ITEM 1. BUSINESS
Overview
We are a Nevada holding company operating in the materials technology industry through our subsidiaries in China. We develop, manufacture and sell a broad range of mineral-based, heat-resistant products capable of withstanding high temperatures, saving energy and boosting productivity in industries such as steel and oil. Our products include refractory products, industrial ceramics, fracture proppants and fine precision abrasives.
Currently, we conduct our operations in China through our wholly owned subsidiaries, Henan GengSheng Refractories Co., Ltd. (“Refractories”), Zhengzhou Duesail Fracture Proppant Co., Ltd. (“Duesail”), Henan GengSheng Micronized Powder Materials Co., Ltd. (“Micronized”), Guizhou Southeast Prefecture GengSheng New Materials Co., Ltd. (“Prefecture”) and Henan Yuxing Proppant Co., Ltd., (“Yuxing”) , and through our majority owned subsidiary, Henan GengSheng High-Temperature Materials Co., Ltd. (“High-Temperature”). Through our wholly owned BVI subsidiary, GengSheng International, and its wholly owned Chinese subsidiary, Refractories, which has an annual production capacity of approximately 127,000 tons, we manufacture refractories products. We manufacture fracture proppant products through Duesail, which has an annual production capacity of approximately 66,000 tons, and Yuxing, which has designed annual production capacity of approximately 60,000 tons. We manufacture fine precision abrasives products through Micronized, which has designed annual production capacity of approximately 22,000 tons. Through our majority owned subsidiary, High-Temperature, which has an annual production capacity of approximately 150,000 units, we manufacture industrial and functional ceramic products.
We sell our products to over 170 customers in the iron, steel, oil, glass, cement, aluminum, chemical and solar industries located in China and other countries in Asia, Europe and North America. Our refractory customers are companies in the steel, iron, petroleum, chemical, coal, glass and mining industries. Our fracture proppant products are sold to oil and gas companies. Our industrial ceramics are used in the utilities and petrochemical industries. Our fine precision abrasives are marketed to solar companies and optical equipment manufacturers. Our largest customers, measured by percentage of our revenue, mainly operate in the steel industry and oil industry. Currently, most of our revenues are derived from the sale of our monolithic refractory products and fracture proppants products to customers in China and in the United States.
Our principal executive offices are located at No. 88 Gengsheng Road, Dayugou Town, Gongyi, Henan, People’s Republic of China 451271 and our telephone number is (86) 371-6405-9818.
Available Information
We are required to file annual, quarterly and current reports, proxy statements and other information required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s Public Reference Room located at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet website at http://www.sec.gov, from which interested persons can electronically access our SEC filings.
We make available free of charge through our internet site http://www.gengsheng.com our annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; proxy statements, if any, Forms 3, 4 and 5 filed by or on behalf of directors, executive officers and certain large stockholders; and any amendments to those documents filed or furnished pursuant to the Exchange Act. These filings will become available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.
In addition, the following information is available on the Investor Relations page of our website: (i) Corporate Governance and (ii) Quarterly Results. These documents will also be available in print without charge to any person who requests them by writing or telephoning our principal executive offices: China GengSheng Minerals, Inc. No.88 Gengsheng Road, Dayugou Town, Gongyi, Henan, 451271, P.R. China, Tel: ((86) 371-6405-9818, Fax: ((86) 371-6405-9846. The information posted on our website is not incorporated into this annual report on Form 10-K.
Corporate Structure
We conduct our operations in China through our wholly owned subsidiaries, Refractories, Duesail, Yuxing, Micronized and Prefecture and through our majority owned subsidiary, High-Temperature.
The following chart reflects our organizational structure as of the date of this report.
Corporate History
We were originally incorporated under the laws of the State of Washington, on November 13, 1947, under the name Silver Mountain Mining Company. From our inception until 2001, we operated various unpatented mining claims and deeded mineral rights in the State of Washington, but we abandoned these operations entirely by 2001. On August 15, 2006, we changed our domicile from Washington to Nevada when we merged with and into Point Acquisition Corporation, a Nevada corporation. From about 2001 until our reverse acquisition of Powersmart on April 25, 2007, which is discussed in the next section entitled "Acquisition of Powersmart and Related Financing", we were a blank check company and had no active business operations. On June 11, 2007, we changed our corporate name from "Point Acquisition Corporation" to "China Minerals Technologies, Inc." and subsequently changed our name again to "China GengSheng Minerals, Inc." on July 26, 2007.
Acquisition of Powersmart and Related Financing
On April 25, 2007, we completed a reverse acquisition transaction through a share exchange with Powersmart Holdings Limited whereby we issued to the sole shareholder of Powersmart Holdings Limited, Shunqing Zhang, 16,887,815 shares of China GengSheng Minerals, Inc. common stock, in exchange for all of the issued and outstanding capital stock of Powersmart Holdings Limited. By this transaction, Powersmart Holdings Limited became our wholly owned subsidiary and Mr. Zhang became our controlling stockholder.
On April 25, 2007, we also completed a private placement financing transaction pursuant to which we issued and sold 5,347,594 shares of our common stock to certain accredited investors for $10 million in gross proceeds. In connection with this private placement, we paid a fee of $683,618 to Brean Murray Carret & Co., LL, or Brean Murray, and Civilian Capital, Inc. for services as placement agents for the private placement. We also issued to Brean Murray Carret & Co., LLC and Civilian Capital, Inc. warrants for the purchase of 374,331 shares of our common stock in the aggregate. The warrants are immediately exercisable, have piggyback registration rights and have a three-year term, expiring on April 26, 2010. On March 10, 2010, Brean Murray Carret & Co., LLC exercised the warrant cashlessly, which was converted to 108,349 shares of the Corporation’s common stock, and on April 21, 2010, Civilian Capital, Inc. exercised the warrant cashlessly, which was converted to 27,869 shares of the Corporation’s common stock.
Also, on April 25, 2007, our majority stockholder, Shunqing Zhang, entered into an escrow agreement with the private placement investors, pursuant to which, Mr. Zhang agreed to deposit in an escrow account a total of 2,673,796 shares of the Company's common stock owned by him, to be held for the benefit of the investors. Mr. Zhang agreed that if the Company did not attain a minimum after-tax net income threshold of $8,200,000 for the fiscal year ended December 31, 2007 and $13,500,000 for the fiscal year ending December 31, 2008, the escrow agent may deliver his escrowed shares to the investors, based upon a pre-defined formula agreed to between the investors and Mr. Zhang. However, if the after-tax net income threshold is met, the shares in escrow will be returned to Mr. Zhang. In addition, on April 25, 2007, Mr. Zhang entered into a similar escrow agreement with HFG International, Limited. Under such agreement, Mr. Zhang placed into escrow a total of 638,338 shares of the Company's common stock to cover the same minimum net income thresholds as described above with respect to the investor make-good. Similarly, if the thresholds were not achieved in either year, the escrow agent must release certain amounts of the make-good shares that were put into escrow. We met the after-tax net income threshold of $8,200,000 for the fiscal year ended December 31, 2007 and the pro rata shares in escrow were returned to Mr. Zhang, while we did not meet the after-tax net income threshold of $13,500,000 for the fiscal year ended December 31, 2008, and the pro rata shares in escrow were transferred to the investors on March 8, 2010.
On January 4, 2011, the Company and certain institutional investors entered into a securities purchase agreement pursuant to which the Company sold to such investors an aggregate of 2,500,000 shares of common stock at a price of $4.00 per share for aggregate gross proceeds to the Company of $10,000,000. Each purchaser received warrants, exercisable for $4.00 per share for the six-month period beginning July 10, 2011 and ending January 11, 2012, to purchase 40% of the shares of common stock purchased by the purchaser in the offering. The net proceeds from the offering was approximately $9,350,000. The Company paid an aggregate fee equal to 5.5% of the gross proceeds received to Rodman & Renshaw, LLC for services as placement agent. The shares of common stock, warrants to purchase common stock and shares of common stock issuable upon exercise of the investor warrants were issued pursuant to a prospectus supplement dated as of January 10, 2011, which was filed with the Securities and Exchange Commission in connection with a takedown from the Company’s shelf registration statement on Form S-3 (File No. 333-165486), which became effective on April 28, 2010, and the base prospectus dated as of April 28, 2010 contained in such registration statement.
Segmental Information
Our operating segments are functioned by our manufacturing facilities and include four reportable segments: refractories, industrial ceramics, fracture proppants and fine precision abrasives.
For financial information relating to our business segments, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 23 to the consolidated financial statements appearing elsewhere in this annual report. For a discussion of the risks attendant to our foreign operations and of any dependence on one or more of the Company’s segments upon such foreign operations, please see Item 1A, “Risk Factors”.
Our Products and Markets
The following table set forth sales information about our product mix in each of the last two years.
(All amounts, other than percentages, in thousands of U.S. dollars)
Refractories
Our largest product segment is the refractories segment, which accounted for approximately 60.5% of total revenue in 2011. Our refractory products have high-temperature resistant qualities and can function under thermal stress that is common in many heavy industrial production environments. Because of their unique high-temperature resistant qualities, the refractory products are used as linings and key components in many industrial furnaces, such as steel production furnaces, ladles, vessels, and other high-temperature processing machines that must operate at high temperatures for a long period of time without interruption. The majority of our customers are in the iron, steel, cement, chemical, coal, glass, petro-chemical and nonferrous industries.
We provide a customized solution for each order of our monolithic refractory materials based on customer-specific formulas. Upon delivery to customers, the monolithic materials are applied to the inner surfaces of our customers’ furnaces, ladles or other vessels to improve the productivity of that equipment. The product benefits our customers as it lowers the overall cost of production and improves financial performance. The reasons that the monolithic materials can help our customers improve productivity, lower production costs and achieve stronger financial performance include the following: (i) monolithic refractory castables can be cast into complex shapes which are unavailable or difficult to achieve by alternative products such as shaped bricks; (ii) monolithic refractory linings can be repaired, and in some cases, even reinstalled, without furnace cool-down periods or steel-production interruptions, and therefore improve the steel makers’ productivity; (iii) monolithic refractories can form an integral surface without joints, enhancing resistance to penetration, impact and erosion, and thereby improving the equipment’s operational safety and extending their useful service lives; (iv) monolithic refractories can be installed by specialty equipment either automatically or manually, thus saving construction and maintenance time as well as costs; and (v) monolithic refractories can be customized to specific requirements by adjusting individual formulas without the need to change batches of shaped bricks, which is a costly procedure. Our refractory products and their features are described as follows:
Castable, coating, and dry mix materials. Offerings within this product line are used as linings in containers such as a tundish used for pouring molten metal into a mold. The primary advantages of these products are speed and ease of installation for heat treatment.
Low-cement and non-cement castables. Our low-cement and non-cement castable products are typically used in reheating furnaces for producing steel. These castable products are highly durable and can last up to five years.
Pre-cast roofs. These products are usually used as a component of electric arc furnaces. They are highly durable, and in the case of our corundum-based, pre-cast roof, products can endure approximately 160 to 220 complete operations of furnace heating.
We also have a production line for pressed bricks, which is a type of “shaped” refractory, for steel production. The annual designed production capacity of our shaped refractory products is approximately 15,000 metric tons.
Finally, we provide a full-service option to our steel customers, which include refractory product installation, testing, maintenance, repair and replacement. Refractory products sales are often enhanced by our on-site installation and technical support personnel. Our installation services include applying refractory materials to the walls of steel-making furnaces and other high temperature vessels to maintain and extend their lives. Our technical service staff assure that our customers can achieve their desired productivity objectives. They also measure the refractory wear at our customer sites to improve the quality of maintenance and overall performance of our customers’ equipment. Full-service customers contributed approximately 32.0% of the Company’s total sales in 2011, compared with 46.6% in 2010. We believe that these services, together with our refractory products, provide us a strategic advantage for profits.
Industrial Ceramics
Industrial Ceramics accounted for approximately 0.6% of the total revenue in 2011. Our industrial ceramic products, including abrasive balls and tiles, valves, electronic ceramics and structural ceramics, are components for a variety of end products such as fuses, vacuum interrupters, electrical components, mud slurry pumps, and high-pressure pumps. Such end use products are used in the electric power, electronic component, industrial pump, and metallurgy industries.
Fracture Proppants
Fracture Proppants accounted for approximately 29.3% of the total revenue in 2011. Our fracture proppant products are very fine ball-like pellets, used to reach pockets of oil and natural gas deposits that are trapped in the fractures under the ground. Oil drillers inject the pellets into those fractures, squeezing out the trapped oil or natural gas, which leads to higher yield. Our fracture proppant products are available in several different particle sizes (measured in millimeters). They are typically used to extract crude oil and natural gas, which increases the productivity of crude oil and natural gas wells. These products are highly resistant to pressure. In October 2007, our fracture proppant products were recognized by China National Petroleum Corporation (the “CNPC”), China Petroleum & Chemical Corporation (the “Sinopec”) and the China National Offshore Oil Corporation (the “CNOOC”) as their supplier of fracture proppant products for their oil and gas-drilling operation.
Fine Precision Abrasives
Fine Precision Abrasives accounted for 9.6% of our total revenue in 2011. Fine precision abrasives are used for producing a super-fine, super-consistent finish on certain products. A high-strength polyester backing provides a uniform base for a coating of micron-graded mineral particles that are uniformly dispersed for greater finishing efficiency. Our fine precision abrasives are made from silicon carbide (“SiC”). They are ultra-fine, high-strength pellets with uniform shape, and are used for surface-polishing and slicing of precision instruments such as solar panels. Currently, the type of abrasives that we produce is in high demand among solar-energy companies. Solar energy companies use fine precision abrasives to cut silicon bars and to polish equipment surfaces so that they can be smooth and reflective. Our products can be utilized in a broad range of areas including machinery manufacturing, electronics, optical glass, architecture, industry development, semiconductor, silicon chip, plastic and lens.
Our Competition Strength and Challenges
With over 1,500 manufacturers in China, the refractory market in which we compete is highly fragmented and highly competitive. In each of our product segments, there is at least one major competitor. Many of our products are made to industry specifications and may be interchangeable with our competitors’ products. Some of our competitors are large and well-established companies, such as Puyang Refractories Co., Ltd., Wuhan Ruisheng Specialty Refractory Materials Co., Ltd., and Beijing Lirr Refractories Co., Ltd., and their financial resources and ability to gain market share may be greater than ours, which limits our pricing power in the market. Due to the diversity of our product offering, we believe that we still enjoy a competitive advantage as many of our competitors do not offer the entire spectrum of our product line.
Refractories and Industrial Ceramics
Through our wholly-owned Chinese subsidiaries Refractories and High-Temperature, we manufacture refractory products and industrial ceramic products in China. We are well positioned to compete in the refractories segment and the industrial ceramics segment, because of our long-standing business relationships with major steel companies, the quality and diversity of our products and our competitive price.
We have distinguished ourselves through our customer service team that provides a full range of refractory services, including refractory construction, on-site maintenance and technical support. Our national registered laboratory with high-quality research team meets our customer’s diverse product requirements in a timely manner based on the differences of construction sites. Our products compete on efficient operations, price differential and our quality of service.
Most of our large customers, measured by percentage of our revenue, operate in the steel industry. The steel industry is characterized by intense price competition, which results in continuing emphasis on our need to increase product productivity and performance. Our strategy has been to fulfill the steel industry’s need by developing technologically advanced refractory products to help our customers increase their productivity. We believe that the trend towards greater productivity in the highly competitive steel industry will continue to provide a growing opportunity for our products, especially monolithic refractories.
Fracture Proppants
We first started production of fracture proppant products in December 2006, through our wholly-owned BVI subsidiary, GengSheng International, and its wholly-owned Chinese subsidiary, Duesail. Our products have passed the testing conducted by China Petroleum and Chemical Industry Association (the “CPCIA”), which strengthens our competitiveness in the market compared to our competitors. We were recognized as their fracture proppant supplier by China National Petroleum Corporation (CNPC), China Petroleum & Chemical Corporation (Sinopec) and China National Offshore Oil Corp. (CNOOC), who monopolize the oil and gas drilling business in China, and we are the signed provider for China National Offshore Oil Corp. (CNOOC). Our main competitors for the production of fracture proppants are Carbo Ceramics Inc. and Saint-Gobain Proppants (Guanghan) Co., Ltd, while these two companies are both subsidiaries of international magnates, which focus on international sales. In April 2009, we doubled our production capacity of Duesail to 66,000 tons and the new production line at Duesail can provide wide range of products, sizing from 52M Pa, 69M Pa to 86M Pa and 102M Pa. On July 19, 2011, we finished construction of the second fracture proppant manufacturing facility in Gongyi, Henan Province. The new facility is expected to increase the Company’s annual proppant manufacturing capacity by 60,000 tons to 126,000 tons.
Fine Precision Abrasives
We finished construction of the facility and started trial production for fine precision abrasives in July 2009, and commercially launched the abrasives products through our wholly-owned BVI subsidiary, Gengsheng International Corporation, and its wholly-owned Chinese subsidiary Micronized. Our fine precision abrasives facility is designed to have a production capacity of 22,000 tons per year. Our products can be used in wire slicing of solar ingots for solar cell makers to make wafers and polishing surface of solar panels or high-precision instruments. Our main competitors are two Japanese companies, namely Nanxing and FUJIMI, which currently have the largest share of the fine precision abrasives market in China. We started commercial production in 2010 and signed a long-term contract with one of the main players in solar industry in China to supply our products in 2011.
Overall, we believe that our competitive strengths include the following:
Market Position. We believe that we hold a competitive position in the monolithic refractory marketplace. According to the most recent Chinese steel industry publication available, during 2010, total national sales were approximately 36 billion, 70% of which were from refractories applied in steel making, of which 73% is monolithic refractories. The industry is highly competitive and consists of more than 2,000 manufacturers. However, we believe our well recognized “GengSheng” brand, leading position in research and development and full-service business model place us in a strong competitive position in the monolithic refractory market. We have broad customer base, good recognition of the “GengSheng” brand, flexible manufacturing capabilities and easily accessed distribution channels. These capabilities enable us to introduce new refractory product categories to our customers efficiently and cost-effectively.
Broad Product Offering. Our refractory product segment offers over 25 product categories that cover a wide range of customer specifications for use in the iron and steel manufacturing industries, in industrial furnaces and other heavy machinery. Our broad product offerings allow us to offer our customers a single-source solution for many of their refractory product requirements.
Diversified End Market/Customer Base. We sell our refractory products in over 25 provinces in China and 11 overseas countries. In 2011, we had over 170 customers for the refractories segment, and none of them accounted for more than 20% of our 2011 net sales. Our largest customer in refractories segment, Shandong Steel Co., Ltd, Rizhao Subsidiary accounted for 11.1% of 2011 net sales. Our broad product line and diversified target markets and customer base have contributed to greater stability in our sales and operating profit margin. We have long term relationships with steel and iron industry leaders in China, such as Shangdong Steel, Anshan Steel and Bao Steel.
Experienced Management Team. Our senior management team has an average of over 20 years of experience in the refractory industry and with the company.
Access to Raw Materials. We are located in Gongyi, Henan Province, an area of China which has abundant reserve of bauxite and other key raw materials used in refractory manufacturing. We have diversified our access to raw materials by acquiring Guizhou, a subsidiary of our wholly own subsidiary Refractories, to secure and stabilize the supply and the price of raw materials. Guizhou has access to bauxite reserve and provided processed raw material for Refractories. It is currently not in operation due to the electricity shortage in the area, but we can resume operation anytime if we need to further secure and stabilize the supply and the price of raw materials.
Research and Development Capabilities. We utilize our research and development capabilities to supply our customers with cutting edge refractory products designed to meet their specific demands. To achieve the highest quality product developments, we established a modern, state-of-the-art laboratory in China dedicated to quality control and testing.
Maintenance Service Capabilities. We dedicate over 300 employees to the installation and service of our products at the client sites. This service contributes greatly to positive business relationship with our customers and makes our products more attractive and competitive.
Our Customers
We have over 170 customers in 25 Chinese provinces, as well as in greater Asia, North America and Europe. Our customers include some of the largest steel and iron producers and petroleum and chemical producers in China and elsewhere. During 2011, two of our customers, Shanghai Jolly Trading Co., Ltd (“Jolly”) and Shandong Steel Co., Ltd, Rizhao Subsidiary (“Rizhao”) represented 10% or more of our consolidated sales. Our sales to Jolly amounted to $10.9 million or 14.1% of our revenue and sales to Rizhao amounted to $8.5 million or 11.1% of our revenues. Two of our customers, Rizhao and AMSAT International Co., (“AMSAT”) represented 10% or more of our consolidated sales in 2010. Our sales to Rizhao were $9.0 million or 14.5% of our revenues and sales to AMSAT were $6.5 million or 10.4% of our revenues for 2010.
During 2011, our top ten customers among our segmental lines, which are listed below, accounted for approximately 63.9% of our consolidated revenues.
Our Top 10 Customers
(As of December 31, 2011)
Our Suppliers of Raw Materials
The principal raw materials used in our refractory products and fracture proppants products are various forms of aluminum oxide, including bauxite, corundum, processed AI203, magnesia, calcium aluminates cement, resin, and silica. Bauxite is used in the production of refractory materials, fracture proppants products and some industrial ceramic products. Bauxite is abundantly available from mines close to our manufacturing facilities. We purchase a significant portion of our magnesia requirements from sources in Liaoning Province. If we experience supply interruptions of our raw materials, we believe that we could still obtain adequate supplies from alternate sources in local areas or elsewhere in China. However, we may incur higher costs related to transportation and storage. The average costs of some of our raw materials from 2010 to 2011 are as follows:
