GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 – Background
The Company (formerly known as American Construction Company) was established on August 5, 2002 for the purpose of commencing the business of general construction contracting. It was the Company's objective to provide to its customers timely and durable construction for their residential and commercial needs. We established a subsidiary for the purpose of achieving the above stated objectives in Saskatchewan, Canada and to enter the residential and commercial construction industry in this market.
To accomplish the above objective the founder of our company, Jeff Mabry established American Construction Company (a Nevada company) on August 5, 2002. American Construction Company then established its subsidiary, West Dee Construction Ltd. (a Saskatchewan, Canada Company) on August 8, 2002 by purchasing 100 shares from its treasury.
On October 14, 2004, American Construction Company and General Steel Investment Co., Ltd (referred to as General Steel) and Northwest Steel Company, a Nevada corporation, entered into an Agreement and Plan of Merger (the "Agreement") pursuant to which American Construction Company acquired General Steel, and it’s 70% ownership in its subsidiary Daqiuzhuang Metal Sheet Co., Ltd (Daqiuzhuang Metal) in exchange for shares of the Company’s common stock, of which 22,040,000 shares was a new issuance by the Company, and 7,960,000 shares are from certain shareholders of the Company, which in aggregate, constituted 96% of the total issued and outstanding shares of the Company.
Under the terms of the Agreement, General Steel will remain a 100% owned subsidiary of the Company. The transaction contemplated by the Agreement was intended to be a “tax-free" reorganization pursuant to the provisions of Section 351 and 368(a) (1) (A) of the Internal Revenue Code of 1986, as amended. The stockholders of General Steel, as of the closing date of the merger own approximately 96% of the Company's common stock outstanding as of October 15, 2004 (excluding any additional shares to be issued on outstanding options, warrants and other securities convertible into common stock).
The accounting for these transactions is identical to that resulting from a reverse-acquisition, except that no goodwill or other intangible assets is recorded. Accordingly, the financial statements of General Steel Investment Co., Limited are the historical financial statements of the Company, formerly the operations of Daqiuzhuang Metal Sheet Co., Ltd.
Based on the Company's Plan of Merger with General Steel Investment Co., Ltd., the Board of Directors determined to change the Registrant's fiscal year end from January 31 to December 31.
The Company through its subsidiary Daqiuzhuang Metal principally engages in the manufacturing of hot rolled carbon and silicon steel sheets which are mainly used on tractors, agricultural vehicles and in other specialty markets. The Company sells its products through both retailers and wholesalers.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 – Background, (continued)
Daqiuzhuang Metal Sheet Co., Ltd. (referred to as Daqiuzhuang Metal) was established on August 18, 2000 in Jinghai county, Tianjin city, Hebei province, the People’s Republic of China (PRC). The Articles of Corporation provides for a 10 year operating term beginning on August 18, 2000 with registered capital of $ 9,583,200. The Company is a Chinese registered limited liability company with a legal structure similar to a limited liability company organized under state laws in the United States of America. There is no discriminatory provision for the minority shareholders and the 30% shareholders will receive their distribution of retained earnings according to their ownership percentage in Daqiuzhuang Metal.
Note 2 – Restatement of financial statements
The Company is restating the consolidated financial statements as of December 31, 2005 and March 31, 2006 and for the three months ended March 31, 2006 and 2005 for corrections in accounting which include:
1. Restating the carry amount of redeemable stock issued in 2005 and amortizing the difference between redemption amount and fair value as interest expense over the 18 months period from issuance date using an implied interest rate in accordance with SFAS 150, The amount originally recorded as liability was discounted at an average market rate with the difference between the discounted amount and the cash received was treated as reduction in paid-in-capita and the difference between discounted amount and redemption value was to be amortized over the 18 months from issuance date. In addition, certain disclosures in notes 3, 5 and 19 to the consolidated financial statements are being restated to reflect the correction. The effects of this restatement are as follows:
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2 – Restatement of financial statements, continued
| Consolidated balance sheet | |
| | | December 31, 2005 | |
| | | Previously | | | | | |
| | Reported | | Adjustments | | Restated | |
| Shares subject to mandatory redemption | | $ | 2,115,906 | | $ | (395,031 | ) | $ | 1,720,875 | |
| Paid-in capital | | | 6,395,617 | | | 475,741 | | | 6,871,358 | |
| Retained Earnings | | | 4,287,946 | | | (80,710 | ) | | 4,207,236 | |
| Total liabilities and shareholders' equity | | | 58,993,216 | | | - | | | 58,993,216 | |
| | | | | | | | | | | |
| Consolidated balance sheet | |
| | | March 31, 2006 | |
| | | Previously | | | | | | | |
| | | Reported | | | Adjustments | | | Restated | |
| Shares subject to mandatory redemption | | $ | 2,150,476 | | $ | (314,877 | ) | $ | 1,835,599 | |
| Paid-in capital | | | 6,395,617 | | | 475,741 | | | 6,871,358 | |
| Retained Earnings | | | 4,620,507 | | | (160,864 | ) | | 4,459,643 | |
| Total liabilities and shareholders' equity | | | 66,345,016 | | | - | | | 66,345,016 | |
| | | | | | | | | | | |
| Consolidated statement of income and other comprehensive income | |
| | | March 31, 2006 | |
| | | Previously | | | | | | | |
| | | Reported | | | Adjustments | | | Restated | |
| Other expense, net | | $ | (79,985 | ) | $ | (80,154 | ) | $ | (160,139 | ) |
| Net income | | | 332,561 | | | (80,154 | ) | | 252,408 | |
| Comprehensive income | | | 453,966 | | | (80,154 | ) | | 373,813 | |
| Earnings per share, basic and diluted | | | 0.011 | | | (0.003 | ) | | 0.008 | |
| | | | | | | | | | | |
| Consolidated statement of cash flows | |
| | | March 31, 2006 | |
| | | Previously | | | | | | | |
| | | Reported | | | Adjustments | | | Restated | |
| Interest expense accrued on | | | | | | | | | | |
| mandantory redeemable stock | | $ | 34,570 | | $ | 80,154 | | $ | 114,724 | |
| 2. | Reclassifying advances on equipment purchases to Other Assets - non-current from current assets on the March 31, 2006 and December 31, 2005 balance sheets |
| 3. | Reclassifying certain accounts on the statements of cash flows for the three months ended March 31, 2006 and 2005 as follows: |
| a. | Reclassified accrued interest expense accrued on mandatory redeemable stock from financing activities to operating activities |
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2 – Restatement of financial statements, continued
| b. | Reclassified notes receivable from investing activities to operating activities since it is related to inventory sales |
| c. | Separated restricted cash from cash and classified restricted cash in investing activities |
| d. | Reclassified deposits due to sales representatives and advances on equipment purchases from operating activities to investing activities |
| 4. | Restating borrowings and payments on short term loan - bank and short term notes payable on a gross basis vs. net basis as previously reported |
Further, we have added or revised certain disclosures in notes 1, 3, 5,7, 12, 13, 16, 20, and 22 to provide more detail information and explanations.
