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EX-32.1 - SECTION 906 CERTIFICATE OF CHIEF EXECUTIVE OFFICER AND PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER - CD INTERNATIONAL ENTERPRISES, INC.exh32-1.htm
EX-31.1 - SECTION 302 CERTIFICATE OF CHIEF EXECUTIVE OFFICER - CD INTERNATIONAL ENTERPRISES, INC.exh31-1.htm
EX-31.2 - SECTION 302 CERTIFICATE OF PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER - CD INTERNATIONAL ENTERPRISES, INC.exh31-2.htm
EX-10 - ?AT-THE-MARKET? PROGRAM AGREEMENT BETWEEN CHINA DIRECT INDUSTRIES, INC. AND GLOBAL HUNTER SECURITIES, LLC DATED FEBRUARY 14, 2011. - CD INTERNATIONAL ENTERPRISES, INC.exh10-56.htm


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q

[√]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2010

or
   
[  ]
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________ to ____________

Commission file number: 001-33694

 
CHINA DIRECT INDUSTRIES, INC.
(Exact name of registrant as specified in its charter)

   
Florida
13-3876100
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
   
431 Fairway Drive, Suite 200, Deerfield Beach, Florida
33441
(Address of principal executive offices)
(Zip Code)
   
954-363-7333
(Registrant’s telephone number, including area code)
   
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.         Yes [√] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [  ] No [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

       
Large accelerated filer
[  ]
Accelerated filer
[ ]
       
Non-accelerated filer
[  ]
Smaller reporting company
[√]
(Do not check if smaller reporting company)
     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes [  ] No [√]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date34,986,770 shares of common stock were issued and outstanding as of February 11 2011.

 
 

 
 
 



TABLE OF CONTENTS

PART I. - FINANCIAL INFORMATION
Page No.
 
Item 1.
Financial Statements.
1
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
23
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
37
 
Item 4.
Controls and Procedures.
38
PART II - OTHER INFORMATION
 
 
Item 1.
Legal Proceedings.
38
 
Item 1A.
Risk Factors.
38
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
38
 
Item 3.
Defaults Upon Senior Securities.
38
 
Item 4.
(Removed and Reserved).
39
 
Item 5.
Other Information.
39
 
Item 6.
Exhibits.
39
   
Signatures
43

 

 
i

 
 
 



INDEX OF CERTAIN DEFINED TERMS USED IN THIS REPORT

When used in this report the terms:

 
 
“China Direct Industries”, “we”, “us” or “our” refers to China Direct Industries, Inc., a Florida corporation, and our subsidiaries;
 
 
“CDI China”, refers to CDI China, Inc., a Florida corporation, and a wholly owned subsidiary of China Direct; and
 
 
“PRC” refers to the People’s Republic of China.
 
Magnesium Segment

 
 
“Chang Magnesium”, refers to Taiyuan Changxin Magnesium Co., Ltd., a company organized under the laws of the PRC and a 51% owned subsidiary of CDI China;
 
 
“Chang Trading”, refers to Taiyuan Changxin YiWei Trading Co., Ltd., a company organized under the laws of the PRC and a wholly owned subsidiary of Chang Magnesium;
 
 
“Excel Rise”, refers to Excel Rise Technology Co., Ltd., a Brunei company and a wholly owned subsidiary of Chang Magnesium;
 
 
“CDI Magnesium”, refers to CDI Magnesium Co., Ltd., a Brunei company and a 51% owned subsidiary of Capital One Resources;
 
 
“Asia Magnesium”, refers to Asia Magnesium Corporation Limited, a company organized under the laws of Hong Kong and a wholly owned subsidiary of Capital One Resource;
 
 
“Golden Magnesium” refers to Shanxi Gu County Golden Magnesium Co., Ltd., a company organized under the laws of the PRC and a 52% owned subsidiary of Asia Magnesium;
 
 
“Pan Asia Magnesium”, refers to Pan Asia Magnesium Co., Ltd., a company organized under the laws of the PRC and a 51% owned subsidiary of CDI China;
 
 
“Baotou Changxin Magnesium”, refers to Baotou Changxin Magnesium Co., Ltd., a company organized under the laws of the PRC, a 51% owned subsidiary of CDI China, and a 39% owned subsidiary of Excel Rise. Effectively China Direct holds a 70.9% interest;
 
 
“IMG” or “International Magnesium Group”, refers to International Magnesium Group, Inc., a Florida corporation and a 100% owned subsidiary of China Direct Industries; and
 
 
“IMTC” or “International Magnesium Trading”, refers to International Magnesium Trading Corp., a company organized under the laws of Brunei and a 100% owned subsidiary of CDI China.
 
 
“Ruiming Magnesium”, refers to Taiyuan Ruiming Yiwei Magnesium Co., Ltd., a company organized under the laws of the PRC and an 80% majority owned subsidiary of CDI China.

Basic Materials Segment

 
 
“Lang Chemical”, refers to Shanghai Lang Chemical Co., Ltd., a company organized under the laws of the PRC and a 51% owned subsidiary of CDI China;
 
 
“CDI Jingkun Zinc”, refers to CDI Jingkun Zinc Industry Co., Ltd., a company organized under the laws of the PRC and a 95% owned subsidiary of CDI Shanghai Management;
 
 
“CDI Jixiang Metal”, refers to CDI Jixiang Metal Co., Ltd., a company organized under the laws of the PRC and a wholly owned subsidiary of CDI China;
 
 
“CDI Metal Recycling”, refers to Shanghai CDI Metal Recycling Co., Ltd., a company organized under the laws of the PRC and an 83% owned subsidiary of CDI Shanghai Management;
 
 
“CDI Beijing”, refers to CDI (Beijing) International Trading Co., Ltd., a company organized under the laws of the PRC and a 51% owned subsidiary of CDI Shanghai Management; and
 
 
“CDII Trading”, refers to CDII Trading, Inc., a Florida corporation and a 100% owned subsidiary of China Direct Industries.

Consulting Segment

 
 
“China Direct Investments”, refers to China Direct Investments, Inc., a Florida corporation, and a wholly owned subsidiary of China Direct;
 
 
“CDI Shanghai Management”, refers to CDI Shanghai Management Co., Ltd., a company organized under the laws of the PRC and a wholly owned subsidiary of CDI China; and
 
 
“Capital One Resource”, refers to Capital One Resource Co., Ltd., a Brunei company, and a wholly owned subsidiary of CDI Shanghai Management.


 
ii

 
 
 


PART 1 - FINANCIAL INFORMATION

Item 1.
Financial Statements.

CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS


   
December 31, 2010
   
September 30, 2010
 
ASSETS
 
(Unaudited)
       
Current Assets:
           
    Cash and cash equivalents
  $ 8,077,437     $ 10,110,818  
    Marketable securities available for sale
    7,687,572       2,221,290  
    Marketable securities available for sale-related parties
    587,460       672,735  
    Accounts receivables, net of allowance of $280,100 and $214,701, respectively
    16,147,851       15,235,983  
    Accounts, loans and other receivables, and prepaid expenses - related parties
    7,600,813       7,680,222  
    Inventories, net
    8,471,086       6,372,925  
    Prepaid expenses and other current assets, net
    12,377,153       8,552,369  
    Current assets of discontinued operations
    51,345       51,345  
    Restricted cash, current
    620,145       5,091,023  
       Total current assets
    61,620,862       55,988,710  
    Property, plant and equipment, net
    37,544,674       37,512,261  
    Intangible assets
    187,292       194,541  
    Property use rights, net
    2,245,172       1,970,585  
    Long-lived assets of discontinued operations
    196,078       196,078  
       Total assets
  $ 101,794,078     $ 95,862,175  
                 
LIABILITIES AND EQUITY
               
Current Liabilities:
               
    Loans payable-short term
  $ 2,859,418     $ 5,613,532  
    Accounts payable and accrued expenses
    9,988,938       11,250,879  
    Accounts and other payables-related parties
    8,471,558       3,973,704  
    Advances from customers and deferred revenue
    1,878,718       2,797,315  
    Other liabilities
    2,905,929       1,073,926  
    Taxes payable
    495,448       877,840  
    Current liabilities of discontinued operations
    10,653       80,000  
       Total liabilities
    26,610,662       25,667,196  
                 
CHINA DIRECT INDUSTRIES INC. EQUITY
               
    Preferred Stock: $.0001 par value, stated value $1,000 per share
    1,006,250       1,006,250  
    Common Stock: $.0001 par value;  31,966,021 and 31,657,244 outstanding, respectively
    3,197       3,166  
    Additional paid-in capital
    65,784,345       65,032,845  
    Accumulated other comprehensive income
    2,717,922       1,795,387  
    Accumulated deficit
    (14,868,360 )     (17,643,217 )
       Total China Direct Industries, Inc. stockholders' equity
    54,643,354       50,194,431  
    Noncontrolling interests
    20,540,062       20,000,548  
       Total equity
    75,183,416       70,194,979  
       Total liabilities and equity
  $ 101,794,078     $ 95,862,175  

The accompanying notes are an integral part of these unaudited financial statements.


 
- 1 -

 
 
 


CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

   
For the three months ended December 31,
 
   
2010
   
2009
 
             
Revenues
  $ 45,762,889     $ 19,810,732  
Revenues-related parties
    6,713       2,441,797  
     Total revenues
    45,769,602       22,252,529  
Cost of revenues
    39,238,556       20,428,311  
     Gross profit
    6,531,046       1,824,218  
                 
Operating expenses:
               
   Selling, general, and administrative
    3,602,281       2,999,223  
   Other operating income
    (374,980 )     (205,720 )
       Operating income (loss)
    3,303,745       (969,285 )
Other income (expense):
               
   Other income (expense):
    171,519       (47,686 )
   Interest expense
    (7,747 )     (1,001 )
   Realized (loss) income on investment securities available for sale
    (118,412 )     34,691  
       Total other income (expense)
    45,360       (13,996 )
        Income (Loss) from continuing operations before income taxes
    3,349,105       (983,281 )
   Income tax benefit
    73,284       110,373  
       Net income (loss)
    3,422,389       (872,908 )
   Net loss (income) attributable to noncontrolling interests-continuing operations
    43,447       (111,608 )
      Net income (loss) attributable to China Direct Industries
  $ 3,465,836     $ (984,516 )
                 
Deduct dividends on Series A Convertible Preferred Stock:
               
   Preferred stock dividend
    (20,130 )     (40,183 )
   Deemed dividend - beneficial conversion feature
    (600,693 )     -  
   Deemed dividend - warrant revaluation
    (76,705 )     -  
      Net income (loss) attributable to common stockholders
  $ 2,768,308     $ (1,024,699 )
                 
Basic and diluted income (loss) per common share
               
   Basic
  $ 0.09     $ (0.04 )
   Diluted
  $ 0.09     $ (0.04 )
   Basic weighted average common shares outstanding
    31,818,874       27,381,946  
   Diluted weighted average common shares outstanding
    31,818,874       27,381,946  

The accompanying notes are an integral part of these unaudited financial statements.
 
