ITEM 1. BUSINESS
Overview
Harbin Electric, Inc. (“Harbin Electric”), is a holding company incorporated in Nevada with its principal place of business based in the People’s Republic of China (“PRC”). Through our U.S. and China-based subsidiaries, we design, develop, manufacture, supply, and service a wide range of electric motors including linear motors, specialty micro-motors, and industrial rotary motors, with a focus on innovation, creativity, and value-added products. We sell our products principally in China, but also to certain international markets. The terms “Harbin,” “Harbin Electric,” “we,” “Company,” “us” and “our” and similar terms refer to Harbin Electric and its subsidiaries, unless otherwise expressly stated or the context requires otherwise.
We currently operate the following four manufacturing facilities in China:
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Harbin Tech Full Electric Co., Ltd. (“Harbin Tech Full”) is located in the government-designated Development Zone in the city of Harbin with approximately 50,000 square meters of land and manufactures linear motors and linear motor integrated systems.
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Shanghai Tech Full Electric Co., Ltd. (“Shanghai Tech Full”) is located in the Shanghai Zhuqiao Airport Industrial Zone with 40,800 square meters of land and manufactures specialty micro-motors.
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Weihai Tech Full Simo Motor Co., Ltd. (“Weihai Tech Full”) is located in Weihai with approximately 150,000 square meters of land and primarily manufactures small to medium sized industrial rotary motors.
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Xi’an Tech Full Simo Motor Co., Ltd. (“Xi’an Tech Full Simo”) was acquired in October 2009 and manufactures primarily medium to large sized industrial rotary motors. Xi’an Tech Full Simo is located in Xi’an city’s Economy and Technology Development Zone and occupies approximately 200,000 square meters of land.
We offer three major product lines: linear motors (“LMs”) and integrated systems, specialty micro-motors, and industrial rotary motors. LMs operate on the same physical principles as a traditional motor, but the stator, or non-moving component, is flat, rather than cylindrical, producing linear, rather than rotational, force. LMs can be configured into different sizes and shapes. We believe that, for a variety of applications, our LMs have advantages over traditional electric motors, in terms of design, energy output, energy efficiency, and precision movement. By obviating pneumatic stops, belts, pulleys, and gears that rotary motors require to move and position their loads, LMs can provide higher levels of performance in accuracy, resolution, repeatability, and speed, with less maintenance and down-time. We sell our LMs to a broad range of customers in China and in the United States, including those involved in the energy industry, factory automation, food processing, packaging industries, power generation systems, and mass transportation and freight transportation systems.
Specialty micro-motors are used for various automation functions for automotives, precision instrument and machinery, office equipment, medical devices, consumer electronics, etc. We currently focus on developing products used for automobile interior automations. We have developed many innovative products that are used for car seat automation, back seat folding, electric power steering (EPS), automated window, and automated trunk opening. Our automobile specialty micro-motors are purchased by customers who are first-tier suppliers to the automobile industry. We supply these products to domestic customers and also export them to OEM suppliers in North America.
We offer a wide range of industrial rotary motors including small, medium, and large-sized motors and some specialized motors such as high/low voltage motors and speed control motors. Our industrial rotary motors are widely used for trains, power plants, steel processing, agricultural machineries, heavy machineries, material industry, construction industry, chemical industry, HVAC, aviation, navigation, hi-tech fields, etc. Our branded “Simo Motor” manufactured by Xi’an Tech Full Simo and “Wenbao Motor” manufactured by Weihai Tech Full are among the best-known motors in China and have received national awards. These products are primarily purchased by domestic customers throughout China.
Significant Developments
In December 2006, the Company formed Shanghai Tech Full Electric Co., Ltd., a wholly-owned subsidiary, to develop and manufacture automobile specialty micro-motors and their components and accessories. The Company had invested approximately $93.1 million in this facility as of December 31, 2009.
On April 9, 2007, the Company entered into an Agreement (the “Original Agreement”) with Shelton Technology, LLC (“Shelton”), whereby the Company and Shelton agreed to work together through the Company’s newly formed, wholly-owned subsidiary, Advanced Automation Group, LLC (“AAG”) to design, develop and manufacture customized industrial automation controllers. The initial term of the arrangement ran from April 9, 2007 to August 31, 2008. During the initial term, Shelton was entitled to receive 49% of the profits earned by AAG. Pursuant to the terms of the Letter Agreement, Shelton had assigned to AAG all of its existing customer accounts and granted to AAG an exclusive royalty free worldwide license to its technology and intellectual property related to precision servo motor controllers for industrial automation, while the Company was required to invest a total of $3 million in installments in AAG by March 31, 2009. On December 11, 2008, the Company and Shelton entered into a first amendment to the Original Agreement to extend the term of the Original Agreement from August 31, 2008 to December 31, 2008. On April 21, 2009, the Company and Shelton entered into a second amendment to the Original Agreement to extend the term to June 30, 2009. On December 7, 2009, the Company and Shelton entered into a third amendment to the Original Agreement to further extend the Original Agreement to December 31, 2009. The Company had invested a total of $2.0 million in AAG as of December 31, 2009 and has the remaining $1.0 million to be invested. The Company and Shelton are currently continuing the work jointly and in the process of developing a new agreement. We have included the financial results of AAG in our consolidated financial statements beginning April 2007.
On July 10, 2008, Harbin Tech Full entered into an Equity and Assets Transfer Agreement (the “2008 Agreement”) with Wendeng Second Electric Motor Factory, a PRC corporation (”Wendeng”), the Committee of Labor Union of Wendeng Second Electric Motor Factory (the “Labor Committee”) and the People’s Government of Zhangjiachan Town and Wendeng County (“Zhangjiachan Town”) with respect to the acquisition by Harbin Tech Full of Weihai Hengda Electric Motor (Group) Co., Ltd. (“Hengda”) Pursuant to the terms of the 2008 Agreement, Harbin Tech Full acquired (i) all of the outstanding shares of Hengda, (ii) all other assets of Wendeng, and (iii) all remaining equity of Hengda’s subsidiaries not then owned by Hengda, which consisted of 9.1% of Wendeng Wanda Chemical Products Limited Liability Company, 4.4% of Wendeng Wenbao Electrical Motors Limited Liability Company, 10% of Wendeng Chengxin Electrical Motors Limited Liability Company and 9.1% of Wendeng Yongheng Electrical Instruments Limited Liability Company (“Hengda Subsidiaries”), for an aggregate price of RMB375,000,000 (approximately US$54.7 million) paid in cash. The transaction was closed on July 15, 2008. The name of Hengda was changed to Weihai Tech Full in June 2009. We have included the financial results of Weihai Tech Full in our consolidated financial statements beginning July 2008.
In October 2008, the Company, through AAG formed Advanced Automation Group Shanghai Co., Ltd. (“AAG Shanghai”), to design, develop, manufacture, sell and service custom industrial automation controllers for linear motors. AAG had invested $500,000 in AAG Shanghai as of December 31, 2009.
On October 2, 2009, Harbin Tech Full entered into an Equity Acquisition Agreement (the “2009 Agreement”) with Xi’an Simo Electric Co. Ltd. (“Simo”) and Shaanxi Electric Machinery Association (“Shaanxi Electric” and collectively with Simo, the “Selling Shareholders”) whereby Harbin Tech Full agreed to acquire (i) 100% of the outstanding shares of Xi’an Simo Motor Incorporation (Group) (“Simo Motor”), which is 99.94% owned by Simo and 0.06% owned by Shaanxi Electric, and (ii) all corresponding assets of Simo Motor, including but not limited to, all of the manufacturing equipment, real estate, land use rights, stocks, raw materials, automobiles, intellectual property, receivables, other receivables, payables, business contracts and external investments owned by Simo Motor for an aggregate price of up to RMB 763,179,799 (approximately US$112 million) payable in cash. On October 22, 2009, Harbin Tech Full paid RMB 572,700,000 (approximately US$84 million) to the selling shareholders of Simo Motor. On January 25, 2010, after verification of the assets and capital of Simo Motor, Harbin Tech Full paid an additional RMB 190.5 million (approximately US$27.9 million) to the selling shareholders of Simo Motor. The acquisition also included 15 wholly-owned and 8 majority-owned subsidiaries by Simo Motor. As a result, the Company’s ownership to Simo Motor and all subsidiaries averages to 87.2%. The remaining 12.8% is owned by noncontrolling shareholders. The transaction was closed on October 13, 2009 and the name of Simo Motor was changed to Xi’an Tech Full Simo Motor Co., Ltd. We have included the financial results of Xi’an Tech Full Simo in our consolidated financial statements for the three months ended December 31, 2009.
INDUSTRY OVERVIEW
The linear motor (“LM”) industry is a fast-growing industry in China. Historically, traditional rotary motors have been used in various industries throughout China, but performance and efficiency issues associated with traditional rotary motors have spurred an interest in the industry to consider alternative technologies such as LMs. Compared with traditional rotary motors, we believe that LMs are simpler to control, easier to operate, more reliable and capable of reducing operating costs in the long term.
Unlike rotary motors that rely on centrifugal rotation, or torque, a linear motor is an electric motor that transmits force through a magnetic field without the need for a mechanical linkage. An axis driven by a linear motor requires little or no contact between moving parts. Reduced contact between moving surfaces translates to reduced friction and reduced vibration. As a result, there is no backlash, windup, wear or maintenance that is normally associated with traditional rotary motors. Many applications that require some sort of linear motion can benefit from the use of LMs. We believe that, for a variety of applications, LMs have advantages over traditional rotary motors, in terms of design, energy output, energy efficiency, and precision movement. By obviating pneumatic stops, belts, pulleys, and gears that rotary motors require to move and position their loads, LMs can provide higher levels of performance in accuracy, resolution, repeatability, and speed, with less maintenance and down-time.
Micro-motors are widely used in applications such as automobile interior automation, medical devices, communication equipment, information systems, home appliances, defense industry, and many other industrial applications. While China has become a leading micro-motor supplier in the world, we believe that China is still at the early stage of its industrialization and the demand for micro-motors will continue to grow in many areas. Currently the Company is focusing on growing its automobile specialty micro-motors business, however, is also interested in expanding into other application areas.
Automobile specialty micro-motors are used for various automation functions in an automobile. In order to stay competitive and attract customers, automakers have been trying to keep their cost down while offering enhanced functionality and automation features in an automobile, which drives up the degree of automation in an automobile. The automobile’s interior automation is increasingly becoming a standard package, which was once only seen in high-end, luxury passenger cars. This trend has created a new market for new types of automobile specialty micro-motors that automate different parts of an automobile including car seats, front and back, windows, trunks, door locks, mirrors, sliding doors, roofs, etc. We believe that the worldwide demand for automobile specialty micro-motors with low cost and high quality is rapidly growing. Global automakers are increasingly sourcing auto parts from low cost countries including China.
Traditional rotary motors have historically dominated China’s and the world’s electric motor market. Industrial rotary motors are widely used to power machinery and equipment in all industries such as petrochemical and chemical, metallurgical and mining, textile, ventilation, machine tools, to name just a few. Traditional rotary motor market is highly fragmented in China, with a few large state-owned manufacturers and many smaller private operators. The Company entered the industrial rotary motor business through the acquisition of Weihai Tech Full in July 2008 and further expanded this business and strengthened our competitive position in the industry through the acquisition of Xian Tech Full Simo in October 2009. These business expansions allowed the Company to become one of the largest and most diversified developer and manufacturer of electric motors in China.
OUR STRATEGY
Our objective is to develop a global brand and to be a world class enterprise that develops and manufactures a broad range of electric motors from linear motors, to specialty micro-motors, to industrial rotary motors with a focus on highly specialized, energy-efficient, customized, and value-added products for domestic and international customers. We expect that our scale and size will grow and our product offerings will be broadened. To achieve this objective, we plan to execute the following key business strategies:
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Strengthen Our Design and Development Capabilities. To meet the changing needs of our customers, we intend to continue to improve and strengthen our in-depth product development and design capabilities. We will continue to recruit talents world-wide to strengthen our research and development team and expand collaborations with other research and engineering institutions. We intend to capitalize on the strength of our research and development capability and focus on developing energy efficient and environmentally friendly electric motors in all of our product lines: linear motors, automotive motors, and industrial rotary motors;
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Further Grow Market Share in Linear Motor Market. We are expanding our customer base by developing new products for existing and new customers. We successfully developed a “Tower Type Oil Pump” driven by permanent magnetic linear motors for the oil industry. We also designed the Cylinder Permanent Magnetic Linear Servo Motor which can be applied in many different applications including printers, air compressors and food slicers. We have entered a joint project to build China’s first coal transportation line using the linear motor propelled freight train. We have successfully developed a LM propulsion system for the first “Made in-China” LM driven metro train to support the build-up of urban mass transportation system across China;
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Expand Customer Base and Product Offering in Micro Motor Market. We have constructed a brand new facility in Shanghai that is close to the network of auto parts OEM suppliers around Shanghai. This new facility is focused on serving the market for automotive applications and has annual capacity of 10 million unit automotive motors. We believe it is the largest manufacturing facility of automotive motors integrated with product development and design capabilities in China. It began production in October 2009. This will allow us to serve many international and domestic customers and produces variety of products at the same time and in the same place. We intend to supply the fast growing domestic automobile industry and capture the international auto markets that increasingly source auto parts from China. We are also interested in expanding into other industrial applications;
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Grow Industrial Rotary Motors Business with Focus on High Efficient Specialized Products. We entered the industrial rotary motors business through an acquisition in July 2008. We further expanded the business and strengthened our leading position in the electric motor industry through another acquisition in October 2009. These expansions have provided us a solid manufacturing platform and access to a broad base of industrial customers. With continued economic growth and accelerated industrialization and urbanization in China, as well as the global efforts to reduce energy consumption and protect the environment, we expect the demand for high efficiency and high quality industrial rotary motors to continue to grow in China. We intend to capitalize on our research and product development capability and become an industry leader in China in developing and offering high efficient, high quality industrial rotary motors;
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Maintain Our Competitive Strength - Offer High Quality and Low Cost Products with High Content of Technology. We compete with global competitors that offer high quality products and with domestic competitors that offer low cost products. However, customers are increasingly focusing on high engineering content and quality of products with low cost. We intend to differentiate ourselves from other competitors by providing high quality and low cost products with high content of technology supported by our own development and design capabilities and low cost production; and
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Focus on Organic Growth Effectively Mixed with Acquisitions When Opportunities Arise. We intend to grow our business through penetrating different markets at different stages of our development and effectively mix organic growth with acquisitions when opportunities arise.
PRODUCTS AND SERVICES
We design, develop, manufacture, supply, and service a wide range of electric motors, with a focus on innovation, creativity, and value-added products. We develop products according to our customers’ specifications using our proprietary process technology and expertise. With close customer relationships, in depth understanding of local markets and customer needs, fast development cycle, assurance of high quality products, and low development and production costs, we hope to be able to outperform our international and domestic peers.
Presently, we offer three key product lines:
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Linear motors and their integrated application systems
A linear motor is an electric motor that converts the electric energy through a magnetic field into linear motion without the need for a mechanical linkage. An axis driven by a linear motor requires little or no contact between moving parts. Reduced contact between moving surfaces translates to reduced friction and reduced vibration. As a result, there is no backlash, windup, wear or maintenance that is normally associated with industrial rotary motors. Many applications that require some sort of linear motion can benefit from the use of linear motors.
Compared to rotary motors, the advantages of linear motors include simplicity, reliability, and low maintenance due to fewer moving parts; precision movement; compact size; quiet motor operation; energy-efficient; easy customization due to simplicity.
Linear motors can be designed in different sizes and shapes such as flat, pancake, cylindrical, round, etc. Our primary linear motor products include the following:
A. Flat linear asynchronous motor series (self-cooled)
The flat linear asynchronous motor series is widely applied in transmission systems such as the production transportation line, the crane, postal service sorting machine, baggage sorting machine, printed matter sorting machine, automatic linear door, and revolving door applications. The flat linear asynchronous motor series is self-cooling using the ambient environment.
B. Flat three-phase linear asynchronous motor (forced ventilation)
The flat three-phase linear asynchronous motor is also used in transmission systems such as the production transportation line, the crane, postal service sorting machine, baggage sorting machine, printed matter sorting machine, automatic linear door, and revolving door applications. Unlike the self-cooling design of our flat linear asynchronous motor series, our flat three-phase linear asynchronous motor uses forced ventilation, which is loaded with radiator, bottom board, and air blower to reduce and dissipate heat.
C. Integrated linear motor application systems
An integrated linear motor application system consists of one or more linear motors, controllers, and other auxiliary components. We have developed linear motors and their integrated application systems used in the oil industry, factory automation, packaging, logistic systems, and food industry. Applications mainly include production transportation conveyor line, the postal service mail sorting machine, the baggage sorting machine, the printed matter sorting machine, food and meat slicer, oil pump machine of oilfield, and automated power switch. We are developing a LM propulsion system to drive freight trains for China’s first coal transportation line built on LM technology.
We have successfully developed a high efficiency linear motor propulsion system powering China’s first domestically developed and manufactured LM driving metro train. Compared to the traditional rotary motor propelled metro transit system widely in use in the world, the LM driving metro train provides higher performance efficiency with lower energy consumption. It can negotiate steep grades and cope with tight curves and corners, lower maintenance cost, provide a safer ride under severe weather conditions such as rain and snow, and it is quieter and more comfortable. It is environmentally friendly and contributes to making cities “greener”. Additionally, due to the simplicity of the LM propulsion system, the vehicle body is more compact, reducing the cross section of underground tunnels by about 40%, thus accelerating construction of the tracks and providing significant cost savings.
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Automobile specialty micro-motors
Automobile specialty micro-motors are used for various automation functions in an automobile. We have developed products that are used for car seat automation, back seat folding, EPS (electric power steering), automated windows, and automated trunk opening. Several other types of specialty micro-motors are under development including micro-motors used for door locks, gas pedals, ABS, gas pumps, and engine gas jets.
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Industrial rotary motors
We manufacture various industrial rotary motors such as high/low voltage motors, AC/DC motors and speed control motors including small, medium and large sized. Our industrial rotary motors are used mainly for the following applications:
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Freight train driving motors
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Power plants
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Metallurgical and mining industry
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Chemical and petrochemical industry
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Construction machinery
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Agricultural equipment and machinery
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Transportation machinery
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Machine tools
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Medical devices
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Ventilation equipment
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Air compressors
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Electric pumps
MANUFACTURING PROCESS
We employ state-of-the-art manufacturing equipment, production lines, inspection and testing equipment, and quality control systems at our manufacturing facilities. Our Harbin and Shanghai manufacturing facilities are constructed following the international standards that enable us to meet the demands of high quality engineering to ensure product reliability and durability. We are upgrading our acquired Weihai and Xi’an facilities by adding new and more efficient production equipment. All of our facilities in the PRC have extra spaces that can accommodate capacity expansion in the future when the need arises.
Generally, there are two stages of design and development before the main production process. In the first process stage, the technical design of the motor is drawn based on customer defined parameters such as the speed, force, heat output and size of the motor. In the second process stage, the working prototype is produced, and testing and validation of the prototype are conducted. The main production process can be carried out only after the working prototype passes the various testing and validation protocols. The actual manufacturing process consists of winding the coils, laminating the primary and secondary elements, and hermetic casing for protection and durability among other procedures. The last stage is testing and validation.
SERVICES
We provide after-sale services to our customers. For our linear motor and specialty micro-motor businesses, our products are customized products which are customer specific. We typically offer a warranty on our products, only in the event of defects, for two years from the date of shipment, and expect to absorb the costs of servicing if our products fail within the two-year warranty period. For our industrial rotary motor business, our products are standardized products. We provide product warranty for repair one year from the date of shipment. Historically, the returns and defects have not been material. We generally provide on-site services at a client location within 24 hours to fix problems during the warranty period. After the warranty period expires, we offer after-sale services for a fee.
MARKETING
In our linear motor and specialty micro-motor businesses, we receive proposals and contracts mostly through referrals. We have a marketing and sales team that focuses on providing support and consultancy to customers. We target our products to the global original equipment manufacturers (“OEMs”) as components or in integrated systems. We also collaborate with major system integrators to jointly develop and market new products. We have a close involvement with our customers to jointly develop and customize products for customers’ specific needs. We believe this active working relationship with customers has allowed us to win repeat business, create visibility and enhance our growth.
In our industrial rotary motor business, we have a well established sales network and distribution channel across the country at each of our Weihai and Xi’an facility. We provide sales incentives to the sales team and encourage them to cross sell products produced by other facilities. Sometimes, we offer promotions according to the market trend.
We also participate in industry trade shows, technical conferences, professional seminars and exhibitions, and use these events to promote our products, generate sales, and build brand awareness.
We are actively exploring the international markets for our products and developing business outside of China. We have established a wholly-owned subsidiary in the U.S. - Advance Automation Group, LLC. This subsidiary serves as the company’s research and development center that is specialized in industrial automation controller technology. Through this subsidiary, we believe that we can capitalize on the U.S.-based world class development expertise and a China-based electric motor manufacturing capability, expand our business into the industrial automation controller market, and enhance Harbin Electric’s existing R&D projects. We expect that this project will also provide us greater reach into the U.S. and international markets. We also have an executive office in New York that supports our sales and customer relationship management.
See Note 15 to our Consolidated Financial Statements for information with respect to the geographic markets in which we operate and generate revenue.
SOURCES AND AVAILABILITY OF RAW MATERIALS (VENDORS)
The raw materials used by us are mainly semi-finished products and component materials including fans, radiators, silicon steel sheet, cast iron, aluminum, enameled copper wire, metal plating, and control cabinets. We believe that alternative sources are available for such materials other than our current suppliers.
One major vendor provided approximately 16% of the Company’s purchases of raw materials for the year ended December 31, 2009. Two major vendors provided approximately 39% of the Company’s purchases of raw materials for the year ended December 31, 2008, with each vendor individually accounting for 23% and 16%, respectively. Five major vendors provided approximately 80% of the Company’s purchases of raw materials for the year ended December 31, 2007, with each vendor individually accounting for 27%, 22%, 13%, 12% and 6%, respectively. The Company’s accounts payable to these vendors was $0 and $1,055,730 at December 31, 2009 and, 2008, respectively.
CUSTOMERS
One major customer accounted for approximately 12% of the net revenue for the fiscal year ended December 31, 2009. At December 31, 2009, the total receivable balance due from this customer was $11,494,287, representing 12% of total accounts receivable. Three major customers accounted for 43% of the net revenue for the fiscal year ended December 31, 2008, with each customer individually accounting for 16%, 15% and 12%, respectively. At December 31, 2008, the total receivable balance due from these customers was $26,253,907, representing 87% of total accounts receivable. Five major customers accounted for 72% of the net revenue for the year ended December 31, 2007, with each customer individually accounting for 20%, 20%, 13%, 10% and 9%, respectively.
RESEARCH AND DEVELOPMENT
We recruit talent world-wide. Our in-house Research & Development team is made of top researchers and engineers with diverse experience and specializations in linear motors, micro motors, automotive motors, automations and controllers, as well as in manufacturing technologies and processes. We have developed many new products and own numerous patents in China including twenty patents related to our LM and automobile specialty micro-motors products as of December 31, 2009. Our product design and development work includes both the development of new products and the modification of existing products. Development work is also conducted to improve manufacturing processes. Our strategy is to leverage the in-house product research and development capability with outside research from China’s scientific research institutions.
We collaborate closely with various scientific research institutions to advance development of new products and manufacturing processes. For example, one of our joint research and development projects was the program with Zhejiang University where we jointly developed a Permanent Magnetic Synchronization Servo Motor used for a meat and food slicer in the food industry. We have also successfully developed a high efficiency LM propulsion system for LM propelled metro train working jointly with the Institute of Electrical Engineering of the Chinese Academy of Sciences (“IEECAS”) and Changchun Railway Vehicles Co. Ltd. (“CRC”), Changchun, China. We have on-going relationships with Zhejiang University, Shanghai Micro-Motors Research Institute, and Institute of Electrical Engineering of the Chinese Academy of Sciences (IEECAS).
We have several new types of automotive specialty micro-motors under development including micro-motors used for door lock, gas pedal, ABS, gas pump, and engine gas jet.
Costs associated with research, new product development, and product improvements are treated as expenses when incurred and amounted to $2,093,366, $1,170,169, and $1,064,074 for the years ended December 31, 2009, 2008 and 2007, respectively.
EMPLOYEES
As of December 31, 2009, the Company had a total of approximately 4,900 employees. We believe that we have good working relationships with our employees, most of whom are located in Harbin, the capital of Heilongjiang Province, Weihai, a coastal city in Shandong Province, Xi’an, the capital of Shaanxi Province, and Shanghai. We are not a party to any collective bargaining agreements, and none of our employees are subject to collective bargaining agreements.
We have employment contracts with most of our employees. Employment contracts are designed to adhere to both State and Provincial employment and social security regulations under applicable Chinese or the U.S. law. We have signed confidentiality agreements with all of our employees.
COMPETITION
We believe that the principal factors affecting the Company’s competitive position include:
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understanding our customers’ time-to-market, technology and cost requirements;
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access to industrial supply chain and raw material providers;
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price and cost;
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product quality;
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design capabilities and development efficiency;
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customer relationships; and
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technical support.
In our customized linear motor and specialty micro-motor business, we believe that we compete favorably with respect to each of these criteria. We do not believe that there are any direct competitors of any meaningful size that operate using the same business model as ours within the PRC.
The market in the industrial rotary motor product line is large and very fragmented and is very competitive in China. Our products are in competition with similar products produced by other large state-owned manufacturers and many smaller privately-owned operators.
