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KEYUAN PETROCHEMICALS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and result of operations contains forward-looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in the "Risk Factors" section of the other reports we file with the Securities and Exchange Commission. Actual results may differ materially from those contained in any forward-looking statements. The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in the financial statements of Keyuan for the three and six months ended June 30, 2014 and 2013 and should be read in conjunction with such financial statements and related notes included in this report and the Company's Annual Report on Form 10-K for the year ended December 31, 2013. Overview Operating through our wholly-owned subsidiaries, Ningbo Keyuan, Ningbo Keyuan Petrochemicals, Keyuan Synthetic Rubbers and Guangxi Keyuan, our operations include (i) a production facility with an annual petrochemical production capacity of 720,000 metric tons (MT) of a variety of petrochemical products, (ii) a Styrene-Butadience-Styrene (the "SBS") production facility with a designed annual production capacity of 70,000 MT, (iii) facilities for the storage and loading of raw materials and finished goods and (iv) manufacturing technologies that can support our manufacturing process with relatively low raw material costs and high utilization and yields, all of which are led by a management team consisting of petrochemical experts with proven track records from some of China's largest state-owned enterprises in the petrochemical industry. In January 2012, we signed a cooperation agreement with Fangchenggang City to build a new petrochemicals production facility for the Guangxi Project. According to the cooperation agreement, the government of Fangchenggang City is responsible for providing the land use rights for the facility. This new production facility, as a part of our expansion plan, will improve our competitive position by extending and expanding our supply chain and manufacturing base. Once the facility is fully operational, it is expected to have an annual production capacity of 400,000 metric tons of ABS. In August 2013, we commenced engineering and facility construction. We are currently in the process of land leveling which is expected to be completed by the end of August 2014. According to the current schedule, construction of facilities and installation of pipe lines will be complete by the end of 2014. However, our schedule is subject to further adjustment pending the status of financing. The total investment amount to construct this new production facility is approximately USD $300 million. We plan to fund the construction and operation of the new production facility through outside financing. If such financing is not available on terms acceptable to us, construction of this facility will be delayed until appropriate financing is available. 18 Our organization chart is as follows: [[Image Removed]] Our Facility and Equipment Facility As of June 30, 2014, we have invested a total of approximately $97.1 million in the newly added construction and improvement of our production facility. Our current production facility encompasses approximately 1.3 million square feet, including 594,000 square feet for production and 19,500 square feet for laboratories and offices. We also acquired the land use right of an additional 1.2 million square feet of land in August 2010 for our expansion. We have a total of 100,000 MT of storage capacity, consisting of 50,000MT of storage capacity for raw materials and 50,000 MT for finished products. As a part of our expansion plan, we intend to add 50,000 MT of new storage capacity in 2014, after which our total storage capacity will be 150,000 MT. We completed construction of two new tanks with approximately 34,000 MT of storage capacity in June 2013 and the installation of pilings and pumps was completed in late October 2013. At the date of this Report, we have submitted the report and the related documents to the local environmental department for inspection and approval. Once we obtain the approval from the local environmental department, the two storage tanks will become operational. We expect that the operation will commence at the end of August 2014, if there are no adjustments required by the local environmental department. For the rest of approximately 16,000 MT of new storage capacity, we are planning to start the construction in October 2014 and expect to complete the work at the end of September 2015. We have an on-site ocean shipping dock with 5,000 MT of shipping capacity and a 10-truck loading facility. Approximately 90% of our feedstock and finished products use this shipping dock. We also have adjacent access to another shipping dock with an additional 50,000 MT of shipping capacity. During the first three months of 2014, we started the application to the local government in Ningbo to upgrade the classification of our own dock so that we can unload foreign cargo vessels under the 50,000 MT cargo capacity to our dock directly. We expect that the upgrading will be completed by the end of 2016 and we will be able to save additional logistics costs and storage fees once it is completed. 