ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Note Regarding Forward-Looking Statements
The following discussion
of the financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial
statements and related notes thereto. The following discussion contains forward-looking statements. General Steel Holdings, Inc.
is referred to herein as “we,” “our,” “us” and “the Company.” The words or phrases
“would be,” “will allow,” “expect to,” “intends to,” “will likely result,”
“are expected to,” “will continue,” “is anticipated,” “estimate,” or similar expressions
are intended to identify forward-looking statements. Such statements include those concerning our expected financial performance,
our corporate strategy and operational plans. Actual results could differ materially from those projected in the forward-looking
statements as a result of a number of risks and uncertainties, including: (a) those risks and uncertainties related to general
economic conditions in the PRC, including regulatory factors that may affect such economic conditions; (b) whether we are able
to manage our planned growth efficiently and operate profitable operations, including whether our management will be able to identify,
hire, train, retain, motivate and manage required personnel or that management will be able to successfully manage and exploit
existing and potential market opportunities; (c) whether we are able to generate sufficient revenues or obtain financing to sustain
and grow our operations; and (d) whether we are able to successfully fulfill our primary requirements for cash which are explained
below under “Liquidity and Capital Resources.” Unless otherwise required by applicable law, we do not undertake, and
we specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences, developments, unanticipated
events or circumstances after the date of such statement. Additional information regarding certain factors which could cause actual
results to differ from such forward-looking statements include, but are not limited to, those described in Item 1A, “Risk
Factors”, to our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 filed with the SEC on February 15,
2013.
Recent Developments and First Quarter Highlights
The first quarter of
2012 was highlighted with the following:
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Sales in the first quarter of 2012 decreased by 8.8% to $648.0
million, from $710.5 million in first quarter of 2011, due to decreased sales volume as well as a decrease in the average
selling price of our products. For the first quarter of 2012, sales volume of rebar in Shaanxi Longmen Iron and Steel Co.
Ltd. ("Longmen Joint Venture") totaled 1.1 million metric tons, a decrease of 6.6%, compared to 1.2 million metric tons in
the first quarter of 2011, with an average selling price of $588.7 per ton, compared to $606.6 per ton in the first quarter
of 2011.
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Gross profit in the first quarter of 2012 totaled $5.6 million, or
0.9% of total revenue, as compared to a gross profit of $5.0 million, or 0.7% of total revenue in the first quarter of 2011. Gross
profit in the first quarter of 2012 also had a turnaround as compared to a gross loss of $150.7 million, or (19.0)% of total revenue
in the fourth quarter of 2011.
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Total finance expenses in the first quarter of 2012 totaled $48.3
million, of which, $10.8 million was the interest expense on capital lease as compared to $0 in the same period of 2011, and $37.5
million was the interest expense on bank borrowings, related parties borrowings and discounted notes receivable as compared to $14.1 million in the first quarter
of 2011.
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Loss per share was $0.63 in the first quarter of 2012, compared to
a loss of $0.16 per share in the first quarter of 2011. The increase in the loss in the first quarter was mainly due to the increased
interest expenses on capital lease, bank borrowings, related parties borrowings and discounted notes receivable expenses.
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On March 27, 2012, we launched another share repurchase program to
repurchase up to an aggregate of 2,000,000 shares of our common stock (the “Share Repurchase Program”). Together with
the previous share repurchase program launched in December 2010 and this newly announced Share Repurchase Program, it brought the
total authorized shares of our common stock available for purchase to 4,000,000. As of March 31, 2012, we had repurchased 1,090,978
shares of common stock in open market transactions at an average price of $1.70 per share pursuant to the above mentioned expansion
of the Share Repurchase Program.
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OVERVIEW
We were incorporated
on August 5, 2002, in the State of Nevada. We are headquartered in Beijing, China and operate a portfolio of Chinese steel companies.
We serve various industries and produce a variety of steel products including, but not limited to: reinforced bars (“rebar”),
hot-rolled carbon, spiral-weld pipes and high-speed wire. Our current aggregate annual production capacity of steel products is
7 million metric tons of crude steel. Our individual product categories have a variety of demand drivers, such as rural income,
infrastructure construction and energy consumption. Domestic economic conditions are also an overall demand driver for all our
products.
Our vision is to become
one of the largest and most profitable non-government owned steel companies in the PRC. Our mission is to grow our business organically
and through the acquisition of Chinese steel companies to increase their profitability and efficiencies by utilizing western management
practices and advanced production technologies, and the infusion of capital resources.
Our two-pronged growth strategy focuses
on a combination of capacity expansion, as well as optimizing operating efficiencies and leverage:
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We aim to grow our revenue by increasing capacity and through continual
cooperation and partnerships with leading state-owned enterprises (SOEs).
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We aim to drive profitability through improved operational efficiencies
and optimization of our cost structure.
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Unless the context indicates otherwise,
as used herein the terms “General Steel”, the “Company”, “we”, “our” and “us”
refer to General Steel Holdings, Inc.
Steel-Related Subsidiaries and Raw Material Trading Company
We presently have controlling interests in
four steel-related subsidiaries and one raw material trading subsidiary:
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General Steel (China) Co., Ltd. (“General Steel (China)”);
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Baotou Steel - General Steel Special Steel Pipe Joint Venture Company Limited (“Baotou Steel Pipe Joint Venture”);
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Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”);
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Maoming Hengda Steel Co., Ltd. (“Maoming Hengda”); and
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Tianwu General Steel Material Trading Co., Ltd. (“Tianwu Joint Venture”).
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Our Company, together with our subsidiaries,
majority owned subsidiaries and valuable interest entity, are referred to as the Group.
General Steel (China) Co., Ltd
General Steel (China), formerly known as
“Tianjin Daqiuzhuang Metal Sheet Co., Ltd.”, started operations in 1988.
On May 14, 2009, General
Steel (China) changed its official name from “Tianjin Daqiuzhuang Metal Sheet Co., Ltd.” to better reflect its role
as a merger and acquisition platform for steel company investments in China. In some instances, General Steel (China) retains
the use of the name “Daqiuzhuang Metal” for brand recognition purposes within the industry.
On January 1, 2010,
General Steel (China) entered into a lease agreement with Tianjin Daqiuzhuang Steel Plates Co., Ltd. (the “Lessee”),
whereby General Steel (China) leases its facility located at No. 1, Tonga Street, Daqiuzhuang Town, Jinghai County, Tianjin City
to the Lessee (the “Lease Agreement”). The Lease Agreement provides approximately 776,078 square feet of workshops,
land, equipment and other facilities to the Lessee and allows the Company to reduce overhead costs while providing a recurring
monthly income stream resulting from payments due under the lease. The initial term of the Lease Agreement was from January 1,
2010 to December 31, 2011 and the monthly base rental rate due to General Steel (China) was approximately $0.2 million (RMB1.7
million). On July 28, 2011, General Steel (China) signed a supplemental agreement with the Lessee to extend the lease for an additional
five years to December 31, 2016. However, due to current steel market conditions, the Lessee has informed us that they do not intend
to continue with the lease at June 30, 2012. There is no penalty for early termination. General Steel (China) currently does not
have plans to lease the facility to another company and as such, a write-down in the carrying value of property, plant and equipment
in relation to this event has been assessed and the impairment amount was estimated to be $5.5 million (RMB 35.1 million) was recorded
in the selling, general and administrative expenses in the second quarter of 2011. Management also re-evaluates the fair value
of its long-term assets on annual basis, or if there is a triggering event, which would require an assessment sooner.
Baotou Steel - General Steel Special
Steel Pipe Joint Venture Company Limited
On April 27, 2007, General
Steel (China) and Baotou Iron and Steel Group Co., Ltd. (“Baotou Steel”) entered into an Amended and Restated Joint
Venture Agreement, amending the Joint Venture Agreement entered into on September 28, 2005, to increase General Steel (China)'s
ownership interest in the related joint venture to 80%. The joint venture’s name is Baotou Steel - General Steel Special
Steel Pipe Joint Venture Company Limited, a Chinese limited liability company (“Baotou Steel Pipe Joint Venture”).
Baotou Steel Pipe Joint Venture obtained its business license from government authorities in the PRC on May 25, 2007,
and started its operations in July 2007. Baotou Steel Pipe Joint Venture has four production lines capable of producing 100,000
metric tons of double spiral-weld pipes primarily used in the energy sector to transport oil and steam. These pipes have a diameter
ranging from 219mm to 1240mm, a wall thickness ranging from 6mm to 13mm, and a length ranging from 6m to 12m. Presently, Baotou
Steel Pipe Joint Venture sells its products using an internal sales force to customers in the Inner Mongolia Autonomous Region
and the northwest region of the PRC.
Shaanxi Longmen Iron and Steel Co., Ltd
Effective June
1, 2007, through General Steel (China) and Tianjin Qiu Steel Investment Co., Ltd. (“Qiu Steel”), a 99% owned
company of General Steel (China), we entered into a Joint Venture Agreement with Shaanxi Longmen Iron & Steel Group Co.,
Ltd. (“Long Steel Group”) to form Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”).
Through General Steel (China) and Qiu Steel, we invested approximately $39.3 million in cash and collectively held a 60%
ownership interest in Longmen Joint Venture until April 29, 2011 when we entered into a 20-year Unified Management Agreement
(the “Unified Management Agreement”) with Longmen Joint Venture, Shaanxi Coal and Chemical Industry Group Co.,
Ltd. (“Shaanxi Coal”) and Shaanxi Iron and Steel Group co., Ltd. (“Shaanxi Steel”). Longmen Joint
Venture was determined to be a Variable Interest Entity (“VIE”) and we are the primary beneficiary.
Long Steel Group, located
in Hancheng city, Shaanxi Province, in China’s Western region, was founded in 1958 and incorporated in 2002. Long Steel Group
is owned by a state owned entity through Shaanxi Steel. Long Steel Group holds the remaining 40% ownership interest in Longmen
Joint Venture and operates as a fully-integrated steel production facility. Fewer than 10% of steel companies in China have
fully-integrated steel production capabilities.
Currently, Longmen
Joint Venture has five branch offices, four consolidated subsidiaries/VIE and five entities in which it has a noncontrolling
interest. It employs approximately 9,600 full-time workers. In addition to steel production, Longmen Joint
Venture operates transportation services through its Changlong Branch, located in Hancheng city, Shaanxi Province. Changlong
Branch owns 185 vehicles and provides transportation services exclusively to Longmen Joint Venture.
Longmen Joint Venture’s
rebar products are categorized within the steel industry as “longs” (referencing their shape). Rebar is generally considered
a regional product because its weight and dimension make it ill-suited for cost-effective long-haul ground transportation. By our
estimates, the market demand for rebar in Shaanxi Province is six to eight million metric tons per year. Slightly more than half
of this demand comes from Xi’an, the capital of Shaanxi Province, located 180km from Longmen Joint Venture’s main steel
production site. Currently, we estimate that we have an approximate 72% share of the Xi’an market for rebar.
An established regional
network of approximately one hundred and twenty-eight distributors together with those small distributors and three sales offices
sell Longmen Joint Venture’s products. All products sell under the registered brand name of “Yulong”, which has
strong regional recognition and awareness. Rebar and billet products carry ISO 9001 and 9002 certification and other of Longmen
Joint Venture’s products have won national quality awards. Products produced at the facility have been used in the construction
of the Yangtze River Three Gorges Dam, the Xi’an International Airport, the Xi’an city subway system and the Xi Luo
Du and the Xiang Jia Ba hydropower projects.
