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CHINA FIRE & SECURITY GROUP, INC. - 10-Q - Management's Discussion and Analysis or Plan of Operation(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements Some of the statements contained in this Form 10-Q are not historical facts and are forward-looking statements, which can be identified by the use of terminology such as estimates, projects, plans, believes, expects, anticipates, intends, or the negative or other variations, or by discussions of strategy that involve risks and uncertainties. We urge you to be cautious of the forward-looking statements, that such statements, which are contained in this Form 10-Q reflect our current beliefs with respect to future events and involve known and unknown risks, uncertainties, and other factors affecting our operations, market growth, services, products, and licenses. No assurances can be given regarding the achievement of future results, as actual results may differ materially as a result of the risks we face, and actual events and conditions that may differ from the assumptions underlying the statements that have been made regarding anticipated events. Factors that may cause actual results, our performance or achievements, or industry results, to differ materially from those contemplated by such forward-looking statements include without limitation: our ability to attract and retain management to integrate and maintain technical information and management information systems; our ability to raise capital when needed and on acceptable terms and conditions; the intensity of competition; and general economic conditions. All written and oral forward-looking statements made in connection with this Form 10-Q that are attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Given the uncertainties that surround such statements, you are cautioned not to place undue reliance on such forward-looking statements. General The following discussion and analysis provides information which the management of China Fire & Security Group, Inc., ("we," "our," "us," the "Company" or "CFSG") believes to be relevant to an assessment and understanding of the Company's results of operations and financial condition. This discussion should be read together with the Company's financial statements and the notes to financial statements, which are included in this report. Overview We are engaged in the design, development, manufacturing and sale of fire protection products and services for large industrial firms in China and international markets. We have developed a proprietary product line that addresses all aspects of industrial fire safety from fire detection to fire system control and extinguishing. The Company is one of the first companies in China to leverage high technology for fire protection and safety on behalf of its clients , which include iron and steel companies, power plants, petrochemical plants, as well as, special purpose construction companies in China and other international markets. Reorganization We were organized as a Florida corporation on June 17, 2003. On September 1, 2006, we entered into a share exchange agreement, pursuant to which we acquired all of the outstanding capital shares of China Fire Protection Group Inc. in exchange for a controlling interest in our common shares. The transaction was completed on Oct 27, 2006. China Fire Protection Group was organized on June 2, 2006 for the purpose of acquiring all of the capital shares of Sureland Industrial Fire Safety Limited ("Sureland Industrial"), a Chinese corporation, and, Sureland Industrial Fire Equipment Co., Ltd. ("Sureland Equipment"), a Chinese corporation, which collectively engage in the design, development, manufacturing and sale of fire protection products and services for large industrial firms in China. As a result of the transactions described above, both Sureland Industrial and Sureland Equipment became wholly-owned subsidiaries of China Fire Protection Group Limited ("China Protection"), and China Protection is a wholly-owned subsidiary of Unipro. 28 -------------------------------------------------------------------------------- On February 9, 2007, Unipro changed its name to China Fire & Security Group, Inc. ("CFSG") and started trading on the OTC Bulletin Board under its new ticker symbol CFSG. On July 16, 2007, China Fire & Security Group, Inc. began trading on the Nasdaq Capital Market and retained the ticker symbol CFSG. CFSG owns, through its wholly owned subsidiary China Fire Protection Group, Inc., Sureland Industrial and Sureland Equipment (jointly "Sureland"). Sureland is engaged primarily in the design, development, manufacture and sale in China of a variety of fire safety products for the industrial fire safety market as well as the design and installation of industrial fire safety systems in which it uses a combination of third party fire safety products and its own fire safety products. To a minor extent, it provides maintenance services for customers of its industrial fire safety systems. Its business is primarily in China, but it has recently begun contracting to manufacturing products for the export market and it has begun providing a fire safety system for a Chinese company operating abroad. Sureland markets its industrial fire safety products and systems primarily to major companies in the iron and steel, power and petrochemical industries in China. It has also completed projects for highway and railway tunnels, wine distilleries and a nuclear reactor. It is expanding its business in the transportation, wine, vessels, nuclear energy, and public space markets. Its products can be readily adapted for use on vessels and in exhibition halls and theaters. It plans to expand its marketing efforts to secure business in these industries. Sureland has internal research and development facilities engaged primarily in furthering fire safety technologies. It believes that its technologies allow it to offer cost-effective and high-quality fire safety products and systems. It has developed products for industrial fire detecting and extinguishing. It believes that it is the largest manufacturer in China that has successfully developed a comprehensive line of linear heat detectors. In May 2009, Beijing Shian Kexin Technology Co., Ltd. ("Shian Kexin") was incorporated in Beijing, China under the laws of the PRC with registered capital of RMB 5,000,000 