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CHINA CARBON GRAPHITE GROUP, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) This quarterly report on Form 10-Q contains forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. These risks and uncertainties include, but are not limited to, the factors described in the section captioned "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission. In some cases, you can identify forward-looking statements by terms such as "anticipates," " believes," "could," "estimates," "expects," "intends," "may," "plans," "potential," "predicts," "projects," "should," "would" and similar expressions intended to identify forward-looking statements. Forward-looking statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, undue reliance should not be placed on these forward-looking statements. Also, forward-looking statements represent our estimates and assumptions only as of the date of this report. This Annual Report should be read in its entirety and with the understanding that our actual future results may be materially different from what we expect. Except as required by law, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, even if new information becomes available in the future. Overview We are engaged in the manufacture of graphite-based products in the PRC. Our products are used in the manufacturing process of other products, particularly non-ferrous metals and steel, and are incorporated in various types of products or processes, such as atomic reactors. We currently manufacture and sell primarily the following types of graphite products: o graphite electrodes; o fine grain graphite; and o high purity graphite. Based on information we receive about our industry in the course of our business, we believe that we are the largest wholesale supplier of fine grain graphite and high purity graphite in China and one of China's largest producers and suppliers of graphite products overall. Approximately 40% of our products are sold directly to end users in China, primarily consisting of steel manufacturers. All other sales are made to over 200 distributors located throughout 22 provinces in China. Our distributors then sell our products to end users both in China and in foreign countries, including, among others, Japan, the United States, Spain, England, South Korea and India. In 2012, our revenues and profits decreased from 2011 due to a decrease in demand for our products, which resulted from more competitive market conditions, as discussed in greater detail below under the heading "Results of Operations." This trend continues into 2013. The steel industry started to recover in 2010, in particular since the third quarter of 2010. Our revenues, gross profits and gross margins improved significantly during the second half of 2010, which continued into the end of 2011. In 2012, our revenues decreased due to slowdown of steel. Our gross margin for the three months ended March 31, 2013 was (8.5)%, compared to 29.0% for the three months ended March 31, 2012 due to the strong competition, and increased deprecation and amortization expenses in the cost of goods sold due to the increased property and equipment used in the manufacturing process. Our cash increased and our accounts receivables decreased during the three months ended March 31, 2013 compared to the three months ended March 31, 2012, while collectability of our receivables remained highly probable. We believe that our allowance for doubtful accounts as of March 31, 2013 was adequate. We plan to continue to focus on increasing the percentage of our high margin products including large size ultra-high power graphite electrodes, high purity graphite and fine gain graphite. The current budgeted investment for the construction of our new production facility was approximately $17.7 million in the aggregate. Approximately $11.4 million had been spent as of March 31, 2013. 31 -------------------------------------------------------------------------------- Some of our expansion plans, including the expansion of our product offerings to include nuclear, solar and semiconductor products and pursuing an acquisition, would likely require us to obtain additional financing from equity or debt markets, or borrow additional funds from local banks. There is no assurance that we will be able to raise any funds on terms favorable to us, or at all. In the event that we issue shares of equity or convertible securities, holdings of our existing stockholders would be diluted. In addition, there is no assurance that we will successfully manage and integrate the production and sale of new products. At March 31, 2013, we had short-term bank loans of approximately $45.2 million. These bank loans, which are secured by liens on our fixed assets and land use rights, are due between June 2013 and March 2014, including approximately $40 million owed to the Construction Bank of China. During the three months ended March 31, 2013, pursuant to a secured line of credit obtained from China Construction Bank in January 2012, the Company rolled over all of its short-term bank loans from the China Construction Bank. In January 2012, the Company entered into a secured line of credit agreement with China Construction Bank for borrowings up to $149 million (or RMB 930 million) between January 10, 2012 and August 4, 2015, which is secured by liens on our fixed assets and land use rights. Under the secured line of credit, the Company is entitled to draw funds through sub-agreements of bank loans, foreign currency loans, bank acceptance notes, letter of credit, or bank guarantee letter. As of March 31, 2013, the unpaid principal balance drawn from the secured line of credit was $51.4 million, including $39.6 million of short-term bank loans and $11.8 million of notes payable. Historically, we have rolled over our short-term loans when they became due. However, we cannot assure investors that our lenders, including the Construction Bank of China, will not demand repayment when these loans mature. If our lenders demand repayment when due, we may be unable to obtain the necessary funds to pay off these loans, which could result in the imposition of penalties, including a 