On September 24, 2007,
Longmen Joint Venture acquired a 74.92% ownership interest in Longmen Iron and Steel Group. Environmental Protection Industry
Development Co., Ltd. (“Longmen EPID”). At the same time, Longmen Joint Venture entered into an equity transfer
agreement with Long Steel Group to acquire a 36% ownership interest in its subsidiary, Hualong Fire Retardant Materials Co., Ltd.
(“Hualong”). Longmen Joint Venture paid $0.4 million (RMB 3.3 million) in exchange for the ownership interest and is
the largest shareholder in Hualong. Hualong’s facility produces fire-retardant materials used in various steel making
processes.
In January 2010, Longmen
Joint Venture completed its acquisition of the remaining 25.08% interest in Longmen EPID pursuant to an equity transfer agreement
with Shaanxi Fangxin Industrial Co., Ltd. (“Shaanxi Fangxin”), the other shareholder of Longmen EPID for RMB 8.7 million.
Longmen EPID then became a branch of Longmen Joint Venture.
From June 2009 to March
2011, we worked with Shaanxi Steel to build new iron and steel making facilities including two 1,280 cubic meter blast furnaces,
two 120 metric ton converters, one 400 square meter sintering machine and some auxiliary systems. As a result, Longmen Joint
Venture incurred certain costs of construction as well as economic losses on suspended production of certain small furnaces and
other equipment to accommodate the construction of the new equipment, on behalf of Shaanxi Steel.
Dismantling of certain
assets and a sub-lease of Longmen Joint Venture’s land associated with the construction by Shaanxi Steel began in June 2009.
At the beginning of the construction in June 2009, Longmen Joint Venture reached an oral agreement with Shaanxi Steel that all
costs incurred related to the construction would be reimbursed by Shaanxi Steel. From that point forward, through construction
and testing and until the completion of the project in March 2011, Longmen Joint Venture recorded the related costs as they were
incurred according to the nature of these costs and recognized the related receivable from Shaanxi Steel. In December 2010, Shaanxi
Steel and Longmen Joint Venture were able to finalize the amount of costs incurred by Longmen Joint Venture to be reimbursed and
executed in two signed agreements between the two parties on December 20, 2010. Therefore, to compensate us, in the fourth quarter
of 2010, Shaanxi Steel reimbursed Longmen Joint Venture $11.1 million (RMB 70.1 million) related to the value of assets dismantled
and rent under a 40-year property sub-lease that was entered into by the parties in June 2009, and $29.0 million (RMB 183.1 million)
for the reduced production efficiency caused by the construction. In addition, in 2010 and 2011, Shaanxi Steel reimbursed Longmen
Joint Venture $14.2 million (RMB 89.5 million) and $14.2 million (RMB 89.3 million), respectively, for trial production costs related
to the new equipment.
During the period
from June 2010 to March 2011, as construction progressed and certain of the assets came online, Longmen Joint Venture used the
assets free of charge to produce saleable units of steel products during this period. As such, the cost of using these assets and
therefore the fair value of the free rent received was imputed with reference to what the depreciation charge would have been on
these assets had they been owned or under capital lease to Longmen Joint Venture during this period. This cost of $7.0 million
(RMB 43.9 million) each year were deferred and will be recognized over the term of the land sub-lease similar to the other charges
and credits related to the construction of these assets.
The amount of reimbursement
is deferred as lease income and recognized as a component of the property that was sub-leased during the construction, and is to
be amortized to income over the remaining terms of the 40-year sub-lease.
For the three months
ended March 31, 2012 and 2011, we recognized lease income of $0.5 million and $0.5 million, respectively. As of March 31, 2012
and December 31, 2011, the deferred lease income on the land sub-lease was $78.6 million and $78.5 million, respectively. The remaining
life of amortization was 37.5 years as of March 31, 2012.
On April 29, 2011, we
entered into a 20-year Unified Management Agreement (the “Unified Management Agreement”) with Longmen Joint Venture,
Shaanxi Coal and Shaanxi Steel. Shaanxi Steel is the controlling shareholder of Long Steel Group which is the non-controlling interest
holder in Longmen Joint Venture, and Shaanxi Coal, a state-owned entity, the parent company of Shaanxi Steel. Under the terms of
the Unified Management Agreement, all manufacturing machinery and other equipment of Longmen Joint Venture plus the $586.2 million
(or approximately RMB 3.7 billion) of the newly constructed iron and steel making facilities owned by Shaanxi Steel which includes
one 400m
2
sintering machine, two 1,280m
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blast furnaces, two 120 ton converters and some auxiliary systems,
are managed collectively as a single virtual asset pool (“Asset Pool”). Longmen Joint Venture manages the Asset Pool
as the principal operating entity and is responsible for the daily operation of the new and existing facilities.
Furthermore, under the
terms of the Unified Management Agreement, Shaanxi Coal has committed to providing Longmen Joint Venture with raw materials, including
coke and coal, at a cost not higher than the market rate. In addition, the Unified Management Agreement includes provisions pursuant
to which both Shaanxi Coal and Shaanxi Steel are expected to provide financial support, including credit guarantees, as needed
for operations by Longmen Joint Venture. In October 2012, Shaanxi Steel agreed that it will not demand capital lease payment from
Longmen Joint Venture until October 2014. In March 2013, Shaanxi Coal has agreed to provide bank loan guarantees to Longmen Joint
Venture for amount of RMB 2.0 billion ($310.5 million).
Longmen Joint Venture
pays Shaanxi Steel for the use of the newly constructed iron and steel making facilities at an amount equal to the depreciation
expense on the equipment constructed by Shaanxi Steel in addition to 40% of the pre-tax profit generated by the Asset Pool. The
remaining 60% of the pre-tax profit is allocated to Longmen Joint Venture. As a result, our economic interest in the profits generated
by the Asset Pool decreased from 60% to 36%. However, the overall capacity under the management of Longmen Joint Venture has increased
by three million tons, or 75%. The Unified Management Agreement is also expected to improve Longmen Joint Venture’s cost
structure through sustainable and steady sourcing of key raw materials and reduced transportation costs. The distribution of profit
is subject to a prospective adjustment after the first two years based on each entity’s actual investment of time and resources
into the Asset Pool.
The parties to the Unified
Management Agreement have agreed to establish the Shaanxi Longmen Iron and Steel Unified Management Supervisory Committee (“Supervisory
Committee”) to ensure that the facilities and related resources are being operated and managed according to the stipulations
set forth in the Unified Management Agreement. However, the Board of Directors of Longmen Joint Venture remains as the controlling
decision-making body of Longmen Joint Venture and the Asset Pool.
The Unified Management
Agreement constitutes an arrangement that involves a lease which met certain of the criteria of a capital lease and therefore,
the lease is accounted for as such by Longmen Joint Venture. See Note 15 - “Capital lease obligations” and Note 16
-“Profit sharing liability” of the Notes to Condensed Consolidated Financial Statements included herein.
In November
2010, we brought online a 1,200,000 metric ton capacity rebar production line which was renovated based on an existing 800,000
metric ton capacity rebar production line. In July 2011, we brought online a 1,000,000 metric ton capacity high speed wire production
line. These two installed production lines were both relocated from the Maoming Hengda (as defined below) facility and consume
less energy when running at maximum efficiencies compared to our previous production line.
Maoming Hengda Steel Co., Ltd
On June 25, 2008, through
our subsidiary Qiu Steel, we paid approximately $7.1 million (RMB 50 million) in cash to purchase 99% of Maoming Hengda Steel Group,
Ltd. (“Maoming Hengda”). The total registered capital of Maoming Hengda is approximately $77.8 million (RMB 544.6
million).
Maoming Hengda’s
core business is the production of rebar products used in the construction industry. Located on 140 hectares (approximately
346 acres) in Maoming city, Guangdong Province, the Maoming Hengda facility previously had two production lines capable of annual
production capacities of 1.8 million metric tons of 5.5mm to 16mm diameter high-speed wire and 12mm to 38mm diameter rebar. The
products were sold through nine distributors targeting customers in Guangxi Province and the Western region of Guangdong.
To take advantage of
a stronger market demand in Shaanxi Province, in the second quarter of 2009, we relocated the 800,000 metric ton capacity rebar
production line from Maoming Hengda’s facility to Longmen Joint Venture. In December 2010, we relocated the 1,000,000
metric ton capacity high-speed wire production line from Maoming Hengda’s facility to Longmen Joint Venture to meet
the increased demand in Shaanxi Province.
In December 2010, we
brought online a new 400,000 ton capacity rebar production line. The new rebar line was constructed as a result of a
strategic alliance agreement between Maoming Hengda and Zhuhai Yueyufeng Iron and Steel Co., Ltd. (“Yueyufeng”), executed
on February 3, 2010. According to this agreement, Yueyufeng paid $4.4 million in advance in three installments to support
the construction of the rebar production line for Maoming Hengda, and charged Maoming Hengda an interest at rate of 10% annually.
The interest expense incurred was recorded in finance expense.
Tianwu General Steel Material Trading Co., Ltd
We formed Tianwu General
Steel Material Trading Co., Ltd. (“Tianwu Joint Venture”) with Tianjin Material and Equipment Group Corporation (“TME
Group”). The contributed capital of Tianwu Joint Venture is approximately $2.9 million (or RMB 20 million), and we
hold a 60% controlling interest. TME Group is one of the largest and most diversified commodity trading groups in China.
Tianwu Joint Venture sources raw materials,
mainly overseas iron ore, and is expected to supply approximately 20% to 50% of our imported iron-ore needs, amounting to approximately
two to three million metric tons on an annual basis.
Production Capacity Information Summary by Subsidiary
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General Steel
(China)
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Baotou Steel Pipe
Joint Venture
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Longmen Joint
Venture
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Maoming
Hengda
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Annual Production Capacity (metric tons)
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Crude Steel
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7 million
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Processing
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400,000
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100,000
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3.6 million
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400,000
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Main Products
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Hot-rolled sheet
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Spiral-weld pipe
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Rebar/High-speed
wire
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Rebar
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Main Application
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Light Agricultural vehicles
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Energy transport
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Infrastructure and
construction
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Infrastructure and
construction
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Marketing and Customers
We sell our products
primarily to distributors, and we typically collect payment from these distributors in advance. Our marketing efforts are
mainly directed toward those customers who have demanding requirements for on-time delivery, general inquiries and product quality.
We believe that these requirements as well as product planning are critical factors in our ability to serve this segment of the
market.
Our revenue is dependent,
in large part, on significant contracts with a limited number of large customers. For the three months ended March 31, 2012, approximately
45.0% of our sales were to five customers. We believe that revenue derived from our current and future large customers will continue
to represent a significant portion of our total revenue.
Moreover, our success
will depend in part upon our ability to obtain orders from new customers, as well as the financial condition and success of our
customers and general economic conditions in China.
Demand for our Products
Overall, domestic economic growth is an
important driver of our products, especially from construction and infrastructure projects, rural income growth and energy demand.
