipment to the solar industry. The Company also makes textile dyeing and finishing machines. The Company is the sole owner of Fulland Limited (“Fulland”), a Cayman Island limited liability company, which was organized on May 9, 2007. Fulland owns
100% of the capital stock of Green Power Environment Technology (Shanghai) Co., Ltd. (“Green Power”) and Wuxi Fulland Wind Energy Equipment Co., Ltd. (“Fulland Wind Energy”), which are wholly foreign-owned enterprises (“WFOE”) organized under the laws of the People’s Republic of China (“PRC” or “China”). Green Power is a party to a series of contractual arrangements, as fully described below, dated October 12, 2007 with Wuxi Huayang Electrical Power Equipment Co., Ltd. (“Electrical”) and Wuxi Huayang Dyeing Machinery Co., Ltd. (“Dyeing”), both of which are limited liability companies organized under the laws of, and based in, the PRC. Electrical and Dyeing are sometimes collectively referred to as the “Huayang Companies.”
Fulland was organized by the owners of the Huayang Companies as a special purpose vehicle for purposes of raising capital, in accordance with requirements of the PRC State Administration of Foreign Exchange (“SAFE”). On May 31, 2007, SAFE issued an official notice known as Hui Zong Fa [2007] No. 106 (“Circular 106”), which requires the owners of any Chinese company to obtain SAFE’s approval before establishing any offshore holding company structure for foreign financing as well as subsequent acquisition matters in China. Accordingly, the owners of the Huayang Companies, Mr. Jianhua Wu and Ms. Lihua Tang, submitted their application to SAFE in early September 2007. On October 11, 2007, SAFE approved their application, permitting these Chinese
citizens to establish Fulland as a special purpose vehicle for any foreign ownership and capital raising activities by the Huayang Companies.
Electrical was formed on May 21, 2004, and Fulland Wind Energy was formed on August 27, 2008. Electrical produces large-scaled forged rolled rings that are up to three meters in diameter for the wind-power and other industries. In 2009, the Company began to produce and sell forged products through Fulland Wind Energy. Through Fulland Wind Energy, the Company manufactures and machines all forged products, including wind products such as shafts, rolled rings, gear rims, gearboxes, bearings and other components and finished products and assemblies for the wind power industry, and solar products, including large-scale equipment used in the manufacturing process
for the solar industry. The Company refers to this segment of its business as the forged rolled rings and related components division.
Dyeing, which was formed on August 17, 1995, produces and sells a variety of high and low temperature dyeing and finishing machinery for the textile industry. The Company refers to this segment as the dyeing division.
Basis of presentation
The Company’s consolidated financial statements include the financial statements of its wholly-owned subsidiaries, Fulland, Green Power and Fulland Wind Energy, as well as the financial statements of Huayang Companies, Dyeing and Electric. All significant intercompany accounts and transactions have been eliminated in consolidation.
F-8
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Basis of presentation (continued)
Pursuant to Accounting Standards Codification (“ASC”) Topic 810, the Huayang Companies are considered variable interest entities (“VIE”), and the Company is the primary beneficiary. The Company’s relationships with the Huayang Companies and their shareholders are governed by a series of contractual arrangements between Green Power, the Company’s wholly foreign-owned enterprise in the PRC, and each of the Huayang Companies, which are the operating companies of the Company in the PRC. Under PRC laws, each of Green Power, Dyeing and Electrical is an independent
legal entity and none of them is exposed to liabilities incurred by the other parties. The contractual arrangements constitute valid and binding obligations of the parties of such agreements. Each of the contractual arrangements and the rights and obligations of the parties thereto are enforceable and valid in accordance with the laws of the PRC. On October 12, 2007, the Company entered into the following contractual arrangements with each of Dyeing and Electrical:
Consulting Services Agreement. Pursuant to the exclusive consulting services agreements between Green Power and the Huayang Companies, Green Power has the exclusive right to provide to the Huayang Companies general business operation services, including advice and strategic planning, as well as consulting services related to the technological research and development of dyeing and finishing machines, electrical equipment and related products (the “ Services ”). Under this agreement, Green Power owns the intellectual property rights developed or discovered through research and development, in the course of providing the Services, or derived from the provision of the Services. The Huayang Companies shall pay a quarterly consulting service fees in Renminbi (“RMB”) to Fulland that is equal to all of the Huayang Companies’ profits for such quarter.