Globally, we also compete with many foreign companies. Some of our global competitors are larger in size or are divisions of large diversified companies and have substantially greater financial resources and technical capabilities.
PRC REGULATIONS
The principal regulation governing foreign currency exchange in China is the Foreign Currency Administration Rules (1996), or the Rules, as amended and adopted on August 1, 2008. Under the Rules, once certain procedural requirements are met, Renminbi (“RMB”) is convertible for current account transactions, including trade and service-related foreign exchange transactions and dividend payments, but not for capital account transactions, including direct investment, loans or investments in securities outside China, without prior approval of the State Administration of Foreign Exchange of the People’s Republic of China, or its local counter-parts. Since a significant amount of our future revenues will continue to be denominated in RMB, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.
In addition, regulations were promulgated by the State Development and Reform Commission, or SDRC, the Ministry of Commerce of the People’s Republic of China, or MOFCOM and the State Administration of Foreign Exchange, or SAFE, that requires registration with, and approval from, PRC government authorities in connection with direct or indirect offshore investment activities by individuals who are PRC residents and PRC corporate entities. These regulations may apply to future offshore or cross-border acquisitions, if any, as well as to the equity interests in offshore companies held by our PRC stockholders who are considered PRC residents. We intend to make all required application and filings, and will require the stockholders of the offshore entities in our corporate group who are considered PRC residents to make the application and filings, as required under these regulations and under any implementing rules or approval practices that may be established under these regulations. However, because these regulations are relatively new and lacking implementing rules or reconciliation with other approval requirements, it remains uncertain how these regulations and any future legislation concerning offshore or cross-border transactions, will be interpreted and implemented by the relevant government authorities. The approval criteria by SDRC and MOFCOM agencies for outbound investment by PRC residents are not provided under the relevant SDRC and MOFCOM regulations. Also, the criteria for registration with SAFE agencies, and whether such registration procedure is discretionary, are still uncertain as the criteria, if any, are not provided for under relevant SDRC regulations. Furthermore, there is a lack of relevant registration precedents for us to determine the registration criteria in practice. Accordingly, we cannot provide any assurances that we will be able to comply with, qualify under or obtain any registration or approval as required by these regulations or other related legislations. Further, we cannot assure you that our stockholders would not be considered PRC residents, given uncertainties as to what constitutes a PRC resident for the purposes of the regulation, or that if they are deemed PRC residents, they would or would be able to comply with the requirements. Our failure or the failure of our PRC resident stockholders to obtain these approvals or registrations may restrict our ability to acquire a company outside of China or use our entities outside of China to acquire or establish companies inside of China, which could negatively affect our business and future prospects.
With respect to our subsidiaries in the PRC and to the extent that we form any additional subsidiaries in the PRC, the ability of any PRC operating subsidiary to make dividend and other payments to us may be restricted by factors such as changes in applicable foreign exchange and other laws and regulations. For example, under the SAFE regulations discussed above, the foreign exchange activities of a PRC subsidiary are conditioned upon the compliance with the SAFE registration requirements by the stockholders of any offshore entities who are PRC residents. Failure to comply with these SAFE registration requirements may substantially restrict or prohibit the foreign exchange inflow to and outflow from a PRC subsidiary, including, remittance of dividends and foreign-currency-denominated borrowings by a PRC subsidiary. In addition, a PRC operating subsidiary is required, where applicable, to allocate a portion of their net profit to certain funds before distributing dividends, including at least 10% of their net profit to certain reserve funds until the balance of such fund has reached 50% of their registered capital. These reserves can only be used for specific purposes, including making-up cumulative losses of previous years, conversion to equity capital, and application to business expansion, and are not distributable as dividends. A PRC operating company is also required, where applicable, to allocate an additional 5% to 10% of their net profits to a statutory common welfare fund. The net profit available for distribution from a PRC operating company is determined in accordance with generally accepted accounting principles in China, which may materially differ from a determination performed in accordance with U.S. GAAP. As a result, we may not receive sufficient distributions or other payments from these entities to enable us to make dividend distributions to our stockholders in the future, even if our U.S. GAAP financial statements indicate that our operations have been profitable.
The address of our corporate headquarters is No. 9, Ha Ping Xi Lu, Ha Ping Lu Ji Zhong Qu, Harbin Kai Fa Qu, Harbin, China, 150060. Our telephone number is: 86-451-8611-6757. Our internet address is www.harbinelectric.com. You can find on our website, free of charge, our Annual and Quarterly Reports on Forms 10-K and 10-Q, Current Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act.
Item 1A.
Item 1A. Risk Factors
An investment in our common stock is very risky. You should carefully consider the risk factors described below, together with all other information in this Form 10-K, before making an investment decision. If any of the following risks actually occurs, our business, financial condition or operating results could be materially and adversely affected. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment. Additional risks and uncertainties not currently foreseeable to us may also impair our business operations.
GENERAL RISKS RELATING TO OUR BUSINESS
Our rapid growth may strain our resources.
Our revenues increased by 85% for the year ended December 31, 2009 versus the year ended December 31, 2008, and 85% in 2008 over 2007; however, it is unlikely that we will maintain such growth in the long term and cannot assure any growth of our business for any period. Our rapid expansion will place significant strain on our management and our operational, accounting, and information systems. We expect that we will need to continue to improve our financial controls, operating procedures, and management information systems. We will also need to effectively hire, train, motivate, and manage our employees. Our failure to manage our growth could disrupt our operations and ultimately prevent us from generating the profits we expect.
Our debt may constrict our operations, and cash flows and capital resources may be insufficient to make required payments on our indebtedness and future indebtedness.
As of December 31, 2009, we had approximately $9.1 million debt outstanding under our Guaranteed Senior Secured Floating Rate Notes (the “Notes”) issued in August 2006. Additionally, our PRC subsidiaries had a total of approximately $48.8 miilion loans outstanding as of December 31, 2009. These loans were obtained from local PRC banks, our noncontrolling shareholders, and also unrelated individual companies. They are used to support our working capital. These obligations could have important consequences to you. For example, they could:
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reduce the availability of our cash flow to fund future working capital, capital expenditures, acquisitions and other general corporate purposes;
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limit our ability to obtain additional financing for working capital, capital expenditures, and other general corporate requirements;
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expose us to interest rate fluctuations because the interest rate for the Notes is variable; and
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place us at a competitive disadvantage compared to competitors that may have proportionately less debt.
In addition, our ability to make scheduled payments or refinance our obligations depends on our successful financial and operating performance, cash flows, and capital resources, which in turn depend upon prevailing economic conditions and certain financial, business, and other factors, many of which are beyond our control. If our cash flows and capital resources are insufficient to fund our debt obligations, we may be forced to reduce or delay capital expenditures, sell material assets or operations, obtain additional capital, restructure our debt, or declare bankruptcy. Furthermore, our obligations under the Notes are secured by our shares of Advanced Electric Motors, Inc., our Delaware subsidiary through which we own our PRC operating subsidiaries. These security interests could result in our loss of the business, if we default on the Notes.
Covenants in the Indenture governing our Notes and the Purchase Agreement pursuant to which the Notes were initially sold, restrict our ability to engage in or enter into a variety of transactions.
Our “Notes” were issued pursuant to an Indenture, dated as of August 30, 2006, between us and The Bank of New York, as Trustee. The Indenture contains various covenants that may limit our discretion in operating our business. In particular, we are limited in our ability to merge, consolidate or transfer substantially all of our assets, issue preferred stock of subsidiaries, create liens on our assets to secure debt, make capital expenditures, incur additional indebtedness and pay dividends. The Indenture also requires us to maintain certain financial ratios. These covenants and ratios could have an adverse effect on our business by limiting our ability to take advantage of financing, merger and acquisition or other corporate opportunities and to fund our operations.
The Purchase Agreement dated August 29, 2006, pursuant to which the Notes were initially sold, provides that the initial purchasers of the Notes and their assignees have a right of first offer for so long as such persons continue to hold any Notes with respect to any issuances of new equity securities by us other than shares of stock issued to employees, officers and directors pursuant to bona fide employee benefit plans. This right of first offer contained in the Purchase Agreement could adversely impact our ability to do future equity offerings.
Our success depends on our management team and other key personnel, the loss of any of whom could disrupt our business operations.
Our future success will depend in substantial part on the continued service of the members of our senior management. The loss of the services of one or more of our key personnel could impede implementation of our business plan and result in reduced profitability. We do not carry key person life insurance on any of our officers or employees. Our future success will also depend on the continued ability to attract, retain and motivate highly qualified technical sales and marketing customer support.
Because of the rapid growth of the economy in China, competition for qualified personnel is intense. We cannot assure you that we will be able to retain our key personnel or that we will be able to attract, assimilate or retain qualified personnel in the future.
We depend on the supply of raw materials and key component parts, and any adverse changes in such supply or the costs of raw materials may adversely affect our operations.
One, two, and five major vendors provided approximately 16%, 39%, and 80% of the Company’s purchases of raw materials for the years ended December 31, 2009, 2008, and 2007, respectively. Any material change in the spot and forward rates could have a material adverse effect on the cost of our raw materials and on our operations. In addition, if we need alternative sources for key component parts for any reason, these component parts may not be immediately available to us. If alternative suppliers are not immediately available, we will have to identify and qualify alternative suppliers, and production of these components may be delayed. We may not be able to find an adequate alternative supplier in a reasonable time period or on commercially acceptable terms, if at all. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. An inability to obtain our key source supplies for the manufacture of our products might require us to delay shipments of products, harm customer relationships or force us to curtail or cease operations.
We may experience material disruptions to our manufacturing operation.
While we seek to operate our facilities in compliance with applicable rules and regulations and take measures to minimize the risks of disruption at our facilities, a material disruption at one of our manufacturing facilities could prevent us from meeting customer demand, reduce our sales and/or negatively impact our financial results. Any of our manufacturing facilities, or any of our machines within an otherwise operational facility, could cease operations unexpectedly due to a number of events, including:
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unscheduled maintenance outages;
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prolonged power failures;
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an equipment failure;
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disruptions in the transportation infrastructure including roads, bridges, railroad tracks;
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fires, floods, earthquakes, or other catastrophes; and
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other operational problems.
We may not be able to adequately protect and maintain our intellectual property, which could weaken our competitive position.
Our success will depend on our ability to continue to develop and market electric motor products. We have been granted 20 patents in China relating to linear motor and automobile specialty micro-motor applications. No assurance can be given that such patents will not be challenged, invalidated, infringed or circumvented, or that such intellectual property rights will provide a competitive advantage to us. The implementation and enforcement of PRC intellectual property laws historically have not been vigorous or consistent, primarily because of ambiguities in the PRC laws and a relative lack of developed enforcement mechanisms. Accordingly, intellectual property rights and confidentiality protections in the PRC are not as effective as in the United States and other countries. Policing the unauthorized use of proprietary technology is difficult and expensive, and we might need to resort to litigation to enforce or defend patents issued to us or to determine the enforceability, scope and validity of our proprietary rights or those of others. Such litigation will require significant expenditures of cash and management efforts and could harm our business, financial condition and results of operations. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, competitive position, business prospects and reputation. In addition, since we have chosen to secure patents only in China, we may not be in a position to protect our inventions and technology in other countries in which we sell our product, which could result in increased competition and lower pricing for our products.
RISKS RELATING TO DOING BUSINESS IN THE PEOPLE’S REPUBLIC OF CHINA
China’s economic policies could adversely affect our business.
Substantially all of our assets are located in China and substantially all of our revenues are derived from our operations in China. Accordingly, our results of operations and prospects are subject, to a significant extent, to economic, political and legal developments in China.
While China’s economy has experienced significant growth in the past 30 years, it has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations.
The economy of China has been changing from a planned economy to a more market-oriented economy. In recent years the Chinese government has implemented measures emphasizing market forces for economic reform, reduction of state ownership of productive assets, and establishment of corporate governance in business enterprises; however, a substantial portion of productive assets in China are still owned by the Chinese government. In addition, the Chinese government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over China’s economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy, and providing preferential treatment to particular industries or companies.
PRC laws and regulations governing our current business operations are sometimes vague and uncertain and any changes in such laws and regulations may harm our business.
There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations including, but not limited to, the laws and regulations governing our business, and the enforcement and performance of our arrangements with customers in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. We are considered foreign persons or foreign funded enterprises under PRC laws and, as a result, we are required to comply with PRC laws and regulations. These laws and regulations are sometimes vague and may be subject to future changes, and their official interpretation and enforcement may involve substantial uncertainty. The effectiveness of newly enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. We cannot predict what effect the interpretation of existing or new PRC laws or regulations may have on our business.
Inflation in the PRC could negatively affect our profitability and growth.
The PRC economy has experienced rapid growth. Rapid economic growth could lead to growth in the money supply and rising inflation. If prices for our products rise at a rate that is insufficient to compensate for the rise in the cost of supplies, it may harm our profitability. In order to control inflation in the past, the PRC government has imposed controls on bank credit, limits on loans for fixed assets and restrictions on state bank lending. Such policies can lead to a slowing of economic growth. Rises in interest rates by the central bank would likely slow economic activity in China which could, in turn, materially increase our costs and also reduce demand for our products.
PRC regulations relating to mergers, offshore companies, and Chinese stockholders, if applied to us, may limit our ability to operate our business as we see fit.
Regulations govern the process by which we may participate in an acquisition of assets or equity interests. Depending on the structure of the transaction, the new regulation will require Chinese parties to make a series of applications and supplemental applications to various government agencies. In some instances, the application process may require the presentation of economic data concerning a transaction, including appraisals of the target business and evaluations of the acquirer, which are designed to allow the government to assess the transaction. Government approvals will have expiration dates by which a transaction must be completed and reported to the government agencies. Compliance with the new regulations is likely to be more time consuming and expensive than in the past and the government can now exert more control over the combination of two businesses. Accordingly, due to the PRC regulations, our ability to engage in business combination transactions in China through our Chinese subsidiaries has become significantly more complicated, time consuming and expensive, and we may not be able to negotiate transactions that are acceptable to us or sufficiently protective of our interests in a transaction.
If preferential tax concessions granted by the PRC government change or expire, our financial results and results of operations would be materially and adversely affected.
Our results of operation may be adversely affected by changes to or expiration of preferential tax concessions that our Chinese subsidiaries currently enjoy. The statutory tax rate generally applicable to domestic Chinese companies was 33% before January 1, 2008. On January 1, 2008, the new Chinese Enterprise Income Tax (“EIT”) law replaced the existing laws for Domestic Enterprises (“DES”), such as Weihai Tech Full and Xi’an Tech Full Simo, and Foreign Invested Enterprises (“FIEs”), such as Harbin Tech Full, Shanghai Tech Full, and Advanced Automation Group Shanghai, Ltd. The new standard EIT rate of 25% is now applicable to both DES and FIEs. The PRC government provides reduced tax rates for productive foreign investment enterprises in the Economic and Technological Development Zones and for enterprises engaged in production or business operations in the Special Economic Zones. These preferential tax rates are generally graduated, starting at 0% and increasing to the standard EIT rate of 25% over time. Our operations under Harbin Tech Full were subject to a 10% preferential tax rate until December 31, 2010. Our operations under Shanghai Tech Full was subject to 0% preferential tax rate in 2008 and 2009 and will be subject to 11% in 2010, 12% in 2011, 12.5% in 2012, and 25% thereafter. Our operations under Xi’an Tech Full Simo were subject to a 15% preferential tax rate. As a result, the estimated tax savings for the year ended December 31, 2009, 2008 and 2007 amounted to approximately $8.6 million, $6.0 million, and $10.3 million, respectively. Tax laws in China are subject to interpretations by relevant tax authorities. Preferential tax rates may not remain in effect or may change, in which case we may be required to pay the higher income tax rate generally applicable to Chinese companies, or such other rate as is required by the laws of China.
Fluctuation in the value of the RMB may have a material adverse effect on your investment.
The value of RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. Our revenues and costs are mostly denominated in RMB. Any significant fluctuation in value of RMB may materially and adversely affect our cash flows, revenues, earnings and financial position, and the value of our stock in U.S. dollars. For example, an appreciation of RMB against the U.S. dollar would make any new RMB denominated investments or expenditures more costly to us, to the extent that we need to convert U.S. dollars into RMB for such purposes. In addition, the depreciation of significant U.S. dollar denominated assets could result in a charge to our income statement and a reduction in the value of these assets.
We must comply with the Foreign Corrupt Practices Act.
We are required to comply with the United States Foreign Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Foreign companies, including some of our competitors, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in mainland China. If our competitors engage in these practices, they may receive preferential treatment from personnel of some companies, giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining new licenses, which would put us at a disadvantage. Although we inform our personnel that such practices are illegal, we cannot assure you that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties.
The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.
Our ability to operate in China may be harmed by changes in its laws and regulations, including those related to taxation, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of these jurisdictions may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations and interpretations. Government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties.
We are subject to environmental laws and regulations in the PRC.
We are subject to environmental laws and regulations in the PRC. Any failure by us to comply fully with such laws and regulations will result in us being subject to penalties and fines or being required to pay damages. Although we believe we are currently in compliance with the environmental regulations in all material respects, any change in the regulations may require us to acquire equipment or incur additional capital expenditure or costs in order to comply with such regulations. Our profits will be adversely affected if we are unable to pass on such additional costs to our customers.
We may have difficulty establishing adequate management, legal and financial controls in the PRC.
The PRC historically has been deficient in Western style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards.
It will be extremely difficult to acquire jurisdiction and enforce liabilities against our officers, directors and assets based in the PRC.
Because most of our executive officers and several of our directors, including our chairman of the Board of Directors, are Chinese citizens, it may be difficult, if not impossible, to acquire jurisdiction over these persons in the event a lawsuit is initiated against us and/or our officers and directors by a stockholder or group of stockholders in the United States. Also, because the majority of our assets are located in the PRC, it would also be extremely difficult to access those assets to satisfy an award entered against us in the U.S. court.
The legal system in China has inherent uncertainties that may limit the legal protections available in the event of any claims or disputes with third parties.
The legal system in China is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. Since 1979, the central government has promulgated laws and regulations dealing with economic matters such as foreign investment, corporate organization and governance, commerce, taxation and trade. As China’s foreign investment laws and regulations are relatively new and the legal system is still evolving, the interpretation of many laws, regulations and rules is not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit the remedies available in the event of any claims or disputes with third parties. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.
RISKS ASSOCIATED WITH OUR COMMON STOCK
Our common stock may be affected by limited trading volume and may fluctuate significantly.
Our common stock is traded on the Nasdaq Global Select Market. Although an active trading market has developed for our common stock, there can be no assurance that an active trading market for our common stock will be sustained. Failure to maintain an active trading market for our common stock may adversely affect our stockholders’ ability to sell our common stock in short time periods, or at all. In addition, sales of substantial amounts of our common stock in the public market could harm the market price of our common stock. Our common stock has experienced, and may experience in the future, significant price and volume fluctuations, which could adversely affect the market price of our common stock.
We do not anticipate paying cash dividends on our common stock in the foreseeable future.
We do not anticipate paying cash dividends in the foreseeable future. Presently, we intend to retain all of our earnings, if any, to finance development and expansion of our business. The Indenture pursuant to which the Notes were issued prohibits us from paying any dividends on our capital stock while the Notes remain outstanding. PRC capital and currency regulations may also limit our ability to pay dividends. Consequently, the only opportunity for investors to achieve a positive return on your investment in us will be if the market price of our common stock appreciates.
Our directors and officers control approximately one third of our common stock and, as a result, they may exercise some voting control and be able to take actions that may be adverse to your interests.
Our directors and executive officers, directly or through entities that they control, beneficially owned, as a group, approximately 35.08% of our issued and outstanding common stock as of December 31, 2009. This concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive a disadvantage in owning shares in a company with one or several controlling stockholders. Furthermore, our directors and officers, as a group, have the ability to significantly influence the outcome of all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets. This concentration of ownership may have the effect of delaying or preventing a change of control, including a merger, consolidation or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control.
Your percentage ownership in us may be diluted by future issuances of capital stock, which could reduce your influence over matters on which stockholders vote.
Subject to any applicable stockholder approval requirements imposed by the Nasdaq Stock Market, our board of directors has the authority to issue all or any part of our authorized but unissued shares of common stock. Issuances of common stock would reduce your influence over matters on which our stockholders vote.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Description of Property
Our corporate headquarters are located at No. 9, Ha Ping Xi Lu, Ha Ping Lu Ji Zhong Qu, Harbin Kai Fa Qu, Harbin, 150060. We currently operate four manufacturing facilities in China.
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Our Harbin facility is located in the government-designated Development Zone in the city of Harbin and occupies approximately 50,000 square meters of land with state-of-the-art production equipment primarily dedicated to our linear motor products.
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Weihai Tech Full is located in the coastal city of Weihai, Shandong Province, and occupies approximately 150,000 square meters of land.
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Shanghai Tech Full is located in the Shanghai Zhuqiao Airport Industrial Zone and occupies approximately 40,800 square meters of land.
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Xi’an Tech Full Simo, acquired in October 2009, is located in Xi’an city’s Economy and Technology Development Zone and occupies approximately 200,000 square meters of land.
ITEM 3.
ITEM 3. Legal Proceedings
From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business.
We are not currently a party to any material legal proceedings.
ITEM 4.
ITEM 4. Reserved for Future Use by the Securities and Exchange Commission
PART II
ITEM 5.
ITEM 5. Market For Common Equity and Related Stockholder Matters
Or common stock commenced trading on the Nasdaq Global Market on January 31, 2007 under the ticker symbol “HRBN” and was upgraded to Nasdaq Global Select Market effective on January 4, 2010. The following table sets forth the high and low sale prices for our common stock from January 1, 2008 to March 12, 2010, as reported by the Nasdaq Global Market, and the Nasdaq Global Select Market, respectively. The closing price for shares of our common stock on March 12, 2010 was $22.75.
* Through March 12, 2010.
Holders of Record
As of March 11, 2010, there were 34 holders of record of our common stock. The transfer agent for the common stock is StockTrans, Inc. The transfer agent’s address is 44 West Lancaster Avenue, Ardmore, PA 19003, telephone (610)-649-7300.
Dividends
We have not paid any cash dividends on our common stock, and we do not currently intend to pay cash dividends in the foreseeable future.
Stock Price Performance Graph
The following chart compares the cumulative total stockholder return on the Company’s shares of Common Stock with the cumulative total stockholder return of (i) the Nasdaq Stock Exchange Market Index and (ii) a peer group index consisting of companies reporting under the Standard Industrial Classification Code 3621 (Motors & Generators):
The material in this chart is not soliciting material, is not deemed filed with the SEC and is not incorporated by reference in any filing of the Company under the Securities Act of 1933, as amended or the Exchange Act, whether made before or after the date of this Annual Report on Form 10-K and irrespective of any general incorporation language in such filing.
Equity Compensation Plan Information
The following table provides certain information with respect to all of the Company’s equity compensation plans in effect as of December 31, 2009.
Equity Compensation Plan Information
(1) Include forfeited options
Equity Repurchases
None.
Issuance of Unregistered Shares
The Company has sold the following securities within the past three years that were not registered under the Securities Act of 1933:
On June 16, 2007, the Company entered into an Asset Purchase Agreement with Harbin Tech Full, Harbin Taifu Auto Electric Co., Ltd., a limited liability company organized and existing under the laws of the People’s Republic of China (“Taifu Auto”) Harbin Tech Full Industry Co., Ltd., a shareholder of the Taifu Auto (“HTFI”), Tianfu Yang, Suofei Xu and Zedong Xu, shareholders of HTFI, and Tianli Yang, a shareholder of both Taifu Auto and HTFI. Pursuant to the terms of the Asset Purchase Agreement, Taifu Auto agreed to sell substantially all of its non-cash assets to Harbin Tech Full. In consideration for the sale of Taifu Auto’s assets, Taifu Auto will receive an aggregate purchase price consisting of (x) a cash payment in the amount of four million dollars ($4,000,000), and (y) 473,354 newly issued shares of the Company’s common stock. Such issuances were made in an offshore transaction pursuant to Regulation S under the Securities Act of 1933.
On June 24, 2008, the Company entered into a Purchase Agreement with certain investors pursuant to which, on June 25, 2008, the Company sold to the investors 3.5 million shares of our common stock, par value $0.00001 per share at $14.13 per share solely to purchasers that qualified as accredited investors without any general solicitation, as defined in Regulation D, for a total aggregate purchase price of $49,455,000. The proceeds were used to pay for the acquisition by Harbin Tech Full Electric Co. Ltd., our wholly-owned subsidiary and a PRC company, of Weihai Hengda Electric Motor (Group) Co. Ltd., a PRC corporation.
ITEM 6.
ITEM 6. Selected Financial Data
The consolidated statement of operations data for the years ended December 31, 2009, 2008, 2007, 2006, and 2005 and the consolidated balance sheet data presented below as of December 31, 2009, 2008, 2007, 2006, and 2005 are derived from our audited consolidated financial statements and related notes, included elsewhere in this Annual Report on Form 10-K. These audited consolidated financial statements and notes have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, and for the years ended December 31, 2009, 2008, 2007 and 2006 have been audited by Frazer Frost, LLP (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP), an independent registered public accounting firm, and for the year ended December 2005 have been audited by Kabani & Company, Inc., an independent registered public accounting firm.
This data should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K.
Consolidated Statement of Operations Data:
Consolidated Balance Sheet Data:
Footnotes to Five-Year Financial Summary
(a) In October 2009, the Company acquired Xi’an Tech Full Simo, a PRC corporation. The acquisition contributed $44.1 million to total sales and $4.6 million to net income attributable to controlling interest in 2009 and only included the operations for the three months ended December 31, 2009.