 
- 2 -

 
 
CHINA DIRECT INDUSTRIES INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EQUITY
As of December 31, 2010
(Unaudited)

   
Preferred Stock
   
Common Stock
                         
   
Shares
   
Amount
   
Shares
   
Amount
   
Additional Paid-in Capital
   
Accumulated Comprehensive Income
   
Accumulated Deficit
   
Total
 
Balance, September 30, 2010
    1,006     $ 1,006,250       31,657,244     $ 3,166     $ 65,032,845     $ 1,795,387     $ (17,643,217 )   $ 50,194,431  
Dividends paid to preferred stockholders
    -       -       11,911       2       20,128       -       (20,130 )     -  
Restricted stock award - employees
    -       -       184,616       18       87,817       -       -       87,835  
Restricted stock award - Board of Directors
    -       -       29,250       3       34,243       -       -       34,246  
Restricted stock award - consultants
    -       -       3,000       -       -       -       -       -  
Stock option exercised
    -       -       80,000       8       103,192       -       -       103,200  
Foreign currency translation gain
    -       -       -       -       -       517,779       (3 )     517,776  
Unrealized loss on marketable securities available for sale
    -       -       -       -       -       404,755       -       404,755  
Deemed dividends - series A convertible preferred stock
    -       -       -       -       -       -       (677,398 )     (677,398 )
Dividends - warrants valuation change due to deemed dividends - series A preferred stock warrants
    -       -       -       -       506,120       -       -       506,120  
Restricted retained earnings
                                                    6,552       6,552  
Net income
    -       -       -       -       -       -       3,465,836       3,465,836  
Balance, December 31, 2010
    1,006     $ 1,006,250       31,966,021     $ 3,197     $ 65,784,345     $ 2,717,922     $ (14,868,360 )   $ 54,643,354  

The accompanying notes are an integral part of these unaudited financial statements.

 
- 3 -

 
 
CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   
For the three months ended December 31,
 
   
2010
   
2009
 
OPERATING ACTIVITIES:
           
Net income (loss)
  $ 3,422,389     $ (872,908 )
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
               
   Depreciation and amortization
    1,010,572       520,458  
   Allowance for bad debt
    -       (229,176 )
   Stock based compensation
    122,081       167,865  
   Realized (gain) loss on investments in marketable securities
    118,412       (34,379 )
   Gain on change in fair value of derivative liability
    (104,305 )     -  
   Fair value of marketable securities paid for services
    (5,201,329 )     16,668  
Changes in operating assets and liabilities:
               
   Prepaid expenses and other assets
    (3,817,534 )     (3,787,442 )
   Accounts receivable and other assets-related parties
    79,409       1,870,819  
   Inventories
    (2,098,160 )     201,068  
   Accounts receivable
    (911,868 )     (336,146 )
   Accounts payable and accrued expenses
    (1,261,941 )     1,162,305  
   Accounts and other payable - related parties
    4,497,855       11,957  
   Advances from customers
    (918,597 )     (1,340,399 )
   Other payables
    859,794       (1,745,086 )
CASH USED IN OPERATING ACTIVITIES
    (4,203,221 )     (4,394,396 )
                 
INVESTING ACTIVITIES
               
   Increase in notes and loans receivable
    -       (214,927 )
   Proceeds from the sale of marketable securities available for sale
    284,863       705,420  
   Purchases of property, plant and equipment
    (1,317,572 )     -  
CASH (USED IN) PROVIDED BY INVESTING ACTIVITES
    (1,032,709 )     490,493  
                 
FINANCING ACTIVITIES
               
   Decrease in restricted cash
    4,470,878       5,656  
   Increase in loans payable
    -       285,293  
   Decrease in loans payable-related party
    (2,754,114 )     (345,952 )
   Net proceeds from sale of stocks and exercise of warrants/options
    103,200       206,294  
   Capital contribution from minority interest owners
    302,489       -  
CASH PROVIDED BY FINANCING ACTIVITIES
    2,122,453       151,291  
                 
EFFECT OF EXCHANGE RATE ON CASH
    1,080,096       4,196  
Net decrease in cash
    (2,033,381 )     (3,748,416 )
Cash and equivalents, beginning of the period
    10,110,818       12,851,310  
Cash and equivalents, end of the period
  $ 8,077,437     $ 9,102,894  
Supplemental disclosures of cash flow information:
               
   Preferred stock dividend paid in our common stock
  $ 20,130     $ 40,183  
   Deemed dividend - beneficial conversion feature
  $ 600,693     $ -  
   Dividend - warrant valuation
  $ 76,705     $ -  

The accompanying notes are an integral part of these unaudited financial statements.

 
- 4 -

 
 
 
CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
 
NOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business and Organization

China Direct Industries, Inc., a Florida corporation and its subsidiaries are referred to in this report as “we”, “us”, “our”, or “China Direct Industries.”

We are a U.S. company that manages a portfolio of Chinese entities.  We also provide consulting services to both American and Chinese businesses.  We operate in three identifiable segments, as defined by the Financial Standard Board Accounting Standard Codifications (“ASC”) 280, “Segment Reporting:” Magnesium, Basic Materials and Consulting.  In 2006 we established our Magnesium and Basic Materials segments which have grown through acquisitions of controlling interests in Chinese private companies.  We consolidate these acquisitions as either wholly or majority owned subsidiaries.  Through this ownership control, we provide management, marketing, sales and business development services, strategic planning, macroeconomic industry analysis and financial management, seeking to improve the quality and performance of each portfolio company.  We also provide our subsidiaries with investment capital and loans to expand their businesses.

In our Magnesium segment, currently our largest segment by assets, and prior to the nine month transition period ended September 30, 2009, our largest segment by revenues and assets, we produce, sell and distribute pure magnesium ingots, magnesium powder and magnesium scraps.  In our Basic Materials segment, we sell and distribute a variety of products, including industrial grade synthetic chemicals, steel products, non ferrous metals, recycled materials, and industrial commodities.  This segment also includes our zinc ore mining property which has not commenced operations.  

In our Consulting segment, we provide a suite of consulting services to U.S. public companies that operate primarily in China.  The consulting fees we charge vary based upon the scope of the services to be rendered.

We have defined various periods that are covered in this report as follows: 
 
   
“fiscal 2011” — October 1, 2010 through September 30, 2011
   
“first quarter of fiscal 2011” – October 1, 2010 through December 31, 2010
   
“fiscal 2010” — October 1, 2009 through September 30, 2010
   
“first quarter of fiscal 2010” – October 1, 2009 through December 31, 2009

Basis of Presentation

Our interim consolidated financial statements are unaudited. We prepared the consolidated financial statements in accordance with U.S. generally accepted accounting principles for interim financial statements and pursuant to U.S. Securities and Exchange Commission (“SEC”) rules for interim reporting. In the opinion of management, we included all adjustments that are necessary for the fair presentation of our financial position, results of operations, and cash flows for the interim periods presented. Except as disclosed herein, such adjustments are of a normal and recurring nature. Results for the first three months of the year may not necessarily be indicative of full year results. These consolidated financial statements should be read in conjunction with the audited financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2010.

Summary of Significant Accounting Policies

Concentration of Credit Risks

Financial instruments which potentially subject us to concentrations of credit risk consist principally of cash and trade accounts receivable. We deposit our cash with high credit quality financial institutions in the United States and China.  As of December 31, 2010, we had no bank deposits in the United States that exceeded federally insured limits.  At December 31, 2010, we had deposits of $3,127,769 in banks in China.  In China, there is no equivalent federal deposit insurance as in the United States, so the amounts held in banks in China are not insured. We have not experienced any losses in such bank accounts through December 31, 2010.

 
- 5 -

 
 
 
CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
 
At December 31, 2010 and September 30, 2010, bank deposits by geographic area were as follows:

Country
 
December 31, 2010
   
September 30, 2010
 
United States
 
$
4,949,668
     
61
%
 
$
4,851,329
     
48
%
China
   
3,127,769
     
39
%
   
5,259,489
     
52
%
Total cash and cash equivalents
 
$
8,077,437
     
100
%
 
$
10,110,818
     
100
%

In an effort to mitigate any potential risk, we periodically evaluate the credit quality of the financial institutions at which we hold deposits, both in the United States and China.

Foreign Currency Translation

The accompanying consolidated financial statements are presented in United States dollars. The functional currency of our Chinese subsidiaries is the Renminbi (“RMB”), the official currency of the People’s Republic of China (the “PRC”). Capital accounts of the consolidated financial statements are translated into United States dollars from RMB at their historical exchange rates when the capital transactions occurred. Assets and liabilities are translated at the exchange rates as of the balance sheet date. Income and expenditures are translated at the average exchange rates for the three month period ended December 31, 2010 and 2009 as well as the twelve months ended September 30, 2010, respectively. A summary of the conversion rates for the periods presented is as follows:

   
December 31, 2010
   
December 31, 2009
   
September 30, 2010
 
Period end RMB: U.S. dollar exchange rate
    6.6118       6.8372       6.6981  
Average fiscal-year-to-date RMB: U.S. dollar exchange rate
    6.6670       6.8360       6.8214  

The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through PRC authorized institutions.  No representation is made that the RMB amounts could have been, or could be, converted into United States dollars at the rates applied in the translation.

Fair Value of Financial Instruments

We adopted on a prospective basis certain required provisions of ASC Topic 820, “Fair Value Measurements.”  These provisions relate to our financial assets and liabilities carried at fair value and our fair value disclosures related to financial assets and liabilities. ASC Topic 820 defines fair value, expands related disclosure requirements and specifies a hierarchy of valuation techniques based on the nature of the inputs used to develop the fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There are three levels of inputs to fair value measurements - Level 1, meaning the use of quoted prices for identical instruments in active markets; Level 2, meaning the use of quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active or are directly or indirectly observable; and Level 3, meaning the use of unobservable inputs. Observable market data should be used when available.