19 Equipment Our major processing equipment includes the following: ? Heavy oil catalytic pyrolysis processing equipment- risers/generators/precipitators, fuel gas boilers, fractionating tower, absorbing, re-absorbing, and desorbing towers, heat exchangers, pumps, a stabilizing tower; ? Gas fractionation processing equipment- de-propanizing tower, refining propylene tower, de-ethanizination tower, heat exchangers, pumps; ? Ethylbenzene processing equipment- alkylation reactor, anti-alkylation reactor, dehydrogenation reactor, propylene absorbing tower, de-ethylene tower, ethylbenzene recovering tower, heating furnace for benzene, heating furnace for gas, steam overheating furnace, tail gas compressor, washing tower; and ? Liquefied petroleum gas (LPG) and sulfur recovery process- LPG desulfurization extraction tower, dry gas desulfurization tower, regenerating tower, LPG de-mecaptan extraction tower. Our Products We manufacture and supply a variety of petrochemical products, including BenzeneToluene-Xylene Aromatics (BTX Aromatics), propylene, styrene, liquid petroleum gas (LPG), Methyl Tertiary Butyl Ether (MTBE), SBS and other petrochemicals, each of which is described below: ? BTX Aromatics: consisting of benzene, toluene, xylene and other chemical components for further processing into plastics, gasoline and solvents materials widely used in paint, ink, construction coating and pesticide. ? Propylene: a chemical intermediate as one of the building blocks for an array of chemical and plastic products that are commonly used to produce polypropylene, acrylonitrile, oxo alcohols, propylene oxide, cumene, isopropyl alcohol, acrylic acid and other chemicals for paints, household detergents, automotive brake fluids, indoor/outdoor carpeting, textile, insulating materials, auto parts and electrical appliances. ? Styrene: a precursor to polystyrene and several copolymers widely used for packaging materials, construction materials, electronic parts, home appliances, household goods, home furnishings, toys, sporting goods and others. ? LPG: a mixture of hydrocarbon gases used as fuel in heating appliances and vehicles. A replacement for chlorofluorocarbons as an aerosol propellant and a refrigerant which reduces damage to the ozone layer. ? MTBE & Other Chemicals: MTBE, oil slurry, sulphur and others are used for a variety of applications including fuel components, refrigeration systems, fertilizers, insecticides and fungicides, etc. ? SBS: consisting of Styrene and butadiene, widely used for waterproofing building material, asphalt modification, furniture, shoe sole material, tubes, tape, auto parts and electrical applicances. In order to improve our operational results and financial situation, we are adjusting our product portfolio to include Styrene-Ethylene-Butylene-Styrene ("SEBS") which we believe will yield a higher gross margin than some of our current products. SEBS is a product similar to SBS but with more durable product features, and can be produced by our current SBS facility. In order to achieve a stable production value, we have started trial production of monthly approximately 200 -300 MT per month since March 2013. The lab analysis shows the trial production of SEBS has achieved a stable condition since April, 2014, However, The SBS/SEBS price has decreased significantly due to stagnant market conditions. In response, we decided to produce only per customers' order, which is currently approximately 300MT per month. We will increase the production volume accordingly when the market recovers. Production Capacity and Expansion Our annual designed manufacturing capacity is 720,000 MT of a variety of petrochemical products. Our SBS production facility is capable of producing up to 70,000 MT of SBS in full load condition without interruption (100% of utilization rate in ideal conditions). Additionally, we have a total of 100,000 MT of storage capacity, consisting of 50,000 MT of storage capacity for raw materials and 50,000 MT for finished products. Our SBS facility achieved a 41% utilization rate in 2012, the first full year of production, and generated approximately $71 million in sales and $5.9 million in profits. We achieved, in accordance with our annual plan of 63,000 MT of SBS, a 63% utilization rate in 2013; and generated approximately $78 million in sales and $5.6 million in profits. Although we planned to produce 63,000 MT of SBS for the fiscal year 2014, the production in the six months ended June 30, 2014 was 7,639 MT and resulted in revenue of $10.4 million and a loss of $2.5 million. The loss was mainly due to the sales price of SBS products decreased from the $1,915 per MT in December 2013 to $1,863 per MT in June 2014. As a result, we decided to reduce the production of SBS until the market improves. 