50% increase in interest rates and a request from the banks for additional security for the loans. At March 31, 2013, our cash reserves, including restricted cash, were $24.0 million and are insufficient to pay off all of our loans when due. We purchase all of our raw materials from domestic Chinese suppliers. Because we do not have any long-term contracts with our suppliers, any increase in the prices of our raw materials would affect the price at which we can sell our products. If we are unable to pass on increased costs to our customers, we may be unable to maintain our profit margins. Raw material prices increased significantly in 2010 and 2011, but decreased during the year ended December 31, 2012. This trend continues into 2013. Selling price of our products also decreased in 2012 and in the first quarter of 2013, resulting in decreases in our gross margin. As of March 31, 2013 and December 31, 2012, advances to suppliers amounted to $12,503,217 and $1,177,462, respectively. The increase is because the Company advances $11,308,798 for a new construction project as of March 31, 2013. In times of decreasing prices, we may have to sell our products at prices, which are lower than the prices at which we purchased our raw materials. Furthermore, PRC regulations grant broad powers to the government to adjust the price of raw materials and manufactured products. Although the government has not imposed price controls on our raw materials or our products, it is possible that price controls may be implemented in the future, thereby affecting our results of operations and financial condition. 32 --------------------------------------------------------------------------------Results of Operations Three months ended March 31, 2013 and 2012 The following table sets forth the results of our operations for the periods indicated in U.S. dollars and as a percentage of net sales (dollars in thousands): Three months ended March 31, 2013 2012 Sales $ 3,061 100.0 % $ 10,061 100.0 % Cost of goods sold 3,320 108.5 % 7,144 71.0 % Gross profit (loss) (259 ) (8.5 )% 2,917 29.0 % Operating expenses Selling expenses 18 0.6 % 47 0.5 % General and administrative 385 12.6 % 851 8.5 % Depreciation and amortization 68 2.2 % 57 0.6 % Income (loss) from operations (730 ) (23.8 )% 1,962 19.5 % Other income 0.3 0.01 % - - % Other expense - - % - - % Change in fair value of warrants 44 1.4 % (479 ) (4.8 )% Interest expense, net (817 ) (26.7 )% (1,230 ) (12.2 )% Net income (loss) (1,502 ) (49.1 )% 253 2.5 % Preferred Stock Dividend (5 ) (0.1 )% (5 ) (0.1 )% Net income (loss) available to common shareholders $ (1,507 ) (49.2 )% $ 248 2.5 % Sales. During the three months ended March 31, 2013, we had sales of $3,060,918, compared to sales of $10,061,210 for the three months ended March 31, 2012, a decrease of $7,000,292, or approximately 69.6%. Sales decrease was mainly attributable to a significant decrease in the demand for our products during the three months ended March 31, 2013, which resulted from the struggle of steel companies. The breakdown of revenues for each of graphite electrodes, fine grain graphite and high purity graphite, during the three months ended March 31, 2013 and 2012, respectively, was as follows: March 31, March 31, 2013 % of Total 2012 % of Total Sales Sales Sales Sales Graphite Electrodes $ 80,960 2.6 % $ 456,647 4.5 % Fine Grain Graphite 1,394,956 45.6 % 4,467,350 44.4 % High Purity Graphite 1,491,521 48.7 % 5,051,089 50.2 % Others (1) 93,481 3.1 % 86,124 0.9 % Total $ 3,060,918 100.0 % $ 10,061,210 100.0 % (1) "Other" sales represent revenue generated by sales of semi-processed products and other types of products. 33 --------------------------------------------------------------------------------Cost of goods sold; gross margin . Our cost of goods sold consists of the cost of raw materials, utilities, labor, and depreciation expenses in our manufacturing facilities. During the three months ended March 31, 2013, our cost of goods sold was $3,320,320, compared to $7,143,606 for the cost of goods sold for the three months ended March 31, 2012, a decrease of $3,823,286, or approximately 53.5%. The decrease in the cost of sales was mainly due to decrease in sales volume. Our gross margin decreased from 29.0% for the three months ended March 31, 2012 to (8.5)% for the three months ended March 31, 2013. This decrease is mainly due to decreased sales price due to competition and less demand and increased cost of goods sold due to increased depreciation allocated to the cost of goods sold due to the transfer of construction in progress to property and equipment since the end of 2012. Operating expenses. Operating expenses totaled $470,411 for the three months ended March 31, 2013, compared to $955,201 for the three months ended March 31, 2012, a decrease of $484,790, or approximately 50.8%. Selling, general and administrative expenses Selling expenses decreased from $46,798 for the three months ended March 31, 2012 to $17,941 for the three months ended March 31, 2013, a decrease of $28,857, or 61.7%. The decrease was mainly due to decreased sales commission and lower shipping and handling expenses during the three months ended March 31, 2013 as compared to the three months ended March 31, 2012, which resulted from lower sales. Our general and administrative expenses consist of salaries, office expenses, utilities, business travel, amortization expenses, public company expenses (including legal expenses, accounting expenses and investor relations expenses) and stock compensation. General and administrative expenses were $384,582 for the three months ended March 31, 2013, compared to $851,399 for the three months ended March 31, 2012, a decrease of $466,817, or 54.8%. The decrease in general and administrative expenses was mainly due to decreased consulting expenses, decreased bad debt expenses offset by increased salary expenses for the three months ended March 31, 2013 compared to the three months ended March 31, 2012. 