Most of our financial instruments are carried at fair value, including, all of our cash equivalents, investments classified as available for sale securities and assets held for sale, with unrealized gains or losses recognized as Other Comprehensive Income (OCI), net of tax. Virtually all of our valuation measurements are Level 1 measurements.

Marketable Securities

Marketable Securities that we receive from our clients as compensation are generally restricted for sale under Federal securities laws. Our policy is to liquidate securities received as compensation when market conditions are favorable for sale. Since these securities are often restricted, we are unable to liquidate them until the restriction is removed. We recognize revenue for the common stock we receive as compensation based on the fair value at the time the common stock is granted or at the time service has been rendered and for common stock purchase warrants based on the Black-Scholes valuation model. Pursuant to ASC Topic 320, “Investments –Debt and Equity Securities” our marketable securities have a readily determinable and active quoted price, such as from NASDAQ, NYSE Amex, the Over the Counter Bulletin Board, and the Pink Sheets and any unrealized gain or loss is recognized as an element of comprehensive income based on changes in the fair value of the security as quoted on an exchange or an inter-dealer quotation system. Once liquidated, any realized gain or loss on the sale of marketable securities is reflected in our net income for the period in which the security was liquidated.

 
- 6 -

 
 
 
CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
 
We perform an analysis of our marketable securities at least on an annual basis to determine if any of these securities have become other than temporarily impaired. If we determine that the decline in fair value is other than temporary we recognize the amount of the impairment as a realized loss into our current period net income(loss). This determination is based on a number of factors, including but not limited to (i) the percentage of the decline, (ii) the severity of the decline in relation to the enterprise/market conditions, and (iii) the duration of the decline.

Derivative Warrant Liabilities

ASC Subtopic 815-40 (formerly EITF 07-5), “Contracts in Entity’s Own Equity,” requires that entities recognize as derivative liabilities the derivative instruments, including certain derivative instruments embedded in other contracts that are not indexed to an entity’s’ own stock . Pursuant to the provisions of ASC Section 815-40-15, an entity should use a two-step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument’s contingent exercise and settlement provisions. The adoption of ASC Subtopic 815-40 has affected the accounting for (i) certain freestanding warrants that contain exercise price adjustment features and (ii) convertible bonds issued by foreign subsidiaries with a strike price denominated in a foreign currency. In the case of any such warrants and convertible bonds, ASC Subtopic 815-40 provides that such warrants and bonds are to be treated as a liability at fair value with changes in fair value recognized in earnings.

We adopted ASC Subtopic 815-40 on December 31, 2010 and reclassified certain warrants we issued in connection with our February 2008 series A convertible preferred stock offering as a liability rather than as stockholders’ equity and recognized the changes in fair value in earnings. The balance of the derivative liabilities as of December 31, 2010 was $66,973 which is classified as other liabilities on our consolidated balance sheet. The cumulative unrealized gain on the change in fair value was $104,305. See Note 11 – Capital Stock – Reclassification of Derivative Liabilities for more details.

Recent Pronouncements

Business Combinations

In January 2011, Accounting Standards Update (ASU) No. 2010-29 clarifies that pro forma revenue and earnings for a business combination occurring in the current year should be presented as though the business combination occurred as of the beginning of the year or, if comparative statements are presented, as though the business combination took place as of the beginning of the comparative year.

The disclosures required of public entities in respect of a business combination occurring during the current reporting period called for in ASC Section 805-10-50 have been amended as follows:

 
·
If comparative financial statements are not presented, pro forma revenue and earnings of the combined entity should be based on the assumption that the business combination took place as of the beginning of the current year.

 
·
If comparative financial statements are presented (1) pro forma revenue and earnings of the combined entity should be based on the assumption that the business combination occurred as of the beginning of the comparative year, and (2) in the year following the business combination, pro forma information should not be revised if comparative statements for the year in which the acquisition occurred are presented (even if such year is the earliest period presented).

 
·
To require disclosure of the nature and amounts of any material nonrecurring adjustments directly attributable to the business combination included in the pro forma revenue and earnings (i.e., supplemental pro forma information).

The new and amended disclosures should be applied prospectively to business combinations consummated on or after the start of the first annual reporting period beginning on or after December 15, 2010, with earlier application permitted. We have adopted this guidance.

A variety of proposed or otherwise potential accounting standards are currently under study by standard setting organizations and various regulatory agencies.  Due to the tentative and preliminary nature of those proposed standards, management has not determined whether implementation of such proposed standards would be material to our consolidated financial statements. 


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

NOTE 2 – EARNINGS PER SHARE

Under the provisions of ASC Topic260, “Earnings Per Share,??basic income (loss) per common share is computed by dividing income (loss) available to common shareholders by the weighted average number of shares of common stock outstanding for the periods presented. Diluted income (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that would then share in the income of the company, subject to anti-dilution limitations. For the three months ended December 31, 2010 and 2009, the effect of stock options, warrants and restricted stock awards is antidilutive.  Accordingly, basic and diluted income (loss) per share is the same for both periods presented.

The following table sets forth the computation of basic and diluted income (loss) per share for the three months ended December 31, 2010 and 2009:

   
Three months ended December 31,
 
   
2010
   
Per Share
   
2009
   
Per Share
 
(in thousands except per share amounts)
 
(Unaudited)
         
(Unaudited)
       
NUMERATOR:
                       
Net income (loss) attributable to China Direct Industries Inc.
  $ 3,466     $ 0.11     $ (985 )   $ (0.04 )
Series A preferred stock:
                               
Preferred stock dividend
    (20 )     (0.00 )     -       -  
Deemed dividend - beneficial conversition feature
    (601 )     (0.02 )     -       -  
Dividend - warrant valuation
    (77 )     (0.00 )     (40 )     -  
Numerator for basic EPS, net income (loss) attributable to common stockholders (A)
  $ 2,768     $ 0.09     $ (1,025 )   $ (0.04 )
DENOMINATOR:
                    -       -  
Denominator for basic and diluted earnings per share-weighted average number of common shares outstanding ( B)
    31,819       -       27,382       -  
Basic and Diluted Income per Common Share:
                               
Income (loss) per share-basic and diluted (A)/( B)
  $ 0.09       -     $ (0.04 )     -  

We excluded 2,292,980 stock options, 5,499,664 common stock warrants and 210,303 shares of restricted common stock as of December 31, 2010 as their effect was antidilutive.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

NOTE 3 – COMPREHENSIVE INCOME

Comprehensive income is comprised of net income and other comprehensive income or loss. Other comprehensive income or loss refers to revenue, expenses, gains and losses that under US GAAP are included in comprehensive income but excluded from net income as these amounts are recorded directly as adjustments to stockholders’ equity.

Our other comprehensive income consists of currency translation adjustments, unrealized loss on marketable securities available for sale, net of taxes and unrealized loss on marketable securities available for sale-related party, net of taxes. The following table sets forth the computation of comprehensive income (loss) for the three months ended December 31, 2010 and 2009, respectively:
 
   
Three months ended December 31,
 
   
2010
   
2009
 
(in thousands)
 
(Unaudited)
   
(Unaudited)
 
Net income (loss)
  $ 3,422     $ (873 )
Other comprehensive (loss) income, net of tax
               
Unrealized gain (loss) on marketable securities held for sale, net of taxes
    405       (268 )
Foreign currency translation gain (loss)
    792       (428 )
Total other comprehensive income (loss)
    1,197       (696 )
Comprehensive income (loss)
    4,619       (1,569 )
Comprehensive loss (income) attributable to the noncontrolling interests
    43       (112 )
Foreign currency translation (gain) loss - noncontrolling interests
    (274 )     384  
Comprehensive income (loss) attributable to China Direct Industries, Inc.
  $ 4,388     $ (1,297 )

NOTE 4 – MARKETABLE SECURITIES

Marketable securities available for sale and marketable securities available for sale-related party at December 31, 2010 and September 30, 2010 consist of the following:

Company
 
December 31,
2010
   
% of Total
   
September 30,
2010
   
% of Total
 
   
(Unaudited)
                   
China America Holdings, Inc.
  $ 571,123       7 %   $ 950,250       33 %
China Logistics Group, Inc.
    822,720       10 %     515,625       18 %
Dragon International Group Corp.
    15,971       0 %     22,815       1 %
China Armco Metals, Inc.
    -       0 %     277,600       10 %
Sunwin International Neutraceuticals, Inc.
    504,000       6 %     455,000       16 %
Dragon Capital Group Corp.
    587,460       7 %     672,735       23 %
USChina Channel, Inc.
    5,773,758       70 %     -       0 %
Marketable securities held for sale
  $ 8,275,032       100 %   $ 2,894,025       100 %

On December 31, 2010, we received a total of 4,740,694 shares of USChina Channel, Inc. (“USCC”) common stock as the stock-based payment for consulting services we provided to USCC in connection with its acquisition of China Education Schools, Ltd.  In connection with the consulting service we provided USCC, we paid $170,000 to acquire an additional 758,124 shares of USCC’s common stock in a private sale. We accounted for the USCC common stock as marketable securities available for sale. Pursuant to ASC Topic 820, “Fair Value Measurements.”, we used the quoted price for the USCC’s securities to value the shares of USCC’s common stock and recognized $4,977,728 or $1.05 per share as our consulting service revenue for the three months ended December 31, 2010.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

As of December 31, 2010 the aggregated carrying value of the USCC common stock totaled $5,773,758. The share price of the USCC common stock was based on the quote from the over the counter market system. The USCC common stock is restricted from resale under Federal securities laws and cannot be readily resold by us absent their registration under the Securities Act of 1933 (the “Securities Act”) or the availability of an exemption from the registration requirements under the Securities Act.

The investments in marketable securities available for sale-related party totaled $587,460 and $672,735 at December 31, 2010 and September 30, 2010, respectively and are comprised solely of the securities of Dragon Capital Group Corp. (“Dragon Capital”).  Mr. Lisheng (Lawrence) Wang, the CEO and Chairman of the Board of Dragon Capital, is the brother of Dr. James Wang, our CEO and Chairman of the Board of Directors. These securities were issued by Dragon Capital as compensation for consulting services.  Dragon Capital is a non-reporting company whose securities are quoted on the Pink Sheets.  As such, under Federal securities laws, securities of Dragon Capital generally cannot be resold by us absent a registration of those securities under the Securities Act.  