Note 3 – Summary of significant accounting policies
Basis of presentation
The consolidated financial statements of General Steel Holdings, Inc. reflect the activities of the following subsidiaries:
| | | | | Pecentage | |
| Subsidiary | | Of Ownership | |
| General Steel Investment Co., Ltd. | | | British Virgin Islands | | | 100.0 | % |
| Tianjin Daqiuzhuang Metal Sheet Co., Ltd | | | P.R.C. | | | 70.0 | % |
The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements include the accounts of General Steel Investment Co., Ltd. and Tianjin Daqiuzhuang Metal Sheet Co., Ltd. (collectively the “Company”). All material intercompany transactions and balances have been eliminated in the consolidation.
Revenue recognition
The Company recognizes revenue when the goods are delivered and title has passed. Sales revenue represents the invoiced value of goods, net of a value-added tax (VAT). All of the Company’s products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product.
Foreign currency translation
The reporting currency of the Company is the US dollar. The Company uses their local currency, Renminbi (RMB), as their functional currency. Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People’s Bank of China at the end of the period.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Foreign currency translation, continued
Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of shareholders’ equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
Translation adjustments resulting from this process are included in accumulated other comprehensive income in the consolidated statement of shareholders' equity and amounted to $121,405 and $0 as of March 31, 2006 and 2005, respectively. The balance sheet amounts with the exception of equity at March 31, 2006 were translated at 8.01 RMB to $1.00 USD as compared to 8.26 RMB at March 31, 2005. The equity accounts were stated at their historical rate. The average translation rate of 8.04 RMB for the three months ended March 31, 2006 was applied to income statement accounts.
Plant and equipment, net
Plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets with 3% residual value. The depreciation expense for the three months ended March 31, 2006 and 2005 amounted to $273,775 and $308,289, respectively.
Estimated useful lives of the assets are as follows:
| | | Estimated | |
| | Useful Life | |
| Buildings | | | 10-30 years | |
| Machinery and equipment | | | 8-15 years | |
| Other equipment | | | 5-8 years | |
| Transportation equipment | | | 10-15 years | |
The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the statements of operations. Maintenance, repairs and minor renewals are charged directly to expenses as incurred. Major additions and betterment to buildings and equipment are capitalized.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Plant and equipment, net, continued
Long-term assets of the Company are reviewed annually as to whether their carrying value has become impaired. The Company considers assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. The Company also re-evaluates the periods of amortization to determine whether subsequent events and circumstances warrant revised estimates of useful lives. As of March 31, 2006, the Company expects these assets to be fully recoverable.
Plant and equipment consisted of the following:
| | | March 31, | | December 31, | |
| | | 2006 | | 2005 | |
| | | Unaudited | | Audited | |
| Buildings and improvements | | $ | 5,426,161 | | $ | 5,391,378 | |
| Transportation equipment | | | 430,894 | | | 485,699 | |
| Machinery | | | 12,884,609 | | | 12,752,995 | |
| Construction in progress | | | 7,605,823 | | | 4,231,318 | |
| Totals | | | 26,347,487 | | | 22,861,390 | |
| Less accumulated depreciation | | | 4,922,449 | | | 4,647,518 | |
| Totals | | $ | 21,425,038 | | $ | 18,213,872 | |
Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles of the United States of America requires management to make estimates and assumptions that affect the amounts reported in the combined financial statements and accompanying notes. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates.
Cash and concentration of risk
Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the People’s Republic of China and Hong Kong. Total cash (including restricted cash balances) in these banks at March 31, 2006 and December 31, 2005, amounted to $4,722,935 and $11,446,120, respectively of which no deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts.
Restricted cash
The Company through its bank agreements is required to keep certain amounts on deposit that are subject to withdrawal restrictions and these amounts are $2,754,551 and $2,735,583 as of March 31, 2006 and December 31, 2005, respectively.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Inventories
Inventories are stated at the lower of cost or market using the weighted average method. Inventories consisted of the following:
| | | March 31, | | December 31, | |
| | 2006 | | 2005 | |
| | Unaudited | | Audited | |
| Supplies | | $ | 1,330,881 | | $ | 1,524,332 | |
| Raw materials | | | 4,510,790 | | | 1,195,022 | |
| Finished goods | | | 10,206,431 | | | 8,011,587 | |
| Totals | | $ | 16,048,102 | | $ | 10,730,941 | |
Inventories consist of supplies, raw materials and finished goods. Raw materials consist primarily of iron and steel used in production. The cost of finished goods included direct costs of raw materials as well as direct labor used in production. Indirect production costs such as utilities and indirect labor related to production such as assembling, shipping and handling costs are also included in the cost of inventory. No work in process inventory existed at March 31, 2006 and December 31, 2005, as all inventory in process was completed and transferred to finished goods prior to the physical inventory count. The Company reviews its inventory annually for possible obsolete goods or to determine if any reserves are necessary for potential obsolescence. As of March 31, 2006 and December 31, 2005, the Company has determined that no reserves are necessary.
Financial instruments
Statement of Financial Accounting Standards No. 107 (SFAS 107), “Disclosures about Fair Value of Financial Instruments” requires disclosure of the fair value of financial instruments held by the Company. SFAS 107 defines the fair value of financial instruments as the amount at which the instrument could be exchanged in a current transaction between willing parties. The Company considers the carrying amount of cash, accounts receivable, other receivables, accounts payable, accrued liabilities and other payables to approximate their fair values because of the short period of time between the origination of such instruments and their expected realization and their current market rate of interest.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Intangible assets
All land in the People’s Republic of China is owned by the government and cannot be sold to any individual or company. However, the government grants the user a “land use right” (the Right) to use the land. Daqiuzhuang Metal acquired land use rights during the years ended in 2000 and 2003 for a total amount of $2,870,902. The land use right is for 50 years. However, Daqiuzhuang Metal's initial business license had ten-year term. The management elected to amortize the land use rights over the ten-year business term. Daqiuzhuang Metal became a Sino Joint Venture in 2004 as discussed in note 1 and obtained a new business license for twenty years; however, the Company decided to coninue amortizing the land use rights over the original ten-year business term.
As of March 31, 2006 and December 31, 2005, accumulated amortization amounted to $982,399 and $902,550. The costs of these rights are being amortized over ten years using the straight-line method.