34 --------------------------------------------------------------------------------Depreciation and amortization expenses Depreciation and amortization expenses totaled $655,449 for the three months ended March 31, 2013, compared to $567,584 for the three months ended March 31, 2012, an increase of $87,865, or approximately 15.48%. For the three months ended March 31, 2013, depreciation and amortization was allocated between costs of goods sold and selling, general and administrative expenses in the amounts of $587,561 and $67,888, respectively. For the three months ended March 31, 2012, depreciation and amortization was allocated between costs of goods sold and selling, general and administrative expenses in the amounts $510,580 and $57,004, respectively. The increase in depreciation and amortization expenses is due to additional fixed assets placed in service. Income (Loss) from operations. As a result of the factors described above, operating loss was $729,813 for the three months ended March 31, 2013, compared to operating income of $1,962,403 for the three months ended March 31, 2012, a decrease of approximately $2,692,216, or 137.2%. Other income and expenses. Our interest expense was $862,448 for the three months ended March 31, 2013, compared to $1,229,745 for the three months ended March 31, 2012, reflecting decreased interest expenses on loans from banks. Expenses from changes in the fair value of our warrants as a result of adopting ASC 820-10 was $44,368 for the three months ended March 31, 2013, compared to $(479,563) for the three months ended March 31, 2012. Income tax. During the three months ended March 31, 2013 and 2012, we benefited from a 100% tax holiday from the PRC enterprise tax. As a result, we had no income tax due for these periods. The enterprise income tax at the statutory rates would have been approximately $0 and $165,203, respectively, for the three months ended March 31, 2013 and 2012 without consideration of adjustments on taxable income. The tax holiday is from 2008 through 2017. Net income (loss). As a result of the factors described above, our net loss for the three months ended March 31, 2013 was $1,502,268, compared to net income of $253,117 for the three months ended March 31, 2012, a decrease of $1,755,385, or 693.5%. Foreign currency translation. Our consolidated financial statements are expressed in U.S. dollars but the functional currency of our operating subsidiary is 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. Translation adjustments resulting from the process of translating the financial statements denominated in RMB into U.S. dollars are included in determining comprehensive income. Our foreign currency translation gain for the three months ended March 31, 2013 was $146,277, compared to $423,897 for the three months ended March 31, 2012, a decrease of $277,620, or 65.5%. 35 --------------------------------------------------------------------------------Preferred Stock Dividend. Pursuant to the terms of a private placement that closed on December 22, 2009 and January 13, 2010, the Series B Preferred Stock offers a 6% dividend. The preferred stock dividend is payable quarterly commencing April 1, 2010. As a result, we incurred dividend expenses of $4,537 and $5,018 for the three months ended March 31, 2013 and 2012, respectively. Net income (loss) available to common stockholders. Net loss available to our common stockholders was $1,506,805, or $(0.06) per share (basic and diluted), for the three months ended March 31, 2013, compared to net income of $248,099, or $0.01 per share (basic and diluted), for the three months ended March 31, 2012. Liquidity and Capital Resources All of our business operations are carried out by Xingyong, and all of the cash generated by our operations has been held by that entity. In order to transfer such cash to our parent entity, China Carbon Graphite Group, Inc., which is a Nevada corporation, we would need to rely on dividends, loans or advances made by our PRC subsidiaries or VIE entity. Such transfers may be subject to certain regulations or risks. To date, our parent entity has paid its expenses by raising capital through private placement transactions. In the future, in the event that our parent entity is unable to raise needed funds from private investors, Xingyong would have to transfer funds to our parent entity through our wholly-owned subsidiaries, Talent and Yongle. PRC regulations relating to statutory reserves and currency conversion would impact our ability to transfer cash within our corporate structure. The Company Law of the PRC applicable to Chinese companies provides that net after tax income should be allocated by the following rules: 1. 10% of after tax income to be allocated to a statutory surplus reserve until the reserve amounts to 50% of the company's registered capital. 2. If the accumulate balance of statutory surplus reserve is not enough to make up the Company's cumulative prior years' losses, the current year's after tax income should be first used to make up the losses before the statutory surplus reverse is drawn. 3. Allocation can be made to the discretionary surplus reserve, if such a reserve is approved at the meeting of the equity owners. 36-------------------------------------------------------------------------------- Therefore, the Company is required to maintain a statutory reserve in China that limits any equity distributions to its shareholders. The maximum amount of the shareholders has not been reached. The company has never distributed earnings to shareholders and has consistently stated in the Company's filings it has no intentions to do so. The RMB is not freely convertible into Dollars. The State Administration of Foreign Exchange ("SAFE") administers foreign exchange dealings and requires that they be conducted though designated financial institutions. Foreign Investment Enterprises, such as Xingyong, may purchase foreign currency from designated financial institutions in connection with current account transactions, including profit repatriation. These factors will limit the amount of funds that we can transfer from Xingyong to our parent entity and may delay any such transfer. In addition, upon repatriation of earnings of Xingyong to the United States, those earnings may become subject to United States federal and state income taxes. We have not accrued any U.S. federal or state tax liability on the undistributed earnings