We typically have supply agreements with terms of one to two years that do not impose minimum purchase requirements. The cost of raw materials purchased during the term of a supply agreement usually is the market price for the raw materials at the time of purchase. Our centralized procurement system helps to reduce raw material costs. We generally are not engaged in speculative raw material commodity contracts and attempt to reflect raw material price changes in the sale price of our products. Our ability to achieve anticipated operating results depends in part on having an adequate supply of raw materials for our manufacturing operations. Because of our strategy to maintain multiple suppliers for each material we source, we do not particularly rely on one single supplier.
Our Sales and Marketing
Our sales and marketing group is comprised of over 100 employees who focus on managing specific product lines across several distribution channels. Our marketing process involves an integrated process of sales leads screening, bidding and negotiating and executing definitive sales agreements.
To maximize the accessibility of our products to a diverse group of end users, we market our products through a variety of distribution channels. We have separate sales and marketing groups that work directly with our customers in each of our target market. Marketing and sales are accomplished through the mailing of brochures, industry trade advertising, trade show exhibitions, online sales and sales presentations.
Our Growth Strategy
The key elements of our growth strategy are summarized as follow:
Adjust Cost Structure Through Operating Efficiency and Productivity Improvements. We regularly evaluate our operating productivity and efficiency and focus on reducing our manufacturing and distribution costs. We have planned to further utilize internal capacity for new refractory product developments while continuing to meet customers’ needs throughout our supply chain. We believe that these initiatives will provide significant costs savings and improve operating profits.
Expand Product Lines and Specialty Product Lines. We seek to identify, develop and commercialize new products that use our core technology. In particular, we intend to develop a variety of specialty, high margin mineral-based products, including fracture proppant products and fine precision abrasives.
Pursue Sales Opportunities in Existing and New Markets. We believe that we have significant growth opportunities by increasing our penetration within our existing customer base, adding new customers, further expanding product offering, and pursuing additional marketing channels. In addition to continuing to target leading steel and iron manufacturers for refractory products, we have been receiving contracts from major oil & chemical manufacturers, large wholesalers and solar producer in China who started business with us for our proppant products and fine precision abrasives.
Selectively Pursue Strategic Acquisitions. As a strong competitor in our core refractory manufacturing market, we believe that we are well-positioned to benefit from the consolidation of manufacturers in these markets. We also believe that our management has the ability to identify and integrate strategic acquisitions. We will continue to selectively pursue acquisitions that will improve our market position within our existing target markets, expand our product offerings, and increase our manufacturing efficiency.
Expand International Operations. We are expanding operations to overseas market to increase our presence and our sales efforts in countries outside China. When opportunity arises, we will consider setting up sales office in our main overseas market to better serve our customer.
Regulation
Because our operations are based in China, we are regulated by the national and local laws of the People’s Republic of China. The refractory materials industry is generally subject to national, local laws and regulations related to the environment, health, and safety. The manufacturing of refractory materials involves the release of powder and dust which are classified as environmental pollutants under applicable government laws and regulations. We regularly monitor and review our operations, procedures, and policies for compliance with these laws and regulations. We have made substantial capital investments in our facilities to ensure compliance with environmental and regulatory laws. We believe that our operations are in substantial compliance with the laws and regulations and that there are no violations that would have a material effect on us. The cost of compliance with these laws and regulations is not expected to have a large financial impact on us.
There is no private ownership of land in China. All land ownership is held by the government of the PRC, its agencies and collectives. Land use rights can be obtained from the government for a period up to 50 years, and are typically renewable. Land use rights can be transferred upon approval by the land administrative authorities of the Chinese State Land Administration Bureau upon payment of the required land transfer fee. We have obtained land use right for our primary operating facility located at No. 88 Gengsheng Road, Dayugou Town, Gongyi, Henan Province, our operating facilities of Refractories and High-temperature, and in the process of obtaining land use rights for other manufacturing facilities.
In addition, we are also subject to PRC’s foreign currency regulations. The PRC government has control over Renminbi reserves through, among other things, direct regulation of the conversion of Renminbi into other foreign currencies. Although foreign currencies which are required for “current account” transactions can be bought freely at authorized Chinese banks, the proper procedural requirements prescribed by Chinese law must be met. At the same time, Chinese companies are also required to sell their foreign exchange earnings to authorized Chinese banks and the purchase of foreign currencies for capital account transactions still requires prior approval of the Chinese government.
We do not face any significant government regulation in connection with the production of our products. We do not need any special government permits to produce our products other than those permits that are required of all corporations in China.
Our Intellectual Property
While we consider our patents and trademarks valuable assets, we do not consider any single patent or trademark to be of such material importance that its absence would harm or cause a material disruption of our business. We also consider the production of our refractories to involve proprietary know-how, and we adjust and test the specific composition formulas to ensure optimal product performance.
Patents
We currently own sixty two Chinese patents which are approved by and registered with the China State Intellectual Property Office. The following table lists part of our important patents:
In addition, we have 27 pending patent applications with the China State Intellectual Property Office.
Trademarks
We also own the following registered trademark associated with the brand “GengSheng” that were issued by the State Industrial and Commercial Administration Bureau of the PRC.
Trademark Registered Number Termination Date Use
March 6, 2020 Used for refractories catalogued
as class number 19
Our Research and Development Activities
We believe that the development of new products and new technology is critical to our success. We are continuously working to improve the quality, efficiency and cost-effectiveness of our existing products and develop technology to expand the range of specifications of our products.
We have spent $699,367 and $817,179 on Company-sponsored research and development activities in fiscal years 2011 and 2010 respectively. The expenses on research and development include salary, cost of raw material consumed, testing expenses and other costs incurred for research and development of potential new products. We do not have any customer-sponsored research and development activities.
Litigation
From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. We are currently not a party to any legal proceeding and are not aware of any legal claims that we believe will have a material adverse affect on our business, financial condition or operating results.
Our Employees
As of December 31, 2011, we had approximately 1,300 employees, all of whom are salaried employees and members of a labor union. Approximately 5% of our employees hold a bachelor’s degree, and approximately 1% of our employees hold a master’s degree. We actively recruit our employees from the local market and expect to focus our recruiting efforts on candidates holding bachelor degree in material science, refractory materials and marketing as we implement our expansion plans. We have implemented a comprehensive training program for our employees that focus not only on skills and knowledge for their specific duties, but also on our corporate culture and core values.
Our employees participate in a mandated state pension scheme and social insurance programs managed by Chinese municipal and provincial governments which cover pensions, unemployment and injury insurance. We are required to contribute to the scheme at a rate of 20% of the average monthly salary for employee pensions, 1% of the average monthly salary for the state unemployment fund and 1% of the average monthly salary for injury insurance. Our compensation expenses related to this scheme were $466,371 and $324,810 for the years ended December 31, 2011 and 2010, respectively.
Our Chinese subsidiaries have labor unions which protect employees’ rights, assist in the fulfillment of our economic objectives, encourage employee participation in management decisions and assist in mediating disputes between us and union members. We believe that we maintain a satisfactory working relationship with our employees and we have not experienced any significant labor disputes or any difficulty in recruiting staff for our operations.
China enacted a new Labor Contract Law, which became effective on January 1, 2008. We have updated our employment contracts and employee handbook and been in compliance with the new law. We will work with the employees and the labor union to ensure that the employees obtain the full benefit of the law. We do not anticipate that changes in the law will materially impact our financial results.
ITEM 1A.
ITEM 1A. RISK FACTORS
The market price of our common stock could fluctuate substantially due to a variety of factors, including market perception of our ability to achieve our planned growth, quarterly operating results of other companies in the same industry, trading volume in our common stock, changes in general conditions in the economy and the financial markets or other developments affecting our competitors or us. In addition, the stock market is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market price of securities issued by many companies for reasons unrelated to their operating performance and could have the same effect on our common stock.
RISKS RELATED TO OUR BUSINESS
The slow recovery from the global economic crisis could affect the overall availability and cost of external financing for our operation.
The slow recovery of the global financial markets from the global economic crisis and turmoil may adversely impact our business, the business and financial condition of our customers and the business of potential investors from whom we expect to generate our potential sources of capital financing. Presently it is unclear to what extent the economic stimulus measures and other actions taken or contemplated by the Chinese governments and other governments throughout the world will mitigate the effects of the negative impact caused by the economic turmoil on our industry and other industries that affect our business. Although these conditions have not presently impaired our ability to access credit markets and finance our operations, the impact of the current crisis on our ability to obtain capital financing in the future, and the cost and terms of same, is unclear.
A downturn or negative changes in the highly volatile steel and iron industry will harm our business and profitability.
The iron and steel industries accounted for approximately 60% to 70% of the consumption in the Chinese refractory industry according to the industry association statistics. Because our largest customers are in the steel industry, our business performance is closely tied to the performance of the steel industry. The sector as a whole is cyclical and its profitability can be volatile as a result of general economic conditions, labor costs, competition, import duties, tariffs and currency exchange rates. These macroeconomic factors have historically resulted in wide fluctuations in Chinese and global economies in which steel companies sell their products. In our case, future economic downturns, stagnant economies or currency fluctuations in China or globally could decrease the demand for steel products both in China and overseas and, in turn, could negatively impact our sales, margins and profits.
Industry growth rate for refractory products may decelerate and may affect our future revenue growth.
In China, the production of refractory materials has experienced fast growth in recent years driven largely by growth in China’s steel production. China has become the largest country for producing and consuming refractories, among which 60% to 70% were demanded by companies in the steel industry. Our industry’s growth has been primarily driven by the growth in the Chinese steel industry. According to figures provided by World Steel Association, Chinese steel output grew from an annual output of 157 million tons in 2001 to 696 million tons in 2011, representing a compounded average growth rate of 14.5% . Going forward, however, the forecast provided by the China International Capital Corporation suggests that the annual output of steel in China will not maintain this growth rate.
If the steel industry experiences such a slowdown, our growth prospects will likewise be curtailed. Additionally, the market for monolithic refractories in China is still in the developmental stage, and successful market penetration of the monolithic refractories depends heavily on two factors. First, successful market penetration depends on technological progress that results in products that provide better performance by our customers, new varieties of products that meet our customer’s future requirements, and more efficient and effective installation and maintenance methods. Second, successful market penetration also depends on our marketing strategy and our ability to execute that strategy while maintaining a high quality of service to our customers. Our future revenue growth without acquisitions may maintain, but nevertheless, we may not match our past growth rate.
Our inability to overcome fierce competition in the highly fragmented and highly competitive Chinese refractory market could reduce our revenue and net income.
The refractory market in China is highly fragmented with over 2,000 producers of refractory products, according to the Chairman of the Association of China Refractory Industry. Our competitors manufacture products that are similar to and directly compete with the products that we manufacture and market. We compete with many other refractory manufacturers in China, on a region-by-region basis, and with international competitors on a world-wide basis. Our main competitors are located in China and include Puyang Punai High-temperature Materials Co., Ltd., Wuhan Ruisheng Specialty Refractory Materials Co., Ltd., Beijing Lirr Refractories Co., Ltd. and others. Currently, our primary international competitor is Mineral Technologies, Inc. in the United States.
As a regional market leader in the monolithic refractory marketplace in China, we can buy raw materials in large quantities allowing us to negotiate volume discount that results in lower price than what is offered to our smaller competitors. As our smaller competitors consolidate and grow larger, they may be able to negotiate similar volume discount from raw material suppliers. Under such scenario, any cost advantage that we currently enjoy may be reduced or eliminated altogether. Although our smaller competitors may pay higher materials costs relative to our material costs, their operating and administrative costs may be lower than ours, which may allow our competitors to offer very competitive prices for their products and services. Their competitive prices may force us to lower our prices, and to sell products and services at a loss in order to maintain our market share. Currently, we have a policy for setting a pricing floor so that we do not sell products at a loss; however, we cannot assure that we can maintain this policy indefinitely. Thus, increased competition in our industry could reduce our revenue and net income.
Any decrease in the availability, or increase in the cost, of raw materials and energy could materially increase our costs and jeopardize our current profit margins and profitability.
The principal raw materials used in our refractory products are several forms of the minerals SiO2, Al203, and MgO, including bauxite, mullite, corundum, processed Al203, Spinel, magnesia, calcium aluminates cement, and silica. We use bauxite primarily in the production of refractory materials, fracture proppants and some industrial ceramic products. The availability of these raw materials and energy resources may decrease and their prices can become volatile as a result of, among other things, changes in overall supply and demand levels and new laws or regulations. Our ability to achieve our sales target depends on our ability to maintain what we believe to be adequate inventories of raw materials to meet reasonably anticipated orders from our customers. In 2011, raw material costs accounted for 86.8% of the production cost for refractory products, 50.5% for fracture proppant products and 66.7% for industrial ceramics products and 85.0% for micropowder products.
Our production facilities are located in Gongyi, Henan Province, where there is currently abundant reserve of bauxite and corundum for refractory manufacturing. Although our proximity to bauxite allows us to benefit from a relatively short delivery time and lower shipping costs, we may experience supply shortages or price increases or both due to sharp increases in overall industry demand for bauxite. Besides purchasing bauxite from local suppliers, we also purchase bauxite, mullite, magnesia, calcium aluminates cement and other raw materials from suppliers in Shanxi Province, Shandong Province, Liaoning Province and Gansu Province. All of these locations are outside of Henan Province and any increase in shipping costs will increase our cost of raw materials from these sources and will decrease our revenues and profitability.
Further, if our existing suppliers are unable or unwilling to deliver raw materials needed on time to meet our production schedules, we may be unable to produce certain products, which could result in a decrease in revenues and profitability, a loss of goodwill with our customers, and could damage our reputation as a reliable supplier in our industry. In the event that our raw material and energy costs increase, we may not be able to pass these higher costs on to our customers in full or at all due to contractual agreements or pricing pressures in the refractory market. Any increase in the prices for raw materials or energy resources could materially increase our costs and therefore lower our earnings and profitability.
Actions by the Chinese government could drive up our material costs and could have a negative impact on our profitability.
In past years, the Chinese government has shut down some outdated mineral mines in China. These shutdowns have decreased the overall supply of raw materials needed to produce refractory products. As a result, the materials costs for our products have increased. If the Chinese government shuts down more mineral mines, we could experience further supply shortages and price increases that could have a negative impact on our profitability.
We may experience fluctuation of profit performance and our future profitability is not assured.
As we are facing fierce competition and the cost of our raw materials and energy keep rising, we have experienced significant pressure in refractories segment, our largest product segment which accounted for approximately 60.5% of total revenue in 2011. We may experience fluctuation of profit performance and our profitability is not assured.
Specific factors that may undermine our financial objectives include, among others:
Volatile iron and steel producer spending levels, which particularly affects our refractories segment which constitutes the largest portion of mix;
Adverse changes to our product mix, both fundamentally (resulting from new product transitions, the declining profitability of certain legacy products and the termination of certain products with declining margins, among other things) and due to demand fluctuations;
Intense pricing pressure across our product lines due to competitive forces, which continues to offset many of the cost improvements we are realizing quarter over quarter;
Rising cost of materials and energy that significantly impact our profitability, particularly in our refractories segment;
Execution challenges, which limit revenue opportunities and harm profitability, market opportunities and customer relations;
Continuing high levels of selling, general and administrative, ("SG&A") expenses. Taken together, these factors limit our ability to predict future profitability levels and to achieve our long-term profitability objectives. While some of these factors may diminish over time as we improve our cost structure and focus on enhancing our product mix, several factors, such as continuous pricing pressure, increasing competition, rising costs of raw materials and energy, are likely to remain endemic to our businesses. If we fail to achieve profitability expectations, our business and financial condition may be materially adversely impacted.
We may not be able to implement our business plan because we may be unable to fund the substantial ongoing capital and maintenance expenditures needed for our operations and to invest in new projects at the same time.
Our operations are capital intensive and the nature of our business and our business strategy need substantial additional working capital investment. We need capital to build new production lines, acquire new equipment, maintain the condition of our existing equipment, maintain compliance with environmental laws and regulations, and to pursue new market opportunities. We may not be able to fund our capital expenditures from operating cash flow and from the proceeds of borrowings available for capital expenditures under our credit facilities, and we may need additional debt or equity financing. We cannot assure that this type of financing will be available or, if available, it may result in increased interest expenses, increased leverage and decreased income available to fund further expansion. In addition, future debt financings may limit our ability to withstand competitive pressures and render us more vulnerable to economic downtowns. If we are unable to fund our capital requirements, we may be unable to implement our business plan and our financial performance may be adversely impacted.
Approximately 63.9% of our sales revenues were derived from our ten largest customers, and any reduction in revenues from any of these customers would reduce our revenues and net income.
While we have over 170 active customers, approximately 63.9% of our sales revenue came from our top ten customers in 2011, with Jolly alone accounted for approximately 14.1% of our sales revenue in the same period. If we cease to do business at or above current levels with Jolly or any one of our other largest customers which contribute significantly to our sales revenues, and we are unable to generate additional sales revenues with new and existing customers that purchase a similar amount of our products, then our revenues and net income would decline considerably.
A significant interruption or casualty loss at any of our facilities could increase our production costs and reduce our sales and earnings.
Our manufacturing process requires large industrial facilities for crushing, smashing, batching, molding and baking raw materials. After the refractory products come off the production line, we need additional facilities to inspect, package, and store the finished goods. Our facilities may experience interruptions or major accidents and may be subject to unplanned events such as explosions, fires, inclement weather, acts of God, terrorism, accidents and transportation interruptions. Any shutdown or interruption of any facility would reduce the output from that facility, which could substantially impair our ability to meet sales targets. Interruptions in production capabilities will inevitably increase production costs and reduce our sales and earnings. In addition to the revenue losses, longer-term business disruption could result in the loss of goodwill with our customers. To the extent these events are not covered by insurance, our revenues, margins and cash flows may be adversely impacted by events of this type.
Environmental regulations impose substantial costs and limitations on our operations.
Our products are not considered environmentally hazardous materials, however, the dust produced during our production process is considered hazardous to the environment. We have environmental liability risks and limitations on operations brought about by the requirements of environmental laws and regulations. We are subject to various national and local environmental laws and regulations concerning issues such as air emissions, waste water discharges, and solid and hazardous waste management and disposal. These laws and regulations are becoming increasingly stringent. While we believe that our facilities are in material compliance with all applicable environmental laws and regulations, the risks of substantial unanticipated costs and liabilities related to compliance with these laws and regulations are an inherent part of our business. It is possible that future conditions may develop, arise or be discovered that create new environmental compliance or remediation liabilities and costs. While we believe that we can comply with environmental legislation and regulatory requirements and that the costs of compliance have been included within budgeted cost estimates, compliance may prove to be more costly than anticipated.
Climate change and related regulatory responses may impact our business.