Operating Agreement. Pursuant to the operating agreement among Green Power, the Huayang Companies and the two shareholders of the Huayang Companies, Green Power provides guidance and instructions on the Huayang Companies’ daily operations, financial management and employment issues. The Huayang Companies shareholders must designate the candidates recommended by Green Power as their representatives on the boards of directors of each of the Huayang Companies. Green Power has the right to appoint senior executives of the Huayang Companies. In addition, Green Power agrees to guarantee the Huayang Companies’ performance under any agreements or arrangements relating to the Huayang Companies’ business arrangements with any third party. The Huayang Companies, in return, agree to pledge their accounts receivable and all of their assets to Green Power. Moreover, each of the Huayang Companies agrees that, without
the prior consent of Green Power, it will not engage in any transactions that could materially affect its assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of their assets or intellectual property rights in favor of a third party or transfer of any agreements relating to their business operation to any third party. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended only upon Green Power’s written confirmation prior to the expiration of the this agreement, with the extended term to be mutually agreed upon by the parties.
Equity Pledge Agreement. Under the equity pledge agreement between the Huayang Companies’ shareholders and Green Power, the Huayang Companies’ shareholders pledged all of their equity interests in the Huayang Companies to Green Power to guarantee the Huayang Companies’ performance of their respective obligations under the consulting services agreement. If the Huayang Companies or the Huayang Companies’ shareholders breach their respective contractual obligations, Green Power, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. The Huayang Companies’ shareholders also agreed that, upon occurrence of any event of default, Green Power shall be granted an exclusive, irrevocable power of attorney to take actions in the place and stead of
the Huayang Companies’ shareholders to carry out the security provisions of the equity pledge agreement and take any action and execute any instrument that Green Power may
F-9
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Basis of presentation (continued)
deem necessary or advisable to accomplish the purposes of the equity pledge agreement. The Huayang Companies’ shareholders agreed not to dispose of the pledged equity interests or take any actions that would prejudice Green Power’s interest. The equity pledge agreement will expire two years after the Huayang Companies’ obligations under the consulting services agreements have been fulfilled.
Option Agreement. Under the option agreement between the Huayang Companies’ shareholders and Green Power, the Huayang Companies’ shareholders irrevocably granted Green Power or its designated person an exclusive option to purchase, to the extent permitted under PRC law, all or part of the equity interests in the Huayang Companies for the cost of the initial contributions to the registered capital or the minimum amount of consideration permitted by applicable PRC law. Green Power or its designated person has sole discretion to decide when to exercise the option, whether in part or in full. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended prior to its expiration by written agreement of the parties.
Pursuant to ASC Topic 810 and related subtopics related to the consolidation of variable interest entities, the accounts of the Huayang Companies are consolidated in the accompanying financial statements. As VIEs, the Huayang Companies’ assets and liabilities are included in the Company’s, their sales are included in the Company’s total sales, their income from operations is consolidated with the Company’s, and the Company’s net income includes all of the Huayang Companies net income. Since there is no non-controlling interest in the Huayang Companies, the
Company did not subtract any net income in calculating the net income of the VIEs that is attributable to the Company. Because of the contractual arrangements, the Company has a pecuniary interest in the Huayang Companies that requires consolidation of the Company’s and the Huayang Companies’ financial statements.
Use of estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosures at the date of the financial statements and during the reporting period. Actual results could materially differ from these estimates. Significant estimates in 2012 and 2011 include the allowance for doubtful accounts, the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, assumptions used in assessing impairment of long-term assets and valuation of deferred tax assets, accruals for taxes due, and the value of stock-based compensation and warrant modification expense.
Cash and cash equivalents
For purposes of the consolidated statements of cash flows, the Company considers all highly liquid instruments purchased with a maturity of three months or less and money market accounts to be cash equivalents. The Company maintains cash and cash equivalents with various financial institutions mainly in the PRC and the U.S. As of December 31, 2012 and 2011, balances in banks in the PRC of $1,414,674 and $864,517, respectively, are uninsured.
Fair value of financial instruments
The Company adopted the guidance of ASC Topic 820 for fair value measurements which clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:
F-10
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Fair value of financial instruments (continued)
Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.
Level 2-Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs derived from or corroborated by observable market data.
Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.
The following table presents information about equipment held for sale measured at fair value on a nonrecurring basis as of December 31, 2012:
Quoted Prices in Active Markets for Identical Assets (Level 1)
The Company conducted an impairment assessment on the equipment held for sale based on the guidelines established in FASB ASC Topic 360 to determine the estimated fair market value of the equipment as of December 31, 2012. Upon completion of its 2012 impairment analysis, the Company determined that the carrying value exceeded the fair market value on equipment which is held for sale. The Company recorded an impairment charge of $2,206,253.
The carrying amounts reported in the balance sheets for cash and cash equivalents, restricted cash, notes receivable, accounts receivable, inventories, advances to suppliers, prepaid VAT on purchases, equipment held for sale, prepaid expenses and other, short-term bank loans, bank acceptance notes payable, accounts payable, accrued expenses, capital lease obligations, advances from customers, VAT and service taxes payable and income taxes payable approximate their fair market value based on the short-term maturity of these instruments.
ASC Topic 825-10 “Financial Instruments” allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, unrealized gains and losses for that instrument should be reported in earnings at each subsequent reporting date. The Company did not elect to apply the fair value option to any outstanding instruments.