of our foreign subsidiary because those funds are intended to be indefinitely reinvested in our international operations. Accordingly, taxes imposed upon repatriation of those earnings to the U.S. would reduce the net worth of the Company. Our primary capital needs have been to fund our working capital requirements. Our primary sources of financing have been cash generated from short-term and long-term loans from banks in China, loans from unrelated parties and loans from related parties. Currently and for the last two fiscal years, the Company has managed to operate the business with a low net working capital. The Company's low working capital is primarily due to substantial short-term loans from banks and borrowing from related parties. The Company is able to operate with a low net working capital because of local community and governmental support in Inner Mongolia. For example, the local Chinese government and the Company agreed on terms for the land use rights of 387,838 square meters of land located adjacent to the Company's facilities, as described below under the heading "Summary of Significant Accounting Policies-Land Use Rights." 37 --------------------------------------------------------------------------------At March 31, 2013, we had short-term loans in the aggregate amount of $45,241,000 outstanding, as described below. March 31, December 31, 2013 2012 (unaudited)Bank loan from China Construction Bank, dated August 23, 2012, due August 22, 2013 with an annual interest rate of 6.941% payable monthly, secured by property, equipment, building and land use rights $ 6,440,000 $ 6,420,000 Bank loan from China Construction Bank, dated August 3, 2012, due August 2, 2013 with an annual interest rate of 6.941% payable monthly, secured by property, equipment, building and land use rights 6,440,000 6,420,000 Bank loan from China Construction Bank, dated June 6, 2012, due June 5, 2013 with an annual interest rate of 8.834% payable monthly, secured by property, equipment, building and land use rights 6,440,000 6,420,000 Bank loan from China Construction Bank, dated March 20, 2013, due March 19, 2014 with an annual interest rate of 6% payable monthly, secured by property, equipment, building and land use rights 6,440,000 - Bank loan from Huaxia Bank, dated November 16, 2012, due on November 15, 2013 with an annual interest rate of 7.80% payable quarterly, secured by building and land use rights 5,635,000 5,617,500 Bank loan from China Construction Bank, dated September 7, 2012, due September 6, 2013 with an annual interest rate of 6.941% payable monthly, secured by property, equipment, building and land use rights 4,830,000 4,815,000 Bank loan from China Construction Bank, dated January 11, 2013, due January 10, 2014 with an annual interest rate of 6% payable monthly, secured by property, equipment, building and land use rights 4,830,000 - Bank loan from China Construction Bank, dated September 17, 2012, due September 16, 2013, with an annual interest rate of 6.941% payable monthly, secured by property, equipment, building and land use rights 4,186,000 4,173,000 Bank loan from China Construction Bank, dated January 13, 2012, due January 12, 2013 and repaid, with an annual interest rate of 6.56% payable monthly, secured by property, equipment, building and land use rights - 4,815,000 $ 45,241,000 $ 38,680,500 In January 2012, the Company entered into a secured line of credit agreement with China Construction Bank for borrowings up to $149 million (or RMB 930 million) between January 10, 2012 and August 4, 2015, which is secured by liens on our fixed assets and land use rights. Under the secured line of credit, the Company is entitled to draw funds through sub-agreements of bank loans, foreign currency loans, bank acceptance notes, letter of credit, or bank guarantee letter. As of March 31, 2013, the unpaid principal balance drawn from the secured line of credit was $51.4 million, including $39.6 million of short-term bank loans as disclosed above and $11.8 million of notes payable. Each of these loans is renewable at the lender's discretion. As of March 31, 2013, all land use rights and certain property and equipment were pledged as collateral for our short-term bank loans. Interest expenses were $862,448 and $1,229,745 for the three months ended March 31, 2013 and 2012, respectively. 38 --------------------------------------------------------------------------------The weighted average interest rates for these loans were 7.08% and 6.92% as of March 31, 2013 and December 31, 2012, respectively. Capitalized interest were $178,177 and $0 for the three months ended March 31, 2013 and 2012, respectively. Long term bank loans: March 31, December 31, 2013 2012 (Unaudited) Bank loan from China Construction Bank, dated January 22, 2013, originally due in January 21, 2016, with an annual interest rate of 6.15%, payable monthly, secured by machinery. $ 11,270,000 $ - Bank loan from Credit Union, dated April, 2012, originally due in April 2015, with an annual interest rate of 15.295% payable monthly, secured by machinery. 4,797,800 4,782,900 $ 16,067,800 $ 4,782,900 Historically we have been able to renew our short-term loans on an annual basis. Although we believe that we will be able to obtain extensions of these loans when they mature, we cannot assure investors that such extensions will be granted. In the event repayment of the loans is not extended and we default on our obligations, the lenders could call the loans, foreclose on the collateral securing the loans or seek other remedies. If a lender foreclosed on our land, the lender would acquire the land use rights to such land, which rights are currently held by us. In addition, because we did not pay for the land use rights that were granted to us with respect to a portion of our facilities, we are required to keep such property in good condition and to allocate a portion of the land as a park that can be accessed by the public. In such an event, our operations and financial conditions would be materially adversely affected and we would be forced to cease operations if alternative funding is not obtained. Despite a low amount of working capital, we are able to operate our business