At Longmen Joint
Venture, growth in regional construction and infrastructure projects drives demand for our products. According to the 12th Five
Year National Economic and Social Development Plan (“NESDP”) (2011-2015), development in China’s Western region
is one of the top five economic priorities of the nation. Shaanxi Province, where Longmen Joint Venture is located, has been designated
as a focal point for development in the western region. Longmen Joint Venture is 180 km from Xi’an, the capital city
of Shaanxi Province and it does not have a major competitor within a 250 km radius.
The Western region
of China where our major sale market is located has experienced a higher rate of growth than other Chinese regions in recent years.
Compared to an increase of 9.6% for the national GDP, the GDP increase of 13.9% was reported by Shaanxi Province in 2011 over the
previous year. Additionally, according to Accounting and Corporate Finance Production Statistics in China, Sichuan Province also
reported a GDP increase of 14.7%, where we have opened a sales office in Chengdu City, Sichuan Province to meet the increasing
demand for the construction of steel.
According to the
Shaanxi provincial government, the total fixed asset investment for the Shaanxi Province was approximately RMB 1.0 trillion (approximately
$157.1 billion) for the year ended December 31, 2011, an increase of 18% over 2010.
At the end of June
2009, the State Council Office announced that it approved the Guanzhong-Tianshui Economic Zone development program. This program
covers the development of two western provinces and seven cities from 2009 to 2020.
In addition, the Guanzhong-Tianshui
Economic Zone will concentrate on the development of the Xi’an area. The metropolitan area construction program focuses on
the cities of Xi’an and Xianyang, and their surrounding areas, covering up to 12,000 square kilometers, including the construction
of railways, highways, subways, airport expansion and newly developed areas. Under this program, the Shaanxi provincial government
has announced that it will build approximately 4,500 kilometers of railway with the investment of RMB260 billion (approximately
$41.2 billion) by 2015 and 8,080 kilometers of highway by 2020. The infrastructure and constructions projects provide strong and
stable demand for our steel product in this area, in which we have over 70% of the market share.
In January 2011,
the central government announced a new low-income housing policy. Under this policy, 10 million low-income houses will be
built in 2011, with a total of 36 million low-income houses to be built over a five-year period. To ensure the construction of
the low-income housing, the central government has announced that it will increase its investment in the project by 34.7% over
its 2010 investment to approximately RMB103 billion, and the local governments are expected to increase their investment as well.
As part of this policy,
the Shaanxi provincial government also targets to build 470,000 low-income houses in 2011, covering approximately 30 million square
meters, which is 2.5 times the amount of low-income houses initiated in 2010. This will generate a stable demand for steel construction
within the Shaanxi Province.
In January 2011, the
Shaanxi provincial government announced that it will invest RMB80 billion (approximately $12.2 billion) in the construction of
hydro projects, which is three times the amount invested during the 11th Five Year National Economic and Social Development Plan.
In addition to hydro projects, according to the central government, 5,000 kilometers of high-speed railway will be built in 2011,
with 16,000 total kilometers to be built by 2020.
In May 2011, the
central government passed the Cheng-Yu Economic Zone Plan focusing on Chongqing City and Sichuan Province, covering 206,000 square
kilometers, to further accelerate the development of the Western region of China. We anticipate that in the near future,
the demand for our products will increase in those areas, and we expect that our expanded production capacity will be able to successfully
meet the increase in demand. Furthermore, we have a sales office located in Chengdu to help facilitate such increased demand.
We anticipate strong
demand for our products driven by these and many other construction and infrastructure projects. We believe there will be sustained
regional demand for several years as both the central and provincial governments continue to drive Western region development efforts.
Government supported housing and infrastructure development projects in the Western region of China are driving demand, particularly
in Shaanxi Province, which is the center of Western China's development. Although steel prices faced pressure in the second half
of 2011, they have rebounded in 2012 which, coupled with the strong end-market demand, should support growth in sales of rebar
and other steel products. Notably, during the 2012 National People's Congress, the central government raised its 2012 fiscal spending
budget 14% year-over-year to $1.92 trillion. Under this new budget, public housing has risen to 23% of total spending, which we
believe presents a meaningful opportunity to support the ongoing infrastructure growth in Western China.
At Baotou Steel Pipe
Joint Venture, energy sector growth, which spurs the need to transport oil, natural gas and steam, drives demand for spiral-weld
steel pipe. Presently, demand is fueled by smaller pipeline projects and municipal energy infrastructure projects within the Inner
Mongolia Autonomous Region.
At Maoming Hengda, infrastructure
growth and business development in Maoming city, the surrounding Guangxi cities and the Western region of Guangdong Province, drive
demand for our construction steel products. As a third tier city, the industrialization and urbanization of Maoming city is one
of the focuses of economic development in the west Guangdong Province.
Supply of Raw Materials
The primary raw materials
we use for steel production are iron ore, coke, hot-rolled steel coil and steel billets. Baotou Steel Pipe Joint Venture
uses hot-rolled steel coil as its main raw material. Longmen Joint Venture uses iron ore and coke as its main raw materials.
Maoming Hengda uses steel billets as its main raw material. Iron ore and coke are the main raw material used to produce hot-rolled
steel coil and steel billets. As a result, the prices of iron ore and coke are the primary raw material cost drivers for our products.
Iron Ore
Longmen Joint Venture
has 7 million tons of annual crude steel production capacity. At Longmen Joint Venture, approximately 85% of production costs are
associated with raw materials, with iron ore being the largest component.
In September 2010, we
formed Tianwu Joint Venture with TME Group, one of the largest and most diversified commodity trading groups in China. Tianwu Joint
Venture sources raw materials, mainly overseas iron ore, and is expected to supply approximately 20% to 50% of our imported iron-ore
needs, amounting to approximately two to three million metric tons on an annual basis. For the three months ended March 31, 2012,
we sourced approximately 0.3% of our iron ore purchases from Tianwu Joint Venture directly.
According to the China
Iron and Steel Association, approximately 60% of the China domestic steel industry demand for iron ore must be filled by imports.
At Longmen Joint Venture, we purchase iron ore from four primary sources: Mulonggou mine (owned by Longmen Joint Venture), Daxigou
mine (owned by Long Steel Group, our partner in Longmen Joint Venture), surrounding local mines and mines located abroad. According
to the terms of Longmen Joint Venture’s Agreement with the Long Steel Group, we have a first right of refusal for sales from
the Daxigou mine and for its development. We presently purchase all of the products from this mine.
Coke
Coke, produced from
metallurgical coal (also known as coking coal), is our second most consumed raw material, after iron ore. It requires approximately
550kg to 600kg of coke to make one metric ton of crude steel.
Under the terms of
the Unified Management Agreement, our partner, Shaanxi Coal has committed to providing coke and coal to us at a cost not higher
than the market price.
Our Longmen Joint Venture
facility is located in the center of China’s coal belt. We source all coke used at Longmen Joint Venture from the town in
which Longmen Joint Venture is located. This ensures a dependable, local supply and minimum transportation costs.
The sources and/or our top five major suppliers of our raw materials
for the quarter ended March 31, 2012 are as follows:
Longmen Joint Venture
Name of Major Supplier
|
|
Raw Material
Purchased
|
|
% of Total Raw
Material
Purchased
|
|
|
Relationship with
Company
|
Long Steel Group
|
|
Iron Ore
|
|
|
24.8
|
%
|
|
Related Party
|
Shaanxi Haiyan Coal Chemical Industry Co., Ltd.
|
|
Coke
|
|
|
16.0
|
%
|
|
Related Party
|
Xi'an Pinghe Metallurgical Raw Material Co., Ltd.
|
|
Iron Ore
|
|
|
10.8
|
%
|
|
Related Party
|
Shaanxi Long Steel Group Import & Export Co., Ltd.
|
|
Iron Ore
|
|
|
10.5
|
%
|
|
Related Party
|
China Railway Materials Xi’an Co., Ltd
|
|
Alloy/ Ore Powder
|
|
|
7.2
|
%
|
|
Third Party
|
|
|
Total
|
|
|
69.3
|
%
|
|
|
Baotou Steel Pipe Joint Venture
Name of Major Suppliers
|
|
Raw Material
Purchased
|
|
% of Total Raw
Material
Purchased
|
|
|
Relationship with
Company
|
Baotou Dingxin Steel Trading Co., Ltd.
|
|
Steel coil
|
|
|
93.0
|
%
|
|
Third Party
|
Weifang Jinertai Welding Material Co., Ltd.
|
|
Steel coil
|
|
|
7.0
|
%
|
|
Third Party
|
|
|
Total
|
|
|
100.0
|
%
|
|
|
Maoming Hengda
Name of Major Suppliers
|
|
Items Purchased
|
|
% of Total Items
Purchased
|
|
|
Relationship with
Company
|
Hunan Xiangtan Guoshun Electricity & Coal Co., Ltd.
|
|
Coal
|
|
|
48.8
|
%
|
|
Third Party
|
Hefei Jinggong Accessories Co., Ltd
|
|
Mechanical accessories
|
|
|
5.4
|
%
|
|
Third Party
|
Maoming Yongxin Valve Co., Ltd.
|
|
Mechanical accessories
|
|
|
3.5
|
%
|
|
Third Party
|
Kaifeng Zhonghua Instrument Co., Ltd.
|
|
Mechanical accessories
|
|
|
0.4
|
%
|
|
Third Party
|
Guangzhou Dingding Automatic Machine Co., Ltd
|
|
Mechanical accessories
|
|
|
0.1
|
%
|
|
Third Party
|
|
|
|
|
|
58.2
|
%
|
|
|
Industry Environment
Despite demand
growth experienced during 2010 and 2011, the overall nationwide steelmaking capacity still exceeds steel demand. There is
significant over-capacity in the Chinese steel sector which is putting pressure on operators’ profitability which
became the most significant challenge in the steel manufacturing business. Chinese crude steel capacity is expected to be
around 840 million tons in 2012, which would be 22.1% in excess of the expected 688 million tons of consumption, according to
the HIS Global Insight daily analysis, January 2012.
For steelmakers, operating
performance depends on the volatility of the cost of raw materials. The shortage of these raw materials in the market has allowed
suppliers of iron ore and metallurgical coal to rebuild the pricing mechanisms through the shift from annual to shorter-term price
contracts. This has created numerous challenges for steelmakers as they must now deal with volatility in raw material prices, as
well as maintain margins with fluctuating demand. Over the past two years, we have witnessed
perseverance
in steel prices that has given iron ore producers an opportunity to increase the prices in the next contract; however the
reverse may not be true as steel companies cannot always pass on the rise in iron ore prices to end consumers due to the market
overcapacity and fragmentation.
The central government
has had a long-stated goal to consolidate 50% of domestic steel production among the top ten producers by 2010 and 70% by 2020. Currently,
there are approximately over 500 crude steel producers throughout China, and the top ten producers account for approximately 48%
of total national output. In 2011, the central government had successfully reduced obsolete iron production capacities by 31.92
million tons.
On July 12, 2010, the
Ministry of Industry & Information Technology Commission enacted the Steel Industry Admittance and Operation Qualifications
standards. The new standards specify requirements for all aspects of steel production in China, which include: size of blast furnaces,
size of converters, emission of waste water, dust per ton from steel production, quantity of coal used for each process in
steel production and output capacity. According to the new standards, blast furnaces under 450 cubic meters are targeted
to be eliminated. These standards once again confirmed the central government’s determination to push forward the consolidation
of this fragmented industry. While the operational conditions become more stringent, more small and medium sized companies
will likely to aggressively look for valued partners which could lead to opportunities for high quality acquisitions for us.