Climate change as a result of emissions of greenhouse gases is a significant topic of discussion. It is impracticable to predict with any certainty the impact of climate change on our business or the regulatory responses to it, although we recognize that they could be significant. The most direct impact is likely to be an increase in energy costs, which would increase our operating costs, primarily through increased utility and transportations costs. In addition, many of our customers operate in the manufacturing industry. Any restrictions or penalties imposed under a cap and trade system might significantly impact their operations, which in turn, would adversely affect their demand for our products. However, it is too soon for us to predict with any certainty the ultimate impact, either directionally or quantitatively, of climate change and related regulatory responses.
If our customers and/or the ultimate consumers of products which use our products successfully assert product liability claims against us due to defects in our products, our operating results may suffer and our reputation may be harmed.
Our products are widely used as protective linings in industrial furnaces operating in highly hazardous environments because those furnaces must operate under extremely high temperatures in order to produce iron, steel and other industrial products. Significant property damage, personal injuries and even death can result from the malfunctioning of high temperature furnaces as a result of defects in our refractory products. The costs and resources needed to defend product liability claims could be substantial. We could be responsible for paying some or all of the damages if found liable. We do not have product liability insurance. The publicity surrounding these sorts of claims is also likely damage our reputation, regardless of whether such claims are successful. Any of these consequences resulting from defects in our products would hurt our operating results and stockholder value.
If we are not able to adequately secure and protect our patent, trademark and other proprietary rights our business may be materially affected.
We hold sixty two patents related to our production and some of these patents are key technology widely used in our process to improve the efficiency of production. We also rely on non-disclosure agreements and other confidentiality procedures to protect our intellectual property rights in various jurisdictions. These technologies are very important to our business and it may be possible for unauthorized third parties to copy or reverse engineer our products, or otherwise obtain and use information that we regard as proprietary. Furthermore, third parties could challenge the scope or enforceability of our patents. In certain foreign countries, including China where we operate, the laws do not protect our proprietary rights to the same extent as the laws of the United States. Decided court cases in China’s civil law system do not have binding legal effect on future decisions and even where adequate law exists in China, enforcement based on existing law may be uncertain and sporadic and it may be difficult to obtain enforcement of a judgment by a court of another jurisdiction. In addition, the relative inexperience of China’s judiciary in many cases creates additional uncertainty as to the outcome of any litigation, and interpretation of statutes and regulations may be subject to government policies reflecting domestic political changes. Any misappropriation of our intellectual property could have a material adverse effect on our business and results of operations, and we cannot assure that the measures we take to protect our proprietary rights are adequate.
Expansion of our business may place a significant strain on our management and operational infrastructure and impede our ability to meet any increased demand for our products.
Our business plan is to significantly grow our operations by meeting the anticipated growth in demand for existing products and by introducing new product offerings. Growth in our business may place a significant strain on our personnel, management, financial systems and other resources. Our business growth also presents numerous risks and challenges, including:
Our ability to successfully and rapidly expand sales to potential customers in response to increasing demand;
The costs associated with such growth, which are difficult to quantify, but could be significant; and
The costs associated with developing new products to keep pace with rapid technological changes.
To accommodate the growth and compete effectively, we may need to obtain additional funding to improve information systems, procedures and controls and expand, train, motivate and manage existing and additional employees. Funding may not be available in a sufficient amount or on favorable terms, if at all. If we are not able to manage these activities and implement these strategies successfully to expand to meet any increased demand, our operating results could suffer.
Improvements in the quality and lifespan of refractory products may decrease product turnover and our sales revenues.
Technological and manufacturing improvements have made refractory products more durable and more efficient. While making products more durable and more efficient is generally a positive development, the increased quality and durability of refractory products could lead to declining consumption and turnover of refractory products. With the growth rate in the steel industry decelerating and with the consumption rate of refractory products per metric ton of steel produced decreasing, the refractory industry’s future growth rate may decelerate. We can increase our prices to offset the decrease in product consumption, but we cannot assure that price increases will be acceptable to our customers.
Our new products are complex and may contain defects that are detected only after their release to our customers, which may cause us to incur significant unexpected expenses and lost sales.
Our products are highly complex and must operate at high temperatures for a long period of time. Although our new products are tested prior to release, they can only be fully tested when they are used by our customers. Consequently, our customers may discover defects after new products have been released. Although we have test procedures and quality control standards in place designed to minimize the number of defects in our products, we cannot guarantee that our new products will be completely free of defects when released. If we are unable to quickly and successfully correct the defects identified after their release, we could experience significant costs associated with compensating our customers for damages caused by our products, costs associated with correcting the defects, costs associated with design modifications, and costs associated with service or warranty claims or both. Additionally, we could lose customers, lose market share and suffer damage to our reputation.
Our holding company structure may limit the payment of dividends.
We have no direct business operations, other than our ownership of our subsidiaries. While we have no current intention of paying dividends, should we decide in the future to do so, as a holding company, our ability to pay dividends and meet other obligations depends upon the receipt of dividends or other payments from our operating subsidiaries and other holdings and investments. In addition, our operating subsidiaries, from time to time, may be subject to restrictions on their ability to make distributions to us, including as a result of restrictive covenants in loan agreements, restrictions on the conversion of local currency into U.S. dollars or other hard currency and other regulatory restrictions as discussed below. If future dividends are paid in RMB, fluctuations in the exchange rate for the conversion of RMB into U.S. dollars may reduce the amount received by U.S. stockholders upon conversion of the dividend payment into U.S. dollars.
Chinese regulations currently permit the payment of dividends only out of accumulated profits as determined in accordance with Chinese accounting standards and regulations. Our subsidiaries in China are also required to set aside a portion of their after-tax profits according to Chinese accounting standards and regulations to fund certain reserve funds. Currently, our subsidiaries in China are the only sources of revenues or investment holdings for the payment of dividends. If they do not accumulate sufficient profits under Chinese accounting standards and regulations to first fund certain reserve funds as required by Chinese accounting standards, we will be unable to pay any dividends.
We completed our new fine precisions abrasives production facility in 2009 and we have earned revenue in 2010 and 2011 but we cannot guarantee that we will earn the estimated revenues in the future or that it ultimately will be profitable.
We initiated the construction of our fine precisions abrasives production facility in 2008 and completed it in 2009. We entered into trial production in July 2009 and initiated sales in August 2010. In 2011, the company sold approximately 3,429 ton abrasives. However, we cannot guarantee that we will continue to earn revenue or that the business will be profitable.
We may incur significant costs to ensure compliance with United States corporate governance and accounting requirements.
We may incur significant costs associated with our public company reporting requirements, costs associated with newly applicable corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) and other rules implemented by the Securities and Exchange Commission. We expect all of these applicable rules and regulations to significantly increase our legal and financial compliance costs and to make some activities more time consuming and costly. We also expect that these applicable rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as executive officers. We are currently evaluating and monitoring developments with respect to these newly applicable rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.
If we fail to maintain an effective system of internal control over financial reporting, our ability to accurately and timely report our financial results or prevent fraud may be adversely affected and investor confidence and the market price of our ordinary shares may be adversely impacted.
Section 404 of the Sarbanes-Oxley Act requires annual management assessments of the effectiveness of our internal controls over financial reporting. Pursuant to Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation with the participation of the Company’s management, including our Chairman, Chief Executive Officer and President, Shunqing Zhang, our Chief Financial Officer, Ningfang Liang, of the effectiveness of the Company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of December 31, 2011. Based on this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
However, a control system, no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Furthermore, the design of a control system must reflect the fact that there are internal resource constraints, and the benefit of controls must be weighed relative to their corresponding costs. Because of the limitations in all control systems, no evaluation of controls can provide complete assurance that all control issues and instances of error, if any, within our company are detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur due to human error or mistake. Additionally, controls, no matter how well designed, could be circumvented by the individual acts of specific persons within the organization. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated objectives under all potential future conditions. If we fail to achieve and maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our common stock could drop significantly. In addition, we cannot be certain that material weaknesses or significant deficiencies in our internal controls will not be discovered in the future.
RISKS RELATED TO DOING BUSINESS IN CHINA
Chinese corporate income tax law could adversely affect our business and our net income.
China passed a new Enterprise Income Tax Law, or the New EIT Law, and its implementation regulations, both of which became effective on January 1, 2008. Under the New EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese domestic enterprise for enterprise income tax purposes. The implementing rules of the New EIT Law define de facto management as “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise. On April 22, 2009, the State Administration of Taxation issued the Notice Concerning Relevant Issues Regarding Cognizance of Chinese Investment Controlled Enterprises Incorporated Offshore as Resident Enterprises pursuant to Criteria of de facto Management Bodies, or the Notice, further interpreting the application of the New EIT Law and its implementation with respect to non-Chinese enterprises or group controlled offshore entities. Pursuant to the Notice, an enterprise incorporated in an offshore jurisdiction and controlled by a Chinese enterprise or group will be classified as a “non-domestically incorporated resident enterprise” if (i) its senior management in charge of daily operations reside or perform their duties mainly in China; (ii) its financial or personnel decisions are made or approved by bodies or persons in China; (iii) substantial assets and properties, accounting books, corporate chops, board and shareholder minutes are kept in China; and (iv) at least half of its directors with voting rights or senior management often resident in China. A resident enterprise would be generally subject to the uniform 25% enterprise income tax rate as to its worldwide income. Although the Notice is directly applicable to enterprises registered in an offshore jurisdiction and controlled by Chinese domestic enterprises or groups, it is uncertain whether the PRC tax authorities will make reference to the Notice when determining the resident status of other offshore companies, such as China GengSheng Minerals, Inc., Gengsheng International Corporation and Smarthigh Holding Limited. Since substantially all of our management is currently based in China, it is likely we may be treated as a Chinese resident enterprise for enterprise income tax purposes. The tax consequences of such treatment are currently unclear, as they will depend on how local tax authorities apply or enforce the New EIT Law or the implementation regulations.
In addition, under the New EIT Law and implementation regulations, PRC income tax at the rate of 10% is applicable to dividends payable to investors that are “non-resident enterprises” (and that do not have an establishment or place of business in the PRC, or that have such establishment or place of business but the relevant income is not effectively connected with the establishment or place of business) to the extent that such dividends have their source within the PRC unless there is an applicable tax treaty between the PRC and the jurisdiction in which an overseas holder resides which reduces or exempts the relevant tax. Similarly, any gain realized on the transfer of shares by such investors is also subject to the 10% PRC income tax if such gain is regarded as income derived from sources within the PRC.
If we are considered a PRC “resident enterprise”, it is unclear whether the dividends we pay with respect to our shares, or the gain you may realize from the transfer of our shares, would be treated as income derived from sources within the PRC and be subject to PRC tax. If we are required under the New EIT Law to withhold PRC income tax on our dividends payable to our foreign shareholders, or if you are required to pay PRC income tax on the transfer of your shares, the value of your investment in our shares may be materially and adversely affected.
Future inflation in China may inhibit our ability to conduct business in China.
In recent years, the Chinese economy has experienced periods of rapid expansion and highly fluctuating rates of inflation. During the past ten years, the rate of inflation in China has been as high as 5.9% and as low as -0.8% . These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. High inflation may in the future cause the Chinese government to impose controls on credit or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products and our company.
Our business is largely subject to the uncertain legal environment in China and our legal protection could be limited.
The Chinese legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which precedents set in earlier legal cases are not generally used. The overall effect of legislation enacted over the past 20 years has been to enhance the legal protections afforded to foreign-invested enterprises in China. However, these laws, regulations and legal requirements are relatively recent and are evolving rapidly, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to foreign investors, such as the right of foreign-invested enterprises to hold licenses and permits such as requisite business licenses. In addition, all of our executive officers and our directors are residents of China and not of the U.S., and substantially all the assets of these persons are located outside the U.S. As a result, it could be difficult for investors to effect service of process in the U.S., or to enforce a judgment obtained in the U.S. against our Chinese operations and subsidiaries.
The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.
China only recently has permitted provincial and local economic autonomy and private economic activities. The Chinese government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to taxation, import and export tariffs, 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 the jurisdictions in which we operate 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 or interpretations.
Accordingly, 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 or joint ventures.
Restrictions on currency exchange may limit our ability to receive and use our revenues effectively.
The majority of our revenues are settled in Renminbi, or RMB. Any future restrictions on currency exchanges may limit our ability to use revenue generated in RMB to fund any future business activities outside of China or to make dividend or other payments in U.S. dollars. Although the Chinese government introduced regulations in 1996 to allow greater convertibility of the RMB for current account transactions, significant restrictions still remain, including primarily the restriction that foreign-invested enterprises may only buy, sell or remit foreign currencies after providing valid commercial documents at those banks in China authorized to conduct foreign exchange business. In addition, conversion of RMB for capital account items, including direct investment and loans, is subject to governmental approval in China, and companies are required to open and maintain separate foreign exchange accounts for capital account items. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB.
Failure to comply with PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident stockholders to personal liability, limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially adversely affect us.
In October 2005, the PRC State Administration of Foreign Exchange, or SAFE, issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, generally referred to as Circular 75, which required PRC residents to register with the competent local SAFE branch before establishing or acquiring control over an offshore special purpose company, or SPV, for the purpose of engaging in an equity financing outside of China on the strength of domestic PRC assets originally held by those residents. Internal implementing guidelines issued by SAFE, which became public in June 2007 (known as Notice 106), expanded the reach of Circular 75 by purporting to cover the establishment or acquisition of control by PRC residents of offshore entities which merely acquire “control” over domestic companies or assets, even in the absence of legal ownership; adding requirements relating to the source of the PRC resident’s funds used to establish or acquire the offshore entity; covering the use of existing offshore entities for offshore financings; purporting to cover situations in which an offshore SPV establishes a new subsidiary in China or acquires an unrelated company or unrelated assets in China; and making the domestic affiliate of the SPV responsible for the accuracy of certain documents which must be filed in connection with any such registration, notably, the business plan which describes the overseas financing and the use of proceeds. Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations, and Notice 106 makes the offshore SPV jointly responsible for these filings. In the case of an SPV which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, a retroactive SAFE registration was required to have been completed before March 31, 2006; this date was subsequently extended indefinitely by Notice 106, which also required that the registrant establish that all foreign exchange transactions undertaken by the SPV and its affiliates were in compliance with applicable laws and regulations. Failure to comply with the requirements of Circular 75, as applied by SAFE in accordance with Notice 106, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions. Any such failure could also result in the SPV’s affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the SPV, or from engaging in other transfers of funds into or out of China.
We believe our stockholders who are PRC residents as defined in Circular 75 have registered with the relevant branch of SAFE, as currently required, in connection with their equity interests in us and our acquisitions of equity interests in our PRC subsidiaries. However, we cannot provide any assurances that their existing registrations have fully complied with, and they have made all necessary amendments to their registration to fully comply with, all applicable registrations or approvals required by Circular 75. Moreover, because of uncertainty over how Circular 75 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders. In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Circular 75. We also have little control over either our present or prospective direct or indirect stockholders or the outcome of such registration procedures. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with Circular 75, if SAFE requires it, could subject these PRC resident beneficial holders to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiaries’ ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.
Changes in China's political or economic situation could harm us and our operating results.
Economic reforms adopted by the Chinese government have had a positive effect on the economic development of the country, but the government could change these economic reforms or any of the legal systems at any time. This could either benefit or damage our operations and profitability. Some of the things that could have this effect are:
Level of government involvement in the economy;
Control of foreign exchange;
Methods of allocating resources;
Balance of payments position;
International trade restrictions; and
International conflict.
The Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development, or OECD, in many ways. For example, state-owned enterprises still constitute a large portion of the Chinese economy and weak corporate governance and a lack of flexible currency exchange policy still prevail in China. As a result of these differences, we may not develop in the same way or at the same rate as might be expected if the Chinese economy was similar to those of the OECD member countries.
The value of our securities will be affected by the currency exchange rate between U.S. dollars and RMB.
The value of our common stock will be affected by the foreign exchange rate between U.S. dollars and RMB, and between those currencies and other currencies in which our sales may be denominated. For example, if we need to convert U.S. dollars into RMB for our operational needs and the RMB appreciate against the U.S. dollar at that time, our financial position, our business, and the price of our common stock may be harmed. Conversely, if we decide to convert our RMB into U.S. dollars for the purpose of declaring dividends on our common stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of our earnings from our subsidiaries in China would be reduced.
Our procurement strategy is to diversify our suppliers both in the PRC and overseas. And some of our raw materials and major equipments are currently imported. These transactions are often settled in U.S. dollars or other foreign currency. In the event that the U.S. dollars or other foreign currency appreciate against RMB, our costs will increase. Our profitability and operating results will suffer if we cannot pass the resulted cost increase to our customers. In addition, because our sales to international customers are growing, we are subject to the risk of foreign currency depreciation.
Until 1994, the RMB experienced a gradual but significant devaluation against most major currencies, including the U.S. dollar, and there was a significant devaluation of the RMB on January 1, 1994 in connection with the replacement of the dual exchange rate system with a unified managed floating rate foreign exchange system. Since 1994, the value of the RMB relative to the U.S. dollar has remained stable and has appreciated slightly. Countries, including the United States, have argued that the RMB is artificially undervalued due to China’s current monetary policies and have pressured China to allow the RMB to float freely in world markets. In July 2005, the PRC government changed its policy of pegging the value of the RMB to the U.S. dollar. Under this policy, which was halted in 2008 due to the worldwide financial crisis, the Renminbi was permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. In June 2010, the Chinese government announced its intention to again allow the Renminbi to fluctuate within the 2005 parameters. It is possible that the Chinese government could adopt an even more flexible currency policy, which could result in more significant fluctuation of Renminbi against the U.S. dollar, or it could adopt a more restrictive policy. While the international reaction to the RMB revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in further and more significant appreciation of the RMB against the U.S. dollar.
A slowdown or other adverse developments in the Chinese economy may materially and adversely affect our customers’ demand for our products and services.
All of our operations are conducted in China and a major portion of our revenues are generated from sales to businesses operating in China. Although the Chinese economy has grown significantly in recent years, such growth may not continue. We do not know how sensitive we are to a slowdown in economic growth or other adverse changes in Chinese economy which may affect demand for our products. A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in China may materially reduce the demand for our services and in turn reduce our results of operations.
Failure to comply with the U.S. Foreign corrupt practices act and Chinese anti-corruption laws could subject us to penalties and other adverse consequences.