20 The following chart depicts our production for the six months ended June 30, 2014: [[Image Removed]] Breakdown of the total capability of 348,347 (MT) for main products for the six months ended June 30, 2014 Other than the utilization rate for SBS facility discussed above, the utilization rates for our other facilities are as follows: ? styrene production: 92%; ? propylene: 80%; ? LPG: 80%; ? BTX Aromatic: 95%; and ? MTBE & others: 90% Most of our facilities, except for the SBS facility, have been operating since 2009. Therefore, their current utilization rates for each product have been optimized to achieve stable output, less raw material cost and less equipment maintenance. While we are continuing working on existing equipment upgrades to achieve increased stabilized production, we realize that optimizing the utilization rates for our current facilities is not adequate to develop our business to meet increasing customer demands. More specifically, the increasing market demand in tire and auto parts has resulted in increasing market demand for styrene, ABS and Solution Polymerized Styrene Butadiene Rubber ("SSBR"); and higher requirements related to environmental protection imposed by the PRC government have led to higher demand for transformer oil and catalytic cracking oil. Based on these market trends, we have been focusing on the following improvements to our infrastructure to expand our manufacturing capacity: a) an ABS production facility in Guangxi Province with an annual production capacity of 400,000 MT of ABS. We commenced facility construction in August 2013 and expect to finish the first phase of construction by the end of 2014; b) an oil catalytic cracking processing facility as an extension of our catalytic pyrolysis processing equipment, as well as the feed way of the main raw materials to produce synthetic rubber. This facility can reduce production costs and the market risk in the purchase of raw materials, and improve the stability and efficiency of project production to 200,000 MT of heavy oil per year; c) an increased annual design capacity of our ethylene-styrene facility from 80,000 MT to 200,000 MT, of which 120,000 MT can be used for producing synthetic materials and 80,000 MT can be sold to downstream petrochemical companies. This facility can be considered the bridge between original products and high-value added products and will complete the integration of internal resources; d) a transformer oil facility using hydrogen from the ethylene-styrene facility to complete a double hydrogenation process on original products (BTX Aromatic) for refining transformer oil and producing high value transformer oil with a design capability of 100,000 MT per year. We have completed the facility construction and are currently in the stage of preparing a report to the local environmental department for their inspection and approval; and e) an SSBR production facility with a designed capacity of 150,000 MT per year, using synthetic rubber, styrene and butadiene to produce SSBR by applying our process technology. SSBR can be used as raw material for tires, instead of imported hexakis (methoxymethy) melamine ("HMMM"). We acquired the approval for our catalytic oil processing facility and transformer oil plant from Ningbo local government in February 2013. The foundation piling work was completed in July 2013. As of the date of this Report, we have completed the construction of the main body of the facility and infrastructure. We are currently in the stage of preparing a report to be submitted to the local environmental department for inspection and approval. As of June 30, 2014, the capital invested in the catalytic oil processing facility was $21.9 million. The total estimated cost of our expansion plan is approximately $491.8 million, including $300 million for the Guangxi Project, $19.8 million for the catalytic cracking processing equipment, $30 million for the transformer oil facility and $99.5 million for the SSBR production facility, $40 million for the increased annual design capacity of ethylene- styrene, and $2.5 million for additional storage capacity. Upon full completion of our expansion, our total production capacity will reach 1,723,000 MT per year including, but not limited to, our current petrochemical production of 720,000 MT, styrene of 200,000 MT, catalytic cracking oil of 200,000 MT, ABS of 400,000 MT, SSBR of 150,000 MT and transformer oil of 100,000 MT. The following chart depicts the breakdown of our planned production capacity of 1,723,000 MT. 21 [[Image Removed]] Capacity Breakdown after expansion projects (a total of 1,723,000 MT) We are currently evaluating the timeline for our expansion projects. Our current estimate is as follows: Expansion Project Expected Completion Date Oil Catalytic Processing Facility End of Q4, 2014 Ethylene-Styrene Facility End of Q2, 2015 Transformer Oil Facility End of Q3, 2014 SSBR production facility End of Q4, 2015 ABS Production Facility End of Q4, 2016 New storage capacity of 50,000 MT End of Q3, 2015 Manufacturing and Sales Our total production of finished products was 160,645 MT for the three months ended June 30, 2014, and we generated $184 million in revenue based on the sale of 170,979 MT of petrochemical products. Our total production of finished products was 348,347 MT for the six months end June 30, 2014, and we generated $386 million in revenue based on the sales of 356,517 MT of petrochemical products. Results of Operations The following table sets forth information from our statements of comprehensive income for the three and six months ended June 30, 2014 and 2013. 