We believe the above government policy will strengthen our position as an industry consolidator by creating quantitative qualified
potential acquisition targets.
Intellectual Property Rights
“Qiu Steel”
is the registered trademark under which we sell hot-rolled carbon and silicon steel sheets products produced at General Steel (China).
The “Qiu Steel” logo has been registered with the China National Trademark Bureau under No. 586433. “Qiu Steel”
is registered under the GB 912-89 national quality standard and certified under the National Quality Assurance program.
“Baogang Tongyong”
is the trademark under which we sell spiral-weld steel pipes products produced at Baotou Steel Pipe Joint Venture. This trademark
is registered with China National Trademark Bureau.
“Yu Long”
is the registered trademark under which we sell rebar and high-speed wire products produced in Longmen Joint Venture. The trademark
is registered under the ISO9001:2000 international quality standard.
“Heng Da”
is the registered trademark under which we sell high-speed wire and rebar products produced at our Maoming facility. The trademark
is registered under the ISO9001:2000 international quality standard.
Results of Operations for the Three Months Ended March 31,
2012
Sales
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
The following table sets forth sales and volume in metric tons
for our Longmen Joint Venture.
|
|
Three
months ended
|
|
|
|
|
|
|
|
|
|
March
31, 2012
|
|
|
March
31, 2011
|
|
|
Change
|
|
|
Change
|
|
in thousands,
except metric tons
|
|
Volume
|
|
|
Sales
|
|
|
%
|
|
|
Volume
|
|
|
Sales
|
|
|
%
|
|
|
Volume
%
|
|
|
Sales
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Longmen Joint Venture
|
|
|
1,092,615
|
|
|
$
|
643,275
|
|
|
|
99.3
|
%
|
|
1,169,314
|
|
|
$
|
709,306
|
|
|
|
99.8
|
%
|
|
|
(6.6
|
)%
|
|
|
(9.3
|
)
%
|
Others
|
|
|
82,685
|
|
|
|
4,766
|
|
|
|
0.7
|
%
|
|
19,625
|
|
|
|
1,158
|
|
|
|
0.2
|
%
|
|
|
321.3
|
%
|
|
|
311.7
|
%
|
Total Sales
|
|
|
1,175,300
|
|
|
$
|
648,041
|
|
|
|
100.0
|
%
|
|
1,188,939
|
|
|
$
|
710,464
|
|
|
|
100.0
|
%
|
|
|
(1.1
|
)
%
|
|
|
(8.8
|
)
%
|
Total sales for the
three months ended March 31, 2012 decreased by 8.8% to $648.0 million from $710.5 million for the same period in 2011. The decrease
in sales compared to the same period in 2011 was predominantly due to the combined effects of decreased sales volume and average
selling price. Longmen Joint Venture comprised approximately 99.3% and 99.8% of total sales for the first quarter 2012 and
2011, respectively. Sales volume of rebar decreased by 6.6% to 1.1 million metric tons, compared to 1.2 million metric tons in
the same period in 2011. The average selling price of rebar decreased by 2.9% to approximately $588.7 per ton in the first
quarter of 2012 from approximately $606.6 per ton in the same period of 2011. Our product demands and prices had been rising in
the first three quarters of 2011 until the end of the third quarter of 2011. In the fourth quarter of 2011, as a result of the
China and global steel industry over-capacity, Chinese economic control polices and the financial crisis, commodity prices
abruptly plummeted in the fourth quarter of 2011. With weakened demand, market forces kicked-in and the price of steel dropped
substantially. As such, both our sales volume and prices have dropped during the first quarter of 2012 in comparison to the same
period of 2011.
For the
three months ended March 31, 2012, sales to third parties decreased by 23.5% to $383.8 million as compared to $501.5 million
for the same period in 2011, while sales to related parties increased by 26.4% to $264.2 million as compared to $209.0
million for the three months ended March 31, 2011. The increase of sales to related parties was mainly due to our marketing
strategy to expand our markets in rural areas in Xian city, and Sichuan Province and the sales network to the new related
party customers were established after the first quarter of 2011. As such, we had sales to the new related party customers
during the first quarter of 2012 while we did not have any sales to these customers in the same period of 2011. However,
the decrease of sales to third parties is mainly due to weakened demand resulting from the over-capacity issues discussed
above, along with sales to third parties in the rural areas in Xian city and Sichuan Province being affected by the weakened
demand.
Our five major customers
were all distributors and collectively represented approximately 45.0% of our total sales for the three months ended March 31,
2012 as compared to 32.3% of our total sales for the three months ended March 31, 2011. These five customers included related parties
and major distributors owned by central government. As we are the largest supplier in Shaanxi province, we maintain a good relationship
with these five customers to stabilize our sales channel.
Cost of Goods Sold
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
|
|
Three
months ended
|
|
|
|
|
|
|
|
|
|
March
31, 2012
|
|
|
March
31, 2011
|
|
|
Change
|
|
|
Change
|
|
in thousands,
except metric tons
|
|
Volume
|
|
|
Cost
of
Goods Sold
|
|
|
%
|
|
|
Volume
|
|
|
Cost
of
Goods Sold
|
|
|
%
|
|
|
Volume
%
|
|
|
Cost
of
Goods Sold
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Longmen Joint Venture
|
|
|
1,092,615
|
|
|
$
|
637,177
|
|
|
|
99.2
|
%
|
|
1,169,314
|
|
|
$
|
703,708
|
|
|
|
99.8
|
%
|
|
|
(6.6
|
)
%
|
|
|
(9.5
|
)
%
|
Others
|
|
|
82,685
|
|
|
|
5,234
|
|
|
|
0.8
|
%
|
|
19,625
|
|
|
|
1,707
|
|
|
|
0.2
|
%
|
|
|
321.3
|
%
|
|
|
206.7
|
%
|
Total Cost of Goods Sold
|
|
|
1,175,300
|
|
|
$
|
642,411
|
|
|
|
100.0
|
%
|
|
1,188,939
|
|
|
$
|
705,415
|
|
|
|
100.0
|
%
|
|
|
(1.1
|
)
%
|
|
|
(8.9
|
)
%
|
Our primary
cost of goods sold is the cost of raw materials such as iron ore, coke, alloy and scrap steel. The costs of iron ore and coke
account for approximately 85% of our total cost of sales. The cost of goods sold decreased by 8.9% to $642.4 million in the
first quarter of 2012 from $705.4 million in the same period of 2011. The decrease was mainly driven by the decreasing sales
volume and unit costs of raw materials as a result of the decline in iron ore and coke purchase prices of approximately 6.3%
and 4.7%, respectively for the three months ended March 31, 2012 as compared to the same period in 2011, offset by higher
overhead cost rate being allocated to each individual unit. In addition, we provided valuation allowance of approximately
$13.5 million of inventory for impairment for our raw materials due to the drop in market price of iron ore and coke products
as of March 31, 2012. As such, the average costs of rebar manufactured decreased by 3.1% to approximately $583.2
per ton in the first quarter of 2012 from approximately $601.8 per ton in the same period of 2011.
Gross Profit
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
|
|
Three
months ended
|
|
|
|
|
|
|
March
31, 2012
|
|
|
March
31, 2011
|
|
|
Change
|
|
in
thousands, except metric tons
|
|
Volume
|
|
|
Gross
Profit
(Loss)
|
|
|
Margin
%
|
|
Volume
|
|
|
Gross
Profit
(Loss)
|
|
|
Margin
%
|
|
|
Gross
Profit
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Longmen Joint Venture
|
|
|
1,092,615
|
|
|
$
|
6,098
|
|
|
|
0.9
|
%
|
|
|
1,169,314
|
|
|
$
|
5,598
|
|
|
|
0.8
|
%
|
|
|
8.9
|
%
|
Others
|
|
|
82,685
|
|
|
|
(468
|
)
|
|
|
(9.8
|
)%
|
|
|
19,625
|
|
|
|
(549
|
)
|
|
|
(47.4
|
)%
|
|
|
(14.8
|
)
%
|
Total Gross Profit
|
|
|
1,175,300
|
|
|
$
|
5,630
|
|
|
|
0.9
|
%
|
|
|
1,188,939
|
|
|
$
|
5,049
|
|
|
|
0.7
|
%
|
|
|
11.5
|
%
|
Gross profit for the
first quarter of 2012 was $5.6 million, or 0.9% of total sales, as compared to a gross profit of $5.0 million, or 0.7% of total
sales in the same period in 2011. The increase in gross margin percentage was mainly attributable to the percentage decrease of
average rebar selling price of 2.9%, which was lower than the percentage decrease of costs of rebar manufactured of 3.1% for three
months ended March 31, 2012 as compared to the same period of 2011.
Selling, General and Administrative Expenses (“SG&A”)
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
(in thousands)
|
|
Three months ended
|
|
|
|
|
|
|
March 31, 2012
|
|
|
March 31, 2011
|
|
|
Change %
|
|
|
|
|
|
|
|
|
|
|
|
Selling, General and Administrative Expenses
|
|
$
|
18,629
|
|
|
$
|
14,501
|
|
|
|
28.5
|
%
|
SG&A Expenses As a Percentage of Total Revenue
|
|
|
2.9
|
%
|
|
|
2.0
|
%
|
|
|
|
|
SG&A
expenses, such as travel expenses and transportation fees, executive compensation, salaries and wages, land use rental fees, legal
and accounting fees, increased by 28.5% to $18.6 million for the three months ended March 31, 2012, compared to $14.5 million for
the same period in 2011.
Selling expenses
increased by 69.7% to $8.9 million as compared to $5.3 million in the same period of 2011. The increase was mainly due to the
rise of transportation and sales agent charges at Longmen Joint Venture, which related to the increase of shipment volume and
long distance sales deliveries expanding to markets in rural areas in Xian city, Sichuan Province and Gansu Province.
In addition,
general and administration (“G&A”) expenses increased by 5.1% to $9.7 million as compared to $9.2 million in
the same period of 2011. The increase was mainly due to the rise of executive compensation, salaries and wages, land use
rental fees, legal and accounting and maintenance facility expenses.
Loss from Operations
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
(in thousands)
|
|
Three months ended
|
|
|
|
|
|
|
March 31, 2012
|
|
|
March 31, 2011
|
|
|
Change %
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss from Operations
|
|
$
|
(12,999
|
)
|
|
$
|
(9,452
|
)
|
|
|
37.5
|
%
|
Loss from operations for the three months ended March 31, 2012
increased to $13.0 million from $9.5 million for the same period in 2011. The increase in loss from operations was predominantly
due to the increase in SG&A expenses offset by the increase in gross profit during the three months ended March 31, 2012, as
compared to the same period in 2011.