Our executive officers, employees and other agents may violate applicable law in connection with the marketing or sale of our products, including China’s anti-corruption laws and the U.S. Foreign Corrupt Practices Act, or the FCPA, which generally prohibits United States companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. In addition, we are required to maintain records that accurately and fairly represent our transactions and have an adequate system of internal accounting controls. Foreign companies, including some that may compete with us, are not subject to these prohibitions, and therefore may have a competitive advantage over us. The PRC also strictly prohibits bribery of government officials. However, corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in the PRC.
While we intend to implement measures to ensure compliance with the FCPA and Chinese anti-corruption laws by all individuals involved with our company, our employees or other agents may 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 and other consequences that may have a material adverse effect on our business, financial condition and results of operations. In addition, our brand and reputation, our sales activities or the price of our ordinary shares could be adversely affected if we become the target of any negative publicity as a result of actions taken by our employees or other agents.
The implementation of the new PRC labor law and increases in the labor costs in China may hurt our business and profitability.
On June 29, 2007, the PRC government promulgated a new labor law, the Labor Agreement Law of the PRC, or the New Labor Agreement Law, which became effective on January 1, 2008. The New Labor Agreement Law imposes greater liability on employers and significantly affects the cost of an employer’s decision to reduce its workforce. Further, it requires certain terminations be based upon seniority and not merit. In the event we decide to significantly change or decrease our workforce, the New Labor Agreement Law could adversely affect our ability to enact such changes in a manner that is most advantageous to our business or in a timely and cost-effective manner, thus materially and adversely affecting our financial condition and future operating prospects.
RISKS RELATED TO THE MARKET FOR OUR STOCK
As our common stock is thinly traded, the stock price may be volatile and investors may have difficulty disposing of their investments at prevailing market prices.
On March 4, 2010, our common stock began trading on the NYSE Amex stock exchange (formerly the American Stock Exchange) under the symbol “CHGS”. Prior to March 4, our common stock was traded over-the-counter under the symbol CHGS.OB. Despite the relisting on the larger stock exchange, our common stock remains thinly and sporadically traded and no assurances can be given that a larger market will ever develop, or if developed, that it will be maintained.
Our Common Stock is subject to price volatility unrelated to our operations.
The market price of our common stock could fluctuate substantially due to a variety of factors, including market perception of our ability to achieve our planned growth, quarterly operating results of other companies in the same industry, trading volume in our common stock, changes in general conditions in the economy and the financial markets or other developments affecting our competitors or us. In addition, the stock market is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market price of securities issued by many companies for reasons unrelated to their operating performance and could have the same effect on our common stock.
We cannot assure you that the common stock will be liquid or that it will remain listed on the NYSE Amex.
We cannot assure you that we will be able to maintain the continued listing standards of the NYSE Amex (formerly the American Stock Exchange). The NYSE Amex requires companies to meet certain continued listing criteria including certain minimum stockholders' equity and equity prices per share as outlined in the NYSE Amex Exchange Company Guide. We may not be able to maintain such minimum stockholders' equity or prices per share or may be required to effect a reverse stock split to maintain such minimum prices and/or issue additional equity securities in exchange for cash or other assets, if available, to maintain certain minimum stockholders' equity required by the NYSE Amex. If we are delisted from the NYSE Amex then our common stock will trade, if at all, only on the over-the-counter market, such as the OTC Bulletin Board securities market, and then only if one or more registered broker-dealer market makers comply with quotation requirements. In addition, delisting of our common stock could depress our stock price, substantially limit liquidity of our common stock and materially adversely affect our ability to raise capital on terms acceptable to us, or at all. Delisting from the NYSE Amex could also have other negative results, including the potential loss of confidence by suppliers and employees, the loss of institutional investor interest and fewer business development opportunities. In order to remain listed on NYSE Amex, we are required to maintain a minimum stockholders’ equity of $6 million.
Techniques employed by manipulative short sellers in Chinese small cap stocks may drive down the market price of our common stock.
Short selling is the practice of selling securities that the seller does not own but rather has, supposedly, borrowed from a third party with the intention of buying identical securities back at a later date to return to the lender. The short seller hopes to profit from a decline in the value of the securities between the sale of the borrowed securities and the purchase of the replacement shares, as the short seller expects to pay less in that purchase than it received in the sale. As it is therefore in the short seller’s best interests for the price of the stock to decline, many short sellers (sometime known as “disclosed shorts”) publish, or arrange for the publication of, negative opinions regarding the relevant issuer and its business prospects in order to create negative market momentum and generate profits for themselves after selling a stock short. While traditionally these disclosed shorts were limited in their ability to access mainstream business media or to otherwise create negative market rumors, the rise of the Internet and technological advancements regarding document creation, videotaping and publication by weblog (“blogging”) have allowed many disclosed shorts to publicly attack a company’s credibility, strategy and veracity by means of so-called research reports that mimic the type of investment analysis performed by large Wall Street firm and independent research analysts. These short attacks have, in the past, led to selling of shares in the market, on occasion in large scale and broad base. Issuers with business operations based in China and who have limited trading volumes and are susceptible to higher volatility levels than U.S. domestic large-cap stocks can be particularly vulnerable to such short attacks.
These short seller publications are not regulated by any governmental, self-regulatory organization or other official authority in the U.S., are not subject to the certification requirements imposed by the Securities and Exchange Commission in Regulation AC (Regulation Analyst Certification) and, accordingly, the opinions they express may be based on distortions of actual facts or, in some cases, fabrications of facts. In light of the limited risks involved in publishing such information, and the enormous profit that can be made from running just one successful short attack, unless the short sellers become subject to significant penalties, it is more likely than not that disclosed shorts will continue to issue such reports.
Recently, some short sellers actively attack on Chinese small cap stocks. We are a Chinese small cap public company and may be attacked by some short sellers. While we intend to strongly defend our public filings against any such short teller attacks, oftentimes we are constrained, either by principles of freedom of speech, applicable state law (often called “Anti-SLAPP statutes”), or issues of commercial confidentiality, in the manner in which we can proceed against the relevant short seller. You should be aware that in light of the relative freedom to operate that such persons enjoy - oftentimes blogging from outside the U.S. with little or no assets or identity requirements - should we be targeted for such an attack, our stock will likely suffer from a temporary, or possibly long term, decline in market price.
In addition, as many Chinese small cap public companies have been recently subject to intense scrutiny, criticism and negative publicity by investors, short sellers, financial commentators and regulatory agencies, such as the United States Securities and Exchange Commission, and much of the scrutiny, criticism and negative publicity has centered around financial and accounting irregularities and mistakes, a lack of effective internal controls over financial accounting, inadequate corporate governance policies or a lack of adherence thereto and, in many cases, allegations of fraud, it is not clear what affect this sector-wide scrutiny, criticism and negative publicity will have on our company, our business and our stock price. If we become the subject of any unfavorable allegations, whether such allegations are proven to be true or untrue, we will have to expend significant resources to investigate such allegations and/or defend our company. This situation could be costly and time consuming and distract our management from growing our company. If such allegations are not proven to be groundless, our company and business operations will be severely impacted. It could seriously affect our ability to raise money and your investment in our stock could be rendered worthless.
Our President and CEO hold a significant percentage of our outstanding voting securities.
As of December 31, 2011, Mr. Shunqing Zhang, our President and CEO, was the beneficial owner of approximately 56.8% of our outstanding voting securities. As a result, he possessed significant influence, giving him the ability to elect a majority of our board of directors and to authorize or prevent significant corporate transactions. His ownership and control may impede or delay any future change in control through merger, consolidation, takeover or other business combinations and may discourage a potential acquirer from making a tender offer.
Certain provisions of our articles of incorporation may make it more difficult for a third party to effect a change-in-control.
Our articles of incorporation authorize the Board of Directors to issue up to 50,000,000 shares of preferred stock. The preferred stock may be issued in one or more series, the terms of which may be determined at the time of issuance by the board of directors without further action by the stockholders. These terms may include voting rights including the right to vote as a series on particular matters, preferences as to dividends and liquidation, conversion rights and redemption rights provisions. The issuance of any preferred stock could diminish the rights of holders of our common stock, and therefore could reduce the value of such common stock. In addition, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with, or sell assets to, a third party. The ability of the board of directors to issue preferred stock could make it more difficult, delay, discourage, prevent or make it more costly to acquire or effect a change-in-control, which in turn could prevent the stockholders from recognizing a gain in the event that a favorable offer is extended and could materially and negatively affect the market price of our common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
All land in China is owned by the government authority. Individuals and companies are permitted to acquire rights to use land or land use rights for specific purposes. In the case of land used for industrial purposes, the land use rights are granted for a period of up to 50 years. This period may be renewed at the expiration of the initial and any subsequent terms. Granted land use rights are transferable and may be used as security for borrowings and other obligations.
We have obtained or are in the process of obtaining the right from the relevant governmental authority for periods ranging from 39 to 50 years to use the land on which our facilities are located. We currently have about 31 manufacturing facilities located on five manufacturing sites in China. In our Refractories subsidiary in Gongyi City, Henan Province, we have offices and workshops that total approximately 316,663 square feet. In our High-Temperature subsidiary in Zhengzhou City, Henan Province, we have offices and workshops that total approximately 115,777 square feet. In our Duesail subsidiary in Gongyi City, Henan Province, we have offices and workshops that total approximately 401,449 square feet. In our Micronized subsidiary in Gongyi City, Henan Province, we have offices and workshops that total approximately 739,114 square feet, and we have offices and workshops that total approximately 753,000 square feet in the Yuxing subsidiary.
We believe that our facilities, which are of varying ages and are of different construction types, have been satisfactorily maintained. They are in good conditions and are suitable for our operations and generally provide sufficient capacity to meet our production and operational requirements.
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. We are currently not aware of any such legal proceedings or claims that we believe will have a material adverse affect on our business, financial condition or operating results. 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.
PART II
ITEM 5.
ITEM 5. MARKET FOR OUR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Market Information
On March 4, 2010, our common stock commenced trading on the NYSE Amex Stock Exchange (formerly the American Stock Exchange) under the symbol “CHGS”. Until March 3, 2010, our common stock was traded over-the-counter under the symbol CHGS.OB. The CUSIP number is 16942P101.
The following table sets forth, for the periods indicated, the high and low bid prices of our common stock as reported on the OTC Bulletin Board and NYSE Amex Stock Exchange These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
__________________________________
(1) The above tables set forth the range of high and low bid prices per share of our common stock as reported in our SEC filings and by www.quotemedia.com for the periods indicated. The closing bid prices are only available from the quarter that began on April 1, 2006.
Holders
On December 31, 2011, there were approximately 217 stockholders of record of our common stock. The number of record holders does not include persons who held our common stock in nominee or “street name” accounts through brokers.
Dividend Policy
We have never declared dividends or paid cash dividends. Our board of directors, which currently consists of five directors, has complete discretion on whether to pay dividends, subject to the approval of our shareholders. We currently intend to retain and use any future earnings for the development and expansion of our business and do not anticipate paying any cash dividends in the near future. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that the board of directors may deem relevant.
Securities Authorized for Issuance under Equity Compensation Plans
At the Company’s annual shareholder meeting, which was held on September 28, 2011, the Company’s shareholders approved the 2011 Long-Term Incentive Plan (the “Plan”), which authorized a total of 3,000,000 shares of the Company’ common stock. The maximum number of shares of common stock that may be issued to any one grantee during any calendar year shall not exceed 100,000.
The Plan is designed to enhance the Company’s and its affiliates’ ability to attract and retain highly qualified officers, directors, key employees and other persons, and to motivate such officers, directors, key employees and other persons to serve the Company and its affiliates and to expend maximum effort to improve the business results and earnings of the Company, by providing to such persons an opportunity to acquire or increase a direct proprietary interest in the operations and future success of the Company.
As of April 16, 2012, no securities have been issued under the Plan.
For a detailed description of the Plan, see Schedule 14A Information Proxy Statement filed with the SEC on August 15, 2011.
Recent Sales of Unregistered Securities
On November 1, 2011, the Company issued 8,658 of the restricted shares of the common stock to Lawrence Goldman for his director service.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
As a “smaller reporting company,” as defined by Item 10 of Regulation S-K, the Company is not required to provide this information.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s Discussion and Analysis of Financial Condition and Results of Operations, which we refer to as the MD&A, is intended to help the reader understand our Company, our operations and our present business environment. The MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. Some of the information contained in this discussion and analysis constitutes forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this annual report on Form 10-K particularly under “Special Note Regarding Forward-Looking Statements” and “Risk Factors.” Unless otherwise specified, references to Notes to our consolidated financial statements are to the Notes to our audited consolidated financial statements as of December 31, 2011 and 2010.
Overview
We are a Nevada holding company that operates through our direct and indirect subsidiaries. Through our wholly-owned BVI subsidiary, GengSheng International, and its wholly-owned Chinese subsidiary, Refractories, we manufacture monolithic refractory products in China. Through our wholly-owned BVI subsidiary, GengSheng International, and its wholly-owned Chinese subsidiary, Duesail and Duesail’s wholly-owned subsidiary Yuxing, we manufacture fracture proppant products. Through Micronized, wholly-owned subsidiary of Refractories, we manufacture fine precision abrasives. Through High-Temperature, 89% owned subsidiary of Refractories, we manufacture industrial ceramic products. We have four primary business segments: refractories, industrial ceramics, fracture proppant and fine precision abrasives. Refractories product is a nonmetallic material that is used in heavy industrial processes present with extremely high temperatures, and the main customers for the segment are steel makers. Our industrial ceramic products, including abrasive balls and tiles, valves, electronic ceramics and structural ceramics, are components for a variety of end-use products such as fuses, vacuum interrupters, electrical components, mud slurry pumps, and high-pressure pumps. Such end use products are used in the electric power, electronic component, industrial pump, and metallurgy industries. Our fracture proppants are very fine ball-like pellets, highly resistant to pressure, and used to reach pockets of oil and natural gas deposits that are trapped in the fractures under the ground. Oil drillers inject the pellets into those fractures, squeezing out the trapped oil or natural gas, which leads to higher yield. The fine precision abrasives are essentially very fine, uniformly round, silicon carbide (SiC) based particles. These ultra-fine high-strength particles are applicable in a broad range of applications, including machine manufacturing, electronics, optical glass, architecture, semiconductors, silicon chips, plastics and lenses. In 2011, the refractories segment contributed approximately $46.6 million or 60.5%, of our total revenue of $76.9 million, industrial ceramics contributed approximately $0.4 million or 0.6% of the total revenue, fracture proppants contributed approximately $22.5 million or 29.3% of our total revenue and fine precision abrasives contributed approximately $7.4 million or 9.6% of the total revenue.
We sell our products to over 170 customers in the iron, steel, oil, glass, cement, aluminum, chemical and solar industries located in China and 11 countries in Asia, North America and Europe. Our refractory customers are companies in the steel, iron, petroleum, chemical, coal, glass and mining industries. Our fracture proppant products are sold to oil and gas companies. Our industrial ceramics are products used by the utilities and petrochemical industries. The Company’s fine precision abrasives target solar companies and optical equipment manufacturers. Most of our large customers, measured by percentage of our revenue, mainly operate in the steel industry. Currently, most of our revenues are derived from the sale of our monolithic refractory products and fracture proppants products to customers in China and in the United States. We expect continued revenue growth from fracture proppant products and fine precision abrasives in 2012.
Highlights of Business Operations in 2011
During 2011, our company has maintained a steady growth in sales revenue in spite of significant challenges from both the refractory and fracture proppant markets. From the beginning of 2009, the PRC central government has labeled the steel sector in China an overcapacity-burdened industry and the government is resolved to cut back the industry's excessive capacity. Since then some small and mid-sized steel producers have been shut down, which decreased the demand of refractories. To face the changing market environment, we have since adjusted product offerings in refractories segment, increased full-service contracts and focused on the maintenance of current customers. In the fourth quarter, as the price of raw materials and energy continued to rise, we incurred significant pressure in refractories segment. As many of our contracts are renewed annually, we were unable to quickly pass the increase in costs to our customers and thus resulted in the decrease in gross margin. In fracture proppant segment, our main market remained in the overseas as the international sales brought us higher margin and better payment terms. However, the demand in the U.S. market for fracture proppants products experienced slowdown in the fourth quarter and there is no clear sign of recovery in short term. In fine precision abrasives segment, although we signed a supply contract with one of the main solar producers in China to expand our market share, we still encountered fierce competition from other producers and failed to improve profitability of the segment.
The followings are some financial highlights for the year 2011:
Sales revenue increased by approximately $14.7 million, or 23.7%, to approximately $76.9 million in 2011 from approximately $62.2 million in 2010.
Gross profit decreased by approximately $1.5 million, or 8.4%, to approximately $16.2 million in 2011, from approximately $17.7 million in 2010. Gross margin was 21.1% for 2011, compared with 28.4% for 2010. The decrease in gross margin was largely attributed to the lower gross margin in our refractories segment compared to 2010 resulted from rising costs of raw materials and energy, and the negative gross margin in our fine precision abrasives segment. Net income decreased by approximately $7.8 million, to a net loss of approximately $7.5 million in 2011, from a net income of approximately $264,000 in 2010.
Our consolidated balance sheet as of December 31, 2011 included current assets of approximately $106.0 million and total assets of approximately $148.0 million, with working capital of approximately $11.8 million.
Major Factors that Affect our Financial Condition in 2011
Continued Industry Consolidation of Steel Makers Further Squeezed Our Profit in Refractories Segment
Although the crude steel output in China reached a new record of approximate 696 million metric tons in China, the steel industry still faces overcapacity and weak demand from both domestic and international market. In addition, the PRC government’s continued policy to squeeze out small to mid-sized steel makers reduced the overall demand for refractories. Such impacts on our sales continued in 2011, especially in the fourth quarter, as more small and mid-sized steel makers shut down their production.
Considerable Increase of Raw Material Prices and Decrease in Gross Margin
In 2011, China saw its highest inflation rate in over 10 years. While the overall inflation started to ease in the fourth quarter of 2011, the raw materials prices, labor costs and fuel and utilities costs continued to rise. On the other hand, in a fragmented market, hardly could the selling price of our products keep pace with the increase in raw materials prices on a timely basis. As a result, our gross margin for 2011 was significantly impacted.
Increase in Financing Costs Further Limited Our Ability to Expand Business
The unfavorable payment term offered by our customers in refractories segment and fine precision abrasives segment strained our working capital needs, and as a result significantly increased our financing costs, as banks charged higher interest rates when we discounted more bills receivables to meet our working capital needs.
Results of Operations
The following table summarizes the results of our operations during the fiscal years ended December 31, 2011 and 2010, respectively, and provides information regarding the dollar and percentage increase or (decrease) during such years.
(All amounts, other than percentages, in U.S. dollars)
Sales revenues. Sales revenues increased approximately $14.7 million, or 23.7%, to approximately $76.9 million in 2011 from approximately $62.2 million in 2010. The increase was mainly attributable to increased sales from our fracture proppant segment and fine precision abrasives segment, particularly increased export sales of fracture proppant products compared with 2010.
In our refractory segment, we sold 98,920 metric tons of refractory products in 2011, a 2.7% decrease compared with 101,711 metric tons sold in 2010. The revenue from our refractory products increased to approximately $46.6 million in 2011 from approximately $45.8 million in 2010. The sales revenue increase was primarily due to the increase in the average selling price as we increased the sales to full-service customers. The average selling prices reached $473 per metric ton in 2011, representing a 5.1% increase compared with $450 per metric ton in the same period of 2010.
In our fracture proppant segment, we sold 60,388 metric tons of fracture proppant products in 2011, compared with 41,270 metric tons in 2010. The large increase in sales volume was primarily driven by the strong demand from the US customers who use our proppant products in their new natural gas exploration technologies. Revenue from fracture proppant products was approximately $22.5 million for 2011, an increase of 57.3% compared with approximately $14.3 million in 2010. Average selling price increased to $381 per metric ton in 2011, compared with $347 per metric ton in 2010, as a result of the change in product mix since U.S. customers purchased more high-density products in 2011.