NOTE 5 - INVENTORIES

Inventories at December 31, 2010 and September 30, 2010 consisted of the following:

   
December 31, 2010
   
September 30, 2010
 
   
(Unaudited)
       
Raw materials
  $ 3,215,004     $ 3,478,947  
Finished goods
    5,256,082       2,893,978  
Inventory reserve
    -       -  
Total Inventory
  $ 8,471,086     $ 6,372,925  

Due to the nature of our business and the short duration of the manufacturing process for our products, there is no material work in progress inventory at December 31, 2010 and September 30, 2010. 

NOTE 6 - PREPAID EXPENSES AND OTHER CURRENT ASSETS

At December 31, 2010 and September 30, 2010, prepaid expenses and other current assets, consisted of the following:
 
Description
 
December 31, 2010
   
September 30, 2010
 
   
(Unaudited)
       
Prepayments to vendors for merchandise that had not yet been shipped or services that had not been performed
  $ 9,117,414     $ 5,928,210  
Other receivables
    2,533,238       1,998,534  
Loans receivable
    726,501       608,904  
Security deposits
    -       16,721  
Total
    12,377,153       8,552,369  
 
Other receivables as of December 31, 2010 include a prepaid cost for Baotou Changxin Magnesium land use rights. Baotou Changxin Magnesium owns and operates a magnesium facility capable of producing 20,000 metric tons of pure magnesium per year located on approximately 406,000 square feet of land located in the Shiguai district of Baotou city, in Inner Mongolia. Baotou Changxin Magnesium occupies this land pursuant to an asset acquisition agreement entered into with Baotou Sanhe Mangesium Co., Ltd. to acquire the land use rights for this property, among other assets.  Since the land use right has yet to be transferred from Baotou Sanhe Magnesium Co. to Baotou Changxin Magnesium, the land use right balance of $1,101,509 is included in other prepaid expenses.  The land use right expires in May 2045.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

NOTE 7 - PROPERTY, PLANT AND EQUIPMENT
 
At December 31, 2010 and September 30, 2010, property, plant and equipment, consisted of the following: 
 
Property, Plant and Equipment
           
Description
 
Useful Life
   
December 31, 2010
   
September 30, 2010
 
         
(Unaudited)
       
Building
 
10-40 years
    $ 15,231,461     $ 14,978,242  
Manufacturing equipment
 
5-10 year
      18,872,832       18,650,462  
Office equipment and furniture
 
3-5 year
      476,046       470,238  
Autos and trucks
 
5 year
      1,004,995       995,963  
Construction in progress
    N/A       8,259,680       7,716,777  
Total
            43,845,014       42,811,682  
Less: accumulated depreciation
            (6,300,340 )     (5,299,421 )
Property, Plant and Equipment, Net
          $ 37,544,674     $ 37,512,261  
 
For the three months ended December 31, 2010 and 2009, depreciation expense totaled $1,010,572 and $520,458, respectively. 

NOTE 8 - PROPERTY USE RIGHTS

Property use rights, net of accumulated amortization, consisted of mining and property use rights amounting to $2,245,172 and $1,970,585 at December 31, 2010 and September 30, 2010, respectively. During the three months ended December 31, 2010, Golden Magnesium paid an additional $270,827 to complete the land use rights transaction.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

NOTE 9 - LOANS PAYABLE

The majority of our loans payable are borrowed for general working capital purposes. Loans payable at December 31, 2010 and September 30, 2010 consisted of the following:

Description
 
December 31,
2010
   
September 30,
2010
 
   
(Unaudited)
       
Lang Chemical loan from Bank of Shanghai. Due on February 20, 2011.  5.31% annual interest rate. Guaranteed by China Investment Guarantor Co. Ltd.
  $ 453,734     $ 447,888  
                 
Lang Chemical loan from  China Mingsheng Bank. Due on March 26, 2011. 6.372% annual interest rate. Guaranteed by Chen Jingdong.
    695,726       686,762  
                 
CDI Beijing non-interest bearing loan from Beijing Mingshang Investment Guarantee Co. Ltd. Due on August 31, 2011. Guaranteed by Chi Chen.
    -       4,478,882  
                 
CDI China loan from Sunwin Tech Group, Inc. Due on March 30, 2011. 3% annual interest rate. Secured by pledge of CDI China assets.
    500,000       -  
                 
Lang Chemical loan from Industrial and Commercial Bank of China. Due on October 15, 2011. 5.576% annual interest rate.  Guaranteed by Zhu Qian and Chen Jingdong.
    302,489       -  
                 
CDI Beijing loan from Bank of Hongzhou. Due on October 21, 2011.  6.672% annual interest rate. Guranteed by Chi Chen.
    907,468       -  
                 
          Total
    2,859,418       5,613,532  
Less: Current Portion
    (2,859,418 )     (5,613,532 )
                 
Loans payable, long-term
  $ -     $ -  

NOTE 10 - RELATED PARTY TRANSACTIONS

List of Related Parties

We have specified the following persons and entities as related parties with ending balances as of December 31, 2010 and September 30, 2010:
 
 
Yuwei Huang, is executive vice president of our Magnesium segment, a member of the board of directors, chief executive officer and chairman of Chang Magnesium, chairman of Baotou Changxin Magnesium, chairman of YiWei Magnesium, and chief executive officer and vice chairman of Golden Magnesium;
 
Taiyuan YiWei Magnesium Industry Co., Ltd., a company organized under the laws of the PRC (“YiWei Magnesium”), is a minority interest owner in Chang Magnesium;
 
Lifei Huang, is the daughter of Yuwei Huang;
 
Lifei Huang, is a registered representative of Pine Capital Enterprises Inc., a company organized under the laws of the Cayman Islands (“Pine Capital”);
 
Lifei Huang, is a registered representative of Wheaton Group Corp., a company organized under the laws of Brunei Darussalam (“Wheaton”);
 
LuCheng Haixu Magnesium Co., Ltd., a company organized under the laws of the PRC (“Haixu Magnesium”), is legally represented by an officer of Chang Magnesium;

 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
 
 
Lingshi Xinghai Magnesium Co., Ltd., a company organized under the laws of the PRC (“Xinghai Magnesium”), is legally represented by an officer of Chang Magnesium;
 
NanTong Langyuan Chemical Co., Ltd., a company organized under the laws of the PRC (“NanTong Chemical”), is owned by Jingdong Chen and Qian Zhu, the minority interest owners of Lang Chemical;
 
Jingdong Chen, is vice president of our Basic Materials segment and chief executive officer of Lang Chemical;
 
Qian Zhu, is chief financial officer of Lang Chemical. Jingdong Chen and Qian Zhu are husband and wife;
 
Chen Chi is vice president of our Basic Materials Segment and minority interest owner of CDI Beijing;
 
Zhongmen International Investments Co., Ltd., a company organized under the laws of the PRC (“Zhongmen International”), is legally represented by an officer of CDI Beijing.

As of December 31, 2010, Accounts, loans, and other receivables and prepaid expenses- related parties were $7,600,813 and which consists of Accounts receivable – related party of $1,532,206, Prepaid expenses – related parties of $3,250,023, Loans receivable – related parties of $1,438,253, and Due from related parties of $1,380,330 as set forth below:

Accounts Receivable – related parties

At December 31, 2010 we reported accounts receivable – related parties of $1,532,206 comprised of the following:

 
$744,320 due Baotou Changxin Magnesium from YiWei Magnesium for inventory provided;
 
$4,696 due Chang Magnesium from Wheaton for inventory provided; and,
 
$783,190 due Golden Magnesium from YiWei Magnesium for inventory provided.

At September 30, 2010 we reported accounts receivable – related parties of $2,119,582 comprised of the following:

 
$834,758 due Baotou Changxin Magnesium from YiWei Magnesium for inventory provided;
 
$4,635 due Chang Magnesium from Wheaton for inventory provided; and,
 
$1,280,189 due Golden Magnesium from YiWei Magnesium for inventory provided.

Prepaid Expenses – related parties

At December 31, 2010 we reported prepaid expenses – related parties of $3,250,023 comprised of the following:

 
$75,631 prepaid by Chang Magnesium to Haixu Magnesium to for future delivery of inventory;
 
$2,545,244 prepaid by Chang Magnesium to YiWei Magnesium to for future delivery of inventory;
   
$109,148 prepaid by IMTC to YiWei Magnesium for future delivery of inventory; and
   
$520,000 prepaid by IMTC to Wheaton for future delivery of inventory.

At September 30, 2010 we reported prepaid expenses – related parties of $3,982,163 comprised of the following:

 
$204,536  prepaid by Baotou Changxi Magnesium to YiWei Magnesium for future delivery of inventory;
 
$74,656 prepaid by Chang Magnesium to Haixu Magnesium to for future delivery of inventory;
 
$120,838 prepaid by Chang Magnesium to Xinghai Magnesium to for future delivery of inventory;
 
$3,217,076 prepaid by Chang Magnesium to YiWei Magnesium to for future delivery of inventory,
   
$4,544 prepaid by Golden Magnesium to Senrun Coal for future delivery of coke gas for fuel;
   
$120 prepaid by Golden Magnesium to YiWei Magnesium for future delivery of inventory; and
   
$360,393 prepaid by IMTC to YiWei Magnesium for future delivery of inventory.

Restricted Cash, current
 
       As of December 31, 2010 our restricted cash, current totaled $620,145. At September 30, 2010 we reported Restricted cash, current of $5,091,023 which is principally comprised of the cash proceeds of the $4,478,882 loan from Beijing Mingshang Investment Guarantee Co., Ltd. (the “Beijing Mingshang Loan”) personally guaranteed by Mr.Chen. Mr. Chen used the restricted cash as collateral for his personal purposes.  As of December 31, 2010, Mr. Chen paid off the Beijing Mingshang loan and closed the restricted cash account in which the net cash proceeds from the loan originally resided.
  
 
- 13 -

 
 
 
CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

Loans Receivable – related parties

At December 31, 2010 we reported loan receivables – related parties of $1,438,253 comprised of the following:

 
$1,403,467 due Lang Chemical from NanTong Chemical for funds advanced for working capital purposes; and
 
$34,786 due Chen Chi from CDI Beijing for funds advanced for working capital purposes.