or approximately $748,500. Shian Kexin is 100% owned by Sureland Industrial. In May 2009, Shenyang Hongshida Electronics Co., Ltd. ("Hongshida") was incorporated in Shenyang, Liaoning Province, China under the laws of the PRC with registered capital of RMB 10,000,000 or approximately $1,547,000. On June 30, 2011 the shareholder meeting of Hongshida decided to reduce the registered capital from RMB 10,000,000 (approximately $1,547,000) to RMB 6,000,000 (approximately $928,200). As of the date of this report, this transaction is still in progress. Management estimates any potential penalty and fee inccurred for the reduction in registered capital will be immaterial. Hongshida is 80% owned by Beijing Hua An Times Fire Safety Technology Co., Ltd. ("Beijing Hua An") with a 20% non-controlling interest owned by an unrelated party. Beijing Hua An is 100% owned by Sureland Industrial. During the first quarter of 2010, our wholly-owned subsidiary, China Fire Protection Group, Inc. entered into an agreement with Zeetech System Private Limited ("Zeetech"), our subsidiary in which we control 100% (99% direct holding, 1% through nominee holding where the nominee agrees to hold the shares on behalf of CFPG), pursuant to which China Fire Protection Group Inc.'s entire interest (75%) in Sureland Industrial shall be transferred to Zeetech. On March 12, 2010, the restructuring transaction was approved by the Chinese Ministry of Commence. Subsequent to the transfer, China Fire & Security Group, Inc. still holds 100% of the interest in Sureland Industrial through its subsidiaries. During the fourth quarter of 2010, our wholly-owned subsidiary, China Fire Protection Group, Inc. entered into an agreement with Zeetech System Private Limited ("Zeetech") pursuant to which Zeetech's entire interest (75%) in Sureland Industrial shall be reverted back to China Fire Protection Group, Inc. On December 9, 2010, the reverse transaction was approved by the Chinese Ministry of Commence. Subsequent to the transaction, China Fire & Security Group, Inc. still holds 100% of the interest in Sureland Industrial through its subsidiaries. As of June 30, 2011, Sureland operates more than 20 sales and liaison offices in China. Sureland has been ranked as the leading Chinese industrial fire safety company and the largest contractor by the China Association for Fire Prevention based on six major factors including total revenue, growth rate, net profit, return on assets, investment in research and development and intellectual property. Sureland's key products include linear heat detectors and water mist extinguishers, whose sales volumes are the largest in China. Its products have been used by its customers in more than 20 provinces throughout China. 29 -------------------------------------------------------------------------------- On May 20, 2011, we entered into an Agreement and Plan of Merger (the "Merger Agreement") with Amber Parent Limited, an exempted company incorporated in the Cayman Islands ("Parent"), and Amber Mergerco, Inc., a Florida corporation and a wholly owned subsidiary of Parent ("Merger Sub"), providing for the merger of Merger Sub with and into the Company (the "Merger"), with the Company surviving the merger as a wholly owned subsidiary of Parent. Parent and Merger Sub are both affiliates of funds managed by Bain Capital Partners, LLC. The consummation of the Merger is subject to several closing conditions, which include the approval of the shareholders of China Fire & Security Group, Inc. at a special meeting that will take place on September 22, 2011. For further information concerning the Merger, see the description included in Note 1 to the consolidated financial statements, which is incorporated by reference herein. Critical Accounting Policies and Estimates While our significant accounting policies are more fully described in Note 2 to our consolidated financial statements appearing at the end of this report, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our reported financial results. Certain of the Company's accounting policies require higher degree of judgment than others in their application. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our financial statements: Revenue recognition Revenue is recognized when it is probable that the economic benefits will flow to the Company as follows: 1. Revenue recognition of total solution contracts: Historically more than 70% of our revenues are derived from long-term, fixed price total solution contracts for which revenues and estimated profits are recognized using the percentage of completion method of accounting. Under this method revenue recognized based upon the ratio that incurred costs to date bear to total estimated contract costs at completion with related cost of sales recorded as costs are incurred. Contract costs include all direct material and labor costs and those indirect costs related to contract performance. Selling and administrative costs are charged to expense as incurred. Risks and uncertainties inherent in the estimation process could affect the amounts reported in our financial statements. The key assumptions used in the estimate of costs to complete relate to the unit material cost, the quantity of materials to be used, the installation cost and those indirect costs related to contract performance. The estimate of unit material cost is reviewed and updated on a quarterly basis, based on the updated information available on the supply markets. The estimate of material quantity to be used for completion and the installation cost is also reviewed and updated on a quarterly basis, based on the updated information on the progress of projection execution. If the supply market conditions or the progress of projection execution were different, it is likely that materially different amounts of contract costs would be used in the percentage of completion method of accounting. Thus the uncertainty associated with those estimates may impact our consolidated financial statements. 2. Revenue from product sales is recognized when the goods are delivered and title has passed. Product sales revenue is presented net of a value-added tax ("VAT"). The Majority of the Company's products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product. 