Concentrations of credit risk
The Company’s operations are carried out in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC’s economy. The Company’s operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in North America. The Company’s results may be adversely affected by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad,
and rates and methods of taxation, among other things.
F-11
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Concentrations of credit risk (continued)
Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is maintained with state-owned banks within the PRC, and none of these deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts. A significant portion of the Company’s sales are credit sales which are primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas;
however, concentrations of credit risk with respect to trade accounts receivables is limited due to generally short payment terms. The Company also performs ongoing credit evaluations of its customers to help further reduce credit risk.
Restricted cash consists of cash deposits held by a bank to secure bank acceptance notes payable to the bank.
Notes receivable
Notes receivable represents trade accounts receivable due from various customers where the customers’ bank has guaranteed the payment of the receivable. This amount is non-interest bearing and is normally paid within six months. Historically, the Company has experienced no losses on notes receivable. The Company’s notes receivable totaled $88,029 and $53,420 at December 31, 2012 and 2011, respectively.
Accounts receivable
Accounts receivable are presented net of an allowance for doubtful accounts. The Company maintains allowances for doubtful accounts for estimated losses. The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balance, a customer’s historical payment history, its current credit-worthiness and current economic trends. Accounts are written off after exhaustive efforts at collection. At December 31, 2012
and 2011, the Company has established, based on a review of its outstanding balances, an allowance for doubtful accounts in the amounts of $2,592,057 and $2,618,608, respectively.
Inventories
Inventories, consisting of raw materials, work in process and finished goods related to the Company’s products are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, the Company will record reserves for the difference between the cost and the market value. These reserves are recorded based on estimates. The Company recorded an inventory reserve of $135,980 and $172,557 at December 31, 2012 and 2011,
respectively.
F-12
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Advances to suppliers
Advances to suppliers represent the cash paid in advance for the purchase of raw material from suppliers. The advance payments are intended to ensure preferential pricing and delivery. The amounts advanced under such arrangements totaled $593,104 and $219,347 as of December 31, 2012 and 2011, respectively.
Property and equipment
Property and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. The Company examines the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.
Included in property and equipment is construction-in-progress which consisted of factory improvements and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation of the assets. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use.
Equipment held for sale
Long-lived assets are classified as held for sale when certain criteria are met. These criteria include: management’s commitment to a plan to sell the assets; the availability of the assets for immediate sale in their present condition; an active program to locate buyers and other actions to sell the assets has been initiated; the sale of the assets is probable and their transfer is expected to qualify for recognition as a completed sale within one year; the assets are being marketed at reasonable prices in relation to their fair value; and it is unlikely that significant changes will be made to the plan to sell the assets. We measure long-lived assets to be disposed of by sale at the lower of carrying amount or fair value, less associated costs to sell. At December 31, 2012, the Company
reflected certain electro-slag re-melted (“ESR”) equipment that was used in 2010 and 2011 to produce forged products for the high performance components market as equipment held for sale on the accompanying consolidated balance sheet.
Impairment of long-lived assets
In accordance with ASC Topic 360, the Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable, or at least annually. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value. For the year ended December 31, 2012, the Company incurred an impairment charge in operations of $2,206,253 on the electro-slag re-melted
equipment. The valuation of the electro-slag re-melted equipment, and the amount of the impairment charge, was based on an impairment assessment conducted on the equipment held for sale at December 31, 2012. The Company did not record any impairment charge for the year ended December 31, 2011.
F-13
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Advances from customers
Advances from customers at December 31, 2012 and 2011 amounted to $1,851,987 and $1,166,942, respectively, and consist of prepayments from customers for merchandise that had not yet been shipped. The Company will recognize the deposits as revenue as customers take delivery of the goods and title to the assets is transferred to customers in accordance with the Company’s revenue recognition policy.
Revenue recognition
Pursuant to the guidance of ASC Topic 605 and ASC Topic 360, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. The Company recognizes revenues from the sale of dyeing and finishing equipment, forged rolled rings and other components upon shipment and transfer of title. The other elements may include installation and, generally, a one-year warranty. Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally within a couple
days of the delivery of the equipment. Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period. For the years ended December 31, 2012 and 2011, amounts allocated to installation and warranty revenues were minimal. Based on historical experience, warranty service calls and any related labor costs have been minimal. All other product sales with customer specific acceptance provisions, including the forged rolled rings, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.
Income taxes
The Company is governed by the Income Tax Law of the PRC and the U.S. Internal Revenue Code of 1986, as amended. The Company accounts for income taxes using the liability method prescribed by ASC Topic 740, “Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is more-likely-than-not that
some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rates is recognized as income or loss in the period that includes the enactment date.