In our industrial ceramics segment, revenue was approximately $430,000 for 2011 compared with approximately $1.2 million in 2010. The decrease was primarily attributable to the low demand for our products in 2011.
In our fine precision abrasives segment, we realized sales of approximately $7.4 million. The revenue was approximately $0.9 million in 2010. The sales of fine precision abrasives products started in the third quarter of 2010.
Cost of goods sold. Our cost of goods sold increased approximately $16.2 million, or 36.5%, to approximately $60.7 million for 2011 from approximately $44.5 million in 2010. As a percentage of net revenues, the cost of goods sold increased by approximately 7.3% to 78.9% in 2011 from 71.6% in 2010. This increase was primarily due to the higher raw materials costs, energy costs and labor costs compared with 2010.
Gross profit. Our gross profit decreased approximately $1.5 million, or 8.4% to approximately $16.2 million for 2011 from approximately $17.7 million in 2010. Gross profit as a percentage of net revenues was 21.1% for 2011, as compared with 28.4% for 2010. The percentage decrease was mainly attributable to the decreased gross margin in our fine precision abrasives segment and the increase in the cost of raw materials, energy and labor costs in refractories segment compared with 2010.
Allowance for doubtful accounts. Allowance for doubtful accounts increased 205.5%, to approximately $1.3 million for 2011, from approximately $0.4 million for 2010. The increase was primarily due to the change in our provisioning policy based on the management's analysis of settlement patterns and historical information which increased the allowance for accounts receivables aged over three years and other receivables which have uncertainties in collectability.
General and administrative expenses. Our general and administrative expenses increased 22.1%, to approximately $7.0 million for 2011, from approximately $5.7 million for 2010. The increase was primarily due to the higher salary and personnel expenses, depreciation expenses and legal fees. As a percentage of net revenues, general and administrative expenses decreased 0.1% to 9.1% in 2011, compared with 9.2% in 2010.
Impairments on goodwill and intangible assets. Impairment expenses on goodwill and intangible assets were approximately $751,000 for 2011. There was no impairment expense in 2010. The increase was attributable to the write-off of goodwill related to the acquisition of one of our subsidiaries and the write-off of intangible assets related to an unpatented technology acquired in 2007. Based on the results of the impairment review performed by the management at the end of 2011, the probability of recovering the carrying value of the goodwill and intangible assets are considered unlikely and thereafter fully impaired.
Selling expenses. Selling expenses increased by approximately $1.1 million to approximately $9.5 million compared with approximately $8.4 million in 2010. As a percentage of net revenues, our selling expenses decreased to 12.3% for 2011, as compared with 13.5% for 2010. The decrease in selling expenses was primarily attributable to the change in product mix as we sold more fracture proppants products and fine abrasive products which normally incurred lower selling expenses than refractory segment. The decrease was partially offset by the increase in the transportation costs, higher post-sales service expenses in our refractory segment.
Research and development expenses. Our research and development expenses decreased to approximately $699,000 for 2011, compared with approximately $817,000 for 2010 due to fewer R&D activities.
Government grant income. Our government grant income was approximately $380,000 for 2011 compared with approximately $123,000 for 2010.
Impairment on deposit for acquisition of a non-consolidated affiliate. Impairment on deposit for acquisition of a non-consolidated affiliate was approximately $1.2 million for 2011. This non-cash impairment charge was related to our investment in Yili YiQiang Silicon Limited (“Yili”). The impairment was attributable to the operating results of Yili and uncertainties surrounding silicon carbide industry. No impairment expenses on deposit were identified in 2010.
Finance costs. Our finance costs increased by approximately $3.5 million, or 198.6% to approximately $5.3 million for 2011, from approximately $1.8 million for 2010. This substantial increase was primarily due to an increase of approximately $2.0 million in bills discounting charges as we discounted more bills receivable instead of holding them to maturity; and an increase of approximately $1.5 million in interest expenses as we increased borrowing activities for 2011.
(Loss) income before income taxes and non-controlling interests. Our loss before income taxes and non-controlling interest was approximately $7.2 million for 2011, compared with approximately $0.8 million income for 2010. The decrease was primarily attributable to the loss from operations, higher finance costs and non-cash impairment charges during 2011.
Income taxes. Our income taxes were approximately $325,000 for 2011, a decrease of approximately $197,000 or 37.7% from approximately $522,000 for 2010.
Net (loss) income. Our net loss for 2011 was approximately $7.5 million, a decrease of approximately $7.8 million from an income of approximately $264,000 in 2010. The decrease was attributable to the factors described above.
Liquidity and Capital Resources
As of December 31, 2011, we had cash and cash equivalents of $3.6 million and restricted cash of approximately $21.1 million. Our current assets were approximately $106.0 million and our current liabilities were approximately $94.2 million as of December 31, 2011 which resulted in a current ratio of approximately 1.12. Total stockholders’ equity as of December 31, 2011 was approximately $53.8 million. The following table sets forth a summary of our cash flows for the periods indicated:
Operating Activities
Net cash used in operating activities was approximately $3.5 million in 2011, compared with net cash used in operating activities of approximately $7.6 million in 2010. The decrease in net cash used in operating activities was primarily due to the increase in bills payables, trade payables and other payables during 2011, which was partly offset by the increase in trade receivables, bills receivables and lower income compared to 2010.
Investing Activities
Net cash used in investing activities during 2011 was approximately $13.9 million, an increase of approximately $7.5 million from net cash used in investing activities of approximately $6.4 million during 2010. The increase in net cash used in investing activities in 2011 was primarily due to the expansion of our fracture proppants production lines and the construction and renovation of our office buildings.
Financing Activities
Net cash provided by financing activities was approximately $20.0 million during 2011, compared with net cash provided by financing activities of approximately $13.9 million during 2010. The increase in cash flow from financing activities was primarily due to net proceeds from our January 2011 equity financing of $9.3 million, net increase in loans of $5.3 million and the increase of restricted cash of $5.0 million.
Loan Facilities
In 2011, we secured new loans totaling approximately $107.6 million from banks for our working capital needs, and we repaid approximately $104.9 million in bank loans during the year ended December 31, 2011. As a result, the balance of all our bank loans and bank borrowings as of December 31, 2011 was approximately $46.0 million, which includes approximately $29.5 million short-term bank loans and approximately $16.5 million of bank borrowings secured by bank deposits.
As of December 31, 2011, the detail of all our short-term bank loans and bank borrowings are as follows:
All amounts, other than percentages, are in U.S. dollar.
We have approximately $29.5 million of facility bank loans, maturing from January 9, 2012 to December 5, 2012 and approximately $16.5 million of bank borrowings secured by bank deposits. We will also consider refinancing debts. However, we cannot provide assurance that we will be able to refinance any of our debts on terms favorable to us in a timely manner.
Below is a brief summary of the payment obligations under material contracts to which we are a party:
On January 18, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with Industrial and Commercial Bank of China (“ICBC”), whereby ICBC has agreed to loan approximately $3.1 million (RMB 20 million) to Refractories for a term of one year, at an interest rate of 5.81% per year on all outstanding principal. The outstanding balance was approximately $2.8 million (RMB 18 million) as of December 31, 2011.
On March 21, 2011, our subsidiary, Duesail, entered into a short-term working capital loan agreement with Bank of China of Gongyi (“BC”), whereby BC has agreed to loan approximately $0.9 million (RMB 6 million) to Duesail for a term of one year, at an interest rate of 8.76% per year on all outstanding principal.
On April 18, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with Luoyang Bank (“LYB”), whereby LYB has agreed to loan approximately $3.1 million (RMB 20 million) to Refractories for a term of one year, at an interest rate of 6.94% per year on all outstanding principal.
On April 28, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with Agricultural Bank of China (“ABC”), whereby ABC has agreed to loan approximately $6.3 million (RMB 40 million) to Refractories for a term of one year, at an interest rate of 6.94% per year on all outstanding principal.
On May 13, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with China CITIC Bank (“CITIC”), whereby CITIC has agreed to loan approximately $2.4 million (RMB 15 million) to Refractories for a term of one year, at an interest rate of 6.94% per year on all outstanding principal.
On June 28, 2011, our subsidiary, Duesail, entered into a short term working capital loan agreement, with City Credit Cooperatives in Gongyi whereby City Credit Cooperatives has agreed to loan approximately $0.8 million (RMB5 million) to Duesail for a term of one year, at an interest rate of 12.1% per year on all outstanding principle.
On September 22, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with Shanghai Pudong Development Bank Village Bank of Gongyi (“SPDVB”), whereby SPDVB has agreed to loan approximately $0.7 million (RMB 4.5 million) to Refractories for a term of one year, at an interest rate of 6.56% per year on all outstanding principal.
On September 16, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with SPDVB, whereby SPDVB has agreed to loan approximately $0.8 million (RMB 5 million) to Refractories for a term of one year, at an interest rate of 6.56% per year on all outstanding principal.
On September 16, 2011, our subsidiary, Duesail, entered into a short-term working capital loan agreement with SPDVB, whereby SPDVB has agreed to loan approximately $0.4 million (RMB 2.5 million) to Duesail for a term of one year, at an interest rate of 8.53% per year on all outstanding principal.
On September 22, 2011, our subsidiary, Duesail, entered into a short-term working capital loan agreement with Shanghai Pudong Development Bank (“SPD”), whereby SPD has agreed to loan approximately $1.6 million (RMB 10 million) to Duesail for a term of one year, at an interest rate of 7.22% per year on all outstanding principal.
On September 27, 2011, our subsidiary, Duesail, entered into a short-term working capital loan agreement with Kaifeng Commercial Bank (“KCB”), whereby KCB has agreed to loan approximately $4.7 million (RMB 30 million) to Duesail for a term of one year, at an interest rate of 8.53% per year on all outstanding principal.
On October 12, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with SPD, whereby SPD has agreed to loan approximately $1.6 million (RMB 10 million) to Refractories for a term of one year, at an interest rate of 7.22% per year on all outstanding principal.
On October 14, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with SPDVB, whereby SPDVB has agreed to loan approximately $0.4 million (RMB 2.7 million) to Refractories for a term of one year, at an interest rate of 6.56% per year on all outstanding principal.
On December 12, 2011, our subsidiary, Duesail, entered into a short term working capital loan agreement with City Credit Cooperatives in Gongyi, whereby City Credit Cooperatives has agreed to loan approximately $2.8 million (RMB 18 million) to Duesail for a term of one year, at an interest rate of 11.808% per year on all outstanding principle.
On December 27, 2011, our subsidiary, Refractories, entered into a short-term working capital loan agreement with China Merchants Bank (“CMB”), whereby CMB has agreed to loan approximately $150,000 (RMB 950,000) to Refractories for a term of one year, at an interest rate of 6.56% per year on all outstanding principal.
Critical Accounting Policies
Basis of consolidation
The accompanying consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America.
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.
Use of estimates
In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. These accounts and estimates include, but are not limited to, the valuation of trade receivables, other receivables, inventories, deferred income taxes, provision of warranty, the estimation on useful lives of property, plant and equipment and the impairment of goodwill and know-how. Actual results could differ from those estimates.
Allowance for doubtful accounts
The Company establishes an allowance for doubtful accounts based on management’s assessment of the collectibility of trade receivables. A considerable amount of judgment is required in assessing the amount of the allowance. The Company considers the historical level of credit losses and applies percentages to aged receivable categories. The Company makes judgments about the creditworthiness of each customer based on ongoing credit evaluations, and monitors current economic trends that might impact the level of credit losses in the future. If the financial condition of the customers were to deteriorate, resulting in their inability to make payments, a larger allowance may be required.
Based on the above assessment, the management changed the general provisioning policy for the year ended December 31, 2011 to make allowance equivalent to 5% (2010 : 5%) of trade receivables due from 1 to 2 years, 40% (2010 : 40%) of trade receivables due from 2 to 3 years and 90% (2010 : 70%) of trade receivables due over 3 years. Additional specific provision is made against trade receivables to the extent which they are considered to be doubtful.
Bad debts are written off when identified. The Company does not accrue interest on trade receivables.
Impairment of long-lived assets
Long-lived assets are tested for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The Company recognizes impairment of long-lived assets in the event that the net book values of such assets exceed the future undiscounted cash flows attributable to such assets.
Financial guarantee issued
The Company has acted as guarantor for bank loans granted to certain local authorities and certain business associates. The Company assessed its obligation under this guarantee pursuant to the provision of ASC 460 “Guarantee”. The Company recognized in its consolidated financial statements a liability for that guarantee at fair value at the date of inception and recognized as an expense in profit or loss immediately. The amount of guarantee liability is amortized in profit or loss over the term of the guarantee as income from financial guarantees issued.
Revenue recognition
Pure products sales - Sales revenue is recognized when the significant risks and rewards of ownership have been transferred to the buyer at the time when the products are delivered to and accepted by customers, the sales price is fixed or determinable and collection is reasonably assured.
Products sales with installation, testing, maintenance, repair and replacement - This kind of contract is signed as a whole such that all of these services are provided for one fixed fee, and it does not separate the components of products, installation, testing, maintenance, repair and replacement. After delivery of products/materials to customers, the Company will do the installation and testing works, which takes one to two days, before acceptance and usage by customers. The product life cycle is very short and can normally be used for 80 cycles of production by customers (about two to three days). Thereafter the customers will need maintenance, repair and replacement of the Company’s materials. For each maintenance, repair and replacement, the Company will supply materials and do the installation and testing works again, which are regarded as separate sales by the Company. In other words, the Company will have sales to this kind of customers every couple of days. This kind of sales revenue is recognized when the significant risks and rewards of ownership have been transferred to the buyer at the time when the installation and testing works are completed and after acceptance by customers, the sales price is fixed or determinable and collection is reasonably assured.
Revenue from sales of the Company's product represents the invoiced value of goods, net of the value-added tax ("VAT"). The Company's products that are sold in the PRC are subject to VAT at a rate of 17 percent of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials, other materials or costs included in the cost of producing the Company's products.
Warranty
The Company maintains a policy of providing after sales support for certain products by way of a warranty program. As such these products are guaranteed for usage over a pre-agreed period of time of service life or a pre-determined number of heating times. Further, the relevant customers are allowed to defer the settlement of certain percentage (normally 10%) of the billed amount for certain period of time (normally one year) after acceptance of the Company’s products under the warranty program. As of December 31, 2011 and 2010, such receivables amounted to $976,145 and $1,241,255 respectively and were included in trade receivables.
Since such products were well developed and highly mature, the Company did not encounter any significant claims from such customers based on past experience. Only a fraction of the Company’s sales are under warranty programs. Sales with warranty programs of $9.1 million and $3.4 million accounted for 11.8% and 5.5% of total revenues for the fiscal years of 2011 and 2010, respectively. The warranty programs guarantee the products for usage over a pre-agreed period of time of service life or a pre-determined number of heating times. If a claim qualifies under the program, the Company will be responsible to repair the system.
Based on the materiality criteria of SAB Topic 1.M, the Company begins accruing for warranty expenses at the time of sale when the warranty programs reach 10% of total sales or when warranty expenses reach 5% of net income.
During the year of 2010, as the warranty expenses reached 5% of net income thus material to the consolidated financial statements, the Company began accruing of warranty expenses and making a general provision for warranty. The closing balance of this provision is equal to 2% of relevant sales for the year of 2011 (See note 13).
Stock-based compensation
The Company adopted the provisions of ASC 718, which requires the use of the fair value method of accounting for share-based compensation. Under the fair value based method, compensation cost related to employee stock options or similar equity instruments which are equity-classified awards, is measured at the grant date based on the value of the award and is recognized over the requisite service period, which is usually the vesting period. ASC 718 also requires measurement of cost of a liability-classified award based on its current fair value.
Recently issued accounting pronouncements
In July 2010, the FASB issued ASU 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”. The objective of ASU 2010-20 is to provide financial statement users with greater transparency about an entity’s allowance for credit losses and the credit quality of its financing receivables. Under ASU 2010-20, an entity is required to provide disclosures so that financial statement users can evaluate the nature of the credit risk inherent in the entity’s portfolio of financing receivables, how that risk is analyzed and assessed to arrive at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. ASU 2010-20 is applicable to all entities, both public and non-public and is effective for interim and annual reporting periods ending on or after December 15, 2010. Comparative disclosure for earlier reporting periods that ended before initial adoption is encouraged but not required. However, comparative disclosures are required to be disclosed for those reporting periods ending after initial adoption. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
The FASB issued ASU 2011-02, “Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”. The amendments to Topic 310 clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulties. A creditor should evaluate whether it is probable that the debtor would be in payment default on any of its debts in foreseeable future without the modification. In addition, the amendments to Topic 310 clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a troubled debt restructuring. An entity should disclose the total amount of receivables and the allowance for credit losses as of the end of the period of adoption related to those receivables that are newly considered impaired under Section 310-10-35 for which impairment was previously measured under Subtopic 450-20, Contingencies - Loss Contingencies. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements”. The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. The guidance in this ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.
In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. The FASB and the International Accounting Standard Board (IASB) works together to ensure that fair value has the same meaning in U.S. GAAP and IFRSs and that their respective fair value measurement and disclosure requirements are the same (except for minor differences in wording and style). The Boards concluded that the amendments in this ASU will improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. The amendments in this ASU explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. The amendments in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.
In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. In this ASU, the entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This Update eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments in this ASU are to be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early application by public entities is permitted. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
In September 2011, the FASB issued ASU 2011-08, “Intangibles - Goodwill and Other (Topic 350)”. The amendments in this ASU permits an entity to first assess qualitative factors to determine whether it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity's financial statements for the most recent annual or interim period have not yet been issued. The Company is evaluating the impact of this ASU and does not expect its adoption to have a significant impact on the Company's consolidated financial statements.
In September 2011, the FASB issued ASU 2011-09, “Compensation - Retirement Benefits - Multiemployer Plans (Subtopic 715 - 80)”. The amendments in this ASU will require additional disclosures about an employer's participation in a multiemployer pension plan. Previously, disclosures were limited primarily to the historical contributions made to the plans. ASU 2011-09 applies to nongovernmental entities that participate in multiemployer plans. ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2011, and early adoption is permitted. ASU 2011-09 should be applied retrospectively for all prior periods presented. The Company is evaluating the impact of this ASU and does not expect its adoption to have a material impact on the Company's consolidated financial statements.
In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210)”. The objective of this Update is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this Update. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45. An entity is required to apply the amendments retrospectively for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company is evaluating the impact of this ASU and does not expect its adoption to have a material impact on the Company's consolidated financial statements.
In December 2011, the FASB issued ASU 2011-12, “Comprehensive Income (Topic 220)”. The amendments in this Update supersede certain pending paragraphs in Accounting Standards Update No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”, to effectively defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early application is permitted. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a “smaller reporting company,” as defined by Item 10 of Regulation S-K, the Company is not required to provide this information.
ITEM 8.
ITEM 8. FINANCIAL STATEMENT AND SUPPLEMENTARY DATA
Consolidated Financial Statements
The financial statements required by this item begin on page hereof.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
Disclosure Controls and Procedures
We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) that are designed to ensure that information that would be required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time period specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including to our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As required by Rule 13a-15 under the Exchange Act, our management, including our Chief Executive Officer, Mr. Shunqing Zhang, and our Chief Financial Officer, Mr. Ningfang Liang, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2011. Based on our assessment, Mr. Zhang and Mr. Liang determined that, as of December 31, 2011, our disclosure controls and procedures were effective.
Internal Controls over Financial Reporting
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. Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP, and 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 as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that our receipts and expenditures are being made only in accordance with the authorization of our management and directors; and
3) 	
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2011. In making this assessment, management used the framework set forth in the report entitled Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2011.
The Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures and its internal control processes will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of error or fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that the breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control