Other Income (Expense)
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
(in thousands)
|
|
Three months ended
|
|
|
|
|
|
|
March 31, 2012
|
|
|
March 31, 2011
|
|
|
Change %
|
|
|
|
|
|
|
|
|
|
|
|
Interest income
|
|
$
|
5,556
|
|
|
$
|
1,063
|
|
|
|
422.7
|
%
|
Finance/interest expense
|
|
|
(37,527
|
)
|
|
|
(14,119
|
)
|
|
|
165.8
|
%
|
Financing cost on capital lease
|
|
|
(10,839
|
)
|
|
|
-
|
|
|
|
-
|
|
Change in fair value of derivative liabilities
|
|
|
(13
|
)
|
|
|
3,552
|
|
|
|
(100.4
|
)%
|
Gain (loss) on disposal of equipment
|
|
|
(119
|
)
|
|
|
(397
|
)
|
|
|
(70.0
|
)%
|
Income (loss) from equity investment
|
|
|
(43
|
)
|
|
|
1,655
|
|
|
|
(102.6
|
)%
|
Foreign currency transaction gain
|
|
|
385
|
|
|
|
619
|
|
|
|
(37.8
|
)%
|
Lease income
|
|
|
530
|
|
|
|
452
|
|
|
|
17.3
|
%
|
Other non-operating income (expense), net
|
|
|
(143
|
)
|
|
|
305
|
|
|
|
(146.9
|
)%
|
Total other expense, net
|
|
$
|
(42,213
|
)
|
|
$
|
(6,870
|
)
|
|
|
514.5
|
%
|
Total other expense,
net, for the three months ended March 31, 2012 were $42.2 million, a 514.5% increase compared to $6.9 million for the same period
in 2011. The increase was mainly a result of an increase of $34.2 million in financial expense, of which, $10.8 million was interest
expense on capital lease, which we did not have for the first three months ended March 31, 2011, and $23.4 million of interest
expense increase was primarily due to increased discounted notes receivable during the quarter of 2012 as compared to the same
period in 2011 with higher discount rate than 2011 after the central government tightened the funding policy. The increased discount
notes receivables in the first quarter of 2012 as we intended to cash out the notes receivables early before the maturity date
to finance our operations.
The change in fair
value of derivative liabilities for the three months ended March 31, 2012 was a loss of $0.01 million compared to a gain of $3.6
million for the same period in 2011.
According to
U.S. GAAP, our December 2007 notes, December 2007 warrants and the December 2009 warrants are considered derivatives and therefore
are carried at their fair market value at each financial reporting date with any changes in the fair value reported as gains or
losses in our income statements. One of the major drivers used to calculate the value of the derivatives is our stock price.
Income Taxes
For the three months
ended March 31, 2012 and 2011, we had a total tax provision of $0.5 million and a tax benefit of $2.8 million, respectively. For
the three months ended March 31, 2012 and 2011, we had current income tax provisions for our profitable subsidiaries, amounting
to $0.3 million and $0.7 million, respectively. We had deferred income tax benefit of $3.5 million for the three months ended March
31, 2011, due to the Group’s net operating loss carried forward to offset operating income for the next five years. After
the filing of the Form 10-K/A for the year ended December 31, 2010, management evaluated our future operating forecast based on
the current steel market condition, and concluded the net operating loss may not be fully realizable and decided to provide 100%
valuation allowance for the deferred tax assets. For the three months ended March 31, 2012, we evaluated the deferred tax assets
remained in Baotou Steel Pipe Joint Venture and concluded the net operating loss may not be fully realizable and to provide 100%
valuation allowance for the deferred tax assets. As such, we provided an allowance against the remaining deferred tax assets as
of December 31, 2011 and had $0.2 million of deferred provision for income taxes.
For the three months
ended March 31, 2012 and 2011, we had effective tax rates of (1.0%) and 16.9%, respectively. The negative effective tax rate for
the three months ended March 31, 2012 was mainly due to a consolidated loss before income tax while we provided 100% valuation
allowance for the deferred tax assets at Longmen Joint Venture and Baotou Steel Pipe Joint Venture.
Net Loss
Three months ended March 31, 2012 compared with three
months ended March 31, 2011
(in thousands)
|
|
Three months ended
|
|
|
|
|
|
|
March 31, 2012
|
|
|
March 31, 2011
|
|
|
Change %
|
|
|
|
|
|
|
|
|
|
|
|
Net Loss
|
|
$
|
(55,748
|
)
|
|
$
|
(13,571
|
)
|
|
|
310.8
|
%
|
Net Loss attributable to General
Steel Holdings, Inc.
Three months ended March 31, 2012 compared with three months
ended March 31, 2011
(in thousands)
|
|
Three months ended
|
|
|
|
|
|
|
March 31, 2012
|
|
|
March 31, 2011
|
|
|
Change %
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
$
|
(55,748
|
)
|
|
$
|
(13,571
|
)
|
|
|
310.8
|
%
|
Less:
Net loss attributable to the noncontrolling interest
|
|
|
(20,964
|
)
|
|
|
(4,654
|
)
|
|
|
350.4
|
%
|
Net loss attributable to General Steel Holdings, Inc.
|
|
$
|
(34,784
|
)
|
|
$
|
(8,917
|
)
|
|
|
290.1
|
%
|
Net loss
attributable to us for the three months ended March 31, 2012 increased to $34.8 million compared to $8.9 million for the same
period in 2011. The increase in net loss attributable to us for the three months ended March 31, 2012 was mainly a result of
an increase of $10.8 million in interest expense on the capital lease and an increase in $23.4 million of interest expense on
bank borrowings, related parties borrowings and discounted notes receivables.
We
have subsidiaries in which we do not have a 100% ownership interest. Allocation of income or loss to these non-controlling interests
is based on the percentage of their equity investment times the subsidiaries’ net income or loss.
Liquidity and capital resources
As of March 31, 2012,
our current liabilities exceeded the current assets by approximately $735.2 million. Given our expected capital expenditure in
the foreseeable future, we have comprehensively considered our available sources of funds as follows:
|
·
|
Financial support and credit guarantee from related parties; and
|
|
·
|
Other available sources of financing from domestic banks and other financial institutions given our credit history.
|
Based on the
above considerations, our Board of Directors is of the opinion that we have sufficient funds to meet our working capital requirements
and debt obligations as they become due. As a result, our unaudited consolidated financial statements for the three months ended
March 31, 2012 have been prepared on a going concern basis.
As of March 31, 2012, we had cash and restricted
cash aggregating $540.0 million, of which $455.5 million was restricted.
We believe our cash
flows generated from operations and financing, which include customer prepayments and vendor financing, existing cash balances,
and credit facilities will be adequate to finance our working capital requirements, fund capital expenditures, make required debt
and interest payments, pay taxes, and support our operating strategies.
The steel business
is capital intensive and we utilize leverage greater than our industry peers, which we believe enables us to generate revenue
compared to our shareholder equity at a rate higher than our industry peers. We utilize leverage in the form of credit from banks,
vendor financing and customer deposits and from other sources. This blended form of financing reduces our reliance on any single
source.
Substantially all our
operations are conducted in China and all of our revenues are denominated in Renminbi (RMB). RMB is subject to the exchange control
regulation in China, and, as a result, we may have difficulty distributing any dividends outside of China due to People’s
Republic of China (“PRC”) exchange control regulations that restrict its ability to convert RMB into U.S. Dollars.
Under applicable PRC
regulations, foreign-invested enterprises in China may pay dividends only out of their accumulated profits, if any, determined
in accordance with PRC accounting standards and regulations. In addition, a foreign-invested enterprise in China is required to
set aside at least 10.0% of its after-tax profit based on PRC accounting standards each year to its general reserves until the
accumulative amount of such reserves reaches 50.0% of its registered capital. These reserves are not distributable as cash dividends.
The board of directors of a foreign-invested enterprise has the discretion to allocate a portion of its after-tax profits to staff
welfare and bonus funds, which may not be distributed to equity owners except in the event of liquidation. Under PRC law, RMB is
currently convertible into U.S. Dollars under a company’s “current account,” which includes dividends, trade
and service-related foreign exchange transactions, without prior approval of the State Administration of Foreign Exchange (SAFE),
but is not from a company’s “capital account,” which includes foreign direct investments and loans, without the
prior approval of the SAFE.
As of March 31, 2012, the amount of our restricted
net assets was $20.7 million.
We have previously raised
money in the U.S. capital markets which provides the capital needed for our operation and for General Steel Investment Co, Ltd.
(“General Steel Investment”). Thus, the foreign currency restrictions and regulations in the PRC on the dividends distribution
will not have a material impact on the liquidity, financial condition and results of operation of our Company and General Steel
Investment.
Although the steel industry
is slowing down due to over-capacity issues in China, in order for us to stay competitive, we are continuing to look
for opportunities to improve our efficiency on our production lines in addition to the 1,200,000 metric ton capacity rebar production
line which was renovated based on an existing 800,000 metric ton capacity rebar production line that we brought online in November
2010. In July 2011, we also brought online a 1,000,000 metric ton capacity high speed wire production line. These two newly installed
production lines were both relocated from the Maoming Hengda (as defined below) facility and are expected to consume less energy
when running at maximum efficiencies compared to our previous production line. In September 2012, we began the construction of
a 900,000 metric ton capacity rebar production line for the purpose of reducing our reprocessing cost and to increase our profit
margin. This 900,000 metric ton capacity rebar production line is expected to require capital resources.
Our management presently
anticipates that our access to credit and cash flow from operations will provide sufficient capital resources to pursue and complete
the construction of the 900,000 metric ton capacity rebar production line. We intend to utilize existing cash, cash flow from operations
and bank loans and credit to complete the 900,000 metric ton capacity rebar production line. Any future facility expansion will
require additional financing and/or equity capital and will be dependent upon the availability of financing arrangements and capital
at the time.
Short-term Notes Payable
As of March 31, 2012,
we had $1.2 billion in short-term notes payable liabilities, which were secured by restricted cash of $440.0 million and restricted
notes receivable of $401.4 million and other assets. These are lines of credit extended by banks for a maximum of six months
and are used to finance working capital. The short-term notes payable must be paid in full at maturity and credit availability
is continued upon payment at maturity. There are no additional significant financial covenants. We pay zero interest on this type
of credit as this is a monetary tool used by China’s central bank to control liquidity over the Chinese monetary system.
Short-term Loans – Banks
As of March 31, 2012,
we had $318.7 million in short-term bank loans. These were bank loans with a one year maturity and must be paid in full upon maturity.
PRC banks have not been impacted as heavily by the financial crisis as U.S. banks and we believe our current creditors will renew
their loans to us after our loans mature as they did in the past.
As of March 31,
2012 and December 31, 2011, we did not satisfy certain financial covenants on outstanding short term loans and due to the
dissatisfaction of such covenants, a loan with cross default clause was automatically considered as breached, these loans
affected amounted to $12.7 million and $12.6 million respectively. According to the loan agreements, the bank will have the
right to request more collateral or guarantees if the covenant is not satisfied or request for early repayment of the loan if
we could not remediate the dissatisfaction of covenants within a period of time. As of today, we have not received notice
from any bank to request for more collateral or guarantees or early repayment of the short term loans due to the breach.
We are able to repay our short-term notes
payables and short term bank loans upon maturity using available capital resources.
For more details about our debt, see Note
9 in our Notes to the unaudited condensed consolidated financial statements included in this report.
For more details about our related party
debt financing, see Note 20 in our Notes to the unaudited condensed consolidated financial statements included in this report.