3. Revenue from the rendering of Maintenance Services is recognized over the service period on a straight-line basis. In accordance with ASC 605-15, "Revenue Recognition when Right of Return Exists," revenue is recorded net of an estimate of markdowns, price concessions and warranty costs. Such reserve is based on management's evaluation of historical experience, current industry trends and estimated costs. 30 --------------------------------------------------------------------------------Foreign currency translation The reporting currency of the Company is the U.S. dollar. The Company uses their local currency, Renminbi and Indian Rupee ("INR"), as their functional currency. Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People's Bank of China at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the consolidated statement of changes in equity. Asset and liability accounts at June 30, 2011 were translated at 6.46 RMB to $1.00 and 45.45 INR to $1.00 as compared to 6.59 RMB to $1.00 and 45.45 INR to $1.00 at December 31, 2010 respectively. Equity accounts were stated at their historical rate. The average translation rates of RMB applied to income statement accounts for the three months ended June 30, 2011 and 2010 were 6.50 RMB, to $1.00 and 6.83 RMB to $1.00, respectively. The average translation rate of INR applied to income statement accounts for the three months ended June 30, 2011 and 2010 were 45.05 INR to $1.00 and 45.66 INR to $1.00, respectively. The average translation rates of RMB applied to income statement accounts for the six months ended June 30, 2011 and 2010 were 6.54 RMB, to $1.00 and 6.82 RMB to $1.00, respectively. The average translation rate of INR applied to income statement accounts for the six months ended June 30, 2011 and 2010 were 45.45 INR to $1.00 and 45.72 INR to $1.00, respectively Cash flows are also translated at average translation rates for the periods; therefore, amounts reported in the statement of cash flows will not necessarily agree with changes in the corresponding balances in the balance sheets. 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. Historically, the Company has not engaged in any currency trading or hedging transactions, although there is no assurance that the Company will not enter into such transactions in the future. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles of the United States of America requires management to make estimates and assumptions that affect the amounts reported in the combined financial statements and accompanying notes. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates. Certain of the Company's accounting policies require higher degrees of judgment than others in their application. These include the recognition of revenue and earnings from system contracting projects under the percentage of completion method, impairment of long-lived assets and the allowance for doubtful accounts. Management evaluates all of its estimates and judgments on an on-going basis. Accounts receivable Accounts receivable represents amounts due from customers for products sales, maintenance services and system contracting projects. The credit term is generally for a period of three months for major customers. Each customer has a maximum credit limit. The Company seeks to maintain strict control over its outstanding receivables. Overdue balances are reviewed regularly by senior management. In order to mitigate the adverse liquidity impact of the delays in customer payments, we can negotiate with our suppliers for a better payment term, in order to slow down our payments to our suppliers in the future. However, due to the limited number of qualified suppliers available in the market, the potential delay in our payments to suppliers cannot significantly offset the adverse liquidity impact of the delays from our customer payments. Allowance for doubtful accounts We establish an allowance for doubtful accounts based on management's assessment of the collectability of our account receivables. A considerable amount of judgment is required in assessing the amount of the allowance. We consider the historical level of credit losses, apply percentages to aged receivable categories, make judgments about the creditworthiness of each customer based on ongoing credit evaluations, and monitor current economic trends that might impact the level of credit losses in the future. If the financial condition of the customers were to deteriorate, resulting in their inability to make payments, a larger allowance may be required. 31 -------------------------------------------------------------------------------- Based on the above assessment, during the reporting years, the management establishes the general provision policy to make an allowance equivalent to the sum of 3% of the amount of accounts receivables less than 1 year, 15% of the amount of accounts receivable between 1 year to 2 years, 40% of the amount of accounts receivable between 2 years to 3 years and 100% of amount of accounts receivable above 3 years. Additional specific provisions are made against account receivables to the extent which they are considered to be doubtful. Bad debts are written off against the allowance for doubtful accounts when identified. We do not accrue any interest on accounts receivable. Historically, losses from uncollectible accounts have not deviated from the general allowance estimated by the management and no bad debts have been written off against allowance for doubtful accounts directly to the statements of operations. This general provisioning policy has not changed since its establishment and the management considers that the aforementioned general provisioning policy is adequate and does not expect to change this established policy in the near future. Any changes to the estimates of our general provision policy could have a material effect on our results of operations. Valuation of Long-Lived Assets We assess the impairment of long-lived assets, which includes goodwill, identifiable intangible assets, and property and equipment ("P&E"), at least annually for goodwill or whenever events or changes in circumstances indicate that the carrying value may not be recoverable for all long-lived assets. Changes in the underlying business could adversely affect the fair value of the enterprise and intangible asset and P&E asset groups. Important factors which could require an impairment review include: (i) underperformance relative to expected historical or projected future operating results; (ii) changes in the manner of use