Intangible assets of the Company are reviewed annually as to whether their carrying value has become impaired. The Company considers assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. The Company also re-evaluates the periods of amortization to determine whether subsequent events and circumstances warrant revised estimates of useful lives. As of March 31, 2006, the Company expects these assets to be fully recoverable.
Total amortization expense for the three months ended March 31, 2006 and 2005, amounted to $73,718 and $71,773, respectively.
Shares subject to mandatory redemption
The Company has adopted Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. FAS 150 established classification and measurement standards for three types of freestanding financial instruments that have characteristics of both liabilities and equity. Instruments within the scope of FAS 150 must be classified as liabilities within the Company’s Consolidated Financial Statements and be reported at settlement date value. The provisions of FAS 150 are effective for (1) instruments entered into or modified after May 31, 2003, and (2) pre-existing instruments as of July 1, 2003. In November 2003, through the issuance of FSP 150-3, the FASB indefinitely deferred the effective date of certain provisions of FAS 150, including mandatory redeemable instruments as they relate to minority interests in consolidated finite-lived entities.
The Company issued new redeemable stock in September, 2005. The amount is presented as a liability on balance sheet at the fair market value on the date of issuance plus accrued interest at the balance sheet date, see note 19.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Income taxes
The Company has adopted Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (SFAS 109). SFAS 109 requires the recognition of deferred income tax liabilities and assets for the expected future tax consequences of temporary differences between income tax basis and financial reporting basis of assets and liabilities. Provision for income taxes consist of taxes currently due plus deferred taxes. There are no deferred tax amounts at March 31, 2006 and December 31, 2005.
The charge for taxation is based on the results for the year as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.
Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit.
In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probably that taxable profit will be available against which deductible temporary differences can be utilized.
Deferred tax is calculated at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity.
Deferred tax assets and liabilities are offset when they relate to income taxes levied by the same taxation authority and the Company intends to settle its current tax assets and liabilities on a net basis.
Under the Income Tax Laws of PRC, the Company is generally subject to an income tax at an effective rate of 33% (30% state income taxes plus 3% local income taxes) on income reported in the statutory financial statements after appropriate tax adjustments, unless the enterprise is located in a specially designated region where it allows foreign enterprises a two-year income tax exemption and a 50% income tax reduction for the following three years.
The Company’s subsidiary, Daqiuzhuang Metal Sheet Co., Ltd., became a Chinese Sino-foreign joint venture at the time of the merger on October 14, 2004 and it became eligible to receive a tax benefit. The Company is exempt from income taxes for the years ended December 31, 2005 and 2006 and 50% income tax reduction for the years ended December 31, 2007, 2008 and 2009. The Company received the tax exemption approval from the local tax authorities during the last quarter of 2005 and the Company had been recording a provision for income taxes for the first three quarters of 2005. During the last quarter of 2005 the Company reversed the provision for income taxes once they received the approval from the local tax authorities.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Income taxes, continued
The local Chinese tax authority waived the perviously accrued tax accumulated prior to January 1, 2005 in the amount of $253,250 which was recorded as other nonoperating income for the three months ended March 31, 2006 for previously accrued income taxes.
The provision for income taxes for the period ended March 31 consisted of the following:
| | | 2006 | | 2005 | |
| | Unaudited | | Unaudited | |
| Provision for China Income Tax | | $ | - | | $ | 265,231 | |
| Provision for China Local Tax | | | - | | | 29,470 | |
| Total provision for income taxes | | $ | - | | $ | 294,701 | |
The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the three months ended March 31:
| | | 2006 | | 2005 | |
| U.S. statutory rates | | | 34.0 | % | | 34.0 | % |
| Foreign income not recoginized in USA | | | (34.0 | ) | | (34.0 | ) |
| China income taxes | | | - | | | 33.0 | |
| Total provision for income taxes | | | - | % | | 33.0 | % |
The estimated tax savings for the three months ended March 31, 2006 amounted to $191,674. The net effect on earnings per share had the income tax been applied would decrease earnings per share from $0.011 to $0.005.
Value added tax
Enterprises or individuals who sell commodities, engage in repair and maintenance or import and export goods in the PRC are subject to a value added tax in accordance with Chinese laws. The value added tax standard rate is 17% of the gross sales price. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of the Company’s finished products can be used to offset the VAT due on sales of the finished product.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 – Summary of significant accounting policies, (continued)
Value added tax, continued
Taxes payable consisted of the followings:
| | | March 31, | | December 31, | |
| | 2006 | | 2005 | |
| | Unaudited | | Audited | |
| VAT taxes payable | | $ | 1,954,124 | | $ | 1,290,982 | |
| Income taxes payable | | | - | | | 385,510 | |
| Misc taxes | | | 1,147 | | | 5,838 | |
| Totals | | $ | 1,955,271 | | $ | 1,682,330 | |
Recently issued accounting pronouncements
In February 2006, the SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”), which amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”). FAS 155 provides guidance to simplify the accounting for certain hybrid instruments by permitting fair value remeasurement for any hybrid financial instrument that contains an embedded derivative, as well as, clarifies that beneficial interests in securitized financial assets are subject to FAS 133. In addition, FAS 155 eliminates a restriction on the passive derivative instruments that a qualifying special-purpose entity may hold under FAS 140. FAS 155 is effective for all financial instruments acquired, issued or subject to a new basis occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of SFAS No. 155 is not expected to have a material effect on the Company’s financial position or results of operations.
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets” (FAS 156”), which amends SFAS No., 140. FAS 156 specifically provides guidance addressing the recognition and measurement of separately recognized servicing assets and liabilities, common with mortgage securitization activities, and provides an approach to simplify efforts to obtain hedge accounting treatment. FAS 156 if effective for all separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006, with early adoption being permitted. The adoption of SFAS No. 156 is not expected to have a material effect on the Company’s financial position or results of operations.
Note 4 – Consolidated financial statements and condensed footnotes
The interim consolidated financial statements presented herein have been prepared by the Company and include the unaudited accounts of the Company and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in the consolidation.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
These consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and the instructions for Form 10-Q and Article 10 of Regulation S-X.
Certain information and footnote disclosures that are normally included in financial statements presented in accordance with generally accepted accounting principles have been condensed or omitted. Management of the Company believes the disclosures made are adequate to make the information presented not misleading. The condensed consolidated financial statements should be read in conjunction with the Company’s audited financial statements included in its Annual Report on Form 10-K dated March 31, 2006.