(b) Net income attributable to controlling interest in 2009 included special non-cash and non-recurring items totaling a net loss of $24.2 million or $(0.94) per diluted share. See Management Discussions and Analysis. Excluding these non-recurring and non-cash charges, the adjusted net income attributable to controlling interest was $43.4 million.
(c) In July 2008, the Company acquired Weihai Hengda Electric Motor (Group) Co., Ltd., a PRC corporation. The acquisition contributed $27.6 million to total sales and $1.7 million to net income in 2008. The 2009 results reflected a full-year contribution from this acquisition compared to only six-month contribution in 2008.
(d) In June 2007, the Company acquired Harbin Taifu Auto Electric Co., Ltd., a PRC corporation through an Asset Purchase Agreement. The acquisition contributed to the results of operations starting in the quarter ended September 30, 2007.
(e) Net income in 2006 included non-cash gains of $6.4 million “Change in Fair Value of Warrants” due to an accounting adjustment.
(f) The significant increase in accounts receivable and inventories was mainly due to the acquisition of Xi’an Techu Full Simo in October 2009.
ITEM 7.
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and the notes to those financial statements appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Forward Looking Statements” and “Item 1A. Business-Risk Factors” and elsewhere in this Annual Report on Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements.
As used in this report, the terms “Company”, “we”, “our”, “us” and “Harbin” refer to Harbin Electric, Inc., a Nevada corporation.
PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
The following discussion of our financial condition and results of operations should be read in conjunction with our audited and unaudited consolidated financial statements and the notes to those financial statements set forth commencing on page of this report. In addition to historical information, this discussion and analysis contains forward-looking statements that relate to future events and expectations and, as such, constitute forward-looking statements. Forward-looking statements include those containing such words as “anticipates,” “believes,” “estimates,” “expects,” “hopes,” “targets,” “should,” “will,” “will likely result,” “forecast,” “outlook,” “projects” or similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from those expressed or implied in the forward-looking statements.
Company Overview
We were incorporated under the laws of the state of Nevada and, along with our wholly-owned subsidiaries, are headquartered in Harbin, China. We design, develop, manufacture, supply, and service a wide range of electric motors, with a focus on innovation, creativity, and value-added products. Our major product lines include linear motors, specialty micro-motors, and industrial rotary motors. Our products are purchased by a broad range of customers including those customers in the energy industry, factory automation, food processing, packaging industries, power generation systems, and mass transportation and freight transportation systems, petrochemical, metallurgical, mining, textile, and agricultural industries. We supply domestic China and other international markets. We operate four major manufacturing facilities in China, covering approximately 450,000 meters of land, and have an employee base of approximately 4900 engineers, production technicians and other employees.
We are subject to risks common to companies operating in China, including risks inherent in our distribution and commercialization efforts, uncertainty of foreign regulatory and marketing approvals and laws, reliance on key customers, enforcement of patent and proprietary rights, the need for future capital and retention of key employees. We cannot provide assurance that we will generate revenues or achieve and sustain profitability in the future.
Executive Summary
Harbin Electric performed well in 2009 despite weak economic conditions early on. This was also a year of significant strategic, operational and financial accomplishments as we further strengthened our leadership position in the electric motor industry in China. Faster economic growth in the second half of the year fueled by the massive government stimulus program and continued industrialization created a positive environment for our business. The Company achieved total revenues of $223.2 million in 2009, an 85% increase compared with $120.8 million in 2008. Net income attributable to controlling interest totaled $19.6 million ($0.77 per diluted share) in 2009, which included $24.2 million charges related to non-recurring and non-cash items. Excluding these non-recurring and non-cash items, on a comparable basis, the adjusted net income attributable to controlling interest totaled $43.8 million ($1.71 per diluted share), compared with net income of $25.4 million ($1.19 per diluted share) in 2008. The successful acquisition and integration of Xi’an Tech Full Simo in October contributed $44.1 million to total revenues and $4.6 million to net income attributable to controlling interest.
On the financial front, we raised additional equity capital which allowed us to repay a significant portion of our existing indebtedness, completed the acquisition of Xi’an Simo, and maintained a strong balance sheet as we continue to implement our growth strategy. The Company generated a total of $62.5 million cash flow from operations in 2009.
As 2010 begins, we expect to move the Company forward to a sustained profitability by leveraging our solid financial position and a promising portfolio of products. Although the first quarter is traditionally slower with the long Chinese new-year holiday, we do not expect this seasonality to impact our business significantly compared to the fourth quarter. We also expect that the Chinese government’s commitment to sustainable economic growth and the accelerated industrialization and urbanization of China will continue to drive our business and support our long term growth objectives. In 2010, we expect to continue the integration of Xi’an Tech Full Simo, capture the synergies, advance R&D, and further strengthen our competitive position in the industry.
Critical Accounting Policies and Estimates
We believe that the application of the following accounting policies, which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. Our critical accounting policies and estimates present an analysis of the uncertainties involved in applying a principle, while the accounting policies note to the financial statements (Note 2) describe the method used to apply the accounting principle.
Accounts Receivable
The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reverses. The estimated loss rate is based on our historical loss experience and also contemplates current market conditions. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified.
Inventories
Inventory is valued at the lower of cost or market value, as determined on a first-in, first-out basis, using the weighted average method. Management compares the cost of inventory with the market value and an allowance is made for writing down the inventory to its market value, if lower than cost. On an ongoing basis, inventories are reviewed for potential write-down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. When inventory is written-down to the lower of cost or market, it is not marked up subsequently based on changes in underlying facts and circumstances. Inventory is composed of raw material for manufacturing electrical motors, work in process and finished goods within the Company’s warehouse premise or consigned at a customer site.
Inventory levels are maintained based on projections of future demand and market conditions. Any sudden decline in demand and/or rapid product improvements and technological changes can result in excess and/or obsolete inventories. To the extent we increase our reserves for future periods, operating income will be reduced. Because most of our products are customized and unique to a particular customer, there is a risk that we will forecast inventory needs incorrectly and purchase or produce excess inventory. As a result, actual demand may differ from forecasts, and such differences, if not managed, may have a material adverse effect on future results of operations due to required write-offs of excess or obsolete inventory. To mitigate such exposure, sometimes we require a binding purchase order or a signed agreement by our customers agreeing to pay for and take possession of finished goods inventory parts for the duration of the agreement.
Revenue Recognition
The Company recognizes sales at the date of shipment to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. For products that are required to be examined by customers, sales revenue is recognized after the customer examination is passed. Payments received before all of the relevant criteria for revenue recognition are recorded as customer deposits.
In addition, revenue recognition could be negatively impacted by returns. For our linear motor and specialty micro-motor businesses, our products are custom products which are customer specific, and no returns are allowed. We warrant our product for repair, only in the event of defects for two years from the date of shipment. We charge such costs to cost of goods sold. For our industrial rotary motor business, our products are standardized products and returns are allowed within three days upon receipt of products by customers. We provide product warranty for repair one year from the date of shipment. Historically, the returns and defects have not been material. Should returns increase in the future it would be necessary to adjust the estimates, in which case recognition of revenues could be delayed.
Stock-Based Compensation
We are required to estimate the fair value of share-based awards on the date of grant. The value of the award is principally recognized as expense ratably over the requisite service periods. The fair value of our restricted stock units is based on the closing market price of our common stock on the date of grant. We have estimated the fair value of stock options and stock purchase rights as of the date of grant or assumption using the Black-Scholes option pricing model, which was developed for use in estimating the value of traded options that have no vesting restrictions and that are freely transferable. The Black-Scholes model considers, among other factors, the expected life of the award and the expected volatility of our stock price. We evaluate the assumptions used to value stock options and stock purchase rights on a quarterly basis. The fair values generated by the Black-Scholes model may not be indicative of the actual fair values of our equity awards, as it does not consider other factors important to those awards to employees, such as continued employment, periodic vesting requirements and limited transferability.
The Company is required to measure the cost of the equity instruments issued in exchange for the receipt of goods or services from other than employees at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services.
Stock compensation expense is recognized based on awards expected to vest. GAAP requires forfeitures to be estimated at the time of grant and revised in subsequent periods, if necessary, if actual forfeitures differ from those estimates. There were no estimated forfeitures as the Company has a short history of issuing options.
Derivative Financial Instruments
The Company used a cross-currency interest rate swap to hedge its exposure under the 2012 Notes. The derivative is initially recognized in the balance sheet at cost and subsequently re-measured at fair value each reporting period. Changes in the fair values of derivatives accounted for as cash flow hedges, to the extent they qualify for hedge accounting, are recorded in accumulated other comprehensive income, net of deferred taxes; changes in fair values of derivative financial instruments not qualifying as hedges are reported in income.
At the inception of a hedge transaction, the Company documents the relationship between hedging instruments and hedged items, as well as its risk management objective and the strategy for undertaking the hedge. This process includes linking all derivatives designated to specific firm commitments of forecast transactions. The Company also documents its assessment, both at inception and on an ongoing basis, of whether the derivative financial instruments that are used to hedge are highly effective in offsetting changes in fair values or cash flows of hedged items.
The Company terminated the cross-currency interest rate swap agreement during the third quarter of 2009. Therefore, this derivative financial instrument is no longer recognized in the quarterly financial statements as a liability beginning in the third quarter of 2009.
Fair Value of Financial Instruments
On January 1, 2008, the Company adopted FASB’s accounting standard related to fair value measurements and 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.
Adoption of New Accounting Standards
Effective January 1, 2009, a total of 2,030,158 warrants previously treated as equity pursuant to the derivative treatment exemption are no longer afforded equity treatment because the strike price of the warrants is denominated in US dollar, a currency other than the Company’s functional currency, the Chinese Renminbi. As a result, the warrants are not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of the warrants outstanding will be recognized currently in earnings until such time as the warrants are exercised or expired.
As such, effective January 1, 2009, the Company reclassified the fair value of these warrants from equity to liability, as if these warrants were treated as a derivative liability since their issuance in August 2006. On January 1, 2009, the Company reclassified from additional paid-in capital, as a cumulative effect adjustment, $6.1 million to beginning retained earnings and $7.4 million to warrant liabilities to recognize the fair value of such warrants. As of December 31, 2009, the Company has 366,697 warrants outstanding. The fair value of the outstanding warrants was $4.6 million. The Company recognized a total of $13.2 million loss from the change in fair value of the warrants for the year ended December 31, 2009. The Company uses the Black-Scholes Option Pricing Model to value its options and warrants, and considering certain key input, including the trading price on reporting date, volatility of its stock, conversion price, remaining term of the warrants , dividend rate , and the risk-free interest rate for the warrant life.
Recently Adopted Accounting Standards
In January 2009, the FASB’s accounting standard regarding other investments providing additional guidance which amended the impairment model to remove the exclusive reliance on “market participant” estimates of future cash flows used in determining fair value. Changing the cash flows used to analyze other-than-temporary impairment from the “market participant” view to a holder’s estimate of whether there has been a “probable” adverse change in estimated cash flows allows companies to apply reasonable judgment in assessing whether an other-than-temporary impairment has occurred. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB’s accounting standard regarding fair value measurements and disclosures providing additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased and also includes guidance on identifying circumstances that indicate a transaction is not orderly for fair value measurements. This guidance shall be applied prospectively with retrospective application not permitted. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB’s accounting standard regarding debt and equity securities requires to make the other-than-temporary impairments guidance more operational and to improve the presentation of other-than-temporary impairments in the financial statements. This guidance will replace the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired debt security until recovery with a requirement that management assert it does not have the intent to sell the security, and it is more likely than not it will not have to sell the security before recovery of its cost basis. This guidance provides increased disclosure about the credit and noncredit components of impaired debt securities that are not expected to be sold and also requires increased and more frequent disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. Although this guidance does not result in a change in the carrying amount of debt securities, it does require that the portion of an other-than-temporary impairment not related to a credit loss for a held-to-maturity security be recognized in a new category of other comprehensive income and be amortized over the remaining life of the debt security as an increase in the carrying value of the security. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB issued an accounting standard that requires disclosures about fair value of financial instruments not measured on the balance sheet at fair value in interim financial statements as well as in annual financial statements. Prior to this guidance, fair values for these assets and liabilities were only disclosed annually. This guidance applies to all financial instruments and requires all entities to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In June 2009, the FASB issued an accounting standard amending the accounting and disclosure requirements for transfers of financial assets. This guidance is effective for the Company beginning in 2010. Should the Company’s accounts receivable securitization programs not qualify for sale treatment under the revised rules, future securitization transactions entered into on or after January 1, 2010 would be classified as debt and the related cash flows would be reflected as a financing activity. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In June 2009, the FASB updated an accounting standard regarding consolidation guidance which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance clarifies that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. This guidance requires an ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity. This guidance also requires additional disclosures about a company’s involvement in variable interest entities and any significant changes in risk exposure due to that involvement. This guidance is effective for fiscal years beginning after November 15, 2009. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In August 2009, the FASB issued an Accounting Standards Update (“ASU”) regarding measuring liabilities at fair value. This ASU provides additional guidance clarifying the measurement of liabilities at fair value in circumstances in which a quoted price in an active market for the identical liability is not available; under those circumstances, a reporting entity is required to measure fair value using one or more of valuation techniques, as defined. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In October 2009, the FASB issued an ASU regarding accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing. This ASU requires that at the date of issuance of the shares in a share-lending arrangement entered into in contemplation of a convertible debt offering or other financing, the shares issued shall be measured at fair value and be recognized as an issuance cost, with an offset to additional paid-in capital. Further, loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. This ASU is effective for fiscal years beginning on or after December 15, 2009, and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In November 2009, the FASB issued an ASU regarding accounting for stock dividends, including distributions to shareholders with components of stock and cash. This ASU clarifies that the stock portion of a distribution to shareholders that contains components of cash and stock and allows shareholders to select their preferred form of the distribution (with a limit on the amount of cash that will be distributed in total) should be considered a stock dividend and included in EPS calculations as a share issuance. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements
In December 2009, FASB issued ASU No. 2009-16, Accounting for Transfers of Financial Assets. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140.The amendments in this Accounting Standards Update improve financial reporting by eliminating the exceptions for qualifying special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, the amendments require enhanced disclosures about the risks that a transferor continues to be exposed to because of its continuing involvement in transferred financial assets. Comparability and consistency in accounting for transferred financial assets will also be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
In December, 2009, FASB issued ASU No. 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R). The amendments in this Accounting Standards Update replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which reporting entity has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. An approach that is expected to be primarily qualitative will be more effective for identifying which reporting entity has a controlling financial interest in a variable interest entity. The amendments in this Update also require additional disclosures about a reporting entity’s involvement in variable interest entities, which will enhance the information provided to users of financial statements. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
In January 2010, FASB issued ASU No. 2010-01- Accounting for Distributions to Shareholders with Components of Stock and Cash. The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
In January 2010, FASB issued ASU No. 2010-02 - Accounting and Reporting for Decreases in Ownership of a Subsidiary - a Scope Clarification. The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity. The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. The Company does not expect the adoption of this ASU to have a material impact on the Company’s consolidated financial statements.
In January 2010, FASB issued ASU No. 2010-06 - Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. 2) Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarify existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
Results of Operations
Year Ended December 31, 2009 Compared to Year Ended December 31, 2008
Revenue
For the year ended December 31, 2009, total revenues were $223.2 million, compared with $120.8 million in 2008, reflecting an 85% growth year-over-year. Strong sales growth resulted from the acquisition of Xi’an Tech Full Simo, which contributed $44 million to total sales, as well as higher sales across all product lines. By product line, linear motor sales were up 19% from 2008 primarily due to higher oil pumps sales (519 units in 2009 compared to 214 units in 2008) and new sales from our linear motor propulsion systems developed for coal transportation trains ($7.3 million), as the Company started to deliver the products during the 4th quarter. This was somewhat offset by declines in other linear motors and in export sales. Sales of specialty micro motors were up 17% from 2008. Sales of industrial rotary motors increased from $28 million to $116 million including the contribution from the new acquisition. International sales totaled $21.6 million in 2009, compared with $20.2 million in 2008.
The following table sets forth the amounts and the percentage relationship to revenues in our consolidated statements of income for the years ended December 31, 2009 and 2008:
The following table presents the revenue contribution by percentage by each of our product line in 2009 versus 2008.
Net Income
The Company recorded a net income available to controlling interest of $19.6 million, or $0.77 per diluted share, which included special non-cash and non-recurring items totaling a net loss of $24.2 million or $(0.94) per diluted share. This compared with a net income of $25.4 million, or $1.19 per diluted share in 2008. Total weighted average diluted share count at the end of 2009 was 25.7 million compared to 21.3 million at the end of 2008. The increase was mainly due to the 7.2 million common shares issued in August 2009 in an equity financing, which resulted in some earnings dilution.
The management of Harbin Electric uses non-GAAP adjusted net earnings to measure the performance of the Company’s business internally by excluding non-recurring items as well as special non-cash charges. The Company’s management believes that these non-GAAP adjusted financial measures allow the management to focus on managing business operating performance because these measures reflect the essential operating activities of Harbin Electric and provide a consistent method of comparison to historical periods. The Company believes that providing the non-GAAP measures that management uses internally to its investors is useful to investors for a number of reasons. The non-GAAP measures provide a consistent basis for investors to understand Harbin Electric's financial performance in comparison to historical periods without variation of non-recurring items and non-operating related charges. In addition, it allows investors to evaluate the Company's performance using the same methodology and information as that used by the management. Non-GAAP measures are subject to inherent limitations because they do not include all of the expenses included under GAAP and because they involve the exercise of judgment of which charges are excluded from the non-GAAP financial measure. However, the management of Harbin Electric compensates for these limitations by providing the relevant disclosure of the items excluded.
The following table provides the non-GAAP financial measure and a reconciliation of the non-GAAP measure to the GAAP net income.
The non-recurring and non-cash items in 2009 included:
(1) The second quarter had $1.17 million (RMB 8 million) government grant, which was awarded in June 2009 to the Company’s subsidiary HTFE by the Harbin municipal government to support the Company’s subway train project that qualifies as engaging in China’s advanced industrialization;
(2) During the third quarter, the Company repurchased $26.5 million 2012 Notes at a discount of 15% and the outstanding $6 million 2010 Notes at a discount of 3%, which resulted in a total gain of $4.16 million. As a result of the debt repurchase, the Company recorded a $7.3 million additional amortization of debt discount and debt issuance costs associated with the repurchased portion of the debt;
(3) During the third quarter, the Company also terminated the cross currency interest rate swap agreement that was intended as a cash flow hedge on the scheduled payments of the $38 million 2012 Notes. As a result, $9 million was transferred from the accumulated other comprehensive loss into earnings as a loss from termination of the swap; and
(4) In 2009, the Company also recorded a loss of $13.2 million due to changes in fair value of warrants.
Gross Profit
The following table presents the average gross profit margin by each of our product line in 2009 versus 2008. Overall gross profit margin declined to 34.3% in 2009 from 39.3% in 2008 due to changes in the product mix as sales of lower-margin industrial rotary motors expanded, in part as a result of the acquisition of Xi’an Tech Full Simo.
Operating Expenses
Selling, general and administrative expense (SG&A) of $18.7 million in 2009 was higher than the $11.9 million in 2008, reflecting higher costs associated with increased sales activities such as shipping and handling costs and the addition of administrative costs from the newly acquired company Xi’an Tech Full Simo and our start up of Shanghai Tech Full. Higher depreciation expense and increased auditing expense and consulting expense related to the acquisition and Sabanes-Oxley 404 compliance contributed to the higher SG&A. However, as a percentage of total sales, the Company’s total operating expense declined year-over-year to 8.4% in 2009 from 9.9% in 2008.
Operating profits in 2009 were $55.8 million compared to $34.4 million in 2008, with the operating margin at 25.0% and 28.5%, respectively for 2009 and 2008. The decline of the operating margin was primarily driven by changes in product mix as lower margin industrial rotary motor business expanded more rapidly as a result of acquisition. Before the contribution from the acquisition of Xi’an Tech Full Simo ($9.9 million), operating profits were $45.9 in 2009 and operating margin was 25.6%.
Interest Expense (net)
Net interest expense was $12.3 million in 2009, which included $10.9 million amortization of debt discount and $1.3 million amortization of debt issuance costs, of which $7.93 million was related to the debt repurchase in the third quarter of 2009. Excluding these special charges, net interest expense was $5.0 million. This compares to net interest expense of $6.1 million in 2008. The reduction of interest expense was mainly due to reduction of our debt. Interest income earned on cash deposit included in the net interest expense was $0.9 million in 2009 and $0.8 million in 2008.
Other Income (net)
Other income, net, totaled $5.5 million in 2009 compared to $1.6 million in 2008. This item mainly included income from recycling scrap materials and selling production waste, government grant, and a government subsidy in an amount that is equal to a 2.5% tax rate reduction granted to Harbin Tech Full to encourage its high-technology related businesses. The dollar amount of the assistance to Harbin Tech Full was approximately $1.1 million in 2009 and $0.8 million in 2008.
Income Tax
The income tax provision was $7.8 million in 2009 versus $4.5 million in 2008. Some of our subsidiaries receive preferential tax treatment either due to its being located in an economic development zone or due to its approved status as engaging in the development of high-technology. Harbin Tech Full is subject to 10% preferential tax rate until December 31, 2010 and 15% thereafter. Our operations under Shanghai Tech Full was subject to 0% preferential tax rate in 2009 and will be subject to 11% in 2010, 12% in 2011, 12.5% in 2012, and 25% thereafter. Our operations under Xi’an Tech Full Simo were subject to a 15% preferential tax rate. Weihai Tech Full is subject to the 25% standard income tax rate. The standard income tax rate for all corporations in China is 25%.
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
Revenue
For the year ended December 31, 2008, the Company reported sales of $120.8 million, up 85% compared with sales of 65.4 million in 2007. Total sales consisted of 41% from linear motors and its integrated application systems, 28% from automobile specialty micro-motors, 23% from industrial rotary motors, and 8% from controllers and armatures. For comparison, total sales in 2007 consisted of 56% from linear motors and the integrated application systems, 28% from automobile specialty micro-motors, and 16% from controllers, armatures and other special motors.
The year-over-year sales growth was primarily attributable to the $27.6 million sales from our industrial rotary motor business acquired in July 2008. Higher sales from the other two core product lines also contributed significantly to the sales growth, with linear motor sales up 36% and automobile specialty micro-motor sales up 87% year-over-year. Excluding the acquisition of Weihai Tech Full in July 2008, revenues from existing products increased to $93.2 million, representing a 43% increase from 2007.
International sales totaled $20.2 million or 17% of total sales in 2008. This compares to international sales of $8.1 million in 2007, representing a 149% growth from the prior year.
The following table sets forth the amounts and the percentage relationship to revenues in our consolidated statements of income for the years ended December 31, 2008 and 2007:
Net Income
Full year 2008 net income totaled $25.4 million ($1.19 per diluted share), compared with net income of $16.9 million ($0.91 per diluted share) in 2007. The acquisition of Weihai Tech Full in July 2008 contributed $1.7 million to the total net income. Compared with 2007, the benefits of sales growth from new products and the acquisition as well as lower interest expense and higher other income were partially offset by higher SG&A costs and the provision for income taxes that began in 2008. Total weighted average diluted share count at the end of 2008 was 21.3 million compared to 18.6 million at the end of 2007. The increase was mainly due to the 3.5 million common shares issued in June 2008, which resulted in some earnings dilution in 2008.
Gross Profit
Total gross profits of $47.5 million consisted of 6% from the acquisition of Weihai Tech Full and 94% from the existing businesses. This was $15.0 million higher in 2008 than in 2007, due principally to higher sales from existing products and newly added sales from acquisition. The overall gross profit margin was 39.3% in 2008 compared to 49.6% in 2007. The decline in gross profit margin is primarily driven by changes in product mix where sales contribution from our lower margin products including industrial rotary motors and auto specialty micro-motors increased more. The gross margin for industrial rotary motor products was negatively impacted by higher raw material prices in 2008 compared to 2007. Excluding the acquisition, the average gross profit margin was 47.8% for 2008.
Operating Expenses
Selling, general and administrative expense (SG&A) of $11.9 million in 2008 was higher than the $7.7 million in 2007, reflecting higher costs associated with increased sales activities such as shipping and handling costs and the addition of administrative costs from the newly acquired company Weihai Tech Full. Higher depreciation expense and increased auditing, consulting, and legal expense related to the acquisition and Sabanes-Oxley 404 compliance work as well as higher stock based compensation expense contributed to the higher S&A. However, as a percentage of total sales, the Company’s total operating expense declined year-over-year to 9.9% in 2008 from 11.7% in 2007.
Operating profits of $34.4 million were $10.7 million higher in 2008 than in 2007, with the operating margin at 28.5% and 36.3%, respectively for 2008 and 2007. The decline of the operating margin was primarily driven by changes in product mix due to the addition of lower margin industrial rotary motor business through the acquisition. Excluding the contribution from the acquisition ($1.7 million), operating profits were $32.7 with the operating margin at 35.1% in 2008.
Interest Expense (net)
Interest expense, net, of $6.1 million in 2008 decreased from $6.6 million in 2007 reflecting lower average debt balances and lower interest rates on the variable rate 2010 Notes. Non-cash amortization expense of debt discount and debt issuance cost totaled $5.0 million for both years. This non-cash item reduced the annual earnings by $0.24 per diluted share in 2008 and $0.27 per diluted share in 2007.