At September 30, 2010 we reported loan receivables – related parties of $1,528,911 comprised of the following:

 
$1,324,309 due Lang Chemical from NanTong Chemical for funds advanced for working capital purposes;
 
$74,648 due Chen Chi from CDI Beijing for funds advanced for working capital purposes;
 
$119,437 due Baotou Changxi Magnesium from Haixu Magnesium for funds advanced for working capital purposes; and
 
$10,517 due Ruiming Magnesium from YiWei Magnesium for funds advanced for working capital purposes.

Due from related parties

At December 31, 2010 we reported due from related parties of $1,380,330 comprised of the following:

   
$204,180 due Baotou Changxi Magenesium from YiWei Magnesium for working capital purposes;
 
$120,996 due Baotou Changxi Magnesium from Xinghai Magnesium for working capital purposes;
 
$851,508 due Chang Magnesium from YiWei Magnesium for working capital purposes;
 
$126,088 due Chang Magnesium from Xinghai Magnesium for working capital purposes;
 
$121 due Golden Magnesium from Yiwei Magnesium for working capital purposes;
 
$19,662 due Ruiming Magnesium from Haixu Magnesium for working capital purposes; and
 
$57,775 due CDI Beijing from Zhongmen International for working capital purposes.

At September 30, 2010 we reported due from related parties of $49,566 comprised of the following:

 
$49,566 due CDI Beijing from Zhongmen International for working capital purposes.

As of December 31, 2010, Accounts and other payables – related parties were $8,471,558 which consists of Accounts payable – related parties of $2,861,350, Loans payable – related parties of $623,128, and Due to related parties of $4,987,080 as set forth below:

Accounts Payable – related parties

At December 31, 2010 we reported accounts payable – related party of $2,861,350 comprised of the following:

 
$15,333 due from Baotou Changxi Magnesium to Haixu Magnesium for purchases of goods;
 
$2,844,721 due from IMTC to Pine Capital for purchases of goods;
 
$958 due from Golden Magnesium to YiWei Magnesium for purchases of goods; and
   
$338 due from Golden Magnesium to Xinghai Magnesium for purchases of goods.

At September 30, 2010 we reported accounts payable – related party of $40,558 comprised of the following:

 
$12,200 due from Chang Magnesium to Pine Capital for purchases of goods;
 
$15,135 due from Baotou Changxi Magnesium to Haixu Magnesium for purchases of goods;
   
$11,396 due from Golden Magnesium to YiWei Magnesium for purchases of goods;
 
$1,493 due from Golden Magnesium to Haixu Magnesium for purchases of goods; and
   
$334 due from Golden Magnesium to Xinghai Magnesium for purchases of goods.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

Loan Payable – related parties

At September December 31, 2010 we reported loan payable – related parties of $623,128 comprised of the following:

 
$623,128 due to Zhu Qian for funds advanced for working capital of Lang Chemical.

At September 30, 2010 we reported loan payable – related parties of $60,990 comprised of the following:

 
$60,990 due to Pine Capital for funds advanced for working capital of Golden Magnesium.

Due to related parties

At December 31, 2010 we reported due to related parties balance of $4,987,080 comprised of the following:

 
$3,872,157 due to YiWei Magnesium for the balance of the purchase price for Ruiming Magnesium;
$122,569 due to Pine Capital for working capital of Golden Magnesium;
$130,070 due to Xinghai Magnesium for working capital of Ruiming Magnesium; and
$862,284 due YiWei Magnesium for working capital of Ruiming Magnesium.

At September 30, 2010 we reported due to related parties balance of $3,872,157 comprised of the following:

 
$3,872,157 due to YiWei Magnesium for the balance of the purchase price for Ruiming Magnesium .

NOTE 11 – CAPITAL STOCK

Preferred Stock and Related Dividends

We have 10,000,000 shares of preferred stock, par value $.0001, authorized, of which we designated 12,950 as our Series A Convertible Preferred Stock in February 2008.  At December 31, 2010 and September 30, 2010 there were 1,006 shares of Series A Convertible Preferred Stock outstanding. The Series A Convertible Preferred Stock has a stated value per share of $1,000, carries an 8% per annum dividend rate payable quarterly in arrears and is convertible into common stock at $1.80 per share after giving effect to a price reduction in connection with a December 30, 2010 offering of our securities. During the three months ended December 31, 2010 and 2009, we paid $20,130 of ordinary dividend in the form of 11,911 shares of our common stock and $40,183 ordinary dividend in the form of 29,255 shares of our common stock, respectively. 

On February 11, 2008, we entered into a Securities Purchase Agreement with accredited investors to sell 12,950 shares of our Series A Preferred Stock which was convertible into common stock at $7.00 per share. This class of preferred stock carries an embedded contingent beneficial conversion option that allows the conversion price to reset, contingent upon certain future transactional events. As of May 31, 2009, 1,006 shares of our Series A Preferred Stock were issued and outstanding. On June 15, 2009, we registered a direct offer of our common stock at $1.85 per share, and therefore as provided under the original Securities Purchase Agreement, we should have accounted for this conversion price reduction from $7.00 to $1.85 per share as additional intrinsic values beneficially extended to this class of stockholders in the three month interim period ended June 30, 2009, in which the first conversion price reset occurred. We made a determination that even if we retrospectively applied the adjustments to reflect such accounting changes to the prior periods, the net effect would be immaterial from both a quantitative and qualitative standpoint.

ASC 470-20 provides that upon the resolution of the contingency, a corresponding adjustment is required to account for and recognize the excess number of shares to be received multiplied by the stock price on the original commitment date as additional intrinsic economic benefits extended to this class of shareholders. Based on the facts and circumstances in our case, the preliminary re-measurement for this contingent beneficial conversion option amounted to $600,693, representing the remaining undiscounted portion of the net proceeds allocated to the outstanding 1,006 shares of Series A Preferred Stock at the original offer. As of December 31, 2010, we recorded a total discount of $600,693 to account for the additional intrinsic values for the outstanding 1,006 shares of Series A Preferred Stock, accreted the full amount immediately as this class of preferred stock does not have a stated redemption date or finite life, and recognized it as a one-time deemed dividend or a reduction to our retained earnings and a corresponding increase in additional paid-in capital.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

Reclassification of Derivative Liabilities

As of December 31, 2010 the Series A Preferred stockholders held an aggregate of 143,750 common stock purchase warrants, which contained a downside ratchet provision, that would allow the exercise price of these warrants to reset, contingent upon certain future transactional events. The terms of these warrants provide that if we sell common stock at a price per share less than the then exercise price of the warrants then we are required to reduce the exercise price of those warrants to the lower price of the subsequent sale. On June 15, 2009, we registered a direct offer of our common stock, which reduced the exercise price of the 143,750 warrants to purchase our common stock from $8.00 to $1.85 per share. On December 30, 2010, we entered into an engagement letter with Rodman & Renshaw for the sale of our common stock at $1.80 per share, which again reset the exercise price of the aforementioned warrants from $1.85 to $1.80 per share.

ASC Topic 815 “Derivatives and Hedging” requires any warrant (or embedded feature) that is not indexed to an entity’s own stock to be classified as a derivative liability instead of part of the permanent equity, with changes in fair value to be recognized into the then current earnings. Even though we should have adopted EITF 07-05 (currently ASC 815-40), beginning on January 1, 2009, applicable to our financial statements, we made a determination that even if we retrospectively applied the adjustments to reflect such accounting changes to the prior periods, the net effect would be immaterial from both a quantitative and qualitative standpoint.

As of December 31, 2010, we reclassified the 143,750 common stock purchase warrants with the downside ratchet provision from additional paid-in capital of the permanent equity into derivative liabilities to reflect the cumulative accounting effects on our balance sheet, with the cumulative effects on changes in fair values of derivative liabilities recognized in the current period of our statement of operations. In conjunction with the re-measurements and reclassifications, we recognized $76,705 as a one-time deemed dividend and a reduction to retained earnings, and recorded a corresponding increase in additional paid-in capital, to reflect the increase in fair value of the 143,750 warrants for the reduction of their exercise price. We reclassified $171,278 to derivative liabilities from additional paid-in capital on our balance sheet, and recorded a net amount of $104,305 as an unrealized gain into our current earnings to reflect the cumulative effects on changes in fair value of derivative liabilities.

As of December 31, 2010, the carrying mount of $66,973 reflected the then current fair value of the derivative liabilities.

Inputs used in making the above determinations included:

   
2009
 
   
June 30
   
September 30
   
December 31
 
Value of per common share
  $ 1.72     $ 1.57     $ 1.18  
Expected time to exercise (year)
    2       1.75       1.5  
Expected volatility
    130 %     127 %     102 %
Risk-free interest rate
    1.11 %     0.81 %     1.14 %
Dividend yield
    0 %     0 %     0 %

   
2010
 
   
March 31
   
June 30
   
September 30
   
December 31
 
Value of per common share
  $ 1.54     $ 1.14     $ 1.21     $ 1.51  
Expected time to exercise (year)
    1.25       1       0.75       0.5  
Expected volatility
    103 %     78 %     75 %     90 %
Risk-free interest rate
    1.14 %     0.32 %     0.27 %     0.19 %
Dividend yield
    0 %     0 %     0 %     0 %

Common Stock

We have 1,000,000,000 shares of common stock, par value $.0001, authorized. At December 31, 2010 and September 30, 2010 there were 31,966,021 and 31,657,244 shares of common stock issued and outstanding, respectively.

During the three months ended December 31, 2010, we issued a total of 308,777 shares of our common stock comprised of:  11,911 shares to pay dividends on 1,006 shares of our series A preferred stock; 80,000 shares in connection with the exercise of options; 29,250 shares to board members as compensation; 3,000 shares issued for consulting services, and 184,616 were issued to employees as compensation.

 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

Stock Incentive Plans

The following table sets forth our stock incentive plan activities during the three months ended December 31, 2010 and changes during the period is as follows:

Description
 
Shares underlying options
   
Weighted average
exercise price
 
Outstanding at September 30, 2009
    3,655,670     $ 10.83  
     Converted to Restricted Stock Award (1)
    (953,940 )   $ 4.49  
     Cancelled
    (40,000 )     3.75  
     Adjusted (2)
    (288,750 )     1.14  
Outstanding at September 30, 2010
    2,372,980     $ 10.83  
    Exercised
    (80,000 )     1.29  
Outstanding at December 31, 2010
    2,292,980     $ 15.30  
Exercisable at December 31, 2010
    2,292,980     $ 15.30  

(1)           Options previously awarded to employees to purchase 953,940 shares of our common stock with exercise prices ranging from $2.50 to $5.00 were converted into 476,970 shares of stock and restricted stock on February 17, 2010 with vesting dates ranging from immediate to October 1, 2010.  The total additional stock-based compensation expense as a result of the conversion is $328,952.  The aggregate intrinsic value of our outstanding and exercisable options at December 31, 2010 and September 30, 2010 was $2,292,980 and $2,372,980, respectively.