The Company applied the provisions of ASC 740-10-50, “Accounting for Uncertainty in Income Taxes,” which provides clarification related to the process associated with accounting for uncertain tax positions recognized in our financial statements. Audit periods remain open for review until the statute of limitations has passed. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the Company’s liability for income taxes. Any such adjustment could be material to the Company’s results of operations for any given quarterly or annual period based, in part, upon the results of operations for the
given period. As of December 31, 2012 and 2011, the Company had no uncertain tax positions, and will continue to evaluate for uncertain positions in the future.
F-14
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Stock-based compensation
Stock-based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC Topic 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The Financial Accounting Standards Board (“FASB”) ASC also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.
Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the vesting period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. The Company records compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated, based on the then current fair value, at each subsequent reporting date.
Shipping costs
Shipping costs are included in selling expenses and totaled $1,124,667 and $1,192,268 for the years ended December 31, 2012 and 2011, respectively.
Employee benefits
The Company’s operations and employees are all located in the PRC. The Company makes mandatory contributions to the PRC government’s health, retirement benefit and unemployment funds in accordance with the relevant Chinese social security laws. The costs of these payments are charged to the same accounts as the related salary costs in the same period as the related salary costs. Employee benefit costs totaled $186,010 and $150,493 for the years ended December 31, 2012 and 2011, respectively.
Advertising
Advertising is expensed as incurred and is included in selling, general and administrative expenses on the accompanying consolidated statements of income and comprehensive income and totaled $20,678 and $6,041 for the years ended December 31, 2012 and 2011, respectively.
Research and development
Research and development costs are expensed as incurred. The Company did not incur any research and development expense in 2012 and 2011.
F-15
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Foreign currency translation
The reporting currency of the Company is the U.S. dollar. The functional currency of the parent company is the U.S. dollar and the functional currency of the Company’s operating subsidiaries is the Chinese Renminbi (“RMB”). For the subsidiaries and affiliates, whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. As a result, amounts relating to assets and
liabilities reported on the statements of cash flows may not necessarily agree with the changes in the corresponding balances on the balance sheets. Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income. The cumulative translation adjustment and effect of exchange rate changes on cash for the years ended December 31, 2012 and 2011 was $(3,732) and $41,142, respectively. Transactions denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing on the transaction dates. Assets and liabilities denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing at the balance sheet date with any transaction gains and losses that arise from exchange rate fluctuations
on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
All of the Company’s revenue transactions are transacted in the functional currency of the operating subsidiaries and affiliates. Other than for the purchase of equipment from non-Chinese suppliers, the Company does not enter into any material transaction in foreign currencies. Transaction gains or losses have not had, and are not expected to have, a material effect on the results of operations of the Company.
Asset and liability accounts at December 31, 2012 and 2011 were translated at 6.31610 RMB to $1.00 and at 6.36470 RMB to $1.00, respectively, which were the exchange rates on the balance sheet dates. Equity accounts were stated at their historical rate. The average translation rates applied to the statements of income for the years ended December 31, 2012 and 2011 were 6.31984 RMB and 6.47351 RMB to $1.00, respectively. Cash flows from the Company’s operations are calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the consolidated statements of cash flows will not
necessarily agree with changes in the corresponding balances on the consolidated balance sheets.
Reverse stock split
The Company effected a one-for-ten reverse stock split on March 6, 2012. All share and per share information has been retroactively adjusted to reflect this reverse stock split.
Change in state of incorporation; reduction in authorized preferred stock
ASC Topic 260 “Earnings per Share,” requires presentation of both basic and diluted earnings per share (“EPS”) with a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic EPS excludes dilution. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
Basic net income per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. Potentially dilutive common stock consist of common stock issuable upon the conversion of series A convertible preferred stock (using the if-converted method) and common stock purchase warrants (using the treasury stock method).
F-16
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
Parties are considered to be related to the Company if the parties, directly or indirectly, through one or more intermediaries, control, are controlled by, or are under common control with the Company. Related parties also include principal owners of the Company, its management, members of the immediate families of principal owners of the Company and its management and other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an
extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. The Company discloses all related party transactions. All transactions are recorded at fair value of the goods or services exchanged.
Accumulated other comprehensive income
Comprehensive income is comprised of net income and all changes to the statements of stockholders’ equity, except those due to investments by stockholders, changes in paid-in capital and distributions to stockholders. For the Company, comprehensive income for the years ended December 31, 2012 and 2011 included net income and unrealized gains from foreign currency translation adjustments.
Recent accounting pronouncements
In August 2012, the FASB issued Accounting Standards Update (“ASU”) 2012-03, “Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (SAB) No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB Accounting Standards Update 2010-22 (SEC Update)” in Accounting Standards Update No. 2012-03. This update amends various SEC paragraphs pursuant to the issuance of SAB No. 114. The adoption of ASU 2012-03 is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
F-17
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Recent accounting pronouncements (continued)
In October 2012, the FASB issued ASU 2012-04, “Technical Corrections and Improvements” in Accounting Standards Update No. 2012-04 ("ASU 2012-04"). The amendments in this update cover a wide range of topics in the Accounting Standards Codification. These amendments include technical corrections and improvements to the Accounting Standards Codification and conforming amendments related to fair value measurements. The amendments in this update will be effective for fiscal periods beginning after December 15, 2012. The adoption of ASU 2012-04 is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
Other accounting standards that have been issued or proposed by FASB that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption. The Company does not discuss recent pronouncements that are not anticipated to have an impact on or are unrelated to its financial condition, results of operations, cash flows or disclosures.