In the opinion of management, the unaudited consolidated financial statements reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position of the Company as of March 31, 2006 and December 31, 2005, and the results of operations, changes in shareholders’ equity and cash flows for the three months ended March 31, 2006 and 2005. Interim results are not necessarily indicative of full year performance because of the impact of seasonal and short-term variations.
Note 5 – Earnings per share
The Company reports earnings per share in accordance with the provisions of SFAS No. 128, "Earnings Per Share." SFAS No. 128 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock.
Under SFAS 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", entities that have issued mandatory redeemable shares of common stock or entered into forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares of common stock in exchange for cash shall exclude the common shares that are to be redeemed or repurchased in calculating basic and diluted earnings per share. Thus the 1,176,665 shares described in note 18 have been excluded from the earnings per share calculation.
The weighted average number of shares used to calculate EPS for the three months ended March 31, 2006 (31,250,000), 2005 (31,250,000) reflect only the shares outstanding for those periods.
Note 6 – Supplemental disclosure of cash flow information
Interest paid amounted to $499,877 and $440,221 for the three months ended March 31, 2006 and 2005, respectively.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Income tax payments amounted to $0 and $485,615 for the three months ended March 31, 2006 and 2005, respectively.
Note 7 – Accounts receivable and allowance for doubled accounts
The Company conducts its business operations in the People’s Republic of China. Account receivables include trade accounts due from the customers. Management believes that the trade accounts are fully collectible as these amounts are being collected throughout the year. Also, management reviews its accounts receivable on a regular basis to determine if the bad debt allowance is adequate and adjusts the allowance amount at year end. The allowance for doubtful accounts as of March 31, 2006 and December 31, 2005 amounted to $1,414 and $1,371 respectively.
Note 8 – Notes receivable and note receivable - related party
Notes receivable represents trade accounts receivable due from various customers where the customers’ bank has guaranteed the payment of the receivable. This amount is non-interest bearing and is normally paid within three to six months. The Company has the ability to submit their request for payment to the customer’s bank earlier than the scheduled payment date. However the Company will incur an interest charge and a processing fee when they submit a payment request early. The Company had $998,400 and $4,960 outstanding as of March 31, 2006 and December 31, 2005, respectively.
The note receivable from related party represents a note from Yang Pu Automotive Investment Limited for business purpose on November 15, 2005. The note is in the amount of RMB 24,000,000, translated to $2,995,200, for one year with an interest rate at 7% and due at maturity. The Company periodically reviews the financial statements of Yang Pu Automotive Investment Limited to determine its ability to repay the debt.
Note 9 – Prepaid expenses
Prepaid expenses at March 31, 2006 consisted of the followings:
| | | Current | | Long-term | | Total | |
| Rent | | $ | 44,928 | | $ | 333,715 | | $ | 378,643 | |
| Land use right | | | 20,136 | | | 503,356 | | | 523,492 | |
| Total | | $ | 65,064 | | $ | 837,071 | | $ | 902,135 | |
The Company rented a dormitory for its employees during 2005. The rent is for ten years starting on January 1, 2006 at RMB 90,000 per quarter or RMB 360,000 per year. The Company's prepayment at March 31, 2006 amounted to RMB 3,034,000 or $378,643.
The Company also entered into another rental agreement on July 21, 2005 to rent the land use right for its manufacture expansion. The total amount of the rental is RMB 8,067,400 for a period of 50 years starting on September 1, 2005. The Company made a prepayment of RMB 4,234,981 or $528,505 and prepaid balance remained at March 31, 2006 amounted to RMB 4,194,644 or $523,492.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 10 – Advances on inventory purchases
Advances on inventory purchases are monies deposited or advanced to outside vendors or related parties on future inventory purchases. Due to the high shortage of steel in China, most of the Company’s vendors require a certain amount of money to be deposited with them as a guarantee that the Company will receive their purchases on a timely basis.
This amount is refundable and bears no interest. The Company has a legal binding contract with their vendors for the guarantee deposit, which is to be returned to the Company at the end of the contract. The inventory is normally delivered within one month after the monies has been advanced. The total outstanding amount was $14,398,985 and $10,716,293 as of March 31, 2006 and December 31, 2005, respectively.
Note 11 – Other payable - related party
The Company has a short term loan from Golden Glister Holdings Limited. Golden Glister Holdings Limited is incorporated in the territory of the British Virgin Islands which our president Yu Zuo Sheng is the majority shareholder. The amount was loaned to General Steel Investment Co., Ltd for business operations. The Company had $330,000 and $980,000 outstanding on this loan as of March 31, 2006 and December 31, 2005, respectively. This amount is short-term and is non interest bearing.
See report of independent registered public accounting firm
Note 12 – Short term loans - bank
Short term loans - bank represent amounts due to various banks which are due on demand or normally within one year. These loans can be renewed, are short term bearing no interest and has not due date. The table below summarizes the loans outstanding at March 31, 2006 and December 31, 2005.
| | | March 31, | | December 31, | |
| | 2006 | | 2005 | |
| Loans from China Bank, JingHai Branch, due | | | | | | | |
| November 2006. Monthly interest only payment at | | | | | | | |
| 6.138% per annum, secured by equipment | | | | | | | |
| and property | | $ | 1,123,200 | | $ | 1,116,000 | |
| | | | | | | | |
| Loans from Agriculture Bank, DaQiuZhuang Branch, due | | | | | | | |
| various dates from May 2006 to March 2007. | | | | | | | |
| Monthly interest only payments in 2005 ranging from | | | | | | | |
| from 6.696% to 7.533% per annum, guaranteed by an | | | | | | | |
| unrelated third party and secured by property and | | | | | | | |
| equipment | | | 10,021,440 | | | 10,068,800 | |
| | | | | | | | |
| Loan from Construction Bank of China, JinHai Branch, due | | | | | | | |
| August 15, 2006. Monthly interst only payment at | | | | | | | |
| 7.4604% per annum, secured by properties | | | 1,010,880 | | | 1,004,400 | |
| | | | | | | | |
| Loans from ShangHai PuFa Bank, due various dates from | | | | | | | |
| July 2006 to March 2007. Monthly interest only | | | | | | | |
| payments ranging from 6.138% to 6.42% per month, | | | | | | | |
| guaranteed by an unrelated third party | | | 6,240,000 | | | 6,200,000 | |
| | | | | | | | |
| Loans from China Merchants Bank, due various dates from | | | | | | | |
| June 2006 to September 2006. Quarterly interest only | | | | | | | |
| payments, annual interest rate of 5.859% to 5.86%, | | | | | | | |
| guaranteed by an unrelated third party | | | 8,112,000 | | | 8,060,000 | |
| | | | | | | | |
| Loan from Construction Bank of China, due August 21, 2006 | | | | | | | |
| Monthly interest only payment at 7.4604% per annum, | | | | | | | |
| guaranteed by an unrelated third party | | | 673,920 | | | 669,600 | |
| | | | | | | | |
| Loans from Shenzhen Development Bank, Tianjin Branch | | | | | | | |
| due various dates from February to March 2007 | | | | | | | |
| Quarterly interest only payments ranging | | | | | | | |
| from 5.856% to 5.859%, secured by inventories | | | 4,992,000 | | | - | |
| Totals | | $ | 32,173,440 | | $ | 27,118,800 | |
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 13 – Short term notes payable
Short-term notes payable are lines of credit extended by the banks. When purchasing raw materials, the Company often issues a short term note payable to the vendor. This short term note payable is guaranteed by the bank for its complete face value. The banks usually require the Company to deposit a certain amount of cash deposit at the bank as a guarantee deposit.