of the assets or the strategy for our overall business; (iii) negative industry or economic trends; (iv) our enterprise fair value relative to net book value. Our impairment evaluation of identifiable intangible assets and P&E includes an analysis of estimated future undiscounted net cash flows expected to be generated by the assets over their remaining estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over the remaining estimated useful lives, we record an impairment loss in the amount by which the carrying value of the assets exceeds the fair value. We determine fair value based on either market quotes, if available, or discounted cash flows using a discount rate commensurate with the risk inherent in our current business model for the specific asset being valued. Major factors that influence our cash flow analysis are our estimates for future revenue and expenses associated with the use of the asset. Different estimates could have a significant impact on the results of our evaluation. If, as a result of our analysis, we determine that our amortizable intangible assets or other long-lived assets have been impaired, we will recognize an impairment loss in the period in which the impairment is determined. Any such impairment charge could be significant and could have a material negative effect on our results of operations. Share-based Compensation We applied ASC 718, Compensation - Stock Compensation (formerly SFAS No. 123R, Share-Based Payment). ASC 718 requires that all share-based compensation be recognized as an expense in the consolidated financial statements and that such cost be measured at the fair value of the award and requires compensation cost to reflect estimated forfeitures. The determination of the fair value of share-based compensation awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, which include our expected stock price volatility over the term of the awards, actual and projected share option exercise behaviors, risk-free interest rates and expected dividends. The volatility of the Company's common stock was estimated by management based on the historical volatility of our common stock, the risk free interest rate was based on the Treasury Constant Maturity Rates published by the U.S. Federal Reserve for periods applicable to the expected life of the share option, the expected dividend yield was based on the Company's current and expected dividend policy, and the projected share option exercise behaviors is based on one-half of the sum of the vesting period and the contractual life of each share option. This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date. Any uncertainty associated with these assumptions may impact our consolidated financial statements might affect our valuation when the options are granted. 32 --------------------------------------------------------------------------------Inventories Inventories are stated at the lower of cost or market, using the weighted average method. Raw materials consist primarily of materials used in production. Finished goods consist primarily of equipment used in product sales and system contracting projects. The costs of finished goods include direct costs of raw materials as well as direct labor used in production. Indirect production costs such as utilities and indirect labor related to production such as assembling, shipping and handling costs are also included in the cost of inventory. The Company reviews its inventory periodically to determine if any reserves are necessary for potential obsolescence. Costs and estimated earnings in excess of billings The current asset, "Costs and estimated earnings in excess of billings" on contracts, represents revenues recognized in excess of amounts billed. Billings in excess of costs and estimated earnings The current liability, "Billings in excess of costs and estimated earnings" on contracts, represents billings in excess of revenues recognized. Plant and equipment Plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets with a 5% residual value. Recently issued accounting pronouncements In April 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standard Update No. 2011-02, Receivables (Topic 310) - A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring, which clarify when a modification or restructuring of a receivable constitutes a troubled debt restructuring. In evaluating whether such a modification or restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that two conditions exist: (1) the modification or restructuring constitutes a concession and (2) the debtor is experiencing financial difficulties. The guidance will be effective for our interim and annual reporting periods beginning after June 15, 2011 and will be applied retrospectively to the beginning of the annual period of adoption. The adoption of this newly issued guidance did not have material impact on our consolidated financial statements. In May 2011, FASB issued Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs No. 2011-0, which provides additional guidance for fair value measurements. These updates to the ASC or Codification include clarifications regarding existing fair value measurement principles and disclosure requirements, and also specific new guidance for items such as measurement of instruments classified within stockholders' equity and disclosures regarding the sensitivity of Level 3 measurements to changes in valuation model inputs. These updates to the Codification are effective for interim and annual periods beginning after December 15, 2011. We do not expect the implementation of this guidance to have a material impact on its consolidated financial statements. In June 2011, the FASB issued Comprehensive Income (Topic 220) - Presentation of Comprehensive Income (ASU No. 2011-05), which updates the Codification to require the presentation of the components of net income, the components of other comprehensive income (OCI) and total comprehensive income in either a single continuous statement of comprehensive income or in two separate, but consecutive statements of net income and comprehensive income. These updates do not affect the items reported in OCI or the guidance for reclassifying such items to net income. These updates to the Codification are effective for interim and annual periods beginning after December 15, 2011. We do not expect the implementation of this guidance to have a material impact on its consolidated financial statements. 