The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. After evaluating the collectability of individual receivable balances, the Company decreased the allowance for doubtful accounts in the amount of $46,672 for the year ended December 31, 2012 and increased the allowance for doubtful accounts in the amount of $720,302 for the year ended December 31, 2011.
For the year ended December 31, 2012, the Company decreased reserve for obsolete inventory in the amount of $37,882 as the part of reserved inventory in prior years had been sold out in 2012. For the year ended December 31, 2011, the Company did not make any change for reserve for obsolete inventory.
F-18
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
For the years ended December 31, 2012 and 2011, depreciation expense amounted to $6,519,394 and $5,351,359, respectively, of which $4,983,679 and $4,238,590, respectively, is included in cost of revenues and the remainder is included in operating expenses. Depreciation is not taken during the period of construction or equipment installation. Upon completion of the installation of manufacturing equipment or any construction in progress, construction in progress balances will be classified to their respective property and equipment category.
In 2011, the Company entered into a non-cancelable capital lease agreement with expiration date of June 3, 2014. Accordingly, the asset related to the capital lease in the amount of $785,583 and $791,628, respectively, is included in the accompanying consolidated balance sheets in property and equipment as of December 31, 2012 and 2011. For the years ended December 31, 2012 and 2011, the depreciation expense related to the capital lease in the amount of $71,204 and $0, respectively, is included in cost of revenues.
NOTE 5 – LAND USE RIGHTS
There is no private ownership of land in China. Land is owned by the government and the government grants land use rights for specified terms. The Company’s land use rights have terms of 45 and 50 years and expire on January 1, 2053 and October 30, 2053. The Company amortizes the land use rights over the term of the respective land use right. For the years ended December 31, 2012 and 2011, amortization of land use rights amounted to $93,537 and $91,316, respectively. At December 31, 2012 and 2011, land use rights consisted of the following:
The Company measures long-lived assets to be disposed of by sale at the lower of carrying amount or fair value, less associated costs to sell these assets. The assets held for sale is no longer subject to depreciation as they are not used in operations. As of December 31, 2012, the Company committed to a plan to sell certain ESR equipment that was used to produce forged products for the high performance components market as equipment held for sale on the accompanying consolidated balance sheet. The Company evaluated equipment for impairment at December 31, 2012. The
Company compared the estimated fair values of the equipment to its carrying value with impairment indicators and recorded an impairment charge for the excess of carrying value over fair value. For the year ended December 31, 2012, the Company incurred an impairment charge in operations of $2,206,253 on ESR equipment. Although the Company is actively seeking and negotiating with potential buyers, the Company can give no assurances that the sale process will be successful and, if it were successful, there are no assurances as to the amount or timing of any potential proceeds.
NOTE 7 – SHORT-TERM BANK LOANS
Short-term bank loan represents an amount due to a bank that is due within one year. This loan can be renewed with the bank upon maturity. At December 31, 2012 and 2011, short-term bank loans consisted of the following:
Loan from Agricultural and Commercial Bank, due and repaid on March 30, 2012 with annual interest at December 31, 2011 of 7.88%, secured by certain assets of the Company.
$
-
$
628,466
Loan from China Merchants Bank, due and repaid on May 20, 2012 with annual interest rate of 6.73% at December 31, 2011, respectively.
-
471,350
Loan from Agricultural and Commercial Bank, due on October 10, 2012 with annual interest rate of 5.75%, secured by certain assets of the Company and repaid on August 22, 2012.
Loan from Bank of Communications, due and repaid on May 14, 2012 with annual interest rate adjusted quarterly based on 120% of People’s Bank of China’s base rate.
-
471,350
Loan from Bank of Communications, due and repaid on May 23, 2012 with annual interest rate adjusted quarterly based on 120% of People’s Bank of China’s base rate.
Loan from Bank of China, due on January 16, 2013 with annual interest rate of 7.35% at December 31, 2012, secured by certain assets of the Company, renewed on due date (see Note 16).
949,953
-
Total short-term bank loans
$
2,216,558
$
2,356,749
F-20
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
Bank acceptance notes payable represents amounts due to a bank which are collateralized and typically renewed. All bank acceptance notes payable are secured by the Company’s restricted cash which is on deposit with the lender. At December 31, 2012 and 2011, the Company’s bank acceptance notes payables consisted of the following:
China Merchants Bank, non-interest bearing, due and paid on January 15, 2012, collateralized by 100% of restricted cash deposited.