The Company has the following short term notes payable outstanding as for March 31, 2006 and December 31, 2005:
| | | March 31, | | December 31, | |
| | 2006 | | 2005 | |
| | Unaudited | | Audited | |
| China Bank, Jing Hai Branch, various amounts, due | | | | | | | |
| May 2006, restricted cash required 50% of loan | | | | | | | |
| amount, guaranteed by the Company | | $ | 1,447,680 | | $ | 1,438,400 | |
| | | | | �� | | | |
| Agricultural Bank of China, various amounts, due dates | | | | | | | |
| ranging between June and July 2006, | | | | | | | |
| restricted cash required of 50% of loan amount, | | | | | | | |
| guaranteed by the Company and an unrelated | | | | | | | |
| third party | | | 1,497,600 | | | 1,488,000 | |
| | | | | | | | |
| ShangHai PuFa Bank, due May 2006, restricted | | | | | | | |
| cash required of 50% of loan balance, guaranteed | | | | | | | |
| by an unrelated third party | | | 2,496,000 | | | 2,480,000 | |
| Totals | | $ | 5,441,280 | | $ | 5,406,400 | |
Total interest expense for the three months ending March 31, 2006 and 2005 on all debt amounted to $499,877 and $440,221, respectively.
Note 14 – Customer deposits
Customer deposits represent amounts advanced by customers on product orders. The product normally is shipped within six months after receipt of the advance payment and the related sale is recognized in accordance with the Company’s revenue recognition policy. As of March 31, 2006 and December 31, 2005, customer deposits amounted to $2,572,512 and $1,276,536, respectively.
Note 15 – Deposits due to sales representatives
The Company has entered into agreements with various entities to act as the Company’s exclusive sales agent in a specified area. These exclusive sales agents must meet certain criteria and are required to deposit a certain amount of money with the Company. In return the sales agents receive exclusive sales rights to a specified area and discounted prices on products they order. These deposits bear no interest and are required to be returned to the sales agent once the agreement has been terminated. The Company had $1,581,216 and $1,261,080 in deposits due to sales representatives outstanding as of March 31, 2006 and December 31, 2005, respectively.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 16 – Major customers and suppliers
The Company has 5 major customers which represent approximately 62% and 43% of the Company’s total sales for the three months ended March 31, 2006 and 2005, respectively. The Company did not have any one significant customer that represented more than 10% of the total sales for the quarter ended March 31, 2006 and 2005.
For the three months ended March 31, 2006 and 2005, the Company purchases approximately 97% and 90%, respectively, of their raw materials from four major suppliers.
Note 17 – Minority interest
Minority interest represents the outside shareholders’ 30% interest in Tianjin Daqiuzhuang Metal Sheet Co., Ltd.
Note 18 – Other expenses and income, net
Other income and expense for the three months ended March 31 consist of the following:
| | | 2006 | | 2005 | |
| | Unaudited | | Unaudited | |
| Finance/interest expense | | $ | (546,218 | ) | $ | (441,659 | ) |
| Interest income | | | 60,033 | | | 17,427 | |
| Other nonoperating income | | | 354,844 | | | 11,551 | |
| Other nonoperating expense | | | (28,798 | ) | | (3,065 | ) |
| Total other expense | | $ | (160,139 | ) | $ | (415,746 | ) |
Other nonoperating income includes the previously accrued income tax expense. During 2005, the Company has received an approval from the P.R.C. local government for a two year income tax exemption and a three year 50% reduction in income tax rates. The local Chinese tax authority waived the previously accrued income tax accumulated prior to January 1, 2005 in the amount of $253,250 which was recorded as other nonoperating income during the three months ended March 31, 2006 .
Note 19 –Reclassifications
Certain amounts for the three months ended March 31, 2005 in the accompanying financial statements have been reclassified to conform to the 2006 presentation. These reclassifications have no effect on net income or cash flows.
Note 20 – Private Offering of Redeemable Stock
The Company has offered an aggregate of 3,333,333 shares of Common Stock par value $0.001 in a private placement to investors at a purchase price of $1.50 per share. On September 18, the Company entered into a subscription agreement with certain investors to sell a total of 1,176,665 shares of common stock at $1.50 per share. In addition, two warrants are attached to each share of common stock and each warrant gives the warrant holder the right to purchase an additional share of common stock or a total of 2,353,330 of common stock in the future. The warrants can be exercised on the second anniversary date at $2.50 per share and on the thrid anniversary date at $5.00 per share. The number of shares attached to the warrants will be adjusted due to dividends and changes in the capital stock structure changes. At the option of the investors the Company maybe required to repurchase the 1,176,665 shares of common stock 18 months after the closing date at a per share price of $1.95.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
I Under this private offering, the Company raised a total of $1,765,000 and received net proceeds of $1,606,150 net of $158,850 of commissions paid.
In accordance with Accounting Principles Board Opinion No. 14, the Company determined the fair value of the detachable warrants issued with redeemable stock using the Black-Scholes option pricing model under the following assumptions: risk free interest rate of 3.85%, dividend yield of 0% and volatility of 11%. The estimated value of the warrants is zero
In accordance with SFAS 150, the Company has recorded this stock issuance as a liability in the financial statements due to the mandatory redemption provision. The shares were recorded at fair market value on the date of issuance, which is the net cash proceeds, plus any accrued interest up to December 31, 2005. The difference between the net proceeds, $1,606,150, and the redemption amount, $2,294,497, which is $688,347, will be accrued and amortized as interest expense over an 18 month period beginning in October 2005 and ending in March 2007. The following table reconciles the March 31, 2006 carrying amount as follows:
| Balance at 12/31/2005 | | $ | 1,720,875 | |
| Interest amortized during the first quarter | | | 114,724 | |
| Balace at 3/31/2006 | | $ | 1,835,599 | |
Total interest amortized since issuance to March 31, 2006 amounted to $229,449 and $458,898 is the remaining amount left to be acrrued and amortized through March 2007.