22 Comparison of the three and six months ended in June 30, 2013 and 2012 (in thousands) For the three months Year to Year Comparison For the six months Year to Year Comparison Ended June 30, Increase Percentage Ended June 30, Increase Percentage 2014 2013 /(Decrease) change 2014 2013 /(Decrease) change sales $ 184,536 $ 94,257 $ 90,279 96 % $ 386,430 $ 303,811 $ 82,619 27 % Cost of sales 174,845 91,628 83,217 91 % 369,596 292,360 77,236 26 % Gross profit 9,691 2,629 7,062 269 % 16,834 11,451 5,383 47 % Operating expensesSelling expenses 307 236 71 30 % 625 403 222 55 % General and administrative expenses 3,266 2,621 645 25 % 6,748 5,591 1,157 21 % Total operating expenses 3,573 2,857 716 25 % 7,373 5,994 1,379 23 % Income (Loss)from operations 6,118 (228 ) 6,346 2,783 % 9,461 5,457 4,004 73 % Other income (expenses): Interest income: 3,089 3,151 (62 ) (2 )% 5,880 3,902 1,978 51 % Interest expense, net (6,620 ) (7,045 ) 425 (6 )% (11,588 ) (10,441 ) (1,147 ) 11 % Foreign exchange gain (loss), net (1,694 ) 4,652 (6,346 ) (136 )% (4,139 ) 6,205 (10,344 ) (167 )% Non-operating income (expenses) (1,402 ) (715 ) (687 ) 96 % (2,862 ) (1,095 ) (1,767 ) 161 % Total other (expenses) Income (6,627 ) 43 (6,670 ) (15,512 )% (12,709 ) (1,429 ) (11,280 ) (789 )% Income(loss) before income taxes (509 ) (185 ) (324 ) 175 % (3,248 ) 4,028 (7,276 ) (181 )% Income tax expense 511 312 199 64 % 511 1,607 (1,096 ) (68 )% (Loss) Net Income (1,020 ) (497 ) (523 ) 105 % (3,759 ) 2,421 (6,180 ) (255 )% Other comprehensive income Foreign currency translation adjustment 381 1,101 (720 ) (65 )% (459 ) 1,623 (2,082 ) (128 )% Comprehensive income (loss) $ (639 ) $ 604 $ (1,243 ) (206 )% $ (4,218 ) $ 4,053 $ (8,271 ) (204 )% 23 Sales: Our sales for the three months ended June 30, 2014 were approximately $185 million, compared to $94 million for the three months ended June 30, 2013, an increase of $90 million, or 96%. The increase was mainly due to the increase in sales and production volume in the second quarter of 2014, compared with the 40 days of production interruptions in the second quarter of 2014, which resulted in 98,000 metric tons of lost production. During the three months ended June 30, 2014, we sold 170,979 metric tons of petrochemical products at an average price of $1,079 per metric ton, compared to85,999 metric tons of petrochemical products at an average price of $1,096 per metric ton in the three months ended June 30, 2013. The average sales price per MT in the second quarter of 2014 dropped 1.5% compared with the same period of 2013, mainly due to the stagnant condition of the overall SBS market. Sales for the six months ended June 30, 2014 were approximately $386 million, compared to $304 million for the six months ended June 30, 2013, an increase of $82 million, or 27%. The increase in our sales was due to the increase in sales and production volume in the second quarter of 2014, compared with the 40 days of production interruptions in the second quarter of 2013. Compared with the average sales price for the six months ended June,30,2013, the average sales price in the same period of 2014 decreased 3.5% from $1,123 to $1,084 per MT. The decrease was mainly due to the decrease in the price of SBS products of 18% from $2,173 per MT to $ 1,782 per MT. Cost of Sales: Our cost of sales was approximately $175 million for the three months ended June 30, 2014, or 95% of sales, as compared to approximately $92 million, or 97 % of sales for the three months ended June 30, 2013. Our cost of sales are primarily composed of the costs of direct raw materials (mainly heavy oil, benzene, butadiene and carbinol), labor, depreciation and amortization of manufacturing equipment and facilities, and other overhead. The decrease in the percentage of cost of sales was mainly due to the average unit cost of raw material dropped from $1,065 for three months ended June 30 2013 to $ 1,021 for the comparable period of 2014. The Company commenced trading of heavy oil in April 2013, whereby the Company functions as an agent on behalf of a Hong-Kong based customer. For the three months ended June 30, 2014 and 2013, the trading of heavy oil consists of purchases of approximately $70.1 million and $130.0 million, respectively, and sales of approximately $69.8 million and $129.4 million, respectively, resulting in a loss of $0.3 million and $0.6 million, respectively, that has been included in cost of sales. Our cost of sales was approximately $370 million for the six months ended June 30, 2014, or 95.64% of sales, as compared to approximately $292 million, or 96.44% of sales for the six months ended June 30, 2013. In the six months ended June 30, 2013, our average cost of finished product was $1,034 per metric ton, as compared to $ 1,080 per metric ton in the six months ended June 30, 2013, a decrease of 4.3%. For the six months ended June 30, 2014, the trading of heavy oil consists of purchases of approximately $170.1 million, and sales of approximately $169.0 million, resulting in a loss of $1.1 million, that has been included in cost of sales in the condensed consolidated statement of comprehensive income. Energy required for production of our products consists of water, electricity and steam, the costs of which are attributed to cost of sales rather than operating expense. The supply prices of these energy sources in China have historically been very stable