There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during our fiscal quarter ended December 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors, Executive Officers, Promoter and Control Persons
Identification of Directors and Executive Officers
The following sets forth the name and position of each of our current executive officers and our directors. All directors of our Company hold office until our next annual board meeting or until their successors have been elected and qualified. The executive officers of our Company and operating subsidiary are appointed by our board of directors and hold office until their death, resignation or removal from office.
There are no arrangements or understandings between our directors and executive officers and any other person pursuant to which any director or officer was or is to be selected as a director or officer, and there are no arrangements, plans or understandings as to whether non-management shareholders will exercise their voting rights to continue to elect the current board of directors. There are also no arrangements, agreements or understandings to our knowledge between non-management shareholders that may directly or indirectly participate in or influence the management of our affairs.
Identification of Certain Significant Employees
Other than the executive officers named above, the Company does not have any “significant employees.”
Family Relationships
There are no family relationships among our directors or officers.
Business Experience
The following is a brief account of the education and business experience during at least the past five years of each director, executive officer and key employee of our Company and operating subsidiary, indicating the person’s principal occupation during that period, and the name and principal business of the organization in which such occupation and employment were carried out.
Shunqing Zhang, age 58. Mr. Zhang became CEO and President of China GengSheng Minerals, Inc. on April 25, 2007 and has served as Chairman of the Board since May 3, 2007. Mr. Zhang was elected Chairman of the Board and CEO of Henan Gengsheng in December, 2005. Prior to that, he served as President of Henan Gengsheng for June 2002 to December 2005, and served as Chairman of the Board and President of the Gengsheng Industry Group of Henan Province, from 1997 to 2002. Prior to that, Mr. Zhang served as Director of the Academy of the Ministry of Metallurgy Lofa Resistance Associated Experimental Plant in Gongyi City, a refractories manufacturer, from 1986 to 1997. Mr. Zhang holds an associate degree from China Central Radio and TV University. In December of 2008, Mr. Zhang was awarded the title of "Gongyi City's Most Influential Person in the 30 Years of Opening & Reform" by the City of Gongyi in Henan Province. In naming Mr. Zhang, the city cited his achievements in creating jobs in the local community, stimulating the rapid growth of Gongyi's economy and setting excellent examples of taking social responsibilities. As Chief Executive Officer of the Company, Mr. Zhang provides the Board with an intimate understanding of the Company’s operations and industry.
Ningfang Liang, age 39. Mr. Liang became our Chief Financial Officer on July 7, 2011. Mr. Liang has over 16 years of finance and accounting experience, including over six years at U.S. public companies, where he managed SEC reporting, internal control, GAAP compliance, as well as internal auditing, financial analysis and management reporting activities. Prior to joining the Company, Mr. Liang worked as Finance Manager at White Mountains Re Ltd, the reinsurance subsidiary of White Mountains Insurance Group, Ltd. from December 2008 to June 2011. Additionally, he has held senior finance and accounting positions at American International Group, Inc. from December 2006 to December 2008, Celgene Corporation from January 2005 to December 2006, and China Construction Bank from July 1993 to May 2002. Mr. Liang is a licensed CPA in the states of New Jersey and Illinois and is a member of the American Institute of Certified Public Accountants. He holds a Bachelor’s degree in finance from Shanghai University of Finance and Economics, and an MBA from the University of Illinois Urbana-Champaign.
Ming He, age 41. Mr. He joined Shengkai Innovations, Inc. (NASDAQ: VALV) in March 2010 and serves as the Chief Financial Officer. Between January 2007 and February 2010, Mr. He served as CFO of Usunco Automotive Limited / Equicap, Inc. From October 2004 until January 2007, Mr. He served as the Senior Manager of SORL Auto Parts, Inc. (NASDAQ: SORL). Mr. He holds designations of Chartered Financial Analyst and Illinois Certified Public Accountant. He received his Master of Science degree in Accountancy in 2004 and Master of Business Administration degree in Finance in 2003 from University of Illinois at Urbana-Champaign. He also received his Bachelor of Arts degree from Shanghai Institute of Foreign Trade in 1992. Mr. He serves as the chair of the Audit Committee and is a member of the Compensation Committee and Nominating and Corporate Governance Committee of the Board.
Jingzhong Yu, Age 47. Prof. Yu currently is an accounting professor at Zhongnan University of Economics and Law and has served in such position since 1985. Prof. Yu also served as an investment advisor from December 2003 to December 2007 to China Wanke Co., Ltd., which is a residential property developer, 999 Group, which is a pharmaceutical manufacturing company, Sanyi Group., Ltd., which is in the equipment and machinery manufacturing business, and China National Salt Industry Corporation, which is in the business of producing salt and salt chemicals. From December 2003 to June 2008, Prof. Yu served as an investment advisor to China Tobacco Group, which manufactures tobacco products. Prof. Yu serves as the chair of the Compensation Committee and is a member of the Audit Committee and Nominating and Corporate Governance Committee of the Board.
Ningsheng Zhou, Age 53. Prof. Zhou has been a professor and director of High Temperature Materials Institute of Henan University of Science and Technology since 2004. From 2000 to 2004, he was a Vice President of Luoyang Institute of Refractories Research (LIRR) in China. Mr. Zhou is an expert in refractories R&D and applications with 30 years of experiences in the refractory industry. Mr. Zhou received his Ph. D. degree from University of Montreal in Canada in 2000 and a Master of Science degree in Inorganic Non-Metallic Materials from LIRR in 1987. He received his Bachelor of Science degree in Refractories Technology from Wuhan University of Science and Technology in 1982 and also worked as a visiting scholar in Germany during 1991 and 1993.
Hsin-I Lin, Age 59. Mr. Lin has been with Rim Asia Capital Partners since 2004, where he served as Partner. Prior to joining Rim Asia Capital Partners, he worked as a Partner at SVO, from 2002-2004. Mr. Lin has approximately twenty years of experience in business administration, direct investment, corporate finance, and investment banking in the United States and China. Mr. Lin received his B.A. from Tamkang University in Taiwan, his M.A. from Waseda University in Japan, his M.B.A from Oklahoma City University in the United States and his PhD in economics from Northwest University in China.
Except as noted above, there are no other agreements or understandings for any of our executive officers or directors to resign at the request of another person and no officer or director is acting on behalf of nor will any of them act at the direction of any other person. Directors are elected until their successors are duly elected and qualified.
Board Meetings and Committees
Board Composition. All actions of board of directors require the approval of a majority of the directors in attendance at a meeting at which a quorum is present. Our board of directors is composed of Mr. Shunqing Zhang, who is also our President and Chief Executive Officer, Mr. Ming He, Mr. Jingzhong Yu, Mr. Ningsheng Zhou, and Mr. Hsin-I Lin. The Board has determined that the following directors, who constitute a majority of the Board (three), are independent in accordance with the NYSE Amex and SEC rules governing director independence: Ming He, Jingzhong Yu and Hsin-I Lin.
Meetings of the Board of Directors. During 2011, the Board of Directors met seven times. During that period, each of the incumbent directors attended 100% of the aggregate number of meetings held by the Board and by each of the committees on which such director served.
Board Committees. Our Board of Directors currently has three standing committees: the Audit Committee, the Compensation Committee and the Nominating Committee. The principal functions and the names of the directors currently serving as members of each of those committees are set forth below. In accordance with applicable NYSE Amex and SEC requirements, the Board of Directors has determined that each director serving on the Audit, Compensation and Nominating committees is an independent director.
Audit Committee. The Audit Committee assists the Board in fulfilling its oversight responsibilities with respect to our financial matters. The Audit Committee operates under a written charter, a copy of which is available on our website at www.gengsheng.com under the heading “Investor Relations.” Under the charter, the committee’s principal responsibilities include reviewing our financial statements, reports and releases; reviewing with the independent auditor all critical accounting policies and alternative treatments of financial information under generally accepted accounting principles; and appointing, compensating, retaining and overseeing the work of the independent auditor.
The Audit Committee met three times during 2011. The current members of the Audit Committee are Ming He (Chairman), Jingzhong Yu and Hsin-I Lin. The Board of Directors has determined that Mr. He is an “audit committee financial expert,” as that term is defined in SEC rules.
Compensation Committee. The Compensation Committee has the primary authority to determine our compensation philosophy and to establish compensation for our executive officers. The Compensation Committee operates under a written charter, a copy of which is available on our website at www.gengsheng.com under the heading “Investor Relations.” Under the charter, the committee’s principal responsibilities include making recommendations to the Board on the Company’s compensation policies, determining the compensation of senior management, making recommendations to the Board on the compensation of independent directors and approving performance-based compensation.
The Compensation Committee did not meet during 2011. The current members of the Compensation Committee are Jingzhong Yu (Chairman), Ming He and Hsin-I Lin.
Nominating Committee. The Nominating Committee provides for the nomination of persons to serve on our Board. The qualifications of recommended candidates also will be reviewed and approved by the full Board. The Committee considered the following factors when qualifying candidates: current composition of the Board and the characteristics of each candidate under consideration, including that candidate’s competencies, experience, reputation, integrity, independence, potential for conflicts of interest and other appropriate qualities. When considering a director standing for re-election, in addition to the factors described above, the Committee considers that individual’s past contribution and future commitment to the Company. The independent directors evaluate all candidates, regardless of the source from which the candidate was first identified, based upon the totality of the merits of each candidate and not based upon minimum qualifications or attributes. The Nominating Committee operates under a written charter, a copy of which is available on our website at www.gengsheng.com under the heading “Investor Relations.”
The Nominating Committee did not meet during 2011. The current members of the Nominating Committee are Hsin-I Lin (Chairman), Ming He and Jingzhong Yu.
Involvement in Certain Legal Proceedings
To the best of our knowledge, during the past ten years, none of our officers or directors were involved in any of the following: (1) any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; (2) any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses); (3) being subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; and (4) being found by a court of competent jurisdiction (in a civil action), the Commission or the Commodities Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended or vacated.
Section 16(A) Beneficial Ownership Reporting Compliance
Under U.S. securities laws, directors, certain executive officers and persons holding more than 10% of our common stock must report their initial ownership of the common stock, and any changes in that ownership, to the SEC. The SEC has designated specific due dates for these reports. Mr. Hsin-I Lin, our director, filed a Form 3 on October 17, 2011 to report his director appointment on October 5, 2011.
Code of Ethics
On April 25, 2007, our then sole director adopted a code of ethics pursuant to Section 406 of the Sarbanes-Oxley Act of 2002 that applies to all of our directors, officers and employees, including our principal executive officer, principal financial officer, and principal accounting officer. The code of ethics is designed to deter wrongdoing and to promote:
Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
Full, fair, accurate, timely and understandable disclosure in reports and documents that we file with, or submit to, the SEC, and in other public communications that we made;
Compliance with applicable government laws, rules and regulations;
The prompt internal reporting of violations of the code to the appropriate person or persons; and
Accountability for adherence to the code.
The code requires the highest standard of ethical conduct and fair dealing of its senior financial officers, or SFO, defined as the Chief Executive Officer and Chief Financial Officer. While this policy is intended to only cover the actions of the SFO, in accordance with Sarbanes-Oxley, we expect our other officers, directors and employees will also review our code and abide by its provisions. We believe that our reputation is a valuable asset and must continually be guarded by all associated with us so as to continue the trust, confidence and respect of our suppliers, customers and stockholders.
Our SFO are committed to conducting business in accordance with the highest ethical standards. The SFO must comply with all applicable laws, rules and regulations. Furthermore, SFO must not commit an illegal or unethical act, or instruct or authorize others to do so.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Table
The following table sets forth information concerning all cash and non-cash compensation awarded to, earned by or paid to the following persons for services rendered in all capacities during the noted periods: Shunqing Zhang, our President and Chief Executive Office, and Ningfang Liang, our Chief Financial Officer.
No executive officer’s salary and bonus exceeded $100,000 in any of the applicable years. The following information includes the dollar value of base salaries, bonus awards, the number of stock options granted and certain other compensation, if any, whether paid or deferred.
SUMMARY COMPENSATION TABLE
Outstanding Equity Awards at Fiscal Year End
None.
Employment Agreement
As required by applicable PRC law, we have entered into employment agreements with most of our officers, managers and employees. Our subsidiary Henan Gengsheng has employment agreements with the following named executive officers:
Shunqing Zhang. Mr. Zhang’s preliminary employment agreement became effective as of January 1, 2007 and expired on December 31, 2009. We have renewed his employment agreement in January 2010 and 2012, which will expire on December 31, 2013, and we expect that this agreement will be renewed by the parties upon its expiration. Mr. Zhang is receiving an annual salary of approximately $78,700 under the agreement.
Ningfang Liang. Pursuant to employment agreement that the Company and Mr. Liang entered into on June 30, 2011, Mr. Liang will be entitled to an annual salary of $90,000. The employment agreement has an initial term (the “Initial Term”) commencing as of June 27th, 2011 and expiring on June 26th, 2012, and continuing on a year-to-year basis thereafter unless terminated by either party on not less than thirty (30) days notice prior to the expiration of the Initial Term or any one-year extension.
Director Compensation
On November 18, 2009, we appointed Mr. Ming He and Mr. Jingzhong Yu as our independent directors, with engagement term to be one year. On July 15, 2011, we appointed Mr. Ningsheng Zhou as our director. On October 5, 2011, we appointed Mr. Hsin-I Lin as our independent director, with engagement term to be one year. Our board consists of five members, including the CEO, Mr. Shunqing Zhang, sits as the Chairman of the Board, Mr. Ningsheng Zhou, and along with the three independent directors. During the 2011 fiscal year, we did not pay Mr. Shunqing Zhang any compensation for his services as our director. For their function as directors, we paid Mr. Zhou, Mr. He, Mr. Yu and Mr. Lin in the amount of $18,588 (RMB 120,000), $25,000, $7,745 (RMB 50,000) and $6,250 respectively. We do reimburse our directors for reasonable travel expenses related to duties as a director.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Security Ownership of Certain Beneficial Owners and Management
The following table sets forth information regarding beneficial ownership of our common stock as of April 16, 2012 (i) by each person who is known by us to beneficially own more than 5% of our common stock; (ii) by each of our officers and directors; and (iii) by all of our officers and directors as a group.
Unless otherwise specified, the address of each of the persons set forth below is in care of GengSheng International, No. 88 Gengsheng Road, Dayugou Town, Gongyi, Henan, China 451271.
* Less than 1%
1Beneficial ownership is determined in accordance with the rules of the SEC and generally includes voting or investment power with respect to securities. Each of the beneficial owners listed above has direct ownership of and sole voting power and investment power with respect to the shares of our common stock.
2As of April 16, 2012, a total of 26,803,044 shares of our common stock are considered to be outstanding pursuant to SEC Rule 13d-3(d)(1). For each beneficial owner above, any options exercisable within 60 days have been included in the denominator.
Changes in Control
There are no arrangements known to us, including any pledge by any person of our securities, the operation of which may at a subsequent date result in a change in control of our Company.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
Transactions with Related Persons
There were no material transactions, or series of similar transactions, during our last two fiscal years, or any currently proposed transactions, or series of similar transactions, to which our Company or any of our subsidiaries was or is to be a party, in which the amount involved exceeded the lesser of $120,000 or 1% of the average of our total assets at year-end for the last two completed fiscal years and in which any director, executive officer or any security holder who is known to us to own of record or beneficially more than five percent of any class of our common stock, or any member of the immediate family of any of the foregoing persons, had an interest.
Promoters and Certain Control Persons
See the heading “Transactions with Related Persons” above.
Director Independence
Our board of directors is currently composed of five members, Mr. Shunqing Zhang, who is also our President and Chief Executive Officer, Mr. Ningsheng Zhou, Mr. Ming He, who is an independent director and Chairman of Audit Committee, Mr. Jingzhong Yu, who is an independent director and Chairman of Compensation Committee and Mr. Hsin-I Lin, who is an independent director and Chairman of Nominating and Corporate Governance Committee. Mr. Zhang and Mr. Zhou are not an “independent director” as defined by Section 303A.02 of the NYSE Listed Company Manual.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
PKF Hong Kong, is our independent registered public accounting firm engaged to examine our consolidated financial statements since the date of recapitalization on April 25, 2007.
Fees for the fiscal years ended December 31, 2011 and 2010
Audit Fees. PKF Hong Kong, was paid aggregate fees of approximately $143,485 and $136,160 for professional services rendered for the audit of our annual financial statements and for the reviews of the financial statements for the fiscal years ended December 31, 2011 and 2010.
Audit Related Fees. PKF Hong Kong, was not paid additional fees for the fiscal years December 31, 2011 and December 31, 2010 for assurance and related services reasonably related to the performance of the audit or review of our financial statements.
Tax Fees. PKF Hong Kong, was not paid any fees for the fiscal years ended December 31, 2011 and December 31, 2010 for professional services rendered for tax compliance, tax advice and tax planning. This service was not provided.
All Other Fees. PKF Hong Kong, was paid no other fees for professional services during the fiscal years ended December 31, 2011 and December 31, 2010.
Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors
Our audit committee and board of directors reviewed and approved all audit services provided by PKF Hong Kong, and has determined that the firm's provision of such services to us during 2011 is compatible with and did not impair the independence of PKF Hong Kong. It is the practice of our audit committee and board of directors to consider and approve in advance all auditing services provided to us by our independent auditors.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The following documents are filed as part of this report:
Exhibit No.
Description
Exhibit No.
Description
Exhibit No.
Description
Notes to exhibits
* Filed herewith
China GengSheng Minerals, Inc.
Consolidated Financial Statements
For the years ended December 31, 2011 and 2010
Index to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
China GengSheng Minerals, Inc.
We have audited the accompanying consolidated balance sheets of China GengSheng Minerals, Inc. (the "Company") and its subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations and comprehensive loss, equity and cash flows for each of the years ended December 31, 2011 and 2010. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company and its subsidiaries as of December 31, 2011 and 2010, and the consolidated results of their operations and their cash flows for each of the years ended December 31, 2011 and 2010 in conformity with accounting principles generally accepted in the United States of America.
PKF
Certified Public Accountants
Hong Kong, China
April 16, 2012
F - 1
China GengSheng Minerals, Inc.
Consolidated Balance Sheets
COMMITMENTS AND CONTINGENCIES (Note 21)
F - 2
China GengSheng Minerals, Inc.
Consolidated Balance Sheets (Cont'd)
The accompanying notes are an integral part of these consolidated financial statements.
F - 3
China GengSheng Minerals, Inc.
Consolidated Statements of Operations and Comprehensive Loss
The accompanying notes are an integral part of these consolidated financial statements.
F - 4
China GengSheng Minerals, Inc.
Consolidated Statements of Cash Flows
F - 5
China GengSheng Minerals, Inc.
Consolidated Statements of Cash Flows (Cont’d)
The accompanying notes are an integral part of these consolidated financial statements.
F - 6
China GengSheng Minerals, Inc.
Consolidated Statements of Equity
The accompanying notes are an integral part of these consolidated financial statements.
F - 7
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
1.
Corporate information
The Company was originally incorporated on November 13, 1947, in accordance with the laws of the State of Washington as Silver Mountain Mining Company. On August 20, 1979, the Articles of Incorporation were amended to change the corporate name of the Company to Leadpoint Consolidated Mines Company. On August 15, 2006, the Company changed its state of incorporation from Washington to Nevada by means of a merger with and into a Nevada corporation formed on May 23, 2006, solely for the purpose of effecting the reincorporation and changed its name to Point Acquisition Corporation. On June 11, 2007, the Company changed its name to China Minerals Technologies, Inc. and on July 26, 2007, the Company changed its name to China GengSheng Minerals, Inc. On March 4, 2010, the Company’s common stock began trading on the NYSE Amex Stock Exchange (formerly the American Stock Exchange) under the symbol “CHGS”. Prior to March 4, 2010, the Company’s common stock traded on the Over-the-Counter Bulletin Board under the symbol “CHGS.OB”.
Currently the Company has the following eight subsidiaries:
F - 8
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
2.
Description of business
The Company is a holding company whose primary business operations are conducted through its subsidiaries located in the PRC’s Henan Province. Prefecture is located in Guizhou Province and is manufacturing corundum materials, a major raw material for monolithic refractory. Through its operating subsidiaries, the Company produces and markets a broad range of monolithic refractory, functional ceramics, fracture proppant, fine precision abrasives, and corundum materials.
The principal raw materials used in the products are several forms of aluminum oxide, including bauxite, processed AI2 O3 and calcium aluminates cement, and other materials, such as corundum, magnesia, resin and silica, which are primarily sourced from suppliers located in the PRC. The production facilities of the Company, other than the Prefecture’s sub-processing factory located in Guizhou, are also located in Henan Province.
Refractories products allow steel makers and other customers to improve the productivity and longevity of their equipment and machinery. Functional ceramic products mainly include abrasive balls and tiles, valves, electronic ceramics and structural ceramics. Fracture proppant products are used to reach trapped pockets of oil and natural gas deposits, which lead to higher productivities of oil and natural gas wells. Due to their heat-resistant qualities and ability to function under thermal stress, refractories serve as components in industrial furnaces and other heavy industrial machinery. Corundum materials are a major raw material for producing monolithic refractory. Fine precision abrasive is the Company’s new product that was commercially launched in the fourth quarter of 2009, and is used for slicing the solar-silicon bar and polishing the equipment surface. The Company’s customers include some of the largest steel and iron producers located in 25 provinces in the PRC, as well as in the United States and other countries in Asia, and Europe.
3.
Summary of significant accounting policies
Basis of consolidation
The accompanying consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America.