Other Income (net)
Other income, net, totaled $1.6 million in 2008 compared to other expenses, net, of $0.2 million in 2007. The other income in 2008 mainly consisted of income from recycling scrap materials and selling production waste and a government subsidy in an amount that is equal to a 2.5% tax rate reduction granted to Harbin Tech Full beginning in 2008 tax year to encourage its high-technology related businesses. The dollar amount of the subsidy to Harbin Tech Full was approximately $0.8 million in 2008.
Income Tax
According to the Provisional Regulations of the People's Republic of China on Income Tax and the approval by the local tax bureau and the Management Regulation of Harbin Economic and Technological Development Zone, from July 1, 2004 through December 31, 2007, Harbin Tech Full was exempted from income tax. A reduced income tax rate of 10% has been approved for January 1, 2008 to December 31, 2010. Weihai Tech Full is subject to the 25% standard income tax rate.
The income tax provision was $4.5 million in 2008 versus none in 2007. The income tax that Harbin Tech Full began to pay on earnings starting on January 1, 2008 has resulted in a reduction in our growth of net earnings compared to previous periods.
Liquidity and Capital Resources
Overview
A major factor in the Company’s liquidity and capital resource planning is its generation of operating cash flow, which is strongly dependent on the demand for our products. This is supplemented by our financing activities in the capital markets including potentially debt and equity, which supports major acquisitions and capital investments for business growth.
Our liquidity position remains adequate, with $92.9 million in cash and cash equivalents as of December 31, 2009, compared to $48.4 million as of December 31, 2008. The increase in cash and cash equivalents was mainly driven by cash generated from operations, cash proceeds from the conversion of outstanding warrants and option exercise, and cash proceeds from the issuance of 7,187,500 shares of common stock at $16 per share in a public offering during the third quarter. Cash provided by operating activities totaled $62.5 million in 2009 compared to $42.3 million in 2008. Net proceeds from the conversion of warrants and option exercise totaled $11.9 million. Net proceeds from stock issuance totaled $107.5 million. Capital spending from operations for 2009 totaled approximately $16.5 million, compared to $32.8 million for 2008. The capital spending in both periods reflects primarily the investments in the construction and upgrading of our facilities and purchases of new equipment.
At December 31, 2009, several items under our current assets and current liabilities including accounts receivables, inventories, accounts payables, short term loans and customer deposits increased significantly compared with the levels at December 31, 2008. Accounts receivables, increased by $63.0 million. Inventories increased by $52.0 million. Accounts payables increased by $38.7 million. Short term loans increased by $40.2 million. Customer deposits increased by $17.3 million. These significant changes in our current assets and current liabilities were primarily due to acquisition of Xi’an Tech Full Simo. The $28.7 million amounts due to original shareholders at December 31, 2009 represented the unpaid portion of the purchase price for the acquisition of Xi’an Tech Full Simo.
Cash Provided by Operating Activities
Cash provided by operating activities totaled $62.5 million. The major components of cash provided by operating activities are consolidated net income (net income attributable to both controlling and noncontrolling interest) adjusted for non-cash income and expense items and changes in operating assets and liabilities.
Financing Activities
On August 29, 2006, the Company, Advanced Electric Motors, Inc. (“AEM”), Citadel Equity Fund Ltd. (“Citadel”) and Merrill Lynch International (“Merrill Lynch” and, together with Citadel, the “Investors”) entered into a purchase agreement (the “Purchase Agreement”) relating to the purchase and sale of (a) $50.0 million aggregate principal amount of the Company’s Guaranteed Senior Secured Floating Rate Notes (collectively, the “Notes”) and (b) fully detachable warrants (the “Warrants”) to purchase an aggregate of 3,487,368 shares of our common stock. The transaction closed on August 30, 2006. Interest on the Notes is payable semi-annually in arrears, commencing March 1, 2007.
The Notes are governed by an indenture, dated August 30, 2006, entered among the Company, AEM, as guarantor, and The Bank of New York, as trustee for the Notes (the “Indenture”). Of the $50.0 million aggregate principal amount of the Notes, Citadel subscribed to $38.0 million of the principal amount of the Notes, which were scheduled to mature on September 1, 2012 (the “2012 Notes”), and Merrill Lynch subscribed to $12.0 million of the principal amount of the Notes, which were schedule to mature on September 1, 2010 (the “2010 Notes”). Pursuant to the indenture, AEM has agreed, and all of our other existing and future subsidiaries (other than subsidiaries domiciled in the People’s Republic of China) are obligated, to guarantee, on a senior secured basis, to the Investors and to the trustee the payment and performance of our obligations.
As security for the Notes, we and The Bank of New York, as collateral agent, entered into a share pledge agreement, dated August 30, 2006, to secure the Notes by pledging all the shares of AEM common stock held by us.
The 2010 Notes bore interest, payable semi-annually in arrears, commencing March 1, 2007, at a rate equal to LIBOR plus 4.75%. The 2010 Notes were subject to mandatory redemption semi-annually commencing March 1, 2008 in the principal amount $2,000,000 at a price equal to 100% of such principal amount.
The 2012 Notes bear interest, payable semi-annually in arrears, commencing March 1, 2007, at a rate equal to LIBOR plus 3.35%. The 2012 Notes are subject to mandatory redemption semi-annually commencing September 1, 2009 in the principal amounts of $2,400,000 on September 1, 2009, $3,800,000 on March 1, 2010, $9,900,000 on September 1, 2010 and March 1, 2011, and $4,000,000 on September 1, 2011, March 1, 2012 and September 1, 2012, in each instance at price equal to 100% of such principal amount.
The Warrants are governed by a warrant agreement, dated August 30, 2006, between us and The Bank of New York, as warrant agent. The Warrants consist of (i) six-year warrants to purchase an aggregate of 2,192,308 shares of our common stock, at an exercise price of $7.80 per share (the “First Tranche 2012 Warrants”), (ii) six-year warrants to purchase an aggregate of 525,830 shares of our common stock at an exercise price of $10.84 per share (the “Second Tranche 2012 Warrants”) and (iii) three-year warrants to purchase an aggregate of 769,230 shares of our common stock at an exercise price of $7.80 per share (the “2009 Warrants”). The First Tranche 2012 Warrants and the Second Tranche 2012 Warrants were issued to Citadel, and the 2009 Warrants were issued to Merrill. Each Warrant is exercisable at the option of the Warrant holder at any time through the maturity date of such Warrant.
On July 14, 2009, the Company entered into a Letter Agreement with Merrill Lynch and ABN AMRO Bank N.V., London Branch, pursuant to which Merrill Lynch and ABN/AMRO each agreed to waive each and every applicable provision of the Indenture but only to the fullest extent necessary solely to permit the Company to repurchase, all (but not part), of the remaining $6 million 2010 Notes held by Merrill Lynch ($3 million) and ABN AMRO Bank N.V., London Branch ($3 million) on or prior to July 31, 2009 for a repurchase price equal to 97% of the aggregate principal amount of the 2010 Notes plus accrued and unpaid interest to but excluding the repurchase date. On July 31, 2009, the Company paid a total of $5,983,844 to repurchase the 2010 Notes, which was comprised of $5,820,000 representing 97% of the $6,000,000 aggregate principal amount of the 2010 Notes held by the Merrill Lynch and ABN AMRO Bank N.V., London Branch plus $163,844 representing accrued and unpaid interest on the 2010 Notes to but excluding the repurchase date of the 2010 Notes. On August 5, 2009, the 2010 Notes were cancelled.
On June 1, 2009, the Company and Citadel Equity Fund Ltd. (“Citadel”) entered into a Letter Agreement (the “Citadel Agreement”), pursuant to which Citadel agreed to waive each and every applicable provision of the Indenture but only to the fullest extent necessary solely to permit the Company to repurchase, at its option, all (but not part), of the $26.5 million 2012 Notes held by Citadel (“Citadel Notes”) on or prior to August 31, 2009 for repurchase price equal to 85% of the aggregate principal amount of the Citadel Notes plus accrued and unpaid interest to but excluding the repurchase date. On August 7, 2009, the Company paid a total of $23,131,997 to repurchase the Citadel Notes, which amount was comprised of $22,525,000 representing 85% of the $26,500,000 aggregate principal amount of the 2012 Notes held by Citadel plus $606,997 representing accrued and unpaid interest on the Citadel Notes to but excluding the repurchase date. On August 11, 2009, the Citadel Notes were cancelled.
In 2009, the Company used total of $32,745,000 cash to repurchase and repay a total of $36,900,000 aggregate principal amount of the 2010 and 2012 Notes, including the mandatory redemption of $2.0 million principal amount of the 2010 Notes on March 1, 2009 and $2.4 million principal amount of the 2012 Notes on September 1, 2009.
In 2009, a total of 1,663,461 warrants were exercised including 1,428,846 of First Tranche 2012 Warrants and 234,615 of 2009 Warrants. The 1,428,836 First Tranche 2012 Warrants were exercised in consideration for an exercise price paid in cash. The Company received net cash proceeds of $11,144,999 as a result of such exercise. As of December 31, 2009, a total of 366,697 Second Tranche 2012 Warrants remained outstanding. None of First Tranche 2012 Warrants and 2009 Warrants remains outstanding.
On August 4, 2009, the Company closed a public offering of 6,250,000 shares of its common stock at a price of $16.00 per share. The Company received net proceeds of approximately $93.4 million from the offering, after deducting underwriting discounts and estimated offering expenses. The offering was underwritten by Roth Capital Partners, LLC (“Roth”), pursuant to the Underwriting Agreement by and between the Company and Roth dated as of July 30, 2009. On August 17, 2009, the Company issued an additional 937,500 shares of common stock at the public offering price of $16.00 per share, pursuant to the over-allotment option exercised in full by Roth in connection with its public offering that closed on August 4, 2009. The exercise of the over-allotment option brings the total number of shares sold by the Company in this public offering to 7,187,500 and the total gross proceeds to $115 million. The aggregate net proceeds received by the Company totaled approximately $107.5 million, after deducting underwriting discounts and commissions and offering expenses payable by the Company.
Investment Activities
On October 2, 2009, Harbin Tech Full, a wholly-owned subsidiary of the Company, entered into an Equity Acquisition Agreement (the “Agreement”) with Xi’an Simo Electric Co. Ltd. (“Xi’an Simo”) and Shaanxi Electric Machinery Association (“Shaanxi Electric” and collectively with Xi’an Simo, the “Selling Shareholders”) whereby Harbin Tech Full agreed to acquire (i) 100% of the outstanding shares of Xi’an Simo Motor Incorporation (Group) (“Simo Motor”), which is 99.94% owned by Xi’an Simo and 0.06% owned by Shaanxi Electric, and (ii) all corresponding assets of Simo Motor, including but not limited to, all of the manufacturing equipment, real-estate, land use rights, stocks, raw materials, automobiles, intellectual property, receivables, other receivables, payables, business contracts and external investments owned by Simo Motor for a purchase price of equal to no less than six (6) times and no more than eight (8) times the 2008 audited net profits of Simo Motor. Pursuant to the Agreement, Harbin Tech Full was required to make a payment to the Selling Shareholders equivalent to six (6) times the 2008 audited net profit of Simo Motor within ten (10) business days after the effectiveness of the Agreement. Upon verification of the assets and capital of Simo Motor within seven months of the closing date of the acquisition, Harbin Tech Full may be required to make an additional payment to the Selling Shareholders in an amount not to exceed two (2) times the 2008 audited net profit of Simo Motor.
On October 13, 2009, the Company completed the acquisition of Simo Motor. On October 22, 2009, the Company paid approximately $84.0 million (RMB 572.7 million) to the Selling Share holders. As of the closing date, Harbin Tech Full had completed the registration of the share transfer with the requisite PRC authorities and had obtained the required business registration and transfer of licenses of Simo Motor, all as contemplated by the Agreement. On October 13, 2009, Simo Motor changed its name to Xi’an Tech Full Simo Motor Co. Ltd.
In January 2010, the Company made an additional cash payment in an amount of $27.9 million to the Selling Shareholders representing the unpaid portion for the acquisition of Simo Motor. The acquisition of Simo Motor is fully paid for after this payment pursuant to the Agreement.
The Company used a portion of the proceeds from the public offering it completed in August 2009 to finance the payment of the acquisition.
Liquidity and Capital Resources Outlook
The Company expects to be able to meet projected capital expenditures, service existing debt and meet working capital requirements during 2010 through current cash balances and cash from operations, supplemented as needed by financing activities including obtaining short-term bank loans from banks in China for our working capital needs. Capital spending for 2010 is targeted at approximately $40-50 million primarily for investments in expanding our production capacities as well as improving technology and manufacturing efficiency at our Harbin, Weihai, and Xi’an facilities.
The Company has $9.1 million of debt repayment obligations in 2010 toward our 2012 Notes.
The Company was in compliance with its debt covenants at December 31, 2009. The Company’s debt covenants require the maintenance of the "Consolidated Tangible Net Worth Threshold" and a “Fixed Charge Coverage Ratio”. Consolidated Tangible Net Worth Threshold, as defined in the covenants, shall be equal to $25.0 million from the debt issue date until the first annual anniversary thereof, and at each annual anniversary of the debt issue date shall increase by an amount equal to $10.0 million. Fixed Charge Coverage Ratio shall be maintained at above 1.25 to 1, which means, as defined, (a) EBITDA for the most recent four consecutive fiscal quarters minus cash capital expenditures for such period minus the positive amount of any decrease in working capital during such fiscal year (or plus the amount of any increase in working capital during such fiscal year, as the case may be) to (b) the Fixed Charges. "Fixed Charges", as defined in the covenants, means the sum of (a) the Consolidated Interest Expense for such period that is anticipated to accrue during a period consisting of the Fiscal Quarter in which such determination date occurs and the three Fiscal Quarters immediately subsequent thereto, (b) the principal amount of consolidated Financial Covenant Debt having a scheduled due date during such period and (c) all cash dividends payable on Capital Stock in respect of such period. The calculation excludes certain items as defined in the covenants.
For our long-term strategic growth, the Company will continue to rely upon debt and capital markets for any necessary long-term funding not provided by operating cash flows. Funding decisions will be guided by our capital structure planning objectives. The primary objectives of the Company’s capital structure planning are to maximize financial flexibility and preserve liquidity while controlling interest expense.
Cross-currency interest rate hedge
The Company's operations are exposed to a variety of global market risks, including changes in foreign currency exchange rates and interest rates. These exposures are managed, in part, with the use of a financial derivative. The Company uses financial derivatives only to hedge exposures in the ordinary course of business and does not invest in derivative instruments for speculative purposes.
On April 17, 2007, the Company entered a cross-currency interest rate swap agreement (the “Transaction”) with Merrill Lynch, effectively exchanging the LIBOR plus 3.35% variable rate interest payable on the $38 million principal amount of 2012 Notes for a 7.2% RMB fixed interest rate. The agreement requires semi-annual payments on March 1 and September 1 through the maturity of the agreement on September 1, 2012. Merrill Lynch required the Company to deposit $1,000,000 to secure the agreement. The deposit may be increased to $2,500,000, if the exchange rate for RMB to USD falls below 6.5, and to $4,000,000, if the exchange rate falls below 5.5. This swap is designated and qualified as a cash flow hedge.
On September 16, 2009, the Company entered an agreement with Merrill Lynch to terminate the SWAP (“Unwind Term”), pursuant to which the Company was required to make a termination payment of $9 million (“Termination Payment”) to Merrill Lynch on September 21, 2009. Upon receipt of the Termination Payment by Merrill Lynch, Merrill Lynch and the Company were deemed to have agreed, as of September 21, 2009, (i) the Transaction and all of the respective rights and obligations of Merrill Lynch and the Company were cancelled and terminated; (ii) Merrill Lynch released and discharged the Company from and agreed not to bring a claim against the Company with respect to any obligations arising and to be performed in connection with the Transaction after September 21, 2009; and (iii) the Company released and discharged Merrill Lynch from and agreed not to bring a claim against Merrill Lynch with respect to any obligations arising and to be performed in connection with the Transaction and the Guaranty thereof after September 21, 2009. On September 21, 2009, the Company made the Termination Payment of $9 million to Merrill Lynch.
Contractual Obligations
The Company enters into non-cancelable purchase commitments with its vendors. As of December 31, 2009, and December 31, 2008, the Company was obligated under the non-cancelable commitments to purchase materials totaling to $456,174 and $305,100, respectively. These commitments are short-term and expire within one year. The Company has experienced no losses on these purchase commitments over the years.
As discussed in Note 14, the Company entered into a swap agreement that required a $1,000,000 deposit to secure the Transaction. On September 21, 2009, the Company terminated the Transaction and the $1,000,000 cash deposit was returned to the Company.
As discussed in Note 11, the 2010 Notes are subject to mandatory redemption semi-annually commencing March 1, 2008 in the principal amount of $2,000,000 at a price equal to 100% of such principal amount. As of August 5, 2009, the 2010 Notes have been repurchased by the Company and are no longer outstanding. The 2012 Notes are subject to mandatory redemption semi-annually commencing September 1, 2009 in the principal amount $2,400,000 on September 1, 2009, $3,800,000 on March 1, 2010, $9,900,000 on September 1, 2010 and March 1, 2011, and $4,000,000 on September 1, 2011, March 1, 2012 and September 1, 2012, in each instance at a price equal to 100% of such principal amount. Holders of the 2012 Notes may require the Company to repurchase such Notes at 100% of the principal amount thereof at any time after September 1, 2011. As of August 11, 2009, an aggregate principal amount of $26,500,000 of the 2012 Notes has been repurchased by the Company. On September 1, 2009, the Company redeemed additional $2,400,000 million principal amount of the 2012 Notes pursuant to the mandatory redemption schedule set forth in the Indenture governing the 2012 Notes. As of December 31, 2009, a total of $9,100,000 2012 Notes remained outstanding. The Company expects to follow the mandatory redemption schedule with respect to the 2012 Notes and pay off the remainder of the 2012 Notes on September 1, 2010.
On September 8, 2006, HTFE entered into an agreement (“Land Use Agreement”) with Shanghai Lingang Investment and Development Company Limited (“Shanghai Lingang”) with respect to HTFE’s lease and use of 40,800 square meters of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the “Site”). The term of the land use agreement is 50 years. In June 2009, the Land Use Agreement was revised with the land size increased to a total of approximately 53,000 square meters. The aggregate amount HTFE shall pay to Shanghai Lingang is now approximately $6.28 million (RMB42.84 million) ("Fee"), approximately 93% or $5.85 million (RMB 38.9 million) has been paid as of December 31, 2009 with the balance payable in installments. Prepayment in the amount of $2.72 was transferred to intangible assets after the land was put in use. The remaining amount paid is recorded as advances on intangible assets for $3,133,512 and $1,481,670 as of December 31, 2009 and December 31, 2008, respectively.
In October 2008, the Company, through its wholly-owned subsidiary Advanced Automation Group, LLC (“AAG”), formed Advanced Automation Group Shanghai, Ltd. (“AAG Shanghai”), a wholly-owned subsidiary in China, to design, develop, manufacture, sell and service custom industrial automation controllers for linear motors. The registered capital is $1 million. AAG has invested $500,000 in AAG Shanghai through December 31, 2009.
The Company entered into an agreement (“Original Agreement”) with Shelton Technology, LLC on April 9, 2007 whereby the Company and Shelton agreed to work together through the Company’s wholly-owned subsidiary, Advanced Automation Group, LLC (“AAG”), to design, develop and manufacture custom industrial automation controllers. Pursuant to the Original Agreementthe Company is required to invest a total of $3 million in AAG while Shelton contributes an exclusive worldwide royalty-free license for motorized automation technology. Shelton is entitled to receive 49% of any profits earned by AAG through the initial term of the Agreement which ended August 31, 2008. The Company and Shelton entered into a first amendment to the Original Agreement on December 11, 2008 to extend the term of the Original Agreement from August 31, 2008 to December 31, 2008. On April 21, 2009, the Company and Shelton entered into a second amendment to the Original Agreement to further extend the term to June 30, 2009. On December 7, 2009, the Company and Shelton entered into the third amendment to the Original Agreement to further extend the term to December 31, 2009. The Company has contributed a total of $2.0 million to AAG as of December 31, 2009. The remaining $1.0 million contribution to AAG is to be made at a mutually agreed later date. The Company and Shelton are continuing their joint work and are currently in process of developing a new agreement to extend the arrangement between them with respect to this work.
The following table discloses aggregate information about our contractual obligations as of December 31, 2009 and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands).
Harbin Electric Inc. and Subsidiaries
As of December 31, 2009 (in thousands)
Off Balance Sheet Arrangements
We do not have any off balance sheet arrangements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Company's operations are exposed to a variety of global market risks, including the effect of changes in foreign currency exchange rates and interest rates. These exposures are managed, in part, with the use of a financial derivative. The Company uses financial derivatives only to hedge exposures in the ordinary course of business and does not invest in derivative instruments for speculative purposes.
Foreign Exchange Risk
We currently conduct substantially all of our operations through our PRC subsidiaries. The functional currency of our PRC subsidiaries is the Chinese RMB. The financial statements of our Chinese subsidiary are translated to United States dollars using year-end exchange rates as to assets and liabilities and average exchange rates as to revenues, expenses, and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. 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.
As the majority of our net revenue, 77% of consolidated costs and expenses, and substantially all of our assets are denominated in RMB, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, if the RMB depreciates against the U.S. dollar, the value of our RMB revenues, earnings, and assets, as expressed in our U.S. dollar financial statements could decline. In addition, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for business purposes, the U.S. dollar equivalent of the RMB we convert would be reduced. On the other hand, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar could reduce the amount of the U.S. dollars available. In addition, the appreciation of the RMB could make our customers’ products more expensive to purchase, because some of our customers are involved in the export of goods, which may have an adverse impact on their sales. A decrease in sales by our customers could have an adverse effect on our operating results.
The local currencies in the countries in which we sell our products may fluctuate in value in relation to other currencies. Such fluctuations may affect the costs of our products sold and the value of our local currency profits. While we are not conducting any meaningful operations in countries other than China at the present time, we may expand to other countries and may then have an increased risk of exposure of our business to currency fluctuation.
The PRC government imposes control over the conversion of RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.
Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.
Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.
Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.
Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar.
Since a significant amount of our future revenues are expected to be denominated in RMB, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.
Translation adjustments resulting from this process amounted to $(70,011), $9,513,907 and $7,162,512 for the fiscal years ended December 31, 2009, 2008 and 2007, respectively. The balance sheet amounts with the exception of equity at December 31, 2009 and 2008 were translated 6.84 RMB to $1.00 and 6.85 RMB to $1.00, respectively. The equity accounts were stated at their historical exchange rate. The average translation rates applied to the revenues, expenses and cash flows statement amounts for the fiscal years ended December 31, 2009, 2008 and 2007 were 6.84 RMB, 6.96 RMB and 7.62 RMB to $1.00, respectively. Simo Motor was acquired in October 2009, and the average translation rate applied to Simo Motor’s statement of income and cash flow was 6.84 RMB to $1.00.
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to the 2010 Notes and 2012 Notes, as described under Liquidity and Capital Resources. Our future interest expense will fluctuate in line with any change in our borrowing rates and therefore affect our cash flows and results of operations.
Derivative Instrument
To mitigate our exposure to volatility in interest rates and foreign currency exchange rates fluctuation associated with the 2012 Notes, in 2007, the Company entered a cross-currency interest rate swap agreement, which was terminated in September 2009, as described under Liquidity and Capital Resources - Cross-currency interest rate hedge.
Inflation
According to the National Bureau of Statistics of China, the change in Consumer Price Index in China was (0.7%), 5.9%, and 4.8% in 2009, 2008, and 2007, respectively.
Our most liquid assets are cash and cash equivalents. Because of their liquidity, these assets are not directly affected by inflation. Because we intend to retain and continue to use our equipment, furniture and fixtures and leasehold improvements, we believe that the incremental inflation related to replacement costs of such items will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and contract services, which could increase our level of expenses and the rate at which we use our resources.
We believe that inflation has not had a material impact on the Company's operations in recent years.
Concentration of Credit Risks
The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents, for cash flow statement purposes. Cash includes cash on hand and demand deposits in accounts maintained with banks within the PRC and banks in the United States. Certain financial instruments, which subject the Company to concentration of credit risk, consist of cash. The Company maintains balances at financial institutions which, from time to time, may exceed Federal Deposit Insurance Corporation insured limits for the banks located in the Unites States. Balances at financial institutions or state owned banks within the PRC are not covered by insurance. As of December 31, 2009 and 2008, the Company had deposits in excess of federally insured limits totaling $92,701,730 and $47,783,767, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.
One major customer accounted for approximately 12% of the net revenue for the fiscal year ended December 31, 2009. At December 31, 2009, the total receivable balance due from this customer was $11,494,287, representing 12% of total accounts receivable. Three major customers accounted for approximately 43% of the net revenue for the year ended December 31, 2008, with each customer individually accounting for 16%, 15% and 12%, respectively. At December 31, 2008, the total receivable balance due from these customers was $26,253,907, representing 87% of total accounts receivable. Five major customers accounted for 72% of the net revenue for the year ended December 31, 2007, with each customer individually accounted for 20%, 20%, 13%, 10% and 9%, respectively. At December 31, 2007, the total receivable balance due from these customers was $19,338,613, representing 83% of total accounts receivable.