as a result of PRC government policy. Accordingly, the potential impact of changing energy costs to our production is minimal. Following are the costs for water, electricity and stream for the six months ended June 30, 2014 and 2013 (amounts in thousands): For the Six Months Ended June 30, 2014 2013 (Unaudited) (Unaudited) Water 667 685 Electricity 5,015 5,763 Steam 1,606 Total energy cost was approximately $7,288 for the six months ended June 30, 2014, which constitutes approximately 1.9 % of sales. Total energy cost was approximately $6,448 for the three months ended June 30, 2013, which constitutes approximately 2.1% of sales. Gross Profit: Gross profit for the three months ended June 30, 2014 was approximately $9.7 million as compared to $2.6 million for the comparable period in 2013, an increase of approximately $7.1 million or 269 %. The increase was mainly due to the increased sales and production volume during the period compared with the production suspension in the comparable period in 2013. 24 Gross profit for the six months ended June 30, 2014 was approximately $17 million as compared to $11 million for the comparable period in 2013. Our gross margin increased from 3.6 % for the six months ended June 30, 2013 to 4.4 % for the six months ended June 30, 2014. The main reason for the increase in the gross margin is mainly due to the increased production and lower unit costs. Operating Expenses: Operating expenses, including selling expenses, and general and administrative expenses, were approximately $3.6 million, or 1.9% of sales for the three months ended June 30, 2014, as compared to $2.9 million, or 3% of sales for the comparable period in 2013, an increase of approximately $0.7 million or 25%. The increase was mainly due to due to increases in loan guarantee fees of $0.1million and increased R&D expenses of $0.4 million related to Ningbo Keyuan Synthetic Rubbers' application as a national high-tech enterprise. Operating expenses, including selling expenses and general and administrative expenses, were approximately $7.4 million, or 1.9 % of sales for the six months ended June 30, 2014, as compared to $6 million, or 2% of sales for the comparable period in 2013, an increase of approximately $1.4 million. The increase in the expenses was due to general increases in R&D expense, welfare fees and taxes. Interest Income/Expense (net): For the three months ended June 30, 2014, interest income and interest expense were approximately $3.1 million and $6.6 million, respectively; as compared to interest income and interest expense of approximately $3.1 million and $7.0 million, respectively, for the comparable period in 2013. The increase in interest income / expense was mainly due to higher borrowings and deposits in the period. For the six months ended June 30, 2013, interest income and interest expense were approximately $5.9 million and $11.6 million, respectively, as compared to interest income and interest expense of approximately $3.9 million and $10.4 million, respectively, for the comparable period in 2013. The increase in interest income / expense was mainly due to higher borrowings and deposits. Net loss: Net Loss was approximately $1 million for the three months ended June 30, 2014, as compared to net loss of approximately $0.5 million in the same period in 2013, an increase of $0.5 million, or 105%. This increase in loss was mainly due to the foreign exchange loss of $1.7 million from the depreciation of RMB, compared to an exchange gain of $4.7 million in the same period of 2013. Net loss was approximately $3.8 million for the six months ended June 30, 2014, as compared to net income of approximately $2.4 million in the same period in 2013, a decrease of $ 6.2 million, or 255 %. This decrease was mainly due to the foreign exchange loss of $4.1 million, compared to a foreign exchange gain of $6.2 million in the same period of 2013. The exchange rate for USD to RMB appreciated from 6.31 to 1 on January 1, 2013, to 6.17 to 1 on June 30, 2013, however, the exchange rate for USD to RMB depreciated from 6.11 to 1 on January 1, 2014, to 6.16 to 1 on June 30, 2014. Foreign Currency Translation Adjustment: Our reporting currency is the U.S. dollar. Our local currency, Renminbi (RMB), is our 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 statement of shareholders' equity. 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. Currency translation adjustments resulting from this process are included in accumulated other comprehensive income and amounted to $0.4 million for the three months ended June 30, 2014. The balance sheet amounts at June 30, 2014 and 2013, with the exception of equity, were translated at RMB 6.1538 and RMB 6.1728 to 1.00 U.S. dollar respectively. The equity accounts were translated at their historical rates. The average translation rates applied to income statement accounts for the three months ended June 30, 2014 and 2013 were RMB 6.1633 and RMB 6.2023, respectively, to 1.00 U.S. dollar. 