(2)             Reflects an adjustment to the schedule of outstanding stock options included in Note 13 Stockholders’ Equity - Stock Option Plans to our September 30, 2009 consolidated financial statements footnotes included in our 2009 Transition Report on Form 10-K which incorrectly included options to purchase 288,750 shares of our common stock at $1.14 per share.

On June 2, 2010 we modified the exercise price of options to purchase 80,000 shares of our common stock previously awarded to David Stein, our former chief operating officer, from $5.00 per share to $1.29 per share as compensation for consulting and advisory services provided by Mr. Stein. The total additional stock-based compensation expense as a result of the modification was $32,604. On December 30, 2010, David Stein exercised the 80,000 shares.

The weighted average remaining contractual life and weighted average exercise price of options outstanding at December 31, 2010, for selected exercise price ranges, are as follows:

Exercise Price Range
   
Number of options outstanding
   
Weighted average remaining contractual life (Years)
   
Weighted average exercise price
   
Options Exercisable
   
Weighted average remaining contractual life (Years)
 
$ 2.25 - $2.49       400       3.81     2.25       400       3.81  
$ 2.50 - $2.99       44,000       1.33       2.50       44,000       1.33  
$ 5.00 - $7.49       226,000       1.38       5.00       226,000       1.38  
$ 7.50 - $9.99       637,000       2.00       7.50       637,000       2.00  
$ 10.00 - $14.99       625,000       3.01       10.00       625,000       3.01  
$ 15.00 - 29.99       500       2.44       15.00       500       2.44  
$ 30.00 - 56.24       760,000       2.07       30.00       760,000       2.07  
$ 56.25 - $60.00       80       3.92       56.25       80       3.92  
          2,292,980       2.23     $ 15.30       2,292,980       2.23  


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

Common Stock Purchase Warrants

A summary of the status of our outstanding common stock purchase warrants granted as of December 31, 2010 and changes during the period is as follows:

   
Shares underlying warrants
   
Weighted average
exercise price
 
Outstanding at September 30, 2009
    5,834,664     $ 6.95  
   Adjustment (1)
    75,000       5.00  
   Exercised
    (260,000 )     1.14  
  Expired
    (150,000 )     10.50  
Outstanding at September 30, 2010
    5,499,664       6.92  
  Additions
    -       -  
Outstanding at December 31, 2010
    5,499,664       6.92  
Exercisable at December 31, 2010
    5,499,664     $ 6.92  
 
 
(1)
Reflects an adjustment to reverse the cancellation of 75,000 warrants to purchase shares of our common stock at $5.00 per share entered in error in the nine month transition period ended September 30, 2009.

Exercise Price Range
   
Number of Warrants outstanding
   
Weighted average remaining contractual life (Years)
   
Weighted average exercise price
   
Warrants Exercisable
   
Weighted average remaining contractual life (Years)
 
$ 0.01 - $2.24       247,500       1.52     $ 1.55       247,500       1.52  
$ 2.25 - $2.49       1,351,352       3.96       2.31       1,351,352       3.96  
$ 2.50 - $2.99       50,000       0.92       2.50       50,000       0.92  
$ 3.00 - $4.99       50,000       0.67       4.00       50,000       0.67  
$ 7.50 - $9.99       1,906,250       2.12       8.00       1,906,250       2.12  
$ 10.00 - $14.99       1,894,562       0.69       10.00       1,894,562       0.69  
          5,499,664       2.03     $ 6.92       5,499,664       2.03  
 
NOTE 12 - SEGMENT INFORMATION

Our reportable segments are strategic business units that offer different products and services.  Each segment is managed and reported separately based on the fundamental differences in their operations.  Condensed consolidated information with respect to these reportable segments after giving effect to the discontinuance of the operations of Pan Asia Magnesium for the three months ended December 31, 2010 and 2009 are as follows:

For the three months ended December 31, 2010:

(in thousands)
 
Magnesium
   
Basic Materials
   
Consulting
   
Discontinued Operations
   
Consolidated
 
Revenues
  $ 21,282     $ 19,182     $ 5,299     $ -     $ 45,763  
Revenues - related party
    7       -       -       -       7  
Total revenues
  $ 21,289     $ 19,182     $ 5,299     $ -     $ 45,770  
Interest income (expense)
  $ 1     $ 18     $ (27 )   $ -     $ (8 )
Net (loss) income
  $ (465 )   $ 146     $ 3,641     $ -     $ 3,422  
Net (loss) income attributable to CDII      (2.7      41        3,641        -        3,645  
Segment assets at December 31, 2010
  $ 65,578     $ 20,490     $ 15,479     $ 247     $ 101,794  


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

For the three months ended December 31, 2009:

(in thousands)
 
Magnesium
   
Basic Materials
   
Consulting
   
Discontinued Operations
   
Consolidated
 
Revenues
  $ 5,852     $ 13,391     $ 568     $ -     $ 19,811  
Revenues - related party
    2,442       -       -               2,442  
Total revenues
  $ 8,294     $ 13,391     $ 568             $ 22,253  
Interest income (expense)
  $ 1     $ (42 )   $ 40             $ (1 )
Net income (loss)
  $ 39     $ 70     $ (982 )           $ (873 )
Net (loss) income attributable to CDII      (6      40        (1,019              (985
Segment assets at December 31, 2009
  $ 47,109     $ 15,741     $ 14,622     $ 247     $ 77,719  

NOTE 13 - FOREIGN OPERATIONS

As of December 31, 2010 and 2009 the majority of our revenues and assets are associated with subsidiaries located in the PRC. The revenues for the three months ended December 31, 2010 and 2009 as well as assets at December 31, 2010 and 2009 were as follows:

   
For three months ended December 31, 2010
 
(in thousands)
 
United States
   
People’s Republic of China
   
Total
 
Revenues
  $ 5,298     $ 40,465     $ 45,763  
Revenues – related party
    -       7       7  
Total revenues
  $ 5,298     $ 40,472     $ 45,770  
Identifiable assets at December 31, 2010
  $ 16,779     $ 85,015     $ 101,794  

   
For the three months ended December 31, 2009
 
(in thousands)
 
United States
   
People’s Republic of China
   
Total
 
Revenues
  $ 328     $ 19,483     $ 19,811  
Revenues – related party
    -       2,442       2,442  
Total revenues
  $ 328     $ 21,925     $ 22,253  
Identifiable assets at December 31, 2009
  $ 12,866     $ 64,853     $ 77,719  

 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
 
NOTE 14 – INCOME TAXES

Our income (loss) in the U.S. is subject to applicable Federal, State, and Local tax statues.  Our income (loss) in China is subject to taxation in the Peoples Republic of China concerning Foreign Investment Enterprises and Foreign Enterprises and local income tax laws (the “PRC Income Tax Laws”). Pursuant to the PRC Income Tax Laws, unless special tax incentives are granted, all enterprises in China are subject to taxation at a statutory rate of 25%.

The components of income (loss) for the three months ended December 31, 2010 and 2009 before income tax consisted of the following:

Decscripton
 
December 31, 2010
   
December 31, 2009
 
             
U.S. Operations
  $ 1,460,778     $ (1,228,380 )
China Operations
    1,888,329       245,099  
Discontinued Operations
    -       -  
Total income (loss)
  $ 3,349,107     $ (983,281

The income tax (expense) and benefit for income taxes for the three months ended December 31, 2010 and 2009 are composed of the following:

Description
 
December 31, 2010
   
December 31, 2009
 
             
Current:
           
     Federal
  $ (20,000 )     -  
     State
    -       -  
     Chinese Operations
    93,284       110,373  
Total benefit and (expense)
    73,284       110,373  
Deferred:
               
     Federal
    -       -  
     State
    -       -  
Total provision
    -       -  
Grand total
  $ 73,284     $ 110,373  


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

The table below summarizes the reconciliation of our income tax benefit (expense) computed at the federal statutory rate and the actual tax provision for the three months ended December 31, 2010.

Description
 
December 31, 2010
 
       
Income tax (expense) benefit provision at Federal statutory rate
  $ (1,172,187 )
State income tax (expense) benefit, net of Federal (expense) benefit
    (120,568 )
US and state tax rate under/exceeding China tax rate
    187,550  
China reduced tax rate zones
    685,648  
Decrease in valuation account
    492,841  
Income tax benefit
  $ 73,284  

We have recorded a current Federal tax provision for an expected Alternative Minimum Tax liability for the three months ended December 31, 2010. Since we have accumulated Federal net operating losses of approximately $10.2 million as of December 31, 2010, given the lack of positive taxable income trend in prior periods, the net operating loss carry-forward has been fully reserved, and therefore the deferred tax asset is zero.
 
The IRS is currently auditing our consolidated income tax return for 2008. We expect the audit to be completed in the second quarter of 2011.
 
NOTE 15 - COMMITMENTS AND CONTINGENCIES

Contingencies

Pan Asia Magnesium

On November 19, 2010, our subsidiary CDI China, Inc. filed an Application for Arbitration with the China International Economic and Trade Arbitration Commission,  Beijing Office, 6/F, CCOIC Building, No.2 Huapichang Hutong, Xicheng District, Beijing, 10035, China, Case No. (2010) CIETAC Beijing [021100], against Shanxi Jinyang Coal & Coke (Group) Co., Ltd. and Tian Runlian seeking to terminate the November 1, 2007 Joint Venture Agreement entered into among CDI China, Inc. (“CDI China”), Shanxi Jinyang Coal & Coke (Group) Co., Ltd. (“Shanxi Jinyang Coal”) and Tian Runlian (“Runlian”) to form Pan Asia Magnesium, Ltd. (“Pan Asia”). Shanxi Jinyang Coal and Runlian are the noncontrolling shareholders of our subsidiary Pan Asia Magnesium

The application for arbitration alleges that Shanxi Jinyang Coal and Runlian breached the November 1, 2007 Joint Venture Agreement, among other things, and seeks termination of the Joint Venture Agreement, arbitration fees and legal fees from Shanxi Jinyang Coal and Runlian. If the arbitration panel rules in our favor, termination of the Joint Venture Agreement would result in the dissolution of Pan Asia Magnesium in addition to the other remedies sought in that proceeding.