We depend on a few key suppliers to provide the raw materials and key component parts for the manufacture of our products. And adverse changes in such supply or the costs of raw materials may adversely affect our operations. In addition, if we need alternative sources for key component parts for any reason, these component parts may not be immediately available to us. If alternative suppliers are not immediately available, we will have to identify and qualify alternative suppliers, and production of these components may be delayed. We may not be able to find an adequate alternative supplier in a reasonable time period, or on commercially acceptable terms, if at all. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. Our inability to obtain our key source supplies for the manufacture of our products may require us to delay shipments of products, harm customer relationships or force us to curtail or cease operations. One major vendor provided approximately 16% of the Company’s purchases of raw materials for the year ended December 31, 2009. Two major vendors provided approximately 39% of the Company’s purchases of raw materials for the period ended December 31, 2008, with each vendor individually accounting for 23% and 16%, respectively. Five vendors provided 80% of the Company’s purchase of raw materials for the year ended December 31, 2007, with each vendor individually accounting for 27%, 22%, 13%, 12% and 6%, respectively. The Company’s accounts payable to these vendors was $0 and $1,055,730 at December 31, 2009 and 2008, respectively.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
The management of the Company is responsible for the preparation of the consolidated financial statements in this Annual Report on Form 10-K and for establishing and maintaining adequate internal controls over financial reporting. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, which are considered appropriate to present fairly the Company’s consolidated financial position, results of operations and cash flows on a consistent basis. Management has also prepared the other information in this report and is responsible for its accuracy and consistency with the consolidated financial statements.
As can be expected in a complex and dynamic business environment, some financial statement amounts are based on estimates and judgments. Even though estimates and judgments are used, measures have been taken to provide reasonable assurance of the integrity and reliability of the financial information contained in this annual report on Form 10-K.
The consolidated financial statements for the years ended December 31, 2009, 2008, and 2007 prepared in response to this item are included in a separate section of this Report. See “Index to Consolidated Financial Statements” on Page. They have been audited by Frazer Frost, LLP (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP), an independent registered public accounting firm. During its audits, Frazer Frost, LLP (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP), was given unrestricted access to all financial records and related data, including minutes of all meetings of shareholders and the board of directors and all committees of the board. Management believes that all representations made to the independent auditors during their audits were valid and appropriate.
Sales Distribution by Product Lines and Percentage of International Business
The following table sets forth the percentage of revenues by our major product lines and the percentage of our international business for the years ended December 31, 2009, 2008 and 2007.
ITEM 9.
ITEM 9 A. Controls and Procedures
(a) Evaluation of Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2009, as such term is defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based on this evaluation, our principal executive officer and principal financial officer have concluded that during the period covered by this Annual Report on Form 10-K, the Company’s disclosure controls and procedures are effective as of such date at a reasonable assurance level to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
(b) Management’s Annual Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. These controls are designed under the supervision of the Company's CEO and CFO to provide reasonable assurance to management and the Board of Directors regarding the reliability of financial reporting and the preparation of the Company's financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that:
1. Pertain to the maintenance of records that in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
2. Provide reasonable assurance that transactions are recorded properly to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors;
3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of our assets that could have a material effect on the financial statements: and
4. Provide reasonable assurance as to the detection of fraud.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
As of December 31, 2009, management has made a comprehensive review, evaluation and assessment of the effectiveness of the Company's internal control over financial reporting. In making its assessment of the effectiveness of the Company’s internal control over financial reporting, management used the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Management excluded Xi’an Tech Full Simo from its assessment of internal control over financial reporting as of December 31, 2009 because it was acquired by the Company during 2009. Xi’an Tech Full Simo is a wholly owned subsidiary of the Company and represents 40%, 20%, and 24% of the Company’s consolidated total assets, total revenue, and net income as of and for the year ended December 31, 2009.
Based on our evaluation, our principal executive officer and principal financial officer have concluded as of the end of the period covered by our Annual Report on Form 10-K for the year ended December 31, 2009, our internal controls over financial reporting were effective.
Our independent registered public accounting firm, Frazer Frost, LLP (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP), with direct access to our Board of Directors through our Audit Committee, has audited our consolidated financial statements and independently assessed the effectiveness of our internal control over financial reporting as of December 31, 2009, as stated in their report which is included in this Annual Report on Form 10-K.
(c) Management Process to Assess the Effectiveness of Internal Control over Financial Reporting
To comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, the Company followed a comprehensive compliance process across our major operations to evaluate our internal control over financial reporting, engaging employees at all levels of the organization. Our internal control environment includes a corporate-wide attitude of integrity and control consciousness. This is exemplified by our ethics education program that includes long-standing principles and policies on ethical business conduct that require employees to maintain the highest ethical and legal standards in the conduct of our business. We have distributed the Board of Directors approved policy on ethics and code of business conduct to all employees and required them to study and abide by the policy. We encourage any employee may report suspected violations of law or our policy. The internal control system further includes careful selection and training of supervisory and management personnel, appropriate delegation of authority and division of responsibility, dissemination of accounting and business policies throughout the Company, and an extensive program of internal audits with management follow-up. Our Board of Directors, assisted by the Audit Committee, monitors the integrity of our financial statements and financial reporting procedures, the performance of our internal audit function and independent auditors, and other matters set forth in its charter. The Committee, which currently consists of three independent directors, meets regularly with representatives of management, and with the independent auditors and the Internal Auditor, with and without management representatives in attendance, to review their activities. We have engaged an external consultant firm who has helped us to establish our internal control process over financial reporting and has continued to help us to assess and improve the effectiveness of our internal control over financial reporting.
(d) Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting that occurred during the fiscal year covered by this Annual Report on Form 10-K that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Attestation Report of the Registered Public Accounting Firm
To the Board of Directors and Stockholders of Harbin Electric, Inc.
We have audited Harbin Electric, Inc. and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Item 9A
ITEM 9B. Other Information.
On August 20, 2009, the Company held its fourth annual meeting of stockholders. There were two proposals presented to the stockholders at the meeting.
Proposal 1 was the election of the following five directors to serve for a one year term or until their respective successors have been duly elected and qualified.
Proposal 2 was the ratification of the appointment of Frazer Frost, LLP (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP) as the Company’s independent auditor for the 2009 fiscal year. There were 8,115,527 votes FOR, 20,141 votes AGAINST and 40,850 votes ABSTAINED.
PART III
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance
The following table sets forth the names and ages of our current directors and executive officers, their principal offices and positions and the date each such person became a director or executive officer. Executive officers are elected annually by our Board of Directors. Each executive officer holds his office until he resigns, is removed by the Board or his successor is elected and qualified. Directors are elected annually by our stockholders at the annual meeting. Each director holds his office until his successor is elected and qualified or his earlier resignation or removal.
The following persons are the directors and executive officers of our company:
Name
Age
Title
Director Since
Tianfu Yang
Chief Executive Officer and Chairman of the Board of Director
January 24, 2005
Zedong Xu
Chief Financial Officer
January 24, 2005
Ching Chuen Chan (1)(2)(3)
Independent Director
February 1, 2005
Boyd Plowman (1)(2)(3)
Independent Director
December 1, 2009
David Gatton (1)(2)(3)
Independent Director
February 1, 2005
Yunyue Ye
Independent Director
October 12, 2006
Tianli Yang
Vice President
January 24, 2005
Lanxiang Gao
Director
September 26, 2008
Christy Shue
Executive Vice President & Corporate Secretary
December 15, 2007
(1) Serves as a member of the Audit Committee.
(2) Serves as a member of the Compensation Committee.
(3) Serves as a member of the Nominating and Corporate Governance Committee.
Tianfu Yang, Chairman & Chief Executive Officer - Since May 2003, Mr. Yang has been the Chairman and CEO of Harbin Tech Full Electric Co., Ltd. From 2000 until now, he has been the Chairman and CEO of Harbin Tech Full Industry Co., Ltd. From 1994 to 2000, he was the President of Harbin Tianheng Wood Industry Manufacture Co., Ltd. From 1991 to 1994, Mr. Yang was the President of Hong Kong Lianfa Real Estate Company. From 1988 to 1991, he was the President of Hong Kong Property Management Development. From 1986-1988, he was the President of Helongjiang Cultural Development Company and Guangzhou Subsidiary Company. Mr. Yang graduated from Zhejiang University with a Masters degree in Electric Motor Automation and Control. From 1978 to 1979, he was a professional member in the Heilongjiang Province Aeromodelling Team, twice becoming free-style aeromodelling champion in national competition. Mr. Yang is currently the commissioner of the China Electro-Technical Society (CES) in the Linear Motor and Electromagnetism Eradiation Specialist Committees. Mr. Yang is also a Deputy representing Heilongjiang Province to the 11th National People’s Congress (NPC).
Zedong Xu, Chief Financial Officer - Since 2003, Mr. Xu has been the Chief Financial Officer of Harbin Tech Full Electric Co, Ltd. From 2000 until present, he has been the CFO of Harbin Tech Full Industry Co., Ltd. From September 1998 to 2000, he was employed as the Chief Financial Officer for Harbin WanDa Electrical home appliances. From 1996 to 1998, Mr. Xu worked as a financial manager for Harbin High Technology Torch Daya Real Estate Co., Ltd. Mr. Xu Zedong is a qualified CPA under China’s accountancy program. He graduated in 1992 from Harbin Electrical Engineering College with a BA in Project Management.
Chan Ching Chuen, Board Member, Chairman of Nominating Committee - Mr. Chan is an Honorary Professor at Hong Kong University's Department of Electrical and Electronics Engineering. From 1976 through present, Mr. Chan earned many professorships in honorary, visiting and guest roles at world renowned institutions such as University of Hong Kong, University of California Berkeley and Davis, Zhejiang University, Grenoble Polytechnic, France, Massachusetts Institute of Technology, USA and Tsing Hua University, Beijing among others. He is a Fellow of the Royal Academy of Engineering, U.K., the Chinese Academy of Engineering, the Ukraine Academy of Engineering Sciences and a Fellow and Past Vice President of Hong Kong Academy of Engineering Sciences. He is also a Fellow of IEEE, IEE and HKIE, Past President of the Hong Kong Institution of Engineers. He was awarded the IEE International Lecture Medal in 2000 and lecturing on electric vehicles worldwide. In 2001, he was selected as one of Asia's Best Technology Pioneers by Asiaweek. During his career, Mr. Chan has advised on various consultancy projects for large corporations such as Ford Motor Company, Honda R & D Co Ltd., National Institute of Environmental Studies, Japan, Sumitomo Corporation and Mitsubishi Electric Corporation as well as serving as advisor to government agencies. Mr. Chan graduated from Tsing Hua University in 1959 with an MSc in Electrical Engineering later achieving his PhD in 1982 from University of Hong Kong. From 1959 through 1966, Mr. Chan started his career lecturing at China University of Mining & Technology. From 1967 to 1976, he was Electrical Machines Designer in Shanghai. He was awarded the Doctor of Technology honoris causa from Loughborough University, U.K. in 2008.
Boyd Plowman, Board Member, Chairman of Audit Committee - Mr. Plowman joined Harbin Electric’s board of directors on December 1, 2009 as an independent board member. Mr. Plowman is the retired Executive Vice President and Chief Financial Officer of Fleetwood Enterprises, Inc. (“Fleetwood”) where he was employed from 1969 until 1987 and from 1997 until 2008. Fleetwood was the world’s largest producer of recreational vehicles and manufactured housing. During his career with Fleetwood, Mr. Plowman held numerous leadership positions including Controller, Treasurer, and Financial Vice President. During his second stint with Fleetwood, he served as Executive Vice President and Chief Financial Officer until his retirement in 2008. He also served as President and Chief Executive Officer of Lee & Associates (Inland Empire Region). Lee & Associates is one of the leading commercial real estate brokerage firms in the United States. Prior to that, Mr. Plowman served as a Director and Chairman of the Audit Committee for Corporate Insurance and Reinsurance Company Limited (CIRCL), a Bermuda-based company reinsuring risks for captive insurance companies. Earlier in his career, Mr. Plowman worked as a senior tax accountant at Arthur Andersen & Co. and Ernst & Ernst. He earned his bachelor’s degree from Utah State University and was a certified public accountant. Mr. Plowman is the co-founder and President of Boyd Plowman & Associates, Inc., a firm involved in venture capital, merchant banking, and consulting services regarding real estate, capital formation, and financial services.
David Gatton, Board Member, Chairman of Compensation Committee - Since 1985 Mr. Gatton has served as the Chairman and President of Development Initiatives, Inc, a Washington, D.C.-based government relations firm specializing in urban affairs, business development and marketing, serving a variety of public and private clients. Mr. Gatton advises cities, organizations, and companies on business development strategies, public/private partnerships and marketing initiatives. He has advised various organizations on tax reform, economic development initiatives and a variety of environmental laws, including the reauthorization of the Clean Water Act, the Safe Drinking Water Act, the Resource Conservation and Recovery Act, Superfund and the Clean Air Act. Some of Mr. Gatton’s major accomplishments include: development of U.S.-Sino Memorandum of Cooperation between U.S. and China Association of Mayors, development of a national brownfield redevelopment initiative, development of several multifamily low- and moderate-income housing developments, business development strategies 13 for various private firms, and assistance in development of economic development projects for numerous cities. Mr. Gatton holds a B.A. from Cornell College and a Master’s degree from Harvard University.
Yunyue Ye, Board Member - Mr. Ye is currently a professor in Electrical Engineering at Zhejiang University. Mr. Ye also currently serves as Director of the Aerospace Electric and Electrical Motor Institute of Zhejiang University and Director of the Linear Motor Institute of the Chinese Electrotechnical Society. Mr. Ye was also Council Member of the China Electrotechnical Society. Mr. Ye graduated from Zhejiang University in 1978.
Tianli Yang, Vice President - Since January 2005, Tianli Yang has been Vice President of Harbin Electric. From 2003 until now, he was the vice president of Harbin Tech Full Electric Co., Ltd. From 2000 until now, Mr. Yang has been the Vice President of Harbin Tech Full Industry Co., Ltd. From 1985-2000 he was employed in the China State Construction Engineering Corporation (“CSCEC”), in various positions, including post of Chief Administration Officer. Mr. Yang graduated from Heilongjiang University in 1985 with a BA in Chinese Language & Literature.
Lanxiang Gao, Board Member - Ms. Gao joined the Company in September 2007 as Chief Operating Officer of Shanghai Tech-Full Electric Co., Ltd., a wholly owned subsidiary of the Company. Ms. Gao worked as an engineer for Shanghai No.21 Research Institute, a research and development institution under the state-owned China Electronics Technology Group for over 30 years. She managed a development and production project of office automation motors in collaboration with Sankyo Seiki, Inc. of Japan for 10 years and served as the Senior Engineer managing micro motor research and development, with a focus on the development of specialty micro-motors of automobile seats for two years. Ms. Gao has won numerous government sponsored Science & Technology Progress Awards including a First Place Prize due to her outstanding contributions in the research and development of electric motors. Ms. Gao graduated from Zhejiang University, China with a major in Electrical Engineering.
Christy Y. Shue, Executive Vice President of Finance and Investor Relations and Corporate Secretary - Ms. Shue joined Harbin Electric on December 15, 2007. Prior to joining the Company, she was a Vice President and a Senior Investor Relations Consultant at Christensen, an Investor Relations advisory firm, advising U.S. listed Chinese Companies on managing capital market related issues including investor relations, corporate governance, disclosure, and investor communications. Prior to joining Christensen, Ms. Shue was Manager, Investor Relations for International Paper, serving as one of the company's spokespersons since 2003 to craft and communicate the company's messages to the financial community. Ms. Shue also has extensive experience in financial analysis and planning, financial accounting, and marketing research, having worked in various divisions and functions during her career with International Paper. Ms. Shue holds a Ph.D. in chemistry from Purdue University and an M.B.A. in finance/international business from the Stern School of Business, New York University. She earned her Bachelor of Science degree from Sichuan University, China.
Board Leadership Structure
The Board of Directors believes that Mr. Yang’s service as both Chairman of the Board and Chief Executive Officer is in the best interest of the Company and its stockholders. Mr. Yang possesses detailed and in-depth knowledge of the issues, opportunities and challenges facing the Company and its business and is thus best positioned to develop agendas that ensure that the Board’s time and attention are focused on the most critical matters. His combined role enables decisive leadership, ensures clear accountability, and enhances the Company’s ability to communicate its message and strategy clearly and consistently to the Company’s shareholders, employees, customers and suppliers.
CORPORATE GOVERNANCE
Board of Directors
We have six members serving on our Board of Directors. Each board member is nominated for election at our annual meeting to serve until the next annual meeting of stockholders and until their successors are duly elected and qualified. If there is a vacancy left by unexpected event such as death or sickness, our Board of Directors will appoint a new member as necessary to fill the vacancy.
Director Qualifications
We seek directors with established strong professional reputations and experience in areas relevant to the strategy and operations of our businesses. We also seek directors who possess the qualities of integrity and candor, who have strong analytical skills and who are willing to engage management and each other in a constructive and collaborative fashion. We also seek directors who have the ability and commitment to devote significant time and energy to service on the Board and its committees. We believe that all of our directors meet the foregoing qualifications.
Certain of our directors have strong technological backgrounds that are relevant to our industry. Certain of our directors have backgrounds in accounting, public company reporting, compliance and management. We believe that the backgrounds and skills of our directors bring a diverse range of perspectives to the Board.
Meetings of the Board of Directors and Committees
The Board of Directors held five (5) meetings during 2009. The Audit Committee held five (5) meetings in 2009. The Compensation Committee held four (4) meetings in 2009. The Nominating and Corporate Governance Committee held one (1) meeting in 2009. Each director is expected to attend meetings of our Board of Directors and meetings of committees of our Board of Directors of which he is a member, and to spend the time necessary to properly discharge his respective duties and responsibilities. No director attended less than 75% of the meetings of any committee of which the director was a member. We do not have a policy with regard to Board members’ attendance at annual meetings of stockholders. Tianfu Yang, Lanxiang Gao, David Gatton, Ching Chuen Chan and Yunyue Ye attended the Company’s previous annual meeting in person.
Board Committees
The Board of Directors has an Audit Committee, Nominating and Corporate Governance Committee and a Compensation Committee.
Nominating and Corporate Governance Committee
The purpose of the Nominating and Corporate Governance Committee is to assist and advise the Board of Directors with respect to identifying individuals qualified to become members of the Board of Directors, evaluating the overall functioning and performance of the Board of Directors and its committees and developing and overseeing a set of corporate governance guidelines for the Company. Ching Chuen Chan, David Gatton, and Boyd Plowman are members of the Nominating and Corporate Governance Committee. There have been no changes to the procedures by which the stockholders of the Company may recommend nominees to the Board of Directors since the filing of the Company’s Definitive Proxy Statement on July 9, 2009, as amended on July 14, 2009, for its Annual Meeting of Stockholders, which was held on August 20, 2009. A copy of our Nominating and Corporate Governance Committee Charter can be found on our website at www.harbinelectric.com and can be made available in print free of charge to any shareholder who requests it.
The Nominating and Corporate Governance Committee evaluates all nominees, including current directors who may be up for re-election, based on several different professional criteria and in accordance with the minimum requirements as established in its charter and in the Company’s Articles of Incorporation and Bylaws. The Nominating and Corporate Governance Committee will consider candidates recommended by stockholders. Stockholders can recommend qualified candidates for the Board of Directors by submitting the candidate’s name and qualifications to: Ching Chuen Chan, Chairman, Nominating and Corporate Governance Committee, Harbin Electric, Inc., 20 Ramblewood Road, Shoreham, NY 11786. There are no differences in the manner in which the Nominating and Corporate Governance Committee evaluates nominees for director based on whether the nominee was recommended by a stockholder. Among other things, the Nominating and Corporate Governance Committee takes into account, when acting upon nominees, factors such as familiarity with the industry in which the Company operates, experience in working with China-based companies, the relevant expertise of its directors and director nominees, whether the director or nominee would be considered independent, the time that the director or nominee will be able to devote to Company matters, experience with US public companies, language skills and other factors. The Nominating and Corporate Governance Committee believes that it is appropriate to include representation of senior management on the Board of Directors
Compensation Committee
The Compensation Committee evaluates and determines the salaries and incentive compensation for our officers. The function of the Compensation Committee is to evaluate and determine the compensation levels of the Company’s Named Executive Officers, including the Chief Executive Officer; and the equity allocations relating to the Company’s equity programs. David Gatton, Ching Chuen Chan, and Boyd Plowman are members of our Compensation Committee. The Compensation Committee Charter was amended on January 22, 2009. A copy of our Amended and Restated Compensation Committee Charter can also be found on our website at www.harbinelectric.com and can be made available in print free of charge to any shareholder who requests it. No member of our Compensation Committee has at any time been an officer or employee of ours or our subsidiaries. No interlocking relationship exists between our Board of Directors or Compensation Committee and the Board of Directors or Compensation Committee of any other company, nor has any interlocking relationship existed in the past.
Audit Committee
The Company has a separately designated standing audit committee in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. The audit committee members for the year ended December 31, 2009 consisted of Boyd Plowman, David Gatton, and Ching Chuen Chan. Each of these members are considered “independent” under the current independence standards of NASDAQ Marketplace Rule 5605(a)(2) and meet the criteria for independence set forth in Rule 10A-3(b)(1) of the Securities Exchange Act of 1934, as amended, as determined by the Board of Directors. The audit committee assists the Board of Directors in its oversight of the Company’s financial reporting process. The Audit Committee is directly responsible for the appointment, retention and termination of the independent accountants. The Audit Committee reviews with the independent accountants the scope and results of audits, our internal accounting controls and audit practices and professional services rendered to us by our independent accountants. A copy of our Audit Committee Charter can be found on our website at www.harbinelectric.com and can be made available in print free of charge to any shareholder who requests it.
Our board of directors has determined that we have at least one audit committee financial expert, as defined in the Exchange Act, serving on our audit committee. Boyd Plowman is the “audit committee financial expert” and is an independent member of our board of directors.
REPORT OF THE AUDIT COMMITTEE
The role of the Audit Committee is to assist the Board of Directors in its oversight of the Company’s financial reporting process. As set forth in the Charter, management of the Company is responsible for the preparation, presentation and integrity of the Company’s financial statements, accounting and financial reporting principles and internal controls and procedures designed to assure compliance with accounting standards and applicable laws and regulations. The independent auditors are responsible for auditing the Company’s financial statements and expressing an opinion as to their conformity with generally accepted accounting principles.
In the performance of this oversight function, the Audit Committee has reviewed and discussed the audited financial statements for the fiscal year ended December 31, 2009 with management, and has discussed with the independent auditors the matters required to be discussed by Statement of Auditing Standards No. 61, Communication with Audit Committee, as currently in effect. The Audit Committee has received the written disclosures and the letter from the independent auditors required by Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees, as currently in effect, and has discussed with the independent auditors the independent auditors’ independence; and based on the review and discussions referred above, the Audit Committee recommended to the Board of Directors that the audited financial statements be included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009 for filing with the SEC.
The members of the Audit Committee are not professionally engaged in the practice of auditing or accounting, are not experts in the fields of accounting or auditing, including in respect of auditor independence. Members of the Committee rely without independent verification on the information provided to them and on the representations made by management and the independent accountants. Accordingly, the Audit Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal control and procedures designed to assure compliance with accounting standards and applicable laws and regulations. Furthermore, the Audit Committee’s consideration and discussions referred to above do not assure that the audit of the Company’s financial statements has been carried out in accordance with generally accepted accounting principles or that the Company’s auditors are in fact “independent”.
Based upon the reports, review and discussions described in this report, and subject to the limitations on the role and responsibilities of the Committee referred to above and in the Charter, the Committee recommended to the Board that the audited financial statements be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, be filed with the Securities and Exchange Commission.
THE AUDIT COMMITTEE
Boyd Plowmans (Chairman)
David Gatton
Ching Chuen Chan
COMPLIANCE WITH SECTION 16(a) OF EXCHANGE ACT
Based on the Company’s review of copies of Forms 3, 4 and 5 filed with the Securities and Exchange Commission (the “SEC”) or written representations from certain reporting persons, we believe that during fiscal year 2009, all of the executive officers and board of directors complied with the filing requirements of Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
CODE OF ETHICS
We adopted a code of ethics that applies to our Chief Executive Officer and Chief Financial Officer, and other persons who perform similar functions. A copy of our Code of Ethics is filed as Exhibit 14.1 to our 2005 Annual Report on Form 10-KSB and is available on our website www.harbinelectric.com. Our Code of Ethics can be made available in print free of charge to any shareholders who requests it. Our Code of Ethics is intended to be a codification of the business and ethical principles which guide us, and to deter wrongdoing, to promote honest and ethical conduct, to avoid conflicts of interest, and to foster full, fair, accurate, timely and understandable disclosures, compliance with applicable governmental laws, rules and regulations, the prompt internal reporting of violations and accountability for adherence to this Code.
ITEM 11.
ITEM 11. Executive Compensation
Compensation Discussion and Analysis
This compensation discussion describes the overall compensation practices at the Company and specifically describes the compensation for the following named executive officers (“Named Executive Officers”):
·
Tianfu Yang, Chairman and Chief Executive Officer
·
Zedong Xu, Chief Financial Officer
·
Tianli Yang, Vice President
·
Christy Shue, Executive Vice President of Finance and Investor Relations and Corporate Secretary
The Board of Directors appointed the Compensation Committee of our Board of Directors to evaluate and determine the compensation programs of the Company’s Named Executive Officers, including the Chief Executive Officer and the Chief Financial Officer.
Compensation Philosophy and Objectives
Our primary goal with respect to our compensation programs has been to attract and retain the most talented and dedicated employees in key positions in order to compete effectively in the market place, successfully execute our growth strategies, and create lasting shareholder value. The Compensation Committee evaluates both individual and Company performance when determining the compensation of our executives. Our executives’ overall compensation is tied to the Company financial and operational performance, as measured by revenues and net income, as well as to accomplishing strategic goals such as merger and acquisitions and fund raising. The Compensation Committee believes that a significant portion of our executive’s total compensation should be at-risk compensation that is linked to stock-based incentives to align their interests with those of shareholders.