$
-
$
314,233
NOTE 9 - CAPITAL LEASE OBLIGATION
In 2011, the Company entered into a non-cancelable capital lease agreement with expiration date of June 3, 2014. The asset and liability under the capital lease are recorded at the lower of the present value of the minimum lease payments or the fair value of the asset. The asset and future obligations related to the capital lease are included in the accompanying consolidated balance sheets in property and equipment and capital lease obligations, respectively. Minimum future lease payments under the capital lease are as follows:
Years ending December 31,
Amount
2013
$
372,807
2014
175,346
Total minimum lease payments
548,153
Less: amount representing interest
(66,918
)
Less: security deposit due
(97,066
)
Present value of net minimum lease payment
384,169
Less: current portion
(251,413
)
Long-term portion
$
132,756
NOTE 10 – INCOME TAXES
The Company accounts for income taxes pursuant to the accounting standards that require the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statements and the tax basis of assets and liabilities, and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards. Additionally, the accounting standards require the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Realization of deferred tax assets, including those related to the U.S. net operating loss carry forwards and to the temporary differences related to the deduction of impairment losses in PRC for income tax purposes as compared to financial statement purposes, are dependent upon future taxable income during the
periods in which those temporary differences become deductible or are utilized.
Net deferred tax asset related to the U.S. net operating loss carry forward has been fully offset by a valuation allowance. The Company is governed by the Income Tax Law of the PRC and the U.S. Internal Revenue Code of 1986, as amended. Effective in January 2008, under the Income Tax Laws of PRC, Chinese companies are generally subject to an income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments. The Company’s VIEs (Dyeing and Electric) and the Company’s subsidiary, Fulland Wind Energy, are subject to these statutory rates. The
Company’s wholly-owned subsidiary, Fulland Limited was incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, this entity is not subject to income taxes.
F-21
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
Cleantech Solutions International, Inc. was incorporated in the United States and has incurred an aggregate net operating loss of approximately $4,748,000 for income tax purposes through December 31, 2012, subject to the Internal Revenue Code Section 382, which places a limitation on the amount of taxable income that can be offset by net operating losses after a change in ownership. The net operating loss carries forward for United States income taxes, and may be available to reduce future years’ taxable income. These carry forwards will expire, if not utilized, through 2032. Management believes that the realization of the benefits from these losses appears not more than likely due to the Company’s limited operating history and continuing losses for United States income tax purposes. Accordingly, the
Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. Management will review this valuation allowance periodically and make adjustments as necessary.
The Company has cumulative undistributed earnings from its foreign subsidiaries of approximately $51 million and $47 million as of December 31, 2012 and 2011, respectively, which is included in the consolidated retained earnings and will continue to be indefinitely reinvested in the Company’s PRC operations. Accordingly, no provision has been made for any deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.
The table below summarizes the differences between the U.S. statutory federal rate and the Company’s effective tax rate for the years ended December 31, 2012 and 2011:
2012
2011
U.S. statutory rates
34.0
%
34.0
%
U.S. effective rate in excess of China tax rate
(10.4
)%
(10.4
)%
Other
1.4
%
1.4
%
U.S. valuation allowance
3.8
%
3.9
%
Total provision for income taxes
28.8
%
28.9
%
For the years ended December 31, 2012 and 2011, income tax expense related to our operations in the PRC and amounted to $1,701,602 and $2,340,471, respectively.
The tax effects of temporary differences under the Income Tax Law of the PRC that give rise to significant portions of deferred tax assets and liabilities as of December 31, 2012 and 2011 are as follows:
The valuation allowance at December 31, 2012 and 2011 were $1,614,245 and $1,388,805, respectively, related to the U.S. net operating loss carry forward. During 2012, the valuation allowance was increased by approximately $225,000 from the prior year.
In assessing the ability to realize the deferred tax asset from the loss on impairment of equipment held for sale in PRC, management considers whether it is more likely than not that some portion or the entire deferred tax asset will be realized. The Company concluded that the temporary difference on the impairment loss of equipment held for sale in PRC will be deductible or utilized on the future PRC taxable income and a deferred tax asset of $551,890 has been set up at December 31, 2012.