25 Liquidity and Capital Resources The following table sets forth a summary of our cash flows for the periods indicated: For the Six Months Ended June 30, 2014 2013 (Unaudited) (Unaudited) Net cash provided by (used in) operating activities 15,027 (86,791 ) Net cash used in investing activities (25,176 ) (28,318 ) Net cash provided by financing activities 6,721 94,266 Net cash provided by operating activities was approximately $15 million for the six months ended June 30, 2014, as compared approximately $86.8 million used in operations for the same period in 2013. The primary reason for the increase is the consumption tax refund which was received in a more timely manner in 2014 compared to 2013 Net cash used in investing activities was approximately $25.7 million and $28.3 million for the six months ended June 30, 2014 and 2013, respectively. The net cash used in investing activities is primarily due to our increasing investments in the construction of our infrastructures and facilities in accordance with our expansion plan. Net cash provided by financing activities amounted to approximately $6.7 million for the six months ended June 30, 2014, compared with approximately $94.3 million for the same period in 2013, as more funds were available from operations in 2014 resulting in reduced need for short term borrowings. 26 The Company commenced trading of heavy oil in April 2013, whereby the Company functions as an agent on behalf of a Hong-Kong based customer. For the six months ended June 30, 2014, the trading of heavy oil consists of purchases of approximately $170.1 million, and sales of approximately $169.0 million, resulting in a loss of $1.1 million, that has been included in cost of sales in the condensed consolidated statement of comprehensive income. Consumption Tax Refund At June 30, 2014 and December 31, 2013, the Group recorded an estimated consumption tax recoverable amounting to approximately $16.2 million and $46.1 million, respectively.In July 2014, a refund of approximately $7 million was received. In addition, management expects approximately $3.1 million of consumption tax to be refunded in September 2014, and that approximately $6 million will be deductible against future consumption tax obligations. Bank Loans We have entered into loan agreements with our primary lenders, Bank of China, China Construction Bank, Agricultural Bank of China, etc. under which we have term loans. As of August14, 2014, we had an aggregate principal amount of approximately $583 million in bank loans outstanding under the loan agreements, with maturity dates from July 2014 to June 2015 and interest rates from 1.1% to 7.2% per annum. Before we enter into loan agreements with a lender, the lender will approve a comprehensive credit line which is the maximum amount of the loans we can obtain from the lender within a certain time period. The comprehensive credit line is usually secured by one or more third party guaranties or liens on our property and equipment, or a security deposit. Once the comprehensive credit line is approved, we will enter into an individual loan agreement with the lender each time we obtain a loan from the lender under the credit line. Therefore, we typically have multiple loan agreements under one comprehensive credit line with one lender as long as the credit limit has not been reached. Though different lenders have different forms for loan agreements, loan agreements usually contain similar material terms such as the amount of a loan, the term of a loan, interest rate, etc. In addition, some loan agreements specify the purposes of loans, and lenders are permitted to monitor the use of loans and our business. The loan agreements generally do not require us to maintain specific ratios or working capital requirements. In the event that lenders observe abnormal use of a loan or a substantial loss in our business or other event that could potentially have a substantial negative impact on our ability to repay the loans on time, they can either amend or terminate the loan agreements, or request additional financial covenants to secure the loans. If we fail to repay loans in a timely manner, or fail to obtain written consent from the lenders regarding extension/renewal applications, we may be subject to default interest or the loans may be canceled. Historically, we have no record of default on any of our loans and, as a result, we do not anticipate that our loans will not be renewed when their terms expire. However, we cannot guarantee that one or more of our loans will not be renewed or extended at the end of their terms, which could have a material negative impact upon our liquidity which could impact our ability to purchase raw materials, make upgrades and improvements to our infrastructure or otherwise negatively impact our business and operations. 