As part of our
working capital management, Longmen Joint Venture has entered into a number of sale and purchase back contracts
(“Contracts”) with third party companies and two 100% owned subsidiaries of Longmen Joint Venture, named Yuxin
Trading Co., Ltd. (“Yuxin”) and Yuteng Trading Co., Ltd. (“Yuteng”). Pursuant to the Contracts,
Longmen Joint Venture sells rebar to the third party companies at a certain price, and within the same month, Yuxin and
Yuteng will purchase back the rebar from the third party companies at a price between 0.6% to 3.2% higher than the original
selling price from Longmen Joint Venture. Based on the Contract terms, Longmen Joint Venture is paid in advance for the rebar
sold to the third party companies and Yuxin and Yuteng are given a credit period of several months to one year for the
purchase back of the inventory from the third party companies. There is no physical movement of the inventory during the sale
and purchase back arrangement. The margin between 0.6% to 3.2% is determined by reference to the bank loan interest rates at
the time when the Contracts are entered into, plus an estimated premium based on the financing sale amount, which represents
the interest charged by the third party companies for financing Longmen Joint Venture through the above sale and purchase
back arrangement. As such, the revenue and cost of goods sold arising from the above transactions are recorded on a net basis
and the incremental amounts paid by Yuxin and Yuteng to purchase back the goods are treated as financing costs in the
consolidated financial statements.
Total financing sales
for the three months ended March 31, 2012 and 2011 amounted to $144.2 million and $159.7 million, respectively, which were eliminated
in our consolidated financial statements. The financial cost related to financing sales for the three months ended March 31, 2012
and 2011 amounted to $1.2 million and $1.6 million, respectively.
Liquidity
Our accounts have been
prepared in accordance with U.S. GAAP on a going concern basis. The going concern basis assumes that assets are realized and liabilities
are extinguished in the ordinary course of business at amounts disclosed in the financial statements. Our ability to continue as
a going concern depends upon aligning our sources of funding (debt and equity) with our expenditure requirements and repayment
of the short-term debt facilities as and when they fall due.
The steel business
is capital intensive and as a normal industry practice in PRC, our Company is highly leveraged. Debt financing in the form of short
term bank loans, loans from related parties, financing sales, bank acceptance notes, and capital leases have been utilized to finance
the working capital requirements and the capital expenditures of our Company. As a result, our debt to equity ratio as of March
31, 2012 and December 31, 2011 were (13.6) and (19.8), respectively. As of March 31, 2012, our current liabilities exceed current
assets (excluding non-cash items) by $733.1 million. And as of June 30, 2013, our estimated current liabilities may exceed current
assets (excluding non-cash items) by $777.4 million.
Longmen Joint Venture,
as our most important operating subsidiary, accounted for a majority of our total sales. As such, the majority of our working capital
needs to come from Longmen Joint Venture. Our ability to continue as a going concern depends heavily on Longmen Joint Venture’s
operations. Longmen Joint Venture has obtained different types of financial supports, which include line of credit from banks,
vendor financing, financing sales, other financing and sales representative financing.
With the financial
support from the banks and the companies above, management is of the opinion that we have sufficient funds to meet our future operations,
working capital requirements and debt obligations until the end of June 30, 2014. The detailed breakdown of Longmen Joint Venture’s
estimated cash flows items are listed below.
|
|
Cash inflow (outflow)
(in millions)
|
|
|
|
For the twelve months ended
June 30, 2014
|
|
Estimated current liabilities over current assets (excluding non-cash items) as of June 30, 2013 (unaudited)
|
|
$
|
(777.4
|
)
|
Projected cash financing and outflows:
|
|
|
|
|
Cash provided by line of credit from banks
|
|
|
202.1
|
|
Cash provided by vendor financing
|
|
|
477.6
|
|
Cash provided by financing sales
|
|
|
79.6
|
|
Cash provided by other financing
|
|
|
43.8
|
|
Cash provided by sales representatives
|
|
|
35.2
|
|
Cash projected to be used in operations in the twelve months ended June 30, 2014
|
|
|
(27.7
|
)
|
Net projected change in cash for the twelve months ended June 30, 2014
|
|
$
|
33.2
|
|
As a result, the unaudited
condensed consolidated financial statements for the three month period ended March 31, 2012 have been prepared on a going concern
basis.
Cash-flow
Operating Activities
Net cash used in operating
activities for the three months ended March 31, 2012 was $167.0 million compared to net cash provided by operating activities of
$54.1 million in the same period of 2011. This change was mainly due to the combination of the following factors:
|
·
|
The impact of some non-cash items included in net income of $31.3 million, compared to $7.6 million in the same period in 2011. The non-cash items included the following:
|
|
-
|
Depreciation, amortization and depletion;
|
|
-
|
change in fair value of derivative liabilities;
|
|
-
|
loss on disposal of equipment;
|
|
-
|
bad debt allowance;
|
|
-
|
reservation of mine maintenance fee;
|
|
-
|
stock issued for service and compensation;
|
|
-
|
amortization of deferred financing cost on capital lease;
|
|
-
|
income (loss) from equity investments;
|
|
-
|
foreign currency transaction gain;
|
|
-
|
deferred tax assets; and
|
|
-
|
deferred lease income.
|
|
·
|
The primary reasons for the material fluctuations in cash inflow were as follows:
|
|
-
|
Notes receivable: The decrease of notes receivable was mainly due to the collection of notes receivable when they became due during the three months ended March 31, 2012;
|
|
-
|
Accounts payable – related
parties: The increase in accounts payable – related parties was mainly due to Longmen Joint Venture paying less to our
related parties as compared to the same period in 2011. Pursuant to the supplier financing agreements signed between Longmen
Joint Venture and its suppliers, those suppliers agreed not to demand certain cash payment; and
|
|
-
|
Other payables – related party: The increase in other payables – related parties was mainly due to Longmen Joint Venture paying less to our related parties as compared to the same period in 2011. Pursuant to the related party financing agreements signed between Longmen Joint Venture and those related parties, they agreed not to demand certain cash payment.
|
|
·
|
The primary reasons for material fluctuations in cash outflow were as follows:
|
|
-
|
Accounts receivable, including related parties: The increase in the first three months of 2012 was mainly due to fewer payments collected from sales made to third parties and related parties;
|
|
-
|
Other receivables, related parties: The increase in the first three months of 2012 was mainly due to the increase of interest receivable from our related parties and funding to one of our related parties and the balance was repaid during the second quarter of 2012;
|
|
-
|
Inventories: The increase in inventories in the first three months of 2012 was mainly due to the increase in finished goods inventories as compared to the stocking level as of December 31, 2011 because the sales volume for the three months ended March 31, 2012 decreased. In addition, as the cost of raw materials continues to drop slightly during the first three months of 2012, we continued to stock up our raw materials by keeping them at a minimal level to meet our production needs;
|
|
-
|
Advances on inventory purchases, including related parties: The increase was mainly due to the fact that more advance payments were made for raw material purchases to meet future production capacity. Advance payment is a prevailing requirement on iron ore purchases in the steel production industry;
|
|
-
|
Accounts payables: The decrease was mainly due to the payments that we made to our vendors when the credit terms were due while we were holding off our payments to our related parties vendors as discussed in the operating cash inflow section. In addition, we made an adjustment to reduce our accounts payable we accrued in prior periods which related to our construction project upon completion of the project; and
|
|
-
|
Customer deposits, including related parties: The decrease was mainly due to the Chinese and global steel industry over-capacity which led to lower demands from our customers on our products, and as such, we received fewer advanced payments made by our customers.
|
Investing activities
Net cash used
in investing activities was $133.1 million for the three months ended March 31, 2012 compared to net cash used in investing
activities of $15.3 million for the three months ended March 31, 2011. Fluctuation in cash outflow between the two periods
was mainly due to the increase of restricted cash. Restricted cash was used as a pledge for our notes payable as required by the
bank. In the first three months of 2012, such balance increased because we needed more notes payable to settle with suppliers.
We also loaned $65.3 million to our related parties, for which we were earning interest on these loans. In addition, the increase
in cash used was also due to more advance or purchase payments made on equipment purchase in the first three months of 2012 compared
to the same period in 2011. Furthermore, $3.0 million cash held on Hancheng Tongxing Metallurgy Co., Ltd was deconsolidated on
March 1, 2012.
Financing activities
Net cash provided
by financing activities was $264.2 million for the three months ended March 31, 2012 compared to net cash used in financing activities
of $14.6 million for the three months ended March 31, 2011. Compared to the same period in 2011, the increase of cash inflow from
financing activities was mainly driven by the following:
|
·
|
Notes receivable - restricted: The decrease
of notes receivable was mainly due to more notes receivable became due and collected by banks during the three months ended March
31, 2012.
|
|
·
|
Short Term Notes Payable: We issued more
notes payable to banks for the three months ended March 31, 2012 as they became due compared to the same period in 2011. We collected
more notes receivable resulting from our sales transaction and more of our notes receivable were pledged when settling with our
suppliers with notes payable.
|
|
·
|
Short Term Loan: We borrowed more money
from banks, related parties and other parties for the three months ended March 31, 2012 as they became due compared to the same
period in 2011.
|
There are no
restrictions to distribute or transfer other funds from General Steel Investment to us.
We have never declared
or paid any cash dividends to our shareholders. If there are any declaration and payment of dividends, this, as well as the amount
of dividends declared and paid will be subject to our By-Laws, charter and applicable Chinese and U.S. state and federal laws,
including the approval from the shareholders of each subsidiary which intends to declare such dividends, if applicable.
Shelf Registration SEC Form S-3
On October 22, 2009,
our shelf registration statement on Form S-3, for an aggregate offering amount of $60 million, was declared effective by the SEC.
Impact
of Inflation
We are subject to
commodity price risks arising from price fluctuations in the market prices of the raw materials we use in our products. 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 influenced by the overall economic conditions in China. We manage our price risks
through productivity improvements and cost-containment measures. We do not believe that inflation risk is material to our
business or our financial position, results of operations or cash flows.
Compliance with Environmental Laws and Regulations
Longmen Joint Venture:
Together with our
joint venture partners Long Steel Group and Shaanxi Steel, we have invested RMB 580 million in a series of comprehensive
projects to reduce our waste emissions of coal gas, water, and solid waste. In 2005, we received ISO 14001 certification for
our overall environmental management system. We have received several awards from the Shaanxi provincial government as a
result of our increased effort in environmental protection.
We have spent in
excess of $8.8 million (RMB 57 million) on a comprehensive waste water recycling and water treatment system. The 2,000 cubic
meter/h treatment capacity systems were implemented at the end of 2005. In 2010, 1.08 metric tons of new water was consumed
per metric ton of steel produced.
We have one
10,000 cubic meter coke-oven gas tank, one 50,000 cubic meter blast furnace coal gas tank and one 80,000 cubic meter
converter furnace coal gas tank to collect the residual coal gas produced from our facility and that of surrounding
enterprises. We also have spent $35.6 million (RMB 230 million) on a thermal power plant with two 25 Kilowatt generators that
use the residual coal gas from the blast furnaces and converters as fuel to generate power.
We have several plants
to further process solid waste generated from the steel making process into useful products such as construction materials, building
blocks, porcelain tiles, curb tops, ornamental tiles, as well as other products.
In 2009, we treated
and recycled about 6.8 million tons of waste water, 335,320 tons of slag, 130 million m³ of gas from the converters and 6.1
billion m³ of gas from the blast furnaces. We also reused 855,714 tons of hot steam and generated 433 million KWH of electricity.