through bank financing, loans from related and unrelated parties and issuing equity in exchange for certain services provided. Our long-term goal is to continue to roll over short-term loans and obtain positive cash flows from collecting our outstanding accounts receivable and sales of inventory until our new facility is operating at full capacity. We have the ability to manage and predict our cash flow for inventory purchases and advances to suppliers because the length of the time it takes to complete purchase orders for customers, which on average is six months. Our customers must order products well in advance of productions, as a purchase order is fulfilled only six months after such order is placed, thereby allowing us to predict cash flow. During the interim, we expect that anticipated cash flows from future operations, short-term and long-term bank loans and loans from unrelated or related parties will be sufficient to fund our operations through at least the next twelve months, provided that : o we generate sufficient business so that we are able to generate substantial profits, which cannot be assured; 39--------------------------------------------------------------------------------o our banks continue to provide us with the necessary working capital financing; and o we are able to generate savings by improving the efficiency of our operations. We may require additional equity, debt or bank funding to finance acquisitions or to allow us to produce graphite for the nuclear industry, which is one of our primary growth strategies. We can provide no assurances that we will be able to enter into any additional financing agreements on terms favorable to us, if at all, especially considering the current global instability of the capital markets. At March 31, 2013, cash and cash equivalents were $1,680,254, compared to $129,746 at December 31, 2012, an increase of $1,550,508. Restricted cash increased to $22,379,000 as of March 31, 2013 from $22,149,000 as of December 31, 2012, which was restricted as a requirement by our lenders. Our working capital deficit increased by $1,368,946 to a deficit of $1,860,693 at March 31, 2013 from a deficit of $491,747 at December 31, 2012. As of March 31, 2013, accounts receivable, net of allowance, was $7,142,892, compared to $11,239,002 at December 31, 2012, a decrease of $4,096,110, or 36.45%. The decrease was mainly due to decreased sales during the three months ended March 31, 2013. Accounts receivable are recorded at the invoiced amount and do not bear interest. Our management reviews the adequacy of our allowance for doubtful accounts on an ongoing basis, using historical collection trends and the aging of receivables. Management also periodically evaluates individual customer's financial condition, credit history, and the current economic conditions to make adjustments in the allowance when it is considered necessary. The Company believes its allowance was sufficient as of March 31, 2013. As of March 31, 2013, inventories were $48,181,039, compared to $48,417,875 at December 31, 2012, a decrease of $236,836, or 0.49%. The decrease in inventories is because the Company is keeping lower inventory due to slower sales. As of March 31, 2013, prepaid expenses were $785,438, compared to $280,779 at December 31, 2012, an increase of $504,659, or 179.74%. The increase in prepaid expenses is attributable to increased prepaid services during the quarter ended March 31, 2013 offset by the amortization of various prepaid consulting fees paid from stock issuances. Advances to suppliers increased from $1,177,462 at December 31, 2012 to $12,503,217 at March 31, 2013, an increase of $11,325,755. The increase is because the Company advances $11,308,798 for a new construction project as of March 31, 2013. No allowance for doubtful accounts was necessary for the balance of advances to suppliers. Notes payable reflect our obligations to bank lenders who have guaranteed our future payment obligations as requested by certain of our suppliers. Notes payable increased from $40,606,500 to $40,733,000 from December 31, 2012 to March 31, 2013. The increase is due to the Company obtaining additional fund to secure its inventory. The notes payable were secured by $22,379,000 of restricted cash at March 31, 2013. Notes payable allow the Company to reserve more cash resources for other operating expenses. Restricted cash represents amounts held by a bank as security for bank acceptance notes and is subject to withdrawal restrictions. 40--------------------------------------------------------------------------------Three months ended March 31, 2013 Compared to Three months ended March 31, 2012 The following table sets forth information about our net cash flow for the three months indicated: Cash Flows Data: For Three Months Ended March 31 2013 2012 Net cash flows used in operating activities $ (15,210,594 ) $ (8,089,943 ) Net cash flows used in investing activities $ (11,577,432 ) $ (429,610 ) Net cash flows provided by financing activities $ 28,335,251 $ 8,363,985 Net cash flow used in operating activities was $15,210,594 for the three months ended March 31, 2013, compared to $8,089,945 for the three months ended March 31, 2012, an increase of $7,120,649, or 88.0%. The increase in net cash flow used in operating activities was mainly due to less increase in accounts receivable of $4.1 million, less payments made to acquire inventories of $4.5 million, which was offset by, increased net loss of $1.8 million, increased payments for advance to suppliers of $6.1 million and more payments made for other receivable of $7.2 million. Net cash flow used in investing activities was $11,577,432 for the three months ended March 31, 2013, compared to $429,610 for the three months ended March 31, 2012, an increase of $11,147,822, or 2,594.9%. Approximately $0.11 million was spent on construction costs and $2 thousand was spent for property and equipment and $11.6 million was spent for construction in progress for our new construction during the three months ended March 31, 2013. Approximately $0.6 million was spent on construction costs and $0.02 million was spent for property and equipment for our new factory during the three