Additionally, the Compensation Committee has determined that an executive officer who is a Chinese national and is based in China will be entitled to a locally competitive package and an executive officer who is an expatriate or who is based in the U.S. will be paid a salary commensurate with those paid to the executives in the U.S. The Compensation Committee evaluates the appropriateness of the compensation programs annually and may make adjustments after taking account the subjective evaluation described previously.
We apply our compensation policies consistently for determining compensation of our Chief Executive Officer as we do with the other executives. The Compensation Committee assesses the performance of our Chief Executive Officer annually and determines the base salary and incentive compensation of our chief executive officer.
Our Chief Executive Officer is primarily responsible for the assessment of our other executive officers’ performance. Ultimately, it is the Compensation Committee’s evaluation of the chief executive officer’s assessment along with competitive market data that determines each executive’s total compensation.
Elements of Our Executive Compensation Programs
Base Salary. All full time executives are paid a base salary. Base salaries for our named executives are set based on their professional qualifications and experiences, education background, scope of their responsibilities, taking into account competitive market compensation levels paid by other similar sized companies for similar positions and reasonableness and fairness when compared to other similar positions of responsibility within the Company. Base salaries are reviewed annually by the Compensation Committee, and may be adjusted annually as needed.
Annual Bonuses. The Company does not pay guaranteed annual bonuses to our executives or to employees at any level because we emphasize pay-for-performance. The Compensation Committee determines cash bonuses towards the end of each fiscal year to award our executive officers including our Chief Executive Officer and Chief Financial Officer based upon a subjective assessment of the Company’s overall performance and the contributions of the executive officers during the relevant period.
Equity Incentive Compensation. A key element of our pay-for-performance philosophy is our reliance on performance-based equity awards through the Company’s stock option plan. This program aligns executives’ and shareholders’ interests by providing executives an ownership stake in the Company. Our Compensation Committee has the authority to award equity incentive compensation, i.e. stock options, to our executive officers in such amounts and on such terms as the Compensation Committee determines in its sole discretion. The Compensation Committee reviews each executive’s individual performance and his or her contribution to our strategic goals and determines the amount of stock options to be awarded towards the end of the fiscal year. The Compensation Committee grants equity incentive compensation at times when there are not material non-public information to avoid timing issues and the appearance that such awards are made based on any such information. The exercise price is the closing market price on the date of the grant.
Service-Based Stock Option Awards and Severance Plan. In certain circumstances, the Compensation Committee makes service-based stock option awards to retain key employees, recruit new senior-level executives, or recognize a significant promotion. Service based stock option awards are used infrequently and can be awarded any time during the year. Occasionally a severance plan is provided to retain or recruit a top executive talent at the sole discretion of the Compensation Committee.
Other Compensation. We provide our executives with certain other benefits, including reimbursement of business and entertainment expenses, health insurance, vacation and sick leave plan. The Compensation Committee in its discretion may revise, amend or add to the officer’s executive benefits as it deems necessary. We believe that these benefits are typically provided to senior executives of similar companies in China and in the U.S.
Summary Compensation Table
The following table sets forth all cash compensation paid or to be paid by the company, as well as certain other compensation paid or accrued, for each of the last three fiscal years of our company to each Named Executive Officer.
(1) Valuation based on the dollar amount of option grants recognized for financial statement reporting purposes pursuant to FAS 123(R) with respect to 2007. See Note 17 of consolidated financial statements for assumptions made in the valuations.
(2) Valuation based on the dollar amount of option grants recognized for financial statement reporting purposes pursuant to FAS 123(R) with respect to 2008. See Note 18 of consolidated financial statements for assumptions made in the valuations.
(3) Valuation based on the dollar amount of option grants recognized for financial statement reporting purposes pursuant to FAS 123(R) with respect to 2009. See Note 19 of consolidated financial statements for assumptions made in the valuations.
(4) Such amount represented reimbursement of health insurance, apartment and leased car expenses.
Grant of Plan Based Awards
No grant of any award pursuant to the Company’s 2005 Stock Option Plan was made in 2009 to any Named Executive Officer.
Outstanding Equity Awards At Fiscal Year-End
(1) Mr. Tianfu Yang received a stock option grant of 30,000 shares in February 2006 at an exercise price of $8.10 per share, all of which were vested and were exercisable as of December 31, 2009.
(2) Ms. Christy Shue received a stock option grant of 260,000 shares in December 2007 at an exercise price of $15.60 per share, 160,667 of which vested and were exercisable as of December 31, 2009.
Aggregate Option Exercises In Last Fiscal Year and Value Realized on Exercise
The following table shows the options exercised on vesting by the Named Executive Officers in 2009 and the value realized at December 31, 2009.
(1) The dollar amounts shown above are determined by multiplying (i) the number of shares acquired at exercise by (ii) the difference between the closing price of our Common Stock at the date of exercise and the option exercise price.
Pension Benefits
We do not sponsor any qualified or non-qualified defined benefit plans.
Nonqualified Deferred Compensation
We do not maintain any non-qualified defined contribution or deferred compensation plans.
Employment Contract
We have employment contracts with our employees. Employment contracts are designed to adhere to both State and Provincial employment and social security regulations under applicable Chinese or the U.S. law. We have signed confidentiality agreements with all of our employees.
On November 26, 2007, in connection with the Employment Agreement dated November 27, 2007 between the Company and Christy Young Shue, the Company’s Executive Vice President of Finance and Investor Relations, the Company granted options (the “Options”) to purchase 260,000 shares of the Company’s Common Stock, at an exercise price $15.60, the closing price on November 26, 2007. One-fifth (1/5) of the options (52,000 shares) vested immediately. The remaining options vest over a 3-year period, with 13.33% shares vesting on the 180th day of the effective date of the Employment Agreement, and the balance vesting thereafter on a semi-annual basis over the course of the following three (3) years.
Potential Payment Upon Termination of Change in Control
In the event Ms. Shue's employment is terminated without cause, she will be eligible to receive any base salary earned to the date of termination, a severance amount equal three (3) times her current base salary in effect on the date of termination and the immediate vesting of any unvested options.
Director Compensation
The following table summarizes compensation that our directors earned during 2009 for services as members of our Board.
(1) During the fiscal year ended December 31, 2005, Mr. Ching Chuen Chan received a stock option award of 50,000 shares at an exercise price of $3.10 per share, all of which have vested and are exercisable as of December 31, 2009. In 2009, Ching Chuen Chan exercised 25,000 shares of options in a cash transaction.
(2) Mr. David Gatton received a stock option grant of 10,000 shares in February 2006 at an exercise price of $8.10 per share, all of which have vested and are exercisable as of December 31, 2009. During the fiscal year ended December 31, 2005, Mr. David Gatton received a stock option award of 50,000 shares at an exercise price of $3.10 per share, all of which have vested and are exercisable as of December 31, 2009. In 2009, Mr. Gatton exercised 45,000 shares of options (including 25,000 shares owned by his wife) in a cashless transaction.
(3) Mr. Patrick McManus deceased in July 2009.
(4) Representing the cash compensation received by Mr. Feng Bai from January - August 20, 2009. Mr. Feng Bai ceased to be a member of the Board of Directors as of August 20, 2009.
(5) Representing the cash compensation received by Mr. Boyd Plowman for December 2009. Mr. Boyd Plowman joined the Board of Directors on December 1, 2009.
(6) Ms. Lanxiang Gao received a stock option grant of 30,000 shares in February 2006 at an exercise price of $8.10 per share, all of which vested and were exercisable as of December 31, 2009 Ms. Gao received her stock options as compensation for serving as the Chief Operating Officer of Shanghai Tech Full Electric Co., Ltd, a wholly owned subsidiary of Harbin. In 2009, Ms. Gao exercised 12,500 shares of options in a cashless transaction.
(7) Valuation is based on the dollar amount of option grants recognized for financial statement reporting purposes pursuant to FAS 123(R) with respect to 2009. See Note 19 of consolidated financial statements for assumptions made in the valuations.
(8) Mr. Boyd Plowman received a stock option grant of 30,000 shares in December 2009 at an exercise price of $20.02 per share, 15,000 of which have vested and are exercisable as of December 31, 2009. Valuation is based on the dollar amount of option grants recognized for financial statement reporting purposes pursuant to FAS 123(R) with respect to 2009. See Note 19 of consolidated financial statements for assumptions made in the valuations.
STOCK INCENTIVE PLAN
Our long term incentives are in the form of stock options to directors, executives, employees and consultants under the 2005 Stock Option Plan (the “Plan”). The objective of these awards is to advance the longer term interests of our Company and our stockholders and complement incentives tied to annual performance. These awards provide rewards to directors, executives and other key employees and consultants upon the creation of incremental stockholder value and attainment of long-term earnings goals. Stock option awards under the Plan produce value to participants only if the price of our stock appreciates, thereby directly link the interests of the participants with those of the stockholders.
On January 31, 2005, the Company granted a total of 150,000 stock options to purchase shares of its common stock to three directors of the Company under the Company’s 2005 Stock Option Plan, pursuant to written agreements (the “Agreements”). Each of these options terminates five (5) years from the date of grant. Per each of the Agreements, options shall become exercisable during the term that Optionee serves as a Director of the Company as follows: (i) 50% of the shares of Stock subject to each of these Options became exercisable immediately as of the date of the Agreements; and (ii) the balance of the shares of stock subject to these Options shall become exercisable in eight (8) equal quarterly installments of three thousand one hundred twenty five (3,125) shares of stock subject to this Option. The first such installment became exercisable as of the last day of the first quarter of calendar year 2005, with an additional 3,125 of such shares becoming exercisable as of such date. An additional 3,125 of such shares became exercisable on the last day of each of the second, third and fourth quarters of 2005 and on the last day of each of the first, second and third quarters of 2006. The Company granted to Optionee the right to purchase the number of shares of Stock set forth in the Agreement, for cash (or other consideration as is authorized under the Plan and acceptable to the Board of Directors of the Company, in their sole and absolute discretion) at $3.10 per share (the “Exercise Price”), such price being not less than eighty-five percent (85%) of the fair market value per share of the Shares covered by this Option as of the date of the Agreement.
On September 26, 2005, in connection with an employment agreement, the Company granted options (the “Options”) to purchase 250,000 shares of the Company’s common stock (the “Common Stock”) at an exercise price $3.93, the closing price on September 23, 2005. One-fifth (1/5) of the Options (50,000 shares) has vested immediately upon granting. The remaining Options shall vest over a 3-year period, with 13.33 % (33,333 shares) vesting on the 180th day from September 26, 2005, and the balance vesting thereafter on a semi-annual basis, proportionately over the course of the following three (3) years. Due to the termination of this employment agreement, 66,667 shares of these options have been forfeited.
On February 6, 2006, the Company granted options to purchase 500,000 shares of the Company’s Common Stock at an exercise price of $8.10, the closing price on February 6, 2006. These options will vest in twelve equal quarterly installments over a three year period commencing on May 6, 2006. These options will expire on February 6, 2011.
On February 26, 2007, the Company granted options to purchase 25,000 shares of the Company’s Common Stock to certain employees at an exercise price of $12.40, the closing price on February 26, 2006. These options will vest per employee agreement dated February 26, 2006.
On November 26, 2007, in connection with the Employment Agreement dated November 27, 2007 between the Company and Christy Young Shue, the Company’s Executive Vice President of Finance and Investor Relations, the Company granted options (the “Options”) to purchase 260,000 shares of the Company’s Common Stock, at an exercise price $15.60, the closing price on November 26, 2007. One-fifth (1/5) of the options (52,000 shares) shall vest immediately. The remaining options shall vest over a 3-year period, with 13.33% shares vesting on the 180th day of the effective date of the Employment Agreement, December 15, 2007, and the balance vesting thereafter on a semi-annual basis over the course of the following three (3) years.
On December 1, 2009, in connection with the Independent Director Agreement (the “Agreement”) dated November 30, 2009 between the Company and Boyd Plowman, the Company granted options (the “Options”) to Mr. Plowman to purchase an aggregate of 30,000 shares of the Company's common stock, at an exercise price of $20.02 per share, the closing price of the Company’s common stock on November 30, 2009. Fifty percent of the options (15,000 shares) shall vest immediately. The remaining options shall become exercisable in twelve (12) equal quarterly installments of one thousand two hundred and fifty (1,250) options, with the first installment to be exercisable as of the last day of the first quarter of calendar year 2010, with an additional 1,250 of options becoming exercisable as of the last day of the subsequent quarter.
Compensation Committee Interlocks and Insider Participation
Members of our Compensation Committee of the Board of Directors were David Gatton, Ching Chuen Chan, and Boyd Plowman. No member of our Compensation Committee was, or has been, an officer or employee of the Company or any of our subsidiaries.
No member of the Compensation Committee has a relationship that would constitute an interlocking relationship with executive officers or directors of the Company or another entity.
Compensation Committee Report
The goal of the Company’s executive compensation policy is to ensure that an appropriate relationship exists between executive compensation and the creation of stockholder value, while at the same time attracting, motivating and retaining experienced executive officers.
The Compensation Committee has reviewed and discussed the discussion and analysis of the Company’s compensation which appears above with management, and, based on such review and discussion, the Compensation Committee recommended to the Company’s Board of Directors that the above disclosure be included in this Annual Report on Form 10-K for the year ended December 31, 2009.
The members of the Compensation Committee are:
David Gatton, Chairman
Ching Chuen Chan
Boyd Plowman
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth certain information with respect to the beneficial ownership of our common stock by:
(i) each person known to beneficially own more than five percent of our common stock;
(ii) each of our directors, nominees, and executive officers; and
(iii) all of our directors and executive officers as a group.
The number of shares beneficially owned by each director, nominee or executive officer is determined under rules of the SEC, and the information is not necessarily indicative of beneficial ownership for any other purpose. Under the SEC rules, beneficial ownership includes any shares as to which the individual has the sole or shared voting power or investment power. In addition, beneficial ownership includes any shares that the individual has the right to acquire within 60 days. Unless otherwise indicated, each person listed below has sole investment and voting power (or shares such powers with his or her spouse). In certain instances, the number of shares listed includes (in addition to shares owned directly) shares held by the spouse or children of the person, or by a trust or estate of which the person is a trustee or an executor or in which the person may have a beneficial interest.
* Indicates less than one percent.
** The address of each director, nominee, and executive officer is c/o Harbin Electric, Inc., No. 9 Ha Ping Xi Lu, Ha Ping Lu Ji Zhong Qu, Harbin Kai Fa Qu, Harbin, People’s Republic of China 150060.
(1)
Based on 31,067,471 shares of common stock outstanding as of December 31, 2009.
(2)
Includes options to acquire 30,000 shares of common stock exercisable within 60 days of December 31, 2009. Also includes 2,950,000 shares of common stock owned by Hero Wave Investments Limited, a British Virgin Islands company (“Hero”). Mr. Yang is the sole owner of the equity of Hero and has voting and dispositive control over the shares of common stock held by Hero.
(3)
Owned by Sea Giant Investments Limited, a British Virgin Islands company (“Sea Giant”). Mr. Yang is the sole owner of the equity of Sea Giant and has voting and dispositive control over the shares of common stock held by Broad Globe.
(4)
Owned by Victory Lake Investments Limited, a British Virgin Islands company (“Victory Lake”). Mr. Xu is the sole owner of the equity of Victory Lake and has voting and dispositive control over the shares of common stock held by Victory Lake.
(5)
Includes options to acquire 18,000 shares of common stock exercisable within 60 days of December 31, 2009.
(6)
Includes options to acquire 15,000 shares of common stock exercisable within 60 days of December 31, 2009.
(7)
Includes options to acquire 10,000 shares of common stock exercisable within 60 days of December 31, 2009, 5,000 of which are held by Mr. Gatton’s wife, Jillian F. McNamara.
(8)
Includes options to acquire 160,667 shares of common stock exercisable within 60 days of December 31, 2009.
(9)
Includes aggregate options to acquire 215,667 shares of common stock in each case exercisable within 60 days of December 31, 2009.
(10)
The Schedule 13G filed on February 4, 2010, was jointly filed by each of the following persons pursuant to Rule 13d-1 promulgated by the Securities and Exchange Commission pursuant to Section 13 of the Securities Exchange Act of 1934, as amended: (i) Citadel Advisors LLC (“Citadel Advisors”), (ii) Citadel Holdings II LP (“CH-II”), (iii) Citadel Investment Group II, L.L.C. (“CIG-II”) and (iv) Mr. Kenneth Griffin (collectively with Citadel Advisors, CH-II and CIG-II, the “Reporting Persons”) with respect to shares of Common Stock of the Company (and/or warrants to purchase such stock) owned by Citadel Equity Fund Ltd., a Cayman Islands limited company (“CEF”), Citadel Derivatives Trading Ltd., a Cayman Islands limited company (“CDT”), Citadel Global Equities Master Fund Ltd., a Cayman Islands limited company (“CG”), Citadel Securities LLC, a Delaware limited liability company (“Citadel Securities”), and certain segregated accounts. Citadel Advisors is the investment manager for CEF, CG and certain segregated accounts, and the portfolio manager for CDT. CH-II is the managing member of Citadel Advisors. CH-I is the non-member manager of Citadel Securities. CIG-II is the general partner of CH-I and CH-II. Mr. Griffin is the President and Chief Executive Officer of, and owns a controlling interest in, CIG-II. The information was derived from a Schedule 13G filed on February 4, 2010.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions, and Director Independence
There were no transactions, since the beginning of the Company’s last fiscal year in which the Company was or is to be a participant and in which any related person had or will have a direct or indirect material interest.
Our board of directors has determined that Mr. Ching Chuen Chan, Mr. David Gatton, Mr. Boyd Plowman, and Mr. Yunyue Ye are considered “independent” under the current independence standards of NASDAQ Marketplace Rule 4200(a)(15) and meet the criteria for independence set forth in Rule 10A-3(b)(1) of the Securities Exchange Act of 1934, as amended, as determined by the Board of Directors.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services
Audit Fees
The aggregate fees for each of the last two years for professional services rendered by the principal accountant for our audits of our annual financial statements and interim reviews of our financial statements included in our fillings with Securities and Exchange Commission on Form 10-KSBs, Form 10-K, and 10-Qs services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those years were approximately:
Audit Related Fees
This category consists of services by our independent auditors that are reasonably related to the performance of the audit or review of our financial statements and are not reported above under Audit Fees. This category includes accounting consultations on transaction and proposed transaction related matters.
We incurred these fees in connection with registration statements, financing, and acquisition transaction.
Tax Fees
The aggregate fees in each of the last two years for the professional services rendered by the principal accountant for tax compliance, tax advice and tax planning were approximately:
All Other Fees
There are no other fees to disclose.
All of the fees paid to Frazer Frost, LLP (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP) for the fiscal years ended December 31, 2009 and 2008 described above were pre-approved by the audit committee.
Policy on Audit Committee Pre-Approval of Services Performed by Independent Registered Public Accounting Firm
The audit committee’s policy is to pre-approve all audit and permissible non-audit services provided by the independent auditors. These services may include audit services, audit-related services, tax services and other services. The audit committee may also pre-approve particular services on a case-by-case basis.
PART IV
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
The following exhibits are filed as part of this Annual Report on Form 10-K:
Exhibit Number
Description
Method of Filing
1.1
Underwriting Agreement, dated July 30, 2009, between the Company and Roth Capital Partners, LLC.
Filed as Exhibit 1.1 to the current report on Form 8-K filed with the Commission on July 30, 2009 and incorporated herein by reference.
3.1
Articles of Incorporation of the Company
Filed as Exhibit 3.1 to the registration statement on Form SB-2 filed with the Commission on October 10, 2003 and incorporated herein by reference.
3.2
Amended and Restated Bylaws of the Company
Filed as Exhibit 3.2 to the Registration Statement on Form S-1 filed with the Commission on October 20, 2008 and incorporated by reference.
3.3
Amendment to the Bylaws of the Company
Filed as Exhibit 4.1 to the current report on Form 8-K filed with the Commission on December 20, 2006 and incorporated herein by reference.
3.4
Articles of Merger dated as of January 27, 2005 by
and between the Company and Torch Executive Services Ltd., a Nevada corporation.
Filed as Exhibit 3.1 to the quarterly report on Form 10-Q filed with the Commission on May 8, 2009 and incorporated herein by reference.
10.1
Registration Rights Agreement dated as of August 31, 2005
Filed as Exhibit 10.1 to the registration statement on Form SB-2 filed with the Commission on April 27, 2006 and incorporated herein by reference.
10.2
Common Stock Purchase Agreement dated as of August 31, 2005
Filed as Exhibit 10.2 to the registration statement on Form SB-2 filed with the Commission on April 27, 2006 and incorporated herein by reference.
10.3
Option Agreement dated as of August 31, 2005
Filed as Exhibit 10.3 to the registration statement on Form SB-2 filed with the Commission on April 27, 2006 and incorporated herein by reference.
10.4
Term Sheet dated August 2, 2006
Filed as Exhibit 10.5 to the current report on Form 8-K filed with the Commission on August 2, 2006 and incorporated herein by reference.
10.5
Agreement on Cooperation between Harbin Tech Full Electric Co., Ltd. and Institute of Electrical Engineering of the Chinese Academy of Sciences
Filed as Exhibit 10.6 to the current report on Form 8-K filed with the Commission on August 25, 2006 and incorporated herein by reference.
10.6
Purchase Agreement among the Company, Advanced Electric Motors, Inc., Citadel Equity Fund Ltd. and Merrill Lynch International, dated August 29,
Filed as Exhibit 4.1 to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.7
Indenture among the Company, Advanced Electric Motors, Inc. and The Bank of New York, as trustee, dated August 30, 2006
Filed as Exhibit 4.2 to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.8(a)
Global Note
Filed as Exhibit 4.3(a) to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.8(b)
Global Note
Filed as Exhibit 4.3(b) to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.9
Registration Rights Agreement between the Company and the Investors, dated August 30,
Filed as Exhibit 4.4 to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.10
Share Pledge Agreement between the Company and The Bank of New York, as collateral agent, dated August 30, 2006
Filed as Exhibit 4.5 to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.11
Warrant Agreement between the Company and The Bank of New York, as warrant agent, dated August 30, 2006
Filed as Exhibit 4.6 to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.12(a)
Global First Tranche 2012 Warrants
Filed as Exhibit 4.7(a) to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.12(b)
Global Second Tranche 2012 Warrants
Filed as Exhibit 4.7(b) to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.12(c)
Global 2009 Warrants
Filed as Exhibit 4.7(c) to the current report on Form 8-K filed with the Commission on September 1, 2006 and incorporated herein by reference.
10.13
Voting Agreement among the Company, Tianfu Yang and Citadel Equity Fund Ltd., dated August 30, 2006
Filed as Exhibit 4.8 to the current report on Form 8-K filed with the Commission on September 1, 2001 and incorporated herein by reference.
10.14
Noncompetition Covenant and Agreement among Citadel Equity Fund Ltd., Merrill Lynch International and Tianfu Yang, dated August 30, 2006
Filed as Exhibit 10.15 to the Registration Statement on SB-2 filed with the Commission on October 4, 2006 and incorporated herein by reference.
10.15
Agreement between Harbin Tech Full Electric Co., Ltd. and Shanghai Lingang Investment and Development Company Limited, dated September 8,
Filed as Exhibit 10.15 to the Registration Statement on SB-2 filed with the Commission on October 4, 2006 and incorporated herein by reference.
10.16
Letter Agreement dated April 9, 2007 by and among Harbin Electric, Inc, Shelton Technology LLC, Shaotang Chen and Xioagang Luo
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on April 13, 2007 and incorporated herein by reference.
10.17
License Agreement dated as of April 9, 2007 by and among Advanced Automation Group. LLC, Shelton Technology, LLC, Shaotang Chen and Xiaogang Luo
Filed as Exhibit 10.2 to the current report on Form 8-K filed with the Commission on April 13, 2007 and incorporated herein by reference.
10.18
Employment Agreement dated April 9, 2007 by and between Advanced Automation Group, LLC and Shaotang Chen
Filed as Exhibit 10.3 to the current report on Form 8-K filed with the Commission on April 13, 2007 and incorporated herein by reference.
10.19
Employment Agreement dated April 9, 2007 by and between Advanced Automation Group, LLC and Xiaogang Luo.
Filed as Exhibit 10.4 to the current report on Form 8-K filed with the Commission on April 13, 2007 and incorporated herein by reference.
10.20
Asset Purchase Agreement dated June 16, 2007, by and between the Company, Harbin Tech Full Electric Co., Ltd., Harbin Taifu Auto Electric Co., Ltd., Tianfu Yang, Tianli Yang, Suofei Xu, Zedong Xu and Harbin Tech Full Industry Co., Ltd.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on June 19, 2007 and incorporated herein by reference.
10.21
Equity Registration Rights Agreement, dated October 17, 2007, by and between the Company, Hero Wave Investment Limited a British Virgin Islands company, and Tianfu Yang, as guarantor.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on October 23, 2007 and incorporated herein by reference.
10.22
Employment Agreement dated November 27, 2007 by and between the Company and Ms. Christy Young Shue
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on November 30, 2007 and incorporated herein by reference.
10.23
Letter of Intent dated March 27, 2008, by and among Harbin Tech Full Electric Co., Ltd., Wendeng Second Electric Motor Factory, The Committee of Labor Union of Wendeng Second Electric Motor Factory and The People’s Government of Zhangjiachan Town, Wendeng County.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on March 31, 2008 and incorporated herein by reference.
10.24
Purchase Agreement, dated June 24, 2008, by and among the Company and the investors party thereto.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on June 26, 2008 and incorporated herein by reference.