F-22
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
(a) Preferred stock issued for warrant modification
On February 7, 2012, in an effort to induce its warrant holder to exercise their warrants, the Company signed an agreement with Barron Partners LP (“Barron”), pursuant to which Barron, as the holder of warrants to purchase 55,158 shares of common stock at $12.00 per share and 165,000 shares of common stock at $16.98 per share, agreed to exchange or convert such warrants into (i) 2,201,582 shares of the Company’s series A preferred stock which are convertible into 73,386 shares of common stock, and (ii) warrants to purchase 73,386 shares of this Company’s common stock at $2.70 per common share, with the proceeds from the exercise of the warrants being used to pay expenses incurred by the
Company in connection with its public company expenses. In connection with the warrant modification, the Company valued the 2,201,582 series A preferred shares issued at fair market value on the date of grant of $197,408 based on the 73,386 common shares issuable upon conversion of the series A preferred stock multiplied by the quoted trading price of the common stock on the grant date of $2.70 per share. In connection with the transaction, on February 7, 2012, the Company revalued the fair market value of the original warrants by using the Black-Scholes option-pricing model. The total fair market value of the original warrants was estimated to be $52,896 on February 7, 2012. The fair market value
of the newly issued exchanged warrants was estimated to be $90,621 using the Black-Scholes option-pricing model. In connection with the Black-Scholes option pricing calculation, the following weighted-average assumptions were used: stock price of $2.70; expected dividend yield 0%; risk-free interest rate of 0.15%; volatility of 139.58% and an expected term of 0.77 year. The Company recorded the difference between the fair market value of original warrants of $52,896 and the fair market value of exchanged warrants of $90,621 which amounted to $37,725 as a warrant modification expense with a corresponding credit of additional paid-in capital. Accordingly, for the year ended December 31, 2012, the Company recorded an aggregate warrant modification expense
of $235,133 on the accompanying consolidated statement of income. For the year ended December 31, 2011, the Company did not record any warrant modification expense.
(b) Common stock issued for services
During the year ended December 31, 2011, the Company issued an aggregate of 1,891 shares of its common stock to its three directors. The shares are valued at the fair value on the grant date based on the quoted trading price of the common stock and the Company recorded stock-based compensation of $30,351.
During the year ended December 31, 2011, the Company issued an aggregate of 3,000 shares of its common stock to its chief financial officer pursuant to an employment agreement which terminated effective December 31, 2011. The shares are valued at the fair value on the grant date based on the quoted trading price of the common stock and the Company recorded stock-based compensation of $59,700.
During the year ended December 31, 2011, the Company issued an aggregate of 12,175 shares of its common stock to employees, of which 4,800 shares were granted to the Company’s chief executive officer. None of the other shares were issued to executive officers or directors. The shares are valued at the fair value on the grant date based on the quoted trading price of the common stock and the Company recorded stock-based compensation of $200,478.
The Company has a consulting agreement with a company that provides the services of its vice president of financial reporting. Pursuant to this agreement, the Company issued 200 shares of common stock on each of March 31, 2011, June 30, 2011, September 30, 2011 and December 31, 2011 and an additional 700 shares in December 2011, for an aggregate of 1,500 shares of common stock. The shares were valued at fair value on the respective dates of grant based on the quoted trading price of the common stock, and the
Company recorded stock-based compensation of $12,220 during the year ended December 31, 2011.
F-23
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
On April 14, 2011, the Company issued 1,300 shares of common stock to an investor relations firm pursuant to an agreement with the firm for the twelve months beginning May 1, 2010. The shares were valued at the fair value on the grant date based on the quoted trading price of the common stock. For the year ended December 31, 2011, the Company recorded stock-based professional fees of $37,440.
On May 26, 2011, the Company issued 1,250 shares of common stock to an investor relations firm pursuant to an agreement with the firm for the twelve months beginning May 1, 2011. The shares were valued at the fair value on the grant date based on the quoted trading price of the common stock, and the Company recorded stock-based professional fees of $15,667 in 2011 and prepaid expenses of $7,833 which was amortized in 2012.
During the year ended December 31, 2012, the Company issued a total of 121,053 shares of common stock pursuant to its 2010 long-term incentive plan, of which 250 shares were issued to a director, 35,000 shares were issued to the chief executive officer, 28,403 shares were issued to the chief financial officer and 57,400 shares were issued to other employees and consultants. These shares were issued for services rendered through December 31, 2012, which have been accounted for as stock-based compensation and for services to be rendered during 2013, which have been accounted for as prepaid expense at December 31, 2012. The shares were valued at the fair market value on the date of grant. During
the year ended December 31, 2012, the Company recorded stock-based compensation of $159,881 and prepaid expense of $281,265, which will be amortized in 2013.
All of the shares issued as compensation, other than the shares issued to the former chief financial officer pursuant to his employment agreement, were issued pursuant to the Company’s long-term incentive plan.
(c) Common stock issued upon conversion of preferred stock
During the year ended December 31, 2011, the Company issued 197,206 shares of common stock upon the conversion of 5,916,176 shares of series A preferred stock.
During the year ended December 31, 2012, the Company issued 439,912 shares of common stock upon the conversion of 13,197,389 shares of series A preferred stock. As of December 31, 2012, the Company had no preferred stock outstanding and all authorized shares of preferred stock were without designation as to series.
(d) Common stock sold for cash
On January 18, 2011, the Company sold 3,501 shares of its common stock to its former chief financial officer for $125,000, representing the market price on January 18, 2011, the date of the stock purchase agreement.