33--------------------------------------------------------------------------------Results of Operations Comparison of the Three Months Ended June 30, 2011 and 2010: For the Three Months Ended June 30, 2011 2010 Y/Y Change Amount ($) % of Total Revenue Amount ($) % of Total Revenue Amount ($) % Revenue System contracting projects 23,303,293 79.4 % 18,267,248 80.0 % 5,036,045 27.6 % Products 5,032,992 17.1 % 3,556,422 15.6 % 1,476,570 41.5 % ? Maintenance Services 1,022,795 3.5 % 1,009,761 4.4 % 13,034 1.3 % ? Total Revenue 29,359,080 100.0 % 22,833,431 100.0 % 6,525,649 28.6 % Total revenues were approximately $29.4 million for the three months ended June 30, 2011 as compared to $22.8 million for the three months ended June 30, 2010, an increase of $6.6 million or 28.6%. This significant increase in our total revenue was primarily due to the increase in revenue from system contracting projects and products sales. The Company recognized revenues from 257 total solution, product sales and maintenance contracts for the three months ended June 30, 2011 as compared to 213 contracts for the three months ended June 30, 2010. Revenues from our total solution system contracting projects increased by $5.0 million to $23.3 million derived from 121 contracts for the three months ended June 30, 2011, compared to $18.3 million derived from 111 contracts for the three months ended June 30, 2010. This increase in revenues from our system contracting projects was mainly attributable to faster progress in projects from the iron and steel industry during the period. Revenues from product sales were $5.0 million with 74 contracts executed for the three months ended June 30, 2011, compared to $3.6 million with 48 contracts executed for the three months ended June 30, 2010. The increase in revenues from product sales was mainly due to the increase in value of product sales contracts executed both from the nuclear industry and the international market in India during the period. Revenues from maintenance services increased by 1.3% to $1.02 million derived from 62 contracts for the three months ended June 30, 2011, compared to $1 .01 million derived from 54 contracts for the three months ended June 30, 2010. The increase in revenues from maintenance services was mainly attributable to the increase in the number of maintenance service contracts executed as a result of the expansion of our customer base during the period. In particular, our three largest clients were Wuhan Iron and Steel Group, Handan Iron and Steel Group, and Anshan Iron and Steel Putian Ltd., which collectively contributed approximately $12.1 million of revenues, representing 41.1 % of total revenues for the three months ended June 30, 2011. Out of the system contracting revenue of $23.3 million for the three months ended June 30, 2011, the iron and steel industry contributed approximately $21.4 million or 91.6 % of the revenue from system contracting projects, while traditional power generation contributed approximately $1.5 million or 6.6 % of the revenue from system contracting projects. Petrochemical, nuclear and other verticals together represented the remaining $0.4 million or 1.8 % of the revenue from system contracting projects. For the three months ended June 30, 2011, the significant increase in reliance on one client for our operating results was due to the significant size of the total solution contract executed with Wuhan Iron and Steel (the "Wuhan Project"). The value of this contract was approximately $92 million, compared to our historical average contract size of $1 million for the iron and steel industry. Therefore, as a result of the continued successful implementation of this project, for the three months ended June 30, 2011, Wuhan Iron and Steel contributed $6.2 million, the largest portion of our sales during the period. By June 30, 2011, the $92 million contract with Wuhan Iron and Steel was 53.9 % completed; as a result, we expect that a large portion of our revenue in future reporting periods will be attributable to the execution of this contract. 34 -------------------------------------------------------------------------------- For the Three Months Ended June 30, 2011 2010 Y/Y Change % of % of Amount ($) Revenue Amount ($) Revenue Amount ($) % Cost of Revenues System contracting projects 12,780,057 54.8 % 7,876,558 43.1 % 4,903,499 62.3 % Products 2,885,347 57.3 % 1,856,133 52.2 % 1,029,214 55.4 % ? Maintenance Services 748,950 73.2 % 705,688 69.9 % 43,262 6.1 % ? Total Cost of Revenues 16,414,354 55.9 % 10,438,379 45.7 % 5,975,975 57.3 % Gross Profit System contracting projects 10,523,236 45.2 % 10,390,690 56.9 % 132,546 1.3 % Products 2,147,645 42.7 % 1,700,289 47.8 % 447,356 26.3 % ? Maintenance Services 273,845 26.8 % 304,073 30.1 % -30,228 -9.9 % ? Total Gross Profit 12,944,726 44.1 % 12,395,052 54.3 % 549,674 4.4 % Cost of revenues for the three months ended June 30, 2011 was approximately $16.4 million, as compared to $10.4 million for the three months ended June 30, 2010, representing an increase of approximately $6 .0 million or 57.3%. The increase in cost of revenues was mainly driven by the increase in material costs and subcontractor costs related to the execution of system contracting projects, product sales and maintenance contracts during the period. Gross profit for the three months ended June 30, 2011 was approximately $12.9 million, as compared to $12.4 million for the three months ended June 30, 2010, a slight increase of approximately $0.5 million or 4.4%. Gross margin for the three months ended June 30, 2011 was 44.1% which is lower than the gross margin of 54.3% for the three months ended June 30, 2010. The decrease in overall gross margin was mainly due to the decrease in the gross margin of system contracting projects, product sales and maintenance services during the period. Gross margin of system contracting projects was 45.2% for the three months ended June 30, 2011, compared to 56.9% for the three months ended June 30, 2010. The decrease in gross margin of system contracting projects was mainly attributable to the following factors: 1) in order to meet the execution timeline for the Wuhan Project, we outsourced certain portions of the project to a subcontractor and such outsourcing resulted in an increase in the overall estimated cost; and 2) the contract mix during the period, as the