During 2010 and
2011, more than $9.3 million (RMB 60 million) was used on the technical upgrade and renovation of our converters and $0.85
billion (RMB 5.5 billion) was used on the upgrade of the blast furnaces and sintering machines.
Off-balance Sheet Arrangements
There were no off-balance
sheet arrangements for the period ended March 31, 2012 that have, or that in the opinion of management, are likely to have,
a current or future material effect on our financial condition or results of operations.
Contractual Obligations and Commercial Commitments
We have certain fixed
contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions,
changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty
regarding the timing and amounts of payments. Throughout our operating history, we have funded our contractual obligations and
commercial commitments through financing arrangements and operating cash flow, including but not limited to, the operating income,
payments collected from the customers in advance and stock issuances. Below, we have presented a summary of the most significant
contractual obligations and commercial commitments in the tables, in order to assist in the review of this information within the
context of our consolidated financial position, results of operations, and cash flows.
The following tables
summarize our contractual obligations as of March 31, 2012 and the effect these obligations are expected to have on our liquidity
and cash flows in future periods.
|
|
Payment due by period
|
|
|
|
|
|
|
|
|
|
Less than
|
|
|
|
|
|
|
|
|
|
|
Contractual obligations
|
|
Total
|
|
|
1 year
|
|
|
1-3 years
|
|
|
3- 5 years
|
|
|
5 years after
|
|
|
|
(in thousands)
|
|
|
|
|
Note payable
|
|
$
|
1,248,235
|
|
|
$
|
1,248,235
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
-
|
|
Bank loans
|
|
|
318,662
|
|
|
|
318,662
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Other loans
|
|
|
382,699
|
|
|
|
382,699
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Deposits due to sales representatives
|
|
|
34,770
|
|
|
|
34,770
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Lease obligations
|
|
|
26,881
|
|
|
|
2,941
|
|
|
|
2,632
|
|
|
|
1,104
|
|
|
|
20,204
|
|
Construction obligations - Longmen Joint Venture
|
|
|
2,956
|
|
|
|
2,956
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
Long term loan – Shaanxi Steel
|
|
|
92,797
|
|
|
|
-
|
|
|
|
79,200
|
|
|
|
13,597
|
|
|
|
-
|
|
Capital lease obligation
|
|
|
314,080
|
|
|
|
-
|
|
|
|
49,350
|
|
|
|
18,946
|
|
|
|
245,784
|
|
Profit sharing liability
|
|
|
311,358
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
311,358
|
|
Total
|
|
$
|
2,732.438
|
|
|
$
|
1,990,263
|
|
|
$
|
131,182
|
|
|
$
|
33,647
|
|
|
$
|
577,346
|
|
Bank loans in the PRC are due either on demand
or, more typically, within one year. These loans can be renewed with the banks subject to bank’s credit evaluation. This
amount includes estimated interest payments as well as principal repayment.
As of March 31, 2012, Longmen Joint Venture
guaranteed bank loans for related parties and third parties, including lines of credit, amounting to $475.4 million, as follows:
Nature of guarantee
|
|
Guarantee
amount
|
|
|
Guaranty Due Date
|
|
|
(In thousands)
|
|
|
|
Line of credit
|
|
$
|
174,764
|
|
|
Various from April 2012 to March 2015
|
Bank loans
|
|
|
261,670
|
|
|
Various from April 2012 to August 2013
|
Confirming storage
|
|
|
33,793
|
|
|
Various from April 2012 to March 2013
|
Financing by the rights of goods delivery in future
|
|
|
1,965
|
|
|
Various from August 2012 to September 2012
|
Others
|
|
|
3,168
|
|
|
|
Total
|
|
$
|
475,360
|
|
|
|
As of March 31, 2012,
we did not accrue any liability for the amounts the Group has guaranteed for third and related parties because those parties are
current in their payment obligations and we have not experienced any losses from providing guarantees. We have evaluated the debt
guarantees and concluded that the likelihood of having to make payments under the guarantees is remote and that the fair value
of the stand-ready obligation under these commitments is not material.
Critical Accounting Policies
Management’s
discussion and analysis of its financial condition and results of operations are based upon our unaudited condensed consolidated
financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.
Our unaudited condensed consolidated financial statements reflect the selection and application of accounting policies which require
management to make significant estimates and judgments. See Note 2 to our Unaudited Condensed 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.
Principles of consolidation – subsidiaries
The accompanying unaudited
condensed consolidated financial statements include the financial statements of our Company, our subsidiaries, our variable interest
entity (“VIE”) for which our Company is the ultimate primary beneficiary, and the VIE’s subsidiaries.
The unaudited condensed
consolidated financial statements have been prepared on a historical cost basis to reflect the financial position and results of
operations of the Company in accordance with the accounting principles generally accepted in the United States of America (“U.S.
GAAP”).
Subsidiaries are those
entities in which our Company, directly or indirectly, controls more than one half of the voting power has the power to govern
the financial and operating policies, to appoint or remove the majority of the members of the board of directors, or to cast a
majority of votes at the meeting of directors.
A VIE is an entity
in which our Company, or our subsidiary, through contractual arrangements, bears the risks of, and enjoys the rewards normally
associated with, ownership of the entity, and therefore our Company or our subsidiary is the primary beneficiary of the entity.
All significant inter-company
transactions and balances have been eliminated upon consolidation.
Consolidation of VIE
Prior to entering into
the Unified Management Agreement on April 29, 2011, Longmen Joint Venture had been consolidated as our 60% direct owned subsidiary.
Upon entering into the Unified Management Agreement on April 29, 2011, Longmen Joint Venture was evaluated by our Company to determine
if Longmen Joint Venture is a VIE and if we are the primary beneficiary.
Based on the projected
profit in this entity and future operating plans, Longmen Joint Venture’s equity at risk is considered insufficient to finance
its activities and therefore Longmen Joint Venture is considered to be a VIE.
We would be considered
the primary beneficiary of the VIE if we have both of the following characteristics:
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a.
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The power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and
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b.
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The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.
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A Supervisory Committee
was formed during the negotiation of the Unified Management Agreement. Given there is both a Supervisory Committee and a board
of directors with respect to Longmen Joint Venture, the powers rights and roles of both bodies were considered to determine which
has the power to direct the activities of Longmen Joint Venture, and by extension, whether we continue to have the power to direct
Longmen Joint Venture’s activities after this Supervisory Committee was formed. The Supervisory Committee, for which we hold
2 out of 4 seats, requires a ¾ majority vote, while the board of directors, which we hold 4 out of 7 seats, requires
a simple majority vote. As the Supervisory Committee’s role is limited to supervising and monitoring management of Longmen
Joint Venture and in the event there is any disagreement between the board of directors and the Supervisory Committee, the board
of directors prevails. In other words, the Supervisory Committee is considered to be subordinate to the board of directors. Thus,
the board of directors of Longmen Joint Venture continues to be the controlling decision-making body with respect to Longmen Joint
Venture. We control 60% of the voting rights of the board of directors, have control over the operations of Longmen Joint Venture
and as such, have the power to direct the activities of the VIE that most significantly impact Longmen Joint Venture ’s economic
performance.
In connection with the
Unified Management Agreement, Shaanxi Coal, Shaanxi Steel and we may provide such support on a discretionary basis in the future,
which could expose us to a loss.
As discussed in Note
1 to Condensed Consolidated Financial Statements - Background, we have the obligation to absorb losses and the rights to receive
benefits based on the profit allocation as stipulated by the Unified Management Agreement. As both conditions are met, we are the
primary beneficiary of Longmen Joint Venture and therefore, continue to consolidate Longmen Joint Venture.
We believe that the
Unified Management Agreement between Longmen Joint Venture and Shaanxi Coal is in compliance with PRC law and is legally enforceable.
The Board of Directors of Longmen Joint Venture continues to be the controlling decision-making body with respect to Longmen Joint
Venture. We control 60% of the voting rights of the board of directors and have control over the operations of Longmen Joint Venture.
As such, we have the power to direct the activities of the VIE. However, uncertainties in the PRC legal system could limit our
ability to enforce the Unified Management Agreement, which in turn, may lead to reconsideration of the VIE assessment.
Longmen Joint Venture
has two 100% owned subsidiaries, Yuxin Trading Co., Ltd. (“Yuxin”) and Yuteng Trading Co., Ltd (“Yuteng”).
In addition, Longmen Joint Venture has two consolidated subsidiaries, Hualong Fire Retardant Material Co., Ltd. (“Hualong”)
and Beijing Huatianyulong International Steel Trading Co., Ltd. (“Huatianyulong”), in which Longmen Joint Venture does
not hold a controlling interest. Hualong and Huatianyulong are separate legal entities which were established in the PRC as limited
liability companies and subsequently acquired by Longmen Joint Venture in June 2007, January 2008 and July 2008, respectively.
Prior to and subsequent to their acquisition by Longmen Joint Venture, these two entities have been operating as self-sustaining
integrated sets of activities and assets conducted and managed for the purpose of providing a return to shareholders consisting
of all the inputs, processes and outputs of a business. However, these two entities do not meet the definition of variable interest
entities. Further consideration was given to whether consolidation was appropriate under the voting interest model, specifically
where the power of control may exist with a lesser percentage of ownership (i.e. less than 50%), for example, by contract, lease,
agreement with other stockholders or by court decree.
Hualong
Longmen Joint Venture,
the single largest shareholder, holds a 36.0% equity interest in Hualong. The other two shareholders, who own 34.67% and 29.33%
respectively, assigned their voting rights to Longmen Joint Venture in writing at the time of the acquisition of Hualong. The voting
rights have been assigned through the date Hualong ceases its business operation or the other two shareholders sell their interest
in Hualong. Hualong’s main business is to supply refractory.
Huatianyulong
Longmen Joint Venture
holds a 50.0% equity interest in Huatianyulong and the other unrelated shareholder holds the remaining 50.0%. The other shareholder
assigned its voting rights to Longmen Joint Venture in writing at the time of acquisition of Huatianyulong. The voting rights have
been assigned through the date Huatianyulong ceases its business operation or the other unrelated shareholder sells its interest
in Huatianyulong. Huatianyulong mainly sells imported iron ore.
We have determined
that it is appropriate for Longmen Joint Venture to consolidate these two entities with appropriate recognition in our financial
statements of the non-controlling interests in each entity, beginning on the acquisition dates as these were also the effective
dates of the agreements with other stockholders granting a majority voting rights in each entity, and thereby, the power of control,
Longmen Joint Venture.
Revenue recognition
We follow the generally
accepted accounting principles in the United States regarding revenue recognition. Sales were recognized at the date of shipment
to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, we have no other
significant obligations and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue
recognition are recorded as customer deposits. Sales represent the invoiced value of goods, net of value-added tax (VAT). All our
products sold in the PRC are subject to a Chinese VAT at a rate of 13% to 17% of the gross sales price. This VAT may be offset
by VAT paid by us on raw materials and other materials included in the cost of producing the finished product.
Accounts receivable, other receivables and allowance for
doubtful accounts
Accounts receivable
include trade accounts due from customers and other receivables from cash advances to employees, related parties or third parties.