27 As of June 30, 2014, 32% of our bank loans (approximately USD $191 million) were guaranteed by our related parties. Usually, a guaranty agreement is executed among a third party, a lender and us pursuant to a credit line approved by the lender. Though different lenders use different forms for loan guaranty agreements, loan guaranty agreements usually contain substantially similar terms. According to a loan guaranty agreement, the guarantor is jointly liable for all our debts to the lender under the corresponding loan agreements and the lender can bring legal action against the guarantor for damages in the event there is a default or breach of any loan agreement under the credit line. The guaranty is independent of any loan agreement under the credit line and irrevocable. In addition, if the credit line is extended or renewed, a written consent from the guarantor is required. Otherwise, the guarantor is only liable for loans under loan agreements that were executed during the original term of the credit line. Beginning in January 2011, certain individual loan guarantors, some of whom are related parties, were paid a monthly fee of approximately 0.3% of the outstanding loan balances as compensation for their guarantees. Through December 31, 2010, no compensation was paid in respect of these guarantees. During the three and six months ended June 30, 2014 and 2013, expenses related to loan guarantee fees of approximately $0.7 million and $0.6 million, and $1.3 million and $1.1 million, respectively. As of June 30, 2014, there was $1.9 million of accrued and unpaid guarantee fees. Historically, all debts have been repaid by the Company in a timely manner. All short-term bank loans are revolving loans whose terms (at the due date of payment) are generally extended by the lender. As of June 30, 2014, we were in compliance with the terms of our loan agreements. As such, management expects most unpaid loan balances will be extended at their due dates. Depending on our capital needs, the Company evaluates whether to apply for additional long-term bank loans. The Company currently has sufficient lines of credit with its banks for both short-termand long-term borrowings. Related Party Transactions The Company considers all transactions with the following parties to be related party transactions. Name of parties Relationship Mr. Chunfeng Tao Majority stockholder Mr. Jicun Wang Principal stockholder Mr. Peijun Chen Principal stockholder Ms. Sumei Chen Member of the Company's Board of Supervisors and spouse of Mr. Wang Ms. Yushui Huang Vice President of Administration, Ningbo Keyuan Ningbo Pacific Ocean Shipping Co., Ltd 100% ownership by Mr. Wang (Ningbo Pacific) Ningbo Xinhe Logistic Co., Ltd 10% ownership by Ms. Huang (Ningbo Xinhe) 28 Related party transactions and amounts outstanding with the related parties as of and for the three and six months ended June 30, 2014 and 2013, are summarized as follows: Three months Six months ended ended June 30 June 30 2014 2013 2014 2013 ($'000) ($'000) ($'000) ($'000) (Unaudited) (Unaudited) (Unaudited) (Unaudited) Purchase of transportation services (a) $ 783 $ 413 $ 1,906 $ 1,041 Loan guarantee fee (b) $ - $ 19 $ - $ 42 June 30, 2013 December 31, 2013 ($'000) ($'000) (Unaudited) Amounts due to related parties (c) $ 381 $ 369 Advance payments to these parties (d) $ 41 $ 55 (a) The Group purchased transportation services of approximately $0.7 million and $0.4 million from Ningbo Xinhe during each of the three months ended June 30, 2014 and 2013, respectively. The Group purchased transportation services of $1.9 million and $1.0 million from Ningbo Xinhe during the six months ended June 30, 2014 and 2013, respectively. (b) Guarantees for Bank Loans Beginning in 2011, loan guarantee fees of 0.3% of the loan principal guaranteed are to be paid quarterly. During the three months ended June 30, 2014 and 2013, loan guarantee fees were approximately nil and $0.02 million for Ningbo Pacific, respectively. During the six months ended June 30, 2014 and 2013, loan guarantee fees were nil and $0.04 million for Ningbo Pacific, respectively. (c) Amounts due to related parties consist of the following. June 30, December 31, 2014 2013 ($'000) ($'000) (Unaudited)Ningbo Xinhe (Transportation expenses) $ 381 $ 369 29 (d) Advance payments to these parties consist of the following. June 30, 2014 December 31, 2013 ($'000) ($'000) (Unaudited) (Unaudited) Ningbo Xinhe $ - $ 12 Mr. Tao 41 43 Total $ 41 $ 55 Relationships and transactions with certain other parties The Group has following relationships and transactions with certain other parties: Name of parties Relationship Ningbo Litong Petrochemical Co., Ltd Former 12.75% nominee shareholder of (Ningbo Litong) Ningbo Keyuan Ningbo Anqi Petrochemical Co., Ltd A related party through September 2011 (Ningbo Anqi) when control transferred Ningbo Lide Investment Co., Ltd. A related party through September 2011 (Ningbo Lide) when control transferred Ningbo Kunde Petrochemical Co, Ltd. A related party through September 2011 (Ningbo Kunde) when control transferred Transactions and amounts outstanding with these parties for the three and six months ended June 30, 2014 and 2013 are summarized as follows: Three months ended Six months ended June 30 June 30 2014 2013 2014 2013 ($'000) ($'000) ($'000) ($'000) (Unaudited) (Unaudited) (Unaudited) (Unaudited)Sales of products (e) $ 7,048 $ 8,809 $ 12,413 $ 50,129 Purchase of raw materials (f) $ 25,255 $ 7,987 $ 35,996 $ 34,703 Guarantee for bank borrowings (g) $ 108,253 $ 94,405 $ 108,253 $ 94,405 Loan guarantee fees (g) $ 688 $ 575 $ 1,322 $ 1,092 June 30, 2013 December 31, 2013 ($'000) ($'000) (Unaudited)Advance received from these parties (h) $ 72 $ - Advance payments to these parties (i) $ 11,730 $ 11,043 Account receivables from these parties (j) $ 5,090 $ 218 (e) The Group sold finished products of approximately $6.9 million and $1.8 million to Ningbo Litong during the three months ended June 30, 