gross margin of system contracting projects represents the average value of the gross margins of different system contracting projects executed during the period. Since gross margins during each quarter are determined by the revenue-weighted average of gross margins which are comprised of the gross margins of different system contracting projects executed during the period, the decrease in gross margins of system contracting projects were primarily due to the different contract mix during the three months ended June 30, 2011. The gross margin of product sales was 42.7% for the three months ended June 30, 2011, compared to 47.8% for the three months ended June 30, 2010. The decrease in the gross margin of product sales was mainly attributable to a lower percentage of self-manufactured proprietary products sold through our product sales contracts during the period, contributing to lower gross margin. Of the products sales in the three months ended June 30, 2011, the percentage of self-manufactured proprietary products decreased to 13.4%, compared to 37.8 % in the three months ended June 30, 2010. The main reason for the shift in sales from self-manufactured products to third-party manufactured products is the percentage of product sales from the nuclear industry and international market from India increased significantly to 52.5 % in the three months ended June 30, 2011, compared to 27.3 % for the same period of last year. Since product sales contracts from both the nuclear industry and international market from India typically use fewer self-manufactured proprietary products than other industries, the higher sales contribution from the nuclear industry and international market in India resulted in a lower percentage of self-manufactured proprietary products during the period. Gross margin of maintenance services was 26.8% for the three months ended June 30, 2011, compared to 30.1% for the three months ended June 30, 2010. This decrease in the gross margin of maintenance services was primarily due to the increase in labor costs associated with the maintenance contracts during the period. 35-------------------------------------------------------------------------------- For the Three Months Ended June 30, 2011 ? ? 2010 ? ? Y/Y Change ? ? % of Total % of Total Amount ($) Revenue Amount ($) Revenue Amount ($) % Operating Expenses Selling Expense 2,370,788 8.1 % 2,209,162 9.7 % 161,626 7.3 % General Administrative 2,689,261 9.2 % 2,618,664 11.5 % 70,597 2.7 % Depreciation and Amortization 266,661 0.9 % 202,055 0.9 % 64,606 32.0 % ? R&D 431,270 1.5 % 399,701 1.8 % 31,569 7.9 % Total ? Operating Expenses 5,757,980 19.6 % 5,429,582 23.8 % 328,398 6.0 % Income ? From Operations 7,186,746 24.5 % 6,965,470 30.5 % 221,276 3.2 % Operating expenses were approximately $5.8 million for the three months ended June 30, 2011 as compared to approximately $5.4 million for the three months ended June 30, 2010, a slightly increase of approximately $0.4 million or 6.0%. This increase in operating expenses was mainly attributable to the increase in selling, general administrative and R&D expenses, and depreciation and amortization during the period. Selling expenses were approximately $2.4 million for the three months ended June 30, 2011 as compared to approximately $2.2 million for the three months ended June 30, 2010, an increase of approximately $0.2 million or 7.3%. The increase in selling expenses was mainly attributable to the increase in the compensation to our sales team and the increase in the expense related to our warranty expenses during the period. General administrative expenses were approximately $2.7 million for the three months ended June 30, 2011, as compared to approximately $2.6 million for the three months ended June 30, 2010, a slight increase of approximately $0.1 million or 2.7%. The increase in general administrative expenses was mainly attributable to increases in overall compensation to our employees during the period. Depreciation and amortization expenses were approximately $0.3 million for the three months ended June 30, 2011 as compared to approximately $0.2 million for the three months ended June 30, 2010, an increase of $64,607 or 32%. The increase in depreciation and amortization expenses was mainly due to the increase in plant and equipment related to business operations. R&D expenses were approximately $0.4 million for the three months ended June 30, 2011 as compared to approximately $0.4 million for the three months ended June 30, 2010, an increase of approximately $31,526 or 7.9%. The increase in R&D expenses was mainly attributable to the variance in expenditures required in different new product development cycles. Operating income was approximately $7.2 million for the three months ended June 30, 2011 as compared to approximately $7.0 million for the three months ended June 30, 2010, an increase of approximately $0.2 million or 3.2%. The increase in operating income was mainly attributable to higher revenues during this period. Total other income net of total other expense was approximately $5,524 for the three months ended June 30, 2011 as compared to approximately $0.4 million for the three months ended June 30, 2010, a decrease of approximately $0.4 million or 98.6%. This decrease was mainly attributable to the increase in bank charges incurred for the security deposits made for new projects developed in India during the period. Income before income tax was approximately $7.2 million for the three months ended June 30, 2011 as compared to approximately $7.4 million for the three months ended June 30, 2010, a decrease of $0.2 million or 2.4%. The main reason for the slight decrease in income before income tax was mainly due to the decrease in gross margin and the increase in operating expenses during the period. Provision for income tax was approximately $1.3 million for the three months ended June 30, 2011 with an effective tax rate of approximately 18.7%, as compared to a $1.1 million provision for income tax for the three months ended June 30, 2010, an increase of $0.2 million. The slight increase in provision for income tax was mainly due to the increase of effective tax rate from 14.3% to 18.7% caused by the expiration of 50% tax deduction claimed by two of our subsidiaries - Sureland Equipment and Beijing Hua'an during current period compared with the same period in prior year. Our net income was approximately $5.8 million for the three months ended June 30, 2011 as compared to approximately $6.3 million net income for the three months ended June 30, 2010, a decrease of $0.5 million or 8.1%. The reason for this decrease in net income was mainly due to the decrease in gross margin and the increase in operating expenses during the period. Currency translation adjustments resulting from RMB appreciation amounted to $1.9 million and $487,746 for the three months ended on June 30, 2011 and 2010, respectively. 