The Company amended its financial statements for the periods ended December 31, 2005 to reflect the changes made to the accounting treatment of the redeemable stock. The company amended its financial statement for the periods ended December 31, 2005 and March 31, 2006 to reflect the changes made to the accounting treatment of the redeemable stock. The original accounting treatment was to record the amount discounted at an average market rate as a liability with the difference between the discounted amount and the cash received treated as reduction in paid-in-capital and the difference between discounted amount and redemption value to be amortized over the 18 months from issuance date.
Note 22 – Retirement plan
Regulations in the People’s Republic of China require the Company to contribute to a defined contribution retirement plan for all employees. All Joint Venture employees are entitled to a retirement pension amount calculated based upon their salary at their date of retirement and their length of service in accordance with a government managed pension plan. The PRC government is responsible for the pension liability to the retired staff.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company became a foreign joint venture entity in the year of 2004. For the year ended December 31, 2005, it was the first year the Company was required to make contributions to the state retirement plan at 20% of the employees’ monthly salary. Employees are required to contribute 7% of their salary to the plan. Total pension expense incurred by the Company amounted to $61,661and $0 for the three months ended March 31, 2006 and 2005, respectively. No contribution was made during the first quarter of 2005 because the Company contributed the total amount near year end of 2005.
Note 22 – Joint venture agreement with Baotou Steel
On September 28, 2005, General Steel Investment Co., Ltd., a wholly owned subsidiary of General Steel Holdings, Inc., entered into a certain Baotou-GSHI Special Steel Joint Venture Agreement (the "Agreement") with Daqiuzhuang Metal Sheet Co., Ltd., and Baotou Iron and Steel (Group) Co., Ltd., a limited liability company formed under the laws of the People's Republic of China (the "Baotou Steel"). The name of the joint venture will be Baotou Steel-General Steel Special Steel Joint Venture Company Limited.
The Joint Venture Company will be located at Kundulun District, Baotou City, Inner Mongolia, China. The stated purposes of the Joint Venture Company are, among others, to produce and sell special steel and to improve the product quality and the production capacity and competitiveness by adopting advanced technology in the production of steel products. The Joint Venture Company shall have a capacity of producing 600,000 tons of specialty steel products a year.
The registered capital of the joint venture will be approximately $24,000,000. The products of the joint venture will be sold in the Chinese market and abroad. The ownership will be comprised of the following:
| | | % Ownership | |
| Baotou Iron and Steel (Group) Co.,Ltd. | | | 49 | % |
| General Steel Investment Co., Ltd. | | | 31 | % |
| Da Qiu Zhuang Metal Sheet Co., Ltd | | | 20 | % |
Baotou Steel shall contribute land, existing equipment and materials at an estimated value of approximately $12,000,000 which will be contributed to the joint venture at the date of the approval of Joint Venture or issuance of the business license. The value of the assets to be contributed by Baotou Steel will be stated at fair market value General Steel Investment Co., Ltd. will contribute approximately $7,500,000 of cash and Daqiuzhuang Metal will contribute approximately $5,000,000 cash. These contributions will be required to be made on the following payment schedule 30% of their capital contribution within 30 days of the date of approval of the Joint Venture; 30% of their capital contribution within 3 months of the date of approval of the Joint Venture; and 40% of their capital contribution within 6 months of the date of approval of the Joint Venture. The Company will use the consolidation method to account for the joint venture.
These contributed assets will be used to commence a new operation. The joint venture will purchase a 100-tonne electric furnace and a refiner furnace to produce high quality specialty steel using advanced technology. This type of specialty steel has not been previously produced by Baotou Steel. This advanced technology has not been previously utilized by Baotou Steel. This new joint venture will aim to enter into a new market segment of high-end specialty steel.
See report of independent registered public accounting firm
GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
This contemplated transaction is not considered a business combination as defined under Article 11 of Regulation S-X. The revenue producing activity for the new entity will be different from that of the existing companies. New high-end special steel products will be produced and marketed to new customers. In order to produce these new products, the new entity will build new facilities on the land to be contributed by Baotou Steel. It will take some equipment to be contributed by Baotou Steel, which are to be substantially modified, and add a 100-ton electric furnace and a refiner to create a new production line. A new sales force will be built to identify and target new customers. The new entity will not carry the names of either of its future owners.
This contemplated transaction is not considered as a business acquisition through a non-monetary exchange under EITF 98-3 because it does not meet the relevant definition thereunder. The assets to be contributed do not include systems, standards, protocols, conventions and rules that act to define the process necessary for normal, self-sustaining operations, such as (i) strategic management processes, (ii) operational processes, and (iii) resource management processes. The assets to be contributed do not include the ability to obtain access to the customers that purchase the outputs of the assets to be contributed. Additionally, while the newly formed entity will receive certain tangible assets, it will be a start-up company. It will need to attract and retain talent to install/modify/acquire equipment, manage operations, as well as to manufacture market and sell products to newly identified customers. The assets to be contributed by Baotou Steel are insignificant compared to the total assets of Baotou Steel. Baotou Steel will continue to operate at its historical levels even assuming the consummation of the contemplated transactions. The respective future owners who will contribute certain assets to the new entity will continue to operate as separate entities. They will not reduce or transfer any of their respective workforces as a result of this transaction. They will continue to operate their existing businesses at their historical levels.
Upon the commencement of the joint venture, the rights of the minority shareholders of Daqiuzhuang Metal Sheet Co. Ltd. will be limited to receiving a distribution of profits from the joint venture; the minority shareholders will not have any voting rights
As of March 31, 2006, the Company has not received the approval of the Baotou Steel Joint venture and it is still under government review and may be subject to further industry sector review by the relevant authorities in China in view of the sensitive nature of the steel industry. The management at this point is uncertain if and when the government approval will be granted. Currently none of the financials of Baotou Steel is incorporated into the Company’s financial statements as there is no ownership or control relationship between the Company and Baotou Steel at this time.
See report of independent registered public accounting firm
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF OPERATIONS
The following is management's discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Form 10Q.
Overview
Following the acquisition of ownership in General Steel Investment Co., Ltd. in October 2004, We have shifted our main business focus to general steel products and steel manufacturing. As our core-operating unit, Tianjin Daqiuzhuang Metal Sheet Co., Ltd. (herein referred to as "Daqiuzhuang Metal") started its operation in 1988. Daqiuzhuang Metal's core business is the manufacturing of high quality hot rolled carbon and silicon steel sheets which are mainly used in the production of tractors, agricultural vehicles, shipping containers and in other specialty markets.