On December 21, 2010 we withdrew the application for the arbitration in conjunction with our discussions with a third party to sell our 51% ownership in Pan Asia Magnesium.  While there is no assurance we will be able to complete a sale of our interest in Pan Asia Magnesium or the amounts we may ultimately realize on a sale of our interest, if any, we may re-file our application for arbitration at any time.

Although we intend to sell our interest in Pan Asia Magnesium or pursue an arbitration action and cannot predict the outcome of either, we established a $7.4 million provision for a contingent loss from discontinued operations reflecting our entire investment in Pan Asia Magnesium in September 2009. Furthermore, litigation is subject to inherent uncertainties and unfavorable rulings could occur. An unfavorable ruling could include monetary damages against us. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on the business or results of operations for the period in which the ruling occurs or future periods.


 
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CHINA DIRECT INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010

Our dispute with the noncontrolling shareholders of Pan Asia Magnesium and Mr. Zhao also involves their claim that in connection with our October 2007 acquisition of Pan Asia Magnesium we should have used the equity method of accounting rather than consolidation. They also claim we failed to disclose certain assets owned by, and obligations of, Shanxi Jinyang that were improperly included in our consolidated financial statements for fiscal 2007 and fiscal 2008. We believe the noncontrolling shareholders’ claims against us are without merit and were made to justify their refusal to allow us to conduct our audit for the 2009 transition period, among other improper purposes.  In addition, we believe that the noncontrolling shareholders and Mr. Zhao became non-responsive to us as a result of the September 29, 2009 decision of our board of directors to commit to a plan to focus our magnesium production efforts with our key Chinese partner, Yiwei Magnesium, a related party, and sell our interest in Pan Asia Magnesium and present it as a discontinued operation beginning with our financial statements for the nine month transition period ended September 30, 2009.  

Other than as described above, we believe there are currently no litigation or legal or administrative proceedings pending against us that are likely to have, individually or in the aggregate, a material adverse effect on our business or our results of operations.

Ruiming Magnesium

On July 13, 2010, we entered into an Equity Transfer Agreement with Pine Capital and Yiwei Magnesium to acquire an 80% interest in Ruiming Magnesium effective as of July 1, 2010, in a cash-and-stock transaction for RMB 44,880,000 or about $6,451,677.  The remaining 20% interest in Ruiming Magnesium is owned by Pine Capital.  Yuwei Huang, our executive vice president – magnesium and member of our board of directors, owns or controls Pine Capital and Yiwei Magnesium. 

The consideration transferred for the 80% interest in Ruiming Magnesium (the “Consideration”) is a total of approximately $6,451,677 subject to certain post closing conditions and is comprised of (i) $2,428,864 in cash, (ii) 769,231 shares of our common stock valued at $846,154, (iii) an assignment of a portion of our interest in Excel Rise in the amount of $2,367,038, and (iv) contingent consideration of approximately $809,621 in the form of cash or our common stock.  The contingent consideration is earned upon Ruiming Magnesium achieving revenues of RMB 61.2 million (approximately $9.2 million) for the fiscal year ending September 30, 2011 with an EBITDA (earnings before interest, taxes, depreciation and amortization) target of no less than RMB 1,200 (approximately $177) per metric ton of production. In addition to the contingent consideration, Pine Capital and Yiwei Magnesium collectively are entitled to receive a cash payment of approximately $809,621 or 622,172 shares of our common stock in the event Ruiming Magnesium achieves revenues of more than RMB 100 million (approximately $14.7 million) during its fiscal year ending September 30, 2011 with EBITDA of no less than RMB 1,200 (approximately $177) per metric ton of production during that fiscal year.  The payment of these shares as part of the contingent consideration is subject to shareholder approval. Since the conditions under which the 769,231 shares of our common stock to be issued had not occurred as of December 31, 2010, $846,154 of the purchase price was classified as additional paid in capital on our consolidated balance sheet. 
 
NOTE 16 – SUBSEQUENT EVENTS

The Company evaluates subsequent events for purposes of recognition or disclosure in the financial statements up through the date that the financial statements are issued and determined there were subsequent events to be disclosed as follows.
 
        In connection with our December 30, 2010 offering of our securities, we issued common stock purchase warrants (the “Warrants”) to purchase up to 777,778 shares of our common stock upon closing of the offering which occurred on January 4, 2011. The Warrants do not carry any downside ratchet provision, and are exercisable beginning six months after the issuance date at an exercise price of $2.00 per share until July 4, 2016. The Warrants may become exercisable on a cashless basis if we fail to maintain the effectiveness of our registration statement. The exercise price and number of shares issuable upon exercise are subject to adjustment in the event of stock splits or dividends, business combinations, rights offerings, sale of assets or other similar transactions. The Warrants are not exercisable to the extent that (a) the number of shares of our common stock beneficially owned by the holder, and (b) the number of shares of our common stock issuable upon the exercise of the Warrants would result in the beneficial ownership by holder of more than 4.99% of our then outstanding common stock. This ownership limitation can be increased to 9.99% by the holder upon 61 days notice to us.
 
On February 14, 2011, we entered into an “At-the-Market” Program Agreement (the “Agreement”), with Global Hunter Securities, LLC (“Global Hunter Securities”), under which we may sell an aggregate of up to $7,136,274 in gross proceeds of our common stock from time to time through Global Hunter Securities, as the agent for the offer and sale of the common stock. Global Hunter Securities may sell the common stock by any method permitted by law, including sales deemed to be an “at the market” offering as defined in Rule 415 of the Securities Act of 1933, including without limitation sales made directly on NASDAQ Global Market, on any other existing trading market for the common stock or to or through a market maker. Global Hunter Securities may also sell the common stock in privately negotiated transactions, subject to our prior approval. We will pay Global Hunter Securities a commission equal to 4% of the gross proceeds of the sales price of all common stock sold through it as sales agent under the Agreement.  The Agreement may be terminated by either party at any time except with respect to any pending sale of our common stock by Global Hunter Securities.

 
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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with the information contained in our unaudited consolidated financial statements and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth in our fiscal 2010 Annual Report on Form 10-K.

Change in Fiscal Year End
 
Effective August 13, 2009, we changed our fiscal year end from December 31 to September 30. We have defined various periods that are covered in this report as follows:

 
 
“fiscal 2011” – October 1, 2010 through September 30, 2011
 
 
“first quarter of fiscal 2011” – October 1, 2010 through December 31, 2010
 
 
“second quarter of fiscal 2011” – January 1, 2011 through March 31, 2011
 
 
“fiscal 2010” — October 1, 2009 through September 30, 2010
 
 
“first quarter of fiscal 2010” – October 1, 2009 through December 31, 2009
 
 
“2009 transition period” — January 1, 2009 through September 30, 2009
 
 
“fiscal 2008” — January 1, 2008 through December 31, 2008

OVERVIEW OF OUR PERFORMANCE AND OPERATIONS

Our Business

We are a U.S. company that manages a portfolio of Chinese entities. We also provide consulting services to Chinese businesses. We operate in three identifiable segments, Magnesium, Basic Materials, and Consulting, in accordance with ASC Topic 280, “Disclosure about segments of an Enterprise and Related Information”. We established our Magnesium and Basic Materials segments in 2006 which have grown through acquisitions of controlling interests in Chinese private companies. We consolidate these acquisitions as either our wholly or majority owned subsidiaries. Through this ownership control, we provide management advice as well as investment capital for their expansion.

As of December 31, 2010, our Magnesium segment represents our largest segment by assets and revenues. We manufacture and sell pure magnesium and related by-products. We also purchase and resell magnesium products manufactured by third parties. Magnesium is the lightest and strongest of the structural metals; it is one fourth the weight of steel, two fifth the weight of titanium and two thirds the weight of aluminum. Magnesium is used in a variety of markets and applications due to the physical and mechanical properties of the element and its alloys. Magnesium ingots are the feedstock for the manufacturing process of titanium and aluminum alloying. Magnesium powder and granules are used as desulphurizer that removes sulfur in the production process of steel. And, various types of magnesium alloys which are produced from the pure magnesium ingots we make are used in aircraft, automobile parts, and in electronic equipment such as computers, cameras and cellular phones.

Our Basic Materials segment engages in the sale and distribution of basic resources within Asia and the global purchase and sale of industrial commodities which includes mineral ores, non-ferrous metals and scrap metals. In this segment we sell and distribute a variety of products including (i) industrial grade synthetic chemicals, (ii) steel products (iii) nonferrous metals, and (iv) recycled materials. Additionally, within this segment we hold the rights to mining properties which we are seeking to sell.

Our Consulting segment provides services to Chinese entities seeking access to the U.S. capital markets. These services include general business consulting, Chinese regulatory advice, translation services, formation of entities in the PRC, coordination of professional resources, strategic alliances and partnerships, advice on effective means of accessing U.S. capital markets, mergers and acquisitions, coordination of Sarbanes-Oxley compliance, and corporate asset evaluations.


 
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Our Performance

We experienced the continued growth in our revenues for the first quarter of fiscal 2011 compared to the same period of fiscal 2010, following a gradual recovery in our revenue growth throughout fiscal 2010. Revenues in the first quarter of fiscal 2011 totaled $45.8 million, an increase of $23.5 million or 105.7%, compared to the same period of fiscal 2010, as a result of an increase in revenues across all of our market segments, including $13.0 million within our Magnesium segment, $5.8 million within our Basic Materials segment, and $4.7 million within our Consulting segment, respectively. The revenue increase in our Magnesium segment was primarily a result of an increase in both customer demand and ferrosilicon spot prices which were partially absorbed by the market leading to higher sales prices. The revenue increase in our Basic Materials segment was a result of the improved economic condition and an increase in inflationary pressures on pricing within the Chinese domestic market. The revenue increase in our Consulting segment was primarily the result of a fee derived from consulting services we provided to USChina Channel Inc. (OTC BB: USCC) in connection with its acquisition of China Education Schools, Ltd. Consulting revenue varies depending on the timing and nature of services we provide to a particular client.