months ended March 31, 2012. Net cash flow provided by financing activities was $28,335,251 for the three months ended March 31, 2013, compared to $8,363,985 for the three months ended March 31, 2012, an increase of $19,971,266 or 238.8%. The increase in net cash flow provided by financing activities was due to the increase in proceeds from unrelated parties, increase in additional notes payable, increase in short-term loans and long-term loans entered into during the three months ended March 31, 2013, which offset mainly by a decrease in the amount of restricted cash of $5.1 million required to secure our notes payable. The Company had borrowed approximately $17.7 million of notes payable for the three months ended March 31, 2013, compared to $10.8 million for the three months ended March 31, 2012. In addition, the aggregate amount of outstanding short-term loans borrowed and repaid increased for the three months ended March 31, 2013. The Company borrowed $11.2 million in short-term bank loans and repaid $4.8 million during the three months ended March 31, 2013, while the Company borrowed $4.8 million in short-term bank loans and repaid $4.8 million for the three months ended March 31, 2012. 41--------------------------------------------------------------------------------Concentration of Business and Credit Risk Most of the Company's bank accounts are in banks located in the PRC and are not covered by any type of protection similar to that provided by the Federal Deposit Insurance Corporation ("FDIC") on funds held in U.S. banks. The Company's bank account in the United States is covered by FDIC insurance. Because the Company's operations are located in the PRC, this may give rise to significant foreign currency risks due to fluctuations in and the volatility of foreign exchange rates between U.S. dollars and RMB. Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash, trade accounts receivables and inventories, the balances of which are stated on the balance sheet. The Company places its cash in banks located in China. Concentration of credit risk with respect to trade accounts receivables is limited due to the diversity of the Company's customers who are located in different regions of China. The Company does not require collateral or other security to support financial instruments subject to credit risk. For the three months ended March 31, 2013, three customers accounted for 10% or more of sales revenues, representing 36%, 23% and 23%, respectively of the total sales. For the three months ended March 31, 2012, three customers accounted for 10% or more of sales revenues, representing 43.2%, 15.0% and 14.3%, respectively of the total sales. As of March 31, 2013, there were two customers that constituted 58% and 25% of the accounts receivable. As of December 31, 2012, there were three customers that constituted 42.2%, 16.5% and 10.3% of the accounts receivable. For the three months ended March 31, 2013, three suppliers accounted for 10% or more of our total purchases, representing 59.7%, 22.6%, respectively. For the three months ended March 31, 2012, three suppliers accounted for 10% or more of our total purchases, representing 33.2%, 22.4%, and 17.0%, respectively.. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements. Significant Accounting Estimates and Policies The discussion and analysis of our financial condition and results of operations is based upon our financial statements that 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 and liabilities. On an ongoing basis, we evaluate our estimates including the allowance for doubtful accounts, the salability and recoverability of our products, income taxes and contingencies. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. 42--------------------------------------------------------------------------------Revenue Recognition We recognize revenue in accordance with ASC 605-25, Revenue Recognition, which states that revenue should be recognized when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) the service has been rendered; (3) the selling price is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. Sales represent the invoiced value of goods, net of value added tax ("VAT"), if any, and are recognized upon delivery of goods and passage of title. In accordance with ASC 605-25, the Company recognizes revenue when persuasive evidence of an arrangement exists, transfer of title has occurred or services have been rendered, the selling price is fixed or determinable and collectability is reasonably assured. The Company derives revenues from the manufacturing and distribution of graphite based products. The Company recognizes its revenues net of VAT. The Company is subject to VAT, which is levied on a majority of the products, at a rate ranging from 13% to 17% on the invoiced value of sales. Output VAT is borne by customers in addition to the invoiced value of sales and input VAT is borne by the Company in addition to the invoiced value of purchases to the extent not refunded for export sales. The Company recognizes revenue upon receipt of the delivery confirmation provided by the customer or distributor. The Company does not provide chargeback or price protection rights to the distributors. The distributor only places purchase orders with the Company once it has confirmed the sale with a third party because this is a specialized business, which dictates that the Company will not manufacture the products until the purchase order is received. The Company allows its customers to return products only if its products are later determined by the Company to be defective. Based on the Company's historical experience, product returns have been insignificant throughout all of its product lines. Therefore, the Company does not estimate deductions or allowances for sales returns. If sales returns occur, they are taken against revenue when products are returned from customers. Sales are presented net of any discounts given to customers. Interest income is recognized when earned. The Company experienced no returns for the three months ended March 31, 2013 and 2012. Comprehensive Income We have adopted ASC 220, Comprehensive Income, formerly known as SFAS No. 130, Reporting Comprehensive Income, which establishes standards for reporting and presentation of comprehensive income (loss) and its components in a full set of general purpose financial statements. We have chosen to report comprehensive income (loss) in the statements of operations and comprehensive income. 