Daqiuzhuang Metal uses a traditional rolling mill production sequence, such as heating, rolling, cutting, annealing, and flattening to process slabs into steel sheets. The sheet sizes are approximately 2,000 mm (length) x 1,000 mm (width) x 0.75 to 2.0 mm (thickness). Limited size adjustments are possible to meet order requirements. "Qiu Steel" is the registered name for our products.
Daqiuzhuang has recently completed an expansion program to build a new plant next to the existing facility with four new production lines to increase its hot-rolled steel sheet production capacity by 150,000 tons. The Company now operates 10 steel production lines capable of processing 400,000 tons of 0.75-2.0 mm hot-rolled carbon steel sheets per year, maintaining a 50% market share of all hot rolled steel sheets used in the production of agricultural vehicles in China.
On September 28, 2005, we signed a joint venture agreement (the “Joint Venture Agreement”) with Baotou Iron and Steel Group (“Baotou Steel”) to form Baotou Steel - General Steel Special Steel Joint Venture Company Limited, a limited liability company formed under the laws of the People’s Republic of China (the “Joint Venture Company”). The Joint Venture Company has not been launched and is not operational yet.
This contemplated transaction is not considered a business combination as defined under Article 11 of Regulation S-X. The revenue producing activity for the new entity will be different from that of the existing companies. New high-end special steel products will be produced and marketed to new customers. In order to produce these new products, the new entity will build new facilities on the land to be contributed by Baotou Steel. It will take some equipment to be contributed by Baotou Steel, which are to be substantially modified, and add a 100-ton electric furnace and a refiner to create a new production line. A new sales force will be built to identify and target new customers. The new entity will not carry the names of either of its future owners.
This contemplated transaction is not considered as a business acquisition through a non-monetary exchange under EITF 98-3 because it does not meet the relevant definition thereunder. The assets to be contributed do not include systems, standards, protocols, conventions and rules that act to define the process necessary for normal, self-sustaining operations, such as (i) strategic management processes, (ii) operational processes, and (iii) resource management processes. The assets to be contributed do not include the ability to obtain access to the customers that purchase the outputs of the assets to be contributed. Additionally, while the newly formed entity will receive certain tangible assets, it will be a start-up company. It will need to attract and retain talent to install/modify/acquire equipment, manage operations, as well as to manufacture, market and sell products to newly identified customers. The assets to be contributed by Baotou Steel are insignificant compared to the total assets of Baotou Steel. Baotou Steel will continue to operate at its historical levels even assuming the consummation of the contemplated transaction. The respective future owners who will contribute certain assets to the new entity will continue to operate as separate entities. They will not reduce or transfer any of their respective workforces as a result of this transaction. They will continue to operate their existing businesses at their historical levels.
The total investment in the Joint Venture Company may be up to US$30,000,000, with an anticipated registered capital of approximately US$24,000,000. Pursuant to the Joint Venture Agreement, Baotou Steel will contribute land, existing equipment and materials whereas General Steel Investment and Daqiuzhuang Metal will each contribute cash capital to the Joint Venture Company. The completion of this transaction is subject to the provision of both General Steel Investment and Daqiuzhuang Metal by Baotou Steel of relevant financial statements and an independent appraisal of the assets to be contributed to the Joint Venture Company, which have not been produced thus far. In addition, China’s State Assets Supervision and Administration Committee will need to assign an independent appraisal firm to perform an appraisal of the assets contributed by Baotou Steel. At this time, we are still waiting for the Chinese government to appoint an appraisal firm to complete the appraisal and the evaluation process of the joint venture project. As a result, at this moment we are not in a position to determine the amount of cash capital General Steel Investment and Daqiuzhuang Metal will be required to contribute to the Joint Venture Company. We are working to encourage relevant parties to provide the requisite documentation and initiate the needed procedures.
| | | % Ownership | |
| Baotou Iron and Steel (Group) Co.,Ltd. | | | 49 | % |
| General Steel Investment Co., Ltd. | | | 31 | % |
| Daqiuzhuang Metal Sheet Co., Ltd | | | 20 | % |
On September 18, 2005, we entered into a certain Subscription Agreement with certain investors and sold an aggregate of 1,176,665 shares of our common stock, in a private placement under Rule 506 of the Securities Act at a purchase price of $1.50 per share.
Under this private placement, we raised $1,765,000 in the aggregate, with a net proceeds of $1,606,150 after deducting $158,850 paid for commissions.
Results of Operations
Our results of operations are largely dependent on the level of general economic activity in China. Economic forecasts indicate continued fast pace growth in China in 2006. As a result, the consumption of our steel products is expected to remain at a high level. We believe that we have successfully positioned ourselves within the Chinese agricultural vehicle market. As this market continues to demonstrate increased demand for steel products, we remain focused on building our leadership position by enhancing the quality of our products and expanding our production capacity. However, we do believe that the highly competitive market will exist throughout 2006, with pressures for shipment volumes and prices. In view of that, we will continue to focus on cost control and new market development.
Our sales revenue mainly comes from the sale of metal sheets in different specifications and steel scrap generated in the cutting process. Our cost of sales includes the cost of its primary raw materials, rollers, energy cost, labor cost, the cost of warehousing and handling finished steel products and freight costs.
Net sales and gross profit
Net sales for the three months ended March 31, 2006 were $20.6 million compared to $20.7 million in the same period of 2005. Shipments for the three months ended March 31, 2006 climbed 29% to 53,547 tons from 41,421 tons due to overall increase in productivity and market development. Average selling price per ton including sale of scrap for the three months ended March 31, 2006 slipped to $383 from $491 in the same period of 2005. The decrease in sales price mainly resulted from the overall steel market downturn, but the impact was offset by the increase in sales volume. This is why our net sales amount is still in line with the same period last year.
Gross profit for the three months ended March 31, 2006 was $1.37 million, a decrease of 27% or $0.5 million from $1.87 million for the same period last year. Gross profit margin decreased to 6.6% from 9.0% for the three months ended March 31, 2006 and 2005. This decrease in gross profit margin is mainly due to the decrease in average selling price. Since April 2005, the price of steel products has been decreasing globally due to the overall increase in steel supply. We have to adjust its products’ prices in order to stay competitive in this market. The management thinks that the pressure on the selling price will be mitigated in 2006 as a result of steel industry consolidation in China and overall increase in demand.