On November 28, 2012, the Company sold 157,966 shares of its common stock to its chief executive officer and his wife for $612,903, representing the market price on November 28, 2012, the date of the stock purchase agreement.
(e) Common stock issued for exercise of warrants
In May 2011, the Company issued 4,185 shares of its common stock upon the cashless exercise of warrants.
During the year ended December 31, 2012, the Company issued 73,386 shares of its common stock upon the exercise of warrants, for which the Company received cash proceeds of $198,142. At December 31, 2012, there were no warrants outstanding.
F-24
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
(f) Series A preferred stock issued upon exercise of warrants
During the year ended December 31, 2011, the Company issued a total of 706,715 shares of series A preferred stock upon the exercise of warrants, for which the Company received total cash proceeds of $400,000. Each share of series A preferred stock was convertible into one-thirtieth of a share of common stock. As of December 31, 2012, there were no shares of series A preferred stock outstanding.
(g) Warrants
Warrant activities for the years ended December 31, 2012 and 2011 were summarized as follows:
In January 2010, the Company’s board of directors adopted, and in March 2010, the stockholders approved the Company’s 2010 long-term incentive plan, which covers 200,000 shares of common stock. The plan provides for the grant of incentive and non-qualified options and stock grants to employees, including officers, directors and consultants. The plan is to be administered by a committee of not less than three directors, each of whom is to be an independent director. In the absence of a committee, the plan is administered by the board of directors. Members of the committee are not eligible for stock options or stock grants pursuant to the plan unless such stock options or stock grant are granted by a majority of the
Company’s independent directors other than the proposed grantee. As of December 31, 2012, the Company had issued a total of 147,991 shares of common stock under the plan.
NOTE 12– STATUTORY RESERVES
The Company is required to make appropriations to reserve funds, comprising the statutory surplus reserve, statutory public welfare fund and discretionary surplus reserve, based on after-tax net income determined in accordance with generally accepted accounting principles of the PRC (the “PRC GAAP”). Appropriation to the statutory surplus reserve should be at least 10% of the after tax net income determined in accordance with the PRC GAAP until the reserve is equal to 50% of the entities’ registered capital or members’ equity. Appropriations to the statutory public welfare fund are at a minimum of 5% of the after tax net income determined in accordance with PRC GAAP. Commencing on January 1, 2006, the new PRC regulations waived the requirement for appropriating retained earnings to a welfare fund.
Prior to December 31, 2009, the Company appropriated the required maximum 50% of its registered capital to statutory reserves for Electric. As of December 31, 2012, the Company had not appropriated the required maximum 50% of its registered capital to statutory reserve for Dyeing and Fulland Wind Energy.
F-25
CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
For the years ended December 31, 2012 and 2011, the Company operated in two reportable business segments - (1) the manufacture of forged rolled rings and related components for the wind power and other industries segment, which also includes the manufacture of the Company’s solar industry products, and (2) the manufacture of dyeing and finishing equipment segment. The Company’s reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations. All of the
Company’s operations are conducted in the PRC.
Information with respect to these reportable business segments for the years ended December 31, 2012 and 2011 was as follows:
(a) The Company does not allocate any general and administrative expenses of its U.S. activities to its reportable segments, because these activities are managed at a corporate level.
The following table sets forth information as to each supplier that accounted for 10% or more of the Company’s purchases for the years ended December 31, 2012 and 2011.
Years Ended December 31,
Supplier
2012
2011
A
21
%
13
%
B
12
%
*
C
18
%
13
%
D
*
14
%
* Less than 10%.
NOTE 15 – RESTRICTED NET ASSETS
Regulations in the PRC permit payments of dividends by the Company’s PRC VIEs only out of their retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Subject to certain cumulative limit, a statutory reserve fund requires annual appropriations of at least 10% of after-tax profit, if any, of the relevant PRC VIE’s and subsidiary. The statutory reserve funds are not distributable as cash dividends. As a result of these PRC laws and regulations, the Company’s PRC VIE’s and its subsidiary are restricted in their abilities to transfer a portion of their net assets to the Company. Foreign exchange and other regulations in PRC may further restrict
the Company’s PRC VIEs and its subsidiary from transferring funds to the Company in the form of loans and/or advances.
As of December 31, 2012 and 2011, substantially all of the Company’s net assets are attributable to the PRC VIE’s and its subsidiary located in the PRC. Accordingly, the Company’s restricted net assets at December 31, 2012 and 2011 were approximately $77,514,000 and $71,294,000, respectively.
NOTE 16 – SUBSEQUENT EVENTS
On January 4, 2013, the Company renewed its loan with Bank of China in the amount of $949,953. The loan is due January 3, 2014 with interest at the annual rate of 7.35% and secured by certain assets of the Company.
F-27
Dates Referenced Herein and Documents Incorporated by Reference