10.25
Registration Rights Agreement, dated June 24, 2008, by and among the Company and the investors party thereto.
Filed as Exhibit 10.2 to the current report on Form 8-K filed with the Commission on June 26, 2008 and incorporated herein by reference.
10.26
Equity and Assets Transfer Agreement, dated July 10, 2008, by and between Harbin Tech Full Electric Co. Ltd., Weihai Hengda Electric Motor (Group) Co. Ltd., Wendeng Second Electric Motor Factory, the Committee of Labor Union of Wendeng Second Electric Motor Factory, the People’s Government of Zhangjiachan Town and Wendeng County.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on July 11, 2008 and incorporated herein by reference.
10.27
Amendment to Letter Agreement, dated as of December 11, 2008 between the Company and Shelton Technology, LLC.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on December 16, 2008 and incorporated herein by reference.
10.28
Second Amendment to Letter Agreement , dated as of April 21, 2009 between the Company and Shelton Technology, LLC..
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on April 24, 2009 and incorporated herein by reference.
10.29
Amendment to Employment Agreement, dated April 1, 2009 by and between the Company and Ms. Christy Young Shue.
Filed as Exhibit 10.1 to the quarterly report on Form 10-Q filed with the Commission on May 8, 2009 and incorporated herein by reference.
10.30
Letter Agreement between the Company and Citadel Equity Fund Ltd. dated June 1, 2009.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on June 5, 2009 and incorporated herein by reference.
10.31
Merrill Lynch International (“Merrill”) and ABN AMRO Bank N.V., London Branch (“ABN”) Letter Agreement among the Company, Merrill and ABN dated July 14, 2009.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on July 20, 2009 and incorporated herein by reference.
10.32
Abax Letter Agreement among the Company, Abax Jade and Abax Nai Xin dated July 14, 2009.
Filed as Exhibit 10.2 to the current report on Form 8-K filed with the Commission on July 20, 2009 and incorporated herein by reference.
10.33
Equity Acquisition Agreement between Harbin Tech Full Electric Co. Ltd., Xi’an Simo Electric Co. Ltd. and Shaanxi Electric Machinery Association dated October 2, 2009.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on October 7, 2009 and incorporated herein by reference.
10.34
SWAP Termination Agreement between the Company and Merrill Lynch International, dated as of September 16, 2009.
Filed as Exhibit 10.5 to the quarterly report on Form 10-Q filed with the Commission on November 9, 2009 and incorporated herein by reference.
10.35
Independent Director Agreement dated November 30, 2009, between the Company and Boyd R. Plowman.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on December 2, 2009 and incorporated herein by reference.
10.36
Third Amendment to the Letter Agreement
between the Company and Shelton Technology, LLC
dated as of December 7, 2009.
Filed as Exhibit 10.1 to the current report on Form 8-K filed with the Commission on December 8, 2009 and incorporated herein by reference.
14.1
Code of Ethics and Business Conduct
Previously filed.
21.1
List of subsidiaries
Filed as Exhibit 21.1 to the Registration Statement on Form S-1 filed with the Commission on October 20, 2008 and incorporated by reference.
23.1
Consent of Frazer Frost, LLP, (a successor entity of Moore Stephens Wurth Frazer and Torbet, LLP)
Filed herewith.
31.1
Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a)
Filed herewith.
31.2
Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a)
Filed herewith
32.1
Certification of the Chief Executive Officer and the Chief Financial Officer pursuant 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Filed herewith
Exhibit 99.1
Press Release Announcing Fourth Quarter and 2009 Financial Results
Filed herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 16, 2010
By:
/s/ Tianfu Yang
By:
Tianfu Yang
Title:
Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934, this Report has been signed below by the following person on behalf of the Registrant and in the capacities and on the dates indicated.
Signature
Title
Date
NAME
TITLE
/s/ Tianfu Yang
Chief Executive Officer, Director and Chairman of the Board
March 16, 2010
Tianfu Yang
/s/ Zedong Xu
Chief Financial Officer (Principal Accounting Officer)
March 16, 2010
Zedong Xu
/s/ Lanxiang Gao
Director
March 16, 2010
Lanxiang Gao
/s/ Ching Chuen Chan
Director
March 16, 2010
Ching Chuen Chan
/s/ Boyd Plowman
Director
March 16, 2010
Boyd Plowman
/s/ David Gatton
Director
March 16, 2010
David Gatton
/s/ Yunyue Ye
Director
March 16, 2010
Yunyue Ye
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Stockholders of Harbin Electric, Inc
We have audited the accompanying consolidated balance sheets of Harbin Electric, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income and other comprehensive income, changes in equity, and cash flows for each of the years in the three-year period ended December 31, 2009. Harbin Electric, Inc.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Harbin Electric, Inc. as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Harbin Electric, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2010 expressed a unqualified opinion.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2009 AND 2008
See report of independent registered public accounting firm.
The accompanying notes are an integral part of these consolidated financial statements.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
See report of independent registered public accounting firm.
The accompanying notes are an integral part of these consolidated statements.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
See report of independent registered public accounting firm.
The accompanying notes are an integral part of these consolidated statements.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
See report of independent registered public accounting firm.
The accompanying notes are an integral part of these consolidated financial statements.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Note 1 - Nature of Business
Harbin Electric, Inc. (“the Company” or “Harbin Electric”) is a Nevada Corporation, incorporated on July 9, 2003. Through its subsidiaries, the Company designs, develops, engineers, manufactures, sells and services a wide array of electric motors including linear motors, specialty micro-motors, and industrial rotary motors, with focus on innovation, creativity, and value-added products. Products are sold in China and to certain international markets.
Current development
On October 2, 2009, Harbin Electric acquired Xi’an Tech Full Simo Motor Co., Ltd. (“Simo Motor”). Simo Motor formerly known as Xi’an Simo Motor Incorporation (Group), was initially established in 1955 as a State-Owned Enterprise and one of the major backbone companies of China’s electric motor industry. In January 2004, Simo Motor was privatized as a shareholding company from the former Xi’an Electric Motor Works under the corporate laws of the PRC. Simo Motor develops and manufactures various industrial motors. Simo Motor sells its products primarily in China and also in the advanced industrial markets of North America, Europe and Asia as well as in Africa, Southeast Asia and the Middle East. Simo Motor has developed to a large enterprise group which consists of 15 wholly-owned and 8 majority owned subsidiaries mainly engaged in manufacturing and selling of electric motors. As a result, the Company’s ownership to Simo Motor and all subsidiaries averages to 87.2%. The remaining 12.8% is owned by noncontrolling shareholders. See Note 16 for further discussion.
Note 2 - Summary of Significant Accounting Policies
Basis of presentation
The consolidated financial statements of Harbin Electric Inc. reflect the activities of the following subsidiaries. All material intercompany transactions have been eliminated.
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include the accounts of all directly and indirectly owned subsidiaries listed above.
Since Simo Motor was acquired in October 2009, its operating results for the three months ended December 31, 2009 were included in the consolidated statements.
Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the reported amounts of assets, liabilities, revenue and expenses, and disclosures about contingent assets and liabilities. Such estimates and assumptions by management affect accrued expenses, the valuation of accounts receivable, inventories, and long-lived assets, legal contingencies, lives of plant and equipment, lives of intangible assets, business combinations, goodwill, calculation of warranty accruals, taxes, share-based compensation and others.
Although the Company regularly assesses these estimates, actual results could materially differ. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Foreign currency transactions
Our reporting currency is the US dollar. The functional currency of PRC subsidiaries is the Chinese Renminbi (“RMB”). Our results of operations and financial position of the PRC subsidiaries are translated to United States dollars using the year end exchange rates as to assets and liabilities and weighted average exchange rates as to revenues, expenses and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. The resulting currency translation adjustments are recorded as a component of accumulated other comprehensive income (loss) within stockholders’ equity. As a result, translation adjustments amount related to assets and liabilities reported on the consolidated statement of cash flows will not necessarily agree with changes in the corresponding consolidated balances on the balance sheet. 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.
Translation adjustments resulting from this process amounted to $(70,011), $9,513,907 and $7,162,512 for the fiscal years ended December 31, 2009, 2008 and 2007, respectively. The balance sheet amounts with the exception of equity at December 31, 2009 and 2008 were translated 6.84 RMB to $1.00 and 6.85 RMB to $1.00, respectively. The equity accounts were stated at their historical exchange rate. The average translation rates applied to the revenues, expenses and cash flows statement amounts for the fiscal years ended December 31, 2009, 2008 and 2007 were 6.84 RMB, 6.96 RMB and 7.62 RMB to $1.00, respectively. Simo Motor was acquired in October, 2009, and the average translation rate applied to Simo Motor’s statement of income and cash flow was 6.84 RMB to $1.00.
Transaction loss of $88,993, $358,460 and $118,247 were recognized during fiscal years ended December 31, 2009, 2008 and 2007.
Concentration of risks
The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents, for cash flow statement purposes. Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the PRC and with banks in the United States. The Company maintains balances at financial institutions which, from time to time, may exceed Federal Deposit Insurance Corporation insured limits for the banks located in the Unites States. Balances at financial institutions or state owned banks within the PRC are not insured. As of December 31, 2009 and 2008, the Company had deposits in excess of federally insured limits totaling $92,701,730 and $47,783,767, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.
One major customer accounted for approximately 12% of the net revenue for the fiscal year ended December 31, 2009. At December 31, 2009, the total receivable balance due from this customer was $11,494,287, representing 12% of total accounts receivable. Three major customers accounted for 43% of the net revenue for the fiscal year ended December 31, 2008, with each customer individually accounting for 16%, 15% and 12%, respectively. At December 31, 2008, the total receivable balance due from these customers was $26,253,907, representing 87% of total accounts receivable. Five major customers accounted for 72% of the net revenue for the year ended December 31, 2007, with each customer individually accounting for 20%, 20%, 13%, 10% and 9%, respectively.
One major vendor provided approximately 16% of the Company’s purchases of raw materials for the year ended December 31, 2009. Two major vendors provided 39% of the Company’s purchase of raw materials for the year ended December 31, 2008, with each vendor individually accounting for 23% and 16%, respectively. Five major vendors provided 80% of the Company’s purchase of raw materials for the year ended December 31, 2007, with each vendor individually accounting for 27%, 22%, 13%, 12% and 6%, respectively. The Company’s accounts payable to these vendors was $0 and $1,055,730 at December 31, 2009 and 2008, respectively.
The Company's operations are carried out in the PRC. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC's economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in the North America and Western Europe. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Restricted cash
Restricted cash represent amounts set aside by the Company in accordance with the Company’s debt agreements with certain financial institutions. These cash amounts are designated for the purpose of paying down the principal amounts owed to the financial institutions, and these amounts are held at the same financial institutions with which the Company has debt agreements in the PRC. Due to the short-term nature of the Company’s debt obligations to these banks, the corresponding restricted cash balances have been classified as current in the consolidated balance sheets.
Notes receivable
Notes receivable arose from sale of goods and represented commercial drafts issued by customers to the Company that were guaranteed by banks of the customers. Notes receivables were interest-free with maturity dates of three or six months from date of issuance.
Accounts receivable
Accounts receivable are presented net of an allowance for bad debts account. The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reverses. The estimated loss rate is based on our historical loss experience and also contemplates current market conditions. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified.
Inventories
Inventory is valued at the lower of cost or market value, as determined on a first-in, first-out basis, using the weighted average method. Management compares the cost of inventory with the market value and an allowance is made for writing down the inventory to its market value, if lower than cost. On an ongoing basis, inventories are reviewed for potential write-down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. When inventory is written-down to the lower of cost or market, it is not marked up subsequently based on changes in underlying facts and circumstances. Inventory is composed of raw material for manufacturing electrical motors, work in process and finished goods within the Company’s warehouse premise or consigned at a customer site.
Plant and equipment
Plant and equipment are stated at cost. Expenditures for maintenance and repairs are charged to earnings as incurred; additions, renewals and betterments are capitalized. When assets are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations. Depreciation of plant and equipment is provided using the straight-line method for substantially all assets with estimated lives as follows:
Estimated Useful Life
Buildings
years
Vehicle
years
Office equipment
years
Production equipment
years
Construction in progress represents the costs incurred in connection with the construction of buildings or new additions to the Company’s plant facilities. No depreciation is provided for construction in progress until such time as the assets are completed and placed into service. Maintenance, repairs and minor renewals are charged directly to expense as incurred. Major additions and betterment to buildings and equipment are capitalized. Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
The Company recognizes an impairment loss when estimated cash flows generated by those assets are less than the carrying amounts of the asset. Based on management review, the Company believes that there were no impairments as of December 31, 2009.
Goodwill and other intangible assets
Goodwill - the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed shall be recognized as goodwill. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis in the fourth quarter or more frequently if there are indicators of impairment exist. For purposes of our goodwill impairment test, a two-step test is used to identify the potential impairment and to measure the amount of goodwill impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.
Land use rights - all land in the People’s Republic of China is government owned. However, the government grants “land use rights” (the “Right”). The Company has the right to use the land for 50 years and amortizes the Right on a straight line basis over 50 years.
Patents - capitalized patent costs represent legal costs incurred to establish patents and the portion of the acquisition price paid attributed to patents upon the assets acquisition on July 16, 2007. Capitalized patent costs are amortized on a straight line method over the related patent terms generally from 6 to 10 years.
The Company evaluates intangible assets for impairment, at least annually and whenever events or changes in circumstances indicate that the assets might be impaired. We perform our annual impairment test in the fourth quarter.
Our impairment test consists of a comparison of the fair value of the intangible asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to the excess. As of December 31, 2009, management believes there was no impairment.
Accounting for long-lived assets
Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We assess the recoverability of the assets based on the undiscounted future cash flow the assets are expected to generate and recognize an impairment loss when estimated undiscounted future cash flow expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. When we identify an impairment, we reduce the carrying amount of the asset to its estimated fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values. As of December 31, 2009, management believes there was no impairment.
Stock-based compensation
We record share-based compensation expense based upon the grant date fair value of share-based awards. The value of the award is principally recognized as expense ratably over the requisite service periods. We use the Black-Scholes Merton (“BSM”) option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates to determine fair value. The Company’s expected volatility assumption is based on the historical volatility of Company’s stock. The expected life assumption is primarily based on the simplified method of the terms of the options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
The Company is required to measure the cost of the equity instruments issued in exchange for the receipt of goods or services from other than employees at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Stock compensation expense is recognized based on awards expected to vest. GAAP requires forfeitures to be estimated at the time of grant and revised in subsequent periods, if necessary, if actual forfeitures differ from those estimates. There were no estimated forfeitures as the Company has a short history of issuing options.
Revenue recognition
The Company recognizes sales at the date of shipment to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. For products that are required to be examined by customers, sales revenue is recognized after the customer examination is passed. Payments received before all of the relevant criteria for revenue recognition are recorded as customer deposits.
In addition, revenue recognition could be negatively impacted by returns. For our linear motor and specialty micro-motor businesses, our products are custom products which are customer specific, and no returns are allowed. We warrant our product for repair, only in the event of defects for two years from the date of shipment. We charge such costs to cost of goods sold. For our industrial rotary motor business, our products are standardized products and returns are allowed within three days upon receipt of products by customers. We provide product warranty for repair one year from the date of shipment. Historically, the returns and defects have not been material. Should returns increase in the future it would be necessary to adjust the estimates, in which case recognition of revenues could be delayed.
Shipping and handling costs are included in selling, general and administrative costs and totaled $2,896,231, $1,665,628 and $647,585 for the years ended December 31, 2009, 2008 and 2007, respectively.
Income taxes
The Company utilizes the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. GAAP also requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. As of January 1, 2007, income tax positions must meet a more-likely-than-not recognition threshold to be recognized. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. No material deferred tax amounts were recorded at December 31, 2009, 2008, and 2007, respectively.
The charge for taxation is based on the results for the reporting period as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.
The Company’s operating subsidiaries located in PRC are subject to PRC income tax. The new Chinese Enterprise Income Tax (“EIT”) law was effective on January 1, 2008. Under the new Income Tax Laws of PRC, a company is generally subject to income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriated tax adjustments. HTFE is located in a specially designated region where HTFE is subject to a 10% EIT rate from January 1, 2008 to December 31, 2010. Weihai is currently at the standard 25% income tax rate. Our operations under STFE was income tax exempt in 2008 and 2009, and will be subject to preferential income tax rate of 11% in 2010, 12% in 2011 and 12.5% in 2012 since its located in an economic development zone. Simo Motor is located in the Province of Shaanxi which is in the mid-west region of China, a specially designated region where the government grants special income tax rates to qualified entities. Simo Motor qualifies for the “Go-west” special income tax rate of 15% promulgated by the government and therefore is subject to a 15% EIT rate from year 2007 to 2010.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
The Company’s subsidiaries were paying the following tax rate for the years ended December 31:
(a) Weihai was acquired in July 2008 and the tax rate only applied to its results of operations included in the consolidated financial statements, which is the six-months-period ended December 31, 2008 and the fiscal year ended December 31, 2009.
(b) STFE was income tax exempt for the years ended December 31, 2009 and 2008, and no operational income was generated for the year ended December 31, 2008 and 2007.
(c) Simo Motors was acquired in October 2009 and the tax rate only applied to its results of operations included in the consolidated financial statements, which is the three-month-period ended December 31, 2009.
The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the years ended December 31:
(d) The 14 % represents the $34,762,948 of expenses incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the year ended December 31, 2009.
The estimated tax savings for the years ended December 31, 2009, 2008 and 2007 amounted to $8,638,041, $6,007,426, and $10,260,615, respectively. The net effect on earnings per share attributable to controlling interest had the income tax been applied would decrease earnings per share from $0.77 to $0.43 in 2009, $1.25 to $0.95 in 2008, and $0.99 to $0.38 in 2007.
Harbin Electric, AEM and AAG were organized in the United States and have incurred net operating losses for income tax purposes for the year ended December 31, 2009. The net operating loss carry forwards for United States income taxes amounted to $29,276,137 which may be available to reduce future years’ taxable income. These carry forwards will expire, if not utilized, starting from 2026 through 2029. Management believes that the realization of the benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. The net change in the valuation allowance for the year ended December 31, 2009 was an increase of approximately $3,157,259. Management will review this valuation allowance periodically and make adjustments accordingly.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $128,862,919 as of December 31, 2009, which is included in consolidated retained earnings and will continue to be indefinitely reinvested in international operations. Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.
Value added tax
Sales revenue represents the invoiced value of goods, net of a value-added tax (“VAT”). All of the Company’s products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product. The Company recorded VAT Payable and VAT receivable net of payments in the financial statements. The VAT tax return is filed offsetting the payables against the receivables.
VAT on sales and VAT on purchases amounted to $40,292,224 and $25,943,303 for the year ended December 31, 2009. VAT on sales and VAT on purchases amounted to $12,278,874 and $7,217,430 for the year ended December 31, 2008, and $9,747,272 and $5,138,433 for the same period of 2007, respectively. Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government.
Advertising costs
The Company expenses the cost of advertising as incurred in selling, general and administrative costs. The Company incurred $139,252, $230,307 and $1,183 for the years ended December 31, 2009, 2008 and 2007, respectively.
Research and development costs
Research and development costs are expensed as incurred. The costs of material and equipment that are acquired or constructed for research and development activities and have alternative future uses are classified as plant and equipment and depreciated over their estimated useful lives.
Business combinations
Effective January 1, 2009, we account for business combinations using the acquisition method of accounting. The acquisition method requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. The provisions of the acquisition method related to income tax adjustments apply to all business combinations regardless of consummation date. As a result of implementing the acquisition method, acquisition costs of approximately $926,000, which included legal, accounting and investment banking fees were expensed during the year ended December 31 2009 in connection with the Simo Motor acquisition. This acquisition is further described in Note 16, “Business Combination”.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This is an exit price concept for the valuation of the asset or liability. In addition, market participants are assumed to be buyers and sellers in the principal market for the asset or liability. Fair value measurements for an asset assume the highest and best use by these market participants. As a result of these standards, we may be required to record assets which we do not intend to use or sell (defensive assets) and/or to value assets at fair value measures that do not reflect our intended use of those assets. Many of these fair value measurements can be highly subjective and it is also possible that other professionals, applying reasonable judgment to the same facts and circumstances, could develop and support a range of alternative estimated amounts.
Derivative instrument
The Company uses a cross currency interest rate swap, a derivative financial instrument, to hedge the risk of rising interest rates on their variable interest rate debt. This type of derivative financial instrument is known as a cash flow hedge. Cash flow hedges are defined by GAAP as derivative instruments designated as and used to hedge the exposure to variability in expected future cash flows that is attributable to a particular risk. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income, net of income taxes and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivatives representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
At the inception of the transaction, the Company documents the relationship between hedging instruments and hedged items, as well as its risk management objective and the strategy for undertaking various hedge transactions. This process includes linking all derivatives designated to specific firm commitments of forecast transactions. The Company also documents its assessment, both at inception and on an ongoing basis, of whether the derivative financial instruments that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. Any portion deemed ineffective is recorded in earnings with the effective portion reflected in accumulated other comprehensive.
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 liability, either directly or indirectly, for substantially the full term of the financial instruments.
·
Level 3 inputs to the valuation methodology are unobservable and significant to the fair value.
As of December 31, 2009, the outstanding principal on the Company’s 2012 Notes payable , evaluated under these accounting standards, amounted to $7,660,210. Management concluded the carrying values are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and if applicable, their stated interest rate approximates current rates available.
Effective January 1, 2009, a total of 2,030,158 warrants previously treated as equity pursuant to the derivative treatment exemption is no longer afforded equity treatment because the strike price of the warrants is denominated in US dollar, a currency other than the Company’s functional currency, the Chinese RMB. As a result, the warrants are not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of these warrants will be recognized currently in earnings until such time as the warrants are exercised or expired. The Company reclassified the fair value of these warrants from equity to liability, as if these warrants were treated as a derivative liability since their issuance in August 2006. On January 1, 2009, the Company reclassified from additional paid-in capital, as a cumulative effect adjustment, $6.1 million to beginning retained earnings and $7.4 million to warrant liabilities to recognize the fair value of such warrants. As of December 31, 2009, the Company has 366,697 warrants outstanding. The fair value of the outstanding warrants was $4.6 million. The Company recognized a total of $13.2 million loss from the change in fair value of the warrants for the year ended December 31, 2009.
These common stock purchase warrants do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the Black-Scholes Option Pricing Model using the following assumptions:
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We have no reason to believe future volatility over the expected remaining life of these warrants likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is based on U.S. Treasury securities according to the remaining term of the warrants.
Other than the derivative instruments, the Company did not identify any assets and liabilities that are required to be presented on the balance sheet at fair value.
Recently Adopted Accounting Standards
In January 2009, the FASB’s accounting standard regarding other investments providing additional guidance which amended the impairment model to remove the exclusive reliance on “market participant” estimates of future cash flows used in determining fair value. Changing the cash flows used to analyze other-than-temporary impairment from the “market participant” view to a holder’s estimate of whether there has been a “probable” adverse change in estimated cash flows allows companies to apply reasonable judgment in assessing whether an other-than-temporary impairment has occurred. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB’s accounting standard regarding fair value measurements and disclosures providing additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased and also includes guidance on identifying circumstances that indicate a transaction is not orderly for fair value measurements. This guidance shall be applied prospectively with retrospective application not permitted. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB’s accounting standard regarding debt and equity securities requires to make the other-than-temporary impairments guidance more operational and to improve the presentation of other-than-temporary impairments in the financial statements. This guidance will replace the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired debt security until recovery with a requirement that management assert it does not have the intent to sell the security, and it is more likely than not it will not have to sell the security before recovery of its cost basis. This guidance provides increased disclosure about the credit and noncredit components of impaired debt securities that are not expected to be sold and also requires increased and more frequent disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. Although this guidance does not result in a change in the carrying amount of debt securities, it does require that the portion of an other-than-temporary impairment not related to a credit loss for a held-to-maturity security be recognized in a new category of other comprehensive income and be amortized over the remaining life of the debt security as an increase in the carrying value of the security. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB issued an accounting standard that requires disclosures about fair value of financial instruments not measured on the balance sheet at fair value in interim financial statements as well as in annual financial statements. Prior to this guidance, fair values for these assets and liabilities were only disclosed annually. This guidance applies to all financial instruments and requires all entities to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In June 2009, the FASB issued an accounting standard amending the accounting and disclosure requirements for transfers of financial assets. This guidance is effective for the Company beginning in 2010. Should the Company’s accounts receivable securitization programs not qualify for sale treatment under the revised rules, future securitization transactions entered into on or after January 1, 2010 would be classified as debt and the related cash flows would be reflected as a financing activity. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
In June 2009, the FASB updated an accounting standard regarding consolidation guidance which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance clarifies that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. This guidance requires an ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity. This guidance also requires additional disclosures about a company’s involvement in variable interest entities and any significant changes in risk exposure due to that involvement. This guidance is effective for fiscal years beginning after November 15, 2009. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In August 2009, the FASB issued an Accounting Standards Update (“ASU”) regarding measuring liabilities at fair value. This ASU provides additional guidance clarifying the measurement of liabilities at fair value in circumstances in which a quoted price in an active market for the identical liability is not available; under those circumstances, a reporting entity is required to measure fair value using one or more of valuation techniques, as defined. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In October 2009, the FASB issued an ASU regarding accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing. This ASU requires that at the date of issuance of the shares in a share-lending arrangement entered into in contemplation of a convertible debt offering or other financing, the shares issued shall be measured at fair value and be recognized as an issuance cost, with an offset to additional paid-in capital. Further, loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. This ASU is effective for fiscal years beginning on or after December 15, 2009, and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In November 2009, the FASB issued an ASU regarding accounting for stock dividends, including distributions to shareholders with components of stock and cash. This ASU clarifies that the stock portion of a distribution to shareholders that contains components of cash and stock and allows shareholders to select their preferred form of the distribution (with a limit on the amount of cash that will be distributed in total) should be considered a stock dividend and included in EPS calculations as a share issuance. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements
In December 2009, FASB issued ASU No. 2009-16, Accounting for Transfers of Financial Assets. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140.The amendments in this Accounting Standards Update improve financial reporting by eliminating the exceptions for qualifying special-purpose entities from the consolidation guidance and the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, the amendments require enhanced disclosures about the risks that a transferor continues to be exposed to because of its continuing involvement in transferred financial assets. Comparability and consistency in accounting for transferred financial assets will also be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
In December, 2009, FASB issued ASU No. 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This Accounting Standards Update amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R). The amendments in this Accounting Standards Update replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which reporting entity has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. An approach that is expected to be primarily qualitative will be more effective for identifying which reporting entity has a controlling financial interest in a variable interest entity. The amendments in this Update also require additional disclosures about a reporting entity’s involvement in variable interest entities, which will enhance the information provided to users of financial statements. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
In January 2010, FASB issued ASU No. 2010-01- Accounting for Distributions to Shareholders with Components of Stock and Cash. The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
In January 2010, FASB issued ASU No. 2010-02 - Accounting and Reporting for Decreases in Ownership of a Subsidiary - a Scope Clarification. The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity. The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. The Company does not expect the adoption of this ASU to have a material impact on the Company’s consolidated financial statements.