Cost of sales
Overall cost of sales slightly increased to $19.3 million for the three months ended March 31, 2006 from $18.8 million for the same period of 2005. Cost of sales as percentage of sales increased from 91.0% to 93.4%. Average cost per ton was $360 and $455, respectively for the three months ended March 31, 2006 and 2005. In summary the increase in cost of sales mainly resulted from the increase in the sales volume.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, such as executive compensation, office expenses, legal and accounting charges, travel charges, and various taxes were $0.74 million in the first quarter of 2006, compared to $0.65 million in the first quarter of 2005, a 13.6% increase. A large component of the increase came from the legal and accounting expenses and investor and public relations charges for the public listed company.
Other income (expense)
Other income (expense) for the three months ended March 31, 2006 consisted mainly of finance charges, interest income and other non-operating income (expense). Interest expense was $0.55 million in the first quarter of 2006, compared to $0.44 million in the first quarter of 2005. Outstanding bank loans increased to $32.2 million from $27.1 million as of March 31, 2006 and 2005, respectively. This increase in debt borrowing is mainly used for the construction of the new plant.
Income taxes
We did not carry on any business and did not maintain any branch office in the United States during the three months ended March 31, 2006 and 2005. Therefore, no provision for withholding or U.S. federal income taxes or tax benefits on the undistributed earnings and/or losses of the Company has been made.
Pursuant to the relevant laws and regulations in the People's Republic of China, Daqiuzhuang Metal, as a foreign owned enterprise in the People's Republic of China, is entitled to an exemption from the PRC enterprise income tax for two years commencing from its first profitable year. We have been approved for this tax benefit and will be exempt from income tax for the years ended December 31, 2005 and 2006 and 50% income tax reduction for the years ended December 31, 2007, 2008 and 2009.
Liquidity and capital resources
Due to the good market demand for our steel products, we plan to maintain higher-than-average debt to equity ratio to better position ourselves in this fast growing market. The bank loans are considered short-term for the purpose of the preparation of the financial statements because they are renewable with the banks every year. Due to the recent joint venture agreement with Baotou Iron and Steel (Group) Co., Ltd., we are reserving cash for the first 30% of its capital contribution, approximately $3.7 million, which needs to be paid when the business license for the joint venture is issued. Cash balance including restricted cash amounted to $4.9 million and $11.4 million as of March 31, 2006 and 2005.
Operating activities
Net cash used in operating activities for the three months ended March 31, 2006 was $8.3 million compared to $7.7 million provided by operating activities in the same period last year. Increase in accounts receivable, inventories, and advance on inventory purchases, and less customer deposit became the major factors of this increase in cash used in operating activities. As the raw materials price showed signs of going back up in March this year, the management decided to stock up raw materials inventory in order to maximize the profitability.
Investing activities
Net cash used in investing activities was $3.0 million for the three months ended March 31, 2006 compared to $4.8 million used in investing activities in the same period last year. We have been building a new plant with four new production lines next to the existing facility since the third quarter last year. As of March 31, 2006, We have spent $7.6 million on construction in progress.
Financing activities
Net cash provided by investing activities was $4.9 million for the three months ended March 31, 2006 compared to $1.1 million provided by investing activities in the same period last year. We signed a new borrowing agreement with Shenzhen Development Bank to borrow $4,992,000. The proceeds were mainly used to pay for inventory purchases and the construction of the new plant.
Compliance with environmental laws and regulations
Based on the equipment, technologies and measures adopted, we are not considered a high-pollution factory in China. The production process does not need much water and produces only a minimal amount of chemical pollution. We use gas-fired reheat furnaces recommended by the State Environmental Protection Agency to heat our raw materials and semi-finished products.
In 2005, the Daqiuzhuang County ordered an environmental clean-up campaign and required harmless waste water discharge. In order to meet these requirements, we invested $94,190 to remodel our industrial water recycling system to reduce new water consumption and industrial water discharge. This wastewater recycling system is able to process 350 tons of wastewater daily. We can realize approximately $10,000 savings per year using this system. As for the remodeling of gas furnace and desulphurization of discharged gas, the local government has not posted any control measures currently and we have no plans to proceed with this remodeling until such time regulations are mandated.
We believe that future costs relating to environmental compliance will not have a material adverse effect on our financial position. There is always the possibility, however, that unforeseen changes, such as new laws or enforcement policies, could result in materially adverse costs.
Impact of inflation
We are subject to commodity price risks arising from price fluctuations in the market prices of the raw materials. We have generally been able to pass on cost increases through price adjustments. However, the ability to pass on these increases depends on market conditions driven by the overall economic conditions in China. We manage the price risks through productivity improvements and cost-containment measures.
Management does not believe that inflation risk is material to our business or our financial position, results of operations or cash flows.
Off-balance sheet arrangements
There are currently no off-balance sheet arrangements.
OUTLOOK
Certain statements contained herein constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements of General Steel Holdings, Inc. ("the Company”) or industry results, to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements. The Company's future operating results are dependent upon many factors, including but not limited to the risk factors discussed in this periodic report and developments beyond the Company's control as well as other risk factors discussed in the Company's periodic filings with the Securities and Exchange Commission which are available for review at www.sec.gov under "Search for Company Filings."
We are expecting strong results in the second quarter of 2006 as shipments and average realized prices are expected to improve compared to the first quarter of 2006. Due to our new plant’s full operation in the second quarter of 2006, we expect a considerable jump on the sales volume compared to the same period of 2005. In addition, our selection of steel strip as our new raw materials could also increase our productivity and reduce manufacturing costs.
ACCOUNTING STANDARDS
CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of its financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Our financial statements reflect the selection and application of accounting policies which require management to make significant estimates and judgments. See note 2 to our consolidated financial statements, "Summary of Significant Accounting Policies." Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe that the following reflect the more critical accounting policies that currently affect our financial condition and results of operations.
Revenue recognition
The Company recognizes revenue when the goods are delivered and title has passed. Sales revenue represents the invoiced value of goods, net of a value-added tax (VAT). All of the Company’s products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product.
Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles of the United States of America requires management to make estimates and assumptions that affect the amounts reported in the combined financial statements and accompanying notes. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates.
Inventories
We record reserves against our inventory to provide for estimated obsolete or unsalable inventory based on assumptions about future demand for its products and market conditions. If future demand and market conditions are less favorable than management's assumptions, additional reserve could be required. Likewise, favorable future demand and market conditions could positively impact future operating results if previously reserved for inventory is sold.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, General Steel’s management carried out an evaluation, with the participation of General Steel’s principal executive officer and principal financial officer, of the effectiveness of General Steel’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934). Based upon that evaluation, General Steel’s principal executive officer and principal financial officer concluded that General Steel’s disclosure controls and procedures were effective as of the end of the period covered by this report.
There were no changes in General Steel’s internal controls over financial reporting that occurred during General Steel’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, General Steel’s internal control over financial reporting.