36-------------------------------------------------------------------------------- Comprehensive income, which aggregates currency adjustment and net income, was approximately $7.8 million for the three months ended June 30, 2011 as compared to approximately $6.8 million for the three months ended June 30, 2010, an increase of $1 million or 14.7%. Comparison of the Six Months Ended June 30, 2011 and 2010: For the Six Months Ended June 30, 2011 2010 Y/Y Change % of Total % of Total Amount ($) Revenue Amount ($) Revenue Amount ($) % Revenue System contracting projects 37,922,657 75.3 % 33,788,996 77.2 % 4,133,661 12.2 % Products 10,222,258 20.3 % 8,087,021 18.5 % 2,135,237 26.4 % ? Maintenance Services 2,210,041 4.4 % 1,901,140 4.3 % 308,901 16.2 % ? Total Revenue 50,354,956 100.0 % 43,777,157 100.0 % 6,577,799 15.0 % Total revenues were approximately $50.4 million for the six months ended June 30, 2011 as compared to approximately $43.8 million for the six months ended June 30, 2010, an increase of approximately $6.6 million or 15.0 %. This increase was primarily due to the increase in our revenues from system contracting projects, product sales and maintenance services. We recognized revenues from 310 total solution, product sales and maintenance contracts for the six months ended June 30, 2011 as compared to 260 contracts for the six months ended June 30, 2010. Revenues from system contracting projects increased by 12.2% to $37.9 million derived from 140 contracts for the six months ended June 30, 2011, compared to $33.8 million derived from 127 contracts for the six months ended June 30, 2010. This increase in the revenues from system contracting projects was mainly attributable to the increase in the number of system contracting projects we executed and the continued successful execution of large projects for Wuhan Iron and Steel Group and Handan Iron and Steel Group during the period. Revenues from product sales were $10.2 million with 104 contracts executed for the six months ended June 30, 2011, compared to $8.1 million with 78 contracts executed for the six months ended June 30, 2010. The increase in revenues from product sales was mainly due to the increase in value of product sales contracts executed both in the nuclear industry and the international market in India during the period. The revenues from maintenance services also increased by 16.2 % to $2.2 million derived from 66 contracts for the six months ended June 30, 2011, compared to $1.9 million derived from 55 contracts for the six months ended June 30, 2010. The increase in revenues from maintenance services was mainly attributable to the increase in the number of maintenance service contracts executed as the result of the expansion of our customer base during the period. In particular, the three largest customers were Wuhan Iron and Steel Group, Handan Iron and Steel Group, and Anshan Iron and Steel Putian Ltd., which collectively contributed approximately $22.5 million of revenues, representing 44.6 % of total revenues for the six months ended June 30, 2011. For the Six Months Ended June 30 2011 2010 Y/Y Change % of % of Amount ($) Revenue Amount ($) Revenue Amount ($) % Cost of Revenues System contracting projects 19,809,275 52.2 % 15,187,843 44.9 % 4,621,432 30.4 % Products 5,693,828 55.7 % 3,310,200 40.9 % 2,383,628 72.0 % ? Maintenance Services 1,608,473 72.8 % 1,251,906 65.9 % 356,567 28.5 % ? Total Cost of Revenues 27,111,576 53.8 % 19,749,949 45.1 % 7,361,627 37.3 % Gross Profit System contracting projects 18,113,382 47.8 % 18,601,153 55.1 % -487,771 -2.6 % Products 4,528,430 44.3 % 4,776,821 59.1 % -248,391 -5.2 % ? Maintenance Services 601,568 27.2 % 649,234 34.1 % -47,666 -7.3 % ? Total Gross Profit 23,243,380 46.2 % 24,027,208 54.9 % -783,828 -3.3 % 37-------------------------------------------------------------------------------- Cost of revenues for the six months ended June 30, 2011 was approximately $27.1 million, as compared to $19.7 million for the six months ended June 30, 2010, an increase of approximately $7.4 million or 37.3%. Gross profit for the six months ended June 30, 2011 was approximately $23.2 million, as compared to $24.0 million for the six months ended June 30, 2010, a decrease of approximately $0.8 million or 3.3%. Gross margin for the six months ended June 30, 2011 was 46.2 %, which is lower than the gross margin of 54.9 % for the six months ended June 30, 2010. The decrease in our gross margin was mainly due to the decrease in the gross margins of our system contracting projects, product sales and maintenance services during the period. Gross margin of system contracting projects was 47.8% for the six months ended June 30, 2011, compared to 55.1% for the six months ended June 30, 2010. The decrease in gross margin of system contracting projects was mainly attributable the following factors: 1) in order to meet the execution timeline for the Wuhan Project, we outsourced certain portions of the project to a subcontractor and such outsourcing resulted in an increase in the overall estimated cost; and; 2) the contract mix during the period, as the gross margin of system contracting projects represents the average value of the gross margins of different system contracting projects executed during the period. Since gross margins during each quarter are determined by the revenue-weighted average of gross margins which are comprised of the gross margins of different system contracting projects executed during the period, the decrease in gross margins of system contracting projects were primarily due to the different contract mix during the six months ended June 30, 2011. The gross margin of product sales was 44.3% for the six months ended June 30, 2011, compared to 59.1% for the six months ended June 30, 2010. The decrease in the gross margin of product sales was mainly attributable to a lower percentage of self-manufactured