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.
Noncontrolling interest
Noncontrolling interest resulted from the consolidation of an 89.33% owned subsidiary, High-Temperature.
Use of estimates
In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. These accounts and estimates include, but are not limited to, the valuation of trade receivables, other receivables, inventories, deferred income taxes, provision of warranty, the estimation on useful lives of property, plant and equipment and the impairment of goodwill, and know-how and deposit for acquisition of a non-consolidated affiliate. Actual results could differ from those estimates.
F - 9
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont'd)
Concentrations of credit risk
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and cash equivalents, restricted cash, trade, bills and other receivables. As of December 31, 2011 and 2010, substantially all of the Company’s cash and cash equivalents and restricted cash were held by major financial institutions located in the PRC and Hong Kong, which management believes are of high credit quality. With respect to trade and other receivables, the Company extends credit based on an evaluation of the customer’s financial condition. The Company generally does not require collateral for trade and other receivables and maintains an allowance for doubtful accounts of trade and other receivables.
Regarding bills receivable, they are undertaken by the banks to honor the payments at maturity and the customers are required to place deposits with the banks equivalent to a certain percentage of the bills amount as collateral. These bills receivable can be sold to any third party at a discount before maturity. The Company does not maintain allowance for bills receivable in the absence of bad debt experience and the payments are undertaken by the banks.
During the reporting periods, customers represented 10% or more of the Company’s consolidated sales are:
During the reporting periods, no customers represented 10% or more of the Company’s trade receivables.
Cash and cash equivalents
Cash and cash equivalents include all cash, deposits in banks and other highly liquid investments with initial maturities of three months or less to be cash equivalents. As of December 31, 2011, cash and cash equivalents of approximately $2.4 million were denominated in Hong Kong dollar and were placed with banks in Hong Kong. Approximately $1.2 million were denominated in Renminbi (“RMB”) and were placed with banks in the PRC. As of December 31, 2010, almost all the cash and cash equivalents were denominated in Renminbi (“RMB”) and were placed with banks in the PRC. Cash and cash equivalents denominated in RMB are not freely convertible into foreign currencies and the remittance of these funds out of the PRC is subject to exchange control restrictions imposed by the PRC government.
Restricted Cash
Deposits in banks pledged as collateral for bills payable and bank loans (Note 4) that are restricted in use are classified as restricted cash under current assets.
Allowance for doubtful accounts
The Company establishes an allowance for doubtful accounts based on management’s assessment of the collectibility of trade receivables. A considerable amount of judgment is required in assessing the amount of the allowance. The Company considers the historical level of credit losses and applies percentages to aged receivable categories. The Company makes judgments about the creditworthiness of each customer based on ongoing credit evaluations, and monitors current economic trends that might impact the level of credit losses in the future. If the financial condition of the customers were to deteriorate, resulting in their inability to make payments, a larger allowance may be required.
Based on the above assessment, the management changed the general provisioning policy for the year ended December 31, 2011 to make allowance equivalent to 5% (2010 : 5%) of trade receivables due from 1 to 2 years, 40% (2010 : 40%)of trade receivables due from 2 to 3 years and 90% (2010 : 70%) of trade receivables due over 3 years. Additional specific provision is made against trade receivables to the extent which they are considered to be doubtful.
Bad debts are written off when identified. The Company does not accrue interest on trade receivables.
F - 10
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Inventories
Inventories are stated at the lower of cost or market. Cost is determined on a weighted average basis and includes all expenditures incurred in bringing the goods to the point of sale and putting them in a saleable condition. In case of manufacturing inventories and work in progress, cost includes an appropriate share of production overheads based on normal operating capacity. In assessing the ultimate realization of inventories, the management makes judgments as to future demand requirements compared to current or committed inventory levels. Our reserve requirements generally increase as our projected demand requirements increases; decrease due to market conditions and product life cycle changes. The Company estimates the demand requirements based on market conditions, forecasts prepared by its customers, sales contracts and orders in hand.
In addition, the Company estimates net realizable value based on intended use, current market value and inventory ageing analyses. The Company writes down the inventories for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventories and the estimated market value based upon assumptions about future demand and market conditions.
Based on the above assessment, the Company establishes a general policy to make a 50% provision for inventories aged over 1 year. Historically, the actual net realizable value is close to the management’s estimation.
Property, plant and equipment
Property, plant and equipment are stated at cost less accumulated depreciation. Cost represents the purchase price of the asset and other costs incurred to bring the asset into its existing use.
Depreciation is provided on straight-line basis over their estimated useful lives. The principal effective depreciation rates are as follows:
Maintenance or repairs are charged to expense as incurred. Upon sale or disposition, the applicable amounts of asset cost and accumulated depreciation are removed from the accounts and the net amount less proceeds from disposal is charged or credited to income.
Construction in progress mainly represents expenditures in respect of the Company’s new offices and factories under construction. All direct costs relating to the acquisition or construction of the Company’s new office and factories are capitalized as construction in progress. No depreciation is provided in respect of construction in progress.
Intangible assets
The Company accounts for goodwill and intangible assets in accordance with the provisions of ASC 350 (previously SFAS No. 142). The provisions of ASC 350 (i) prohibit the amortization of goodwill and indefinite-lived intangible assets, (ii) require that goodwill and indefinite-lived intangible assets be tested annually for impairment (and in interim periods if certain events occur indicating that the carrying value may be impaired), and (iii) require that reporting units be identified for the purpose of assessing potential future impairments of goodwill.
F - 11
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Intangible assets (Cont’d)
The intangible assets of the Company are comprised of unpatented technology. Unpatented technology is determined to have an expected useful life and can be used up to 2015 as detailed in Note 9a. Unpatented technology is stated at cost of purchase less any accumulated amortization and any identified impairment losses in the annual impairment review.
Goodwill
Goodwill is recognized upon acquisition of the equity interest in the acquiree, which represent the excess of the purchase price over the fair value of acquired identified net assets of the acquiree at the time of acquisition. It is stated at cost less impairment losses.
The goodwill was identified upon the acquisition of 100% equity interest in Prefecture, which represented the excess of the purchase price of $875,400 over the fair value of acquired identified net assets of Prefecture of $434,311 at the time of acquisition on June 12, 2008. Since its acquisition, annual impairment reviews have been performed by management and the goodwill was considered fully impaired as of December 31, 2011.
Land use rights
Land use rights are stated at cost less accumulated amortization. Amortization is provided using the straight-line method over the terms of the leases of 39 to 50 years obtained from the relevant PRC land authority.
Impairment of long-lived assets
Long-lived assets are tested for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The Company recognizes impairment of long-lived assets in the event that the net book values of such assets exceed the future undiscounted cash flows attributable to such assets.
Government grant
The government grant is recognized in the consolidated statements of operations and comprehensive loss when the relevant performance criteria are met. Grants applicable to purchase of property, plant and equipment are amortized over the life of the depreciable assets.
The government grants for the year ended December 31, 2010 were mainly incentive payment of $122,914 from the local government for the advanced technology subsidy paid to Refractories.
The government grants of $379,505 for the year ended December 31, 2011 included subsidized interest payments of $356,270 and incentive payment of $23,235 for the advanced technology subsidy provided by the local government.
Financial guarantee issued
The Company has acted as guarantor for bank loans granted to certain local authorities and certain business associates. The Company assessed its obligation under this guarantee pursuant to the provision of ASC 460 “Guarantee”. The Company recognized in its consolidated financial statements a liability for that guarantee at fair value at the date of inception and recognized as an expense in profit or loss immediately. The amount of guarantee liability is amortized in profit or loss over the term of the guarantee as income from financial guarantees issued.
Capitalized interest
The interest cost associated with the major development and construction projects is capitalized and included in the cost of the project. When no debt is incurred specifically for a project, interest is capitalized on amounts expended on the project using weighted-average cost of the Company's outstanding borrowings. Capitalization of interest ceases when the project is substantially complete or development activity is suspended for more than a brief period.
F - 12
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Revenue recognition
Pure products sales - Sales revenue is recognized when the significant risks and rewards of ownership have been transferred to the buyer at the time when the products are delivered to and accepted by customers, the sales price is fixed or determinable and collection is reasonably assured.
Products sales with installation, testing, maintenance, repair and replacement - This kind of contract is signed as whole such that all of these service are provided for one fixed fee, and it does not separate the components of products, installation, testing, maintenance, repair and replacement. After delivery of products/materials to customers, the Company will do the installation and testing works, which takes one to two days, before acceptance and usage by customers. The product life cycle is very short and can normally be used for 80 cycles of production by customers (about two to three days). Thereafter the customers will need maintenance, repair and replacement of the Company’s materials. For each maintenance, repair and replacement, the Company will supply materials and do the installation and testing works again, which are regarded as separate sales by the Company. In other words, the Company will have sales to this kind of customers every couple of days. This kind of sales revenue is recognized when the significant risks and rewards of ownership have been transferred to the buyer at the time when the installation work and testing are completed and after acceptance by customers, the sales price is fixed or determinable and collection is reasonably assured.
Revenue from sales of the Company's product represents the invoiced value of goods, net of the value-added tax ("VAT"). The Company's products that are sold in the PRC are subject to VAT at a rate of 17 percent of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials, other materials or costs included in the cost of producing the Company's products.
Selling expenses
Selling expenses mainly consist of advertising, commission, entertainment, salaries, shipping and handling cost and traveling expenses which are incurred during selling activities.
Advertising, shipping and handling costs
Advertising, shipping and handling costs and other product-related costs are charged to expense as incurred.
Advertising expense amounting to $19,459 and $13,909 for the years ended December 31, 2011 and 2010, respectively, were included in selling expenses.
Shipping and handling costs amounting to $3,482,695 and $3,277,177 for the years ended December 31, 2011 and 2010, respectively, were included in selling expenses.
Research and development expenses
Research and development expenses include cost of raw material consumed, testing expenses and other costs incurred for research and development of potential new products. They are expensed when incurred. Research and development costs amounted to $699,367 and $817,179 for the years ended December 31, 2011 and 2010, respectively.
Warranty
The Company maintains a policy of providing after sales support for certain products by way of a warranty program. As such these products are guaranteed for usage over a pre-agreed period of time of service life or a pre-determined number of heating times. Further, the relevant customers are allowed to defer the settlement of certain percentage (normally 10%) of the billed amount for certain period of time (normally one year) after acceptance of the Company’s products under the warranty program. As of December 31, 2011 and 2010, such receivables amounted to $976,145 and $1,241,255 respectively and were included in trade receivables.
Since such products were well developed and highly mature, the Company did not encounter any significant claims from such customers based on past experience. Only a fraction of the Company’s sales are under warranty programs. Sales with warranty programs of $9.1 million and $3.4 million accounted for 11.8% and 5.5% of total revenues for the fiscal years of 2011 and 2010, respectively. The warranty programs guarantee the products for usage over a pre-agreed period of time of service life or a pre-determined number of heating times. If a claim qualifies under the program, the Company will be responsible to repair the system.
F - 13
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Warranty (Cont’d)
Based on the materiality criteria of SAB Topic 1.M, the Company begins accruing for warranty expenses at the time of sale when the warranty programs reach 10% of total sales or when warranty expenses reach 5% of net income.
During the year of 2010, as the warranty expenses reached 5% of net income thus material to the consolidated financial statements, the Company began accruing of warranty expenses and making a general provision for warranty. The closing balance of this provision is equal to 2% of relevant sales for the year of 2011 (see Note 13).
Cost of sales
Cost of sales consists primarily of material costs, freight charges, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs, wages, employee compensation, depreciation and related costs, which are directly attributable to the production of products. Write-down of inventory to lower of cost or market is also recorded in cost of sales.
General and administrative expenses
General and administrative expenses consist of rent paid, office expenses, staff welfare, consumables, research and development costs, labor protection and salaries and wages which are incurred at the administrative level and exchange difference.
Stock-based compensation
The Company adopted the provisions of ASC 718, which requires the use of the fair value method of accounting for share-based compensation. Under the fair value based method, compensation cost related to employee stock options or similar equity instruments which are equity-classified awards, is measured at the grant date based on the value of the award and is recognized over the requisite service period, which is usually the vesting period. ASC 718 also requires measurement of cost of a liability-classified award based on its current fair value.
Income taxes
The Company uses the asset and liability method of accounting for income taxes pursuant to ASC 740 “Income Taxes”. Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statements’ carrying amounts of existing assets and liabilities and loss carry forwards and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Comprehensive income (loss)
The Company has adopted ASC 220, “Comprehensive Income”, which establishes standards for reporting and display of comprehensive income (loss), its components and accumulated balances. Components of comprehensive income (loss) include net income (loss) and foreign currency translation adjustments.
F - 14
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Foreign currency translation
The functional currency of the Company is RMB and RMB is not freely convertible into foreign currencies. The Company maintains its financial statements in the functional currency. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at rates of exchange prevailing at the balance sheet date. Transactions denominated in currencies other than the functional currency are translated into the functional currency at the exchanges rates prevailing at the dates of the transaction. Exchange gains or losses arising from foreign currency transactions are included in the determination of net income for the respective periods.
For financial reporting purposes, the financial statements of the Company which are prepared using the functional currency have been translated into United States dollars. Assets and liabilities are translated at the exchange rates at the balance sheet dates and revenue and expenses are translated at the average exchange rates and stockholders’ equity is translated at historical exchange rates. Any translation adjustments resulting are not included in determining net income but are included in foreign exchange adjustment to other comprehensive income, a component of stockholders’ equity. The exchange rates in effect as of December 31, 2011 and 2010 were RMB1 for $0.1574 and $0.1517 respectively. The average exchange rates for the years end December 31, 2011 and 2010 were RMB1 for $0.1549 and $0.1480 respectively. There is no significant fluctuation in exchange rate for the conversion of RMB to US dollars after the balance sheet date.
Recorded in other comprehensive income are translation exchange gains which amounted to $1,716,651 and $1,614,615 for the two years ended December 31, 2011 and 2010, respectively.
Basic and diluted earnings (loss) per share
The Company reports basic earnings (loss) per share in accordance with ASC 260 “Earnings Per Share”. Basic earnings (loss) per share are computed using the weighted average number of shares outstanding during the periods presented. The weighted average number of shares of the Company represents the common stock outstanding during the reporting periods.
Commitments and Contingencies
Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated.
Off-balance sheet arrangements
Apart from the guarantee given as stated in Note 21(b) by the Company to third parties, the Company does not have any off-balance sheet arrangements.
Fair value of financial instruments
ASC 820 requires the disclosure of the estimated fair value of financial instruments including those financial instruments for which fair value option was not elected. The Company’s financial instruments carried at fair value include warrant liabilities only. The required disclosure is set out in Note 27.
Except for the warrant liabilities, the carrying amount of financial assets and liabilities approximate their fair value due to short maturities.
F - 15
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Recently issued accounting pronouncements
In July 2010, the FASB issued ASU 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”. The objective of ASU 2010-20 is to provide financial statement users with greater transparency about an entity’s allowance for credit losses and the credit quality of its financing receivables. Under ASU 2010-20, an entity is required to provide disclosures so that financial statement users can evaluate the nature of the credit risk inherent in the entity’s portfolio of financing receivables, how that risk is analyzed and assessed to arrive at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. ASU 2010-20 is applicable to all entities, both public and non-public and is effective for interim and annual reporting periods ending on or after December 15, 2010. Comparative disclosure for earlier reporting periods that ended before initial adoption is encouraged but not required. However, comparative disclosures are required to be disclosed for those reporting periods ending after initial adoption. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
The FASB issued ASU 2011-02, “Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”. The amendments to Topic 310 clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulties. A creditor should evaluate whether it is probable that the debtor would be in payment default on any of its debts in foreseeable future without the modification. In addition, the amendments to Topic 310 clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a troubled debt restructuring. An entity should disclose the total amount of receivables and the allowance for credit losses as of the end of the period of adoption related to those receivables that are newly considered impaired under Section 310-10-35 for which impairment was previously measured under Subtopic 450-20, Contingencies - Loss Contingencies. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements”. The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. The guidance in this ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.
In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. The FASB and the International Accounting Standard Board (IASB) works together to ensure that fair value has the same meaning in U.S. GAAP and IFRSs and that their respective fair value measurement and disclosure requirements are the same (except for minor differences in wording and style). The Boards concluded that the amendments in this ASU will improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. The amendments in this ASU explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. The amendments in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.
F - 16
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
3.
Summary of significant accounting policies (Cont’d)
Recently issued accounting pronouncements (cont’d)
In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. In this ASU, the entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This Update eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments in this ASU are to be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early application by public entities is permitted. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
In September 2011, the FASB issued ASU 2011-08, “Intangibles - Goodwill and Other (Topic 350)”. The amendments in this ASU permits an entity to first assess qualitative factors to determine whether it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity's financial statements for the most recent annual or interim period have not yet been issued. The Company is evaluating the impact of this ASU and does not expect its adoption to have a significant impact on the Company's consolidated financial statements.
In September 2011, the FASB issued ASU 2011-09, “Compensation - Retirement Benefits - Multiemployer Plans (Subtopic 715 -80)”. The amendments in this ASU will require additional disclosures about an employer's participation in a multiemployer pension plan. Previously, disclosures were limited primarily to the historical contributions made to the plans. ASU 2011-09 applies to nongovernmental entities that participate in multiemployer plans. ASU 2011-09 is effective for annual periods for fiscal years ending after December 15, 2011, and early adoption is permitted. ASU 2011-09 should be applied retrospectively for all prior periods presented. The Company is evaluating the impact of this ASU and does not expect its adoption to have a material impact on the Company’s consolidated financial statements.
In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210)”. The objective of this Update is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this Update. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45. An entity is required to apply the amendments retrospectively for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company is evaluating the impact of this ASU and does not expect its adoption to have a material impact on the Company's consolidated financial statements.
In December 2011, the FASB issued ASU 2011-12, “Comprehensive Income (Topic 220)”. The amendments in this Update supersede certain pending paragraphs in Accounting Standards Update No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”, to effectively defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early application is permitted. The adoption of this ASU has no material impact on the Company’s consolidated financial statements.
F - 17
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
4.
Restricted cash and bills payable
Notes :-
a)
The Company is requested by certain suppliers to settle amounts owed to such suppliers by the issuance of bills through banks for which the banks undertake to guarantee the Company’s settlement of these amounts at maturity. These bills are interest free and would be usually matured within six months from the date of issuance. As collateral security for the banks’ undertakings, the Company is required to pay the bank charges as well as maintaining deposits with such banks amounts equal 50% or 100% of the bills’ amounts issued.
b)
The amount was held by a third party due to the dispute with one supplier at Prefecture.
5.
Trade receivables, net
An analysis of the allowance for doubtful debts accounts for the years ended December 31, 2011 and 2010 is as follows:
F - 18
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
6.
Other receivables and prepayments, net and advances to senior management
An analysis of the allowance for doubtful accounts for the years ended December 31, 2011 and 2010 is as follows:
Notes :-
a)
As of December 31, 2011, government grant receivables represented incentive bonus of $396,144 from the local government for successful back-door listing and good performance by Refractories.