2014 and 2013, respectively. The Group sold finished products of approximately 0.2 million and nil to Ningbo Lide during the three months ended June 30, 2014 and 2013, respectively. The Group sold finished products of nil and approximately $7 million to Ningbo Kunde during the three months ended June 30, 2014 and 2013, respectively. The Group sold finished products of approximately $12.2 million and $12.1 million to Ningbo Litong, during the six months ended June 30, 2014 and 2013, respectively. The Group sold finished products of approximately 0.2 million and nil to Ningbo Lide during the six months ended June 30, 2014 and 2013, respectively. The Group sold finished products of nil and approximately $38 million to Kunde during the six months ended June 30, 2014 and 2013, respectively. (f) During the three months ended June 30, 2014, the Group purchased raw materials of approximately $16.9 million and $8.3 million from Litong and Lide, respectively. During the three months ended June 30, 2013, the Group purchased raw materials of nil and approximately $8.0 million from Kunde and Lide, respectively. During the six months ended June 30, 2014, the Group purchased raw materials of approximately $27.2 million and $8.8 million from Litong and Lide, respectively. During the six months ended June 30, 2013, the Group purchased raw materials of approximately $2.7 million and $32.0 million from Kunde and Lide, respectively. 30 (g) Guarantees for Bank Loans Guarantee provided during the three Guarantee provided during the six months ended months ended June 30, June 30, 2014 2013 2014 2013 ($'000) ($'000) ($'000) ($'000) (Unaudited) (Unaudited) (Unaudited) (Unaudited) Ningbo Litong $ 75,677 $ 62,056 $ 75,677 $ 62,056 Ningbo Lide 32,576 32,056 32,576 32,056 Total $ 108,253 $ 94,112 $ 108,253 $ 94,112 Bank loans Guaranteed as of June 30, 2014 December 31, 2013 ($'000) ($'000) (Unaudited) Ningbo Litong $ 142,970 $ 109,618 Ningbo Lide 151,166 75,405 Total $ 294,136 $ 185,023 Beginning in January 2011, loan guarantee fees of 0.3% of the loan principal guaranteed are to be paid quarterly. In the three months ended June 30, 2014, loan guarantee fees were $0.25 million and $0.43 million to Ningbo Litong and Ningbo Lide, respectively. In the six months ended June 30, 2014, loan guarantee fees were $0.5 million and $0.83 million for Ningbo Litong and Ningbo Lide, respectively. (h) At June 30, 2014, advance received from these parties consist of amounts due from Litong and Lide of $0.05 million and $0.02 million, respectively. (i) At June 30, 2014, advance payments to these parties consist of payments to Litong and Lide of $7.9 million and $3.8 million, respectively. (j) At June 30, 2014, accounts receivable from these parties consist of amounts receivable from Litong of $5.1 million. 31 Going concern and management's plans The consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company reported a net loss and cash flows provided by operations of approximately $3.8 million and $15 million, respectively, for the six months ended June 30, 2014 and net income and cash flows used in operations of approximately $4.1 million and $53.1 million, respectively, for the year ended December 31, 2013. At June 30, 2014 and December 31, 2013, the Company had a working capital deficit of approximately $236 million and $210 million, respectively. These factors raise substantial doubt about the Company's ability to continue as a going concern. The accompanying condensed consolidated financial statements do not include any adjustments relating to the recoverability or classification of assets, or the amounts and classification of liabilities that may result should the Company be unable to continue as a going concern. The Report of the Independent Registered Public Accounting Firm on our consolidated financial statements as of and for the year ended December 31, 2013 includes a going concern explanatory paragraph which means that the accounting firm has expressed substantial doubt about the Company's ability to continue as a going concern. The Company continues to finance its operations primarily through short-term bank borrowings. Short-term bank borrowings and bills payable amounted to approximately $843 million at June 30, 2014. Management expects that short-term bank financing will continue to be available through at least June 30, 2015. The Company continues to benefit from favorable PRC tax policies related to consumption tax (Note 4) of which approximately $16.2 million was refundable at June 30, 2014. Approximately $7 million was refunded in July 2014 and management expects approximately $3.1 million of consumption tax to be refunded in September 2014, and that approximately $6 million will be deductible against future consumption tax obligations. In addition, management expects that VAT of $30 million is expected to be refunded in late 2014. The ability of the Company to continue as a going concern is dependent upon management's ability to implement its strategic plan, obtain additional capital and generate net income and positive cash flows from operations. There can be no assurance that these plans will be sufficient or that additional financing will be available in amounts or terms acceptable to the Company, if at all. |