In January 2010, FASB issued ASU No. 2010-06 - Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. 2) Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarify existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income or cash flows.
Note 3 - Supplemental disclosure of cash flows
The Company prepares its statements of cash flows using the indirect method as defined under the FAS 95. The following information relates to non-cash investing and financing activities for the years ended December 31, 2009, 2008 and 2007.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Total interest paid amounted to $4,581,551, $4,441,698 and $2,326,267 for the years ended December 31, 2009, 2008 and 2007, respectively. Interest expense in the amount of $3,540,156, $2,114,498 and $980,154 was capitalized into construction in progress for the years ended December 31, 2009, 2008 and 2007, respectively.
Total income tax paid amounted to $7,612,524, $4,509,648 and $0 for the years ended December 31, 2009, 2008 and 2007, respectively.
For the year ended December 31, 2009, notes receivable in the amount of $91,754 was transferred as payment for purchase of equipments. Notes payable of $2,478,961 was transferred from accounts receivable in the amount of $721,198 and accounts payable of $1,757,763. Fixed asset of $55,001 was transferred as payment to accounts payable.
Note 4 - Accounts receivable
Accounts receivable consisted of the following:
The following table consists of allowance for bad debts:
Note 5 - Inventories
The following is a summary of inventories by major category:
As of December 31, 2009 and 2008, total inventory valuation allowance amounted to $8,896,863 and $0. All inventory valuation allowance is from the subsidiary Simo Motor acquired on October 2, 2009.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Note 6 - Advances on inventory purchases
The Company makes advances to certain vendors for inventory purchases. The advances on inventory purchases were $11,718,544 and $3,529,607 as of December 31, 2009 and 2008, respectively.
Note 7 - Plant and equipment
The following table presents details of our property and equipment:
Construction in progress represents labor costs, material, capitalized interest incurred in connection with the construction of the new plant facility in Shanghai and the construction and installation of manufacturing equipment in HTFE, Weihai and Simo Motor. The Company expects to complete the construction of Shanghai plant on or before the end of year 2010.
Depreciation expense for the years ended December 31, 2009, 2008 and 2007 amounted to $3,563,602, $1,608,724 and $567,069, respectively.
For the year ended December 31, 2009, 2008 and 2007, a total of $3,540,156, $2,114,498 and $980,154 of interest was capitalized into construction in progress, respectively.
Note 8 - Advances on non-current assets
Advance for intangible assets
The advances for intangible assets consisted of land use right prepayment. As of December 31, 2009 and 2008, advances for intangible assets amounted to $3,133,512 and $1,892,430, respectively.
On September 8, 2006, HTFE entered into an agreement ("Land Use Agreement") with Shanghai Lingang Investment and Development Company Limited ("Shanghai Lingang") with respect to HTFE’s use of 40,800 square meters of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the "Site"). The size of the land used by HTFE was later revised to a total of approximately 53,000 square meters. The term of the land use agreement is 50 years and the aggregate amount HTFE shall pay to Shanghai Lingang is approximately $6.28 million (RMB42,840,000) ("Fee"), approximately 93% or $5.85 million (RMB 39,880,000) has been paid, as of December 31, 2009, $2.72 million has been transferred from prepayment to land use rights, with the remaining balance payable in installment. HTFE shall register a Sino-foreign joint venture company at the location of Shanghai Lingang, with taxes payable at the same location. HTFE has agreed to compensate Shanghai Lingang for certain local taxes due to the local tax authority in connection with applicable tax generation requirements.
Advance to suppliers
The Company makes advances to certain vendors for construction projects. The advances on equipment and construction were $10,532,902 and $10,416,187 as of December 31, 2009 and 2008, respectively.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Note 9 - Goodwill and other intangible assets
Net intangible assets consist of the following at December 31:
Amortization expense for the years ended December 31, 2009, 2008 and 2007 amounted to $1,166,304, $1,032,674 and $510,023, respectively.
The Company uses the purchase method of accounting for business combinations. Annual testing for impairment of goodwill is performed during the fourth quarter of each year unless events or circumstances indicate earlier impairment testing is required. No impairment loss was recognized for 2009, 2008 and 2007.
Note 10 - Taxes payable
Taxes payable consisted of the following:
Note 11 - Financing
On August 29, 2006, the Company, Citadel Equity Fund Ltd. (“Citadel”) and Merrill Lynch International (“Merrill Lynch” and, together with Citadel, the “Investors”) entered a purchase agreement (the “Purchase Agreement”) relating to the purchase and sale of (a) $50 million aggregate principal amount of the Company's Guaranteed Senior Secured Floating Rate Notes (collectively, the “Notes”) and (b) fully detachable warrants (the “Warrants”) to purchase an aggregate of 3,487,368 shares of our common stock. The transaction closed on August 30, 2006.
The Notes are governed by an indenture, dated August 30, 2006, entered into among the Company, AEM as guarantor, and The Bank of New York, as trustee for the Notes (the “Indenture”). Of the $50 million aggregate principal amount of the Notes, Citadel subscribed to $38 million of the principal amount of the Notes, which were scheduled to mature on September 1, 2012 (the “2012 Notes”), and Merrill Lynch subscribed to $12 million of the principal amount of the Notes, which were scheduled to mature on September 1, 2010 (the “2010 Notes”). Pursuant to the indenture, AEM has agreed, and all of the Company’s other existing and future subsidiaries (other than subsidiaries domiciled in the People's Republic of China) are obligated, to guarantee, on a senior secured basis, to the Investors and to the trustee the payment and performance of our obligations under the Notes.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
The 2010 Notes bore interest, payable semi-annually in arrears commencing March 1, 2007, at a rate equal to LIBOR plus 4.75%. The 2010 Notes bore an additional 4% interest on any overdue principal and premium, if any, including interest on overdue interest, to the extent permitted by law.
The 2012 Notes bear interest, payable semi-annually in arrears commencing March 1, 2007, at a rate equal to LIBOR plus 3.35%. The 2012 Notes bear an additional 4% interest on any overdue principal and premium, if any, including interest on overdue interest, to the extent permitted by law.
On June 1, 2009, the Company and Citadel entered into a Letter Agreement (the “Citadel Agreement”). Pursuant to the Citadel Agreement, the Company was granted the option to repurchase, all (but not part), of the $26.5 million 2012 Notes held by Citadel before August 31, 2009 (“the Proposed 2012 Notes Repurchase”). On August 4, 2009, the Company notified Citadel that pursuant to the Citadel Agreement (i) the Company was exercising its option to consummate the Proposed 2012 Notes Repurchase and (ii) the Proposed 2012 Notes Repurchase shall be consummated on August 11, 2009 (the “Citadel Repurchase Date”) at an aggregate Citadel Repurchase Price of $23,131,997 to be paid in cash, which Repurchase Price shall be comprised of $22,525,000 representing 85% of the $26,500,000 aggregate principal amount of the 2012 Notes held by Citadel (the “Citadel Notes”) plus $606,997 representing accrued and unpaid interest on the Citadel Notes to but excluding the Repurchase Date. On August 11, 2009, the Company made cash payment in accordance with terms of the Citadel Agreement and recorded a gain of $3,975,000 from the repurchase transaction. After principal payment of $2,400,000 made on September 1, 2009, the 2012 Notes balance as of December 31, 2009 amounted to $7,660,210 (net of debt discount of $1,439,790), which will be fully paid off in 2010.
On July 14, 2009, the Company entered into a Letter Agreement with Merrill Lynch International and ABN AMRO Bank N.V., London Branch (the “Merrill Agreement”). Pursuant to the Merrill Agreement, the Company was granted the option to repurchase, all (but not part), of the remaining $6 million 2010 Notes held by Merrill Lynch International ($3 million) and ABN AMRO Bank N.V., London Branch ($3 million) before July 31, 2009. On July 31, 2009, the Company paid a total of $5,983,844 to repurchase the 2010 Notes, which amount was comprised of $5,820,000 representing 97% of the $6,000,000 aggregate principal amount of the 2010 Notes held by the Holders plus $163,844 representing accrued and unpaid interest on the 2010 Notes to but excluding the Repurchase Date. As of August 5, 2009, the repurchase have been completed and the 2010 Notes were cancelled and the Company recorded a gain of $180,000 from the repurchase transaction.
The following table disclosed the combined aggregate amounts of maturities for all the notes payable discussed above for each of the five years following December 31, 2009:
The Warrants are governed by a warrant agreement, dated August 30, 2006, between AEM and The Bank of New York, as warrant agent. The Warrants consist of (i) six-year warrants to purchase an aggregate of 2,192,308 shares of our common stock, at an exercise price of $7.80 per share (the “First Tranche 2012 Warrants”), (ii) six-year warrants to purchase an aggregate of 525,830 shares of our common stock at an exercise price of $10.84 per share (the “Second Tranche 2012 Warrants”) and (iii) three-year warrants to purchase an aggregate of 769,230 shares of our common stock at an exercise price of $7.80 per share (the “2009 Warrants”).
The First Tranche 2012 Warrants and the Second Tranche 2012 Warrants were issued to Citadel, and the 2009 Warrants were issued to Merrill. Each Warrant is exercisable at the option of the Warrant holder at any time through the maturity date of such Warrant.
The warrant agreements contain a cashless exercise provision. During the year ended December 31, 2009, 234,615 of 2009 Warrants outstanding were exercised by cashless transaction and 85,227 shares of common stock were issued upon this exercise. In addition, the remaining 1,428,846 of the First Tranche 2012 Warrants were exercised at price of $7.80.
The fair value of the warrants upon issuance totaled $22,921,113, was treated as a discount on the carrying value of the debt, and is being amortized over the life of the loan using the effective interest method. $10,949,344, $4,489,135 and $4,532,132 were amortized to interest expense for the years ended December 31, 2009, 2008 and 2007, respectively.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Debt issuance costs, initially $2,954,625, are carried in other assets and are amortized over the life of the loan using the effective interest method. $1,313,024, $542,438 and $542,438 were amortized to interest expense for the years ended December 31, 2009, 2008 and 2007, respectively. As of December 31, 2009 and 2008, unamortized debt issuance costs totaled $359,255 and $1,672,279, respectively.
Note 12 -Short term loans
The Company’s short term loans comprise of the following:
Short term loans - bank
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Short term loan - non controlling shareholders represent borrowing from its minority shareholders and amounted to $918,342 and $0 as of December 31, 2009 and 2008, respectively. All amounts are due within one year, uncollaterized and the amount will be paid in the form of cash.
The Company has short term loans from sources other than banks amounted to $5,229,653 and $0 as of December 31, 2009.
Long term loans - bank
The Company’s long term bank loan as of December 31, 2009 and 2008 are as follows:
The above loans are secured by the Company's plants, buildings, land use rights and inventories located within PRC, with carrying net value as follows:
Net interest expense for the years ended December 31, 2009, 2008 and 2007 was comprised of the following:
Note 13 - Due to original shareholders
Due to original shareholders represent the amount that was unpaid for the acquisition of Simo Motors and Wehai, which consisted of the following:
The amount due to Simo Motor original shareholders was paid in January 2010 in full. Amount due to Weihai original shareholders is due in July 2010, which is two years from the acquisition date of July 2008.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Note 14 - Derivative instrument
The Company's operations are exposed to a variety of global market risks, including the effect of changing currency exchange rates and interest rates. These exposures are managed, in part, with the use of a financial derivative. The Company uses financial derivatives only to hedge exposures in the ordinary course of business and does not invest in derivative instruments for speculative purposes.
Effective April 17, 2007, the Company entered into a cross currency interest rate swap agreement with Merrill Lynch exchanging the LIBOR plus 3.35% variable rate interest payable on the $38 million principle amount or 2012 Notes for a 7.2% (3.6% semi-annually) RMB fixed rate interest. The agreement required semi-annual payments on March 1 and September 1 through the maturity of the agreement on September 1, 2012. Merrill Lynch required the Company to deposit $1,000,000 with them to secure the agreement. The deposit may be increased to $2,500,000 if the exchange rate for RMB to USD falls below 6.5, and to $4,000,000 if the exchange rate falls below 5.5. This swap was designated and qualified as a cash flow hedge. The fair value of this swap agreement at April 02, 2007 (inception date) was a payable of $5,387,487, and on September 16, 2009 (the termination date), was a payable of $9,003,322, respectively. Changes in the fair values of derivative instruments accounted for as cash flow hedges, to the extent they qualify for hedge accounting, are recorded in accumulated other comprehensive income. For the years ended December 31, 2009, 2008 and 2007, the Company recorded $3,237,042 as loss and $5,081,414 as gain and $10,844,372 as loss on the derivative instrument, respectively, in other comprehensive income (loss).
Effective September 1, 2009, the whole original swap, with outstanding USD notional of 35,600,000 and outstanding CNY notional of 281,240,000 was unwind with $9,000,000 premium payment made to Merrill Lynch. As a result, $9,000,000 was transferred from the accumulated other comprehensive loss into earnings as a loss from termination of the swap. There were no amounts recorded in the consolidated statements of income in relation to ineffectiveness of this interest swap prior to unwind.
During the year ended December 31, 2009, the Company paid $1,299,764 as hedging payment and the Company recognized $1,123,778 of loss from derivative transactions.
Changes of cross currency hedge are as follows:
Note 15 - Additional product sales information
The Company has a single operating segment. The majority of the Company’s revenue was generated from local sales. Summarized financial information concerning the Company’s revenues based on geographic areas for the years ended December 31, 2009, 2008 and 2007 are as follows:
Note 16 - Business combinations
Acquisition of Xi’an Tech Full Simo Motor Co. Ltd.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
On October 2, 2009, HTFE entered into an Equity Acquisition Agreement (the “Agreement”) with Xi’an Simo Electric Co. Ltd. (“Xi’an Simo”) and Shaanxi Electric Machinery Association (“Shaanxi Electric” and collectively with Xi’an Simo, the “Selling Shareholders”) whereby HTFE agreed to acquire (i) 100% of the outstanding shares of Simo Motor, which is 99.94% owned by Xi’an Simo and 0.06% owned by Shaanxi Electric, and (ii) all corresponding assets of Simo Motor, including but not limited to, all of the manufacturing equipment, real-estate, land use rights, stocks, raw materials, automobiles, intellectual property, receivables, other receivables, payables, business contracts and external investments owned by Simo Motor for an aggregate price of approximately $111.6 million (RMB 763.2 million), payable in cash. The acquisition also included 15 wholly-owned and 8 majority-owned subsidiaries by Simo Motor. As a result, the Company’s ownership to Simo Motor and all subsidiaries averages to 87.2%. The remaining 12.8% is owned by noncontrolling shareholders. On October 13, 2009, the Company completed the acquisition of Simo Motor. As of the closing date, HTFE had completed the registration of the share transfer with the requisite PRC authorities and had obtained the required business registration and transfer of licenses of Simo Motor, all as contemplated by the Agreement. On October 13, 2009, Simo Motor changed its name to Xi’an Tech Full Simo Motor Co. Ltd.
The following table summarizes the net book value and the fair value of the assets acquired and liabilities assumed at the date of acquisition:
Based on an evaluation by an independent appraisal and final asset evaluation by the management, the purchase price exceeded the fair value of Simo Motor’s net assets by $41.8 million, which was recognized as goodwill, see Note 9 for detail.
Acquisition of Weihai Tech Full Simo Motors Co., Ltd.
On July 10, 2008, the Company’s subsidiary HTFE entered into an Equity and Assets Transfer Agreement (the “Agreement”) with respect to the acquisition by HTFE of Weihai Tech Full Simo Motors Co., Ltd., a PRC corporation (“Weihai”) for an aggregate price of approximately $54.7 million (RMB 375 million), payable in cash. In connection with the acquisition of Weihai by Harbin Tech Full, an independent third party appraiser was engaged by Harbin Tech Full to perform an appraisal of certain of the assets of Weihai to be acquired by the Company. The assets evaluated included fixed assets (equipment and buildings), construction in progress, and intangible assets (land-use rights). The appraiser conducted an on-site visit, inspected each item, conducted market research and investigation, followed some asset evaluation policies and regulations issued by the Chinese government, and provided an evaluation report. The Company’s management also performed an internal evaluation, taking into account of the appraiser’s evaluation report, to determine the fair value of these assets reported in the financial statements. For current assets, the management used the adjusted book value. Based on this evaluation, the management determined that the purchase price exceeded the fair value of Weihai’s net assets by $12.3 million, which was recognized as goodwill.
The following table summarizes the net book value and the fair value of the assets acquired and liabilities assumed at the date of acquisition:
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Based on an evaluation by an independent appraisal and final asset evaluation by the management, the purchase price exceeded the fair value of Weihai’s net assets by $12.3 million, which was recognized as goodwill, see Note 9 for detail.
For the above two acquisitions, the acquirer, HTFE and the acquired subsidiaries of the Company, engaged a third party independent appraiser to evaluate and determine the fair value of major assets acquired. The third party independent appraiser is a certified public accountant under the laws of PRC (the “PRC CPA”). The assets evaluated by the independent appraiser included fixed assets (equipment and buildings), construction in progress, and intangible assets (land use rights). The PRC CPA conducted an on-site visit, inspected each item, conducted market research and investigation and provided an evaluation report based on certain asset evaluation policies and regulations issued by the Chinese government. The Company’s management used the PRC CPA’s appraisal reports as a reference to assess the fair value of these assets and reported in the financial statements. For current assets, however, the management used the carrying value on the acquisition date.
Pro Forma
The following unaudited pro forma condensed income statement for the years ended December 31, 2009, 2008 and 2007 were prepared under generally accepted accounting principles, as if the acquisition of Weihai and Simo Motor had occurred the first day of the respective periods. The pro forma information may not be indicative of the results that actually would have occurred if the acquisition had been in effect from and on the date indicated.
Note 17 - Commitments and contingencies
The Company enters into non-cancelable purchase commitments with its vendors. As of December 31, 2009 and 2008, the Company was obligated under the non cancelable commitments to purchase materials totaling to $456,174 and $305,100, respectively. These commitments are short-term and expire within one year. The Company has experienced no losses on these purchase commitments over the years.
On April 9, 2007, the Company entered into an agreement with Shelton Technology, LLC. Under the terms of the agreement, the Company is required to contribute a total of $3 million in installments to AAG by March 31, 2009. The Company has invested a total of $2 million to AAG as of December 31, 2009 and has the remaining $1,000,000 to be invested. Based upon a mutual agreement, the Company will contribute the remaining $1,000,000 to AAG at a later date according to actual needs.
On September 8, 2006, HTFE entered into an agreement (“Land Use Agreement”) with Shanghai Lingang Investment and Development Company Limited (“Shanghai Lingang”) with respect to HTFE’s lease and use of 40,800 square meters of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the “Site”). The size of the land used by HTFE was later revised to a total of approximately 53,000 square meters. The term of the Land Use Agreement is 50 years and totaled $6.28 million (RMB 42.84 million) (“Fee”), approximately 93% or $5.85 million (RMB 39,880,000) of which has been paid with the balance to be paid in installments.
On August 10, 2009, AEM increased its investment capital in its 100% owned subsidiary HTFE from $57 million to $82 million. Of the $25 million increase in capital, $17 Million was paid prior to December 31, 2009 with the remaining $8 million of contribution payable by AEM to be paid prior to September 2011.
Note 18 - Earnings per share
FASB requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. The following is a reconciliation of the basic and diluted earnings per share computations:
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
For the years ended December 31, 2009, 2008 and 2007, a total of 260,000 options were excluded from diluted earnings per share due to the anti-dilutive effect. All other stock options and warrants have been included in the diluted earnings per share calculation for the years ended December 31, 2009, 2008 and 2007.
Note 19 - Shareholders’ equity
Common stock
On August 5, 2009, the Company closed an offering of 6,250,000 shares of its common stock at a public offering price of $16.00 per share. The Company received net proceeds of approximately $93.4 million from the offering, after deducting underwriting discounts and estimated offering expenses.
On August 17, 2009, the Company issued an additional 937,500 shares of common stock at the public offering price of $16.00 per share, pursuant to the over-allotment option exercised in full by Roth Capital Partners, LLC (“Roth”) in connection with its public offering that closed on August 4, 2009. The exercise of the over-allotment option brings the total number of shares sold by the Company in this public offering to 7,187,500 and the total gross proceeds to $115 million. The aggregate net proceeds received by the Company totaled approximately $107.5 million, after deducting underwriting discounts and commissions and offering expenses payable by the Company.
Statutory reserves
The laws and regulations of the People’s Republic of China require that before a Sino-foreign cooperative joint venture enterprise distributes profits to its partners, it must first satisfy all tax liabilities, provide for losses in previous years, and make allocations in proportions determined at the discretion of the board of directors, after the statutory reserve.
Surplus reserve fund
The Company is required to transfer 10% of its net income, as determined in accordance with the PRC accounting rules and regulations, to a statutory surplus reserve fund until such reserve balance reaches 50% of the Company’s registered capital. The transfer to this reserve must be made before distribution of any dividend to shareholders. The Company will transfer at year end 10% of the year’s net income determined in accordance with PRC accounting rules and regulations.
For the year ended December 31, 2009, the Company transferred $8,295,429 representing 10% of the current year’s net income generated by the Company’s subsidiaries located within PRC determined in accordance with PRC accounting rules and regulations, to this reserve. The remaining reserve to fulfill the 50% registered capital requirement amounted to approximately $49.7 million and $25.4 million as of December 31, 2009 and December 31, 2008, respectively.
The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issue is not less than 25% of the registered capital.
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
Warrants
Following is a summary of warrant activity:
Following is a summary of the status of warrants outstanding at December 31, 2009:
Options
On November 30, 2009, the Company granted options to an independent director to purchase an aggregate of 30,000 shares of the Company's common stock, at an exercise price of $20.02 per share, the closing price of the Company’ s common stock on November 30, 2009. The fair values of stock options granted to employees and the independent directors were estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:
Following is a summary of stock option activity:
Following is a summary of the status of options outstanding at December 31, 2009:
See report of independent registered public accounting firm.
HARBIN ELECTRIC, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
On July 12, 2007, the Company’s CEO transferred 280,000 of his own shares to the Company employees and consultants. The shares vest over 5 to 10 years starting July 12, 2007. The Company valued the shares at $13.73 per share, based on the average price for the immediately proceeding fifteen consecutive trading days before June 16, 2007, the date when the Company and HTFE entered into the asset purchase agreement with Harbin Taifu Auto Electric Co., Ltd, the trading price of the stock on the date of transfer, as a capital contribution totaling $3,844,904 by the CEO, the value was amortized over the vesting period.
For the years ended December 31, 2009, 2008 and 2007, stock compensation expense related to options issued amounted to $1,211,037, $1,782,454 and $1,584,234, respectively. As of December 31, 2009 and 2008, total unamortized stock compensation amounted to $2,849,347 and $3,247,571, respectively.
Note 20 - Employee pension
Regulations in the People’s Republic of China require the Company to contribute to a defined contribution retirement plan for all employees. All Joint Venture employees are entitled to a retirement pension amount calculated based upon their salary at their date of retirement and their length of service in accordance with a government managed pension plan. The PRC government is responsible for the pension liability to the retired staff. The employee pension in Harbin generally includes two parts: the first part to be paid by the Company is 20% of the employees’ actual salary in the prior year. If the average salary falls below $1,165 for each individual, $1,165 will be used as the basis. The other part, paid by the employees, is 8% of actual salary with the same minimum requirement. The Company made contributions to employment benefits, including pension, of $334,394, $261,847 and $53,027 for the years ended December 31, 2009, 2008 and 2007, respectively.
Note 21 - Subsequent Events
In January 2010, HTFE made a cash payment in an amount of $27.9 million (RMB 190.5million) representing the unpaid portion for the acquisition of Simo Motor. The acquisition of Simo Motor is fully paid for after this payment pursuant to the Equity Acquisition Agreement.
The Company has performed an evaluation of subsequent events through the date these consolidated financial statements were issued to determine whether the circumstances warranted recognition and disclosure of those events or transactions in the consolidated financial statements as of December 31, 2009.
Note 22 - Quarterly Data (Unaudited)
See report of independent registered public accounting firm.