43 --------------------------------------------------------------------------------Income Taxes We account for income taxes under the provisions of ASC 740, Income Tax, formerly known as SFAS No. 109, Accounting for Income Taxes, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 2008, the new Chinese income tax law sets unified income tax rates for domestic and foreign companies at 25%, except for a 15% corporate income tax rate for qualified high technology and science enterprises. In accordance with this new income tax law, low preferential tax rates in accordance with both the tax laws and administrative regulations prior to the promulgation of this law gradually become subject to the new tax rate within five years after the implementation of this law. We have been recognized as a high technology and science company by the Ministry of Science and Technology of the PRC. The Xing He District Local Tax Authority in the Nei Mongol province granted us a 100% tax holiday with respect to enterprise income tax for ten years from 2008 through 2017. Afterwards, based on the present tax law and our status as a qualified high technology and science company, we will be subject to a corporate income tax rate of 15% effective in 2018. Accounts Receivable and Allowance For Doubtful Accounts Accounts receivables are recognized and carried at the original invoice amount less allowance for any uncollectible amounts. An estimate for allowance for doubtful accounts is made when collection of the full amount is no longer probable. Bad debts are written off as incurred. Accounts receivable are recorded at the invoiced amount and do not bear interest. Management reviews the adequacy of the allowance for doubtful accounts on an ongoing basis, using historical collection trends and aging of receivables. Management also periodically evaluates individual customer's financial condition, credit history, and the current economic conditions to make adjustments in the allowance when it is considered necessary. The allowance for doubtful accounts amounted to $3,717,232 as of March 31, 2013. Management believes that this allowance is sufficient based on a review of customer credit history, historic payment records, aging, the market and other factors. Inventories Inventories are stated at the lower of cost, determined on a weighted average basis, and net realizable value. Work in progress and finished goods are composed of direct material, direct labor and a portion of manufacturing overhead. Net realizable value is the estimated selling price, in the ordinary course of business, less estimated costs to complete and dispose. Management believes that there was no obsolete inventory as of March 31, 2013 or December 31, 2012 and therefore, no allowance for inventory was necessary. 44 --------------------------------------------------------------------------------Property, Plant and Equipment Property, plant and equipment are stated at cost. Major expenditures for betterments and renewals are capitalized while ordinary repairs and maintenance costs are expensed as incurred. Depreciation and amortization is provided using the straight-line method over the estimated useful life of the assets after taking into account the estimated residual value. The Company reviews the carrying value of property, plant, and equipment for impairment whenever events and circumstances indicate that the carrying value of an asset may not be recoverable from the estimated future cash flows expected to result from its use and eventual disposition. In cases where undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized equal to an amount by which the carrying value exceeds the fair value of assets. The factors considered by management in performing this assessment include current operating results, trends and prospects, the manner in which the property is used, and the effects of obsolescence, demand, competition, and other economic factors. Based on this assessment, there was no impairment recorded during the years ended at March 31, 2013 and December 31, 2012. Land Use Rights There is no private ownership of land in China. All land ownership is held by the government, its agencies and collectives. Land use rights are obtained from the government, and are typically renewable. Land use rights can be transferred upon approval by State Land Administration Bureau and payment of the required transfer fee. We record the property subject to land use rights as intangible asset. The Company has land use rights of 386,853 square meters used for operations in Xinghe County, Inner Mongolia, China. The land use rights have terms of 50 years, with the land use right relating to 130,220 square meters expiring in 2052 and the land use right with respect to 256,633 square meters expiring in 2053. In addition, in 2011, the local Chinese government and the Company agreed on terms for the land use rights of 387,838 square meters of land located adjacent to the Company's facilities. The Company was not required to sign a land use right agreement or pay a fee. In exchange, the Company will allow public use of this 387,838 square meters of land and keep the land in good condition. The land use right has a term of 50 years, with such term expiring in January 2060. The value of the land is estimated to be $14,000,000. The Company has not accrued the liability or recorded the land use right asset for this property in accordance with ASC 450, Contingencies. Because of our current relationship and agreement with the local government to keep the land in good condition, we believe that it is unlikely that we will have to pay for the land use right. The bank allows, and the Company uses, this land use right as collateral for its short-term bank loans. We believe that our facilities are sufficient to meet our current and near future requirements and that any additional space that we may require would be available on commercially reasonable terms. 