An allowance for doubtful accounts is established and recorded based on managements’ assessment of potential losses based
on the credit history and relationships with the customers. Management reviews its receivable on a regular basis to determine if
the bad debt allowance is adequate, and adjusts the allowance when necessary. Delinquent account balances are written-off against
allowance for doubtful accounts after management has determined that the likelihood of collection is not probable.
Useful lives of plant and equipment
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 a 3%-5% residual value. The depreciation expense on assets acquired under capital leases is included with
depreciation expense on owned assets.
The estimated useful lives are as follows:
Buildings and Improvements
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10-40 Years
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Machinery
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10-30 Years
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Machinery and equipment under capital lease
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20 Years
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Other equipment
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5 Years
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Transportation Equipment
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5 Years
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We have re-evaluated
the useful lives of depreciation and amortization to determine whether subsequent events and circumstances warrant any revision.
Impairment of long-lived assets
The carrying values
of long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of
an asset may not be recoverable. Based on the existence of one or more indicators of impairment, we measure any impairment of long-lived
assets using the projected discounted cash flow method. The estimation of future cash flows requires significant management judgment
based on our historical results and anticipated results and is subject to many factors.
The discount rate that
is commensurate with the risk inherent in our business model is determined by our management. An impairment charge would be recorded
if we determined that the carrying value of long-lived assets may not be recoverable. The impairment to be recognized is measured
by the amount by which the carrying values of the assets exceed the fair value of the assets.
Use of estimates
The preparation of
financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts
reported in the accompanying unaudited condensed consolidated financial statements and accompanying footnotes. Significant accounting
estimates reflected in our unaudited condensed consolidated financial statements include the useful lives of and impairment for
property, plant and equipment, and potential losses on uncollectible receivables, the recognition of contingent liabilities, the
interest rate used in financing sales, the fair value of the assets recorded under capital lease, the present value of the net
minimum lease payments of the capital lease and the fair value of the profit share liability. Actual results could differ from
these estimates.
Financial instruments
The accounting standard
regarding “Disclosures about fair value of financial instruments” defines financial instruments and requires disclosure
of the fair value of financial instruments held by us. We consider the carrying amount of cash, accounts receivable, other receivables,
accounts payable and accrued liabilities to approximate their fair values because of the short period of time between the origination
of such instruments and their expected realization. For short-term loans and notes payable, we concluded the carrying values are
a reasonable estimate of fair value because of the short period of time between the origination and repayment and their stated
interest rate approximates current rates available.
We also analyze all
financial instruments with features of both liabilities and equity under the accounting standard establishing, “Accounting
for certain financial instruments with characteristics of both liabilities and equity,” the accounting standard regarding
“Accounting for derivative instruments and hedging activities” and “Accounting for derivative financial instruments
indexed to, and potentially settled in, a company’s own stock.” Additionally, we analyze registration rights agreements
associated with any equity instruments issued to determine if penalties triggered for late filing should be accrued under accounting
standard establishing “Accounting for registration payment arrangements.”
Fair value measurements
The accounting standards regarding fair
value of financial instruments and related fair value measurement define fair value, establish a three-level valuation hierarchy
for disclosures of fair value measurement and enhance disclosures requirements for fair value measures. The three levels are defined
as follow:
Level 1: inputs to the valuation methodology
are quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2: inputs to the valuation methodology
include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability,
either directly or indirectly, for substantially the full term of the financial instruments.
Level 3: inputs to the valuation methodology
are unobservable and significant to the fair value.
The December 2007 Warrants
issued in conjunction with the December 2007 Notes and December 2009 Warrants issued in connection with a registered direct offering,
were carried at fair value. The aforementioned warrants and the conversion option embedded in the Notes meet the definition of
a derivative instrument in the accounting standards. Therefore these instruments are accounted for as derivative liabilities and
recorded at their fair value as of each reporting period. As all of the Notes were converted to common stock by the end of 2010,
the derivative instruments include only the outstanding warrants of 6,678,649 as of March 31, 2012 and December 31, 2011. The fair
value was determined using the Cox Rubenstein Binomial Model. Because all inputs to the valuation methodology include quoted prices
are observable, fair value is carried as Level 2 inputs, and the change in earnings was recorded. As a result, the derivative liability
is carried on the balance sheet at its fair value.
We determined that the
carrying value of the profit sharing liability using Level 3 inputs by taking consideration of the present value of our projected
profits/losses with the discount interest rate of 7.3% based on our average borrowing rate. The projected profits/losses in Longmen
Joint Venture were based upon, but not limited to, the following assumptions until April 30, 2031:
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projected selling units and growth in the steel market;
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projected unit selling price in the steel market;
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projected unit purchase cost in the coal and iron ore markets;
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selling and general and administrative expenses to be in line with the growth in the steel market; and
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·
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projected bank borrowings.
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Income Taxes
Income tax
We did not conduct
any business and did not maintain any branch office in the United States during the three months ended March 31, 2012 and 2011.
Therefore, no provision for withholding of U.S. federal or state income taxes has been made. The tax impact from undistributed
earnings from overseas subsidiaries is not recognized as there is no intention for future repatriation of these earnings.
General Steel (China) is located in Tianjin
Costal Economic Development Zone and is subject to an income tax rate of 25%.
Longmen Joint Venture
is located in the Mid-West Region of China. It qualifies for the “Go-West” tax rate of 15% promulgated by the government.
In 2010, the central government announced that the “Go-West” tax initiative was extended for 10 years, and thus, the
preferential tax rate of 15% will be in effect until 2020. This special tax treatment will be evaluated on a year-to-year basis
by the local tax bureau.
Baotou Steel Pipe Joint Venture is located
in Inner Mongolia autonomous region and is subject to an income tax rate of 25%.
Maoming Hengda is located in Guangdong
Province and is subject to an income tax rate of 25%.
Tianwu Joint Venture is located in Tianjin
Coastal Economic Development Zone and is subject to an income tax rate at 25%.
Non-controlling Interest
Effective January 1,
2009, we adopted generally accepted accounting principles regarding noncontrolling interests in our consolidated financial statements.
Certain provisions of this statement are required to be adopted retrospectively for all periods presented. Such provisions include
a requirement that the carrying value of noncontrolling interests (previously referred to as minority interests) be removed from
the mezzanine section of the balance sheet and reclassified as equity.
Further, as a result
of the adoption of this accounting standard, net income attributable to noncontrolling interests is now excluded, from the determination
of consolidated net income. In addition, the foreign currency translation adjustment is allocated between controlling and non-controlling
interests.
Deferred lease income
From June 2009 to March
2011, we worked with Shaanxi Steel to build new state-of-the-art equipment at the site of Longmen Joint Venture. To compensate
Longmen Joint Venture for costs and economic losses incurred during construction of the new iron and steel making facilities owned
by Shaanxi Steel, Shaanxi Steel reimbursed Longmen Joint Venture $11.1 million (RMB 70.1 million) in the fourth quarter of 2010
for the value of assets dismantled, $6.0 million (RMB 38.1 million) for various site preparation costs incurred by Longmen Joint
Venture and rent under a 40-year property sub-lease that was entered into by the parties in June 2009, and $29.0 million (RMB 183.1
million) for the reduced production efficiency caused by the construction. In addition, in 2010 and 2011, Shaanxi Steel reimbursed
Longmen Joint Venture $14.2 million (RMB 89.5 million) and $14.1 million (RMB 89.3 million), respectively, for trial production
costs related to the new iron and steel making facilities.
During the period June
2010 to March 2011, as construction progressed and certain of the assets came online, Longmen Joint Venture used the assets free
of charge to produce saleable units of steel products during this period. As such, the cost of using these assets was imputed with
reference to what the depreciation charge would have been on these assets had they been owned or under capital lease to Longmen
Joint Venture during the free use period. This cost of $7.0 million (RMB 43.9 million) each year were deferred and will be recognized
over the term of the land sub-lease similar to the other charges and credits related to the construction of these assets.
The deferred lease income
is amortized to income over the remaining term of the 40-year land sub-lease.
Capital lease obligations
On April 29, 2011,
we, along with Longmen Joint Venture, entered into a Unified Management Agreement with Shaanxi Steel and Shaanxi Coal under which
Longmen Joint Venture uses the new iron and steel making facilities including one sintering machine, two converters, two blast
furnaces and other auxiliary systems constructed by Shaanxi Steel. As the 20-year term of the agreement exceeds 75% of the assets’
useful lives, this arrangement is accounted for as a capital lease. The ongoing lease payments are comprised of two elements: (1)
a monthly payment based on Shaanxi Steel’s cost to construct the new iron and steel making facilities of $2.3 million (RMB
14.6 million) to be paid over the term of the Unified Management Agreement of 20 years; and (2) 40% of any remaining pre-tax profits
from the Asset Pool which includes Longmen Joint Venture and the newly constructed iron and steel making facilities. The profit
sharing component does not meet the definition of contingent rent because it is based on future revenue and is therefore considered
part of the minimum lease payment for purposes of determining the value of the leased asset and obligation at the inception of
the lease, however, the lease liability is then reduced by the value of the profit sharing component, which is recognized as a
separate financial liability carried at fair value. See Note 16 – “Profit sharing liability” in the Notes to
Condensed Consolidated Financial Statements.
Profit sharing liability
The profit sharing
liability is recognized initially at its estimated fair value at the lease commencement date and included in the initial measurement
and recognition of the capital lease in addition to the fixed payment component of the minimum lease payments. Subsequently, this
financial instrument is accounted for separately from the lease accounting (Note 15 – “Capital lease obligations”
in the Notes to Condensed Consolidated Financial Statements). The initial fair value of the expected payments under the profit
sharing component of the Unified Management Agreement is accreted over the term of the agreement using the effective interest method.
The value of the profit sharing liability will be reassessed each reporting period with any changes reflected prospectively in
the estimate of the effective interest rate.
Based on the performance
of the Asset Pool, no profit sharing payment was made for the three ended March 31, 2012. Payments for the profit sharing are only
made to Shaanxi Steel to the extent any accumulated losses from the Asset Pool have been fully absorbed by profits.
New Accounting Pronouncements
In February 2013, the
FASB issued an accounting standards update ("ASU") No. 2013-02 "Comprehensive Income (Topic 220): Reporting of Amounts
Reclassified Out of Accumulated Other Comprehensive Income," requiring new disclosures for items reclassified out of accumulated
other comprehensive income ("AOCI"), including (1) changes in AOCI balances by component and (2) significant items reclassified
out of AOCI. The guidance does not amend any existing requirements for reporting net income or OCI in the financial statements.
The standards update was effective for reporting periods beginning after December 15, 2012, to be applied prospectively. We are
currently evaluating the impact of adopting this standard on its consolidated financial statements. As this guidance only requires
expanded disclosures, the adoption of this guidance is not expected to have a significant impact on our unaudited condensed consolidated
financial position, results of operations, or cash flows.
In March 2013, the FASB
issued an accounting standards update (“ASU”) No. 2013-05 “Foreign Currency Matters (Topic 830): Parent’s
Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign
Entity or of an Investment in a Foreign Entity,’ requiring the release of the cumulative translation adjustment into net
income when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial
interest in a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity. The standards update
was effective prospectively for fiscal years and interim reporting periods within those years beginning after December 15, 2013.
Early adoption is permitted. We do not expect the adoption of this guidance will have a significant impact on our unaudited condensed
consolidated financial position, results of operations, or cash flows.