proprietary products sold through our product sales contracts during the period, contributing to lower gross margin. Of the products sales in the six months ended June 30, 2011, the percentage of self-manufactured proprietary products decreased to 17.0 %, compared to 39.8 % in the six months ended June 30, 2010. The main reason for the shift in sales from self-manufactured products to third-party manufactured products is the percentage of product sales to the nuclear industry and international market from India increased significantly to 40.1 % in the six months ended June 30, 2011, compared to 23.5 % for the same period of last year. Since product sales contracts from both the nuclear industry and international market from India typically use fewer self-manufactured proprietary products than other industries, the higher sales contribution from the nuclear industry and international market in India resulted in a lower percentage of self-manufactured proprietary products during the period. Gross margin of maintenance services was 27.2% for the six months ended June 30, 2011, compared to 34.1% for the six months ended June 30, 2010. This decrease in the gross margin of maintenance services was primarily due to the increase in labor costs associated with the maintenance contracts during the period. For the Six Months Ended June 30, 2011 ? 2010 ? Y/Y Change ? % of Total % of Total Amount ($) Revenue Amount ($) Revenue Amount ($) % Operating Expenses Selling Expense 4,727,190 9.4 % 4,205,360 9.6 % 521,830 12.4 % General Administrative 5,997,654 11.9 % 5,558,741 12.7 % 438,913 7.9 % Depreciation and Amortization 513,483 1.0 % 402,161 0.9 % 111,322 27.7 % ? R&D 948,852 1.9 % 796,597 1.8 % 152,255 19.1 % Total ? Operating Expenses 12,187,179 24.2 % 10,962,859 25.0 % 1,224,320 11.2 % Income ? From Operations 11,056,201 22.0 % 13,064,349 29.8 % -2,008,148 -15.4 % Operating expenses were approximately $12.2 million for the six months ended June 30, 2011 as compared to approximately $11.0 million for the six months ended June 30, 2010, an increase of approximately $1.2 million or 11.2 %. The increase in operating expenses was mainly due to the increase in our selling expense, general administrative expenses, depreciation and amortization and R&D expenses during the period. 38-------------------------------------------------------------------------------- Selling expenses were approximately $4.7 million for the six months ended June 30, 2011 as compared to approximately $4.2 million for the six months ended June 30, 2010, an increase of approximately $0.5 million or 12.4%. The increase in selling expenses was mainly attributable to the increase in compensation to our sales team and the increase in the expense related to our warranty expenses during the period. General administrative expenses were approximately $6.0 million for the six months ended June 30, 2011, as compared to approximately $5.6 million for the six months ended June 30, 2010, an increase of approximately $0.4 million or 7.9 %. The increase in general administrative expenses was mainly attributable to increases in overall compensation to our employees during the period. Depreciation and amortization expenses were approximately $0.5 million for the six months ended June 30, 2011 as compared to approximately $0.4 million for the six months ended June 30, 2010, an increase of $111,322 or 27.7%. The increase in depreciation and amortization expenses was mainly due to the increase in plant and equipment related to business operations. R&D expenses were approximately $0.9 million for the six months ended June 30, 2011 as compared to approximately $0.8 million for the six months ended June 30, 2010, an increase of $152,255 or 19.1%. The increase in our R&D expenses was mainly attributable to the variance in expenditure required in different product development cycles. Income from operations was approximately $11.1 million for the six months ended June 30, 2011 as compared to approximately $13.1 million for the six months ended June 30, 2010, a decrease of $2.0 million or 15.4%. The decrease in our operating income was mainly attributable to the decrease in our gross margin and increase in our operating expenses during this period. Total net other income was approximately $0.2 million for the six months ended June 30, 2011 as compared to approximately $0.5 million for the six months ended June 30, 2010, a decrease of $302,602 or 58.1 %. This decrease was mainly attributable to the increase in bank charges incurred for the security deposits made for new projects developed in India during the period. Income before income tax was approximately $11.3 million for the six months ended June 30, 2011 as compared to approximately $13.6 million of income before income tax for the six months ended June 30, 2010, a decrease of $2.3 million or 17%. The reason for this decrease in income before income tax was mainly due to the decrease in our gross margin and increase in our operating expenses during the period. Provision for income tax was approximately $2.3 million for the six months ended June 30, 2011 as compared to approximately $2.1 million in provision for income tax for the six months ended June 30, 2010, an increase of $262,969. The slight increase in provision for income tax was mainly due to an increase in the effective tax rate from 15.1% to 20.5% caused by the expiration of 50% tax deduction claimed by two of our subsidiaries - Sureland Equipment and Beijing Hua'an, and offset by the decrease of net income before income tax during the current period compared with the same period in prior year. Our net income was approximately $8.9 million for the six months ended June 30, 2011 as compared to approximately $11.6 million net income for the six months ended June 30, 2010, a decrease of approximately $2.6 million or22.8%. This decrease in the net income was mainly due to the decrease in our gross margin and the increase in our operating expenses during the period. Currency translation adjustments resulting from RMB appreciation amounted to $2.6 million and $467,273 for the six months ended June 30, 2011 and 2010, respectively. Comprehensive income, which aggregates currency adjustment and net income, was approximately $11.6 million for the six months ended June 30, 2011 as compared to approximately $12.0 million for the six months ended June 30, 2010, a decrease of $0.4 million or 3.3 %. |