45 -------------------------------------------------------------------------------- Each intangible asset is reviewed periodically or more often if circumstances dictate, to determine whether its carrying value has become impaired. We consider assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. We also re-evaluate the amortization periods to determine whether subsequent events and circumstances warrant revised estimates of useful lives. Research and Development Research and development costs are expensed as incurred, and are included in general and administrative expenses. These costs primarily consist of the cost of material used and salaries paid for the development of our products and fees paid to third parties. Our research and development expense for the three months ended March 31, 2013 and 2012 has not been significant. Value Added Tax Pursuant to China's VAT rules and regulations, as an ordinary VAT taxpayer we are subject to a tax rate of 17% ("output VAT"). The output VAT is payable after offsetting VAT paid by us on purchases ("input VAT"). Under the commercial practice of the PRC, the Company paid VAT and business tax based on tax invoices issued. The tax invoices may be issued subsequent to the date on which revenue is recognized, and there may be a considerable delay between the date on which the revenue is recognized and the date on which the tax invoice is issued. In the event that the PRC tax authorities dispute the date on which revenue is recognized for tax purposes, the PRC tax office has the right to assess a penalty, which can range from zero to five times the amount of the taxes that are determined to be late or deficient. In the event that a tax penalty is assessed on late or deficient payments, the penalty will be expensed as a period expense if and when a determination has been made by the taxing authorities that a penalty is due. Fair Value of Financial Instruments On January 1, 2008, the Company began recording financial assets and liabilities subject to recurring fair value measurement at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. On January 1, 2009, the Company began recording non-recurring financial as well as all non-financial assets and liabilities subject to fair value measurement under the same principles. These fair value principles prioritize valuation inputs across three broad levels. The three levels are defined as follows: Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liabilities, either directly or indirectly, for substantially the full term of the financial instruments. 46-------------------------------------------------------------------------------- Level 3 inputs to the valuation methodology are unobservable and significant to the fair value. The carrying amounts of financial assets and liabilities, including cash and cash equivalents, accounts receivable, notes receivable, advances to suppliers, other receivables, short-term bank loans, notes payable, accounts payable, advances from customers and other payables, approximate their fair values because of the short maturity period for these instruments. The following table sets forth by level within the fair value hierarchy of the Company's financial assets and liabilities that was used to calculate fair value on a recurring basis as of March 31, 2013: Carrying Value at March 31, Fair Value Measurement at March 31, 2013 2013 Level 1 Level 2 Level 3 Warrant liability $ 179,994 $ - $ - $ 179,994 The following table sets forth by level within the fair value hierarchy of the Company's financial assets and liabilities that was used to calculate fair value on a recurring basis as of December 31, 2012: Carrying Value at December 31, Fair Value Measurement at December 31, 2012 2012 Level 1 Level 2 Level 3 Warrant liability $ 224,362 $ - $ - $ 224,362 Please see Note 3 contained in the Notes to the Consolidated Financial Statements for a description of our warrant liability for the three months ended March 31, 2013 and 2012. The Company did not identify any other non-recurring assets and liabilities that are required to be presented on the balance sheet at fair value. Stock-based Compensation Stock-based compensation includes (i) common stock awards granted to employees and directors for services which are accounted for under FASB ASC 718, Compensation-Stock Compensation, and (ii) common stock awards granted to consultants which are accounted for under FASB ASC 505-50, Equity-Equity-Based Payments to Non-Employees. All grants of common stock awards and stock options to employees and directors are recognized in the financial statements based on their grant date fair values. The Company has elected to recognize compensation expense using the straight-line method for all common stock awards and stock options granted with service conditions that have a graded vesting schedule, with a corresponding charge to additional paid-in capital. 47 --------------------------------------------------------------------------------Common stock awards are granted to directors for services provided. Common stock awards issued to consultants represent common stock granted to non-employees in exchange for services at fair value. The measurement dates for such awards are set at the dates that the contracts are entered into as the awards are non-forfeitable and vest immediately. The measurement date fair value is then recognized over the service period as if the Company has paid cash for such service. The Company did not make significant grants to consultants for any of the periods presented. The Company estimates fair value of common stock awards based on the number of shares granted and the quoted price of the Company's common stock on the date of grant. Stock compensation expenses of $48,375 and $179,100 of were amortized and recognized as general and administrative expenses for the three months ended March 31, 2013 and 2012, respectively. Recent Accounting Pronouncements The Company has reviewed all recently issued, but not yet effective, accounting pronouncements and does not believe the future adoption of any such pronouncements will have a material impact on its financial condition or the results of its operations. |