b)
The loans to third parties mainly represent the loans to companies and government entity which have business connections with the Company. The amounts are interest-free, unsecured and repayable on demand.
The advances to senior management are mainly for handling sourcing activities and for travel and other expenses in the ordinary course of business.
c)
The amounts mainly represent staff drawings for handling sourcing and logistic activities for the Company in the ordinary course of business.
F - 19
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
7.
Inventories, net
Note: During the years ended December 31, 2011 and 2010, no allowance for obsolete inventories was recognized in the cost of goods sold.
8.
Deposit for acquisition of a non-consolidated affiliate, net
The Company paid RMB 15 million (equivalent to $2.36 million) in August 2010 to acquire 24.5% equity interest in Yili YiQiang Silicon Limited ("Yili"), a company established in the PRC and engaged in manufacturing and trading of silicon carbide. Due to some unexpected administrative difficulties in the completion of the acquisition, the aforesaid investment amount paid was only recognized as deposit as the ownership, risks and rewards of 24.5% equity interest in Yili had not been transferred to the Company as of December 31, 2011. However, the management is committed to the completion of this acquisition and expects that it will be completed by May 2012.
The management opined that there is an indication of impairment as the financial position of Yili deteriorated subsequent to the payment of deposit. Based on the impairment review performed by the management with reference to the financial position of Yili as of December 31, 2011, an impairment loss of $1,248,804 was recognized in the consolidated statements of operations and comprehensive loss for the year ended December 31, 2011 as the management assessed the probability of recovering the whole carrying value of the deposit was unlikely.
9.
Intangible assets, net and goodwill, net
F - 20
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
9.
Intangible assets, net and goodwill, net (Cont'd)
Notes :-
a)
During 2007, Refractories entered into a contract with an independent third party to purchase unpatented technology in relation to the production of mortar, at a cash consideration of $342,750. This consideration was mutually agreed between Refractories and such third party and this unpatented technology can be used for an unlimited period of time. Since its acquisition, an annual impairment review was performed by management and it was stated at cost less any impairment losses. In 2011, the expected useful life of the unpatented technology was reviewed and can be used up to 2015. Unpatented technology is stated at cost less any accumulated amortization and any identified impairment losses. Based on the result of the impairment review performed by the management at the end of 2011, the management assessed the probability of recovering the carrying value of the unpatented technology was unlikely and the intangible asset was considered fully impaired.
During the year ended December 31, 2011, the amortization charge was $77,450.
b)
The goodwill was identified upon the acquisition of 100% equity interest in Prefecture, which represented the excess of the purchase price of $875,400 over the fair value of acquired identified net assets of Prefecture of $434,311 at the time of acquisition on June 12, 2008. Since its acquisition, annual impairment reviews have been performed by management. Based on the result of the impairment review performed by the management at the end of 2011, the management assessed the probability of recovering the carrying value of the goodwill was unlikely and the goodwill was considered fully impaired.
10.
Property, plant and equipment, net
(i)
During the reporting periods, depreciation is included in:
During the years ended December 31, 2011 and 2010, property, plant and equipment with carrying amounts of $116,386 and $215,815 were disposed of at considerations of $112,067 and $288,741 resulting in a loss of $4,319 and a gain of $72,926, respectively.
There was no capitalized interest for the years ended December 31, 2011 and 2010 as the amount was immaterial.
(ii)
Construction in Progress
Construction in progress mainly comprises capital expenditure for construction of the Company’s new offices and factories.
F - 21
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
11.
Land use rights
The Company obtained the right from the relevant PRC land authority for periods ranging from 39 to 50 years to use the lands on which the office premises, production facilities and warehouses of the Company are situated.
During the years ended December 31, 2011 and 2010, amortization amounted to $28,428 and $22,129 respectively.
The estimated aggregate amortization expenses for land use right for the five succeeding years are as follows:
As of December 31, 2011, land use rights with net book value of $3,137,961 of the Company were pledged as collateral under certain loan arrangements (Note 15).
F - 22
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
12.
Other payables and accrued expenses
Note :-
a)
Staff welfare payable represents accrued staff medical, industry injury claims, labor and unemployment insurances. All of which are third parties insurance and the insurance premiums are based on certain percentages of salaries. The obligations of the Company are limited to those premiums contributed by the Company.
13.
Provision of warranty
14.
Non-interest-bearing loans
The loans represent interest-free and unsecured loans from Company’s associates and a government entity and are repayable on demand.
F - 23
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
15.
Collateralized short-term bank loans
The above bank loans are denominated in RMB and carry average interest rates at 9.57% (2010 : 5.71%) per annum with maturity dates ranging from one month to twelve months.
The bank loans as of December 31, 2011 were secured by the followings: -
(a)
Guarantee executed by Mr. Shunqing Zhang, the Chairman and CEO of the Company and a shareholder
(b)
Guarantee executed by business associates (Note 21b) up to the amount of $25,420,100;
(c)
Land use rights with carrying amount of $3,137,961 (Note 11);
(d)
Bank deposits of $8,499,600 (Note 4); and
(e)
Bills receivable of $5,419,912.
16.
Common stock
Notes :-
a)
As of January 7, 2011, the Company completed a public placement of 2,500,000 common shares and warrants to purchase up to 1,000,000 common shares at an exercise price of $4 per share for a gross proceeds of $10,000,000 with related issuance expenses of $741,534. According to ASC 815, these warrants are not considered indexed to the Company's own stock and should be classified as financial derivative liabilities at fair value for each reporting period.
b)
On November 1, 2011, the Company granted to one former audit committee member of 8,658 common shares as awards for his service provided for the year of 2011. Further detail is set out in Note 25.
F - 24
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
17.
Statutory and other reserves
The Company’s statutory and other reserves were comprised as follows:
Statutory reserves
Under PRC regulations, all subsidiaries in the PRC may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC GAAP. In addition, these companies are required to set aside at least 10% of their after-tax net profits each year, if any, to fund the statutory reserves until the balance of the reserves reaches 50% of their registered capital. The statutory reserves are not distributable in the form of cash dividends to the Company and can be used to make up cumulative prior year losses.
Special reserve
Before the reorganization, a former subsidiary of Refractories, Gongyi GengSheng Refractories Co., Ltd., was entitled to a special tax concession (“Tax Concession”) because it employed the required number of disabled staff according to the relevant PRC tax rules. In particular, this Tax Concession exempted the subsidiary from paying enterprise income tax. However, these tax savings can only be used for future development of its production facilities or welfare matters, and cannot be distributed as cash dividends. Accordingly, the same amount of tax savings was set aside and taken to special reserve which is not available for distribution. This reserve as maintained by the subsidiary has been combined into Refractories upon the reorganization and is subject to the same restrictions in its usage.
18.
Finance costs
F - 25
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
19.
Income taxes
UNITED STATES
The Company is incorporated in the United States of America (“U.S.”) and is subject to U.S. tax law. No provisions for income taxes have been made as the Company has no U.S. taxable income for reporting periods. The applicable income tax rate for the reporting periods is 34%. The Company has not provided deferred tax on undistributed earnings of its non-U.S. subsidiaries as of December 31, 2011, as it is the Company's current policy to reinvest these earnings in non-U.S. operations.
BVI
GengSheng International and Smarthigh were incorporated in the BVI and are not subject to income taxes under the current laws of the BVI.
PRC
The PRC’s legislative body, the National People’s Congress, adopted the unified Corporate Income Tax Law (“CIT Law”) on March 16, 2007. This new tax law replaces the existing separate income tax laws for domestic enterprises and foreign-invested enterprises and became effective on January 1, 2008. Under the new tax law, a unified income tax rates is set at 25% for both domestic enterprises and foreign-invested enterprises. However, there will be a transition period for enterprises, whether foreign-invested or domestic, that are currently receiving preferential tax treatments granted by relevant tax authorities. Enterprises that are subject to an enterprise income tax rate lower than 25% may continue to enjoy the lower rate and will transit into the new tax rate over a five year period beginning on the effective date of the CIT Law. Enterprises that are currently entitled to exemptions for a fixed term will continue to enjoy such treatment until the exemption term expires. Preferential tax treatment will continue to be granted to industries and projects that qualify for such preferential treatments under the new tax law.
Pursuant to the income tax rules and regulations of the PRC, provision for PRC income tax of the PRC subsidiaries is calculated based on the following rates: -
Note :-
(a)
Entities entitled to a tax holiday in which they are fully exempted from the PRC enterprise income tax for 2 years starting from their first profit-making year after netting off accumulated tax losses, followed by a 50% reduction in the PRC enterprise income tax for the next 3 years (“tax holidays”). Any unutilised tax holidays will continue until expiry while tax holidays were deemed to start from January 1, 2008, even if the entity was not yet making profit after netting off its accumulated tax losses. Duesail is in the third year of tax holidays in 2011. Refractories is in the third year of tax holidays in 2009 and starting from the fiscal year 2011, Refractories is subject to enterprise income tax at unified rate of 15% for three years due to its engagement in an advanced technology industry and has passed the inspection of the provincial high-tech item. The relevant authority granted it a certificate during 2011. Starting from the fiscal year 2011, High-Temperature is subject to enterprise income tax at unified rate of 15% for three years due to its engagement in an advanced technology industry. The relevant authority granted it a certificate during 2011.
F - 26
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
19.
Income taxes (Cont'd)
In July 2006, the FASB issued ASC 740-10-25. This interpretation requires recognition and measurement of uncertain income tax positions using a “more-likely-than-not” approach. The Company adopted this ASC 740-10-25 on January 1, 2007. Under the new CIT Law which became effective on January 1, 2008, the Company may be deemed to be a resident enterprise by the PRC tax authorities. If the Company was deemed to be resident enterprise, the Company may be subject to the CIT at 25% on the worldwide taxable income and dividends paid from the PRC subsidiaries to their overseas holding companies may be exempted from 10% PRC withholding tax. Except for certain immaterial interest income from bank deposits placed with financial institutions outside the PRC, all of the Company’s income is generated from the PRC operation. Given the immaterial amount of income generated from outside the PRC and the PRC subsidiaries do not intend to pay dividends for the foreseeable future, the management considers that the impact arising from resident enterprise on the Company’s financial position is not significant. The management evaluated the Company's tax positions and considered that no provision for uncertainty in income taxes is necessary as of December 31, 2011 and 2010.
The components of the provision for income taxes from continuing operations are:
The effective income tax expenses differ from the PRC statutory income tax rate from continuing operations in the PRC as follows:
During the years ended December 31, 2011 and 2010, the amounts of benefit from the tax holiday and tax concession were $204,899 and $273,868 and the effect on basic earnings (loss) per share were $0.01 and $0.01, respectively.
F - 27
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
19.
Income taxes (Cont’d)
Deferred tax assets (liabilities) as of December 31, 2011 and 2010 are composed of the following:
F - 28
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
20.
Earnings (loss) per share
During the reporting periods, all the potential dilutive shares were not included in the computation of diluted earnings (loss) per share because they were anti-dilutive. Accordingly, the basic and diluted earnings (loss) per share are the same.
21.
Commitments and contingencies
(a)
The Company's operations are subject to the laws and regulations in the PRC relating to the generation, storage, handling, emission, transportation and discharge of certain materials, substances and waste into the environment, and various other health and safety matters. Governmental authorities have the power to enforce compliance with their regulations, and violators may be subject to fines, injunctions or both. The Company must devote substantial financial resources to ensure compliance and believes that it is in substantial compliance with all the applicable laws and regulations.
The Company is currently not involved in any environmental remediation and has not accrued any amounts for environmental remediation relating to its operations. Under existing legislation, management believes that there are no probable liabilities that will have a material adverse effect on the financial position, operating results or cash flows of the Company.
During the years ended December 31, 2011 and 2010, the Company has incurred expenditures for routine pollutant discharge fees amounting to $19,987 and $14,800, respectively. These costs were included in general and administrative expenses.
(b)
The Company guaranteed the following debts of third parties, which is summarized as follows:
In 2010, the Company, in accordance with ASC 460, commenced to recognize the liability arising from guarantees given for the debts granted to third parties by financial institutions.
An analysis of the guarantee liability as of December 31, 2011 and 2010 is as follows:
The fair value of such guarantees is determined by reference to fees charged in an arm’s length transaction for similar services.
F - 29
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
21.
Commitments and contingencies (Cont'd)
Guarantees as of December 31, 2011 are further analyzed as below:-
Notes:-
i)
To maintain a good relationship with the local government of Gongyi City, the Company has been so requested to act as guarantor for bank loans granted to its controlled entity.
ii)
During the year, the Company has acted as guarantor for bank loans granted to certain business associates. Certain of these associates also provided guarantees for bank loans to the Company (Note 15). None of our directors, director nominees or executive officers is involved in normal operation or investing in the business of the guaranteed business associates. All the business associates have a healthy record to pay back loans on a timely manner, in the People’s Bank of China’s (Central Bank of China) credit rating system.
All the above guarantees have no recourse provision that would enable the Company to recover from third parties of any amounts paid under the guarantees and any assets held either as collateral or by third parties that the Company can obtain or liquidate to recover all or a portion of the amounts paid under the guarantees.
If the third parties fail to perform under their contractual obligation, the Company will make future payments including the contractual principal amounts, related interest and penalties.
(c)
As of December 31, 2011, the Company had capital commitments of $1,154,028 in respect of the acquisition of land use right; $1,112,624 in respect of the construction of new office buildings and workshops; and $337,932 in respect of the purchase of machinery, which were not contracted for and provided in these financial statements.
F - 30
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
21.
Commitments and contingencies (Cont'd)
(d)
In accordance with the PRC tax regulations, the Company’s sales are subject to value added tax (“VAT”) at 17% upon the issuance of VAT invoices to its customers. When preparing these consolidated financial statements, the Company recognized revenue when the significant risks and rewards of ownership have been transferred to the buyer at the time when the products are delivered to and accepted by customers, and made full tax provision in accordance with relevant national and local laws and regulations of the PRC.
The Company follows the practice of reporting its revenue for PRC tax purposes when invoices are issued. In the local statutory financial statements prepared under PRC GAAP, the Company recognized revenue on an “invoice basis” instead of when the significant risks and rewards of ownership have been transferred to the buyer at the time when the products are delivered to and accepted by customers. Accordingly, despite the fact the Company has made full tax provision in the consolidated financial statements, the Company may be subject to a penalty for the deferred reporting of tax obligations. The exact amount of penalty cannot be estimated with any reasonable degree of certainty. The management considers it is very unlikely that the tax penalty will be imposed.
22.
Defined contribution plan
The Company has a defined contribution plan for all qualified employees in the PRC. The employer and its employees are each required to make contributions to the plan at the rates specified in the plan. The only obligation of the Company with respect to the retirement plan is to make the required contributions under the plan. No forfeited contribution is available to reduce the contribution payable in the future years. The defined contribution plan contributions were charged to the consolidated statements of income and comprehensive income. The Company contributed $466,371 and $324,810 for the two years ended December 31, 2011 and 2010, respectively.
23.
Segment information
The Company uses the “management approach” in determining reportable operating segments. The management approach considers the internal organization and reporting used by the Company's chief operating decision maker for making operating decisions and assessing performance as the source for determining the Company's reportable segments. Management, including the chief operating decision maker, reviews operating results solely by the revenue of monolithic refractory products, industrial ceramic products, fracture proppant products, fine precision abrasives and operating results of the Company. As such, the Company has determined that it has four operating segments as defined by ASC 280, “Segment Reporting”: refractories, industrial ceramic, fracture proppant and fine precision abrasives.
Adjustments and eliminations of inter-company transactions were not included in determining segment (loss) profit, as they are not used by the chief operating decision maker.
F - 31
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
23.
Segment information (Cont'd)
Segment information by products for the years ended December 31, 2011 and 2010
1 Castable, coating, and dry mix materials & low-cement and non-cement castables generally refer as Monolithic materials.
2 Ceramic plates, tubes, elbows, and rollers generally refer as Ceramic tubes.
3 Ceramic cylinders and plugs comprehensively refer to Ceramic cylinders.
Reconciliation is provided for unallocated amounts relating to corporate operations which is not included in the segment information.
F - 32
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
23.
Segment information (Cont'd)
All of the Company’s long-lived assets are located in the PRC. Geographic information about the revenues, which are classified based on the customers, is set out as follows:
24.
Related party transactions
Apart from the information as disclosed in elsewhere in the consolidated financial statements, the Company had no material transactions carried out with related parties during the reporting periods.
25.
Share-based compensation
The Company issued 27,869 common shares on March 10, 2010 and 108,334 common shares on May 4, 2010 to Civilian Capital, Inc. and Brean Murray Carret & Co., LLC respectively for their exercise of warrants to purchase 374,331 shares of common stock on cashless basis.
In 2011, the Company granted to one former audit committee member of 8,658 common shares as awards for his services provided for the year of 2011. In 2010, the Company granted to two audit committee members of 10,000 common shares for each as awards for their services provided for the year of 2010 and issued 100,000 common shares to RedChip for the services provided. The services of RedCip mainly including introducing and promoting the Company to its broker network, disseminate information about the Company and organize teleconferences. Share-based compensation expenses were calculated based on the market price on the date of common shares issued to those parties. The market price of 8,658 common shares issued to the former audit committee member was $0.92. The market price of 50,000 common shares issued to RedChip on January 1, 2010 was $2.30 per share. The market price of 20,000 common shares granted to two audit committee members and 50,000 common shares issued to RedChip on April 21, 2010 was $2.58 per share. Share-based compensation amounting to $7,965 and $295,600 for the years ended December 31, 2011 and 2010, respectively, were included in general and administrative expenses.
26.
2011 Stock Incentive Plan (the “2011 Plan”)
At the annual meeting of stockholders of the Company held on September 28, 2011, the Company’s stockholders approved the 2011 Plan. The 2011 Plan authorized the Company to grant equity awards to directors, employees (including executive officers), consultants and other service providers, as more fully described and summarized in the Company’s Proxy Statement, which was included in the Schedule 14A filed with the Securities and Exchange Commission on August 15, 2011.
F - 33
China GengSheng Minerals, Inc.
Notes to Consolidated Financial Statements
27.
Warrant liabilities
In accordance with ASC 815, the one year warrants, which were issued in a private placement completed as of January 7, 2011 as stated in Note 16, to purchase up to 1,000,000 common shares are not considered indexed to the Company’s own equity and should be classified as derivative financial liability at fair value for each reporting period. Accordingly, a part of the net proceeds from the public placement amounting to $970,000 representing the fair value at initial recognition, was allocated to warrant liabilities.
The fair value of these warrants was calculated using black-scholes option valuation model. The assumptions that were used to calculate fair value of the warrants as of December 31, 2011 are as follows: -
Expected volatility of 80.45%
Expected dividend yield of 0%
Risk-free interest rate of 0.07%
Expected lives of 11 days
Exercise price of $4 per share
As of December 31, 2011, the fair value of warrant liabilities was $Nil, and corresponding gain on change in fair value of warrant liabilities of $970,000 was recognized in the consolidated statement of operations and comprehensive loss for the year ended December 31, 2011.
Fair value accounting : ASC 820 establishes a valuation hierarchy for disclosure of the inputs to fair value measurement. This hierarchy prioritizes the inputs into three broad levels as follows :-
Level 1 - Quoted prices in active markets for identical assets or liabilities.
Level 2 - Observable inputs other than quoted prices in active markets for identical assets or liabilities.
Level 3 - Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.
The warrant liabilities are determined by using Level 2 inputs. The following tables summarize the changes in Level 2 items measured at fair value on a recurring basis on our consolidated balance sheet during the year ended December 31, 2011 :-
28.
Subsequent events
The Company evaluated all events or transactions that occurred through the date the consolidated financial statements were issued and determined that, except for the transactions described below, there were no material recognizable or subsequent events or transactions which would require recognition or disclosure in the consolidated financial statements.
On January 9, 2012, the Company refunded RMB15 million (equivalent of $2.36 million) of sales receipts in advance to a customer because of the cancellation of sales order.
As of April 5, 2012, Yili YiQiang Silicon Limited ("Yili") held a shareholders' meeting to approve the transfer of 24.5% equity interest in Yili. Yili is applying for the revision of registration documents from the local government entity and the acquisition of Yili is expected to be completed by May 2012 upon the government entity's approval.
F - 34
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: April 16, 2012
CHINA GENGSHENG MINERALS, INC.
/s/ Shunqing Zhang
Shunqing Zhang
Chief Executive Officer and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Signature
Capacity
Date
	
	
	
	
	
	
/s/ Shunqing Zhang
Chief Executive Officer, President and Chairman 	
April 16, 2012 	
Shunqing Zhang 	
(Principal Executive Officer) 	
	
	
	
	
	
	
	
/s/ Ningfang Liang
Chief Financial Officer 	
April 16, 2012 	
Ningfang Liang 	
(Principal Financial and Accounting Officer) 	
	
	
	
	
	
	
	
/s/ Ming He
Director 	
April 16, 2012 	
Ming He 	
	
	
	
	
	
	
	
	
/s/ Jingzhong Yu
Director 	
April 16, 2012 	
Jingzhong Yu 	
	
	
	
	
	
	
	
	
/s/ Ningsheng Zhou
Director 	
April 16, 2012 	
Ningsheng Zhou 	
	
	
	
	
	
	
	
	
/s/ Hsin-I Lin
Director 	
April 16, 2012 	
Hsin-I Lin