Our Magnesium segment sold and distributed 9,337 metric tons of magnesium, including 802 metric tons of magnesium powder, generating revenues of $21.3 million in the first quarter of fiscal 2011, compared to the sale and distribution of 3,532 metric tons on revenues of $8.3 million in the same period of fiscal 2010. Our Basic Materials segment generated revenues of $19.2 million in the first quarter of fiscal 2011 compared to $13.4 million in the same period of fiscal 2010. And, finally, our Consulting segment generated revenues of $5.3 million in the first quarter of fiscal 2011 compared to $0.6 million in the same period of fiscal 2010 primarily due to the addition of a new consulting client and the  fee earned as mentioned above.

Our gross profit in the first quarter of fiscal 2011 amounted to $6.5 million, an increase of $4.7 million, or 258%, compared to the same period in fiscal 2010. Our gross profit margins increased to14.3% in the first quarter of fiscal 2011 as compared to 8.20% in the same period of fiscal 2010, primarily as a result of an increase of 10.3 percentage points in our gross profit margins within our Consulting segment, partially offset by a decrease of 2.29 and 1.43 percentage points within our Magnesium segment and Basic Materials segment, respectively. The improved margin in our Consultant segment was primarily attributable to the  fee from USChina Channel, Inc. for our consulting services rendered in connections with its acquisition of China Education Schools, Ltd. The decrease in margins in our magnesium segment was affected by several factors including the temporary closure of our magnesium production facilities late in the quarter due to the government imposed power restrictions associated with the end of China’s 11th Five Year Plan, a partial absorption of increased ferrosilicon prices largely caused by those same power restrictions and an increase in depreciation expenses primarily from our July 2010 acquisition of Ruiming Magnesium.  Gross margins in our Basic Materials segment were affected by higher input costs and inflationary pressures in China’s domestic market at our Lang Chemical subsidiary compared to the same period of fiscal 2010.

Selling, general and administrative expenses increased $0.8 million in the first quarter of fiscal 2011 compared to the same period of fiscal 2010, primarily due to an increase of $0.8 million and $0.1 million in general and administrative expenses and selling costs, respectively, within our Magnesium segment, and an increase of $0.1 million in selling costs within our Basic Materials segment, which were partially offset by a decrease of $0.3 million in general and administrative expenses within our Consulting segment. In the first quarter of fiscal 2011 we collected $0.4 million from a customer for manufacture processing fees we previously discharged as a bad debt within our Magnesium segment and recognized it as other operating income.

We recognized an unrealized gain of $0.1 million as an adjustment to account for the cumulative effect of a decrease in fair value of derivative liabilities for our warrants we previously issued in connections with the sale of our Series A Convertible Preferred stock in February 2008, which we reclassified from permanent equity to derivative liabilities, with changes in fair value to be recognized in our net earnings. We also recognized a realized loss of $0.1 million in the first quarter of fiscal 2011 for the sale of marketable securities we received for our consulting services compared to a gain of $0.04 million in the same period of fiscal 2010.

Our Outlook

For the remainder of fiscal 2011, we intend to continue to integrate and streamline our PRC based subsidiaries and look to opportunistically grow internally and through strategic acquisitions as global economic conditions improve. At December 31, 2010 we had $35.0 million of working capital including $8.1 million in cash and cash equivalents. While this amount is believed sufficient to meet our current operating cash needs, we expect to seek additional capital to finance the strategic expansion of our magnesium production holdings and finance our cash needs in our commodity trading business.


 
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Recently China’s Central Bank announced its plan to ease its valuation of China’s currency against the U.S. dollar, which is expected to result in a 5% increase in the sales price of U.S. dollar denominated trades in China. An appreciation in the valuation of the RMB may also increase oil and transportation costs in China.

Effective October 20, 2010, China’s Central Bank raised its one-year lending rate to 5.56% from 5.31% for the first time since 2007 as China’s inflation rate accelerated at its fastest pace in the past two years to 3.6% in September 2010 according to a Bloomberg news survey. On December 25, 2010, China’s Central Bank raised China’s benchmark rate by 0.25%. In January, 2011, China’s Central Bank made fighting inflation as its priority and ordered a shift from easy credit to “prudent monetary policy” in 2011. On February 8, 2011, China’s Central Bank raised the benchmark one year lending rate once again to $6.06% in its renewed efforts to combat the country’s inflation.

China’s gross domestic product grew by 9.8% during the first quarter of fiscal 2011 compared to the same period of fiscal 2010, faster than the 9.6% increase seen in the fourth quarter of fiscal 2010, according to the National Bureau of Statistics.  China’s inflation rose 4.6% in December, 2010 from a year earlier. At the same time, China’s Producer Price Index (PPI), another measure of inflation at the whole sale level increased 5.5% over the course of 2010 despite the Chinese Government’s proactive efforts to curb the rampant inflations in the marketplaces. 
 
Magnesium segment. According to the International Magnesium Association (IMA), an industry trade group, in 2010 the China’s magnesium production is estimated to be approximately 653,500 metric tons, an increase from the estimated 460,000 metric tons produced in 2009, with China representing the vast majority of the world’s production.  We anticipate these favorable growth trends will continue in 2011 as both domestic and global demand continues to improve.
 
Our average magnesium ingot sales price during the first quarter of fiscal 2011 was approximately $2,377 per metric ton, which stabilized and improved slightly on average over the course of the past twelve months from an average sales price in the same period of fiscal 2010 of $2,348 per metric ton (Ex Works). Our sales volume increased at a rate of 164.4% compared to the same period of fiscal 2010. These trends reflect our belief that as worldwide demand accelerates prices will begin to rise in response.  In addition, we believe that demand from the global aerospace, automotive and consumer electronics sectors will fuel additional demand for magnesium and other lightweight metals that are made with magnesium.

In anticipation of continuing increases in worldwide demand for our products we reopened Chang Magnesium in April 2010 and completed an upgrade of our Baotou Changxin Magnesium facility to utilize either more energy efficient waste gas or coal to fuel its furnaces and have increased annual production capacity to 24,000 metric tons.  While our facilities were temporarily idled late in 2010 due to government imposed power restrictions, we expect to utilize that capacity in fiscal 2011. We intend to commence production at Baotou Changxin magnesium later in fiscal 2011. We intend to utilize waste gas provided by nearby coke generating plants when they restart operations.

 Based on the overall trends, an increase in our quoting activities and the indications of increased economic activity worldwide, particularly in the automobile industry, management continues to believe that magnesium demand and prices are poised for further recovery during the remainder of 2011 and beyond.  There are no assurances, however, that our beliefs are correct and events outside of our control could adversely impact this segment of our business.

Basic Materials Segment. In fiscal 2010 we witnessed a sustained economic recovery in the Chinese domestic market, driven by an increase in both domestic consumption and market prices. As a result, in the first quarter of fiscal 2011 total revenues from our specialty chemical sales increased 43.3% while our gross profit margins shrank by 1.43 percentage point due to higher input costs and inflationary pressures in China’s domestic market compared to the same period of fiscal 2010. As the Chinese Government has recently implemented plans to combat rampant inflation, management foresees a continued improvement in both our total revenues and gross profit margins for this segment for the remainder of fiscal 2011, largely due to potential revenues from sales of glacial acetic acid, a transparent liquid widely used in textile, pharmaceutical, and plastic industries under a new supply contract with Shanghai Wujing Chemicals Co. Ltd.

In addition, we witnessed a 76% increase in revenue at our CDI Beijing operations with gross margins holding steady at 10.8% and anticipate an increase in sales of various types of reinforcing steel bars during the balance of fiscal 2011 pursuant to a supply contracts with Beijing Tianrun Construction Co, Ltd. and Beijing Chong Construction Co, Ltd. Sales under these agreements are subject to delivery dates to be determined by the parties over the term of the contracts.

In our industrial commodities business we expect to begin shipments of iron ore in the second quarter of fiscal 2011 to our customers in China through the ongoing supply agreements we entered into with suppliers in Mexico and parts of South America.
 

 
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We are currently evaluating strategic alternatives for our zinc ore mine and development stage aluminum recycling business including the partial or full sale of our interest in these businesses. Presently we do not have a timetable for when or if these businesses will be sold.

Consulting Segment. We have been actively marketing our advisory services in China as the U.S. capital market continues to recover. Management expects to add new consulting clients and complete additional transactions during the balance of fiscal 2011 through these enhanced marketing efforts. These efforts include forming strategic alliances with the industry and trade associations under the auspices of the Chinese Government, such as the China Private Enterprises Association, to introduce the U.S. equity market and its advantages to potential clients in China.

Management believes that the demand for our advisory services from China’s small and medium sized private companies will increase during the balance of fiscal 2011 as more companies seek to access the U.S. equity markets. We will particularly focus our efforts on those companies with potential for growth and profitability, which are in need of business development expertise and capital. In addition to the potential transaction fees, we also anticipate to receive additional client fees generated from our ongoing annual service contracts. Management expects that the cash flow from such transactions and activities-based fees will be sufficient to support our advisory operations in the U.S. in fiscal 2011. Overall, Management foresees our Consulting segment to become an important revenue and earnings driver for our future growth in the years to come.
 
RESULTS OF OPERATIONS

The results discussed below are for our first quarter of fiscal 2011 and first quarter of fiscal 2010.

Consolidated Revenues
 

   
Three Months Ended December 31,
       
   
2010
   
2009
       
 (Dollars in thousands)
 
Revenues
   
% of Revenues
   
Revenues
   
% of Revenues
   
% increase
 
Magnesium segment
 
$
21,289
     
47
%
 
$
8,294
     
37
%
   
157
%
Basic Materials segment
   
19,182
     
42
%
   
13,391
     
60
%
   
43
%
Consulting segment
   
5,299
     
11
%
   
568
     
3
%
   
833
%
Total Consolidated
 
$
45,770
     
100
%
 
$
22,253
     
100
%
   
106
%

Total consolidated revenues during the first quarter of fiscal 2011 were $45.8 million, an increase of 106% compared to the same period of fiscal 2010. This increase was culminating an increase in revenues across all of our market segments, as a result of a rise in demands for all of our products and services within our reporting segments, and an inflationary pressure on commodity prices in the both China and the global marketplaces.

Consolidated Operating Income and Expenses
 
   
Three Months Ended December 31,
       
   
2010
   
2009
       
 (Dollars in thousands)
 
Amount
   
% of Revenues
   
Amount
   
% of Revenues
   
Changes in Per. Points
 
Revenues
 
$
45,770
     
100
 %
 
$
22,253
     
100
%
 
n/a
 
Cost of revenues
   
39,239
     
86
%
   
20,428
     
92
%
   
(6)
 
Gross profit
   
6,531
     
14
%
   
1,825
     
8
%